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Rating the Subprime Mess
History tells us that when an economy gets sick — really sick — banks are usually at the heart of the problem. Which makes sense, of course, since a banking system is to an economy what the cardiovascular system is to the body.
Harvard economics professor Kenneth Rogoff and Carmen Reinhart of the University of Maryland recently examined 18 bank-related crises since World War II in industrialized countries to determine whether the current U.S. subprime mortgage mess is similar. What they found were “stunning qualitative and quantitative parallels across a number of standard financial crisis indicators.” Psychologically, the U.S. housing bubble was accompanied by a series of this-time-it’s-different rationalizations closely resembling those that took hold before the 18 previous financial disasters overseas and at home.
Quantitatively, real per-capita output growth after the 18 crises dropped by an average of about two percentage points from its trend level and took more than two years to return to normal. But after the five most severe credit events — Spain (1977), Norway (1987), Finland (1991), Sweden (1991) and Japan (1992) — economic output fell by five percentage points and took more than three years to normalize.
The fiscal cost of repairing the damage from those five bank-related failures ranged from 6 percent to about 20 percent of gross domestic product. If the U.S. subprime crisis ultimately costs just 8 percent of GDP — my reasonably conservative extrapolation based on the Big Five — the tab would come to about $1.1 trillion. That’s more than double the inflation-adjusted cost of the savings and loan debacle of the 1980s, the only U.S. financial disaster to make the list.
So is the current subprime mortgage bust more similar to the Big Five or the 13 relatively benign postwar credit crunches?
On balance, the evidence skews big. Rogoff and Reinhart found that house prices in the United States appreciated by more than the average of the Big Five. Stocks also gained more ground — and held those advances longer. And at more than 6 percent of GDP, the current U.S. account deficit (a broad measure of trade and financial flows) is wider than for any of the five countries before their crisis.
Yet there are reasons to be hopeful. The rate of U.S. economic deceleration is less pronounced and the build-up of public-sector debt less severe than for the other five countries. The aggressive and creative policy response by the Federal Reserve to the recent liquidity crunch also contrasts sharply with that of, for instance, Japanese monetary authorities at the onset of that country’s 1992 financial disaster. Japan kept rates too high for too long, setting in motion a deflationary spiral that was nearly impossible to reverse.
Rogoff and Reinhart assert that the jury is still out on how this crisis will end: “If the United States does not experience a significant and protracted growth slowdown, it should either be considered very lucky or even more ‘special’ (than) most optimistic theories suggest.”
But the evidence leaves little doubt that it is, at the least, a very serious matter.
Thomas D. Saler is a free-lance financial journalist based in Madison, Wis.