Friday, March 8, 2013

8/3/2013: Why Economists Failed to Predict the Twin Crises?

Wonderfully interesting recent CEPR (DP No. 9269) paper titled THE FAILURE TO PREDICT THE GREAT RECESSION. THE FAILURE OF ACADEMIC ECONOMICS? A VIEW FOCUSING ON THE ROLE OF CREDIT by Maria Dolores Gadea Rivas and Gabriel Perez Quiros ( takes up a gargantuan task of trying to answer why (and indeed if) economists failed to predict the latest financial and real economic crises.

In addition, the real economic downturn "has also highlighted the lack of consensus in macroeconomic thinking about how far the financial system influences economic activity."

"Basic economic theory suggests that, in a frictionless world, the shocks originating in credit markets play only a minor role in explaining business cycles. However, the presence of financial imperfections can amplify their effect on the real economy and, thus, disturbances in credit markets can lead to larger cyclical fluctuations in the real economy. These frictions also provide micro-fundamentals for analyzing the channels of transmission." This is known as the financial accelerator mechanism.

However, prior to the crisis, "the most influential dynamic general equilibrium models developed just before the recession by Chistiano et al. (2005) and Smets and Wouter (2007) do not incorporate any financial accelerator mechanism. The debate at that time was about the effect of frictions, nominal and real, and the role of monetary policy to offset these effects on output and inflation."

Since the onset of the crisis, a new strand of literature has taken prominence in economics, dealing more directly with the links between the economic and credit cycles. This literature is empirical, rather than theoretical in nature and focuses on historical data of financial crises. Much of the literature concludes "that there are strong similarities between recent and past crises and, consequently, the Great Recession is nothing new" and that credit growth acts as a powerful predictor of financial crises, with external imbalances useful ind erecting the turning points. Majority of studies conclude that "credit booms tend to be followed by deeper recessions and sluggish recoveries."

Per authors, "all these papers have much in common, both in the stylized facts derived from them and in their methodological foundations. They provide considerable evidence that financial markets, and credit in particular, play an important role in shaping the economic cycle, in the probability of financial crises, in the intensity of recessions and in the pace of recoveries. The argument is that the strong growth of domestic credit and leverage that fuelled the expansion phase became the trigger for a financial crisis and, therefore, for a recession4. A common finding is that downturns associated with financial crashes are deeper and their recoveries slower."

The clarity and the robustness of the new studies' results begs a question as to why "the financial accelerator mechanism did not appear earlier on the agenda of the theoretical business cycle models"? "It seems that the link between financial and real crises is so obvious that economists should have been blind when looking at data before the crisis to miss such an important feature of the data. Significantly, however, all the papers that find this clear empirical evidence date from after the financial crisis started."

The real question to ask, therefore, is "whether this ex post evidence, could be obtained ex-ante and if it is sufficiently robust to assist with economic policy decisions"?

In other words, ex-post crisis studies do not "take into account the fact that recession dating is uncertain in real time. Furthermore, when the macroeconomic variables have the property of accumulating during the expansions periods, a potential bias may arise because these variables usually present high levels just before the turning points. For example, from this literature, an analyst could extract the lesson. However, during long periods of expansions, credit to GDP growth is high and there is no recession. Also, credit as a proportion of GDP accumulates over time endogenously in different theoretical models, …and, therefore, it is endogenously high when expansions are long. Yet these high levels before turning points do not imply any power of the credit to GDP ratio in predicting the turning points. In medical terminology, the previous literature is more interested in the ”anatomy” of financial
crises, after they have occurred, than in ”clinical medicine”, that is, diagnosis from the symptoms. …For the lessons extracted from the data to be of value to policymakers in their day-to-day policy decisions, we have to understand the dynamics of these financial variables in real time without forgetting the uncertainty about turning points."

This is a brilliantly put introduction to the core thesis of the paper: "to consider the cyclical phases and, especially, recessions in an environment of uncertainty. Policymakers that see credit to GDP growing have to decide when the growth is dangerously high and could generate a turning point. If a long expansion keeps generating a high credit to GDP ratio endogenously, to cut credit dramatically could unnecessarily shorten the period of healthy growth."

Put differently, "the key question for a policymaker is to what extent the level of credit to GDP (or its variation) observed in period ”t” increases or not the probability of being in a recession in ”t +1”, or whether it changes the characteristics of future cyclical phases."

To answer these questions, the authors propose "a novel and robust technique for dating and characterizing business cycles and for analyzing the effect of financial and other types of variables. We combine temporal and spatial data and we show that this approach is legitimate, notably reduces the uncertainty associated with the estimation of recession phases and improves forecasting ability in real time."

The key results can be summarized as follows:
-- "Credit build-up exerts a significant and negative influence on economic growth, both in expansion and recession, increasing the probability of remaining in recession and reducing that of continuing in expansion."
-- "However, these effects, although significant, are almost negligible on the business cycle characteristics.
-- The authors show that "there is no significant gain in forecast performance as a consequence of introducing credit."
-- Thus, "in contrast to the previous literature, our findings indicate that the role of credit in the identification of the economic cycle and its characteristics is very limited."

Per original (and by now secondary) question asked the authors claim that their "results also explain why financial accelerator mechanisms have not played a central role in the models that describe business fluctuations. The financial accelerator was not a key point in explaining business fluctuations simply because, empirically, it did not have such a close relationship to the business cycle, either in a sample (prior to the crisis) or in an out of sample approach, once the uncertainty in dating recession periods is included in the model."

This is a really interesting paper with fundamental implications for macroeconomics and one of the earliest attempts to reconcile empirical predictability and theoretical clarity of core modern theory (namely that of the financial accelerator) relating to the financial crises and the links between the financial and real economic crises.
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