When asked what is the worst thing that could happen to the economy German people answer inflation and Americans answer unemployment. This difference is deeply rooted in the experience of the two countries during the turbulent economic times between the two world wars. Germany experienced what is still considered to be one of the worst inflation periods of all times and the U.S. population was traumatized by a sky high unemployment rate. Almost a century later these experiences affect how people think and how societies structure their economic policies – the German authorities place a top priority on controlling inflation whereas the U.S. government is vigilant on unemployment.
The effect of prior negative experiences on expectations and behavior was confirmed recently in a new research report using data from Bulgaria. Bulgaria is a small country is Southern Europe, one of the Soviet satellites that began market and political reforms in the beginning of the 1990’s. It was, however, too eager to liberalize its financial system and too slow to reform its real economy. Government directed lending to politically important enterprises and corruption contributed to a continuous build-up of bad debts in the banking system. By 1996, the situation was unmanageable and a large fraction of the banking system imploded. Many people experienced a significant loss.
Twelve years later, in May 2008, a national polling agency conducted a survey investigating whether the experience of 1996 affects how people were thinking about the financial system. The polling agency inquired about the likelihood of a banking crisis in the next 5 years. The survey also asked whether the respondents or their friends of family had lost money during the crisis of 1996. People who had had a loss in 1996 were significantly more likely to expect another crisis. Clearly, going through a traumatic financial crisis has long-term effects on people’s trust in the stability of the financial system. Furthermore, incomplete trust affects behavior. Low confidence in banks makes people hold on to cash.
Would we see the same effect in the U.S.? How long would it take for people who lost 50 percent of their retirement portfolio and 20-30 percent of the equity in their houses to become enthusiastic investors again? The analysis from Bulgaria suggests that it may take years and possibly decades. This is one more reason to avoid a financial system meltdown.