I think we should just trash the idea that this crisis was unprecedented and no one could have predicted the set of events. It is basically that there were a few economists that saw events coming, it is just that they were ignored. I had written a long article on 3 economists who predicted the crisis/ recession in different ways which I am linking below. However, the list seems to grow as Mark Carney of Bank of Canada points in a speech:
Few forecast these events; although, in an outbreak of retrospective foresight, an increasing number now claim they saw it coming. The reality is that among all the banks, investors, academics and policy-makers, only a handful were able to identify ahead of time the causes and potential scale of the crisis.
(The Handful were - Bill White, formerly of both the Bank of Canada and the Bank for International Settlements; Harvard University’s Ken Rogoff; Nouriel Roubini of New York University; Wynne Godley of Cambridge; and Bernard Connolly of AIG Financial Products).
I came across this paper by Caludio Borio of BIS:
Since the 1980s, a number of episodes of financial market distress have underscored the importance of the smooth functioning of markets for the stability of the financial system. At the heart of these episodes was a sudden and drastic reduction in market liquidity, characterised by disorderly adjustments in asset prices, a sharp increase in the costs of executing transactions and, in the most acute cases, a “seizing up” of markets.
This essay explores the anatomy of market distress as well as the policy options to address it. It argues that, despite appearances, the genesis and dynamics of market distress resemble quite closely those of banking distress and that, contrary to conventional wisdom, the growth of markets for tradable instruments, and hence the greater scope to sell assets and raise cash, need not have reduced the likelihood of funding (liquidity) crises.
Read the entire paper and it is like deja-vu for you. This grudge from William White (one of the people who sw things coming) who is Borio’s colleague (discussed in Bernanke’s profile):
Between 2004 and 2007, White and his colleagues continued to warn about the global credit boom, but they were largely ignored in the United States. “In the field of economics, American academics have such a large reputation that they sweep all before them,” White said. “If you add to that the personal reputation of the Maestro”—Greenspan—“it was very difficult for anybody else to come in and say there are problems building.”
The three men who predicted US crisis
The subprime crisis has led to numerous researches on the subject. Broadly there are two kinds of researches, one that looks at why the crisis happened and two, how can the fallouts from the crisis be limited and the lessons learnt. Within the first category, the research has also shown how this subprime crisis is no different than other crisis.
However, all this research is after the crisis (ex-post as economists call it). How about those economists that had predicted that some crisis/recessionary conditions are on their way? There are three economists (that I know of) had predicted the crisis albeit in their own different way. I don’t know whether they could have predicted the magnitude of the crisis but they could see the developments ahead of others.
The first one is Nouriel Roubini (of New York University). He had predicted in 2006 (when the initial problems in subprime market started) that this is going to be much bigger than expected. Charles Collyns, Deputy Director of IMF in an IMF seminar on Sep 13 2007, said Roubini had made 3 predictions “this time last year”: First, U.S. housing correction would not go away quietly, but would go from bad to worse. Second, weakness in the U.S. subprime mortgage market would cause broader problems in the financial system. Third, he put a high probability on the risk of a recession in the United States and a global hard landing. At that time, two were true and Roubini in his talk explained how third one will still happen. That was in 2007 and we surely see probability of recession has increased.
The second one is James Hamilton (of University of California San Diego) who has expressed his views on the recession via his very popular blog (which he coauthors with Menzie Chinn, of University of Wisconcin; Roubini also has a very useful blog). Though his stance has been very different. He had used a variety of macroeconomic indicators to hint to the readers that US might be heading into a recession. He tracks the various US macroeconomic data releases very closely and used historical time series to show how each economic indicator looked at the time of the previous crisis. The US economic data has been very confusing for quite sometime now with some indicating a slowdown and some no slowdown. So, his probability of recession kept changing but he always hinted worse times ahead. His analysis unlike Roubini (who focused more on the housing markets) was more broadbased. He even developed a new indicator that uses emoticons to suggest whether conditions are good or bad, with a smiling face showing healthy growth prospects ahead and vice-versa. There are no prizes to guess what the emoticon would be at present.
The third one is Raghuram Rajan (of University of Chicago) who via his excellent paper showed how various developments in financial market are posing a risk to the economy. The paper was presented at the Kansas City Fed Symposium in 2005 and the theme for the symposium was “The Greensapn era: Lessons for the Future”. Most of the papers presented at the conference debated at how effective the Greenspan era were, but Rajan took a different stance (He didn’t suggest that Greenspan led to the developments but it was enough to cause discomfort; for details read Donald Kohn’s remarks on the paper). Rajan showed how the competitive and incentive structure in the financial markets has led firms take up much higher risks. He showed that it had become very difficult to generate higher returns (called alpha) than the markets (called beta) and the only way the managers could justify their high salaries was to generate higher returns. Hence, they have been investing in more and more illiquid securities and providing liquidity for the same. This could be dangerous if the markets turn illiquid (like recently) and pose problems for the entire economy.
Unlike the two economists above, Rajan didn’t say when the crisis will come, but the developments have been very similar to what we see now. In his speech in Naples at CSEF-Unicredit Group Conference on 17 December 2008, he revisits his research (calls it the first liquidity crisis of the 21st century) and shows how the perverse incentive structure in the financial system has led to the crisis. This has also led to a lot of debate on how these incentives should be structured and whether regulation should interfere or not.
The three views together explain this crisis much better. The incentive structure explained by Rajan led finance managers to lend fancy loans and then invest in the securities based on similar loans. When the disclosures started it led to an event of problems as Roubini has explained. And finally, Hamilton shows how economic conditions were deteriorating in the US. These are the three economists I know of, who predicted the upcoming crisis in their own way. Let me know, if you know of other economists who predicted the same.