Their title is meant to be ironic. “This time is different” is what policy makers always say before a bubble bursts. Yet each time, according to the authors, the results are fundamentally the same.
But while there are strong patterns in the authors’ mountains of data, this simple summary misses an important fact: There’s dramatic variation in the aftermaths of crises, and much of it is caused by how policy makers respond. This history has important implications today.
Economists have long known that financial crises can devastate an economy for years. “A Monetary History of the United States,” by Milton Friedman and Anna Schwartz, showed in agonizing detail the impact of uncontrolled banking panics in the Great Depression. And previous studies have shown that recessions that involve crises are, on average, more severe than those that don’t.
The Reinhart-Rogoff study emphasizes common patterns across crises. It eschews complicated statistical techniques, relying instead on simple graphs and averages. And the averages are stunning. For 14 major crises since 1929, the associated decline in real per capita gross domestic product averaged 9.3 percent. For postwar crises, it took an average of 4.4 years for output to return to its pre-crisis level.
But study their charts more closely and you’ll find that those averages mask remarkable variation. Norway had only a slight decline in per capita G.D.P. — around 1 percent — after its 1987 crisis, and output was back to its previous level in just three years. By contrast, real per capita G.D.P. in Argentina fell more than 20 percent in conjunction with its 2001 crisis, and took eight years to recover.
The Depression illustrates the variability vividly. Real per capita G.D.P. fell nearly 30 percent in the United States, and didn’t return to its pre-crisis level for a decade. But in Spain, it fell only 9 percent in the Depression as a whole, and actually rose in the year after its 1931 banking crisis.
There was even huge variation within the United States during this period. The Friedman-Schwartz study found four distinct waves of banking panics in the early 1930s. After the first three, output plummeted. But after the last one, in early 1933, output skyrocketed, with industrial production rising nearly 60 percent from March to July. That time was very different.
What explains the variations? Crises don’t happen in isolation. They’re often accompanied by other factors, which differ across episodes. For example, financial crises that happen along with currency crises tend to be followed by much more severe recessions.
Likewise, some panics follow particularly big declines in house and stock prices, which have damaging effects on their own. The most recent recession would likely have been severe — and the recovery slow — even if the financial system hadn’t been stressed, simply because of the decline in wealth and the climb in household indebtedness.
BUT an even larger determining factor is the policy response. Why was the Great Depression so much worse here than in Spain? According to an influential paper by Ehsan Choudhri and Levis Kochin, Spain benefited from not being on the gold standard. Its central bank was able to lend freely and increase the money supply after the panic. By contrast, in 1931, the Federal Reserve in the United States raised interest rates to defend its gold reserves and stay on the gold standard, setting off further declines in output and exacerbating the banking crisis.
Likewise, the policy response largely explains why output fell after the American banking panics in 1930 and 1931, but rose after the final wave in early 1933. After the first waves, the Fed did little, and President Herbert Hoover signed a big tax increase to replenish revenue. After the final wave, President Franklin D. Roosevelt abandoned the gold standard, increased the money supply and began a program of New Deal spending.
A 2009 study by the International Monetary Fund concluded that fiscal expansion can mitigate the impact of crises. But the Reinhart-Rogoff study points out that policy makers’ ability to take strong fiscal action depends on whether they start with high levels of debt. In the current episode, China and South Korea have recovered faster, partly because they have taken more aggressive fiscal stimulus measures. They could do that because they entered the crisis in good fiscal health.
The response to troubles in the banking system also matters. After its banking panic in 1991, Sweden aggressively restored its banks to health. They were nationalized, recapitalized with public funds, and then returned to private control. After three rough years, Sweden grew rapidly, soon returning to its pre-crisis trend.
Japan, by contrast, put off cleaning up its banks after its 1992 crisis. For years, it allowed financial institutions to avoid realizing losses by simply rolling over loans to unproductive or failing companies. Partly as a result, it has struggled almost two decades with anemic growth and deflation. And, unlike Sweden, it is still miles from its pre-crisis trajectory.
So where does this more nuanced interpretation of the evidence leave us? First, as the extreme cases show, financial crises matter. Left uncontrolled, they can leave an economy in shambles for years. So policy makers need to make the financial system less prone to crises, and to fight panics aggressively when they arise. This is a lesson that European leaders, sitting on the edge of a financial meltdown and dithering over a solution, should keep foremost in their minds. And it’s a cautionary tale for those who’d hinder worldwide attempts at stricter financial regulation.
Second, the importance of the policy response in determining the effects of crises argues strongly against complacency here at home. A country as creditworthy as the United States can continue to use fiscal stimulus to help return the economy to full employment. And, as I argued in a previous column, there’s much more the Fed could be doing. Whether we continue to fester or finally embark on a robust recovery depends on whether we choose to use the tools available.
Finally, governments around the world, including our own, should remember that it helps to be in sound fiscal shape before a crisis hits. When we’re all finally through the current mess, governments should rededicate themselves to fiscal responsibility. Being careful in good times gives policy makers the ability to fight crises in bad ones.
Christina D. Romer is an economics professor at the University of California, Berkeley, and was the chairwoman of President Obama’s Council of Economic Advisers.
Article source: http://www.nytimes.com/2011/12/18/business/financial-crises-impact-varies-widely-economic-view.html?partner=rss&emc=rss
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