Wednesday, January 7, 2009

Sub-prime crisis - History repeats itself!

Starting from early last year, in a series of magisterial working papers, comparing an exhaustive list of financial and banking crises across both developed and developing countries, Professors Carmen Reinhart and Kenneth Rogoff have been arguing that the ongoing sub-prime mortgage bubble induced financial crisis is no different from what has been continuosly and repeatedly happening throughout history, in both developed and developing countries. There are fairly conclusive lessons to be learnt from the impact of surges in cross-border capital inflows and equity and property market bubbles on fiscal conditions and economic growth across countries.

Further, based on a historical comparison of how 22 economies, including emerging economies, came out from a major financial crisis, Professors Carmen Reinhart and Kenneth Rogoff claim that the American economy may be in for a long haul back to normalcy.

They find that unemployment rises by 7% on average after a severe financial crisis and doesn’t peak until four years after the crisis; housing prices fall 35% and downturns last six years; output falls 9% from peak to trough over two years; stock-price declines last three and a half years and total 55%; and government debt reaches 86% of GDP. If these are taken as broad indicators, the US unemployment rate will increase to touch 11% by 2011, housing market will not start recovery till 2011, GDP will decline by 4-5% in 2010-11, Dow Jones Industrial Average (DJIA) will fall to 6500, and public debt will touch $12 trillion!



In another paper studying banking crises across history in high and middle-to-low income countries, the same two authors find striking similarities in its impact. They claim that such crises dramatically weakens fiscal positions everywhere - government revenues invariably contract and fiscal expenditures often expand sharply. They find that the fiscal burden of banking crisis arises more from fall in tax revenues due to economic contraction and increased expenditure on fiscal stimulus, than from the cost of bailouts. They also find that systemic banking crises are typically preceded by asset price bubbles, large capital inflows and credit booms, in rich and poor countries alike.

Comparing the US sub-prime mortgage crisis, Prof Reinhart and Rogoff find striking similarities with banking crises in 18 industrialized countries. Their analysis squares up with the existing financial crisis literature that for countries experiencing large capital inflows, equity and housing prices stand out as the best leading indicators.

In a panaoramic analysis of financial crisis, dating from England's fourteenth century default to America's current sub-prime bubble, the same authors confirm the conventional opinion, that crises frequently emanate from the financial centers with transmission through interest rate shocks and commodity price collapses. Their data also documents that "most of these crises accompany default: including inflation, exchange rate crashes, banking crises, and currency debasements". In a grim reminder to emerging economies, they find that periodically spaced "serial defaults are a nearly universal phenomenon as countries struggle to transform themselves from emerging markets to advanced economies".

Examining the history of surges in international capital flows, Prof Carmen and Vince Reinhart finds that in line with earlier studies, "global factors, such as commodity prices, international interest rates, and growth in the world's largest economies, have a systematic effect on the global capital flow cycle". They also find that capital inflow "bonanzas are no blessing for advanced or emerging market economies". In the case of the latter, such bonanzas are associated with "a higher likelihood of economic crises (debt defaults, banking, inflation and currency crashes) and with procyclical fiscal policies and attempts to curb or avoid an exchange rate appreciation - very likely contributing to economic vulnerability". For the advanced economies, though not as adverse, bonanzas are associated with more volatile macroeconomic outcomes for GDP growth, inflation, and the external accounts. Slower economic growth and sustained declines in equity and housing prices follow at the end of the inflow episode.

Update 1
Economix blog has this post about the Reinhart-Rogoff study on how much worse it can get for the US economy.

Update 2
Bradley Shiller puts the US economic situation in historical perspective here and feels that the ongoing recession is not as bad as the previous big recessions.

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