Saturday, June 11, 2011

Early warning indicators missed in Europe

Arguably the most important lesson from the sub-prime mortgage meltdown and the consequent Great Recession is that regulators and policy makers across the board either failed to spot or, if they did, ignored early warning signals of impending problems. Post-facto analysis has revealed ample and clear distress signals across many markets on which regulators and policy makers should have acted on.

As Floyd Norris writes by pointing to the examples of Spain and Ireland, more critical and objective analysis of national macroeconomic data could have given out clear indicators of the crisis ahead. Just five years back, both these countries were the star performers among all Euro zone economies with the highest GDP growth rates and lowest fiscal deficits and debt-to-GDP ratios.

However, as the graphic below shows, this rosy picture masked concerns about the unsustainable debts the private sector in these (and Greece and Portugal) were piling up. These borrowings were fueling rapid economic growth that, in turn, produced rising tax collections, allowing national governments to run budget surpluses. The big problem was that instead of going to productive capital investments, this money was finding its way into the property market, fuelling an unproductive property bubble across these countries.

When the crash came private excesses got nationalized and got converted to public sector debt. The massive bailouts of beleaguered financial institutions, fiscal stimulus spending to prop up the recessionary economy, and the slump in all tax revenues ended up devastating the government fiscal balances.

The financial market regulators clearly failed in their responsibility of broad management of the process of capital allocation. The end-use patterns of these external private capital inflows would have been very clear for anybody who cared to observe. But regulators turned the other way.

Bubbles make a mockery of the rational economic man hypothesis among all stakeholders, even regulators. Regulators living through a bubble have always given the impression of being carried away by its "irrational exuberance" and the feeling that the party will go on forever. Then there is the issue of nobody wanting to "take the punch bowl away when the party is on". How do we know that we are not nipping a new growth cycle in the bud?

But all these instincts flies in the face of all standard macroeconomic and financial market theories. There is ample historical evidence, supporting theories, to show how such distress signals could be forebodings of crisis ahead, if not appropriately addressed. It is a constant theme from history that if private sector deficits reached the levels of Spain, Protugal and Ireland, and they were going into fuelling a bubble, then a debt crisis is not far away. Why did regulators think that "this time is different"?

Does this mean that we need to have exclusive arms within the regulatory and policy making appratus whose main job is to exclusively look for the danger signs and act as devil's advocates? Risk managers in private financial institutions are mandated to do precisely this job for their firms, but failed spectacularly. Can we expect anything different from such managers within government regulatory and policy making machinery?

In any case, spotting early warning signals, dissseminating them widely in a cognitively salient manner, and triggering off actions to mitigate these indicators of distress are arguably the most important areas of work for academics, risk managers, regulators, and policy makers.

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