What is a "financial crisis"? (reply to John Cochrane)

The conventional wisdom says that recessions that follow financial crises last longer than other recessions. In a recent blog post, John Cochrane challenges the conventional wisdom:

Financial crises certainly don't always and inevitably lead to long recessions, as the factoid suggests... 

In a nice article for the Atlanta Fed, Gerald Dwyer and James Lothian went back to the 1800s, and find no difference between recessions with financial crises and those without. Some, like the Great depression and now, last a long time. The others don't.   

Michael Bordo and Joseph Haubrich wrote a somewhat more detailed study of US history, (which I found through John Taylor's blog) concluding 

recessions associated with financial crises are generally followed by rapid recoveries. We find three exceptions to this pattern: the recovery from the Great Contraction in the 1930s; the recovery after the recession of the early 1990s and the present recovery. ... 

In contrast to much conventional wisdom, the stylized fact that deep contractions breed strong recoveries is particularly true when there is a financial crisis. In fact, on average, it is cycles without a financial crisis that show the weakest relation between contraction depth and recovery strength 

This had pretty much been the "stylized facts" when I went to grad school: US output has (so far) returned to trend after recessions. The further it falls, the quicker it rises (growth). Financial crises give sharper and deeper recessions, followed by sharper recoveries, but not, on average, longer ones. This "recovery" is in fact quite unusual, looking more like the Great Depression but unlike the usual pattern.  

As I did minor searches for the facts however, it's clear there is an explosion of work on this subject, so it's hardly the last word.  

When I read this, the first question that popped into my mind was "OK, but how are they defining financial crises?" It turns out that the two sources Cochrane cites disagree on this point. The article by Dwyer and Lothian says:

No U.S. recession since World War II [other than the current recession] has been associated with a financial crisis. 

While the paper by Bordo and Haubrich says:

Consequently, the recessions we associate with a financial crisis are those that start in 1882, 1892, 1907, 1912, 1929, 1973, 1981, and 1990.

That's a big difference! Three post-WW2 financial crises versus zero?

The problem, of course, is that it's difficult to define a financial crisis. Many people seem to use the term to mean "a large drop in asset prices" (this is the definition that leads to the claims that economic models can't forecast financial crises). But there are other possible meanings of the term. For example, "financial crisis" could also mean:

• A large number of bank runs, leading to a liquidity crisis

• A solvency crisis, in which most large financial institutions are found to be insolvent

It seems to me that this third definition - the simultaneous insolvency of most large financial institutions - is the kind of "financial crisis" that most people would casually associate with long recessions and slow recoveries. Note that a steep fall in asset prices is neither necessary nor sufficient to generate a solvency crisis, since firms may have different degrees of leverage.

If we define financial crises as asset price drops, it seems pretty obvious that "financial crises" will be associated with most recessions. This is because asset prices are forward-looking and quick to react to events; any shock that will cause a recession over the next year will cause an asset price almost as soon as the shock is realized. I strongly suspect that Bordo and Haubrich are using this definition, since they claim that a financial crisis happened just before the 1981 recession. Stock prices would obviously fall in reaction to an interest rate hike by the Fed (which most people believe caused the recession in '81).

Dwyer and Lothian seem to be using a different definition of "financial crisis". I'm not sure what their definition is, but my guess is that it is a liquidity crisis or solvency crisis type of definition.

Now, both of Cochrane's sources reach the same conclusion, which is mainly based on pre-WW2 data. I don't know much about pre-WW2 economic history, so I'm not really qualified to evaluate their claims. But I think that the confusion over definitions merits a long hard look into exactly what happened in and before all of those pre-WW2 recessions.

Two more points:

1. Actually, my intuition says that financial crises are not the cause of slow recoveries. My intuition is basically the "balance sheet recession" story, which is about a sudden regime change in people's behavior toward debt and consumption after a long build-up in debt. My intuition says that people's sudden shift to a "balance sheet rebuilding" regime will tend to cause both a long recession and a financial crisis. But then again, this is just my intuition...As Cochrane says, there is lots of research being done on the subject.

2. Cochrane definitely does do a good job of rebutting a factoid tossed off by Bill Clinton, which is that recessions after financial crises last "5 to 10 years". Cochrane cites evidence from Reinhart and Rogoff that shows that the international average has been just under 5 years for recent crises. Although I'm not sure I believe the Reinhart/Rogoff numbers (the Great Depression lasted only 4 years??), it is definitely the case that countries such as Sweden, Finland, and Korea have managed quick recoveries after financial crises. I think we should look at what they did, and see if maybe we can replicate their best practices.