Term Paper: Leading Indicator of Financial Crisis or Financial Catastrophe

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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… [END OF PREVIEW]

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