Growth Dynamics: The Myth of Economic Recovery

Abstract

Although researchers have documented that many financial crises are associated with severe recessions (Graciela Kaminsky and Carmen Reinhart 1999), very little attention has been paid to whether countries recover from such large negative shocks in the sense that output losses are reversed. A few recent papers show persistent output loss from financial crises in a small set of countries. For instance, Cerra and Saxena (2005a) demonstrate that six Asian countries suffered permanent output loss from the Asian crisis, and Cerra and Saxena (2005b) show that only a tiny fraction of the output loss from Sweden's banking crisis in the early 1990s was recuperated. The graphs in Figure 1 illustrate persistent output loss for selected countries following the 1997-1998 Asian financial crisis and the debt crisis of the early 1980s. In addition to financial crises, many countries experience large negative political shocks, which could include violent conflicts such as civil wars, as well as a deterioration in the country's governance. Such political shocks have the potential for significant disruption to economic activ? ity, as illustrated for a few episodes of civil war (Figure 2). This paper systematically documents the behavior of output following financial and political crises in a large set of 190 countries. While the graphs in Figures 1 and 2 are suggestive, our aim is to formally analyze the impact of financial and political shocks on output in a broad set of countries, particularly whether output losses are recovered. Financial shocks comprise currency, banking, and twin financial crises. For political shocks, we examine civil wars, a deterioration in the quality of political governance, and twin political crises comprising both shocks. We choose civil wars rather than interstate conflicts to ensure that the war occurs on the country's own soil. The military theater for some interstate conflicts may not directly encompass all parties to the conflict. In addition, the increase in wartime spending for an international conflict may boost economic activity in some countries. We also examine the economic impact of a deterioration in a country's political governance or institutional quality. Daron Acemoglu, Simon Johnson, and James Robinson (2001) and Acemoglu et al. (2003) use constraints on the power of the political executive as a measure of institutional quality, and find that it is linked to growth and volatility. Thus, we use this measure to study the shock to political governance. Potential endogeneity of the financial or political crisis is an important issue in estimating the output impact of the crisis. That is, the crisis itself may be a function of a slowdown of economic growth or changes in expectations of future growth. We attempt to address this issue using a few methods that are far from definite, but nonetheless uncover some interesting facts. In particular, we find that the forecasts of growth from an autoregressive model and from consensus surveys are optimistic relative to actual growth occurring during and after a crisis.