Friday, May 4, 2012

Slow recoveries after financial crises?

Are recoveries always slower for recessions that follow financial crises? This factoid has become sort of a mantra, or excuse, depending how you look at it.

Former President Bill Clinton chimed in, repeating the factoid thus: "If you go back 500 years, whenever a country’s financial system collapses, it takes between 5 and 10 years to get back to full employment."

I. Facts

I'm not aware of the study Clinton is  referencing, nor of any comprehensive international database on employment and financial crises going back 500 years. But only a nerdy academic would footnote an introduction at a Presidential fund-raiser, and one might excuse a little exaggeration in that circumstance anyway. (I don't mean to pick on Clinton. Lots of people have passed around this factoid. They just don't get written up in the newspapers!)

Reinhart and Rogoff's "Aftermath of Financial Crises" is, I think, the source. Their work actually reflected a fairly recent sample of countries. For example, here is their unemployment graph.

Which they summarize thus:
the aftermath of banking crises is associated with profound declines in output and employment... The unemployment rate rises an average of 7 percentage points over the down phase of the cycle, which lasts on average over four years.
(The paper doesn't offer a comparison with "regular" business cycles, but I presume they have one somewhere.)  In a recent Bloomberg oped, Reinhart and Rogoff repeat that summarizing all their evidence, they think recessions following financial crises are longer and deeper.

As I look at the facts, the wide disparity in outcomes in the picture is more striking to me than the average. Financial certainly don't always and inevitably lead to long recessions, as the factoid suggests.

This is interesting but leaves one hungry for evidence from the United States -- maybe we are different from  Colombia -- and for a longer time period. Recently several authors are picking up this challenge.

In a  nice article for the Atlanta Fed, Gerald Dwyer and James Lothian went back to the 1800s, and find no difference between recessions with financial crises and those without. Some, like the Great depression and now, last a long time. The others don't. 

Michael Bordo and Joseph Haubrich wrote a somewhat more detailed study of US history, (which I found through John Taylor's blog) concluding
recessions associated with financial crises are generally followed by rapid recoveries. We find three exceptions to this pattern: the recovery from the Great Contraction in the 1930s; the recovery after the recession of the early 1990s and the present recovery. ...
In contrast to much conventional wisdom, the stylized fact that deep contractions breed strong recoveries is particularly true when there is a financial crisis. In fact, on average, it is cycles without a financial crisis that show the weakest relation between contraction depth and recovery strength
This had pretty much been the "stylized facts" when I went to grad school: US output has (so far) returned to trend after recessions. The further it falls, the quicker it rises (growth). Financial crises give sharper and deeper recessions, followed by sharper recoveries, but not, on average, longer ones. This "recovery" is in fact quite unusual, looking more like the Great Depression but unlike the usual pattern.

As I did minor searches for the facts however, it's clear there is an explosion of work on this subject, so it's hardly the last word. 

 2. Explanations

Historical averages are not explanations. We are not doomed to repeat history. Clinton echoed a common interpretation: something is written in stone that financial crises lead to long recessions, so don't blame us. But I haven't read much convincing economics about why a financial or banking crisis must inevitably lead to a long recession.

A logical possibility of course is that drawn-out recessions following financial crises (whether the average or just isolated incidents) reflect particularly ham-handed policies followed by governments after financial crises.  Financial crises are followed by  bailouts, propping up zombie banks, stimulus, heavy regulation, generous unemployment and disability benefits, mortgage interventions, debt crises and high distortionary taxation (European "Austerity" consists largely of taxes that say "don't start a business here") and so on. These policies do have their critics as well as their fans. It is certainly possible that these, rather than "financial crisis" are the cause of slow recovery, and thus that slow recovery is a self-inflicted wound rather than an inevitable fate. 

The similar policy mix in the Great Depression is now accused by a strand of scholarship as the prime cause of that depression's extraordinary length, not valiant but sadly insufficient fixes. (For example, see Lee Ohanian; for some more popular summaries see Jim Powell or Amity Shlaes.)

Bordo and Haubrich include capsule histories. I don't agree with them entirely, but they're worth reading for one big reason: We recovered quickly from many financial crises in the 19th and early 20th century, when there was no Fed at all, no stimulus spending, no unemployment insurance, none of the usual "fixes" being applied to this crisis. To read most lefty comment these days on the need for "stimulus," you'd predict that one recession in the 1800s would have led to permanent stagnation.

The wide variation across countries shown above, as well as the wide variation in US financial recessions is really intriguing from this aspect. The question we should be asking is not "how long are financial crisis recessions on average" but "what accounts for the huge variation across time and countries?"

Just a quick Google search will show you that an enormous amount of work is underway on "why is this recovery so slow?" (Sorry, I can't begin to post useful links, just too many to sort through.) Explanations from poor policy, job mismatch, sticky labor markets, housing overhang, and so on abound. The interesting thing is that almost nobody seems to be taking the view that all financial-crisis recessions are the same, or that a long recovery is inevitable. 

Even Reinhart and Rogoff write this way:
 It is interesting to note in Figure 3 that when it comes to banking crises, the emerging markets, particularly those in Asia, seem to do better in terms of unemployment than do the advanced economies. While there are well-known data issues in comparing unemployment rates across countries, 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, when compared to industrial ones, presumably also make workers more anxious to avoid becoming unemployed.
Lots of others (such as Casey Mulligan) also think that high and persistent unemployment is a result of government policies that discourage moving or a return to work. 

On my reading list: In the meantime, Jim Stock and Mark Watson do very careful econometric analysis and conclude that this recession really didn't have much to do with the financial crisis: "no new “financial crisis” factor is needed."  They continue,
More ominously,  we estimate that slightly less than half of the slow recovery in employment growth since 2009Q2, compared topre-1984 recoveries, is attributable to cyclical factors (the shocks, or factors, during the recession), but that most of the slow recovery is attributable to a long-term slowdown in trend employment growth
3. What next?

"Aftermath of Financial Crises" continues,
Third, the real value of government debt tends to explode, rising an average of 86 percent in the major post–World War II episodes. Interestingly, 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 there is considerable divergence among estimates from competing studies. But even upper-bound estimates pale next to actual measured rises in public debt. In fact, the big drivers of debt increases are the inevitable collapse in tax revenues that governments suffer in the wake of deep and prolonged output contractions, as well as often ambitious countercyclical fiscal policies in advanced economies aimed at mitigating the downturn.
And in  From Financial Crisis to Debt Crisis,
..banking crises (both domestic and those emanating from international financial centers) often precede or accompany sovereign debt crises. Indeed, we find they help predict them.
The same crowd that likes to quote Reinhart and Rogoff for the inevitability of long recessions after financial crises should read their work here. It seems like a potent warning for view that we need just a little more borrowed-money stimulus, or that such spending reliably pays for itself by magically generating higher tax revenues.


Oscar Jorda sent along a link to two papers  here and here  covering 14 countries over 140 years. They find episodes of "global instability" -- notice how many of the above graph are 1997 or 1998 -- which is important to digesting just how much information we have. Crises lead to deeper recessions and stronger recoveries. And they look at predictors. I haven't read them yet, but they are on top of the stack.


  1. I note the chart seems to deal with duration of peak to trough and not how long it takes to return to "full" employment.

    A small export oriented economy can return to full employment rapidly by depreciating its currency. The United States cannot do that.

    It is possible that the GDP levels of 2007 were not real. The banking sector in particular appears to have been claiming paper profits that were never really there.

    The length of a financial crisis recession may depend on the availability of foreign capital to make up domestic shortfalls.

    An economic system designed to channel income to high income earners with low propensity to consume may lead to a lengthy downward spiral.

  2. If comparing to the 1800s is informative, then the higher inequality of that century may suggest that there should be no effect on the downward spiral...of course that assumes things like constant MPC

    I am fairly dubious as to how much we can learn from the 1800s having then been on a gold standard should are thoughts fundamentally change when we change the currency systems like that?

  3. detailed narratives of each crisis is required because In Great Depressions of the Twentieth Century, Kehoe and Prescott (2007), together with a team of 22 other economists conclude that bad government policies are responsible for causing great depressions.

    While different sorts of shocks can lead to ordinary business cycle downturns, they conclude that overreaction by governments can prolong and deepen the downturn, turning it into a depression.

  4. Reinhart and Rogoff make some distinctions. They say that the recovery in the emergent economies included in their sample of post-war regional crises is affected by capital outflows and the cycle of debt default, currency depreciation and inflation that usually follows, whilist in the case of global finacial crises and recessions like the Great Depression and the present one, the recovery is affected by the inability of all countries to grow out of recession by increased exports fueled by curency deppreciation. Also, they seem to say that the financial and banking crises in developed economies driven by a bust in housing and real estate assets (as in Spain 1977, Britain, Sweeden, Norway, Finland and Japan in the 1990s) make for a more prolonged and difficult recovery.

  5. On the linkage between energy prices and the financial crisis

    Now, why this link?

    Because it is high time to say what needs to be said about Cochrane. He is no longer a serious thinker or honest broker of the facts. He is nothing but a right wing PR flack who would make Goebbels proud.

    Seriously, what "laws" of economics identify a depression as a financial depression.

    The papers above study the doubling of energy prices under George Bush and conclude, surprise, we didn't have a financial crisis depression we had a doubling of energy prices depression.

    Makes sense to me, but then I work and play in the real world, not the ivory tower at Booth, and that is the world I saw developing in 2006-08.

    Remember what oil prices were on the 4th of July, 2008?

    And, why haven't we come back. Well, may be because high energy prices remain (thanks a lot to Iran) and may be fear over Europe and maybe concern over the costs of Obamacare.

    In sum, Amity Shlaes? Really? Pathetic.

    John, how have you allowed yourself to become such a dishonest cull?

    What laws of economics say that what happened last time around has anything to do with this time around.

    God bless the people in the 1880s who came back from a panic. So what. That world has so little to do with ours it informs nothing.

    Go walk west on Walton, or Chicago or Augusta or Grand, say starting at the 1500 block and look at the buildings that we going up each year. You could learn something by looking up and see the years when each new block was built. The press of new people, alone, may well explain the recovery. Raw materials like lumber from MN and Wis were virtually cost free. One could go on forever about the differences but why argue with a fool. It only makes one look foolish.

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  8. Dr. Cochrane,

    Reinhart and Rogoff have a rebuttal to the studies you discuss above and I would be interested to here your thoughts:


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