The Aftermath of Financial Crises
In today’s Barron’s, Alan Abelson discusses a Reinhart & Rogoff paper (The Aftermath of Financial Crises) which (quite oddly) was the subject of the last speaker’s presentation on Thursday’s Cayman Business Outlook.
Note that we have discussed the fine work of R&R previously (here and here)
Abelson quotes broadly from their most recent paper:
They cite three defining elements of the aftermaths of severe financial crises. First, asset markets of just about every kind suffer a bruising and prolonged battering. On average, for instance, real housing prices plunge 35%, and the agony stretches out over six years, while equity prices lose a whopping 55% over roughly 3½ years.
Second, output and jobs take it on the chin: The unemployment rate shoots up (again, on average) 7 percentage points over four years. Meanwhile, gross domestic product suffers losses averaging more than 9%, but — scant consolation — it happens more quickly, typically in two years or so.
Third, the real value of government debt tends to explode, shooting up an average 86% in the major post-war slumps. Reinhart and Rogoff contend that the huge swelling of such debt owes not, as commonly believed, primarily to bank bailouts and handouts (see, the banks aren’t even very good at raiding the Treasury). What really kites government IOUs, they say, is the drastic shrinkage in tax revenues generated by faltering economies and the “often ambitious countercyclical fiscal policies aimed at mitigating the downturn.” (A timely, obvious example is that $825 billion stimulus package the new administration has its heart set on.)”
But for the full effect, you should go read the original — that’s your weekend homnework assignment. Meanwhile, here’s a paragraph
“Broadly speaking, financial crises are protracted affairs. More often than not, the aftermath of severe financial crises share three characteristics. First, asset market collapses are deep and prolonged. Real housing price declines average 35 percent stretched out over six years, while equity price collapses average 55 percent over a downturn of about three and a half years. Second, the aftermath of banking crises is associated with 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. Output falls (from peak to trough) an average of over 9 percent, although the duration of the downturn, averaging roughly two years, is considerably shorter than for unemployment. Third, the real value of government debt tends to explode, rising an average of 86 percent in the major post–World War II episodes. Interestingly, the main cause of debt explosions is not the widely cited costs of bailing out and recapitalizing the banking system. Admittedly, bailout costs are difficult to measure, and there is considerable divergence among estimates from competing studies. But even upper-bound estimates pale next to actual measured rises in public debt. In fact, the big drivers of debt increases are the inevitable collapse in tax revenues that governments suffer in the wake of deep and prolonged output contractions, as well as often ambitious countercyclical fiscal policies aimed at mitigating the downturn.”
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Sources:
The Aftermath of Financial Crises
Carmen M. Reinhart
University of Maryland. NBER and CEPR
Kenneth S. Rogoff
Harvard University and NBER
December 19, 2008
http://www.economics.harvard.edu/faculty/rogoff/files/Aftermath.pdf
Woe Is Us
ALAN ABELSON
UP AND DOWN WALL STREET
Barron’s JANUARY 24, 2009
http://online.barrons.com/article/SB123275464233911671.html
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January 24th, 2009 at 11:43 am
In the last paragraph of that paper, they mention that all of the historical comparisons were based on episodes that were individual or regional in nature. That’s scary. Who knows the impact of the global nature of this financial crisis.
January 24th, 2009 at 12:23 pm
He speaks “on average.” How many financial crises have there been 3? Not a big sample size to work with.
~~~
BR: There have been 150 major financial cries over the past 2 centuries. . . .
January 24th, 2009 at 12:46 pm
I wish the government would reconsider the stimulus package- what are we trying to stimulate- we have a overburdened populace w/ too much debt on their hands. Any money going to taxpayers will most likely be used to pay bills and put into savings “to hunker down and tough it out”. Lets stop the madness- negative real interest rates and easy money got us into this mess- why continue down that road. America does not have to resume the role of “world consumer”; we can change ourselves from the “decadent self indulgent consumption oriented society” we have become.
January 24th, 2009 at 1:35 pm
Japan’s crisis lingered, say the authors, because the country had to restructure its economy (to accomodate the growth of China’s export potential.) Clearly, we will need restructuring too, but at least Japan had an export economy to work with. How do we restructure a consumption economy built on credit? And how long will that take?
January 24th, 2009 at 2:15 pm
@ BR: “There have been 150 major financial cries over the past 2 centuries. . . .”
… and haven’t they learned anything from this? I believe they saw this coming and did nothing about it. That’s my final answer!
January 24th, 2009 at 2:18 pm
Good Paper.
This fundamental analysis correlates well with what the technical picture predicts for Unemployment Rates and Equities: 10.25% Unemployment Rate and 600 on the S&P 500.
Some of the more interesting takeaways for me….
Figure 2: Real Equity Price Declines.
While the average decline is 55%, the striking feature for me is the frequency of 58-66% declines peak to trough. Not surprising to an Elliotician is that the greatest number of occurrences converge on 61.8%, a magical number for a few. Of course, we all tend to “see what we want to see.” While the sample size of modern financial crises is small, one cannot help to see the consistency of 58-66% equity declines. Applied to the S&P500, this targets around 600.
Figure 2: Duration of Equity Declines.
This surprised me. I would have thought that equity declines would have lasted longer than 3+ average. What is more surprising is that 9 of the 13 past crises saw ONLY 2-3 year declines. This suggests we should see a bottom in stocks between late 2009 – late 2010. Interestingly, the Wave analysis suggests that this bear could last ~2.5 years, to match the duration of the 2000/2 decline. This coincides rather nicely with the Reinhardt and Rogoff analysis.
Figure 4.
That GDP declines only last around 2 Years is also really surprising after a crisis. What’s interesting though is that equity declines lasted LONGER than GDP declines. You would think, if these were “efficient” markets, the equity declines might be equivalent. Theoretically, the stocks should have tumbled well before the GDP turned down and then turned up before GDP was bottoming. This should give some Stock market bulls some concern. The economy may “turn around in late 2009″ as many are predicting, but it MAY not mean much for stocks. I’m would think this occurs because of the Governmental influence on GDP. The GDP stops contracting because of Government stimulus, but the private sector, and stocks, continue to suck wind.
Homework assignment complete….
January 24th, 2009 at 2:55 pm
The other interesting point the authors made was that the unemployment in less developed countries does not rise anywhere near what occurs in more developed countries. The attribute you this to greater wage flexibility (lower).
I think this is an interesting point that should be debated– repealing minimum wage rules. Of course it won’t be debated, but the presence of minimum wage rules, which “feel” good as assets are rising and inflation is screaming, can have some really adverse affects in deflationary spiral/depression. I know that very few people, relatively speaking, work for minimum wage, but perhaps when the shit starts really hitting the fan, more people would be “willing” to work for something less than min. wage in order to survive.
January 24th, 2009 at 3:40 pm
“I know that very few people, relatively speaking, work for minimum wage, but perhaps when the shit starts really hitting the fan, more people would be “willing” to work for something less than min. wage in order to survive.”
Starvation and desperation as economic motivator…nice. My prediction, soaring violent crime and suicides rates.
January 24th, 2009 at 3:44 pm
If there have been 150 crises in the last 200 years, then this situation requires a new name…how about “ruinous debt deflation”?
January 24th, 2009 at 3:46 pm
@Andy Tabbo at 2:18
Liek the good economists they are, R&R calculate all numbers in real terms correcting for inflation/deflation. Thus the paper shows real equity price declines for the US (1929) and Japan (1992) of about 65% and 60% respectively because those two crises resulted in significant deflation. The nominal peak to trough equity declines in those two crises where more like 90% and 80% respectively. If the current deflationary trend continues it might be a mistake to go all in at S&P 600.
January 24th, 2009 at 3:59 pm
Someone always benefits from these crises even if they didn’t engineer them. Same shit, different day.
http://www.alternet.org/story/121243/obama_should_worry_about_the_bush_family_tentacles_undermining_his_plans/
January 24th, 2009 at 4:17 pm
mark:
Noted. And it’s a good point.
in re: 600 on SP500. I’m not recommending going all in at 600. My trading strategy will be to cover shorts below 650. In terms of entering trades, I like to wait for the market “reverse hard” from a theoretical support or resistance area first. And then, once I see a strong reversal, I will enter a trade on some retracement. I use to like trying to be a ‘hero,’ but have lost too much fading big moves.
I don’t have any support for the S&P500 below 595. The next support comes in low 300′s…..So as a citizen of the U.S. I’m really rooting for 600 to hold.
January 24th, 2009 at 4:19 pm
Drivel.
What what what?
1. Assets Down
2. Employment Down Brilliant
3. Debt Up
But there is more: An Insight Not Bailout ( although we can’t measure ) but Tax Rev.Decline.
Thank god, I hadn’t thought about a decrease in tax revenue. Won’t the tax cuts proposed increase revenue?
Would you let Rogoff educate your children?
January 24th, 2009 at 5:39 pm
@AGG Dead on. Kudos. Thanks. What a tangled web they weave. But so incredibly simple. It precedes.
“They could afford to be generous” Adam Smith.
January 24th, 2009 at 5:59 pm
I’m impressed by the size of the sample size, but c’mon — Finland, Colombia, the Philippines, Hungary. What do these countries have in common economically with ours? Their equity markets are tiny & parochial, and who can even begin to comment on the peculiarities of their real estate markets. Even he oft-cited example of Japan doesn’t really tell us that much about our own predicament — so many of the fundamentals are just vastly different. So in this end, this paper merely tells us that financial crises have crushing consequences. i think we have figured that one out on our own, and what this tells about when our equity markets are going to recover or real estate is going to bottom is precisely zero.
January 24th, 2009 at 6:42 pm
All the examples in R & R are crises in a single country or region, not one global financial crisis except for 1929. Whereas the example financial crisis countries are embedded in a healthy global economy (again except 1929), that is not the case this time.
Still, the data are useful.
January 24th, 2009 at 8:40 pm
I don’t know why anyone listens to a bunch of egg-headed profs when the businessmen of our planet have performed such exemplary service: Madoff, Weill, O’Neal, Ebbers, Kozlowski, Lay… the list of the business Hall of Fame is endless. How dare these gov’t know-nothings interfere with the great and good.
On Minkow, On Blodget, On Pinez.
On Hamanaka, On Kerviel, On Ragu
I bow down to the geniuses in the office suite. May your tax cuts be deep. May your private jets be given right-of-way, may your greatness fill the scores of musical dramas for the ages.
January 24th, 2009 at 9:02 pm
i shouldn’t even jump into this conversation, but if you guys think the spx is headed to 600 in the near term, you will be severely burned. read this by kasriel (a favorite of mine) and bangalore: http://www.safehaven.com/article-12412.htm
also, before andy renamed me mistress of the stick, i was known as chicken little… the sky did fall, and now we are picking up the pieces…
January 24th, 2009 at 9:58 pm
O’ Mistress….
The SPX will trade with a 6 handle this year. Of this, I have very little doubt.
In the very near term…who knows? We may get a little more rally here….We may even see the 900′s again. (I can make a bull argument for 900+). Afterall, this is the time of year the market “should” be rallying. I see the market in sort of a little no-man’s land right now. If we rally anywhere close to 900 I would be a scale up seller. I have Sell Stops in place below 800. If SPX trades below 780 I would sell more. 650 bid.
In re: Kasriel and Bangalore….I actually agree with them in regard to economic activity bottoming in late 2009 and 2010. This doesn’t mean the SPX will bottom, though. That was one of my takeaways from that Rogoff analysis.
Good Luck.
January 24th, 2009 at 10:23 pm
The market may actually be fairly valued at this infinitesimal point in time…but it is still going much lower because:
1) Earnings will be getting much worse
2) It overshot on the upside for so long, it will now overshoot on the downside
3) Deflation works on stock prices too
4) Interest rates will rise over the longer term, and this is necessarily a major headwind for equities.
January 25th, 2009 at 10:17 am
150 crises in 200 years, a crisis every 15 months? That sounds like runaway crisis inflation. BR, How many of these were US based? TIA
Was the great depression a single crisis?
Anyway, without quibbling, when there is a crisis asset values decline a lot, unemployment and government deficits go up a lot and it lasts a long time.
1)unemployment is climbing rapidly
2)government deficits have been setting records yearly for 8 mostly good years
3)the admitted recession is 13 mos old now – with the post war record at 16 mos
4)asset values have declined a lot, thus far
what is in the offing?
1)higher unemployment is a slam dunk, how high is high? How quickly can WPA II make a diff?
2)federal deficits are really beyond comprehension
3)the most optimistic recession forecasts are beyond 16 mos
4)hard to imagine asset values climbing while the first 3 are in fast forward
I’m trying to imagine a scenario where we return to full employment & prosperity, balance the budget and pay down the deficit. The best scenario I can come up with is hyperinflation to balance the budget with higher marginal taxes on hyperinflated salaries and assets, elimination of COLA on entitlement programs to cut real government spending and declare victory and withdraw from Iraq and Afgan.
Maybe if we finally implement alternative energy, conservation and the smart grid the industrialized nations will be able to keep their money at home and allow the sandment to return to their world of internecine bliss.
January 26th, 2009 at 1:10 pm
@ Andy T. -
““willing” to work for something less than min. wage in order to survive.”
survive = get by?
It strikes me that while many would be willing to work for less than min. wage, they would not necessarily be able to survive on that wage; it would be just that “some” wage would be better than none.