IMF research on duration of recessions

IMF World Economic Outlook for April 2009 is a must read. The outlook is to be released today but it has posted 2 excellent research chapters . The first one assesses the duration of recessions, recessions with financial stress and global synchronised recessions. The second one analyses how crisis in advanced ecos impact the developing world. 

The transcript of IMF press conference on these 2 chapters is here. The authors explain the results in the meeting:

On average, financial crisis-associated recessions last one and a half years or two quarters longer than other recessions. Furthermore, after the start of such recessions, it takes almost three years to get back to pre-recession output levels, which is more than one and a half years longer than in the case of other recessions.

Second, we found that globally synchronized recessions are also longer and deeper than other recessions and recoveries, and they are more sluggish. So this is sobering evidence for today, given that we have both financial sector driven and globally synchronized recessions. It turns out that in our sample such a combination is rare, and the past suggests that such recessions last almost two years and that it takes over three and a half years for economies to return to pre-crisis output levels.

The next chart illustrates how the probability of remaining in recessions falls when fiscal stimulus is implemented as shown by the blue relative to the red line. The red line shows you the probability of remaining in recession without policies and the blue line is the one that represents the probability of remaining in recessions after implementing fiscal policies. We also find evidence that suggests that the impact of fiscal policy on the strength of the recovery is smaller for economies that have high public debt levels.

There are very few episodes which have both synchronisation and financial stress (just about 6). So we need to take them with a pinch of salt. It says average recovery time for such recession is 3.5 years. So, if we take NBER’s start date for this recession – Demember 2007, we would see recovery sometime in May 2011.  But again in this recession the policy responses have been very aggressive but is also the most severe since 1929. Only time will tell.

The next chapter findings :

Looking beyond advanced economies, what we’re trying to understand is how severe the current crisis is relative to the past, how it spreads across the world and what the implications are for capital flows going forward……Now to answer these questions, we developed a new financial stress index for emerging economies. 

You can see this index in the following chart. The financial stress in advanced economies, the red line, has reached record levels, truly, compared to the past. It’s truly larger than anything we’ve seen in the past. Financial stress in the emerging economies, these are the blue bars. They also surpass the peaks seen during the Asian crisis, but it’s not in a different ballpark.

Now on stress transmission, we find that the stress in emerging economies typically increases almost one for one with the stress in advanced economies, and this also holds true for the current crisis. That said, there’s clearly some regional variation. As you know, emerging Europe was hit especially hard while economies in Latin America weathered the first wave of the stress fairly well.

The main factors accounting for this variation is the strength of financial linkages that emerging economies have with advanced economies. So countries with higher foreign liabilities tend to experience a stronger pass-through of stress from advanced economies. The twist in the current crisis is that bank lending linkages are the main driver, and it’s not what one might expect, the more protracted investment links which had driven the Asian crisis.

What are the implications for capital flows? Historical evidence suggests that a fast recovery of capital flows is unlikely. The reason is the key role of banking sector stress in the current crisis in advanced economies. The bottom line is that while international financial integration brings opportunities for future growth, it comes with risks for emerging economies to suffer contagion from advanced economy stress. This underlines the need for policy frameworks in emerging economies to be strong, and it motivates the recent initiatives here in the Fund to introduce more flexible credit lines for good performers which should help mitigate this contagion.

IMF has been rethinking its strategy on capital inflows and has even suggested some capital controls might help.


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