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Do Financial Crises Hurt Economic Recoveries?

The question of the title seems to be a rhetorical one. With the 2008 global financial crisis fresh in our minds, the logic of the vicious cycle between the economic slowdown, troubles in the banking sector, credit crunch, and the subsequent industrial decline reinforcing the credit conundrums seems quite apparent.

But are the recessions accompanied by financial crises different from other brands of recessions?  And if so, how? The economists are yet to reach the ultimate verdict. And yet, this purely academic question comes to the fore of political debates around the critical junctures in the election cycles, when the public looks for ways to evaluate the policy performance of their leaders.

If “financial crisis recessions” are typically more severe than the rest, then policymakers can get some slack from the public for not “fixing” the economy in a timely manner, otherwise, they should be called to task. So the conventional wisdom goes.

In a series of articles and a 2009 book “This Time is Different”, Carmen Reinhart and Ken Rogoff advance the argument that financial crises are typically very costly affairs, even if we limit ourselves to the case of the industrialized countries. The average growth drops to about 1%, and remains low for at least 2 years.  In most severe cases, the negative growth effects are up to 2 percentage points larger, and the time to recovery (time until the country’s GDP returns to the trend level) is longer. Speaking of the post-crisis recovery in the United States, the authors noted at the time that

Much will depend on how large the shock to the financial system proves to be and, to a lesser extent, on the efficacy of the subsequent policy response.

On the other side of the academic debate, Michael Bordo in the recent Wall Street Journal article takes an exception with the above approach.

He sees the problem in drawing the conclusions from the sample that is “lumping together” different countries with different institutions and financial structures. Moreover, if one looks at a different measure of speed – the growth rate since the recovery starts - then the US recovery from the Great Recession of 2007-2009 is somewhat of an anomaly, based on the US own historical experience.

As we found, since the 1880s, the average annual growth rate of real GDP during recoveries from financial-crisis recessions was 8%, while the growth rate from nonfinancial-crisis recessions was 6.9%.

The argument is not just a quirk of the data. Other authors have argued that the cost of occasional financial crises is but the price the country pays for financial development. And that on average the countries with an experience of an occasional credit crunch growth faster than their financially tranquil counterparts.

Coming back to Bordo’s article, however, a few caveats seem to be in order.

First, historical comparisons, even using the country’s own economic experience, are tricky business. Can we say that the US of 1907 was comparable to the US of 2007 with respect to the financial system in place?

Research suggests that the financial crises of the gold standard era may have been a completely different breed, as compared to the crises of the post-Bretton Woods years. In a 2002 paper Bordo and Eichengreen pointed to the following global phenomenon –the pre-1914 banking crises were in general associated with faster recoveries than their post-1971 counterparts.  This may have happened because the capital flows during the gold standard era were much quicker to return to the post-crisis countries. Perhaps less to do with actual economic policies, and more with the way the global financial system functioned in those times.

Secondly, let us not forget about the phenomenon of the Great Moderation, the general reduction in the volatility of the business cycles since the mid-1980s. These times have been characterized by less pronounced recessions, but also less marked recoveries. And while the magnitude of the economic bust might have been an exception from the Great Moderation rule in 2007-2009, the recovery need not be. Further research on the nature of the Great Moderation may help us better understand this puzzle.

Reinhart and Rogoff in their work once again reminded economists of the line from the great Russian classic: “Happy families are all alike, every unhappy family is unhappy in its own way”. Speaking of economic turmoil, one may say that every financial crisis may be, like the Tolstoy’s unhappy family – each a bit different from the rest.  And the truth is that we have to look quite hard to distinguish and learn from those small existing pockets of economic unhappiness scattered across time and space that clearly resemble one another.

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Guest - Eric on Thursday, 04 October 2012 02:51

Yasya, can you give an example of a recent non-financial recession? I have a hard time recalling one...

Yasya, can you give an example of a recent non-financial recession? I have a hard time recalling one...
Guest - Yasya on Thursday, 04 October 2012 12:57

Eric, you are right that in many, or perhaps nearly all cases the recessions are accompanied by a hit on the financial institutions. After all, firms finance significant part of their operations via borrowing, and if a firm experiences losses and bankrupts, the bank has to write off the loan as well.

However, not in many cases the recession is accompanied by a widespread, systemic failure of banks, or significant losses affecting the entire banking system. For example, the recession you might think of as a "financial recession" may not defined as such. Take late the early 2000s in the US. The dot-com bubble was a stock market speculative bubble, not a banking turmoil. That particular recession was not accompanied by a banking crisis. The NBER has a list of recessions - not all of them had financial crises as a piggyback. http://www.nber.org/cycles.html

There are also cases when a banking turmoil does not neatly coincide with the recession dates (doesn't mean that these crisis are not costly, though). For example, the Savings and Loans crisis in the US that was ongoing between 1985- early 1990s.

Now, there are some interesting reads on what happened before 2008, and how a "shadow banking system" was developed - essentially the 2008 banking crash was a bank run, but by banks and on banks. Here is an NBER article published in December 2008 http://www.immagic.com/eLibrary/ARCHIVES/GENERAL/NBER_US/N081222B.pdf

Here is another paper from the Cleveland Fed by Tallman and Wicker, I think the historical comparisons may be of interest:
http://www.clevelandfed.org/research/workpaper/2010/wp1009.pdf

Eric, you are right that in many, or perhaps nearly all cases the recessions are accompanied by a hit on the financial institutions. After all, firms finance significant part of their operations via borrowing, and if a firm experiences losses and bankrupts, the bank has to write off the loan as well. However, not in many cases the recession is accompanied by a widespread, systemic failure of banks, or significant losses affecting the entire banking system. For example, the recession you might think of as a "financial recession" may not defined as such. Take late the early 2000s in the US. The dot-com bubble was a stock market speculative bubble, not a banking turmoil. That particular recession was not accompanied by a banking crisis. The NBER has a list of recessions - not all of them had financial crises as a piggyback. http://www.nber.org/cycles.html There are also cases when a banking turmoil does not neatly coincide with the recession dates (doesn't mean that these crisis are not costly, though). For example, the Savings and Loans crisis in the US that was ongoing between 1985- early 1990s. Now, there are some interesting reads on what happened before 2008, and how a "shadow banking system" was developed - essentially the 2008 banking crash was a bank run, but by banks and on banks. Here is an NBER article published in December 2008 http://www.immagic.com/eLibrary/ARCHIVES/GENERAL/NBER_US/N081222B.pdf Here is another paper from the Cleveland Fed by Tallman and Wicker, I think the historical comparisons may be of interest: http://www.clevelandfed.org/research/workpaper/2010/wp1009.pdf
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