IMF Survey: The economies directly affected by the Asian crisis experienced varying degrees of recession. Why was it important to determine whether the output impact was temporary or permanent?
Saxena: The question of whether the losses were permanent (in the sense of entailing a lower level of output than if the crisis had not occurred) or temporary has implications for understanding the costs of crises and recessions and for designing more effective policy responses. A permanent loss of output is equivalent to a permanent, continuing loss of welfare, unless it is caused by people voluntarily taking more vacations or other highly unlikely circumstances.
Cerra: Understanding whether the losses are temporary or permanent may also shed light on the nature of shocks that generate recessions. For example, there is a long-standing academic debate over whether the business cycles of industrial countries tend to be generated by supply-side shocks, such as productivity shocks, or by demand shocks that lead to recessions through a combination of real and nominal rigidities in the factor and product markets. Permanent losses in the level of output would be more suggestive of supply shocks.
IMF Survey: What implications does the output impact of a crisis have for economic performance?
Cerra: A permanent effect on output implies a permanent decline in living standards relative to the country’s precrisis trend and relative to other countries. Misunderstandings of such developments could lead one to make incorrect inferences about the effects of policy on economic growth. For example, in other work, we found that Sweden’s banking crisis in the early 1990s led to a permanent loss of output and a fall in its per capita income ranking relative to other advanced countries. A prominent scholar pointed to the fall in the ranking as evidence that Sweden’s welfare state had undermined growth, but a closer study relates the decline to the impact of the banking crisis. So, analysts have to be careful. A permanent decline in the level of output may lead some to conclude that lower long-run growth is the result of policies other than those that contributed to the crisis.
IMF Survey: Is it possible for output to recover to a higher level than before a crisis?
Saxena: A crisis can spur a country to implement beneficial reforms that were not politically feasible under tranquil conditions. Indeed, it is now conventional wisdom that economic crises can facilitate or cause reforms. If so, the recovery could potentially be strong enough to lift output permanently above its precrisis trend.
IMF Survey: What does your study find?
Cerra: Our study shows that all of the Asian crisis countries experienced some permanent output loss despite a rapid rebound in their growth rates. The recovery phase is predominantly characterized by a return to the normal growth rate rather than a higher-than-normal growth rate. Hence, the level of output is permanently lower than its initial trend path.
IMF Survey: Which country was worst hit? What was the extent and duration of damage to output?
Saxena: Our sample consisted of six Asian economies that experienced crises in 1997–98—namely, Hong Kong SAR, Indonesia, Korea, Malaysia, the Philippines, and Singapore. (Unfortunately, because of a lack of quarterly data, we were unable to include Thailand.) Our results show that the permanent cumulative loss of output in the Asian crisis varied from as low as 1.5 percent for the Philippines to 22.3 percent for Indonesia. Our results also indicate that the expected duration of a contraction ranges from one quarter to four quarters, and expansions are expected to last considerably longer than contractions in all of the countries. The longer duration of expansions is a result similar to the findings in the U.S. business cycle literature.
IMF Survey: What do your findings imply for possible policy responses?
Saxena: The appropriate policy responses depend on the type and sources of the loss. A permanent loss is associated with a downward shift in potential output, so attempting to restore output by measures to stimulate demand could be inflationary. In these circumstances, the government should focus on macroeconomic or structural policies that raise productivity and potential output, and eliminate the distortions responsible for the loss.
IMF Survey: Is there more research to be done in this area?
Cerra: A wide range of methods have been used to examine the nature of U.S. business cycles, and more of these methods could be brought to bear in studying crisis-driven recessions and recoveries. Moreover, our understanding of these recessions and recoveries could benefit from advances in the estimation and diagnostics of nonlinear models, such as the Markov switching models used in our study.
Saxena: It would also be interesting to look at more episodes of financial crises and examine whether the extent of output loss in the associated recession is correlated with the strength of the subsequent recovery. In addition, if there are differences in the output effects of recessions that follow financial crises relative to other types of recessions, this might give us clues as to the nature of the permanent and transitory effects. Such work could also shed light on whether there is empirical support for the view that crises lead to reform. The relationship between the frequency and the magnitude of crises and between the trend growth rate and prevalence of crises could also be explored.
Cerra: Further work is needed to flesh out the sources of any permanent loss in output. For example, there might be a persistent rise in unemployment or a decline in productivity caused by a collapse in financial intermediation that creates a wedge between savings and their efficient allocation. Research could also test whether the magnitude of output loss and the behavior of the recovery are functions of economic policy responses.
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Copies of IMF Working Paper No. 03/48, “Did Output Recover from the Asian Crisis?” by Valerie Cerra and Sweta Chaman Saxena, are available for $15.00 each from IMF Publication Services. Please see page 303 for ordering details. The full text is also available on the IMF’s website (http://www.imf.org).