The Aftermath of Financial Crises

John Mauldin reports on some research about what happens in the aftermath of financial crises.

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He cites, professors Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard, who wrote a a recent paper entitled "The Aftermath of Financial Crises."

From Mauldin's letter:

There are very real differences between normal business-cycle recessions and a recession brought on by a financial crisis. The latter are much more severe. Sadly, we are in the latter type.

Reinhart and Rogoff had done an earlier paper on financial crises and their aftermath, just in developed countries, and now they have expanded their research to include developing countries as well. What they have found is that there is not that much difference in general between developed and developing economies after a crisis. (About which I will comment later, but first let's look at their work.) Quoting:

"In our earlier analysis, we deliberately excluded emerging market countries from the comparison set, in order not to appear to engage in hyperbole. After all, the United States is a highly sophisticated global financial center. What can advanced economies possibly have in common with emerging markets when it comes to banking crises? In fact, as Reinhart and Rogoff (2008b) demonstrate, the antecedents and aftermath of banking crises in rich countries and emerging markets have a surprising amount in common.

(Blogger note, the very same point is made by Paul Krugman in his re-released 1999 book, "The Return of Depression Economics.")

"... 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."

(Mauldin, continuing:)
... As long-time readers know, I believe you must be very careful when using average numbers of past performance of investments or economic data. While they can be useful in helping to determine direction, using them as an absolute predictor of future patterns can be quite misleading.