The Ideas Report For Serious Investors

Harvard economics professor Kenneth Rogoff has published a paper (13-page PDF file) and study (82-page PDF file) examining the potential aftermath of the financial implosion we've experienced in recent months. Here's an overview of the two most recent publications, both of which provide a level of analysis and insight that is rarely found in analyses of the ongoing crisis.

The Aftermath of Financial Crises (with Carmen M. Reinhart), manuscript, Harvard University, December 2008. Paper prepared for the American Economic Association Meetings in San Francisco, January 3, 2009.

Introduction:

A year ago, we (Carmen M. Reinhart and Kenneth S. Rogoff, 2008a) presented a historical analysis comparing the run-up to the 2007 U.S. subprime financial crisis with the antecedents of other banking crises in advanced economies since World War II. We showed that standard indicators for the United States, such as asset price inflation, rising leverage, large sustained current account deficits, and a slowing trajectory of economic growth, exhibited virtually all the signs of a country on the verge of a financial crisis—indeed, a severe one. In this paper, we engage in a similar comparative historical analysis that is focused on the aftermath of systemic banking crises.

In our earlier analysis, we deliberately excluded emerging market countries from the comparison set, in order not to appear to engage in hyperbole. After all, the United States is a highly sophisticated global financial center. What can advanced economies possibly have in common with emerging markets when it comes to banking crises? In fact, as Reinhart and Rogoff (2008b) demonstrate, the antecedents and aftermath of banking crises in rich countries and emerging markets have a surprising amount in common. There are broadly similar patterns in housing and equity prices,  unemployment, government revenues and debt. Furthermore, the frequency or incidence of crises does not differ much historically, even if comparisons are limited to the post–World War II period (provided the ongoing late-2000s global financial crisis is taken into account). Thus, this study of the aftermath of severe financial crises includes a number of recent emerging market cases to expand the relevant set of comparators. Also included in the comparisons are two prewar developed country episodes for which we have housing price and other relevant data.

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.

Banking Crises: An Equal Opportunity Menace (with Carmen M. Reinhart), manuscript, Harvard University, December 2008. Also available as NBER Working Paper No. 14587, December 2008.

Abstract:

The historical frequency of banking crises is quite similar in high- and middle-to-low income countries, with quantitative and qualitative parallels in both the run-ups and the aftermath. We establish these regularities using a unique dataset spanning from Denmark’s financial panic during the Napoleonic War to the ongoing global financial crisis sparked by subprime mortgage defaults in the United States.

Banking crises dramatically weaken fiscal positions in both groups, with government revenues invariably contracting, and fiscal expenditures often expanding sharply. Three years after a financial crisis central government debt increases, on average, by about 86 percent. Thus the fiscal burden of banking crisis extends far beyond the commonly cited cost of the bailouts.

Our new dataset includes housing price data for emerging markets; these allow us to show that the real estate price cycles around banking crises are similar in duration and amplitude to those in advanced economies, with the busts averaging four to six years. Corroborating earlier work, we find that systemic banking crises are typically preceded by asset price bubbles, large capital inflows and credit booms, in rich and poor  countries alike.

Introduction:

Until very recently, the study of banking crises has typically focused either on earlier historical experiences in advanced countries, mainly the banking panics before World War II, or else has focused on modern-day emerging market experiences. This dichotomy is perhaps shaped by the belief that for advanced economies, destabilizing, systemic, multi-country financial crises were a relic of the past. Of course, the recent global financial crisis emanating out of the United States and Europe has dashed this misconception, albeit at great social cost.

As this paper will demonstrate, banking crises have long been an equal opportunity menace. We develop this finding using a core sample of sixty-six countries (plus a broader extended sample for some exercises).  We examine banking crises ranging from Denmark’s financial panic during the Napoleonic War to the current “first global financial crisis of the 21st century.” The incidence of banking crises proves to be remarkably similar in the high- and middle-to-low-income countries. Indeed, the tally of crises is particularly high for the world’s financial centers: the United Kingdom, the United States, and France. Perhaps more surprising still are the qualitative and quantitative parallels across disparate income groups. These parallels arise despite the relatively pristine modern sovereign default records of the rich countries.

Three features of our expansive dataset are of particular note.

• First, our data on global banking crises go back to 1800, extending the careful study of Bordo, et al. (2001) that covers back to 1880.
  

• Second, to our knowledge, we are the first to examine the patterns of housing prices around major banking crises in emerging markets, including Asia, Europe and Latin America. Our emerging market data set facilitates comparisons, across both duration and magnitude, with the better-documented housing price cycles in the advanced economies, which have long been known to play a central role in financial crises. We find that real estate price cycles around banking crises are similar in duration and amplitude across the two groups of countries. This result is surprising given that almost all other macroeconomic and financial time series (income, consumption, government spending, interest rates, etc.) exhibit higher volatility in emerging markets.

• Third, our analysis employs the comprehensive historical data on central government tax revenues and debt compiled in Reinhart and Rogoff (2008). These new data afford a new perspective on the tax and debt consequences of the banking crises (Previously, the kind of historical data on debt necessary to analyze the aftermath of banking crises across countries was virtually non-existent for years prior to 1990.)

We find that banking crises almost invariably lead to sharp declines in tax revenues as well significant increases in government spending (a share of which is presumably dissipative). On average, government debt rises by 86 percent during the three years following a banking crisis. These indirect fiscal consequences are thus an order of magnitude larger than the usual bank bailout costs that are the centerpiece of most previous studies. That fact that the magnitudes are comparable in advanced and emerging market economies is also quite remarkable. Obviously, both the bailout costs and the fiscal costs depend on a host of political and economic factors, including especially the policy response as well as the severity of the real shock which, typically, triggers the crisis.

The paper proceeds as follows. Section II provides an overview of the history of banking crises, with particular emphasis on the post-1900 experience. We also document the incidence and frequency of banking crises by country and by region. We discuss the links between banking crises, financial liberalization, the degree of capital mobility, and sovereign debt crises and discuss international financial contagion.

Section III examines some of the common features in the run-up to banking crises across countries and regions over time. The focus is on the systematic links between cycles in international capital flows, credit, and asset prices—specifically, home and equity prices. The next section examines some of the common features of the aftermath of banking crises. We document the toll that the crisis takes on output and government revenues, as well as the typically profound effect on the evolution of government debt during the years following the crisis. The concluding section takes up the question of “graduation.” Specifically, to what extent do countries ever “graduate” from (stop experiencing) serial major financial crises as they seem to graduate from serial sovereign debt crises?

The Harvard Economics Department hosts a collection of Kenneth Rogoff's recent writings.