The aftermath of financial crises

This draft: December 19, 2008

The Aftermath of Financial Crises* Carmen M. Reinhart University of Maryland. NBER and CEPR Kenneth S. Rogoff Harvard University and NBER

* Paper prepared for presentation at the American Economic Association meetings in San Francisco, Saturday, January 3, 2009 at 10:15 am. Session title: “International Aspects of Financial Market Imperfections.” REINHART(corresponding author): School of Public Policy and Department of Economics, 4105 Van Munching Hall, University of Maryland, College Park, Maryland 20742; email: creinhar@umd.edu; ROGOFF: Economics Department, 231 Littauer Center, Harvard University, Cambridge MA 02138-3001; email: krogoff@harvard.edu. The authors would like to thank Vincent R. Reinhart for helpful comments.

A year ago, we (CarmenM. 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 ofeconomic 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 inhyperbole. 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 patternsin 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 recentemerging 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.

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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 andprolonged. 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 averageover 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 widelycited 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...