This Time Is Different: Eight Centuries of Financial Folly Read online

  In 2008, developments took a turn for the worse, and the growth slowdown became more acute. At the beginning of 2009, the consensus—based on forecasts published in the Wall Street Journal—was that this recession would be deeper than the average “Big Five” experience. Note that in severe Big Five cases, the growth rate has fallen by more than 5 percent from peak to trough and has remained low for roughly three years.

  Our final figure in this chapter, figure 13.7, illustrates the path of real public debt (deflated by consumer prices).32 Increasing public debt has been a nearly universal precursor of other postwar crises, although, as we will see in chapter 14, the buildup in debt prior to a crisis pales in comparison to its growth after the crisis has begun, for weak growth crushes tax revenues. The U.S. public debt buildup prior to the 2007 crisis was less than the Big Five average. Comparisons across private debt (which we have already alluded to for the United States) would be interesting as well, but unfortunately, comparable data for the range of countries considered here are not easy to obtain. In the case of the United States, the ratio of household debt to household income soared by 30 percent in less than a decade and could well collapse as consumers try to achieve a less risky position as the recession continues.

  Figure 13.6. Growth in real per capita GDP (PPP basis) and postwar banking crises: Advanced economies.

  Sources: International Monetary Fund (various years), World Economic Outlook, and Wall Street Journal.

  Notes: The consensus forecast (−3.5 percent) for 2009 is plotted for the United States as of July 2009. The year of the crisis is indicated by t.

  One caveat to our claim that the indicators showed the United States at high risk of a deep financial crisis in the run-up to 2007: compared to other countries that have experienced financial crises, the United States performed well with regard to inflation prior to 2007. Of course, the earlier crises in developed countries occurred during a period of declining inflation in the rich countries.

  Figure 13.7. Real central government debt and postwar banking crises: Advanced economies.

  Sources: U.S. Treasury Department; International Monetary Fund (various years), International Financial Statistics; appendixes A.1 and A.2 and sources cited therein; and the authors’ calculations.

  Note: Consumer prices are used to deflate nominal debt. The year of the crisis is indicated by t; t − 4 = 100.

  Summary

  Why did so many people fail to see the financial crisis of 2007 coming? As to the standard indicators of financial crises, many red lights were blinking brightly well in advance. We do not pretend that it would have been easy to forestall the U.S. financial crisis had policy makers realized the risks earlier. We have focused on macroeconomic issues, but many problems were hidden in the “plumbing” of the financial markets, as has become painfully evident since the beginning of the crisis. Some of these problems might have taken years to address. Above all, the huge run-up in housing prices—over 100 percent nationally over five years—should have been an alarm, especially fueled as it was by rising leverage. At the beginning of 2008, the total value of mortgages in the United States was approximately 90 percent of GDP. Policy makers should have decided several years prior to the crisis to deliberately take some steam out of the system. Unfortunately, efforts to maintain growth and prevent significant sharp stock market declines had the effect of taking the safety valve off the pressure cooker. Of course, even with the epic proportions of this financial crisis, the United States had not defaulted as of the middle of 2009. Were the United States an emerging market, its exchange rate would have plummeted and its interest rates soared. Access to capital markets would be lost in a classic Dornbusch/Calvo–type sudden stop. During the first year following the crisis (2007), exactly the opposite happened: the dollar appreciated and interest rates fell as world investors viewed other countries as even riskier than the United States and bought Treasury securities copiously.33 But buyer beware! Over the longer run, the U.S. exchange rate and interest rates could well revert to form, especially if policies are not made to re-establish a firm base for long-term fiscal sustainability.

  - 14 -

  THE AFTERMATH OF FINANCIAL CRISES

  In the preceding chapter we presented a historical analysis comparing the run-up to the 2007 U.S. subprime financial crisis with the antecedents of other banking crises in advanced economies since World War II. We showed that standard indicators for the United States, such as asset price inflation, rising leverage, large sustained current account deficits, and a slowing trajectory of economic growth, exhibited virtually all the signs of a country on the verge of a financial crisis—indeed, a severe one. In this chapter we engage in a similar comparative historical analysis focused on the aftermath of systemic banking crises. Obviously, as events unfold, the aftermath of the U.S. financial crisis may prove better or worse than the benchmarks laid out here. Nevertheless, the approach is valuable in itself, because in analyzing extreme shocks such as those affecting the U.S. economy and the world economy at the time of this writing, standard macroeconomic models calibrated to statistically “normal” growth periods may be of little use.

  In the previous chapter we deliberately excluded emerging market countries from the comparison set in order not to appear to engage in hyperbole. After all, the United States is a highly sophisticated global financial center. What can advanced economies possibly have in common with emerging markets when it comes to banking crises? In fact, as we showed in chapter 10, the antecedents and aftermath of banking crises in rich countries and in emerging markets have a surprising amount in common. They share broadly similar patterns in housing and equity prices, unemployment, government revenues, and debt. Furthermore, the frequency or incidence of crises does not differ much historically, even if comparisons are limited to the post–World War II period (provided that the ongoing global financial crisis of the late 2000s is taken into account). Thus, in this chapter, as we turn to characterizing the aftermath of severe financial crises, we include a number of recent emerging market cases so as to expand the relevant set of comparators.1

  Broadly speaking, financial crises are protracted affairs. More often than not, the aftermath of severe financial crises share three characteristics:

  • First, asset market collapses are deep and prolonged. Declines in real housing prices average 35 percent stretched out over six years, whereas equity price collapses average 56 percent over a downturn of about three and a half years.

  • Second, the aftermath of banking crises is associated with profound declines in output and employment. The unemployment rate rises an average of 7 percentage points during the down phase of the cycle, which lasts on average more than four years. Output falls (from peak to trough) more than 9 percent on average, although the duration of the downturn, averaging roughly two years, is considerably shorter than that of unemployment.2

  • Third, as noted earlier, the value of government debt tends to explode; it rose an average of 86 percent (in real terms, relative to precrisis debt) in the major post–World War II episodes. As discussed in chapter 10 (and as we reiterate here), the main cause of debt explosions is not the widely cited costs of bailing out and recapitalizing the banking system. Admittedly, bailout costs are difficult to measure, and the divergence among estimates from competing studies is considerable. But even upper-bound estimates pale next to actual measured increases in public debt. In fact, the biggest driver of debt increases is the inevitable collapse in tax revenues that governments suffer in the wake of deep and prolonged output contractions. Many countries also suffer from a spike in the interest burden on debt, for interest rates soar, and in a few cases (most notably that of Japan in the 1990s), countercyclical fiscal policy efforts contribute to the debt buildup. (We note that calibrating differences in countercyclical fiscal policy across countries can be difficult because some countries, such as the Nordic countries, have powerful built-in fiscal stabilizers through high marginal tax rates and generous unemployment benefits, w
hereas other countries, such as the United States and Japan, have automatic stabilizers that are far weaker.)

  In the last part of the chapter, we will look at quantitative benchmarks from the period of the Great Depression, the last deep global financial crisis prior to the recent one. The depth and duration of the decline in economic activity were breathtaking, even by comparison with severe postwar crises. Countries took an average of ten years to reach the same level of per capita output as they enjoyed in 1929. In the first three years of the Depression, unemployment rose an average of 16.9 percentage points across the fifteen major countries in our comparison set.

  Historical Episodes Revisited

  The preceding chapter included all the major postwar banking crises in the developed world (a total of eighteen) and put particular emphasis on the ones dubbed the “Big Five” (those in Spain, 1977; Norway, 1987; Finland, 1991; Sweden, 1991; and Japan, 1992). It is quite clear from that chapter, as well as from the subsequent evolution of the 2007 U.S. financial crisis, that the crisis of the late 2000s must be considered a severe Big Five–type crisis by any metric. As a result, in this chapter we will focus on severe systemic financial crises only, including the Big Five crises in developed economies plus a number of famous episodes in emerging markets: the 1997–1998 Asian crises (in Hong Kong, Indonesia, Korea, Malaysia, the Philippines, and Thailand); that in Colombia in 1998; and Argentina’s 2001 collapse. These are cases for which we have all or most of the relevant data to allow for meaningful quantitative comparisons across key indicator variables, such as equity markets, housing markets, unemployment, growth, and so on. Central to the analysis are historical housing price data, which can be difficult to obtain and are critical for assessing the recent episode.3 We also include two earlier historical cases for which we have housing prices: those of Norway in 1899 and the United States in 1929.

  The Downturn after a Crisis:

  Depth and Duration

  In figure 14.1, based on the same data as table 10.8, we again look at the bust phase of housing price cycles surrounding banking crises in the expanded data set. We include a number of countries that experienced crises from 2007 on. The latest crises are represented by bars in dark shading, past crises by bars in light shading. The cumulative decline in real housing prices from peak to trough averages 35.5 percent.4 The most severe real housing price declines were experienced by Finland, Colombia, the Philippines, and Hong Kong. Their crashes amounted to 50 to 60 percent, measured from peak to trough. The housing price decline experienced by the United States during the latest episode at the time of this writing (almost 28 percent in real terms through late 2008 according to the Case-Shiller index) is already more than twice that registered in the United States during the Great Depression.

  Notably, the duration of housing price declines has been quite long lived, averaging roughly six years. Even excluding the extraordinary experience of Japan (with its seventeen consecutive years of real housing price declines), the average remains more than five years. As figure 14.2 illustrates, the equity price declines that accompany banking crises are far steeper than are housing price declines, albeit shorter lived. The shorter duration of a downturn compared with real estate prices is perhaps unsurprising given that equity prices are far less inertial. The average historical decline in equity prices has been 55.9 percent, with the downturn phase of the cycle lasting 3.4 years. As of the end of 2008, Iceland and Austria had already experienced peak-to-trough equity price declines far exceeding the average of the historical comparison group.

  Figure 14.1. Cycles of past and ongoing real house prices and banking crises.

  Sources: Appendixes A.1 and A.2 and sources cited therein.

  Notes: Each banking crisis episode is identified by country and the beginning year of the crisis. Only major (systemic) banking crisis episodes are included, subject to data limitations. The historical average reported does not include ongoing crisis episodes. For the ongoing episodes, the calculations are based on data through the following periods: October 2008, monthly, for Iceland and Ireland; 2007, annual, for Hungary; and Q3, 2008, quarterly, for all others. Consumer price indexes are used to deflate nominal house prices.

  In figure 14.3 we look at increases in unemployment rates across the historical comparison group. (Because the unemployment rate is classified as a lagging indicator, we do not include the most recent crisis, although we note that the U.S. unemployment rate has already risen by 5 percentage points from its bottom value of near 4 percent.) On average, unemployment rises for almost five years, with an increase in the unemployment rate of about 7 percentage points. Although none of the postwar episodes has rivaled the rise in unemployment of more than 20 percentage points experienced by the United States during the Great Depression, the employment consequences of financial crises are nevertheless strikingly large in many cases. For emerging markets the official statistics likely underestimate true unemployment.

  Figure 14.2. Cycles of past and ongoing real equity prices and banking crises.

  Sources: Appendixes A.1 and A.2 and sources cited therein.

  Notes: Each banking crisis episode is identified by country and the beginning year of the crisis. Only major (systemic) banking crisis episodes are included, subject to data limitations. The historical average reported does not include ongoing crisis episodes. For the ongoing episodes, the calculations are based on data through December 2, 2008. Consumer price indexes are used to deflate nominal equity prices.

  Interestingly, figure 14.3 reveals that when it comes to banking crises, the emerging markets, particularly those in Asia, seem to do better in terms of unemployment than the advanced economies. (An exception was seen in the deep recession experienced by Colombia in 1998.) Although there are well-known data issues involved in comparing unemployment rates across countries,5 the relatively poor performance in advanced countries suggests the possibility that greater (downward) wage flexibility in emerging markets may help cushion employment during periods of severe economic distress. The gaps in the social safety net in emerging market economies, compared to industrial ones, presumably also make workers more anxious to avoid becoming unemployed.

  Figure 14.3. Cycles of past unemployment and banking crises.

  Sources: Organisation for Economic Co-operation and Development; International Monetary Fund (various years), International Financial Statistics; Carter et al. (2006); various country sources; and the authors’ calculations.

  Notes: Each banking crisis episode is identified by country and the beginning year of the crisis. Only major (systemic) banking crisis episodes are included, subject to data limitations. The historical average reported does not include ongoing crisis episodes.

  In figure 14.4 we look at the cycles in real per capita GDP around severe banking crises. The average magnitude of declines, at 9.3 percent, is stunning. Admittedly, as we noted earlier, for the post–World War II period, the declines in real GDP have been smaller for advanced economies than for emerging market economies. A probable explanation for the more severe contractions in emerging market economies is that they are prone to abrupt reversals in the availability of foreign credit. When foreign capital comes to a “sudden stop,” to use the phrase popularized by Rudiger Dornbusch and Guillermo Calvo, economic activity heads into a tailspin.6

  Figure 14.4. Cycles of past real per capita GDP and banking crises.

  Sources: Total Economy Database (TED), Carter et al. (2006), and the authors’ calculations.

  Notes: Each banking crisis episode is identified by country and the beginning year of the crisis. Only major (systemic) banking crisis episodes are included, subject to data limitations. The historical average reported does not include ongoing crisis episodes. Total GDP in millions of 1990 U.S. dollars (converted at Geary Khamis PPPs) divided by midyear population.

  Compared to unemployment, the cycle from peak to trough in GDP is much shorter, only two years. Presumably this is partly because potential GDP growth is positive and we are measuring
only absolute changes in income, not gaps relative to potential output. Even so, the recessions surrounding financial crises are unusually long compared to normal recessions, which typically last less than a year.7 Indeed, multiyear recessions usually occur only in economies that require deep restructuring, such as that of Britain in the 1970s (prior to the advent of Prime Minister Margaret Thatcher), Switzerland in the 1990s, and Japan after 1992 (the last due not only to its financial collapse but also to the need to reorient its economy in light of China’s rise). Banking crises, of course, usually require painful restructuring of the financial system and so are an important example of this general principle.

  The Fiscal Legacy of Crises

  Declining revenues and higher expenditures, owing to a combination of bailout costs and higher transfer payments and debt servicing costs, lead to a rapid and marked worsening in the fiscal balance. The episodes of Finland and Sweden stand out in this regard; the latter went from a precrisis surplus of nearly 4 percent of GDP to a whopping 15 percent deficit-to-GDP ratio. See table 14.1.

  Figure 14.5 shows the increase in real government debt in the three years following a banking crisis. The deterioration in government finances is striking, with an average debt increase of more than 86 percent. The calculation here is based on relatively recent data from the past few decades, but recall that in chapter 10 of this book we take advantage of our newly unearthed historical data on domestic debt to show that a buildup in government debt has been a defining characteristic of the aftermath of banking crises for over a century. We look at the percentage increase in debt rather than in debt relative to GDP because sometimes steep output drops complicate the interpretation of debt-to-GDP ratios. We have already emphasized but it bears being stated again, the characteristically huge buildup in government debt is driven mainly by a sharp falloff in tax revenue due to the deep recessions that accompany most severe financial crises. The much-ballyhooed bank bailout costs have been, in several cases, only a relatively minor contributor to the postcrisis increase in debt burdens.