Who’s at Risk For the Next Financial Crisis?

 

Economics
Faculty Researchers Jeffrey Frankel, James W. Harpel Professor of Capital Formation and Growth, Harvard Kennedy SchoolPaper Title Can Leading Indicators Assess Country Vulnerability? Evidence from the 2008-2009 Global Financial Crisis CoauthorGeorge Saravelos MPA/ID 2010, Deutsche Bank

Observers tend to assume that every financial crisis is different. According to this perspective, the world is in so much flux that the lessons gleaned from, say, the international debt crisis of 1982 or the Asian financial crisis of 1997–1998 had little bearing on the global economic recession of 2008–2009. There is some truth to this viewpoint, in that these crises had different causes and originated in different parts of the world. However, Kennedy School Professor Jeffrey Frankel and his coauthor George Saravelos mpa/id 2010 — a currency strategist for Deutsche Bank — wondered whether some lessons might have endured across these historical episodes. Can the leading economic indicators that characterized the countries impacted by one shock help in predicting which countries are most vulnerable to the next? Their recent paper finds that the answer is yes, implying that we don’t have to reinvent the wheel each time disaster strikes.

The 2008–2009 recession, the worst financial crisis since the Great Depression of the 1930s, was devastating to the many people who lost their homes, jobs, savings, or businesses. Because this event was, as Frankel and Saravelos put it, “uniquely broad and relatively synchronized across the global economy,” it is a good test case for assessing the usefulness of key economic variables in signaling a country’s susceptibility to large shocks.

Frankel and Saravelos reviewed more than 80 studies from the pre-2008 literature to discover which variables were most often found to be the “leading indicators of crisis incidence.” According to their meta-analysis, two variables stand: central bank holdings consisting of major foreign currencies (such as dollars, euros, and yen), and past movements in the real exchange rate (shifts in a country’s overall exchange rate relative to its long-run equilibrium). Those countries that had the lowest reserves and the most overvalued currencies had invariably been the hardest hit in the past. A country’s national saving rate was another useful indicator.

Frankel and Saravelos found that reserves and the real exchange rate were the two most important indicators for the 2008–2009 crisis as well. They reached this conclusion, which others had overlooked, by introducing three innovations. First, their analysis relied on five measures for how badly a country was hit, whereas earlier studies had generally looked at a single measure, such as currency devaluation or gdp losses. Second, whereas some researchers had focused on the characteristics of the 2008–2009 event itself, trying to determine what was special about it, Frankel and Saravelos took a different approach, trying to see whether an early warning indicator that worked in past crises also applied to this event. It did, they concluded.

Finally, they tried to spell out more precisely when the crisis began (around the time of the Lehman Brothers collapse in September 2008) and when it ended (in mid-2009). Earlier studies had defined the crisis period as all of 2008, even though the recession did not go global until September. Others had included all of 2009. “If you’re trying to pick out the fastest entry in a horse race, you see which horse got to the finish line first,” Frankel explains. “You don’t see how far a horse wandered around after the race was over, because that information is irrelevant.”

Even though he and his coauthor have concentrated on periods of major economic havoc, Frankel finds some reassurance in their overall finding. “It may be a mistake to assume the world is changing so fast that we have nothing to learn from the past,” he says. “It turns out that if you take a long-term perspective and see what has gotten countries into trouble in the past, that can be useful in determining which of them may be vulnerable to the next shock — whenever the next shock may come.”

— by Steve Nadis

Print print | Email email

“It turns out that if you take a long-term perspective
and see what has gotten countries into trouble in
the past, that can be useful in determining which
of them may be vulnerable to the next shock —
whenever the next shock may come.”