Wednesday, April 9, 2014

Christina Romer: After A Financial Crisis, Economic Disaster Is Not Inevitable

These days, according to the conventional wisdom, financial crises almost inevitably lead to severe, prolonged economic downturns. Carmen Reinhart and Ken Rogoff, economists at Harvard, have come to this conclusion in recent research, and people tend to intuitively view financial shocks this way.

But none of this may actually be inevitable; instead, bad fiscal, monetary, and financial policy may be more to blame. That's the argument Christina Romer, the UC Berkeley economist and former CEA chair, made at a talk organized by the University of Michigan's Ford School of Public Policy yesterday. You can watch the video here.

Romer based her argument partly on new research that she and her husband David Romer, also an economist at Berkeley, are conducting. (They haven't written the paper yet, so the research is preliminary.) They examined financial crises in 24 OECD countries between 1967 and 2007, and after controlling for a number of factors, they found that the typical financial crisis hurt economic growth much less than Reinhart and Rogoff found, with its effects vanishing after about two years and reducing real GDP by roughly 3 percent, as opposed to Reinhart and Rogoff's findings of 9.3 percent.

(Update (4/10): A technical note: Here, for this particular comparison, the Romers analyzed only "moderate" financial crises, where countries reached a financial stress level of 8 out of 16, while Reinhart and Rogoff's number is an average from their entire sample.)

She said that she and David Romer tried to identify and measure financial crises more precisely than the existing literature. They used a scale from 0 to 16 of financial stress and tried not to let the findings be biased by crises that are known to have been followed by severe recessions. She also said they tried to conduct a more precise empirical analysis that would not be biased by how the economy was already doing.

She argued that when financial crises were followed by prolonged economic weakness, it often was due to contractionary fiscal and/or monetary policy (such as in the case of the Great Depression), or due to continued financial stress (as in the case of Japan) -- not because of the original financial crisis.

"I think fiscal contraction is an important part of why the recovery in this particular episode has been so slow," she said. "It's not that financial crises always lead to large and long-lasting falls in output; rather, contractionary policy dealt a second serious negative shock to many economies just as they were starting to recover."

I'd highly recommend watching the whole video. You can watch it here:

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