THE ECONOMIST

SIGNS of weakness in advanced economies seem to have taken some by surprise. In America, GDP growth slipped in the second quarter of 2012 to a revised figure of 1.7% after growing at a rate of 2% in the first. In Britain, the economy is contracting at 0.5% a year based on latest data, adding to an increasing sense of frustration felt towards the government for failing to ensure a faster recovery.

But perhaps we are suffering from memory lapse. To understand the effects of an economic crisis, you have to go back to its roots. A new study by Alan Taylor draws attention back to the causes of the 2008 financial crisis. Through a series of tests run on a sample of 14 advanced economies between 1870 and 2008, Mr Taylor establishes a link between the growth of private sector credit and the likelihood of financial crisis. The link between crisis and credit is stronger than between crises and growth in the broad money supply, the current account deficit, or an increase in public debt.

Over the 138-year timeframe Mr Taylor finds crisis preceded by the development of excess credit, as in Ireland and Spain today, are more common than crisis underpinned by excessive government borrowing, like in Greece. Fiscal strains in themselves do not tend to result in financial crisis.

When the boom period of credit expansion is coupled with growth in public-sector borrowing, however, the subsequent negative impact on the economy will be worse. Why? When a crash occurs, governments will not have the fiscal capacity to buffer the crisis due to their already stretched borrowing levels. Instead, they become forced to retrench and adopt austerity measures—which tend to drag on growth further, prolonging recession.

Carmen M. Reinhart and Kenneth S. Rogoff’s book "This Time Is Different" shows the fiscal balance is worsened during the crisis period by declining revenues and higher expenditures, due to bank bailout costs, higher transfer payments, and debt servicing. A recent Swedish case is illuminating. Before its 1991 banking crisis, Sweden operated a fiscal surplus of 3.8% of GDP. Afterwards, its deficit-to-GDP ratio grew to more than 15%. During the three years from peak-to-trough, loss of GDP per capita was more than five per cent.

Financial crisis recession will tend to result in a longer-term recessionary drag than a “normal” business cycle recession. When a regular recession is preceded by excess credit growth, Mr Taylor finds there tends to be a mild drag on GDP of 50 to 75 bps. By including public debt-to-GDP levels, there is no great variance in the effects. That challenges the assumption a high debt-to-GDP level alone will cause financial instability.

But a financial crisis recession tends to bring about a larger drag on the economy, of 100 to 150 bps. Add in a high level of public debt-to-GDP, near to 100%, and growth tends to drop by 400 bps.

According to Ms Reinhart and Mr Rogoff’s sweeping historical analysis of previous crises, recessions surrounding financial crisis are unusually long compared to normal recessions—which typically last less than a year. The 1929 banking crisis in America resulted in an almost 30% GDP decrease from peak-to-trough, that is over four years. Argentina’s 2001 financial crisis led to more than 20% of GDP loss over four years. Over the same timeframe, Finland’s banking crisis in 1991 shaved off close to 15% of GDP.

It seems likely the long-term recessionary scenario as described by Mr Taylor, Ms Reinhart, and Mr Rogoff is what economies in the West are now experiencing. Within developed markets, the financial sector occupies a larger proportion of the general economy than ever before. In the 1990s and 2000s, the level of private debt on bank balance sheets far outweighed that held by sovereigns, despite a simultaneous increase in sovereign debt levels. Given the greater severity of recession Taylor concludes is likely following a period of both private and public debt accumulation, the damaging effects could go on for some time.