Mark Thoma sends us to Christy Romer:
A Financial Crisis Needn’t Be a Noose: RECESSIONS after financial crises are long and severe, and the subsequent recoveries are protracted…. But while there are strong patterns in the authors’ mountains of data, this simple summary misses an important fact: There’s dramatic variation in the aftermaths of crises, and much of it is caused by how policy makers respond….
Reinhart-Rogoff… emphasizes common patterns across crises…. [T]he averages are stunning. For 14 major crises since 1929, the associated decline in real per capita gross domestic product averaged 9.3 percent….
But… Norway had only a slight decline in per capita G.D.P. — around 1 percent — after its 1987 crisis…. The Depression… G.D.P. fell nearly 30 percent in the United States, and didn’t return to its pre-crisis level for a decade. But in Spain, it fell only 9 percent in the Depression as a whole, and actually rose in the year after its 1931 banking crisis….
What explains the variations?… [C]rises that happen along with currency crises tend to be followed by much more severe recessions…. [B]ig declines in house and stock prices… have damaging effects on their own…. BUT an even larger determining factor is the policy response. Why was the Great Depression so much worse here than in Spain?… Spain benefited from not being on the gold standard. Its central bank was able to lend freely and increase the money supply after the panic. By contrast, in 1931 the Federal Reserve in the United States raised interest rates to defend its gold reserves and stay on the gold standard…. [P]olicy response largely explains why output fell after the American banking panics in 1930 and 1931, but rose after the final wave in early 1933. After the first waves, the Fed did little, and President Herbert Hoover signed a big tax increase to replenish revenue. After the final wave, President Franklin D. Roosevelt abandoned the gold standard, increased the money supply and began a program of New Deal spending….
The Reinhart-Rogoff study points out that policy makers’ ability to take strong fiscal action depends on whether they start with high levels of debt. In the current episode, China and South Korea have recovered faster, partly because they have taken more aggressive fiscal stimulus measures. They could do that because they entered the crisis in good fiscal health…. After its banking panic in 1991, Sweden aggressively restored its banks to health. They were nationalized, recapitalized with public funds, and then returned to private control. After three rough years, Sweden grew rapidly, soon returning to its pre-crisis trend. Japan, by contrast, put off cleaning up its banks after its 1992 crisis….
[W]here does this… leave us?… [P]olicy makers need to make the financial system less prone to crises, and to fight panics aggressively when they arise…. A country as creditworthy as the United States can continue to use fiscal stimulus to help return the economy to full employment. And… there’s much more the Fed could be doing. Whether we continue to fester or finally embark on a robust recovery depends on whether we choose to use the tools available.
Finally, governments around the world, including our own, should remember that it helps to be in sound fiscal shape before a crisis hits…. Being careful in good times gives policy makers the ability to fight crises in bad ones.