Ideas@TheCentre
The aftermath of financial crises
Financial markets here and abroad are again in a funk over a raft of disappointing economic indicators in the United States, Europe and Japan. Day-to-day market commentary isn’t our forte, but it is timely to recall some of the lessons of economic history. Nobody should really be surprised that economic growth in the developed northern hemisphere countries is sluggish in the aftermath of the world’s most severe financial crisis in decades. We should expect more of the same.
The work of researchers such as the American academics Carmen Reinhart and Kenneth Rogoff shows why this gloomy prognosis is realistic. They have trawled through the history of financial crises in painstaking detail and concluded that deep recessions and slow recoveries are the norm after financial crises. The normal business cycle profile, featuring ‘V’ shaped recoveries back to full capacity utilisation and full employment, doesn’t apply because businesses and households are struggling to deleverage. This crisis was made especially toxic by the fact that it originated in the world’s biggest economy and financial centre and that the housing sector was at the heart of the crisis.
Another consistent feature found by Reinhart and Rogoff is that government debt levels explode in the aftermath of financial crises. This in itself can sap the energy of economic recovery. It can even become a long-term drag on economic growth if public debt reaches a certain threshold, quantified by Reinhart and Rogoff as 90% of GDP. Some countries have already passed that level; others are fast approaching.
None of this suggests that we should expect a double-dip recession in the big economies, let alone a return to the despair of 2008–09. But there is every reason to expect low growth and high unemployment to persist for some years in the world’s biggest developed economies. Australia and the emerging economies are better placed, but here too the household sector is being cautious, saving more, and deleveraging.
Robert Carling is a Senior Fellow at The Centre for Independent Studies.
