The costs and causes of financial crises

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.

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).

Of these, the S&P Index is quite well-known. Its logic is similar to that of the variables related to manufacturing in that it reflects the sentiment of market participants. Investors in equities -- if we assume rationality -- are investing based on the expected value of future cash flows. A decline in the S&P 500 therefore means that overall investors are expecting fewer such cash flows. The caution here is that these are expectations of unknown future performance. The yield curve and consumer sentiment are similarly based on market expectations. Industry participant indicators are probably stronger, which is why so many are included. The use of the index, however, lends the benefits of diversification to the analysis. Manufacturer orders could vary based on inventory levels, for example, rather than expected production levels -- or production estimates could prove to be well of the actual demand. Thus, diversification produces an composite indicator that is frequently used to gauge the direction of the economy.

Conclusion

There are a number of different leading indicators of economic crisis, but studies have shown a few to be fairly consistently reliable. The inverted yield curve is always popular, though it may be losing its predictive powers, or see the lag between its appearance and the onset of recession shrink as it becomes a self-fulfilling prophecy. Nevertheless, the track record of the inverted yield curve is good, as Treasury investors appear to recognize risks before the broader market does.

There is also strong evidence to support the idea that the housing market is an excellent predictor. While there is the risk of a false positive, a large bubble in the housing market usually serves as a leading indicator. There are two main reasons for this -- one is that it reflects broad-based growth in the economy that runs the risk of becoming overheated. The other is that the typical monetary policy response to this overheating is to raise interest rates, which is precisely the action that will burst a housing bubble entirely. The baskets of leading indicators that exist are also considered reliable. While any one given indicator could be subject to issues, these composite indices benefit from diversification, and adds value to the Composite Index of Leading Indicators as one to watch.

However, the challenge is for policy makers to understand these different indicators and react to their moves in a manner that does not explicitly signal that recession or crisis is imminent. Already, Fed watchers seek guidance in every line of text from the Open Market Committee, seeking to close the information asymmetry that exists between the central bank and the market. Surely any monetary or fiscal policy, especially in reaction to the appearance of key leading indicators of recession, will be met with panic and will only hasten the process of slowdown. Thus, the biggest challenge for policymakers is to understand the leading indicators that are not published, and not understood as leading indicators. Alternately, government can only set in motion methods of lessening the damage from the slump, rather than trying to pre-emptively battle against the appearance of recession. After all, it is not just market force that cause recessions but also government intervention to try to combat those forces.

Works Cited:

Babecky, J., Havranek, T., Mateju, J., Rusnak, M.,Smidkova, K. & Vasicek, B. (2012). Leading indicators of crisis incidence. European Central Bank Working Papers Series No. 1486.

Chinn, M. & Kucko, K. (2010). The predictive power of the yield curve across time. NBER Working Paper, No. 16398.

Evanoff, D., Kaufman, G. & Malliaris, a. (2013). Asset price bubbles: Lessons from the recent financial crisis. World Financial Review. Retrieved May 1, 2013 from http://www.worldfinancialreview.com/?p=2200