Psychic losses and economics

New research shows that banking crises have a long-term scarring effect on individuals

Alberto Montagnoli and Mirko MoroThe shock of a financial crisis manifestly imposes a considerable burden both on economies and individuals.  There inevitably exists an extensive literature on the economic costs and the channels through which these crises impact on the functioning of the financial markets and the real economy via credit disruption, wealth and output losses.  When compared to all other types of financial crises, banking crises are seen to be distinctive in that they independently affect the whole economic system and can have both direct (e.g. decreased GDP and employment) and indirect (e.g. higher government spending and lower tax revenue) economic impacts on individuals.

For instance, Carmen Reinhart and Kenneth Rogoff, using a sample that spans several centuries and many countries, show that banking crises have a long-lasting effect on both real economic activity and asset prices: housing and equity markets are severely hit, with their decline recorded at about 35 per cent and 56 per cent respectively.  Notably too, unemployment rises for five years and by seven percentage points, on average.  Real GDP per capita falls by an average of about nine per cent, and the duration of the economic downturn is two years.

Nevertheless, banking crises can also have more subtle and frequent consequences.  Crises erode the fundamental trust on which the entire financial system is based, strongly affecting the mutual level of confidence amongst firms, households and banks and in fact reducing the confidence necessary for investment and consumption.  Ultimately, this increases the overall level of uncertainty, which in turn not only increases the range of possible outcomes but also extends our awareness of the extent of potential unknown unknowns.

There is frequently a tendency to under-emphasise, and sometimes to avoid, the importance of uncertainty in the economic system; however, we should never forget that uncertainty is intrinsic to every transaction.  In fact, every economic system is characterised by a certain level of uncertainty – about the borrowers’ ability to repay the lender; about whether commercial banks will be able to provide liquidity on demand; about whether the central bank will provide all the liquidity necessary to the commercial banks once it has set the interest rate; not to mention uncertainty in general about the long-term consequences of government finances.  Hence, any lack of confidence created by financial crises generates a higher ‘system uncertainty’, which will have a negative impact on the level of consumption and investment and, ultimately, on individuals’ well-being.  Indeed, both consumption and investment are mainly driven by perceptions of risk.  The consequences of banking crises can therefore be far-reaching in that they also involve non-monetary, psychic losses, which stem from the erosion of trust and confidence and the build-up of uncertainty, fear of the future and stress.

Recently, some new evidence on the deeper psychological impact of banking crises has emerged.  For instance, Deaton revealed a significant drop in Americans’ life evaluation and a sharp increase in worry and stress, suggesting that well-being measures were very successful at capturing uncertainty and fear about the future.  In particular, he has pointed out that the return of subjective well-being (SWB) to its pre-crisis levels coincided with the end of the period of uncertainty, as measured by the Dow Jones trend.  In one of our recent papers we compared the life satisfaction of individuals living in European countries before and after the banking crisis and found a causal link between banking crises and psychic losses. The evidence suggests that losses not only extend beyond the conventional macroeconomic factors (e.g. GDP, unemployment and inflation rates), but also further still beyond wealth losses and the fiscal costs likely to be associated with a banking crisis resolution.  It is difficult to provide a conclusive answer to what causes this large decline in SWB, but the most likely explanation is a decline in trust and an increase in the level of uncertainty.

These losses in life satisfaction are also rather large.  They are estimated to be equivalent to an increase in the unemployment rate of ten percentage points (holding one’s job status constant).  Put differently, individuals would require an increase in income equivalent to moving from the first to the second income quartile to offset this level of decline in subjective well-being.  Interestingly too, banking crises appear to have a similar impact across socio-economic groups.   They seem to bring about the same level of misery in males and females, the young and the old, the rich and the poor.

In sum, it seems rather clear that the non-monetary cost associated with individuals’ distress is caused by increased uncertainty and lack of trust brought about by the disruption of banking systems.  In a sense, we could say that banking crises have a long-term scarring effect on individuals.  Further research, both at the empirical and theoretical level, is still needed to formulate clear-cut policy implications deriving from this argument.