The International Monetary Fund surveys the world economy and outlines some examples of when financial turmoil turns into economic damage. America could be its poster child for the worst-case scenario.
Not all episodes of financial stress lead to economic slowdowns (that only happens about half the time), but when banking-sector problems do stunt growth, the pain lasts longer. How much longer? "In particular, slowdowns or recessions preceded by banking-related stress tend to involve 2 to 3 times greater cumulative output losses and tend to endure 2 to 4 times as long," the IMF says.
Key points from Chapter 4 of the IMF's latest World Economic Outlook 2008 (bold is mine):
- Episodes of financial turmoil characterized by banking sector distress are more likely to be associated with severe and protracted downturns.
- Financial stress is more likely to be followed by an economic downturn when it is preceded by a rapid expansion of credit, a run-up in house prices and heavy borrowing by households and non-financial firms.
- The current situation of the United States bears some resemblance to previous episodes of banking-related financial stress episodes that were followed by recessions.
Make no mistake. The Great Deleveraging is upon us, and it will remain the biggest stressor on our economy for some time to come.