Those who cannot remember the past are condemned to repeat it.
The world has been littered with many financial crises over the centuries, yet many a time these lessons are ignored, and crises recur. Indeed, there are many clear lessons on the causes of past crises, the severity of their consequences, and how future crises can be prevented or better managed when they occur.
This applies to the 2007-09 global financial crisis that brought colossal disruptions in asset and credit markets, massive erosions of wealth, and unprecedented numbers of bankruptcies. Six years after the crisis began, its lingering effects are still visible in advanced and emerging markets alike. It is, therefore, a good time to take stock.
A new book, “Financial Crises: Causes, Consequences, and Policy Responses”(which I co-edited with M. Ayhan Kose, Luc Laeven, and Fabian Valencia), does exactly that: it provides a comprehensive overview of research on financial crises and surveys policy lessons in the context of a wide range of crises, including banking, balance of payments, and sovereign debt crises. We present four key insights.
- It is hard, but possible, to reduce the incidence of financial crises. Crises can have domestic or external origins and can stem from problems in the balance sheets of private or public sectors. Analyses collected in the book shows that proximate causes of crises include weak supervision and regulation, poorly timed and designed forms of financial liberalization, underpriced deposit insurance, and poorly designed safety nets. Addressing these issues, which is currently being done in many countries through new regulations, improved supervision and other institutional reforms, is therefore of key importance.
- It is hard, but not impossible, to predict crises. Because crises are driven by a variety of factors, it remains a puzzle why they occur in the first place, and predicting where and when they may strike is tricky. However, irrespective of their specific origins, financial crises are often preceded by booms in credit and asset markets, notably housing markets. Given these associations, many have recognized the need to be wary about such booms. Designing and using macroprudential policies to help mitigate these booms has therefore become a welcome priority for policymakers.
- Financial crises often exact large economic costs. A crisis is commonly an amalgam of sharp drops in credit and asset prices, a severe reduction in the supply of external financing, and large-scale balance sheet problems. Analyses in the book show that these disruptions in financial markets often have severe macroeconomic consequences. Notably, recessions with large output losses are common across the various types of crises. The real effects of crises are also quite persistent. While growth eventually returns to its pre-crisis rate, output tends to stay depressed for an extended period of time, especially following banking crises, with no catch-up, on average, to the pre-crisis trend in the medium term.
- Policies can make a big difference. The timing, mix, and depth of policy measures can greatly determine the real costs of crises. On the one hand, expansionary macroeconomic policies can help avoid an even sharper contraction in activity and can allow banks to recover more quickly and renew lending. On the other hand, such policies may discourage more active restructuring – of financial institutions, corporations, and households – and structural reforms, with the risk of prolonging the crisis and depressing growth further into the future. The use of guarantees on bank liabilities can contain liquidity pressures on banks upfront, but come with substantial fiscal contingencies. In contrast, direct capital injections impact the public purse upfront, but some resources can be recovered when public shareholdings are returned to private hands. Striking the right balance, or not, among these various policies, restructurings, and reforms can determine the overall fiscal and economic costs of a crisis.
Prevention is better than a cure
The book presents a wealth of valuable lessons on how to better monitor and reform economies and financial systems to avoid crises and provides an overview of critical policy areas. But it covers more than these insights – it also introduces a comprehensive database covering various types of crises and has lessons from sovereign debt restructuring episodes. And, given that much remains to be explored, the book also provides a guide for future research.
This piece is cross-posted from iMFdirect with permission.