After a financial crisis has struck, blaming others for its cause can strengthen this hubris. Depending on the type of crisis, the politicians will blame the bankers, the bankers will blame the regulators, and the regulators will blame a supranational institution (e.g. the IMF). With it comes the perennial cry for reform, which invariably consists of getting the IMF to do more
(and to do it better); or improving cross border co-operation during times of financial crises, or even to get into the nitty-gritty of market operations to neutralise all future toxic waste from financial weapons of mass destruction. Invariably, we learn nothing from all of this, and the next financial crisis strikes in some region of the world, and the whole sorry cycle starts all over again.
As we noted in a previous article in FOG, economists and economic historians have undertaken a lot of work examining financial crises across time and space. Because we have a better understanding of past financial crises, can we predict where and when they are going to occur?
First, the bad news. Each time a currency crises has occurred over the past 30 years, economists have developed new models to explain them – just after the event. Paul Krugman’s classic first generation model of currency crises, which showed that if authorities are following economic policies inconsistent with a fixed exchange rate regime there comes a point at which the peg is abandoned, was perfect at explaining the Mexico peso in 1976 and 1982. However, it was not very good at explaining why currency crises spread to other countries and how crises can occur in the absence of deterioration in the macroeconomic fundamentals.
Following the ERM crisis in the early-1990s, which could not be explained by Krugman’s model, economists spent much time and effort on developing models showing how speculative attacks occur without a deterioration in the macroeconomic fundamentals. However, these models did not predict the Asian Crisis, so a third generation model was developed. These showed how the combination of increasing debt, low foreign exchange reserves, declining government revenue and rising expectations of devaluation causes a currency crisis. The collapse of the currency is only part of a wider problem with the financial system, which can include ‘crony capitalism’ and moral hazard. Hence in Asia, the macroeconomic fundamentals were strong but the banking sector was characterised by bad loans and unhedged short-term borrowing from foreign banks.
Turning to banking crises, it is instructive to note that despite the publicity surrounding one or two doomsters who correctly called the sub-prime crises, the record of economists predicting bank crisis is not good.
Now for the good news. Contrary to popular belief, currency and banking crises usually do not appear out of the blue. Over the past 40 years, a high proportion have been anticipated by the better-performing leading indicators with only around 15% of crises occurring with one-third or fewer of the indicators flashing a danger signal. However, there is a problem of too many
‘false alarms’ (on the order of one false alarm for every two to five true signals even in the case of the better leading indicators). There is also little evidence that ‘market views’, or analysts’ views, as expressed in spreads, ratings, and surveys, are reliable predictors, important as they may be in determining market access.
For banking crises, the best of the monthly indicators are an appreciation of the real exchange rate, a decline in stock prices, a rise in the money multiplier, a recession, a fall in exports, and the rise in the real interest rate. Among the annual leading indicators of banking crises, a high ratio of short-term capital inflows to GDP came out on top. Micro indicators include the level of bank capitalisation, changes in banks’ capitalisation, shifts in the structure of banks’ balance sheets and rapid change in the maturity structure of banks’ assets and liabilities. The problem with the micro data – and this is especially true for emerging economies – is that
it is not always available or it may be of poor quality. This is either because the institutional arrangements are not in place to produce reliable data even in the best of circumstances or because bankers and their borrowers have a strong incentive to present a rosy picture of their situation (especially when that situation is deteriorating).
For currency crises, the best of the 15 monthly leading indicators were appreciation of the real exchange rate (relative to trend), a banking crisis, a decline in stock prices, a fall in exports, a high ratio of broad money to international reserves, and a recession. Current-account indicators were the best of the pack for the annual indicators.
So, if we know the common grains of most financial crises, why can’t we be smart and devise something that can stop a crisis before it hits? Unfortunately, these common grains have not led to common solutions for prevention for a number of reasons. Despite the warning signals, the authorities believe ‘this time is different’ and are reluctant to act. There can be strong political disincentives domestically for politicians who take unpopular measures that slow economic growth. There is even a collective reluctance at the time of writing for the
G-20 to address the inherent problems with the international monetary system and global imbalances, both of which are the likely kernels for the next financial crisis.
In the light of the past three years, many will argue preventing financial crises has to be a real focus of policymakers going forward. But where should prevention be focused? Over the past 20 years, many emerging market economies have been told by the advanced economies and the supranational institutions that if only they improved their standards of policy making – including adopting fiscal rules and inflation targeting frameworks, better debt management
and the avoidance of dangerous debt structures – then they would avoid financial crises. How the world has changed.
There have been a number of suggestions mooted to address the problems in the banking sector in recent years. These have included reforming Wall Street compensation; improving the regulatory capital and liquidity requirements on banks; significantly increasing collateral requirements for globally traded financial products; and separating capital market banking from standard commercial banking. Those who favour more direct and indirect market discipline to prevent future banking crises (as opposed to regulatory intervention) have suggested the following three instruments would be useful. First, impose more transparency, i.e., force bank managers to disclose publicly various types of information that can be used by market participants for a better assessment of banks’ management. Secondly, change the liability structure of banks, e.g. force bank managers to issue periodically subordinated debt. Thirdly, use market information to improve the efficiency of supervision.
To prevent an exchange rate crisis, policymakers should opt for floating exchange rates and avoid a monetary union in the absence of an optimum currency area (the forthcoming EMU
break-up will be a testament to this).
On a final note, it should be remembered that financial crises over the last 60 years have continued to occur despite vigorous attempts to strengthen the international financial architecture and when our understanding about nominal variables, financial markets and banking structures has made enormous strides. Preventing future financial crises requires more than technical adjustments, it requires changing human nature, which is far harder.
