Crises the Costs of Financial

Crises

The costs of financial crises are, in short, catastrophic. Shocks to financial systems often result in increased government debt, plummeting stock markets, and increased joblessness at the least. At their worst, they can cause regime change, and wipe out life savings. Massive changes in exchange rates can also occur, necessitating shifts in the way the country interacts with the world, and hurting countries dependent on fuel and food imports in particular. Oh, and investors lose a lot of money, too.

Crises are, depending on who you ask, the natural result of capitalism's cycles or they are market failure brought about by government intervention. If either view was correct in its entirety, we would not only know what causes financial crises but would also be in a position both to predict and prevent them. In the real world, where ideology is sidelined, we cannot do away with the forces of capitalism. Quite simply, capitalism works as an economic system because it recognizes and leverages our inherent greed, and the outcomes on the whole are overwhelmingly positive. So capitalism is not going anywhere. The alternative -- which would look a lot like North Korea -- is not desirable to any sane person. Neither is government. Whether you favor "big government" or "small government," the reality is that every government policy affects the market in some way, by altering the patterns by which goods are produced and consumed. Even a purely libertarian government is still a government, and therefore makes policy choices that affect the market. The absence of government -- as one might find in, say, Somalia -- might actually be less desirable than the absence of capitalism.

Complicating matters is that today the world's markets have a high degree of integration. Our most recent crisis, the credit crisis of 2008-2009, took much of the developed world with it, owing to the financial contagion of interconnectness. Not only did financial institutions around the world buy mortgage-backed securities, later known as toxic assets, but nations around the world were heavily invested in the U.S. economy. The contagion spread to Europe, then to Asia, and eventually America's major trading partners either entered recession or saw a slump in their economies as well, their customer base having dried up.

So as long as we live in a world where government intervention in markets co-exists with the forces of capitalism, we will have periodic crises. Prevention, while ideal, can be done some of the time, to some of the potential crises. This is especially necessary because of the contagion effect. We might be able to accept messing up our own economy, but if we take the rest of the world down with us that just makes the recession longer and stronger. In a globalized world, doing what we can to avoid recessions in the first place is good policy. There is little chance, however, that in all the markets around the world we will be able to eliminate financial crises altogether.

Knowing that, we have to do the next best thing. That is to be able to predict crises and start making the right policy choices to lessen their impact, as quickly as possible. Also, if we can predict crises, we might be better able to understand how they form. We can also study crises after the fact -- and we always do - but that knowledge doesn't prevent pain. It only allows us to learn from the pain, which is not the same thing at all. This paper is going to examine the different antecedents of financial crisis. The topic has been subjected to academic scrutiny, as well as scrutiny by those with a horse in the race -- the world's investors. This paper will report those findings and shed light about what the leading indicators of crisis are, and how effective their predictive powers might be.

The big thing to remember about leading indicators is that they are predictors. Every variable is inevitably a human creation, and as such when a variable points towards recession this is a market response to something. An inverted yield curve is a market predictor of slowdown (or more specifically central bank response to an overheated economy, that response designed to slow down the economy). Information asymmetry, or obfuscation, might make it difficult to fully understand why the indicator has change or what that change truly means. This is the challenge, and why those seeking to understand the leading indicators of recession focus on multiple variables.

Leading Indicator -- Asset Bubbles

It has been said by no small number of commentators have attributed the 2008-2009 credit crisis to an asset bubble in the U.S. housing market, not to mention similar bubbles in other countries, notably Spain (Evanoff, Kaufman & Mallaris, 2013). Whether one prefers to leave it there, or trace the bubble back to the policies that helped to fuel it, there was a bubble in place that was easily identifiable. U.S. government agencies publish a large volume of data, so that the existence of the real estate bubble was public knowledge. Part of the problem of course is that many stakeholders were slow to acknowledge that the bubble existed -- naturally to admit this would spark a sell-off, which is not a desirable income unless you have puts on a construction company.

Asset bubbles are a leading indicator, however. They serve this role when we assume that an asset bubble will eventually burst, and that the bursting of the bubble will trigger recession. In hindsight, this all seems fairly self-evident. Looking back today, the real estate bubble in the U.S. is easy to determine, and causal factors like U.S. interest rate policy look obvious on paper. However, there are other factors at work that only came to light after the crisis began. Few would have been aware of the lack of creditworthiness of the collateralized debt instruments built out of those mortgages. There was little talk prior to the collapse about the increase in subprime lending, or that such lending was fuelling much of the strong economy at the time. Naturally, the strong economy was based on positive fundamental factors, not multiple mortgages on castles made of sand.

Bubbles, it should be noted, are difficult to define contemporaneously because nobody is willing to admit that the bubble exists. Shigenori Shiratsuka (2003) of the Bank of Japan notes that euphoria about asset prices in Japan during the 1980s was so strong that nobody ever really considered the possibility that the good times would not last forever. Japan had great fundamentals -- its electronics and cars were conquering the world and growth was high. That none of this was sustainable simply did not occur to enough people, nor to the right ones. There are always contrarians, but even when they are right their views are usually dismissed. The politicians who are responsible for fiscal policy -- and sometimes even the central bankers in charge of monetary policy -- do not want to hear dire warnings in the midst of a booming economy.

He is right -- politicians are not elected to be the bearers of bad news. Moreover, there is asymmetrical information between central bankers and the markets. If the central bank makes a move that the markets are not expecting, the markets will react swiftly, assuming the central bank's move reflects the information asymmetry. The move of the central bank -- cutting interest rates, for example -- would in effect be the means by which information is conveyed to the markets (Romer & Romer, 2000). Thus, even if policymakers suspected that recession was right around the corner and took steps to head it off, the public would see those steps for what they are. Not only would this break the euphoria, but it would likely cause a similarly strong emotional reaction in the other direction -- panic. If politicians had the courage to be contrarians during the euphoric rise of an asset bubble, their moves to defend against the pending recession would surely be a self-fulfilling prophecy, ensuring that recession occurs.

It is also worth considering that all asset bubbles are different. They are, therefore, not perfect predictors of recession. In 2006, it was perfectly reason to identify real estate bubbles in Miami, Spain and Vancouver. The problem is that only of these contributed to crisis. Spain should have been obvious -- the euro and low rates in the Eurozone fueled investment from northern European countries that was unsustainable. For its part, Florida has long had a strongly cyclical real estate market. Vancouver, in contrast, maintains high housing prices today -- the bubble never burst. The lesson is that the fundamentals of the high prices need to be understood to avoid a false positive. With no end of good press, a desirable Pacific Rim location and most important geographic constraints on growth, Vancouver's real estate price trajectory is closer to that of Hong Kong than Florida or Spain. Fundamentals matter, so the presence of high prices and euphoria does not mean that there is a bubble about the burst.

If asset bubbles can be leading indicators of recession, that begs the question what assets are the most important? Several studies have shown that housing prices are critical. They were important in Japan and in 2008 in the United States. Babecky (2012) showed that housing prices consistently predict asset bubbles, minus the occasional false positive. Intuitively this makes sense since any sort of bubble will result in more investment in real estate.

There is a further question that is raised in light of the contagion of the 2008-2009 crisis. Prior to that, as Evanoff (2013) notes, several asset bubbles were effectively contained by monetary policy and did little damage. Most bubbles that cause damage do so in the developing world -- Southeast Asia and Russia in the late 1990s for example -- but in the developed world the damage is usually contained. Frankel and Saravelos (2011) examined the indicators that might shed light on which countries are more likely to experience an economic crisis. Their work identified other variables, including level of reserves and real exchange rate appreciation as being statistically-significant valid leading indicators.

The Babecky (2012) study found that the nominal effective exchange rate, and global inflation are also indicators of bubbles that can be used to predict recession, along with house prices. There are lags associated with these figures, but they can still be used as leading indicators, if they rise quickly during what appears to be an asset bubble. Appreciation remains the key term here -- when asset values are appreciating too quickly there is risk of recession. The intensity of such a recession may still be dependent on the underlying causes of the bubble and the possible contagions that exist within the economies. Nevertheless, the findings show that where an asset bubble appears, inflation rates are likely to increase and the currency is likely to increase in value -- the latter more quickly than the former. At least in developed countries over the past forty years, these leading indicators do presage a recession.

Inverted Yield Curve

Returning to the issue of interest rates, the market for Treasuries in particular is incredibly liquid. Therefore, market movements in Treasuries are considered to be fairly reliable. One market condition that is often cited as a critical leading indicator of recession is the inverted yield curve. Briefly, this occurs when long-term interest rates are lower than short-term rates. Normally, investors need higher returns on long-term bonds because of the time risk. Thus, an inverted yield curve is a predictor of lower rates in the future than exist today. The way that lower rates will occur in the future than today is if the central bank lowers the rate at some point in the future to head off inflation. This again indicates that when inflation breaks through a certain threshold, the economy is probably heading towards recession. The move by the central bank to lower the rate might head off the impending recession, but it may not. The market, which at this point would be speculating on the future rates in advance of confirmed central bank action, is betting that the rates will fall, not that a recession will occur, but there have been correlations established that show a connection between the two. The connection is not causal, but the inverted yield curve does appear to be a leading indicator of recession.

Chinn and Kucko (2010) note that the predictive power of the inverted yield curve has diminished over time. There is a good explanation for this. The inverted yield curve has become famous as a leading indicator, therefore actions that create the inverted curve may spur a response from the central bank. or, more likely, the presence of an inverted yield curve could spark a reaction from investors. Either way, the inverted yield curve could become more likely to appear as investors respond to changes in the environment more quickly. A sustained inversion of the yield curve thus holds more weight than a temporary inversion.

It is also worth considering a reason why the inverted yield curve would still be powerful. Being that is a rather famous leading indicator for recession, the market should react quickly and powerfully to the emergence of the inverted yield curve, bringing about correction without time lag for example. However, this is not the case, mainly because many investors are caught up in the euphoria of the bubble and will seek to explain away the inversion rather than excepting that interest rates are expected to drop, which itself is an indicator of at least a slower pace of growth (Pasha, 2005).

Other Indicators

There are other economic variables that are considered to be leading indicators. Many minor indicators have not proven to be reliable in the way that housing prices, currency exchange rates or inverted yield curves are. These indicators are often grouped into aggregate leading indicators, which make for more reliable measures and better headline numbers. The OECD has its Composite Leading Indicators and in the U.S. The Conference Board has the Composite Index of Leading Indicators. The latter has ten different indicator that have had at least some measurable correlation with the future direction of the economy. These are the average weekly hours worked by manufacturing workers, since factories schedule production in advance of expected demand. Another is the number of initial applications for unemployment insurance, perhaps for the same reason, as is manufacturer's new orders for consumer goods and materials. The speed of delivery of new merchandise to vendors from suppliers is another indicator, as is the amount of new orders for capital goods unrelated to defense. New building permits for residential buildings, the S&P 500, the inflation-adjusted money supply (M2), the yield curve and consumer sentiment are the other components of the Composite Index of Leading Indicators (Investopedia, 2013).