What's the Damage? Medium-term Output Dynamics After Banking Crises

This chapter investigates the medium-term behavior of output following banking crises, and its association with preand post-crisis conditions and policies. We find that output tends to be depressed substantially following banking crises, with no rebound to the precrisis trend. However, growth does eventually tend to return to its precrisis rate, with substantial cross-country variation in outcomes. The depressed path of output typically results from reductions of roughly equal proportions in the employment rate, the capital-tolabor ratio, and total factor productivity. Initial conditions that are strongly associated with medium-run output losses include the short-run change in output, the occurrence of a joint banking-and-currency crisis, and a high precrisis level of investment. Short-run fiscal and monetary stimulus is associated with smaller medium-run deviations of output and growth from the precrisis trend. The recovery from the global financial crisis has been slow and bumpy, with unemployment remaining at high levels, and there are concerns about the prospect of longterm damage to economic activity. In this context, the aftermath of past financial crises may provide useful insights into the medium-term prospects for economies that recently experienced a crisis. To shed light on the medium-term outlook for such economies, this chapter examines the aftermath of banking crises in advanced, emerging, and developing economies over the past 40 years. A first glance at several previous episodes suggests that while banking crises typically lead to large output losses in the short run, what happens to output over the medium run has * The authors would like to especially thank David Romer for his many insights and suggestions. They are grateful also to Olivier Blanchard, Charles Collyns, Jorg Decressin, and to participants at an IMF Research Department seminar. Chris Papageorgiou kindly provided us with computer code to implement the Bayesian Model Averaging analysis. Stephanie Denis, Murad Omoev, and Min Song provided excellent research assistance. This chapter expands on ideas presented in Chapter 4 of the October 2009 World Economic Outlook (International Monetary Fund, 2009a).