At a social affair, last night, an acquaintance brought up the issue of how long this crisis could possibly last. [As usual this analyst stammered.]
Fortunately a study by Harvard’s Ken Rogoff and Carmen Reinhart over previous episodes of financial/banking, real estate crisis should give some clue. (Hat tip: John Maudlin)
Although it is best to be reminded that in reading history, things are always obvious after the fact. And that conditions that have led to the crisis may be “deterministic” to quote Nassim Taleb, whose conditions which have led to such may not be always be identified or observed.
On the real estate bust:
-The cumulative decline in real housing prices from peak to trough averages 35.5 percent.
-The most severe real housing price declines were experienced by Finland, the Philippines, Colombia and Hong Kong. Their crashes were 50 to 60 percent, measured from peak to trough.
-The housing price decline experienced by the United States to date during the current episode (almost 28 percent according to the Case–Shiller index) is already more than twice that registered in the U.S. during the Great Depression
-Notably, the duration of housing price declines is quite long-lived, averaging roughly six years (with Japan 17 years!)
On the Effect to Equities:-the equity price declines that accompany banking crises are far steeper than are housing price declines, if somewhat shorter lived.
-The average historical decline in equity prices is 55.9 percent, with the downturn phase of the cycle lasting 3.4 years
See below…
On Unemployment:
-On average, unemployment rises for almost five years, with an increase in the unemployment rate of about 7 percentage points. While none of the postwar episodes rivals the rise in unemployment of over 20 percentage points experienced by the United States during the Great Depression, the employment consequences of financial crises are nevertheless strikingly large in many cases.
-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.
On GDP:
-The average magnitude of the decline, at 9.3 percent, is stunning.
-post– World War II period, the declines in real GDP are smaller for advanced economies than for emerging market economies. A probable explanation for the more severe contractions in emerging market economies is that they are prone to abrupt reversals in the availability of foreign credit. When foreign capital comes to a “sudden stop,” to use the phrase coined by Guillermo Calvo, Alejandro Izquierdo, and Rudy Loo-Kung (2006), economic activity heads into a tailspin.
-Compared to unemployment, the cycle from peak to trough in GDP is much shorter, only two years.
-the recessions surrounding financial crises have to be considered unusually long compared to normal recessions that typically last less than a year.
On debt buildup-same buildup in government debt has been a defining characteristic of the aftermath of banking crises for over a century. We look at percentage increase in debt, rather than debt-to-GDP, because sometimes steep output drops would complicate interpretation of debt–GDP ratios.
-the characteristic huge buildups in government debt are driven mainly by sharp falloffs in tax revenue and, in many cases, big surges in government spending to fight the recession.
-The much ballyhooed bank bailout costs are, in several cases, only a relatively minor contributor to post–financial crisis debt burdens.
Their conclusion:
``An examination of the aftermath of severe financial crises shows deep and lasting effects on asset prices, output and employment. Unemployment rises and housing price declines extend out for five and six years, respectively. On the encouraging side, output declines last only two years on average. Even recessions sparked by financial crises do eventually end, albeit almost invariably accompanied by massive increases in government debt.
``How relevant are historical benchmarks for assessing the trajectory of the current global financial crisis? On the one hand, the authorities today have arguably more flexible monetary policy frameworks, thanks particularly to a less rigid global exchange rate regime. Some central banks have already shown an aggressiveness to act that was notably absent in the 1930s, or in the latter-day Japanese experience. On the other hand, one would be wise not to push too far the conceit that we are smarter than our predecessors. A few years back many people would have said that improvements in financial engineering had done much to tame the business cycle and limit the risk of financial contagion.
``Since the onset of the current crisis, asset prices have tumbled in the United States and elsewhere along the tracks lain down by historical precedent. The analysis of the post-crisis outcomes in this paper for unemployment, output and government debt provide sobering benchmark numbers for how the crisis will continue to unfold. Indeed, these historical comparisons were based on episodes that, with the notable exception of the Great Depression in the United States, were individual or regional in nature. The global nature of the crisis will make it far more difficult for many countries to grow their way out through higher exports, or to smooth the consumption effects through foreign borrowing. In such circumstances, the recent lull in sovereign defaults is likely to come to an end. As Reinhart and Rogoff (2008b) highlight, defaults in emerging market economies tend to rise sharply when many countries are simultaneously experiencing domestic banking crises.”
Our observations:
-present crisis in the US isn’t just about a real estate crisis but a combination of both real estate and banking crisis since the real estate industry depended on Wall Street to fuel its bubble. This risks extending the duration of the economic slump! The previous averaged about 6 years (Rogoff-Reinhart) where today the US housing bust is only 3 years old!
-the US centric crisis hasn’t been just about real estate bubble bust and bank recapitalization issues but also about falling tax revenues and state deficits and importantly household balance sheet impairments. So it is going to be difficult to make precise assessment using past data.
-for the Philippines today, the decline of 56% squares with “the average historical decline in equity prices is 55.9 percent”. But since we did not suffer from a banking crisis but got unduly affected by the chain process of global forcible selling, “the downturn phase of the cycle lasting 3.4 years” has got to be lower.
-Rogoff-Reinhart: “the declines in real GDP are smaller for advanced economies than for emerging market economies. A probable explanation for the more severe contractions in emerging market economies is that they are prone to abrupt reversals in the availability of foreign credit.”
Previous crisis lumped as one was either “regional or individual” as rightly noted by the authors. Today’s crisis is global (also rightly pointed out). But the important difference is where the crisis emanated from.
Although the apparent fallout dynamics identified by the Rogoff-Reinhart study had been present in today’s crisis even when the epicenter had been in the US, it is because present dynamics has yet been exhibiting the privilege of the US dollar as the world' currency reserve.
But this seems to be changing, for the new year, a news report says that China is offering its neighbors to trade directly in their currency,
from BBC, ``China has said it is to allow some trade with its neighbours to be settled with its currency, the yuan. The pilot scheme was announced in a package of measures designed to help exporters hit by the global downturn…Officials did not say when the trial scheme would start. When it does, the yuan could be used to settle trade between parts of eastern China (Guangdong and the Yangtze River delta) and the territories of Hong Kong and Macau, and between south-west China (Guangxi and Yunnan) and the Asean group of countries (Brunei, Burma, Cambodia, Indonesia, Laos, Malaysia, the Philippines, Singapore, Thailand and Vietnam).”
In short, “abrupt reversals in the availability of foreign credit” could happen on a different context. As the common Wall Street precept says, ``Past performance may not guarantee future outcome."
-Very interesting commentary from Rogoff-Reinhart: ``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.”
Could the welfare “mentality” of developed economies have contributed to the unemployment predicament, compared to “gap filled” or “less safety nets” in emerging markets? Or put differently, has free markets contributed to better employment recovery for EM during the past crisis?
Here we are reminded of Ludwig von Mises in Human Action, ``The policies advocated by the welfare school remove the incentive to saving on the part of private citizens. On the one hand, the measures directed toward a curtailment of big incomes and fortunes seriously reduce or destroy entirely the wealthier peoples power to save. On the other hand, the sums which people with moderate incomes previously contributed to capital accumulation are manipulated in such a way as to channel them into the lines of consumption.”
-Rogoff-Reinhart: “The much ballyhooed bank bailout costs are, in several cases, only a relatively minor contributor to post–financial crisis debt burdens.”
We can see now why Mr. Rogoff had been calling for inflating the value of debts away (see Kenneth Rogoff: Inflate Our Debts Away!). He believes that bailout costs would have a “minor” impact on the economy going forward, but his conclusions were premised upon comparisons made during the past crisis when they had been “individual or regional” in nature, whereas today’s crisis is global.
Thus, it is a wonder just how valid his thesis will be.
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