Past Financial Crises Suggest Pain Far From Over

Naked Capitalism ^ | 01/01/09

[TigerLikesRooster]

Past Financial Crises Suggest Pain Far From Over

Economists Carmen Reinhart and Kenneth Rogoff have been publishing various findings from a large-scale data set they have constructed of past financial crises. They have looked back as far as 800 years, but not surprisingly, most of their output has consisted of analyses of modern crises (you can find some earlier discussions here and here).

/snip

Their work has shown that financial crises are more severe and protracted than "normal" recessions. In some of their previous presentations, they had parsed out financial crises in advanced economies versus those in developing countries, and were surprised to find their trajectories were remarkably similar, so their latest product looks at both types together. It also includes two prewar developed country episodes where Reinhart and Rogoff had sufficient housing price and other relevant data.

Their latest piece looks at how crises generally progress and resolve themselves. The usual outcomes are worse than most commentators forecast for the US (save the fall in average real estate prices):

1. Real housing price declines average over 35% over a six year period. Note in other crises, residential real estate was not necessarily a focus of the bubble. Even excluding Japan (which has suffered a 17 year housing price decline) the average is over 5 years.

2. Equity prices fall 55% over three and a half years.

3. GDP fall an average of 9% (read that twice)

4. Unemployment increases 7% over previous norms.

5. Government debt "explodes", increasing an average of 86%, but the cause is typically not a banking industry recapitalization, but maintaining services in the face of collapsing tax revenues and countercyclical measure ex financial system measures.

[TigerLikesRooster]

Ping!

[the invisib1e hand]

Just reading the VIX suggests the Dow has at least one more violent leg down. Certainly there are enough potential catalysts in the air.

[the invisib1e hand]

One note: no historical analysis can take into account the wealth generating capability (and therefore the "bounceback" capability) of the free market mechanism, specifically the US free market. That will work substantially in favor of recovery.

Of course anyone paying attention expects the free market to be substantially hampered by abuses coming from the new administration, but those will pass eventually.

[NVDave]

CRE defaults, Alt-A and Option ARM defaults, China’s economy about to go into reverse, etc.

Then we need to start considering when and how many muni bond issuers are going to default - and if they do, and the bonds were wrapped by the monolines that are still on their deathbeds... what will happen then? California’s debt situation alone will roil the markets for weeks.

There’s a bunch of shoes waiting to drop this coming year.

And housing is STILL overpriced. Housing has to come back in line with what is supported by people’s incomes, not what is made “possible” with absurd and fancy loan products.

When housing is sustainably affordable based on mean household incomes (ie, that the median home price is back in the area of 3.0X median household income), then home prices can be supported by actual income.

In California, they have easily another 15%+ to fall to get into the range of sustainable home prices without fancy mortgage products.

Debt deflations hurt.

[RayChuang88]

I think their analysis forgets one gigantic factor on why we have ecnomic booms and busts: the use of the income tax to generate revenue for the government.

Because by definition income taxes discourage savings and investment, that results in the rise of too much debt financing for economic advancement, so if there is any form of economic disruption the results can be disastrous, as the sub-prime mortgage meltdown so clearly demonstrates.

This is why we should kibosh the Federal income tax system (a system so complex and unwieldy even the IRS admits it has difficulty figuring it out and costing the US economy probably around US$600 BILLION PER YEAR in compliance costs and pre-compliance economic decision costs in 2008! ) and start over with a government revenue stream based on taxing consumption, which means we generate revenue here in the USA not from 158 million taxpayers but over 300 million people living in the USA and 50 million foreign visitors per year, a lot more stable base for revenue generation.

That's why I'm a big supporter of the FairTax system as the starting point of this change. Because FairTax no longer taxes earning money, we get the following benefits:

1) Income earners will get paychecks as much as 22% larger, thanks to no more tax withholding per paycheck.
2) Americans will actually start to save and invest their income at a much higher rate because of no tax consequences of putting money into savings and investment accounts.
3) Because of the higher savings rate, that means Americans can actually build up a retirement nest egg and/or save up to buy a big-ticket item like a home, automobile or large appliance either in a cash payment and/or with a far smaller loan, since the consumer can afford far bigger down payments. That benefits finance companies, since it means a far higher chance they can get their loans paid back.
4) Americans don't have to go to Byzantine methods to "hide" their assets from the clutches of the IRS. This would end the practice of offshoring assets in places like Bermuda and the Cayman Islands and possibly end a majority of the underground economy.
5) American companies are far less likely to offshore corporate headquarter and manufacturing operations just to reduce their income tax burden. That means higher employment and we could even see cities in the Rust Belt revive as manufacturing operations return to the USA.
6) Foreign investors would pour trillions of dollars into the US financial system, since investing in the USA will no longer have any tax consequences.

[RipSawyer]

The “free market” has not actually existed for a long time, plans being made now will make it very unlikely that a free market will exist for the remainder of my life (I am 64).

[the invisib1e hand]

The “free market” has not actually existed for a long time

I mean you no disrespect, but this is bosh.

Unless of course you mean "free market" in the same way a physicist talks about "frictionless" motion, which is a theoretical fantasy anyway.

Yet, motion occurs and so do free market transactions.

[RipSawyer]

Yet, motion occurs and so do free market transactions.
>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>

Likewise no disrespect but where do you have free market transactions in a country where the government tries to dictate everything, including how much water you can use to flush? We have government either taking over, bailing out or regulating into oblivion everything in sight and plans are being laid to complete the nationalization of medicine. Explain to me where I can find this free market please.

[spetznaz]

Any abuses done by the incoming administration will simply be a continuation of the abuses done by the current one.

[livius]

There would be so many advantages to dumping the IRS and the current income tax that it’s hard to know where to begin. We have built a tax system that actively encourages or even forces bad spending and investment habits. Not to mention the fact that people’s every economic decision is not based on its own feasibility, but its tax impact.

[the invisib1e hand]

Any abuses done by the incoming administration will simply be a continuation of the abuses done by the current one.

I'm sorry I thought this was a rational discussion. Please excuse me.

[RayChuang88]

We have built a tax system that actively encourages or even forces bad spending and investment habits. Not to mention the fact that people’s every economic decision is not based on its own feasibility, but its tax impact.

This is why I think in the end we will finally get off the ridiculous treadmill that is our current income tax system and get something along the lines of FairTax implemented, if only to save Americans from wasting a mind-boggling US$600 BILLION PER YEAR in compliance costs and pre-compliance economic decision costs.

[spetznaz]

You are excused.

[AndyJackson]

Of course anyone paying attention expects the free market to be substantially hampered by abuses coming from the new administration

The biggest problem will be ending the abuses of the free market by those free market operators who got us into this mess in the first place. We have an enormous debt and banking problem to work through.

What fraction of the goods and services that you pay for are goods and services that you would willingly choose to pay for. Things you want are housing, food, shelter, transportation, entertainment, real medical care, etc. Things you don't want are bureaucrats, lawyers, and bankers skimming off the top for no value added. I suggest that WAY too much output of production are wasted by this latter class of folks.

[AndyJackson]

Housing has to come back in line with what is supported by people’s incomes, not what is made “possible” with absurd and fancy loan products. When housing is sustainably affordable based on mean household incomes (ie, that the median home price is back in the area of 3.0X median household income), then home prices can be supported by actual income. In California, they have easily another 15%+ to fall to get into the range of sustainable home prices without fancy mortgage products.

There is an added dimension to this deflation which is that a lot of "median income" that has supported the housing bubble was generated by income earned off of the housing bubble. So, as deflation occurs, incomes that derived from asset inflation will disappear.

This kind of restructuring is going to be very painful.

[WOSG]

“Just reading the VIX suggests the Dow has at least one more violent leg down. Certainly there are enough potential catalysts in the air.”

I disagree. VIX peaks at bottoms. It peaked at an incredible 70 in late November. It was a panic bottom unparalleled in 50 years. That was the bottom for the stock market, which remains undervalued as of now. We wont get that panic VIX reading again, and if we do, time to buy.

Probably we will have a january rally and a pullback in the spring as the market digests whatever nonsense Obama comes up with and Q4 and Q1 numbers are shown to be bleak. Recoverey wont be until later in 2009, but stock market will anticipate that in the late spring when the real rally will occur.

But we have already passed the bottom, the bad news is priced in to the market, and any price under S&P 900 or Dow 9000 is a good buying oppty.

The above super-negative reporting is a good sign that we will be going up soon. It casts a negative pall on the marketplace and makes buyers less certain and willing to invest. The intrepid investor wins.

[the invisib1e hand]

Apologies for appearing rude, but you haven't done your homework on the VIX. To wit: it hasn't been in existence for 50 years and it did not peak recently. Oh, and VIX 70 is not "incredible." Unless you're under 30 and you don't know how to download historical data.

Peace.

[WOSG]

When I said VIX has peaked recently, I meant the peak in late november (nov 18-20) that coincided with the low, VIX went ballistic in mid-Oct then again in November:

http://finance.yahoo.com/echarts?s=%5EVIX#chart6:symbol=^vix;range=3m;indicator=volume;charttype=ohlc;crosshair=on;ohlcvalues=0;logscale=on;source=undefined

VIX above 70 like happened in recent months hasnt happened since at least the crash of 1987. Very unusual and a sign of a significant market panic:

http://finance.yahoo.com/echarts?s=%5EVIX#chart5:symbol=^vix;range=my;indicator=volume;charttype=ohlc;crosshair=on;ohlcvalues=0;logscale=on;source=undefined

VIX under 40 indicates the panic phase is over.

Yes, I’ve done my homework. I was shorting puts at those levels, selling the volatilitiy. Will continue to do so on selected stocks as the market bottoming continues.

Arrogance doesnt become you.

[sanchmo]

CPI-adjusted, the mean US home price from 1950 through about 1995 has increased at a slower rate than real GDP growth - mean home price starting at about $150k in 1940 and reaching about $165k in 1995 (those are approx 2007 dollars, IIRC). Then in 1995-2005 they soared to over $250k.

I figure they need to drop 35% back down & reach $165k mean home price again, plus a little lower because the non-mortgage aspect of this crisis (lost jobs, lost retirement savings, etc) will cause additional over-correction.