Managing Expectations – The Aftermath of Financial Crises

In December 2008, Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard University followed up on work they performed a year earlier and produced a paper entitled “The Aftermath of Financial Crises” which they presented at the American Economic Association meeting in January, 2009 in San Francisco. They studied the 18 global banking and housing crises which occurred in the post World War II period and then added to them the US depression which began in 1929 and a banking crisis in Norway in 1899 for which they had housing data.

I mention their work for two principal reasons. First, looking forward from their initial work in December, 2007, they predicted the financial crisis that would occur in 2008. Second, their analyses of the historical crises noted above seems highly predictive of what has transpired since that time. Knowing we are not out of the woods yet and we still have huge variables in Europe, China, Middle East and US, I think the data show remedies to banking and housing crises take time. This latter issue is important as we must not look for panaceas or miracles to resolve the crises. It takes month by month progress on the journey upward, knowing that the market may fall back on occasion. In our political climate in the US which has little cooperation between factions and a huge amount of impatience, concerted effort is needed.

To keep things simple for me, I like to think the housing crisis and recession generally began at the end of 2007. In some areas of the country, California, Nevada, Florida, e.g. the housing crisis had already begun. I would also like to presume that the unemployment crisis started  at the end of 2008, but it actually started in some places and industries before then. The equity market began bleeding in the spring of 2008, but fell precipitously in September, 2008. For ease of the math, let’s presume it occurred in September, 2008. This makes the arithmetic a little easier to follow.

Their key conclusions are as follows:

  • “First, asset market collapses are deep and prolonged  Real housing price declines average 35% stretched over six years, while equity price collapses average 55% over a downturn of three and a half years.
  • Second, the aftermath of banking crises is associated with profound declines in output and unemployment. The unemployment rate rises an average of 7% over the downphase of the cycle, which lasts over four years.. Output falls (from peak to trough) an average of 9%, 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% in the major post WWII episodes….The big drivers of debt increases are the inevitable collapse in tax revenues that governments suffer….as well as often ambitious countercyclical fiscal policies aimed at mitigating downturn.” They note the cost to bail out and recapitalize the financial system is usually not the key driver of debt increase.

The above speaks of averages, but there are historical crises that were far worse and some that were even better than the averages noted. Yet, if we use the averages as a baseline, they show some telling results that are eerily accurate in the US, but also beg for patience as we work our way out of the crisis. First, they note the average equity downturn is 3 1/2 years. If we use the start of the downturn postulated by me of September, 2008 that places us at March, 2012 as when the equity market recovers. If you look at the first quarter of this year, many equity declines were largely restored and the market was on much better footing. It was not all the way back and has fallen off some since, but I found this math interesting.

The unemployment statistics have shown month by month growth for the last 26 months. It has been less than hoped growth, but jobs were added. We have not fully recovered and definitely have a way to go. Doing the same type of math with 4 years on average of unemployment during a financial crisis and beginning the fall off at the end of 2008, that would place our average recovery at the end of 2012. That may be too soon, but we seem to be slowly climbing our way toward that. While the President has aided the process somewhat, we could have done more with a more cooperative Congress. The President also made the ludicrous announcement after the stimulus in early 2010 that unemployment would be significantly improved by summer of 2010. That was not a very good prediction and gave too much false hope.

On the housing side, improvements are visible, but we have too many people underwater and in trouble with their homes and mortgages. Using the same kind of arithmetic, the above presumed start date of January, 2008 and an average housing decline of six years, that places us at the end of 2013 for a fuller housing recovery. That seems to feel about right given what is happening, but things could turn around in a bad way quickly with the other variables noted above.

The final comment in output shows a much quicker turnaround. Many have referred to this as the “jobless recovery,” but it makes sense. Business has to improve with the available resources you have before you begin hiring again. GDP growth has been apparent for several years, yet it is a little slower than desired. I would add a comment made by Thomas Friedman and Michael Mandlebaum in their book “That Used to be Us.” They noted that China’s GDP fall off in growth from 10% to 7% would impact the global economy far more than slow US or European growth. This shows that we are part of a whole, so we are impacted greatly by others. So, we can show improvement, but it can be dwarfed by China’s slower growth.

So, what can we draw from the above? We need a little more patience on the housing market (end of 2013) and unemployment rates (end of 2012). While the equity market and GDP growth make us feel a little better, we need to be mindful of the debt increase. We have to be smart to pay down the debt and deficit, but pay it down we must. That is why I am a fan of the Bowles-Simpson Plan – it attempts to do both.  Yet, at a bare minimum, we need our leaders to work together toward a reasonable solution that will pay down debt, but not stop growth. The last thing we need is what will unfortunately happen – partisan bickering over whose fault this is and why the bother has not done more.



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