Friday, January 9, 2009

The Aftermath of Financial Crises

Part of what I want to do on this blog is to let people know what I am reading. If you understand a bit about what I read, you understand perhaps a bit better how I come to my decisions. Last night I came across a research paper entitled "The Aftermath of Financial Crises" written by Carmen Reinhart (University of Maryland, NBER and CEPR) and Kenneth Rogoff (Harvard University and NBER).

The authors had previously done research into the aftermath of financial crises in developing countries and this paper expands to include developed countries as well. It is a relatively short read (13 pages) and is quite informative. You don't have to believe everything they say, but you should respect it. I believe there is a consensus out there that we are right in the middle of a pretty severe financial crisis. These authors are ranking what we are going through now right up with what they call the "Big Five" post-war crises that include Spain 1977, Norway 1987, Finland 1991, Sweden 1991, and Japan 1992.

They make some very interesting points regarding expected changes in employment, output, equity prices, housing prices and more. Below is an excerpt:

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. Real housing price declines average 35 percent stretched out over six years, while equity price collapses average 55 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 over the down phase of the cycle, which lasts on average over four years. Output falls (from peak to trough) an average of over 9 percent, although the duration of the downturn, averaging roughly two years, is considerably shorter than for unemployment. 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 aimed at mitigating the downturn.



It's interesting what they say here. That third point about the real value of government debt exploding is certainly a path that we are embarking upon. What is it that we have now, one $700 billion stimulus package down, and a one trillion dollars left to go?

It's been strange hearing economists predict that the way we solve this crisis is to do what got us in this crisis in the first place. We spent too much, we borrowed too much, we leveraged too much. And now the government has reduced interest rates to 0% which necessarily punishes those who wish to save and encourages people to borrow. The government keeps handing out cash to banks and asks them to lend more. The problem is, the American consumer is tapped out. There is a retrenchment of the consumer happening now that is of a degree not seen in some time. How long that retrenchment (and the reduced consumption that goes along with it) lasts will determine the severity and length of this economic downturn.

It is often said that history repeats itself. I prefer saying that history rhymes. I think that is more accurate. To that point, I would like to point out a series of papers written by Ludvig Von Mises. Von Mises was a preeminent economist that was part of the Austrian school of economics. Most people today are taught Keynesian Economics which were developed by another economist, John Maynard Keynes. Keynes is the inventor of all those supply and demand curves you learned about in high school and perhaps in college as well. Von Mises did not agree with everything about the Keynesian school of economic thought. Through his papers published before, during, and after the Great Depression, you can get an idea of what he believed to be the causes of, and the cures to, the Depression. There is a series of papers out there called "The Causes of the Economic Crisis and Other Essays Before and After the Great Depression". The essays contained in this document were published between 1923 and 1946. The last paper from 1946 has a working title of "The Trade Cycle and Credit Expansion: The Economic Consequences of Cheap Money". The conclusions from that paper really allowed me to get a handle on what we are going through today and what effect government intervention may have.

The point of this is to say that the large majority of economists that are prominent today come from the Keynesian school of economic thought. When we hear people talk about a huge majority of advisers and academia folks agreeing on the best way to get us out of whatever malaise we are in, it is because most are believers in the Keynesian school of thought. Those that follow the Austrian school of economic thought were proven to be correct about a lot of the causes of the Depression. Those that are Keynesians believe that we can stimulate demand (and therefore employment and production) by embarking on massive government spending programs. While these programs may make us feel good in the near term because we can see that our government is trying to do something, the long-term consequences of such programs is astounding.

I am hopeful that the Austrian school of economic thought will start to make its way into the mainstream in 2009.

What does this have to do with anything on the School Board. Well, as President Bill Clinton would say, "It's the economy, stupid".

And just in case you were wondering, yes, I do read those things for fun! I love reading material from people that were closer to the history than I am. When I wanted to read about the US Constitution, I read Charles Austin Beard's The Republic first published in 1943. When I wanted to read about the underpinnings of capitalism, there is no shortage of books out there. I chose (among many others) Adam Smith's The Wealth of Nation's (1776), John Chamberlin's The Roots of Capitalism (1977), and Jude Wanniski's The Way the World Works (1978). These books come from a different time and from a different perspective. To me it is fun to see how well these authors have predicted what our world would look like today.

Thanks for reading.

James