Sub-prime - just another banking crisis

While the US sub-prime crisis has gone international some perspective is in order. In recent weeks some very large numbers have been estimated as the “true” cost of the crisis and a major economic meltdown has been predicted.

The betting market has a 72 per cent probability that the US will experience a recession this year. Martin Feldstein - immediate past president of the US National Bureau of Economic Research (NBER) - has written that the US is in recession already. This is a significant claim as the NBER is charged with dating the US business cycle.

The OECD has claimed the sub-prime crisis will eventually cost between US$350 billion to US$420 billion while the IMF estimate the eventual cost to be almost US$1 trillion. To put these numbers into perspective, Australian Gross Domestic Product is about US$1 trillion.

The bad news is that economic growth in 2008 is likely to be low; the good news is that this isn’t the end of civilisation as we know it.

Comparisons to the great depression or the 1970's oil crisis are simply overblown. Indeed the world has been in similar situations many, many times before and survived.

A paper presented by Carmen Reinholt and Kenneth Rogoff (PDF 40KB) at the recent American Economics Association conference shows, so far, that the current financial crisis has close parallels to 18 previous post-war banking crises in OECD economies.

The run-up in US equity markets and housing prices closely tracks the average run-up of previous crises while the slow-down in GDP growth also tracks the average of previous crises. On measures such as public debt and inflation the US is in better shape than the average during previous crises.

That is not to say that the US does not have high levels of public debt, but the growth is public debt has lower than comparable economies experiencing a similar crisis. In short, the Reinhart and Rogoff analysis suggests that the US is experiencing a stock-standard, run-of-the-mill, banking crisis.

The good news is that this crisis will pass. Of course that statement is cold comfort during the crisis. World financial markets are frequently buffeted by financial storms but the 2007-8 credit crunch will pass into history.

The real bad news is that all financial crises are associated with regulatory hang-over. The last crisis gave us Sarbanes-Oxley. The exact form new regulation will take remains to be seen. The important aspect to crises, however, is that they clear out the economic and financial deadwood. During a financial crisis those firms with poor strategy and non-viable business models are exposed. Many fail.

While that may sound somewhat harsh, that is what is supposed to happen during a crisis. Assets are re-organised and restructured into new configurations, new business models are developed, and the market moves on.

The real question is, why the hysteria? If crises are fairly common - say, 18 banking crises over the last 60 years - why would we be overly concerned about yet another crisis? There are at least three answers.