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How Bad Will It Get?

The subprime-mortgage meltdown is strikingly similar to major financial crises in other countries. Will the aftermath be as costly?

Is the U.S. economy in a recession? By a well-known rule of thumb — two or more consecutive quarters of negative growth — no. Gross domestic product grew an estimated 0.6 percent in the first quarter of 2008, the same pace as in the fourth quarter of 2007. Many economists forecast more growth for the rest of the year, albeit small.

But it certainly feels like a recession. Prices at the grocery store and gas pump are soaring. The economy lost jobs in April, for the fourth straight month. Housing prices have been falling steadily, with no bottom in sight. The Commerce Department’s final estimate of first-quarter growth, due out this month, could reverse the estimated minuscule gain.

To date, much of the debate about whether or not we are in a recession, or about to enter one, has framed that (looming) recession as a relatively short and shallow downturn. A recent poll of 52 economists, for example, found that two-thirds believe a recession is under way (hence our “Surviving a Recession” package), but 89 percent of that group expects it to be mild.

But what if we are on the verge of something worse? A recent study shows that the subprime meltdown of 2007 is ominously similar to previous financial upheavals. The study, by economists Carmen M. Reinhart of the University of Maryland and Kenneth S. Rogoff of Harvard University, finds “stunning qualitative and quantitative parallels to 18 earlier postwar banking crises in industrialized countries.” In particular, the huge run-up in housing and equity prices and the acceleration of capital inflows prior to the subprime crisis — “standard financial crisis indicators” — tracked the averages of those indicators for the 18 previous crises.

What happened after the onset of the previous crises? In 13, the average drop in real per-capita growth exceeded 2 percent, and the average time to return to trend growth was two years. But in the “Big Five” crises — in Finland, Japan, Norway, Spain, and Sweden — the losses involved were far greater. Per-capita growth for all five countries fell at least 5 percent and trended well below normal growth for more than three years.

And the costs of cleaning up a Big Five mess were immense. They ranged from 6 percent of Sweden’s GDP, following the collapse of its real-estate and financial bubble in 1991, to perhaps 20 percent or more of Japan’s GDP, the high estimated price of its “lost decade” of the 1990s. To put this in perspective, the U.S. savings-and-loan crisis of the 1980s is estimated to have cost 3.2 percent of GDP.

Telltale Signs

Three of the telltale signs bode poorly. In terms of rising equity prices, “the United States looks like the archetypical crisis country, only more so,” write Reinhart and Rogoff. The difference is that the S&P 500 has remained relatively high so far, thanks probably to the billions pumped into the financial system by the Federal Reserve. Meanwhile, U.S. housing prices are above the average for the Big Five crisis countries (see “Will History Repeat?” at the end of this article).

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