Friday, March 26, 2010

The sub-prime crisis and stimulus in historic perspective

Interesting post by William Easterly who while not underplaying the short run pain caused by financial crises, including the current one, argues that despite such recurrent crises capitalism has survived and gone on to produce unprecedented prosperity. For good measure, he rephrases Keynes’ "in the long run, we are all dead" with "In the long run, we are all better off because our dead ancestors stuck with capitalism".

The graph below shows episodic waves of defaults (involving a high number of countries in each wave) on their external debt (one possible dimension of a financial crisis) by a number of of countries over the last two centuries.

Average per capita income in the world (a shaky estimate, but probably right order of magnitude) increased by a multiple of 12 over 1800-2008, and in the US it shows a steady upward trend from 1870 to the present, despite repeated banking crises (using those identified by Reinhart and Rogoff), with usually little effect of each crisis on output relative to trend (except for the Great Depression)

Mark Thoma makes the important inference from the relative stability of the linear growth trend of US per capita income from 1870 – 2008 that aggressive interventions (which help substantially in the short-run in expediting the recovery) to stimulate the economy is not likely to cause long-run problems. He therefore feels that we should not panic and start reducing stimulus measures too soon, or be too timid with stimulative policies, out of fear it might harm long-run growth.

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