The rise in India’s fiscal deficit is obviously a cause for concern. But we should feel lucky that unlike developed countries, we do not have a banking crisis.
A recent research titled “The Aftermath of Financial Crises” by Carmen M. Reinhart of the University of Maryland and Kenneth S. Rogoff of Harvard University show a striking deterioration in government finances in years following a banking crisis.
They say the increase in government debt in inflation-adjusted terms in the three years following a banking crisis has averaged a huge 86%.
Interestingly, they note that “the characteristic huge build-ups in government debt are driven mainly by sharp fall-offs in tax revenue and, in many cases, big surges in government spending to fight the recession. The much ballyhooed bank bailout costs are, in several cases, only a relatively minor contributor to post–financial crisis debt burdens.”
The research paper also looks at the extent of economic fall and finds that the average per cent decline in inflation-adjusted gross domestic product has been 9.3%, while the average downturn was 1.9 years. Of course, historical averages conceal more than they reveal—during the Great Depression, US output fell by almost 30% and the downturn lasted four years.
What about equity markets? The researchers find that the average peak-to-trough decline during a banking crisis has been 55.9%, while downturns lasted an average 3.4 years. They say the average downturn period in equity markets is much longer than in the economy.
During the Great Depression, the Dow Jones Industrial Average fell from a peak of 380 points in 1929 to a low of 42 points in 1932, went back up to 187 points by 1937 and then moved around 100 points till the end of World War II before moving up. But it wasn’t till 1956 that the highs of 1929 were crossed. After the initial fall, though, the markets didn’t retest the 1929 lows.
Closer to our own time, the Dow hovered around 1,000 from 1966 till 1984. Both the 1930s and 1970s ushered in new brands of capitalism—the world of Bretton Woods, and later, the world of free markets and capital movements.
The moral of the story could well be that during these periods of paradigm change, markets tend to stay flat for long periods.
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