Long‐term Scarring from the Financial Crisis

It is useful to look at the distinction between transitory and permanent effects of a crisis. Financial crises normally bring on a recession, and the output costs can be large, as Hoggarth and Saporta (2001) discuss. In the majority of cases since 1970 in the OECD countries output returns to its trend level and there is no permanent effect. However, there may have been a permanent scar on the level of output in Japan after its crisis in the early 1990s, making the crisis and subsequent recession much more costly. This may reflect the nature and length of the crisis, as the banking sector was left to flounder for some years before its rescue toward the end of the crisis period. This appears to have left a permanent scar because risk premia were subsequently higher, and real asset prices have not fully recovered. Economists think of output being determined, at least in the long run, by factor inputs and technology and not by demand. It is common to summarise these factors into a production function, and we may write this in Constant Elasticity of Substitution (CES) form as Q K L et t t techl t = + − − − −γ δ δρ ρ ρ ( () ( ) ) /1 1 (1) where Qt is output, Kt is capital input, Lt is labour input and labour augmenting technical progress is denoted techlt. There is some evidence that the elasticity of substitution, σ ρ = +1 1/ ( ) is around 0.5 (see Barrell and Pain, 1997). The elasticity of output with respect to capital is therefore approximately the output capital ratio multiplied by the factor share, as can be seen from (1) as ρ = 1 in this case and δγ is the factor share d Q d K Q Klog ( ) / log ( ) ( /) = ρ ρδγ (2) We may write the associated cost minimising factor demands as Log K Q a Log usert t t ( / ) () = −1 σ (3) Log L Q a Log rwage techlt t t t ( / ) ( ) () = − + −2 1σ σ (4) where rwaget is the real wage per unit of labour input and usert is the user cost of capital at t. We calculate the user cost of capital according to a standard Hall-Jorgensen formula: user wacc kdep ctaxrt pdk py t t pdk p