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IN SEARCH OF THE REASONS OF “THE GREAT RECESSION”: TIME FOR A CHANGE IN POLICIES? By – Abeer Khandker* Abstract: The most recent recession of 2007 2009, termed as the “Great Recession”, has left many economists, financial analysts and researchers thinking about its causes, and the search for a good theoretical explanation of this phenomenon has started. A good explanation of this recession would certainly equip societies with tools which would be helpful in preventing such downturns in business activities in future. Most mainstream researchers have found that the Austrian Business Cycle Theory gives the most convincing explanation of this recession. Using monthly data of ten years, this paper is a first attempt at statistically finding out the applicability of this theory in explaining the “Great Recession”, and finding out the answer to the question most economists, policymakers, financial analysts and researchers are asking – is it time for a change? Field of Research: Economics (also includes concepts of Finance and Banking) * Lecturer, Department of Business Administration, ASA University Bangladesh, 23/3, Khilji Road, Shyamoli, Mohammadpur, Dhaka-1207, Bangladesh. Email: [email protected], [email protected] In Search of Reasons of ‗The Great Recession‘: Abeer Khandker 2 1. INTRODUCTION: The most recent global recession during the period of 2007-2009, which has been termed as the ―Great Recession‖, has now almost come to an end. But questions concerning the causes of this recession are starting to arise. Some economists, including Stanford economist and former Reagan adviser John Taylor, point out the flawed policy of former Chairman of the Federal Reserve System, Alan Greenspan, of keeping interest rates too low between 2003 and 2005 as a reason for this recession. Other economists, including Nobel Laureate Paul Krugman and Greenspan‘s successor Ben Bernanke, attribute the crisis to regulatory failure. There have been many other numerous explanations of this crisis as well, such as explanations outlined by Khatiwada and McGirr (2008), DeBoer (2008), Hyun-Soo (2008) and Rasmus (2008), but most of their explanations basically stem from one of the two main causes mentioned earlier. However, the most precise explanation of the recession with a sound theoretical base needs to be derived and studied in order to learn from the mistakes which led to the recession. Throughout the history of economic thought, many schools have explained how business activities in an economy fluctuate, i.e. economies move from booms to recessions. The Keynesian school has dominated much of modern economics, but the events leading to the great recession have renewed the interest of analysts towards the Austrian school of thought. One of the founders of this school, Austrian economist and Nobel laureate Frederich Hayek, provided an explanation of business cycles which was not well received by the mainstream economists of that time, but today there has been a revival of interest towards this theory. The reason behind this is that there are many similarities between the events which led to the recession in USA unfolded and the Austrian theory of Business Cycles. So, the question to be asked here is, whether the Austrian business cycle theory provides the key explanation of the recent recession in USA which spread throughout the world, and if it does, then what lessons can be drawn from it. This paper applies cointegration techniques and causality tests on monthly time series data on housing prices, consumer credit, real GDP and the federal funds rate of the Federal Reserve System (central bank of USA) to find out whether the Austrian Business Cycle theory provides a credible and statistically significant explanation of the recent economic recession. This paper then tries to indicate the lessons that can be drawn from this explanation of the causes of the ‗housing bubble‘, ‗credit crunch‘, the ‗subprime mortgage crisis‘ and the ‗financial crisis‘ on the whole. These analyses will help in concluding whether the time has indeed come to change the ways economic policies, i.e. policies that lead to the rise and fall of business activities, are conducted. 2. THE GLOBAL RECESSION: FACTS AND EXPLANATIONS A chain of events led to the economic recession of 2007 – 2010. After the bursting of the ―NASDAQ Bubble‖ or the ―Dot Com Bubble‖ in 2000 (where bubble refers to temporary and unnatural price hikes) the Federal Reserve System (or simply the ‗Fed‘) started lowering the Federal funds rate to historic levels (upto around 1%) and eased In Search of Reasons of ‗The Great Recession‘: Abeer Khandker 3 credit conditions, where the federal funds rate is the interest rate at which private depository institutions (mostly banks) lend balances (federal funds) at the Federal Reserve to other depository institutions, usually overnight. This has been shown in the following figure: Figure 1: The Federal Funds Rate 6 5 4 3 2 1 0 This expanded the money supply to such an extent that financial institutions started offering loans to buyers with low credit scores, where a credit score represents the creditworthiness of a person. These borrowers are called ‗subprime borrowers‘. Government Sponsored Agencies such as the Federal National Mortgage Association (commonly known as Fannie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac) etc. channeled a large number of these credit flows into the real estate market to expand the secondary market for mortgages through mortgage backed securities. Due to lower federal funds rates, the adjustable rate mortgages charged lower interest rates, and since asset prices are inversely related to interest rates, this credit flow led to increases in housing prices. After the initial success of offering subprime mortgages, the practice expanded dramatically and the terms on which borrowers were given loans started becoming more creative and risky. Now, financial institutions consider the current value of the borrowers‘ property to find out whether a person is eligible for mortgage refinancing or not. For this reason, since housing prices were rising, many of these subprime borrowers took loans they could not afford in the anticipation that they would be able to refinance at more favorable rates once the prices of their houses increased. Easy credit also resulted in excessive investment on housing as well, as a result of which demand for housing started rising and more and more houses were being built. By late 2004, the Federal Reserve System thought that the US economy was growing fast enough and started raising the federal funds rate upto 5.25% in January of 2007. As an immediate result of this, it became much more expensive to borrow money, so less people could afford to buy a house. This caused a fall in the demand for housing and house prices, which had been increasing rapidly in the previous years, began falling moderately. For this reason, subprime borrowers could not refinance their loans, which In Search of Reasons of ‗The Great Recession‘: Abeer Khandker 4 caused many of these borrowers to default and their houses were foreclosed on. The values of the ‗mortgage-backed securities‘ in USA declined sharply as a result of those defaults. These events led to a decline in mortgage cash flows for the banks, banks started facing losses, capital levels of the banks depleted and banks started failing. This created the ‗liquidity crunch‘ or ‗credit crunch‘ in USA, which slowed down business activities, decreased the values of stocks of the banks and businesses and created massive unemployment. Through the financial markets, this crisis spread throughout the world. The chain of events leading to the financial crisis, or recession, has been diagrammatically shown in figure 2: Figure 2: The Chain of Events leading to Recession Low Interest Rates Excessive Loans and the Housing Bubble Excess Housing Inventory Decline of Housing Prices Inability to Refinance Mortgages Mortgage Delinquency and Foreclosure Decline of Mortgage Cash Flow Liquidity Crunch for Businesses Bank Failures Bank Capital Levels Depleted Bank Losses - Decline in Business Investment - Increased Unemployment - Stock Market Crash, etc. Tempelman (2010) suggests that Austrian or Austrian-inspired economists such as William R. White (2006, p. 1), Economic Adviser and Head of the Monetary and Economic Department of the Bank for International Settlements from May 1995 to June 2008, have been precise in predicting that a crisis would be triggered by a collapse of an asset bubble, specifically the real estate bubble. The Austrians blame the lowering of federal funds rate as the main cause of the housing bubble and consequently, the recession. Although it is not straightforward to demonstrate this conclusively, several mainstream scholars such as Taylor (2007, 2009), Jarociński and Smets (2008), Smithers (2009), using different types of statistical techniques, have reached similar conclusions. In Search of Reasons of ‗The Great Recession‘: Abeer Khandker 5 Mainstream economists have also begun to identify links between monetary policy and financial leverage, or debt. New York Fed President Dudley (2009) recently noted that ―[t]here is a growing body of economics literature on this issue that links monetary policy to leverage.‖ Dudley cited research by Tobias Adrian and Hyun Song Shin (2009), who identify what they call a ―‗risk-taking channel‘ of monetary policy,‖ and find that shortterm interest rates—the Fed‘s main monetary policy variable—are an important factor in influencing the amount of financial leverage employed by financial intermediaries. According to a recent Wall Street Journal article, ―[Federal Reserve Chairman Ben] Bernanke has been following Mr. Adrian‘s work closely‖ (Hilsenrath 2009). According to mainstream economic research, bubbles are characterized by an increase in trading volumes, especially by nonprofessional or inexperienced investors (Greenwood and Nagel 2008). Nonprofessionals do not enter a market just because the cost of funding is low. They enter a market because they are under the impression that making money is easy. But the reason behind this is that professionals have been able to make money in part because of a cheap cost of funding. Thus, the sequence is from accommodative monetary policy to a low cost of funding to an increase in the use of financial leverage by professional investors, who buy assets and generate earnings in doing so, and are followed by nonprofessional investors who lack the skills to rationally value assets and end up bidding up asset prices accordingly. 3. AUSTRIAN BUSINESS CYCLE THEORY: THE MOST ACCURATE EXPLANATION? After reviewing the literature on the causes of the ‗Great Recession‘, the question that arises is whether the Austrian business cycle theory, which has been criticized by famous economists like Milton Friedman and Paul Krugman, holds the key explanation of the causes of the recent global recession. To answer that, first a brief look at the theory is necessary. Then in the subsequent sections, some cointegration techniques and causality tests have been used to find out whether the chain of events that lead to a recession according to the Austrian theory occurred in fact in USA during 2007 – 2009. 3.1. A BRIEF OUTLINE OF THE THEORY Austrian economists, such as the famous economist and Nobel laureate Frederich Hayek, state that central bank policies which may look favorable for development are inherently damaging and ineffective and are the principle cause of most business cycles, as they tend to "artificially" set interest rates too low for too long. This, in turn, causes excessive credit creation, speculative "bubbles" and "artificially" low savings. According to the fundamental laws of economics, for any good, if price is below the equilibrium price, there will be a discrepancy between quantity supplied and demanded of that good. Hence, if a monetary expansion artificially pushes market rates of interest below the equilibrium rate of interest, their market-established "clearing" or equilibrium level must bring about a discrepancy between the quantity demanded for loanable funds for investment purposes and the quantity supplied of people's savings for lending purposes. This discrepancy is "filled" by the central bank with fiat money that is lent to In Search of Reasons of ‗The Great Recession‘: Abeer Khandker 6 those who wish to borrow that artificially excessive amount of funds for investment purposes. Since the interest rate is lower than before, it increases the present value of longer term investments to a greater extent than shorter-term investments. Hence, some long term investments would now seem to be profitable, which would not have been the case if the rate of interest had remained at its market-determined level. This results in great malinvestments. An example of this is the recent subprime mortgage crisis of USA, which was the result of the subprime lending practices due to the low federal funds rate (as mentioned in section 2). Moreover, lower interest rates discourage savings and encourage consumption, which also increases demand for consumer goods. Now, the relationship between asset prices and interest rates is well-established and straightforward. Any elementary asset pricing model shows that asset prices tend to rise if interest rates are falling, and fall if interest rates are rising. This means that lowered interest rates creates asset price ‗bubbles‘. This bubble ‗bursts‘, or the asset price starts falling sharply once the interest rates are raised later to their natural levels. A good example of this is the recent housing bubble of USA. After keeping the federal funds rate around 1% for quite a long time, the Fed raised it significantly between July 2004 and July 2006. This contributed to the bursting of the housing bubble. This also caused an increase in 1-year and 5-year ARM (Adjustable Rate Mortgage) rates, making ARM interest rate resets more expensive for homeowners. This contributed to the deflating of the housing bubble, as asset prices generally move inversely to interest rates and it became riskier to speculate in housing. Hence, the main theme of the Austrian business cycle theory is that artificial credit expansion through central bank policies ultimately results in unsustainable booms, leading to asset price bubbles, which leads to recessions. Theoretically, this is the most precise explanation of the Great Recession. That is because the 2002-2007 period stands out as a case of an unsustainable boom. There was a surge in various forms of external finance (export revenues, remittances, private capital flows) that caused a consumption boom in advanced economies and a surge in investment and exports in the developing world led by China and other emerging economies. This happened because the increase in credit flows pushed the cost of capital down (World Bank 2010). Such a growth experience bred a sense of robust optimism about the future, especially among investors in developed economies, leading to an underestimation of risk. This state of mind contributed to the collective complacency of policymakers, development practitioners and multilateral agencies that were evident even at a time when the seeds of a rather severe global economic recession were being sown in the USA. 3.2. INVESTIGATING THE LINKAGES BETWEEN THEORY AND EVIDENCE: The theory of business cycles provided by Austrian economists shows a big similarity with the Great Recession. But empirical testing of this similarity needs to be done if some lessons are to be taken from the apparent failure of monetary policy and the In Search of Reasons of ‗The Great Recession‘: Abeer Khandker 7 financial crisis. The methodology, data and results of this analysis has been provided in the subsequent sections. 3.2.1. METHODOLOGY: The target of the empirical analysis is to find out whether the manipulation of the federal funds rate has triggered the financial crisis or not. For that, variables that need to be considered are: real GDP (rgdp), housing prices (hpi), federal funds rate (ffr), and total consumer credit (tcc). The variables federal funds rate, housing prices and consumer credit are considered in order to find out whether the lowering of the federal funds rate caused the credit expansion, and this in turn caused the housing bubble. The variable real GDP is considered as an indicator of recession, since the NBER (National Bureau of Economic Research) defines an economic recession as: "a significant decline in [the] economic activity spread across the country, lasting more than a few months, normally visible in real GDP growth, ..." For statistically proving cause and effect using time series variables, there are two popular and well-established methods – one of them is testing for cointegration and another one is testing for Causality. This paper uses the Johansen cointegration tests and Granger Causality Tests on the variables to find out the cause and effect relationship between the variables. Many tests of Granger-type causality have been derived and implemented, including Granger (1969), Sims (1972), and Geweke et al. (1983), to test the direction of causality. The tests are all based upon the estimation of autoregressive or vector autoregressive (VAR), models involving (say), the variables X and Y, together with significance tests for subsets of the variables. Guilkey and Salemi (1982) have examined the finite sample properties of these three common tests and suggest that the Granger-type tests should be used in preference to the others. In the case of cointegrated data Granger causality tests may use the I(1) (integrated of order 1) data because of the superconsistency properties of estimation. With two variables X and Y: where ut and vt are zero-mean, serially uncorrelated, random disturbances. On the other hand, Granger causality tests with cointegrated variables may utilize the I(0) (integrated of order zero) data, including an error-correction mechanism, i.e., In Search of Reasons of ‗The Great Recession‘: Abeer Khandker 8 where the error-correction mechanism term is denoted ECM. 3.2.2. DATA: The dataset consists of monthly data for 10 years, ranging from 2000 and 2009. This time period has been chosen because it was in this period that the highly criticized actions of the Fed, i.e. the lowering of the federal funds rate to almost 1%, came into play. The data has been collected from the NBER database and the Bureau of Labor Statistics database of USA. 3.2.3. RESULTS: The first part of the analysis is the cointegration analysis. The target here is whether pairwise cointegration holds between ffr and tcc, tcc and hpi and hpi and gdp. The results of the Johansen cointegration tests (as reported by the popular statistical package STATA) have been shown in the following tables: Table 1: Johansen Cointegration Test Results (ltcc and ffr) Maximum Rank Parameters Log-likelihood trace statistic critical value 0 1 14 17 589.3196 598.5715 21.1509 2.6472 15.41 3.76 Table 2: Johansen Cointegration Test Results (ltcc and hpi) Maximum Rank 0 1 Parameters Log-Likelihood 6 9 488.1737 511.8559 Trace Statistic 47.806 0.4416 Critical Value 15.41 3.76 Table 3: Johansen Cointegration Test Results (hpi and lgdp) Maximum Rank Parameters Log-Likelihood Trace Statistic Critical Value 0 1 6 9 401.0488 417.7983 35.6162 2.1172 15.41 3.76 The tables show that there is evidence that the variables ffr and ltcc (log of tcc), ltcc and hpi, and the variables lgdp and hpi are cointegrated. Now, if the chain of events of the Great Recession is interpreted in terms of the Austrian theory, the lowering of the federal funds rate (ffr) caused excessive loans (tcc), which caused the housing bubble (hpi) and eventually the recession which is evident in real GDP (rgdp). Hence, the In Search of Reasons of ‗The Great Recession‘: Abeer Khandker 9 cointegration tests partially prove this. To complete the analysis, pairwise Granger Causality Tests need to be done on the same variables to see whether these cointegrating relationships can be interpreted as cause and effect relationships. For variables which are I(1), the testing procedures outlined in equations (1) and (2) of the methodology section has been used, and for the variables which are I(0), the testing procedures outlined in equations (1‘) and (2‘) have been used. The test results (as reported by STATA) are shown in the following tables: Table 4: Granger Causality Test Results (ltcc and ffr) Equation ltcc ltcc ffr ffr Excluded ffr ALL ltcc ALL chi2 df 16.514 16.514 0.05669 0.05669 Prob > chi2 2 2 2 2 0 0 0.972 0.972 The table above shows that, the federal funds rate is a Granger cause of the log of Total Consumer Credit, but it is not true the other way round. Hence, this provides a statistically significant evidence of the fact that the low federal funds rate increased the total consumer credit in USA during the period 2000 – 2010. The proof that the total consumer credit and the federal funds rate have a negative relationship is shown in the following regression results of ltcc on ffr , where the coefficient of ffr has a negative sign: Table 5: Regression Results Dependent Variable: ltcc (log of total consumer credit) Coefficient Standard Error Value of z ffr -0.02513 0.006738 -3.73 Constant 14.65095 0.018337 798.98 R-squared: 0.12 Number of Observations: 120 Probability > z 0 0 The Granger Causality test results for ltcc and hpi has been shown as follows: Table 6: Granger Causality Test Results (ltcc and hpi) (as reported by STATA) Equation dltcc dltcc dltcc dhpi dhpi dhpi r r r Excluded dhpi r ALL dltcc r ALL dltcc dhpi ALL chi2 df 13.157 15.391 18.483 5.8875 1.7588 6.1734 9.50E+11 2.50E+12 2.80E+12 Prob > chi2 2 2 4 1 2 3 1 2 3 0.001 0.00 0.001 0.015 0.415 0.103 0.00 0.00 0.00 In the table, dhpi and dltcc refer to the first differenced values of hpi and ltcc, and r refers to the one year lagged values of the residuals of the regression of ltcc on hpi. The In Search of Reasons of ‗The Great Recession‘: Abeer Khandker 10 test result shows that the total consumer credit is a Granger cause of housing prices, while housing prices are also a Granger cause of total consumer credit. This proves the fact that increases in loans increased demand for housing which increased housing prices. On the other hand, this also proves that increases in prices of houses caused increased consumer credit, since increasing housing prices caused people to expect that they would be able to refinance their mortgages. Table 7: Granger Causality Test Results (hpi and lrgdp) Equation lrgdp lrgdp hpi Hpi Excluded hpi ALL lrgdp ALL chi2 df 19.141 19.141 23.024 23.024 Prob > chi2 2 2 2 2 0.00 0.00 0.00 0.00 Table 7 shows that hpi is a Granger cause of lrgdp. This completes the process of proving the statements made earlier in section 3. More precisely, the results show that the low federal funds rate caused excessive credit expansion, which in turn caused the housing bubble and eventually the recession. 4. SOME POLICY IMPLICATIONS: The analysis outlined in the previous sections show that the Austrian Business Cycle theory is indeed a good explanation of the Great Recession. This theory also has some clearcut implications for policy. In the modern times, increasingly mobile capital flows now quickly seek out investment projects that are perceived to provide the most attractive returns. In such an environment, herding behavior and bubbles could encourage malinvestment similar to that predicted by the Austrian theory. Hence, the policy implications are more important now than before. The main policy implication of the whole analysis outlined in this paper is that the optimal policy response to any situation would depend on the underlying causes. In the presence of financial and structural imbalance, such as those which prevailed in USA during the recent financial downturn, traditional demand management policies may not prove to be optimal. This is becoming more true everyday with the development of the financial markets around the world. Hence, it is indeed time for a change, and this change does not include increased government regulation. This change calls for a change in the way government regulation should be conducted. Government regulations should help the market forces to work properly, such that proper signals are conveyed to the economic agents. Government regulations should not try to distort the workings of the market forces. Policies such as fiscal policies and monetary policies tend to use the market forces to generate desired results for the economy. They should not be used to artificially depress prices or interest rates for too long, since this leads the consumers and entrepreneurs to expect that these depressed prices would perpetuate, leading to behavior which might not be considered as rational. In Search of Reasons of ‗The Great Recession‘: Abeer Khandker 11 Similar implications hold for the financial markets. Regulation of financial markets should be in the form of helping out people in making sound financial decisions. There should have been some form of regulation in the United States of America which would have overseen the operation of credit rating agencies. These agencies rate the financial instruments available, which help people in taking investment decisions. These institutions ‗overrated‘ many mortgage-backed securities, which led to widespread malinvestment in the financial market. 5. CONCLUSION: The Austrian Business Cycle theory basically points out the disastrous effects credit expansion can have on the economy, and with highly developed financial markets where slight movements in interest rates are channeled quickly towards investment movements, these disastrous effects are likely to be more profound. Hence, there is a need for a change in the way monetary policies, fiscal policies and every other policy which affects business are operated. This change is particularly essential in developed countries with highly developed financial markets. Policy makers in those as well as other countries should not only depend on Keynesian economics or Monetarist ideologies, but should learn from the events which led to the global recession and keep in mind the policy implications outlined in the previous section. Only then would it be possible to prevent economic downturns of this sort in the future. 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