Financial Crisis: Why Not to Expect Recovery Anytime Soon
SIGNS of weakness in advanced economies seem to have taken some by surprise. In America, GDP growth slipped in the second quarter of 2012 to a revised figure of 1.7% after growing at a rate of 2% in the first. In Britain, the economy is contracting at 0.5% a year based on latest data, adding to an increasing sense of frustration felt towards the government for failing to ensure a faster recovery.
But perhaps we are suffering from memory lapse. To understand the effects of an economic crisis, you have to go back to its roots. A new study by Alan Taylor draws attention back to the causes of the 2008 financial crisis. Through a series of tests run on a sample of 14 advanced economies between 1870 and 2008, Mr Taylor establishes a link between the growth of private sector credit and the likelihood of financial crisis. The link between crisis and credit is stronger than between crises and growth in the broad money supply, the current account deficit, or an increase in public debt.
Over the 138-year timeframe Mr Taylor finds crisis preceded by the development of excess credit, as in Ireland and Spain today, are more common than crisis underpinned by excessive government borrowing, like in Greece. Fiscal strains in themselves do not tend to result in financial crisis.
When the boom period of credit expansion is coupled with growth in public-sector borrowing, however, the subsequent negative impact on the economy will be worse. Why? When a crash occurs, governments will not have the fiscal capacity to buffer the crisis due to their already stretched borrowing levels. Instead, they become forced to retrench and adopt austerity measures—which tend to drag on growth further, prolonging recession.
Carmen M. Reinhart and Kenneth S. Rogoff’s book “This Time Is Different” shows the fiscal balance is worsened during the crisis period by declining revenues and higher expenditures, due to bank bailout costs, higher transfer payments, and debt servicing. A recent Swedish case is illuminating. Before its 1991 banking crisis, Sweden operated a fiscal surplus of 3.8% of GDP. Afterwards, its deficit-to-GDP ratio grew to more than 15%. During the three years from peak-to-trough, loss of GDP per capita was more than five per cent.