Sunday, March 31, 2013

Where are we in the business cycle?

I was at a conference recently in Tokyo, and one of the keynote speakers was Robert Engle (Nobel Prize winner in economics and Professor at NYU), who spoke about his recent research which looks at the notion of what would happen if there was a financial crisis in the future.  This is extremely useful as instead of doing so-called stress tests to see what would happen if specific assets fall in value as far as the financial institutions are concerned ( - hence putting the emphasis on diversification), this turns the approach on it's head and says what happens if all financial assets are worth 40% less, as they were in the 2007-2009 economic downturn.  As Engle and co-authors state in a recent conference paper, "To be specific, whenever the broad (stockmarket) index falls by 40% over the next six months,this is viewed as a crisis."  They then derive a measure called SRISK, which is a measure of systematic risk.

For all those that are interested, the following graph shows the results by country.  So this graph shows a measure of how much current companies (mostly banks) would be underwater if the stockmarket fell by 40% from where we are right now.  Japan is right at the top of the list, principally because Japanese banks are allowed to hold stocks and shares (whereas US banks are not).  But also Japanese banks also hold a lot of Japanese bonds (many on behalf of their customers), so this means that they are not really subject to international contagion.  

This whole exercise though becomes much more interesting if you do the exercise as a % of GDP.  What this gives you is the following chart:

What this now gives you is very interesting as it mirrors recent events.  Cyprus has just had to bail in and bail out it's banks, and of course there have been rumblings of major problems with banks in France as well.  I think the possibility of trouble in France and the Netherlands was the reason why the Netherlands Finance minister, Jeroen Dijsselbloem (who is head of the Eurofin group) said that the Cyprus deal was to be the template for future requests for assistance from the EU.  What is also clear in this chart is that the US is certainly not that risky compared to other countries.  I guess that's one reason why the US stockmarket has been powering ahead, and why although Europe is fretting about the solvency of its banks, whereas the US is not.

But all this talk of future financial downturns got me to thinking about the probability of a recession in any given year and the likelihood that it will be a "financial" sector recession.  The IMF can help here, as they have done a lot of work on recessions, and what might cause them.  One extremely interesting paper is by three economists, Prakash Kannan, Alasdair Scott, and Marco Terrones (see here for the paper).  They look at recessions for all countries, and try to categorize what basically caused these recessions (the so-called "shocks").  The figure below (extracted from their paper), shows their conclusions.
From my perspective what is interesting here is that although financial crises have become more common, so have fiscal policy contractions. We can see the effect of this very clearly now in Europe and in the UK in particular where the cuts are now forcing the UK into a "triple-dip" recession.  In the second part of the figure what is also notable is that there are "shocks" happening all the time, but shocks do not necessarily cause recessions, as we know that recessions are highly correlated between different countries.

One last part of this paper also caught my attention - it is an attempt to compare recessions caused by financial crises to other types of recessions in terms of how the business cycle might change.  The figure is below:
It is clear that on average financial crises cause longer recessions and the recovery takes longer, plus when it does occur it is a much "shallower" recovery than would take place with other types of recession.

So what does this all mean?  Well I would venture to say that although Europe might be struggling to stay out of recession because of the position of their banks and declining stockmarkets, the US appears to be OK, and when the next recession comes here, it will likely not be bank related.  It therefore implies that we have quite a lot of steam left in this expansion cycle this side of the Atlantic, and so we are likely only mid-way through the recovery period.  More on this next time.


  1. This is quite interesting. What I think is particularly characteristic of financial crises is that they often seem to be tied either to corrupt behavior or blatantly incompetent risk management. There still exist financial assets that seem to accomplish more obfuscation than diversification of risk. This is unacceptable, and they are traded by insufficiently trained eyes. Bloomberg News is cluttered almost weekly with reports on legal cases and investigations into insider trading, LIBOR and EURIBOR rigging, fraud, etc.

    It seems quite feasible that financial crisis-induced recessions carry longer recoveries due to inadequate or mistaken policy responses. Austerity can of course be a powerful tool to fix some structural problems, but examples abound in which we can see it's a strategy better suited for the good times, while fiscal and monetary policy can address the shorter term symptoms which really help citizens "on the ground" and create scaffolding necessary to sustain demand until things pick up. In either case, I feel like the structural problems aren't being treated at their roots, with banks remaining free to do the same things they've been doing for over a decade. It's such a shame, because banks can play such a positive role, yet they've lately felt like thorns in the paws of nearly every modern economy in Europe.

  2. Can you explain more how the first graph relates to the second graph (Global System Risk by Country - % of GDP)?

  3. First graph shows the total $ amount of default by the banking sector in each country. The second graph shows this as a % of GDP or the size of the economy.


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