Original Link: http://www.forbes.com/2009/02/10/recession-tarp-japan-opinions-columnists_0211_thomas_cooley.html
By Thomas F. Cooley
Breaking up is hard to do--but worth doing.
As we wait for the other shoes to fall in the current economic and financial crisis, it is useful to reflect yet again on the fact that the situation we are in is not without precedent. It is not the Great Depression (unless we screw up and make it one) nor is it a bread-and-butter recession. But it does have features that we have seen before: A financial crisis caused by a shock to the system followed by a sharp contraction in real activity.
Financial crises are, in fact, quite plentiful. Mexico and Chile in the 1980s, Japan in the 1990s, Sweden, Norway and Finland in the 1990s, to name just a few. The interesting thing about the countries just listed is that they pursued very different policies in response to the financial crises and had very different experiences as a result. What are the themes that emerge?
I described the Swedish approach to their banking crisis a couple of weeks ago, on this Web site. Their crisis was set off by conditions very similar to those experienced in the U.S. Their response was to quickly recognize the problem banks, protect the institutions but not their shareholders, isolate the bad assets in a separate fund, and eventually re-privatize the banks. The approach was not without pain and cost for the Swedish economy, but it was followed by a robust recovery and more than a decade of growth.
Finland's crisis was triggered by a collapse in the former Soviet Union, their biggest trading partner, but it had its roots in the aggressive expansion of credit in the 1980s, de-regulation of the financial sector and bubble-like behavior of asset prices. There, the central bank responded by taking over the central clearing banks for savings banks, which it later privatized. The resulting recapitalization and contraction cost Finland 8% of GDP. The crisis passed and Finland has experienced decent growth since then.
Tim Kehoe and his colleagues have documented the crises and responses that afflicted Chile and Mexico in the early 1980s. Both had their roots in the collapse of commodity prices--copper in Chile and oil in Mexico. Because both countries were very dependent on commodity exports, the collapse of prices imposed severe strains on the banking system.
In Chile, a huge part of the banking system was hit with a severe liquidity crisis. The government took control of the troubled banks. The costs to the economy were severe and GDP contracted for two years. But, over a period of three years, the government liquidated the worst of the banks and re-privatized the salvageable ones. Growth resumed in Chile and it has since been one of the success stories of Latin America.
In Mexico, the government responded to the crisis by nationalizing the banking system. It kept it under government control for nearly a decade before finally privatizing it. In that period, and to some degree since, the government directed the flow of bank financing to favored firms, and others were left to fend for themselves. The results indicate that this approach was less successful. Mexico's economy was completely stagnant from 1982 until 1995 and only began to recover modestly after the next crisis of 1995.