to the crisis is over-estimated even when the 3 immediate pre-crisis years are excluded; hence the extent of any post-crisis decline in the trend is also exaggerated.Note that this is the opposite of the illustration in the introduction, where a relatively recent acceleration in the potential rate of growth causes the pre-crisis trend to be underestimated and post-crisis damage to be understated. Either way, mechanical calculations yield misleading results. It seems unlikely, therefore, that analyses of aggregate data can succeed in resolving the issue. Rather, determining whether long-term growth potential has been impaired will require studying the specific mechanisms through which financial crises affect the economy over time.Top of pageFINANCIAL DISTRESSWhen one considers specific mechanisms through which a financial crisis may affect the growth potential of the economy, the obvious place to start is impairment of the financial system. Weakly capitalized banks will be reluctant to lend. Having been burned in the crisis, they will adopt tighter lending standards. Aspiring borrowers, having suffered balance sheet damage, will have less collateral and be less credit worthy. More stringent regulation adopted in response to the crisis requires financial institutions to hold more capital and liquid assets and to otherwise restrain their lending. The more limited supply of bank credit will mean a higher cost of capital. The lesser availability of finance will mean less investment. This effect is most likely to be felt by smaller, younger firms (start-ups) that are disproportionately the source of innovation and employment growth in normal times, that cannot expand on the basis of internal funds, and that find it difficult to tap securities markets.7In the Great Depression, the evidence of a persistent slump in bank lending is overwhelming (Figures 1 and 2), but evidence of a persistent impact on investment and growth is weak. First, to the slow recovery of lending: in part this reflected balance-sheet problems. Using state-level data, Calomiris and Mason (2003) show that banks with less capital and more real-estate assets in their portfolios (and therefore more losses due to foreclosures) grew their loans more slowly in the 1930s. In part, it reflected the flight from risk and scramble for liquidity by all banks. Calomiris and Wilson (2004), analyzing individual bank data, find that banks curtailed their lending and shifted into holding more liquid, less risky assets (primarily cash and treasury securities) following depositor runs in 19311933.8 Banks cut the share of loans in their portfolios not just by limiting new lending but by allowing existing loans to run off as they matured. In 19341940, FDIC-insured commercial banks held as much as 30% of their assets in cash, 37% in treasury bills and other liquid securities, and only 28% in loans (FDIC, 2008).Figure 1.US Bank Loans Outstanding. Sources: Board of Governors of the Federal Reserve System, All Bank Statistics 18961955; Global Financial Data; and Angus Maddison, Statistics on World Population, GDP and Per Capita GDP, 12006 AD (March update)Full figure and legend (21K)Figure 2.US Bank Loans Outstanding and Real GDP. Sources: Board of Governors of the Federal Reserve System, All Bank Statistics 18961955; Global Financial Data;