Financial Meltdowns Are More Predictable Than We Thought | Working Knowledge (2024)

Financial Meltdowns Are More Predictable Than We Thought | Working Knowledge (1)

Are financial crises predictable? Former United States Federal Reserve Chair Ben S. Bernanke has had his doubts.

Economics can show policymakers “precisely why the choices they made in the past were wrong,” he told Princeton University graduates in 2013. “About the future, not so much.”

But recent research by Harvard Business School Professors Robin Greenwood and Samuel G. Hanson begs to differ. Financial crises, even ones as calamitous as the 2007-2008 banking meltdown, are surprisingly predictable to those who know the warning signs.

Three years of rapid growth in credit and asset prices increased the odds of a crisis to 40 percent.

“Previous authors had shown that there was some ability to predict financial crises,” says Hanson, a professor of business administration in the HBS Finance Unit. “But we were surprised by the magnitude of that predictability.”

More than a decade has passed since risky mortgage lending, excessive borrowing, and soaring housing prices collided in 2008 to trigger one of the more severe financial crises in American history. Since then, economists have been studying the factors that led to that disaster and the subsequent Great Recession to help policymakers avoid a repeat of that painful episode.

Greenwood, Hanson, and colleagues have identified the signs that potentially signal trouble. Three years of rapid growth in credit and asset prices increased the odds of a crisis to 40 percent, up from 7 percent during typical conditions, they reported.

The team studied trends in outstanding credit, stock market values, and home prices from 1950 to 2016 for 42 countries. They found the potential for a financial crisis was highest in years when both stock prices and non-financial business borrowing where rising rapidly, or when both home prices and household debt were growing quickly.

That combination is “a natural signal of an outward shift in the supply of credit, which then sows the seeds of its own destruction,” the researchers write in their working paper Predictable Financial Crises, released in June by the National Bureau of Economic Research. The paper was coauthored by Andrei Shleifer, the John L. Loeb Professor of Economics at Harvard University, and Jakob Ahm Sørensen, a doctoral fellow at the Copenhagen Business School.

Avoiding the 'Red-zone'

The researchers used their findings to devise a predictive gauge called the Red-zone or “R-zone” for short. Countries fall into the “business R-zone” when:

  • Credit extended to firms rises for three years at a rate that reaches the top 20 percent of past experience.

  • Stock market returns reach the top third of past experience during the same period.

The probability that a country in the business R-zone will confront a major financial crisis within three years is 45 percent, based on the team’s research. Countries that fall into the household R-zone—when personal credit and home prices overheat at similar rates—face a 37 percent likelihood of that same fate. R-zone conditions preceded almost two-thirds of the crises that the group studied.

Hanson says that understanding the R-zone could help policymakers take steps to cool down financial markets that are overheating, such as raising overnight lending rates or boosting equity capital requirements at banks. Those tactics might help countries avoid the devastating toll that the 2008 financial crisis exacted and the massive bailouts required to stabilize the system.

Doomed to repeat history?

If it’s so easy to spot the factors that lead to severe breakdowns in the financial system, why do these moments seem to catch monetary policymakers off guard? Hanson offers two reasons:

It’s hard to predict exactly when disaster will strike. Like the drought and high winds that portend a wildfire, rising asset prices and easy borrowing might continue for years until a catalyst causes the situation to combust. Even former United States Treasury Secretary Timothy Geithner would agree, Hanson says.

“I know Tim pretty well,” Hanson says. Continuing the forest fire metaphor, he says, “He’s more of the view that, yes, there are times when it's dry and it’s riskier. But even knowing that it's dry, you still don't know exactly when it's going to happen.”

Adds Greenwood, “Still, our research suggests that the predictability is strong enough to take early action.”

Memories of past catastrophes fade quickly. A financial crisis typically strikes roughly every 20 years, Hanson says. These massive busts are infrequent enough that few policymakers will experience them during their terms, and the next generation of policymakers won’t remember them.

And some things, such as complex socioeconomic and geopolitical breakdowns, are tough to learn vicariously, Hanson says. When the economy recovers, people tend to move on.

“If heads of state could learn from history, then it should be pretty easy for us not to have any wars,” he says. “But wars are rare enough that we’re able to blunder into them again and again.”

Lending for the common good

To be clear, not all borrowing is bad. Record low interest rates for mortgages and other loans are providing a crucial cash injection to people and business owners as the COVID-19 pandemic grinds on.

That said, creditors will likely bear the brunt if financially strapped consumers and businesses start to default on loans. However, even if some companies ultimately go under, borrowing could help “flatten the curve” for bankruptcies, preventing a surge that could inflict more strain on the already struggling economy. Hanson compares such a scenario to attempting to land every airplane in America at LaGuardia Airport in two hours.

“It wouldn’t go well,” he says.

About the author

Danielle Kost is senior editor of Harvard Business School Working Knowledge.

[Image: iStock Photo]

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Financial Meltdowns Are More Predictable Than We Thought | Working Knowledge (2024)

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