Presentation at the HLEG thematic workshop on "Intra-generational and Inter-generational Sustainability", 22-23 September 2014, Rome, Italy, http://oe.cd/StrategicForum2014

1. Three Long Term Costs of Sharp
Deep Downturns
Ravi Kanbur
www.kanbur.dyson.cornell.edu
Presentation to Strategic Forum
Rome, 22-23 September, 2014

2. Panel Members
• Martine Durand, OECD
• Ravi Kanbur, Cornell University
• Joseph Stiglitz, Columbia University
• Ignazio Visco, Bank of Italy
In the presence of Giorgio Napolitano, President
of Italy.

3. Introduction
• We are being asked to consider the long term
consequences of sharp and deep reversals of
macroeconomic fortune.
• In effect, we are being asked to consider whether
there is a strong asymmetry between the
downside and the upside of the trajectory of
economic and social variables.
• Can the effects of a sharp drop during bad times
be made up by a symmetric rise in good times?
Both theory and evidence suggest not.

4. Health
• Let me first of all consider health, and in particular
child development.
• The strongest evidence we have is on child
development in developing countries. Child
development in the hungry years, as quantified by
anthropometric measures, is not made up by an equal
number of good years when food is plentiful
(Hoddinott and others).
• Similar evidence on persistence of the effects of
childhood circumstances is to be found for developed
and developing countries in the work of James
Heckman and collaborators.

5. Health
• Thus macroeconomic downturns which lead,
whether through decline in private income or
through decline in public expenditures, to
short terms negative consequences for health,
will also have long term consequences for
health, productivity and economic growth.

6. Social Tensions and Social Cohesion
• Let me start with an extreme example from a
developing country context.
• Prior to the 1997 financial crisis, all standard
indicators in Indonesia were improving.
• A few weeks into the crisis, ethnic riots began,
resulting in considerable loss of life before
order was restored.
• The social tensions created by those riots
persisted long after the crisis ended.

7. Social Tensions and Social Cohesion
• I propose a two part hypothesis.
• First, a sharp and deep downturn magnifies social tensions,
as jobs and housing become rationed. Pre-existing divides
are sharpened and crystallized by political entrepreneurs.
• Second, the divides once crystallized have persistence; they
do not just dissolve away when the economic crisis
dissipates.
• There is evidence on the link between the rise of extremist
parties and sharp recessions in Europe. Less well
researched is the persistence of the platform of these
parties in the political discourse, as the mainstream parties
modify their own positions in response.

8. Prospect Theory and Wellbeing
• The third area I want to highlight is perhaps somewhat
technical and esoteric.
• The way we typically measure the economic wellbeing
of an individual or a household is to take a snapshot of
income or consumption at a point in time.
• But the Nobel prize winning work of Daniel Kahneman
suggest that there is more to it than this.
• His “Prospect Theory” suggests that individuals assess
their wellbeing relative to a reference point and,
relative to this reference point, falls in consumption or
income are weighted more negatively than increases
are weighted positively.

9. Prospect Theory and Wellbeing
• So the assessment of wellbeing at a point in time is affected by the
full pattern of ups and downs, rather than single snapshot.
• If the reference point is the level of consumption before the
recession, then a deep downturn will be weighted heavily
negatively.
• If the recession persists long enough that the low level of
consumption becomes the reference point, then an upturn which
takes consumption back up to the pre-recession level will of course
increase wellbeing.
• BUT wellbeing will not go back up the pre-recession level. This is
because, following Prospect Theory, the positive change is given
less weight than an equal and opposite negative change.
• Thus, even if consumption is restored to the pre-recession level,
wellbeing will not be, which is a long run cost of the recession.

10. Conclusion
• Sharp deep recessions will have long term
consequences in terms of health, wellbeing
and social tensions.
• All the more reason to avoid them in the first
place!

11. Thank You!