01 February 2012

VoxEU: Understanding past and future financial crises

This column compares the 2007–09 crisis to earlier episodes of banking, currency and sovereign debt distress, and identifies domestic-credit booms and real currency appreciation as the most significant predictors of future crises, in both advanced and emerging economies.

The authors, Pierre-Olivier Gourinchas and Maurice Obstfeld, say their primary goal is to see if there are commonalities in the prologues to past crises as between advanced and emerging countries, and if the relative fortunes of different global regions differed in the recent recession because of significantly different policy choices or financial-market developments. In turn, such information could aid in predicting future crises.

What are the ‘smoking guns’?

The authors' event-study analysis points to:

• escalating leverage as one of the key ‘smoking guns’ in the run-up to both banking and currency crises;
• real exchange rates tend also to be strong, relative to tranquil periods, before all types of crisis.

The build-up of domestic credit prior to the 2007–09 crisis was much more pronounced for advanced than for emerging economies. Within the latter set of countries, the main build-up of leverage occurred in central and eastern Europe, which, not coincidentally, also suffered some of the most severe negative effects on output.

The results are consistent with a string of earlier contributions stressing the perils of rapid domestic-credit growth, as well as with warnings issued by researchers at the Bank for International Settlements since the early 2000s.

While the event-study analysis suggests that occurrences such as domestic-credit booms tend to precede crises on average, it does not allow the authors to determine whether those occurrences are likely to take place also without triggering a crisis – issuing false positive signals, like Paul Samuelson’s celebrated stock market.

To explore that problem, the authors follow a well-developed ‘early warning’ literature and estimate an econometric model of the probability of different varieties of crisis given a set of potential vulnerability indicators such as domestic-credit booms, the current-account deficit, international reserves, real currency appreciation, and a measure of the output gap.

Simple probability models of the type estimated are unable to capture the full range of factors, some social and political, that can influence the likelihood that a crisis breaks out in the near or medium term. Nonetheless, the authors believe that big increases in the crisis probabilities implied by these models should prompt policymakers at least to ask tough questions about the health of countries’ economic and financial fundamentals, and the need for corrective action.

Full column

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