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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 sky high unemployment. 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.
That negative experiences affect expectations and behavior was confirmed recently in a 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 provided credit to politically important enterprises and corruption contributed to a 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 lost their life savings.
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 survey asked people whether a banking crisis is likely in the next 1-5 years. The survey also asked whether the respondents or their friends or family had lost money during the crisis of 1996. The objective was to see how experiences reported in that question affects people's expectations of another crisis. The survey found that only a third of Bulgarians ruled out the possibility of a banking crisis, while a third believed that a crisis is likely or very likely. This is remarkable because Bulgaria has had very successful reforms in its financial system and its economy.
Yet, the survey found that the 1996 crisis still weighed heavily on respondents minds. People who had experienced a large loss in 1996 were almost 50 percent more likely to expect another crisis. Clearly, going through a traumatic financial event has long-term effects on people's trust in the stability of the financial system. Furthermore, incomplete trust affects behavior. People repeatedly mentioned lack of trust as one of the major reasons for not opening a bank account, taking out credit or investing in the stock market.
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 homes to become enthusiastic investors again? The analysis from Bulgaria suggests that it may take years and possibly decades. One more reason to avoid a meltdown of the financial system. The full report it available as a research paper from the Economics Department of Georgia State University in Atlanta, in the U.S.