John Cochrane* On Recessions with Financial Crises

From an interview in the Federal Reserve Bank of Richmond’s Econ Focus:†

EF: Do you think there's any reason to believe recessions following financial crises should necessarily be longer and more severe, as Carmen Reinhart and Kenneth Rogoff have famously suggested?

Cochrane: Reinhart and Rogoff only showed that recessions following financial crises have been, on average, longer and more severe — not even "always," let alone "necessarily." I don't believe they advanced a theory, either, so they really just documented a historical regularity, a correlation and not a cause. So no, I don't believe that, at least not yet. Lots of people tell a story in which it takes a long time to "deleverage," "restore balance sheets," and to work "excess debt" out of the system, but just what that means and why it takes a long time hasn’t been adequately modeled and tested yet.

An alternative explanation for the correlation is that governments tend to do particularly bad things in the wake of financial crises. They tend to bail out borrowers at the expense of lenders, overregulate finance, pass high marginal tax rate wealth transfers, alter property rights, and introduce other distortions. Mortgage foreclosure used to take a few months, and now it can take two years. And then people wonder why lenders aren’t willing to lend at low rates anymore. The Great Depression seems like a classic case of counterproductive policies being put in place after a financial crisis that made the whole episode much deeper and longer. [emphasis added]

Students need to recognize that recessions can occur without financial crises (most recently in 2000-1), that financial crises can occur without recessions (most recently in 1987-9, or 1998). But, they can also occur together, as in 2007-2009. Most people think that we’re worse off if they occur together, and that makes a lot of sense, but surprisingly the data aren’t strong enough to call that a settled question.

* John Cochrane is a macroeconomist working on the borderline of macro and finance (sort of like me, except he’s a superstar). He has been on the faculty at the University of Chicago for close to 30 years, wrote one of the top graduate finance texts, and may win a Nobel Prize in the next 20 years or so. When he talks, you should listen.

† Each Federal Reserve Bank publishes free several things, weekly to annually, that cover macroeconomics and finance at a level that undergraduates can understand. If you’re curious, start looking.