What happens to an economy after a financial crisis? Since there are few who would deny that we’ve been in one, it might be helpful to look at what’s happened in previous crises in other countries. Fortunately, that work has been done for us by Professors Carmen Reinhart of the University of Maryland, and Kenneth Rogoff of Harvard, in a recent paper entitled "The Aftermath of Financial Crises."

There are very real differences between normal business-cycle recessions and recessions brought on by financial crises. The latter are much more severe, and sadly, pertain to the United States.

Reinhart and Rogoff had written an earlier paper on the same subject concerning only developed countries. Now they’ve expanded their research to include developing countries as well. What they’ve found is that there’s not much difference in general between economies after a crisis - which I’ll comment on later. First, let’s look at their work:

"... Broadly speaking, financial crises are protracted affairs. More often than not, the aftermath of severe financial crises share 3 characteristics. First, asset market collapses are deep and prolonged. Real housing price declines average 35% stretched out over 6 years, while equity price collapses average 55 percent over a downturn of about 3.5 years. Second, the aftermath of banking crises is associated with profound declines in output and employment.

...Interestingly, the main cause of debt explosions is not the widely cited 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 deep and prolonged output contractions, as well as often ambitious countercyclical fiscal policies aimed at mitigating the downturn."

As long-time readers know, I believe you must be very careful when using average numbers of past performance of investments or economic data. While they can be useful in helping determine direction, using them as an absolute predictor of future patterns can be quite misleading. As an example, it would be inappropriate to say that unemployment in the US or England will rise to 11% because average unemployment is up 7% over the recent trend numbers in good times. The actual level will, in all likelihood, turn out to be higher or lower, depending on a number of factors.