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Chapter 8. Double Whammy: Crisis and Recession

Author(s):
Ayhan Kose, and Marco Terrones
Published Date:
December 2015
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Chapter Epigraphs

There is a belief among policy makers that serious recessions associated with financial crises are necessarily followed by slow recoveries—like the one we’ve experienced since mid-2009. But this widespread belief is mistaken.

Michael Bordo (2012)

The current weak recovery is unusual because it followed a deep recession. And the fact that the recession was associated with a financial crisis does not invalidate the historical regularity that deep recessions are usually followed by V-shaped recoveries.

John B. Taylor (2013b)

[R]ecessions associated with systemic banking crises tend to be deep and protracted and… this pattern is evident across both history and countries.

Carmen M. Reinhart and Kenneth S. Rogoff (2012c)

The 2009 global recession was a true collapse. It coincided with a global financial crisis and took a heavy toll on the world economy. Are recessions associated with financial crises deeper and longer? And are recoveries that follow such recessions weaker and more protracted?

Different? Or Not?

Many countries experienced financial crises during the global recessions and downturns (Figure 8.1). The latest episode was no exception, but it differed in that there were financial crises in a large number of major advanced economies. The financial crisis was followed by the deepest global recession and the weakest recovery in many of these economies since the Great Depression.

President Obama describes the effects of the 2009 financial crisis on the real economy.

Figure 8.1Financial Crises around Global Recessions and Downturns

(number of crises)

Note: Each bar represents the total number of financial crises that started in the year of the respective global recession or downturn or within two years before or after these events. Financial crises include currency, debt, and banking crises.

Researchers have vigorously debated whether these unpleasant characteristics are related to the severe financial crises in several advanced economies during 2007–09.1 On one side, a number of researchers show that recessions with severe financial market problems often lead to larger contractions in output and last longer. Moreover, they claim that recoveries following such recessions tend to be weaker and slower.2 On the other side, some argue that there is no difference between recoveries following recessions accompanied by financial crises and recoveries following other recessions.3

Recessions, Recoveries, and Financial Crises

To assess whether recessions and recoveries are different when they are associated with financial crises, we employ quarterly data for a core group of advanced economies as in the previous chapter. We use a simple “dating” rule to determine whether a specific recession is associated with a financial crisis. In particular, if a recession started at the same time as or after the beginning of a financial crisis, we consider that recession to be associated with the respective financial crisis. This rule describes a timing association between the two events, but does not imply a causal link. Of the 122 recessions in our sample, 15 are associated with financial crises.4

Recessions associated with financial crises are longer and generally more costly than others. Those associated with the “Big Five” financial crises were particularly costly (Figure 8.2).5 Financial crises are also followed by weak recoveries: it takes as much time to recover to the level of activity reached in the previous peak as the recession itself lasted, whereas cumulative GDP growth in the four quarters after the trough is typically lower than following other types of recessions. For example, cumulative growth one year after the trough for a recession with a financial crisis is 2.5 percentage points lower than in other cases, after controlling for the severity and duration of the previous recession.

Figure 8.2Recessions and Recoveries with Financial Crises: Output

Note: The duration of a recession is the number of quarters from peak to trough. The duration of a recovery is the number of quarters it takes for output to get to the level of the previous peak from the trough. The amplitude of a recession is the change in output from peak to trough, whereas the amplitude of a recovery is the change in output in four quarters following the trough. Duration refers to the average of all episodes, and amplitude is the median of all episodes. Recessions refer to recessions associated with financial crises. Recoveries refer to recoveries that follow recessions associated with financial crises. “Big Five financial crises” refers to the average of recessions associated with the Big Five financial crises: Finland (1990–93), Japan (1993), Norway (1988), Spain (1978–79), and Sweden (1990–93). “Financial crises” refers to the average of recessions associated with financial crises. “Other” refers to the average of other recessions.

Recessions associated with financial crises are often longer and generally more costly than others.

Why Do Crises Produce Different Cyclical Outcomes?

What mechanisms differentiate recessions and recoveries associated with financial crises from those without? A FOCUS box at the end of this chapter summarizes the rich literature that documents that financial crises can prolong and deepen recessions through a variety of channels. To illustrate, sharp declines in asset prices can reduce the net worth of firms and households, limiting their capacity to borrow, invest, and spend. This leads to further drops in asset prices. Banks and other financial institutions might restrict lending when their capital bases diminish during crises, resulting in protracted and deeper recessions.

The substantial changes in the main components of output during recessions reinforce this conclusion. Consumption and investment usually decline much more sharply, leading to more pronounced drops in overall output and employment during recessions coinciding with financial market problems. Moreover, the rate of unemployment typically registers a larger increase during recessions accompanied by financial crises.

Ebullient Expansions Prior to Financial Crises

The nature of expansions that precede financial crises is also an important factor in determining the implications of the associated recessions. These episodes have often been associated with overheated goods and labor markets (Figure 8.3). Relative to other expansions, labor market participation is elevated, nominal wage growth is high, and unemployment is low.

Figure 8.3Expansions prior to Financial Crises: Activity Variables

(in percent)

Note: Each panel shows the median change in the level of the respective variable in the period denoted relative to eight periods before the peak in output. (6)–(8) indicates the change in the respective variable between six periods before and eight periods before the peak in output. (2)–(8) indicates the change in the respective variable between two periods before and eight periods before the peak in output. (0)–(8) indicates the change in the respective variable between the time at the peak in output and eight periods before the peak in output. “Financial crises” refers to the recessions with financial crises. “Other” refers to all other recessions.

In addition, financial markets have often been exuberant, with credit and asset price booms during expansions prior to financial crises (Figure 8.4). The growth rates of credit and asset prices during expansions preceding financial crises are higher than during other expansions.6 Rapid credit growth has typically been associated with shifts in household saving rates and a deterioration in the quality of balance sheets. For example, household saving rates out of disposable income have been noticeably lower in expansions before financial crises. However, after a financial crisis strikes, saving rates increase substantially, especially during recessions.

Figure 8.4Expansions prior to Financial Crises: Financial Variables

(in percent)

Note: Panels show the median change in the level of the respective variable in the period denoted relative to eight periods before the peak in output. (6)–(8) indicates the change in the respective variable between six periods before and eight periods before the peak in output. (2)–(8) indicates the change in the respective variable between two periods before and eight periods before the peak in output. (0)–(8) indicates the change in the respective variable between the time at the peak in output and eight periods before the peak in output. “Financial crises” refers to the recessions with financial crises. “Other” refers to all other recessions.

Taken together, the behavior of these variables suggests that expansions prior to financial crises may be driven by overly optimistic expectations for growth in income and wealth. The result is often overvalued goods, services, and, in particular, asset prices. For a period, this buoyancy appears to confirm optimistic expectations. But when expectations are eventually disappointed, restoring household balance sheets and downward price movements requires sharp adjustments in private behavior. Not surprisingly, a key reason recessions associated with financial crises are so much worse is the resultant decline in private consumption.

Recoveries after Crises Look Different too

Recoveries following financial crises appear to be weaker in many dimensions. The weakness in private demand tends to persist during expansions that follow recessions associated with financial crises (Figure 8.5). Private consumption typically grows more slowly than during other recoveries, and private investment continues to decline after the end of the recession trough. Thus, output growth is sluggish and the unemployment rate continues to rise by more than usual. Although the recovery of domestic private demand from financial crises is weaker than usual, economies hit by financial crises have typically benefited from relatively strong demand in the rest of the world, which has historically helped them export their way out of recession.

Figure 8.5Recoveries following Financial Crises: Activity Variables

(in percent)

Note: Panels show the median change of the respective variable 4, 8, and 12 quarters after the start of the recession. “Financial crises” refers to the recoveries following recessions associated with financial crises. “Other” refers to all other recoveries.

Financial markets often experience prolonged busts during recoveries following recessions associated with financial crises (Figure 8.6). Credit growth falters, whereas in other recoveries it is steady and strong. Asset prices are generally weaker; in particular, house prices experience a prolonged decline.

Figure 8.6Recoveries following Financial Crises: Financial Variables

(in percent)

Note: Panels show the median change of the respective variable 4, 8, and 12 quarters after the start of the recession. “Financial crises” refers to the recoveries following recessions associated with financial crises. “Other” refers to all other recoveries.

What are the implications of these trends for the dynamics of recoveries after financial crises? First, households and firms either perceive a stronger need to restore their balance sheets after a period of overleveraging or are forced to do so by sharp reductions in credit supply. Private consumption growth is likely to be weak until households perceive that they are more financially secure.

Second, expenditures with long planning horizons—notably real estate and capital investment—suffer more markedly from the aftereffects of financial crises. This appears to be strongly associated with weak credit growth. Further, industries that depend heavily on external credit recover much more slowly after these types of recessions.

Medium-Term Implications: it gets Ugly

Financial crises tend to have a long-lasting impact on the level of output. Recent research documents that although the growth of output eventually returns to its precrisis rate, the level of output stays below the precrisis trend over the medium term.7 Specifically, the level of output on average stays about 10 percent below its precrisis trend seven years after a systemic financial crisis in a large number of advanced and emerging market economies.

Turmoil on Wall Street hits Main Street

Declines in the employment rate, the capital-to-labor ratio, and productivity all contribute to the low level of output following financial crises. In the short term, the output loss stems from the decline in total factor productivity.8 In the medium term, losses associated with capital and employment are the major factors keeping the level of output below the precrisis trend.

The long-lasting impact of the 2009 global recession has been particularly visible (Figure 8.7). In addition to the United States and the United Kingdom, many euro area economies struggled to deliver growth that can lead to sizable improvements in income per capita and in labor markets.

Figure 8.7Global Recoveries: Evolution of Output in Major Advanced Economies

(rate per capita in percent)

Note: Time 0 denotes the year of the respective global recession (shaded with gray). Aggregates for euro area and advanced economies are purchasing-power-parity-weighted per capita real output indices. Output index numbers are equal to 100 in the global recession year. For the 2009 episode, data for the 2013–15 period are based on the IMF’s World Economic Outlook forecasts.

Many commentators recognized early the likely adverse implications of the latest global financial crisis over the medium term. For example, in 2009, Carmen Reinhart and Kenneth Rogoff, in an influential book and a series of papers, claimed that the recovery following the 2009 episode would be very weak.9 In 2009, Mohammed El-Erian and Bill Gross (both then with the Pacific Investment Management Company) argued that the global economy had entered into a “new normal” phase.10 They claimed that, in this new phase and for the foreseeable future, the world would experience very slow growth, and the engine of growth would be the systemically important emerging market economies instead of the major advanced ones.11

And the Long-Term Implications: Pessimists Galore

Six years after the global financial crisis, some observers claimed that advanced economies faced what appeared to be a period of “secular stagnation.” The implication is that, following severe financial crises, countries can experience an extended period of sluggish growth and low levels of output and employment in an environment with low real interest rates. Moreover, adverse feedback loops between price and wage deflation can further worsen economic conditions.

The growth forecasts for the advanced economies in September 2008, just before the collapse of Lehman Brothers, have indeed proved quite optimistic (Figure 8.8). In 2015, forecasts from both the IMF and World Bank still suggested that most of these economies were likely to experience much lower growth in the foreseeable future relative to their precrisis trends. Moreover, global real interest rates, which had been declining since 1980, were still expected to remain low.12

Figure 8.8Output Projections

Note: WEO = IMF, World Economic Outlook. Each line shows the gap between output from respective projections and output generated using precrisis average growth between 1996 and 2006. Output level in 2008 is equal to 100.

Lawrence Summers, the former U.S. Treasury secretary, was first to raise the notion that the United States and other advanced economies have been suffering from secular stagnation, setting off a vigorous debate among economists.13 Summers cited many factors that could lead to secular stagnation after a financial crisis: depressed investment and consumption demand, higher risk aversion, increased costs of financial intermediation, debt overhang, and declining costs of durable goods. In a series of articles, Summers made a case for a large fiscal stimulus program to avert stagnation by building up infrastructure and promoting investment in the energy sector in the United States to increase demand.

Recent research also concludes that, in light of the Japanese experience after its banking crisis in the 1990s, some major euro area economies are likely to suffer long stagnation because of delays in the implementation of necessary bank recapitalization and structural reforms.14

Others consider the case for secular stagnation to be weak.15 Kenneth Rogoff claims that weak growth performance since the Great Recession has been similar to the typical dynamics observed following a systemic financial crisis. He emphasizes a different reason for the slow growth after the crisis: the failure of governments to eliminate unsustainable debt levels in the U.S. mortgage markets and in European periphery economies. John Taylor, a Treasury undersecretary for international affairs in the Bush administration, finds a culprit in policy uncertainty, which he says made firms reluctant to invest. Taylor considers policy uncertainty to be a major reason for the slow growth during the latest recovery in the United States. There are also broader discussions about how emerging market and developing economies can face various growth challenges in the future.16

Have We Been Here Before? You Bet!

There were many predictions of an extended period of low growth following earlier global recessions.17

And, as discussed, the recovery after the 1991 global recession—also associated with financial crises—was long and weak. Since 2010, global activity has gradually strengthened and is expected to improve further in the medium term, according to the forecasts at the time of the writing of this book.

However, the global economy faces multiple downside risks, including challenges associated with the transition from unconventional monetary policies, deflationary pressures, fragile growth prospects in the euro area, and a synchronized slowdown in emerging market economies. And there are still concerns about the durability of global financial stability. The bottom line is that it remains to be seen whether advanced economies will continue their expansion or experience a longer period of stagnation in the coming years.

It remains to be seen whether advanced economies will continue their expansion or experience a longer period of stagnation.

Looming Uncertainty: Not Good Either

This chapter explains how recessions accompanied by financial crises differ from those that are not and how the recoveries that follow such episodes are longer and weaker. High levels of uncertainty are another factor prominently cited to explain the sluggish nature of the ongoing recovery; we turn now to the role of uncertainty.

Focus

Financial Disruptions and Activity

Economic developments over the past two decades show vividly that gyrations in financial markets greatly influence real activity around the world. Following the largest housing bubble in its modern history, Japan experienced a massive asset market crash in the early 1990s, which marked the start of its “lost decade.” After prolonged credit booms, many emerging market economies in Asia faced deep financial crises in the second half of the 1990s. The equity market booms of the late 1990s in a number of advanced economies ended with simultaneous busts and recessions. The recent global financial crisis was similar to the earlier episodes. However, the Great Recession was truly seismic, with severe credit crunches and asset price busts leading to the deepest global recession since the Great Depression of the 1930s.

Financial Frictions and Output

A rich research program has explored the interactions between the financial sector and the real economy. For example, Fisher (1933) and Keynes (1936) were among the first to emphasize these interactions during the Great Depression.18 Basic economic theory suggests that, in a world without financial frictions, macroeconomic developments and financial conditions interact closely through wealth and substitution effects (Cochrane 2006).19

However, in the presence of financial frictions, these linkages can be amplified through various channels, including the “financial accelerator” and related mechanisms. According to these mechanisms, decreases (or increases) in asset prices worsen a household’s or a business’s net worth, reducing (or increasing) its capacity to borrow, invest, and consume. This process, in turn, can be amplified and propagated across corporations and households, leading to further decreases (increases) in asset prices over time, thereby creating general equilibrium effects (Bernanke and Gertler 1989; Bernanke, Gertler, and Gilchrist 1999; Kiyotaki and Moore 1997). Many theoretical models emphasize the roles played by movements in credit and asset prices (house and equity) in shaping the evolution of macroeconomic aggregates over the business cycle.

A number of studies examine the roles of asset prices and credit in transmitting and amplifying shocks. For example, some recent studies analyze specifically how endogenous developments in housing markets can magnify and transmit various types of shocks to the real economy in dynamic stochastic general equilibrium models.20 Other studies consider how movements in equity prices can be associated with leverage cycles that are in turn closely related to movements in the real economy (Adrian and Shin 2008; Mendoza 2010). More recently, the emphasis has been on how shocks to the supply of financing can lead to real effects, including recessions and recoveries (Gertler and Kiyotaki 2010; Brunnermeier and Sannikov 2012). In addition to these theoretical studies, empirical work emphasizes the importance of house prices and credit dynamics in shaping business cycles (Leamer 2007; Mendoza and Terrones 2008).

Implications of Asset Price Busts

Claessens, Kose, and Terrones (2012) document the significant role played by asset price busts and the growth of house prices prior to recessions in determining the duration and depth of recessions. The growth of equity prices prior to recessions does not appear to be significantly related to the depth of recessions, and recoveries accompanied by equity booms are not necessarily stronger than those without such booms.

What explains the relatively more important role of housing markets in shaping the length and magnitude of cyclical outcomes? First, housing represents a large share of wealth for most households. Houses are also an important form of collateral against which households can borrow and adjust their consumption patterns (as house prices vary). In contrast, equity ownership is a smaller share of wealth for many households and is typically more concentrated among wealthy households who likely make much smaller adjustments in their consumption over the business cycle. Moreover, equity wealth cannot be used as collateral as easily as housing wealth.

Second, equity prices are more volatile than house prices, implying that changes in house prices are more likely to be permanent than those in equity prices (Cecchetti 2006; Kishor 2007). With changes in wealth seeming more permanent, households tend to adjust their consumption more when house prices increase (decline), leading to larger increases (declines) in output during recoveries (recessions) associated with house price booms (busts) (Helbling and Terrones 2004). In studies using micro data, housing wealth has indeed been found to have a larger effect on consumption than equity wealth.21

Consequently, house price adjustments often have a greater effect on aggregate consumption and output than equity prices do. Empirical studies also indicate that the importance of housing extends also to changes in the main components of output. Consumption and investment usually decline sharply during recessions coinciding with house price busts, which are in turn accompanied by more pronounced drops in employment. Recessions with house price busts tend to be significantly longer and deeper.

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