Wednesday, October 17, 2012

Are recoveries always slow after financial crises and why

Carmen Reinhart and Ken Rogoff have an interesting new Bloomberg column, "Sorry, U.S. recoveries really aren't different." They point to the great Barry Eichengreen and Kevin O'Rourke "Tale of two depressions: what do the new data tell us" columns. (Hat tip, commenter Tim to "slow recoveries after financial crises" who asked what I think. Here's the answer)

Reinhart and Rogoff go after the sequence of studies who have questioned their assertion that recessions after financial crisis are deeper and recoveries slower.
As you can imagine, the argument quickly runs into measurement and sample debates. Reinhart and Rogoff say "Part of the confusion may be attributed to a failure to distinguish systemic financial crises from more minor ones" and "The distinction between a systemic and a borderline event is well established."

Me, I'm still waiting for an economically meaningful definition of "systemic" better than "we'll know it when we see it."  So, the premise here is that there is a clear, visible separation between business cycles associated with (let's all be careful not to jump to "caused by") "systemic" financial crises, "non-systemic" financial crises, and other recessions. I've been doing macro for 30 years, and this clear understanding of the shocks behind any recessions has eluded all the rest of us.

Then, we fight about "how a recovery is measured, and how success is defined." You can feel your eyes getting heavy.

But all this is really beside the point. This latest update does not address or change my basic problem with the whole exercise so far, as it has evolved in the policy debate. (Collecting data is unobjectionable!)

First of all, let us distinguish between recessions following financial crises are "on average" worse and longer or "always" worse and longer, as RR are often misquoted to say -- but they don't do much to clear up the misquote. Recessions following even their definitions of "systemic crisis" vary tremendously in length and depth.

Second, it therefore does not follow that recessions even if  "on average" are worse and longer are "inevitably" worse and longer. Hey, it's not our fault, it's just a law of nature. No. Some recessions are bad and long. Others less so.

Third, then, and most of all, I don't know how we can have this conversation at all without even whispering what the mechanism  might be.

Here's my tentative view: Sure, recessions are worse and longer after financial crises...because governments go completely haywire and screw things up after financial crises. They bail out banks. They hike taxes on "the rich." They transfer wealth. They bail out borrowers. They stomp all over property rights (GM.) Thus, they kill capital markets for a generation. They clamp down on the financial system in horse-left-the-barn efforts to regulate "safety." (We are in this paradox of the 3% mortgage that nobody can qualify for.) They try big "stimulus" plans. They often end up with unsustainable government debts leading to sovereign default or inflation. I'm not making this up. Most of this is in Reinhart and Rogoff's book!  So, perhaps if recessions are longer and deeper after financial crises, not as a matter of economics, but as a matter of particularly bad policy. This is the opposite of inevitability!

You don't have to agree with me, but agree it's logically possible. If so, then the refrain of "recessions are always longer and deeper after financial crises" starts to ring pretty hollow, doesn't it? There is an unwitting implication that the historical average measures some law of economics, that has nothing to do with economic policies. That seems like a pretty big assumption!

Do RR disagree? If so, let's hear loud and clear what they think the economic mechanism is, let's see evidence, and let's see and why policy after such events is only a combination of more or less benevolent responses. Not a word.

The great depression is a wonderful example here. It followed a "systemic" financial crisis by any definition, even mine. (I know it when I see it too!) It was longer or deeper than anything we've seen since as the lovely graph from Eichengreen and O'Rourke on the left here reminds us.

 Now, every single writer  on the great depression thinks it was long and deep primarily because.... wrongheaded government policy made it long and deep. Monetarists point to the Fed, not expanding the money supply enough, reserve requirements, the gold standard, etc. Keynesians think Roosevelt didn't stimulate enough, and only world war II saved us. The wave of new "neoclassical" scholarship points to the disasters of the NRA, cartelization of industries, "war on capital," 70% marginal tax rates,  Smoot-Hawley, financial regulation, unions, etc. Nobody, but nobody thinks the great depression was deep and long because, oh well, that's always the way things are after financial crises.

So why is the 2008 - now recession exempt from the same critique? Why are we following some law of economic nature?  If we don't even talk about mechanism, I don't see how all the averages in the world mean anything.

So what is the message? The closest RR get is to tippy toe around it at the end
This doesn’t mean that policy is irrelevant, of course. On the contrary, at the depth of the recent financial crisis, there was almost certainly a risk of a second Great Depression. However, although it is clear that the challenges in recovering from financial crises are daunting, an early recognition of the likely depth and duration of the problem would certainly have been helpful, particularly in assessing various responses and their attendant risks. 
This is very coy. So, what more than $1.5 trillion deficits (in Keyneisan economics, the whole deficit counts, not just the part labeled "stimulus") and $1.5 trillion monetary expansion do they think the Obama administration and Ben Bernanke should or would they have done, if only they had panicked a little bit more? And are they not acknowledging here that the length and depth of recessions has everything to do with policy, and is not measuring some law of economic nature?

Eichengreen and O'Rourke echo a more explicit sentiment
..policymakers should note that the level of industrial production is still 6% below its previous peak (figure 1). (At the trough it was 13% below its previous peak.) It follows that considerable excess capacity remains in a number of important economies. Exiting now from policies of stimulus in those countries would therefore be premature.
Well, the historical record as they have presented it says absolutely nothing about the efficacy of fiscal stimulus. Neither set of authors claims that, holding the severity of "systemic" financial crises fixed, they have evidence that countries with larger stimulus programs exited more quickly. In fact, RR's compilation of sovereign defaults and inflations after financial crises might suggest exactly the opposite, as a certain regret over stimulus might be settling in in Europe right now.

Without mention of cause, the historical record is just as consistent with my view: a financial crisis can lead to a deep and prolonged recession... so we can't indulge in the usual stimulus/bailout quack medicine that governments follow, which worsens recessions after financial crises.

But Reinhart and Rogoff, with the great data at their fingertips, could be writing about which policies are associated with quicker and slower recoveries. OK, I said "associated,"  and they do say
It is not our intention to closely analyze policy responses that may take years of study to sort out,
If the correlations  come back in ways that don't make sense, will will have a good argument whether  governments that got lucky on recoveries were able to indulge in silly policies.  But since they're basically opining that the Obama administration should have tried stimulus north of 10% of GDP, that cat's out of the bag, and we might as well be debating these facts, not just the averages.

Bottom line, without thinking about mechanisms I don't think we learn anything from these averages. And both sides of the debate are making some big, and often contradictory assumptions. If you conclude "recessions are always long and deep after financial crises" then you're saying policy doesn't really you shouldn't be advocating different policies! If policies matter a lot to the length and severity of recessions, then "recessions are always deep and long after financial crisis" is a meaningless statistic, and a poor fig leaf of an excuse.


  1. Quite agree. To put your point more bluntly, the reason recoveries are slow after serious financial crises is that 95% of politicians and about 50% of economists (Rogoff in particular) haven’t the faintest idea how to reduce government debt without deflationary effects.

    I.e. the explanation is: stupidity, ignorance, cluelessness – further suitable words are to be found in any dictionary of synonyms and antonyms.

  2. Wouldn't it be very likely that any recession that follows a large accumulation of debts by the private sector will take a long time to get out of simply because it takes a long time for people to pay down the debt ? I thought that those who say that "recessions are always long and deep after financial crises" mean exactly that. The next step is to say that government can step in and fill in a shortfall in demand, which is caused by everyone trying to pay down their private debts at once. The degree to which government does this in part determines how long it will take to get out of recession. Isn't this a possibility ?

    1. Yes, those are interesting possibilities. Of course one person's debt is another person's asset. So you need some sort of friction to make this go. And then this is testable -- we can see if "financial crisis" doesn't mean anything, but "levels of debt" correlate with slow recoveries. Similarly, "goverment ..fill in a shortfall of demand" isn't so easy either. They have to take demand from one place and put it somewhere else. Some models do that.
      But this is my point. Unless we talk about the mechanism, we really don't learn anything. Repeating "always slower after financial crises" doesn't teach us anything. But people sure do love to treat it as if it has lots of implications for policy!

    2. I agree with you but isn't Neo-Keneysian economics exactly that? a discussion of those mechanisms ? You are talking about it as if Reinhard-Rogoff is not part of a larger context, but in fact it is, isn't it ?

    3. John, here it is, the correlation between credit buildup prior to recession and then severity of subsequent downturn

    4. Professor, You write, "Sure, recessions are worse and longer after financial crises...because governments go completely haywire and screw things up after financial crises. They bail out banks."

      1. Your then write, "Unless we talk about the mechanism, we really don't learn anything."

      2. So, please explain the mechanism by which bailing the banks out was a screw up of things after the start of the current crises.

      3. And, so that your comments are factual, list all the banks you believe would have been solvent and remained open, had the Gov't not bailed them out. I have worked in banking for 35 years and cannot name one. I know of no one who believes any bank would have survived, had the gov't not bailed out the banks. You made a very bold statement. Back it up.

    5. I believe you are suffering from the common fallacy that bankruptcy involves blowing up a company and leaving a huge crater. Bankruptcy means that shareholders and unsecured creditors take losses. But the bank's operations continue, under new management and new ownership. Bankruptcy is recapitalization, a swap of debt for equity. "Banks" were not bailed out. Bank creditors and management were bailed out. "been solvent" and "remained open" are two different things. Quite a few would not have been "solvent." Almost all would have "remained open," perhaps with a new sign on the front door.
      GM DID go bankrupt.

    6. Sorry, how do "operations" continue? Can you point out which "operations" went on going in Lehman brothers' bankrupcty?
      And who keeps banks "open" if it is not the bailout?

      Moreover, isn't the comparison with GM also questionable, given that the government also bailed it out?

      It's clear things sound smarter when they come out of Chicago / the Midwest, but maybe it is sometimes necessary to put your sleeves up, get your hands dirty and offer some real world advice.

    7. Anonymous, FYI Lehman reopened in less than 10 days after bankruptcy under the new sign of Barclays. On GM you are totally missing the point which is that GM did indeed go bankrupt DESPITE the bailout, which of course is exactly what Prof. Cochrane said, a rescue for the management, and in the GM case I would say the Unions more than the creditors.

  3. Professor Cochrane,

    Great post. You illustrate well the hypocrisy of people like Paul Krugman, who, after publishing a book titled "End This Depression NOW!", has lept to the defense of the Obama administration by claiming that Reinhart and Rogoff were right all along and policy can't really stabilize the economy after a financial crisis.

    With you, however, I'm not exactly sure where you stand on the role of government vis a vis optimal stabilization policy. I don't think you objected to the Fed's initial policy response to the 2001 recession, right? I think you've quoted John Taylor approvingly when he's acknowledged that the Fed should cut short term interest rates to mitigate recessions. If you agree with that, what's so strange about the belief that monetary accommodation was insufficient with this last crisis given the fact that the Fed refused to "cut" interest rates below zero by increasing future inflation expectations?

    If you compare the actual path of the fed funds rate with any Taylor Rule you can imagine, there is a massive gap in 2008/2009 when short term interest rates should have been negative. The "expansion" of the Fed's balance sheet was wholly illusory, because the Fed did not accompany that expansion with adequate forward guidance about the future path of monetary policy. Only in September, 2012, four years after the severity of the crisis became apparent, did Ben Bernanke actually say that he would continue a low interest rate policy AFTER a recovery starts. That type of guidance would have been a lot more helpful in September of 2008.

    All this is a long way of saying that (1) I agree with you that the government distorts the supply side in the aftermath of a financial crisis and (2) I agree with monetarists that the Fed's failure to properly stabilize the economy is the reason why we don't have a more robust recovery. I think (2) was a much bigger factor than (1) in causing the depth of this latest crisis.

    1. I think the fed did a decent job overall. But I don't think it is anywhere near as powerful as you do. The key to prosperity is not "forward guidance." Promises from central bankers are not that credible in the real world. Normal people read them the way they read, oh, say, deficit forecasts.

    2. @Sam,

      Your characterization of Krugman as a hypocrite is incorrect. He is saying (I paraphrase): compared to average recoveries following financial crises, we are on track or even a bit ahead of average, of course we would be doing better if appropriate short-term fiscal stimulus policy was applied, but we could be doing a whole lot worse.

      He makes the above argument, yes to defend the Obama administration from GOP attacks. Krugman criticizes Obama over insufficient stimulus, but at the same time he would much prefer an Obama administration to a Romney one which would inflict serious harm.

    3. Btw, saying the Fed did a decent job is akin to someone stealing your money to make an investment, then partially paying you back because they were unable to recoup 100% of the original investment.

      The Fed is part of the 'mechanism' that caused the crisis therefore theree is no kudos for trying to clena-up the original mess. Especailly when the Fed is unwilling to admit it ever makes a mistake...

    4. @ John Cochrane:

      We'll just have to agree to disagree on the credibility of the promises of central bankers. To paraphrase Scott Sumner, no central bank in control of a fiat currency has ever tried to create inflation and failed. If Bernanke were to announce, with the support of the other members of the FOMC, that the Fed would target 3-4% inflation in the medium term, backed by unlimited open market operations (or engage in targeting the level of NGDP, which is basically the same policy), who could argue? What do you think would happen to TIPS spreads? Unless Rick Perry somehow finds a way to burn down all the printing presses, the Fed is in complete control. Inflation is always and everywhere a monetary phenomenon.

      @ Richard

      You have to admit there's huge inconsistency between publishing a book whose Amazon blurb reads: "a quick, strong recovery is just one step away," and at the same time relying on R&R to support the principle that financial crisis recoveries are somehow "different" and always (or on average) slower. The fact is Krugman believes that this pitiful recovery WAS a policy failure, both of the Fed and of Congress. That's why I call him a hypocrite. He doesn't actually believe that R&R are right. The GOP criticism is besides the point.

    5. Professor Cochrane:

      You said, "Promises from central bankers are not that credible in the real world."

      If there were studies that showed that unexpected Fed announcements had effects on the market, would you change this belief? Or would this be an exception to the EMH for some reason?

    6. Yeah, strange how much attention those markets seem to give the Fed's announcements...

      Paul Krugman is an extremely partisan man. Just shows how intelligent it is possible to be without being rational...

      Also, plenty of money printing and low rates during the Great Depression, no one thinks money was easy then (anymore)...

  4. Well played but I would emphasize two points that didn’t make it into your blog.

    First, we absolutely have to settle the empirical question of whether recessions that follow financial crises, however defined, are associated with slower recoveries. I don’t understand why this is so hard. (And I intend to enjoy the rest of a glorious Texas fall while waiting for my betters to figure it out.)

    Second, and more importantly, establishing that there is an association does us no good until we can identify the source of the relationship. (BTW, I hate it that John used the word mechanism which implies—contrary, I’m sure, to what he believes--that the economy is some sort of physical system.) John argues that understanding why financial crises might lead to slower recoveries can help us in designing better policies during the recovery. Good point. But preventing the next recession is at least as important as recovering from the last recession. You don’t have to be a card-carrying Austrian to think that the same factors that created the financial crises (bad Fed policy, political meddling with GSE’s, idiots running investment banks, whatever) led to wasteful allocation of capital that caused the recession. Understanding that is critical in shaping the policies that really matter to our kids.

    1. "You don’t have to be a card-carrying Austrian to think that the same factors that created the financial crises (bad Fed policy, political meddling with GSE’s, idiots running investment banks, whatever) led to wasteful allocation of capital that caused the recession."

      Indeed. Bad policy to begin with followed by more bad policy in attempts to resolve it. End the Fed. It always starts with the money...

  5. They aren't probably as explicit as one may like in their account, but the mecanisms which inform Reinhart and Rogoff's measurements and comparisons, which they offer in support of their thesis that the recovery after a systemic financial crisis takes longer seems to be a combination between Bernanke's (?) idea about the centrality of and the many problems posed by the credit system in the transmission of shocks (overheating/overleveraging before the crisis and delevraging after the crises, panics, bankruptcies, restructuring etc), coupled with issues of fiscal constraints, threshholds regarding the sustainability of public debt and overall external debt, which the US must now take into account because, per Reinhart and Rogoff, it is no longer as exceptional economically from an international point of view as people think or as it once was.

  6. See also Stanford Professor John Taylor's position:

  7. Grumpy Econ EnthusiastOctober 18, 2012 at 10:07 PM

    Hi Professor Cochrane,

    I was just wondering to make sure if I follow the gist of your argument. Are you hitting RR with the Lucas Critique?

    If so, I think this is a wonderful example. Thank you so much. After reading this blog post, I think that I understand it much better.

  8. Hi professor Cochrane . I think that :
    In the capitalist economy, there is always a mass of goods overproduction. Goods are sold on credit to other businesses, the state and the workers and they create bad assets. In normal conditions, the rate of circulation of money very quickly, so the hole was quickly filled. State tax content of the current future repayment, loan from a place up there, workers mortgage their homes, wages to consumers. ...
     But the gap is widening, to a certain point, the gap is too large and the collapse occurs. When a link on the chain collapse, cash flow is blocked, the flow rate of the currency declined rapidly, and the bad assets continue to reveal. Confidence of people seem to disappear, banks stop lending, businesses stop selling bear .... And all the bad assets in the economy exposed out.
     So why has the crisis small, medium and large? The answer is the speed of circulation of currency, when the velocity of money as quickly, the less likely the bad assets exposed out. Lead to the accumulation of them in a growing economy. And the scale of the crisis worse.
     Over the years, with the advancement of technology, the speed of traffic has continued to increase, so that the world economy has witnessed a long period of stability. But this stability is a sham, the amount of bad assets accumulated too large. And it inflates an unprecedented crisis will occur. However, the advocates of Keynesian policy was temporarily stop them, the bad assets still in the economy, they have not been removed, they just turn into different forms only. Velocity of money has not been raised, and continued economic stagnation. Want to terminate the root condition, only one way is to push the economy into a recession, to completely remove the bad assets

    1. You make a good point. I am not certain if money velocity is the culprit or if it is a side effect of the boom bust cycle. I think the real cause of the bubble is the same as it always is, too much debt.

      But you make a point about reducing the inventories before a recovery can begin. The actions of government have not been helpful here, and in some cases counter-productive.

    2. The problem is not the debt more or less, which is bad debt ( NPL)(an important part of the bad assets). But when the velocity of money is high, bad debt is often obscured. When the velocity of currency decrease, bad debt ( NPL ) will reveal out

  9. Actually you and Krugman come to an agreement of sorts for the first time, and one which I agree with as well.

    It is clear that to make any statement like the one by R&R sound plausible, you have to define a mechanism. And the mechanism you and Krugman are trying to define is similar. In many ways both of you are saying that in times of deep crisis such as this one, liquidity traps maybe as Keynesians would want to call them, we still don't know what the appropriate policy response is. And that is why crisis of this type tend to linger on for much longer.

    Now clearly you have disagreements on what the appropriate response is, and that is why we are having such a problem. In your run of the mill ordinary business cycle recession the profession seems to have come to an agreement that allowing monetary policy to work is the best possible response. But until there is an agreement on what should be done in cases like the current crisis, than yes, recoveries will be longer as politicians are using an "everything but the kitchen sink" approach.

  10. Thanks for the post. As a young armchair economist, I find myself conflicted about the remedies put forth by policy-makers.

    Forgive my ignorance, but I have a few outstanding questions:

    Does the global context within which these recessions/depressions and recoveries occur matter? This past recession was truly global and seems to be on-going.

    Does the nature of job loss -- private v public -- matter? Is there a friction in public to private work transition (I understand that's a very general query)? I thought a large amount of job losses were coming from state and local governments.

    Does de-leveraging matter? Is there any theoretical reason, empirical evidence, or -- heaven forbid -- a logical argument for an indebtedness tipping point in the Western World?


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