macroeconomics

Predictors of Financial and Economic Crises

Elias Nieme

Broward College

ECO2013U: Microeconomics

Dr. Krzysztof Bryniuk

June 1, 2021

Predictors of Economic and Financial Crises

Introduction

The financial crisis that occurred in 2008 is considered the worst financial crisis since the Great Depression. This crisis was caused by a lack of monitoring on multiple economic indicators that indicated the incoming crisis. Although an economic crisis is impossible to prevent forever, previous data from this crisis can be used as tools to know when they might occur. There are numerous indicators and data patterns available to economists that allow them to make reliable economic predictions. This research paper will explain some useful and reliable indicators of an economic crisis. It is focused on housing prices, private sector debt and the Yield Curve, and their relationship with the economy and financial sector as the three of them are tools utilized today to foresee an upcoming crisis, as well as what problems are yet to be resolved.

Financial crises indicators

During the global financial crisis, an overlooked indicator that can still be applied today is the growth in house prices and household income caused by borrowing. Houses were being bought with borrowed money from the bank that people could not afford to pay back. An indicator at the time was that around 56 percent of home purchases were made by individuals who would not be able to afford them under regular lending policies (Baily, Litan & Johnson 2016).(financial crisis 2007- 2 sentences) This growth in homeowners and household is a good indicator that can still be use reliably to overlook the financial sector. During the COVID-19 pandemic, home prices have been rising quickly due to low mortgage rates, low supply and high demand. It was reported that in January of 2021, prices are rising at the fastest rate since 2006, growing more than 10% per year (Olick, 2021).

Another predictor that can be used reliably is the growth of debt within the private sector. According to Richards Vague (2016) debt in the private sector is not necessarily a negative thing, however, it must be monitored closely to regulate that is controlled according to the amount of money that the government is receiving. This debt’s effect can be monitored with the increase of the country’s Gross Domestic Product (GDP), since it can indicate the average debt in relation to the average income. For example, if private debt to GDP has tripled, that means the average household or business has three times the debt in relation to their income (Vague, 2016). Preceding the recession, total debt rose and peaked at around 370 percent of GDP, due to high leverage in the financial sector (Faria, 2018). Due to COVID-19 economists expect global debt to reach 365% of world GDP, which is around $277 trillion. (Lu, 2020).

According to Bauer and Mertens (2018), another accurate and reliable indicator is the Yield Curve, which shows the spread between long-term and short-term interest. It is a regular occurrence that when long-term rates are lower than short-term rates, an economic recession will follow. In previous occurrences, it took between 12 to 18 months after the rates drop for a financial crisis to arrive (Probst, 2019). Interest rates are an accurate indicator since they represent the risk that the borrower has, and lower or higher interest reflect the expectations of investors of the upcoming interest rates.

Achievements and Pending Issues of Financial Crises

After every crisis comes a period where the government must learn from previous events and take safety measures to prevent crisis from occurring due to the same causes as the previous ones. After the 2008 crisis, there have been multiple changes made by the government to help the economy develop in a safe way, but there are also some pending issues that are yet to be resolved.

Due to the 2008 crisis, world leaders of the G20 sat together to discuss and coordinate a common purpose, which was to help prevent the threat of a global depression, thanks to this, many international foundations are now operating to provide financial safety by controlling and proposing regulations that protect all the members (Subran, n.d)

For example, one of the regulations introduced is called Basel III, it is an international regulation designed to reduce risks in the banking sector, by making sure banks maintain proper leverage ratios and maintain a certain amount of capital as reserve. Banks are grouped according to their size and importance to the economy and have different capital requirements according to the group they belong to, this is called the bucketing method (Bloomenthal 2020). Basel III also introduced liquidity requirements and regulations to protect against excessive borrowing.

The establishment of the Financial Stability Board (FSB) is also an important achievement that came from the aftermath of the crisis. The FSB is an international body established after the G20 summit in 2009 as a successor to the Financial Stability Forum. The FSB’s job is to regulate and supervise the members of the G20 in the area of financial markets, it also monitors the members’ implementation of the regulatory standards.

Some areas are still undeveloped and due to that, there are some important pending issues in the economy that the government must address, like the fragility of the supply chain. Most companies utilize a management method called Just-In-Time manufacturing, which has suppliers deliver smaller amounts of material more frequently. Even though this method increased financial performance, inventory was completely on the supplier’s hands, and any time the supplier has problems delivering materials companies are forced to decrease or stop production (Weissman, 2020).

During the COVID-19 pandemic, this has been one of the major problems the economy is facing, emergency and health supplies are hard to acquire, supply is slow and thus productions is almost non-existent. Companies are dependent on overextended supply lines, outsourcing and small inventories, instead of having a reliable domestic source of supply.

Conclusion

Today, there is more available data for economists to indicate and utilize some financial crises indicators. Therefore, the economists can make more accurate and reliable predictions on the development of the economy. There have been many new policies implemented after the 2008 crisis to regulate all financial sectors and reduce risks, international institutions now regulate and supervise countries to help prevent a global crisis. However, an economic crisis was bound to happen at some time, and the COVID-19 pandemic was proof of that. With the help of these tools, their impact can be controlled in time. However, there are still pending issues in financial sector that cannot be overlooked. History has taught us that the times these indicators were ignored or were not monitored properly, an economic crisis falls upon the financial sector.

References

Baily, M., Litan, R., & Johnson, M. (2008, November). The Origins of the Financial Crisis. Business and Public Policy. https://www.brookings.edu/wp-content/uploads/2016/06/11_origins_crisis_baily_litan.pdf

Bauer, M., & Mertens, T. (2018, August 27). Information in the Yield Curve about Future Recessions. https://www.frbsf.org/economic-research/files/el2018-20.pdf

Bloomenthal, A. (2020, July 11). Basel III. Investopedia. https://www.investopedia.com/terms/b/basell-iii.asp

Faria-e-Castro, M. (2018, October 16). Domestic Debt Before and After the Great Recession. Federal Reserve Bank of St. Louis. https://www.stlouisfed.org/on-the-economy/2018/october/domestic-debt-before-after-great-recession

Euler Hermes. The Global Financial Crisis: 10 Years, 3 Achievements, 3 Must Do’s. https://www.eulerhermes.com/en_global/news-insights/economic-insights/1171.html

Lu, M. (2020, December 14). This Chart shows how debt-to-GDP- is rising around the World. World Economic Forum. https://www.weforum.org/agenda/2020/12/global-debt-gdp-covid19/

Olick, D. (2021, March 12). The housing Market stands at a tipping point after a stunningly successful year during the pandemic. CNBC. https://www.cnbc.com/2021/03/12/housing-market-covid-one-year-anniversary.html

Probst, J. (2019, July 12). The ‘yield curve’ is one of the most accurate predictors of a future recession – and it’s flashing warning signs. The Conversation. https://theconversation.com/the-yield-curve-is-one-of-the-most-accurate-predictors-of-a-future-recession-and-its-flashing-warning-signs-119963

State Secretariat for International Finance SIF. Financial Stability Board FSB. https://www.sif.admin.ch/sif/en/home/multilateral/gremien/fsb.html

Vague, R. (2016). The Private Debt Crisis. Democracy. https://democracyjournal.org/magazine/42/the-private-debt-crisis/

Weismann, R. (2020, March 24). Today’s supply chains are too lean. Supplychaindive. https://www.supplychaindive.com/news/lean-supply-chain-jit-inventory-covid-19/574693/