Mind Your Value Judgments of the U.S. Economy

Dec.22.08 | About: SPDR S&P (SPY)

In the leadup to government bailouts this year, a number of commentators said that if the U.S. did succumb to some sort of systemic crisis, it would have shown that despite its wealth, it's no better than a banana-republic. But this view is now being challenged by Ken Rogoff and Carmen Reinhart. In a new NBER paper examining crises in 66 advanced and emerging countries since 1800, they find that:

[N]ot only is the frequency and duration of banking crises similar across developed countries and middle-income countries, so too are quantitative measures of both the run-up and the fall-out. Notably, the duration of real housing price declines following financial crises in both groups are often four years or more, while the magnitudes of the crash are comparable. One striking finding is the huge surge in debt most countries experience in the wake of a financial crisis, with real central government debt typically increasing by about 86 percent on average (in real terms) during the three years following the crisis.

There is one big difference between developing- and advanced-country financial meltdowns, though, which is that the former are typically government default-related while advanced economies have been experiencing "serial" banking crises since the the early 1970's with the end of the Bretton-Woods system.

Rogoff and Reinhart also argue that trying to put a dollar value on the cost of bailouts is "misguided and incomplete" because "the fiscal consequences of banking crises reach far beyond the more immediate bailout costs." Government revenues are severely hit for two to three years after a crisis, and again it doesn't much matter if the country is developing or advanced. In the following chart the blue bars show the average percentage change in tax revenues for advanced economies three years before and after a crisis first develops. The red bar shows the average for the five worst cases -- click here for larger image:


The real loser in crises, however is government debt levels. During the average meltdown, government obligations grew by an immense 83 percent three years after the financial shock. (If that happens in the U.S., by 2010 our national debt would be close to $19 trillion.)

The paper is the latest in a growing list of crises retrospectives, which already includes Rogoff and Reinhart's contribution from last year.