The First Global Crisis of the Twenty-first Century Was it by gabyion

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									The First Global Crisis of the Twenty-first Century:
                Was it Predictable?



                     Saktinil Roy
                 Athabasca University
Introduction
The US Subprime Crisis
 by now a global crisis
 “unprecedented” since the Great Depression


However
 some authors suggest: historical bank-centered
  crises in several other parts of the world could
  foretell the story
 My research reviews and confirms this
  proposition
Introduction (contd...)
In particular, Reinhart & Rogoff (2008a)
   find “striking” similarities between post world-war banking
    crises in advanced economies and the US subprime crisis

   consider a few crisis indicators and suggest certain changes
    in their behaviour as “precursors” of crisis

Reinhart & Rogoff (2008b)
   arrive at the same conclusion with an extended database that
    goes back to 1800 and includes a core sample of sixty-six
    countries
Introduction (contd...)
But the questions really are

   Could we actually “predict” the subprime crisis
    with historical experiences?

   How well in advance?

   Which country experiences would have given the
    best prediction?

   Which indicators are most relevant?
Introduction (contd...)
Some other observations
 Shiller (2008):
   The recent housing boom in the United States was lot more
     pronounced in the low-price tier than in the high-price tier.
   After the bubble burst the sharpest fall in house prices was
     observed in the low-price market

 Krugman (2007):
   Increase in risky mortgage debts in the United States partly as an
    effect of protracted increase in income inequality over the last
    three decades

 Iacoviello (2008) suggests a similar causality:
    Examines the US time series of income distribution and
     household debt from 1963 through 2003
    Finds that long run increase in household debt can be explained
     only by increasing income gaps
Introduction (contd..)
 Figure 1. 1950--2007: US Labor Productivity and Real Wage Rate


 100

  90

  80

  70

  60

  50

  40

  30
       50   55   60   65   70   75    80    85    90   95    00   05

                       Labor productivity        Real wage
Introduction (contd..)
Hence, a couple of other questions

   The historical crisis episodes better
    understood in relation to rise in income
    inequality?

   This could help predict the US experience
    with greater confidence?
Reinhart & Rogoff, 2008a
Postwar Crisis episodes:

   The “Big Five” Crises:
       Spain (1977), Norway (1987), Finland (1991), Sweden
        (1991), Japan (1992)

   Other Postwar Bank-centered Financial Crises:
     Australia (1989), Canada (1983), Denmark (1987),
        France (1994), Germany (1977), Greece (1991),
        Iceland (1985), Italy (1990), New Zealand (1987),
        Britain (1974, 1984,1991, 1995), and the United States
        (1984)
Reinhart and Rogoff, 2008a (contd..)
Indicators:

   Real Estate Real Price
   Real Equity Price
   % of Current Account in GDP
   Growth of Real GDP per Capita
   Public Debt
   Reinhart & Rogoff, 2008a (contd..)
        Figure 1: Real Housing Prices and Banking Crises
135


130


125                                                   US, 2003=100

120


115
Index




110
                                Average for banking crises in
                                   advanced economies
105


100
         Index t-4=100                                      Average for the "Big 5"

  95
        t-4         t-3   t-2     t-1            T              t+1        t+2        t+3
Reinhart & Rogoff, 2008a (contd..)
          Figure 2: Real Equity Prices and Banking Crises
135

130

125
                                     US, 2003=100
120

115

110

105
Index




100

 95           Average for banking crises in
                 advanced economies
 90

 85      Index t-4=100                                   Average for the "Big 5"

 80
        t-4           t-3           t-2        t-1   T     t+1          t+2        t+3
Reinhart & Rogoff, 2008a (contd..)
                      Figure 3: Current Account Balance/GDP on the
                                  Eve of Banking Crises
                      t-4        t-3       t-2        t-1                  t
                 0


                 -1


                 -2
percent of GDP




                 -3


                 -4


                 -5
                        U.S.

                 -6
                                                       Average for banking crises in
                                                          advanced economies
                 -7
Reinhart and Rogoff, 2008a (contd..)
                    Figure 4: Real GDP Growth per Capita and
                            Banking Crises (PPP basis)
           5


           4


           3         US


           2                                          Average for banking crises in
 Percent




                                                         advanced economies


           1

                     Average for the "Big 5" Crises
           0


           -1


           -2
                1
        Reinhart & Rogoff, 2008a (contd..)
                        Figure 5: Public Debt and Banking Crises
        250


        230


        210


        190
                                           Average for banking crises in
Index




        170                                   advanced economies

        150
                                                                           Average for the "Big 5" Crises

        130
                                                                    US, 1997=100
              Index t-10=100
        110


        90
              t-4              t-3   t-2           t-1          T           t+1           t+2           t+3
Reinhart & Rogoff, 2008a (contd..)
Limitations:
   If a certain change in the behavior of an indicator must be accepted
    as a “precursor of crisis” is an issue that must be settled only in
    practice – specifically with an actual out-of-sample forecasting
    exercise
   If we assume that the four year period foreshadows a crisis
    episode, then for “prediction” purposes it is also important to
    know if there were similarities even before this period – this will
    then allow us to distinguish between a period that is “tranquil” and
    a period that is “pre-crisis”
   A comparison of any crisis with the “average” of historical crises
    could be elusive
      There could be differences across countries which might be
        cloaked under the “average” construct
      For prediction purposes such differences need to be controlled
Predicting the US Subprime Crisis
The Problem:

   Specifically, could we predict the crisis
    starting from 2003?

   Same as asking: going back to the year of
    2002 or earlier could we predict that the
    United States was not going to experience
    any financial crisis in 2006 or earlier (except
    the savings and loan crisis in 1984)?
Predicting the US Subprime Crisis
(contd..)

I consider two additional indicators

   Growth difference between average
    productivity and real wage rate
       In the absence of adequate data on Gini coefficient
        and other measures of income inequality this is taken
        as the measure of growth of income gap

   Inflation
       To account for growth of cost of living
Predicting the US Subprime Crisis
(contd..)

Data, Methodology & Criteria:

   For any historical crisis include only eight
    observations prior to the actual occurrence

   Labelling
       “Pre-crisis” period: four years just prior to the crisis
        episode
       “Tranquil” period: four years even prior to the “pre-
        crisis” period
Predicting the US Subprime crisis
(contd..)
   A panel probit model
       The binary dependent variable
        = 1 when “pre-crisis”;
        = 0 when “tranquil”
       To conclude in favour of a crisis incidence within
        a period of four years
         The predicted probability is compared to a pre-specified
          threshold value
         If the probability exceeds the threshold then a crisis
          incidence is predicted
         I consider both 50% and 75% as the threshold
Predicting the US Subprime Crisis
(contd..)
Results:
   Four specifications
     Specification 1A (all postwar crisis episodes)
       Except Public Debt all indicators considered by Reinhart &
        Rogoff (2008a) are significant

     Specification 1B (all postwar crisis episodes)
       The two additional indicators are introduced – only “inequality
        growth” is significant but with a wrong sign

     Specification 2 (only the BIG FIVE crises)
       Only Real Estate Price, Public Debt & Inflation are significant

     Specification 3 [Finland (1991), Italy (1990), Japan (1992), New
      Zealand (1987), UK (1995) & US (1984)]
       Real Estate Price, Public Debt, Current Account and Inequality
        Growth are significant with the correct signs
Predicting the US Subprime Crisis
(contd..)
Within Sample Performance Results
                                        Spec 1A        Spec1B         Spec 2        Spec 3
______________________________________________________________________________________________


Threshold Probability = 50%
Percent of pre-crisis years
correctly called                          86.8           85.3          80.0           79.2

True alarms as percent
of total alarms                           77.6          79.4           94.1          82.6


Threshold Probability = 75%
Percent of pre-crisis years               69.1          64.7           80.0           70.8
correctly called

True alarms as percent
of total alarms                          73.9           74.6           94.1          94.4
Predicting the US Subprime Crisis
(contd..)
Out-of-Sample Performance Results
                                        Spec 1A       Spec1B          Spec 2       Spec 3
______________________________________________________________________________________________


Threshold Probability = 50%
Percent of pre-crisis years
correctly called                          100.0         75.0          100.0          100.0

True alarms as percent
of total alarms                            80.0        100.0            80.0         100.0


Threshold Probability = 75%
Percent of pre-crisis years                 50.0        50.0            75.0         100.0
correctly called

True alarms as percent
of total alarms                           100.0        100.0           100.0         100.0
Predicting the US Subprime Crisis
(contd..)

Interpretations:

   Significance of Real Estate Price:
     Consistent with Shiller (2008) – “irrational exuberance” --
      economists, policy makers & market experts believed in ever-
      rising house prices
     Similar thing was observed during the housing & stock market
      booms in Japan before the financial crisis in 1992 and also in
      Sweden and Finland before the financial crises in 1991.
Predicting the US Subprime Crisis
(contd..)
   Significance of Current Account
     Consistent with Reinhart & Rogoff (2008a, 2008b):
      persistent current account deficit & capital flow
      bonanza are precursors of crisis

   Significance of Public Debt
     Again, consistent with Reinhart and Rogoff (2008a)

   Significance of Inequality Growth
     Like with other historical experiences, rise in earnings
      inequality contributed significantly – consonant with
      Krugman (2007)
Conclusions
 The US Subprime fiasco could be predicted consistently starting
  in 2003
    Earlier than 2005 when Robert Shiller (one of the few
     economists) predicted the crisis

 Despite Alan Greenspan (2007) talking about “froths” in the local markets,
  thus rejecting the possibility of a speculative bubble

 The crisis could be predicted much earlier than February 2007 -- a date
  that the Global Financial Stability Report (ch. 3, April 2009) by the IMF states
  as the earliest when increasing systemic pressures could be signaled

 One got to look at both “similarities” and “dissimilarities” across historical
  crisis experiences

 Apart from the traditional indicators, inequality growth contributed
  significantly

								
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