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 : US Labor Productivity and Real Wage Rate

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..)

Reinhart and Rogoff, 2008a (contd..)

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..) Spec 1A Spec1B Spec 2 Spec 3 ______________________________________________________________________________________________ Threshold Probability = 50% Percent of pre-crisis years correctly called True alarms as percent of total alarms Threshold Probability = 75% Percent of pre-crisis years correctly called True alarms as percent of total alarms Within Sample Performance Results

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 True alarms as percent of total alarms Threshold Probability = 75% Percent of pre-crisis years correctly called True alarms as percent of total alarms

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 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