Are financial crises good, and if so, for whom?

Financial crises hurt economies, there is no doubt. A recent paper by Romain Ranciere, Aaron Tornell and Frank Westermann out in the February 2008 Quarterly Journal of Economics (which has some other work thats very interesting) though argues that some crises are good for long-run economic growth. The authors have a more generally accessible paper here.

Their argument is based on risk taking, which is after all what leads to crises. Too much risk is bad, too little means you grow, but slowly (like India). Just the right amount of risk gives an economy a boost, while leading to rare crises that don't really hurt in the long-run (think Thailand).

They have strong evidence, and I think their results are reasonable, but when I heard about this work, the first thought in my mind was "yeah, but for who?"

So after a few weeks of furtive work, I have come up with a new working paper on how rare crises increase inequality. Ranciere and his co-authors found that the difference in risk taking between Thailand and India accounts for about a third of their growth differences. I find that this risk difference explains 20% of the difference in Gini Coefficients, a common measure of inequality.

This is a pretty big finding, so I double-checked it with income shares by percentile during the 1990s (the only time period with decent data) and found that the top 20% of income earners in a country benefited greatly, while the bottom 40% lost so much that the net effect of risk taking hurts them. The poor, it would seem, would greatly prefer there be less risk taking in their economy.

I also looked into one hypothesis I had as to why there is such a differential effect: employment versus business profits. I found that after a crisis unemployment increases significantly and doesn't settle down for a number of years, while business profit starts increasing again almost immediately after a crisis.

There are plenty of other things going on after a crisis, so this is just one mechanism; there are surely others. At the very least though, the results suggest that, once the US has the current crisis settled down, we shouldn't forget how much the crisis has, and will continue, to hurt the poor.