Current Financial Crisis on Same Path as Past Ones
Looking at the recent subprime-induced financial crisis in a historical context, a new academic study indicates the US will be lucky to escape a material slowdown in growth.
While the argument has been made that the subprime mess is different, the paper illustrates a remarkable similarity in the trajectory of previous crises. And the signs so far are that the current US version is heading down the same path.
The authors, Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard University found that in previous crises the average drop in real per capita output growth was over 2%, and it typically took two years to return to trend. “For the five most catastrophic cases (which include episodes in Finland, Japan, Norway, Spain and Sweden), the drop in annual output growth from peak to trough is over 5%, and growth remained well below pre-crisis trend even after three years.”
Perhaps most striking is that the trajectory of US economic growth surrounding the “US subprime crisis” is virtually identical to previous crises in the developed world.
The authors note that there are some reasons whey the current crisis may end up on the milder end of the spectrum:
“Of course, inflation is lower and better anchored today worldwide, and this may prove an important mitigating factor.”
On the other hand, the apparent decline in U.S. productivity growth and in housing prices does not provide a particularly favorable backdrop for withstanding a credit contraction.
The Economist reports that some argue that the subprime crisis does not strictly correspond to previous banking crises, where losses were concentrated on banks at the heart of the payments and lending systems. “Although the banks are more exposed to losses than at first seemed likely, many distressed creditors are either overseas banks or hedge funds. That has costs of its own, not least damaging uncertainty about where exactly the subprime bodies are buried. But the scattering of losses outside America should export some of the economic harm, “the Economist says.
But the scale and scope of America’s housing boom-and-bust suggest that problems will not be restricted to subprime lending.
Financial Times columnist Martin Wolf concludes from the paper that the chances are high that the US will experience a lengthy period of weak growth in private demand. “Yet the remarkable fact about this turmoil is that emerging economies are emerging as safe havens: growth there is being sustained; and credit spreads have moved little.”
The apparent invulnerability of emerging economies to the US slowdown is noteworthy.
Brad Setser of RGE Monitor also buys the paper’s arguments and adds some further cautionary notes. For example, a disruption in the internal recycling of external flows to the European Union remains a potential risk.
Also, the emerging market central banks and sovereign funds that have channeled the oil savings surplus, the Chinese savings surplus and large private inflows to the US — and to a lesser degree Europe — are also likely to take losses, Setser writes. “Not from credit risk but from currency risk. By and large, though, the currency losses have yet to be realized.”
Once those losses are factored in, the total losses associated with the recent mis-allocation of global savings into US real estate are likely to be even bigger — and a bit more dispersed than the credit losses.
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