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Stop panicking: Capitalism repeatedly recovers from financial crises

UPDATE 2 (3/24, 12:59PM EDT) Tyler Cowen is almost convinced (see end of this post)

UPDATE (3/23, 2:30 EDT): see GREAT responses by Ross Levine and Mark Thoma at the end of this post

I am just beginning to dive into the awesome book by Carmen Reinhart and Ken Rogoff, This Time is Different: Eight Centuries of Financial Folly. Along with great analysis, they have some wonderful pictures, evidence, and data. What I say here is my own take on it.

First, financial crises are remarkably common. Their Figure 5.1 shows the number of countries that have defaulted on their external debt (one possible dimension of a financial crisis) over the last two centuries. The numbers come in episodic waves of defaults and involve a remarkably high number of countries in each wave:

Second, the global capitalist system does well in the long run anyway.  Average per capita income in the world (a shaky estimate, but probably right order of magnitude) increased by a multiple of 12 over 1800-2008, despite repeated epidemics of financial crises.

The US is arguably the country with democratic capitalism the longest, and it also shows a steady upward trend from 1870 to the present, despite repeated banking crises (using those identified by Reinhart and Rogoff), with usually little effect of each crisis on output relative to trend (except for the Great Depression).

Reinhart and Rogoff calculate directly the growth pattern before and after crises in advanced capitalist economies, and growth does indeed recover quickly to the trend growth rate of around 2 percent per capita per annum. 2 percent per capita is roughly the same growth rate that increased US per capita income so much from 1870 to the present.

y-axis reads "Real GDP Growth (Percent)"

I don’t mean to minimize the short run pain that the current financial crisis has caused. It’s horrible. But there is no reason to panic about the long run growth potential looking forward.

The obvious rejoinder is Keynes’ “in the long run, we are all dead.” But we can’t ignore that Capitalism already survived repeated financial crises and has made us all vastly better off despite them. So here’s a counter-quote: “In the long run, we are all better off because our dead ancestors stuck with capitalism.”

UPDATE (3/23, 2:30PM EDT) Ross Levine, the scholar whom I trust most about addressing financial crises, sent me the following comment by email when I asked him his opinion:

This is a great summary!
I would, however, point out that this crisis could be different, depending on your view of the adaptability and elasticity of institutions.  In particular, this crisis, including the build-up and the resolution, involved a massive redistribution of wealth to the very wealthy.  It also involved an unprecedented decline in market discipline through government policy.  Thus, from my perspective, to get the Reinhart and Rogoff result over the next decade or so, this must involve an institutional adjustment to correct the distorted incentives that currently exist.  What are the forces that lead to this type of adjustment in some economies and not in others?

Mark Thoma, on his great blog Economist’s View, responded to my request for a comment. A summary (see his post for his full response):

My take is a bit different. The graph of per capita income from 1870 – 2008 seems to say we shouldn’t worry that aggressive intervention to stimulate the economy will cause long-run problems. It may help substantially in the short-run, but the graph above indicates it’s unlikely to have long-run consequences. So, I agree, let’s not panic. Let’s not panic and start reducing stimulus measures too soon, or be too timid with stimulative policies, out of fear it might harm long-run growth.

….

Finally, on the general “stop panicking” message, when people are hurting — and they are — we ought to panic. Legislators have given little indication that the understand the urgency of the employment problem we face. We need more panic, not less, about the employment situation.

UPDATE 2: Tyler Cowen on a view he “toys with but does not (yet?) hold”:

Financial panics and economic crises are nearly inevitable…

More and more, people will turn to the wisdom of the great 19th century economists on financial panics, bank runs, and the like.  It was an intellectual mistake to think we had ever left that world for good.

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14 Comments

  1. Jim wrote:

    You make it sound like financial crises are self-correcting, but that does not seem to be the case. In just about every financial crisis since 1825, governments have had to implement some combination of bank bailouts, monetary loosening or fiscal stimulus in order to get things on track again. Except for the start of the Great Depression, when the government sat on its hands for too long, and we know how that turned out. So you could also call this a story of how government repeatedly rescues capitalism from itself.

    Posted March 23, 2010 at 4:26 am | Permalink
  2. Rachek wrote:

    Jim,
    Totally agree , such a simplistic and false conclusion by Mr Eastman. The upward curve he show is for the US only. Take a wider sample of countries do the same analysis and see what the curves look like. Then maybe look at different sections of society and see how they have faired in countries with capitalist economies with limited government intervention. Then look at countries with higher levels of goverenment support and service provision to their populations. That would also be interesting!!

    Posted March 23, 2010 at 5:50 am | Permalink
  3. michael wrote:

    Jim and Rachek –
    Maybe you are both wrong. Correct, governments have always intervened after financial crises. And, correct, crises have continued to repeat. But perhaps the former is the cause of the latter. If governments did not intervene then perhaps creative destruction would teach capitalists the true evolutionary lesson of risk, i.e. extinction. One day we will have to try the theories of Weber, Schumpeter, and Hayek just to see what happens when a society does not respond with Keynesian theory. It’s quite possible that crises might then be smaller and less frequent, instead of ever bigger and ever more frequent. That’s because governments and capitalists would better understand the consequences of bad decisions (extinction).

    Posted March 23, 2010 at 6:06 am | Permalink
  4. Manoel Galdino wrote:

    Nice graphics.
    But if you read some of Heckman Works, you will see that family environment is very importat in the developing of children. So, arguably, for the most affected family, the kids may not be dead in the long run, but they will be stucked in a bad fate (crime, unemployment, low salaries etc.).

    Posted March 23, 2010 at 9:01 am | Permalink
  5. David Shea wrote:

    Capitalism yes, but socialism is like hardening of the arteries, harder to “bounce back” Economy needs a “Statin” now !

    Posted March 23, 2010 at 9:22 am | Permalink
  6. Ted H wrote:

    I disagree with the top two commentators. Almost any economy is going to recover from a financial crisis. The question is, how painful and how prolonged do you want it to be? I think the Long Depression illustrates this beautifully. Due to terrible monetary policy (including not acting as lender of last resort), well arguably a bad monetary system; the Long Depression was, well, long and painful, but we eventually recovered. The goal of good monetary policy is to dampen those fluctuations and making the pain shorter so the capitalist engine can get moving again.

    Also, Jim, your history is a bit off. The United States and many European governments were more than willing to let banking panics occur well into the early 1900s. For example, in the Long Depression, it was disastrous how the U.S. let many banks collapse including their own “too big to fail” Cook & Company.

    But yes, our economy will recover. Also, I don’t think anyone thinks that capitalism somehow failed because of this crisis. Capitalism has always been a volatile, nasty system, anyone who’s read a shred of economic history can’t honestly contend otherwise. But it also does a lot of good in the world and is thus far the best and most effective system we have found to organize economic activity.

    Posted March 23, 2010 at 10:42 am | Permalink
  7. William Easterly wrote:

    Jim and Rachek, I think you are reading things that I did NOT say into the post. I didn’t say financial crises are self-correcting, and it would be crazy not to attempt to fix specific problems that caused financial crises each time they happen. My point is just that rich capitalist countries have gotten rich IN SPITE OF repeated financial crises (the US is just a representative example, a similar graph could be done for other rich countries). So preventing financial crises is NOT a necessary condition for a society getting rich under capitalism.

    Posted March 23, 2010 at 11:16 am | Permalink
  8. confused wrote:

    I am curious about this statement:
    “Second, the global capitalist system does well in the long run anyway.”

    Does well by whom and for whom?

    “But we can’t ignore that Capitalism already survived repeated financial crises and has made us all vastly better off despite them.”

    As the first commenter suggested, we can’t know if the capitalist system would survive crisis on its own – man of the “large” problems we’ve seen this century witnessed direct government involvement – meddling a some of my capitalist contemporaries might suggest. I’m also curious – what does survival even mean to an idea, such as capitalism? What does “not surviving” entail? Total break down of the ability of people to pursue a meaningful livelihood? Regressive standard of living? Cats and dogs settling their differences and becoming friends?

    As for making our lives vastly better, doesn’t that statement say a little more than it can possibly prove? I’ve known countless people born into low income families who’ve been unable to live the life they want simply because they lost the birth lottery. Take Jane – born into an immigrant family who lived in a low income neighborhood. Despite being academically bright she dropped out of high school and now five years later she still works day jobs to support her ill parents.

    Posted March 23, 2010 at 3:20 pm | Permalink
  9. juan garrido wrote:

    To Jim and Rachek, please read Rothbard’s Great Depression for some facts on that financial crisis… you will be disapointed with your theoretical model…

    Posted March 23, 2010 at 11:15 pm | Permalink
  10. don noland wrote:

    This is simplistic thinking. Why assume that growth rates will continue along these lines after 200 years, and that the dynamism of capitalism will continue, which was based on huge advances in technology/ production, and the spread of capitalism around the globe? Capitalism continues to be at risk for more major wars and financial crisis, increasingly so. The decline of the US and rise of China and potentially economic blocs is highly destabilizing, as is the global growth in inequality. These sort of graphs are useful, but let’s probe deeper than such impressionistic approaches.

    Posted March 24, 2010 at 1:25 pm | Permalink
  11. Tracy W wrote:

    Does well by whom and for whom?

    Human beings. By and for.

    I’m also curious – what does survival even mean to an idea, such as capitalism?

    From the post, here Bill Easterly is clearly using it in the sense of a growth in real per capita incomes.

    As for making our lives vastly better, doesn’t that statement say a little more than it can possibly prove?

    Actually no. Take for example life expectancy. Life expectancy at birth in the US in 1901 was 49 years, at the end of the century it was 77 years, and similar gains have been enjoyed around the world. http://www.spiritus-temporis.com/life-expectancy/life-expectancy-over-human-history.html

    Infant mortality has declined world-wide from 152 per 1,000 births in 1950-1955 to 52 per 1000 births in 2000-2005. See http://data.un.org/Data.aspx?d=PopDiv&f=variableID%3A77

    Given how hard the death of a child is for that child’s parents, reductions in infant mortality rate do make people’s lives vastly better.

    I’ve known countless people born into low income families who’ve been unable to live the life they want simply because they lost the birth lottery. Take Jane – born into an immigrant family who lived in a low income neighborhood. Despite being academically bright she dropped out of high school and now five years later she still works day jobs to support her ill parents.

    However their ability to lead lives that are something like what they want is higher than in the past. My grandfather was made to leave school by his mother at age 14, despite being academically-bright, as she needed him on the farm to keep the farm going. He wanted to be an engineer. However, thanks to capitalism, he had access to cheap books, radio, and later on TV, keeping him connected with the world outside, and in the 1970s he got to travel overseas for the first time in his life, to the Americas.

    Two centuries earlier neither Jane nor my granddad would have gotten to high school at all.

    Or take the case of a woman who got pregnant outside of marriage back in Victorian times versus a woman who gets pregnant now. In Three Men in a Boat by Jerome K. Jerome, the three men discover the body of a woman who that happened to, who was abandoned by the man in question, and eventually commits suicide out of despair at the struggle to keep herself and the child fed. One of my aunts walked out on her deadbeat husband with *two* kids, and managed to find work enough to support herself and the kids in a three bedroom house.

    I’ll also point out that I know countless people born into high income families who have been unable to live the life they want simply because they lost the birth lottery. One of my mothers’ friends has 3 sons, two of them with muscular dystrophy, which is a fatal disease. Birth lottery. Going back a lot of history, Queen Anne had 17 preganancies, the longest any of her children lived was to age 11. Birth lottery.

    Posted March 25, 2010 at 5:19 am | Permalink
  12. Daniel wrote:

    quite an interesting topic.
    Let’s hope the title proves right ;-)

    Posted March 26, 2010 at 5:54 pm | Permalink
  13. Bill Stepp wrote:

    Financial panics, recessions and depressions are mostly caused by government intervention. I say mostly, rather than without exception, because of the 41 or so episodes identified by George Selgin in a study (sorry I don’t have the reference), something like 34 were caused by government intervention. All the American epsiodes in the 19th and 20th centuries, in addition to the 2001-2 and 2008-9 recessions, were caused by State intervention.
    What we need to do to minimize the risk of future panics and recessions is to get rid of central banks and fiat currency, and replace them with free banking and a gold standard. Problem fixed.
    Get with anarchy!

    Posted March 27, 2010 at 12:23 pm | Permalink
  14. Mr. Econotarian wrote:

    I agree with the concept that capitalism can quickly rebound from a banking crisis. You take your licking in the areas you were over-leveraged, and move into other, more promising avenues.

    However it is unclear if government will always allow this to occur.

    Posted March 29, 2010 at 1:40 am | Permalink

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