Monday, October 06, 2008

Could We Settle For A Lost Decade?

As the darkness descends we couldn't stop ourselves looking out the data for previous banking crises. Just how bad will the coming recession be? Could it really be back to the thirties?

The chart shows what happened to per capita GDP in the decade following three major crises. And to cheer ourselves up we've labelled them the Liquidation crisis (blue line), the Recapitalisation crisis (red line), and the Zombie crisis (green line)

As we can see, the Liquidation crisis was by far the worst. In that one, per capita GDP fell by over 30% in four years, and still hadn't recovered back to pre-crisis levels 10 years later. It was the nightmare of 1930s America: the Great Depression that ensued when the US authorities allowed thousands of their banks and financial institutions to go into liquidation following the stock market crash.

Next worse - albeit much less severe - was the Recapitalisation crisis. In that one, GDP per capita fell by 6% in three years, but then rebounded strongly to surpass pre-crisis levels within five years. This was the much praised Swedish bank rescue of the early 90s, when the Swedish authorities injected taxpayer equity into banks busted by a domestic property market crash. Existing shareholders were wiped out, but the banks were put back on a sound footing, and the taxpayers were later able to sell out at a profit (within just 7 years).

The least bad, by far, was the Zombie crisis. In that one GDP continued to grow, albeit somewhat sluggishly and erratically. At the end of the decade, GDP per capita was 10% higher than when the crisis broke.

Which is a little odd. Because that was the Japanese banking crisis which followed the bursting of their asset bubble in 1990. By common consent, the Japanese authorities made a complete horlicks of managing the fall-out and those ten years have become known as the Lost Decade. It's supposed to be the example of how not to do it.

The Japanese failed to insist on mass bank recapitalisation or even proper loan write-downs. And far from forcing mergers and consolidation, they allowed things to jog along more or less as was. Japanese banks became known as Zombie Banks, a living dead who were incapable of carrying out their basic but vital functions such as extending credit. Japan's population, it is said, suffered much longer than they need have.

And yet in retrospect, facing what we now face, maybe the Bank of Japan and the government didn't do such a bad job after all.

Any chance we could settle for a Lost Decade?

Sadly, no.

For one thing, this is now a global crisis, not confined to one economy. And also, western banks now have to write down their bad debts on a mark to market basis. Since international banking regulations were tightened in the 90s, the option to quietly ignore the bad news for a few years is no longer available... and you can't stuff that particular genii back into the bottle.

So the real choice is between the Liquidation option and the Recapitalisation option.

We know which we'd choose.

Footnote: The chart shows GDP per capita for the specific country concerned. In the case of the Liquidation crisis, the blue line plots the course of US GDP, not world GDP. And as you may know, the US suffered much worse than Britain in the 30s. Indeed, Britain's per capita GDP recovered back to pre-crisis levels within five years. Which kind of makes you wonder why socialism got such a hold here.


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