Economic and Fiscal Consequences of Financial Crises

[BWV]

Carmen Reinhart and Ken Rogoff did a landmark empirical study in 2008 of past financial crises and found the following, which has proved to be prescient in regards to our current situation:
http://www.voxeu.org/index.php?q=node/2877

In a recent paper, Kenneth Rogoff and I examined the international experience with episodes of severe banking crises. The depth, duration and characteristics of the economic slump following the crises traced out a few empirical regularities. Our main findings in that paper can be summarized as follows:

Financial crises are protracted affairs.

Asset market collapses are deep and prolonged.

Real housing price declines average 35% stretched out over six years.

Equity price collapses average 55% over a downturn of about three and a half years.
There are 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.

Real GDP per capita falls (from peak to trough) an average of over 9%, the duration of the downturn averages roughly two years.

There are significant adverse consequences of the financial crisis on government finances.

Tax revenues shrink as the economic conditions deteriorate, the fiscal deficit worsens markedly, and the real value of government debt tends to explode, rising an average of 86% in the major post–World War II episodes.

Figure 1. Past and ongoing real house price cycles and banking crises: peak-to-trough price declines (left panel) and years duration of downturn (right panel)

Figure 2. Past unemployment cycles and banking crises: Trough-to-peak percent increase in the unemployment rate (left panel) and years duration of downturn (right panel)

 

[WhoWee]

You've put a good bit of info on the table - what are your conclusions?

 

[BWV]

You've put a good bit of info on the table - what are your conclusions?

Mine hardly matter, but I think Carmen Reinhart's conclusions which I quoted above are compelling

 

[WhoWee]

Mine hardly matter, but I think Carmen Reinhart's conclusions which I quoted above are compelling

Among other places in time, this compares the 1929 US housing market, the 1998 housing market in Columbia, and the housing market in Finland in 1991.

Now what do these comparisons tell us about the current US housing market?

 

[BWV]

Among other places in time, this compares the 1929 US housing market, the 1998 housing market in Columbia, and the housing market in Finland in 1991.

Now what do these comparisons tell us about the current US housing market?

my parents in Texas were underwater on the house they purchased in the early 80s for nearly 15 years. In parts of Houston it would have been more like 20 years. This was, of course, in nominal dollars. R&R's evidence shows that housing price declines are long lived and take years to recover.

 

[WhoWee]

my parents in Texas were underwater on the house they purchased in the early 80s for nearly 15 years. In parts of Houston it would have been more like 20 years. This was, of course, in nominal dollars. R&R's evidence shows that housing price declines are long lived and take years to recover.

There are areas in NE OH and W PA that only appreciated about 10% from the 1980's until 2007 - then lost about 5%. Another market I'm familiar with is N VA - where property values increased significantly.

I have a very specific example accordingly. In 1982 I priced a 1,500 sq ft ranch in Youngstown, OH - it was priced at $75,000 - in 2007 it sold for $82,000. During the same month in 1982, I toured a ranch house nearly identical to the OH property in Springfield VA. The VA house was priced at $100,000. I happened to drive by the VA property in late 2006/early 2007 and noticed a for sale sign - price $495,000 - it sold for about $460K. As a side note, a builder bought the VA house and demolished it to put up a "McMansion".

To your point about Houston - it went boom to bust in a matter of a few short years. In 1989 we needed a physical office in Texas for our large ticket leasing company. One of our clients provided an entire floor of a downtown high rise to us. I used to fly to Houston every few weeks and sit by myself at a desk in the middle of the empty floor and make phone calls to satisfy the requirement. Our phone bill was proof of occupancy.

 

[mheslep]

What's not clear is why the downturn from financial panics must be long. Could it be because governments inevitably interfere with markets clearing, as the US government has clearly done in our recent case (Home Affordable Modification Program, etc)?

 

[WhoWee]

What's not clear is why the downturn from financial panics must be long. Could it be because governments inevitably interfere with markets clearing, as the US government has clearly done in our recent case (Home Affordable Modification Program, etc)?

My first response is YES!

However, after thinking about it a while - my response is still - YES!

 

[BWV]

the basic rationale is that there is an overwhelming amount of debt that must be worked off. This differs from cyclical recessions which are more about inventory cycles

More depth in this paper by Reinhart & Ken Rogoff

http://www.economics.harvard.edu/files/faculty/51_Aftermath.pdf

and in their book

https://www.amazon.com/dp/0691152640/?tag=pfamazon01-20

 

[mheslep]

the basic rationale is that there is an overwhelming amount of debt that must be worked off. This differs from cyclical recessions which are more about inventory cycles...

Yes, no doubt there's a great deal of debt in financial crises. However, there are mechanisms in place to aid in clearing away debt that don't necessarily include working it off for decades - bankruptcy, foreclosure, etc. Without bankruptcy, I would think the system of creative destruction in business might grind to a halt, with zombie companies beyond any salvation lingering on and never reaching agreement between loaners and borrowers.

 

[BWV]

Yes, no doubt there's a great deal of debt in financial crises. However, there are mechanisms in place to aid in clearing away debt that don't necessarily include working it off for decades - bankruptcy, foreclosure, etc. Without bankruptcy, I would think the system of creative destruction in business might grind to a halt, with zombie companies beyond any salvation lingering on and never reaching agreement between loaners and borrowers.

In theory, debt should not matter at all because there is no debt in aggregate (i.e. every liability is someone else's asset). I have actually heard a prominent economist argue this and maintain that therefore a decline in labor productivity is the only explanation for our current state. The Austrian view would focus on the misallocation of capital created by distortions in the money supply while Keynsians would talk about "animal spirits" run amok. Either way, the economy is saddled with the burden of not only debt, but a glut of unproductive assets (i.e. neighborhoods of mcmansions outside of Las Vegas) and a large segment of the workforce that needs to be reallocated (mortgage underwriters, real estate agents etc). The net effect of mass deleveraging and the realignment of large segments of the workforce is a large decline in aggregate demand and drop in the velocity of money

 

[talk2glenn]

What's not clear is why the downturn from financial panics must be long. Could it be because governments inevitably interfere with markets clearing, as the US government has clearly done in our recent case (Home Affordable Modification Program, etc)?

I don't know that this follows at all. While I am sympathetic to the argument that government price interventions prevent market clearing in the abstract, it is also apparent that they can have a stabilizing effect during periods of crisis - shallower troughs paid for with shorter peaks if you will. This argument is premised on the intervention being temporary and counter cyclical, of course.

The overriding problem during periods of fiscal crisis is asset deflation. Given that prices are falling, there is no incentive for consumers to buy. Rightly, they respond to the expectation that an asset will be cheaper tomorrow by deferring purchases. On the other hand, producers (or asset holders) have an incentive to sell. Rightly, they respond to the expectation that their asset is depreciating by trying to get rid of it as quickly as possible. This makes the supply problem worse, and creates a repeating cyclical downturn. Absent any public intervention, there is every theoretical and empirical reason to expect the downturns to be long and dramatic (though it is not the case that given intervention the downturns necessarily won't be).

Government can act, in an advertised short-run, to either encourage the purchase or delay the sale of the depreciating asset as a mechanism for stabilizing the price. The long-run price trend is unchanged, but instead of a dramatic fall today followed by a dramatic rise tomorrow, we get a relatively stable transitory period as planned future consumption is moved forward. There is some evidence that this worked with the automobile market, and some evidence that is has thus far failed in the housing market. The latter is more likely due to the problems scale being greater than the states effort, rather than a principled failure of the concept.

In theory, debt should not matter at all because there is no debt in aggregate (i.e. every liability is someone else's asset).

True only if the bond market is operating efficiently. You can't simply look at what is, but also what could be. It is not at all clear that the present debt market is efficiently allocated. Substantial debt is tied up in relatively risky real property notes of questionable worth, and a significant portion of the new debt issues is public. While it is not clear that we are presently dealing with substantial problems from the latter (though we certainly will be at some point, as the economy returns to full employment), it is certainly true that the former continues to pose systemic problems.

This returns us to my previous point: the state has an interest in assisting the debt market with deleveraging by offering to buy up the "troubled assets". Granted, this must be balanced against the moral hazard such an occupation creates.

 

[mheslep]

In theory, debt should not matter at all because there is no debt in aggregate (i.e. every liability is someone else's asset). I have actually heard a prominent economist argue this and maintain that therefore a decline in labor productivity is the only explanation for our current state.

Yes I've heard the idea.

The Austrian view would focus on the misallocation of capital created by distortions in the money supply while Keynsians would talk about "animal spirits" run amok.

Yep

Either way, the economy is saddled with the burden of not only debt, but a glut of unproductive assets (i.e. neighborhoods of mcmansions outside of Las Vegas) and a large segment of the workforce that needs to be reallocated (mortgage underwriters, real estate agents etc).

There we disagree. Yes this is indeed currently the case, but I don't see that it is necessarily required. Allow the price of those mcmansions to fall sufficiently and allow the market to operate and it seems to me they must turnover as, say, rental properties, office space, etc; that's what happened with http://en.wikipedia.org/wiki/Resolution_Trust_Corporation" which cleared $394 billion in assets.* That is, if the action is taken quickly enough. Allow those properties to sit in limbo long enough with foreclosure blocks or mortgage prop ups preventing market operation and yes those neighborhoods may decline to the point of no return (ala Detroit).

*Interestingly I don't see the S&L scandal mentioned by Reinhart and Rogoff. Maybe that's a flaw in their work in that they look only full blown financial crises at the national level, and not at financial crises that were contained before they became epidemic.

 

[mheslep]

.

The overriding problem during periods of fiscal crisis is asset deflation. Given that prices are falling, there is no incentive for consumers to buy. Rightly, they respond to the expectation that an asset will be cheaper tomorrow by deferring purchases.

Exactly. There's no getting around that expectation, other than allowing the market to reach bottom as assessed by the players. In large markets like housing I fail to see how the government can fundamentally change this expectation.

... On the other hand, producers (or asset holders) have an incentive to sell. Rightly, they respond to the expectation that their asset is depreciating by trying to get rid of it as quickly as possible. This makes the supply problem worse, and creates a repeating cyclical downturn. Absent any public intervention, there is every theoretical and empirical reason to expect the downturns to be long and dramatic (though it is not the case that given intervention the downturns necessarily won't be)...

The logic of that argument is markets don't work in downturns; that any time there is a downturn it will continue forever but for the saving action of the government. All the government can substantially do here, and has done it seems to me, is interfere with the decline, interminably slow it down, and thus prolong a year or two of declining economic activity into perhaps ten.

 

[WhoWee]

If a company has a bad debt on the books they have 2 basic options. They can either dispose of the account- write off/liquidate, or keep the account - renegotiate/extend terms. If they write it off and/or sell the debt to another party, it will have an immediate impact on the financial statement. If they re-negotiate, it stays on the books - continues to be a risk - but MIGHT generate a higher return than selling at a loss. It might also be possible to renegotiate - then sell the account to achieve a better return. An involvement of the Government in this process would certainly complicate the decision making.

 

[BWV]

I should add what is missing in the debt discussion is the banking system. What defines a systemic financial crisis is that losses on bad debts render the banking system insolvent. In the days before deposit insurance (like the 1870s or the Great Depression) that mean individual savings were wiped out in bank failures. In modern economies that means public funds are used to prop up the system. In either case, the volume of distressed assets dwarfs the potential market for them and the paradox of thrift comes into play - i.e. everyone cannot sell assets and deleverage at once without starting a deflationary spiral -Debt liquidations depress asset prices, the declining asset prices in turn render formerly solvent firm insolvent which then liquidate, etc. The other effect of this destruction of credit is that the money supply contracts.

The 1980s S&L crisis by this definition was not a systemic financial crises because it was regional and the banking system in aggregate remained solvent.

Irving Fisher, the Yale economist (unjustly remembered by the public only for his remark about the stock market in 1929 being on a permanently high plateau) probably identified these dynamics first in his 1933 book:

Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links: (1) Debt liquidation leads to distress setting and to (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes (3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be (4) A still greater fall in the net worths of business, precipitating bankruptcies and (5) A like fall in profits, which in a ” capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies, and unemployment, lead to (7) Pessimism and loss of confidence, which in turn lead to (8) Hoarding and slowing down still more the velocity of circulation.

The above eight changes cause (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.
Evidently debt and deflation go far toward explaining a great mass of phenomena in a very simple logical way.

http://seekingalpha.com/article/104135-irving-fisher-on-debt-deflation-and-depression

 

[LaurieAG]

Compared with 1929 US House price losses almost doubled while unemployment almost halved.

I should add what is missing in the debt discussion is the banking system.

What factors could cause this type of local inverse correlation?