Wednesday, 26 August 2009

Economic Recovery after the Crisis - How Long? Lasting Effects?

Yesterday James Hymas of PrefBlog posted on the papers coming out of the recent Jackson Hole Symposium on Financial Stability and Macroeconomic Policy. One of the papers Hymas links to is Financial Crises and Economic Activity, written by Stephen G Cecchetti, Marion Kohler and Christian Upper.

They study the severity and duration of the numerous past banking and financial crises (no less than 124 between 1970 and 2007, out of which they pick 40 since 1980 to dissect). They estimate that the US and the UK will recover to pre-crisis levels of GDP by mid 2010. Japan will have had the shortest but the most severe recession. Canada is not mentioned. I guess that's because it did not have its own banking and financial crisis, it merely got sideswiped by that of the USA and the others.

They also conclude that there is no such thing as an average crisis and therefore trying to predict based on averages is useless. But they do identify a bunch of factors that influence severity of fall and speed of rebound to come up with their estimation, which is couched with the usual "results can vary a lot from the point number".

One interesting observation they make is that countries with sovereign debt crises who default have much shorter and less severe economic contractions. The money that need not be paid back to foreign lenders then gets used to fund domestic expansion. Hmmm, maybe the USA should stiff the Chinese who own so much of their government debt.

The bad news is that recovering to get to where GDP would have grown to had a crisis not occurred takes years, over 4 years on average. That's even when growth is faster after than before the crisis, as it often is. It's a version of the problem all too familiar to investors - a 50% decline needs a subsequent 100% increase merely to get back to the starting point. Worse, some countries have even suffered from on-going long term lower growth rates after the crisis ends, in other words they suffer lasting damage. Will that be the case this time with the USA or the UK?

For investors, possible longer term post-recovery effects - here the authors offer no opinion as to whether we are likely to face any of these negatives - include:
  • higher real interest rates as hugely increased government borrowing crowds out private borrowers, making capital investment costlier
  • rising actual and expected inflation
  • higher risk premia as both estimates of risk go up and willingness to take on risk goes down, which would lower returns of riskier things like stocks as safe haven assets are favoured

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