What happens after a long, severe financial crisis?

We might like to think that our recent financial crisis is unique, but it has been experienced by several countries, including the United States in 1929. Economists at the University of Maryland, Harvard University and the National Bureau of Economic Research have recently written extensively about what happens after such a financial debacle.

Carmen M. Reinhart of Maryland and Kenneth S. Rogoff of Harvard presented a paper on the Aftermath of Financial Crises at the January meeting of the American Economic Association in San Francisco — it can be found at www.economics.harvard.edu/files/faculty/51_Aftermath.pdf. Incidentally, in early 2008, using 2007 data, the same authors documented that the country was on the verge of a severe financial crisis.

The authors focus on 10 major financial crises in the developed world since 1899 for which relevant data is available. Their data show that the antecedents and aftermath of banking crises in rich countries and emerging markets have much in common. There are broadly similar patterns in housing and equity prices, unemployment, government revenues and debt. Historically, the frequency and incidence of financial crises has not changed markedly in the last century.

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Three characteristics

Major financial crises are generally protracted affairs and share three broad characteristics. First, asset market collapses are deep and prolonged with real housing prices declining 35 percent over a six-year period. Equity price declines averaged 55 percent over a 3.5-year period.

If we assume that U.S. housing prices peaked in 2005, the decline should be over in 2011. Fortunately, housing price declines in the Northern Colorado market have been very small but my data show the leveling-out should be over by spring 2011.

Equity prices, measured by the Dow Jones 30 Industrials, peaked in late 2007 and, we hope, bottomed this past March, only 18 months later. That decline is two years shorter than the average. Some analysts, however, are predicting that the recent rally is a bear-market trap and we will soon see new lows in equity market indices.

Second, the aftermath of banking crises is associated with major declines in output and employment. The unemployment rate rises 7 percentage points over a period of four years and output falls 9 percent over a period of two years.

The U.S. recession started in December 2007 and, perhaps, ended in August after 21 months, just shorter than the average and about as severe in terms of lost output. Unemployment is a trailing indicator and will continue to increase, perhaps well into 2010.

Unemployment in Northern Colorado bottomed in the second quarter of 2007 at about 3.3 percent. I hope it peaked at 7.5 percent early this year, making this a much milder employment recession than normal for countrywide financial crises.

Third, the real value of government debt explodes, rising on average 86 percent. The main cause of debt explosions is not bailing out and recapitalizing the financial system. The biggest cause of national debt increases is the collapse in tax revenues and the ambitious countercyclical fiscal policies invoked to mitigate the recession. These Keynesian policy reactions have been normal and widely used since suggested by the British economist in the early 1930s.

The increase in federal government debt is likely to be greater than the average because of the two wars we are fighting, the decay of our national infrastructure, and the untimely 10-year tax cuts of the previous administration.

What’s ahead?

In their analysis, Reinhart and Rogoff note that the current housing price decline is already more than twice that experienced during the Great Depression. They state that greater downward wage flexibility and fewer social safety nets in emerging markets help cushion employment declines. They conclude that multiyear recessions typically only occur in economies that require deep restructuring beyond mere reworking of the financial system.

The most noteworthy statement the authors make, however, is that we would be wise not to push too far the conceit that we are smarter than our predecessors. Not long ago, many people were saying that improvements in financial engineering had tamed the business cycle and eliminated the risk of financial collapse.

The global nature of the current financial crisis will make it very difficult for many countries to grow their way out of recession by increasing imports or using foreign borrowing. China is currently trying to grow its way out by increasing domestic consumption and exporting to the rest of the world. The United States is following the foreign borrowing route.

In Northern Colorado, I expect housing prices to be increasing early in 2011, unemployment to peak by mid-2010, consumer spending to recover at the same time, and Gross Regional Product to be growing, year-over-year, for much of 2010. We just need to get through the next six months.

John W. Green is a regional economist who compiles the Northern Colorado Business Report’s Index of Leading Economic Indicators. He can be reached at jwgreen@frii.com.