Crises Leave Their Scars

Not long ago I was chatting with a friend of mine.

He is about 24 or 25 years old.

We were talking about economic crisis. That is, factors that could trigger one, and the effects a crisis could have on people’s finances.

And, as we talked, something struck me. His comments sounded rehearsed, as if he was reading from a textbook. As if an economic crisis can only happen in theory…

That’s when I realised…an economic crisis was probably very much a theory to him.

Our lucky country has had 26 years without an economic recession, which means that some generations have never experienced one. My friend has probably never seen an economic crisis.

To be honest, I felt a tinge of envy.

Not having lived through a major downturn means that it is very likely your wealth has not suffered from a major economic downturn.

In a way, having had so many years without a crisis has meant that Australia is one of the few countries in the world still able to offer a range of opportunities. That’s one of the many things that I love about Australia.

But, there are worrying signs.

I see restaurants and shopping malls bursting with customers. They have the latest mobile phones and luxury cars. In other words, it seems like everyone has large amounts of disposable income.

Yet salary growth has been non-existent. And household debt keeps rising.

Is this growth real?

We all saw, during the US subprime crisis in the US, how devastating the effects of fake growth can be.

Unemployment soared to almost 10%.

Property values dropped, which meant that people couldn’t sell property at the price they had bought. Many lost their homes.

10 years on, and the recovery has been weak to say the least.

As The New York Times reported recently:

In August, 78.4 percent of Americans in their prime working years — typically defined as ages 25 to 54 — had jobs, down 1.3 percentage points from when the recession began. That small-sounding change masks a vast human toll: the disappearance of more than 1.5 million workers from the economy. Research has found that many fell into drug addiction and poverty.

‘The question is how a recovery in progress for eight years could have left so many people on the sidelines. Is it a reflection of lingering economic weakness — which traditional stimulus policies might yet address — or long-term forces such as automation, globalization and changing demographics?

‘Recent evidence suggests that the recession’s impact is still echoing through the work force.’

The crisis has left its scars.

Yep, according to a recent blog post by the International Monetary Fund (IMF), a crisis can definitely leave permanent economic scarring.

You see, in economic theory, recessions are usually short lived. That is, in a recession, output suffers a setback in the short term, but then it rebounds back to its pre-recession output level, as you can see in the graph below.

Recession Impact

Source: IMF
[Click to enlarge]

But, according to IMF’s research, a recession can lead to a permanent loss of output. That is, once recession hits, output never recovers its prerecession levels, as you can see in the graph below.

Permanent Impact

Source: IMF
[Click to enlarge]

This is supported by data coming out of the US. Since the 2008 crisis, the US has been constantly revising their potential output estimates down, as you can see in the graph below.

Downward Revision

Source: IMF
[Click to enlarge]

A lower output will definitely have an effect on people’s wealth…

Their result is consistent with a 2009 study from the International Monetary Fund. As the Financial Times reported:

The emerging consensus – for the advanced world at least – is that they [scars] will be deep and long-lived. In its recent World Economic Outlook, the International Monetary Fund examined 88 banking crises between 1970 and 2002 and found, on average, that countries do not earn back all the lost ground after the recession slips into people’s memories. In its database, it found that seven years after a crisis, output had fallen by 10 per cent compared with the pre-crisis path. Economic growth generally returned to the pre-crisis rate, but the loss of output seems permanent.’

A crisis, and loss of output, will also have high impact in younger generations.

We are already seeing an intergenerational clash in several countries. In this fake wealth scenario, older generations are gaining wealth from high stock and property market valuations.

Meanwhile, younger generations are struggling to get jobs and salaries are low. And, what’s even worse, younger generations will be most likely left with their debts.

The US national debt is now at a record of US$21 trillion, or 105% of its GDP. Debt has almost tripled in the last 20 years, with the latest trillion added in just the last six months.

Debt is receiving payment today for work that will be done tomorrow. So, at what lengths can we mortgage our future and that of future generations?

Having never lived through a crisis can help you add wealth, but it can also leave you totally unprepared. That’s why always being prepared for a downturn and choosing sound investments is crucial…even if they haven’t happened in 26 years.

A sudden loss of wealth can set you back years, or worse. Especially if it catches you unaware or off guard…as most crisis do.


Selva Freigedo,
Editor, Markets & Money

Selva Freigedo is an analyst with a background in financial economics. Born and raised in Argentina, she has also lived in Brazil, the US and Spain. She has seen economic troubles firsthand, from economic booms to collapses and the ravaging effects of hyperinflation, high unemployment, deposit freezes and debt default. Selva now writes from her vantage point here in Australia. She is lead Editor at the daily e-letter Markets & Money. And every week, she goes through each report and research note produced by our global network of trusted advisors to find the best investment opportunities for you in Australia and overseas. She packages these opportunities for you in Global Investor.

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