Wednesday, January 23, 2008

The Next Recession When it Comes, Could be a Severe One

Recession talk is all over the financial press and internet these days and the most common rebuttal to the recession argument is what I believe are the six most dangerous words in the English language, “but it is different this time”. A few weeks ago a couple of professors, one from the University of Maryland and the other from Harvard, presented a paper at the American Economic Association that seems to debunk the idea that things are different this time. The article, which is very readable at only 11 pages with just words, graphs, and no calculus, basically examines past banking and currency crises starting in about 1800 and compares them to one another looking for similarities. Using basic variables that are common to many financial crises before the onset of the crisis it then compares these variables to the current US economy. At this point the variables are more relational then causal (their research is not totally complete), but make no mistake the US has all the symptoms of previous banking and currency crises.

The value of this type of research is that it sifts through the data and allows the data to “talk” about the similarities between certain economic variables and financial crises. This is opposed to what is commonly seen in the financial press or from politicians where they pick and choose which data they want to use to support their position. The latter form of analysis is really anecdotes masquerading as statistics.

A summary of the article follows. Portions in italics come from the article. Text in bold is my emphasis.

The first thing covered is of course the data collected and the specific crises used to compare to the US.

Rationalizations for the current situation in the US and why a recession will not occur:

This time, many analysts argued, the huge run-up in U.S. housing prices was not at all a bubble, but rather justified by financial innovation (including to sub-prime mortgages), as well as by the steady inflow of capital from Asia and petroleum exporters.

The huge run-up in equity prices was similarly argued to be sustainable thanks to a surge in U.S. productivity growth a fall in risk that accompanied the “Great Moderation” in macroeconomic volatility.

As for the extraordinary string of outsized U.S. current account deficits, which at their peak accounted for more than two thirds of all the world’s current account surpluses, many analysts argued that these, too, could be justified by new elements of the global economy.

Thanks to a combination of a flexible economy and the innovation of the tech boom, the United States could be expected to enjoy superior productivity growth for decades, while superior American know-how meant higher returns on physical and financial investment than foreigners could expect in the United States.

Reality of what happened in the US:

Starting in the summer of 2007, the United States experienced a striking contraction in wealth, increase in risk spreads, and deterioration in credit market functioning.

The 2007 United States sub-prime crisis, of course, has it roots in falling U.S. housing prices, which have in turn led to higher default levels particularly among less credit-worthy borrowers.

The impact of these defaults on the financial sector has been greatly magnified due to the complex bundling of obligations that was thought to spread risk efficiently. Unfortunately, that innovation also made the resulting instruments extremely nontransparent and illiquid in the face of falling house prices.

The comparison of the US with 18 previous banking and currency crises follows by examining the real housing prices, real equity prices, the percent of current account balance to GDP, real GDP per capita, and public debt as a share of GDP. In all cases the correlation between these variables in previous crises and the current US economy is quite high. The article contains excellent graphs for each of these five variables so the correlation between previous crises and the US can be easily seen.

From the authors:

The correlations in these graphs are not necessarily causal, but in combination nevertheless suggest that if the United States does not experience a significant and protracted growth slowdown, it should either be considered very lucky or even more "special” that most optimistic theories suggest. Indeed, given the severity of most crisis indicators in the run-up to its 2007 financial crisis, the United States should consider itself quite fortunate if its downturn ends up being a relatively short and mild one.

The article is very interesting because it shows the similarities between the US economy as it currently stands and economies of other countries and times (all post WWII) that suffered financial crises. This gives us the opportunity to judge for ourselves the veracity of the arguments used to rebut the projections of a recession.

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