Download In Search Of The Reasons Of The Great Recession : Time For A Change In Policies?:

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.
In Search of Reasons of ‗The Great Recession‘: Abeer Khandker 12
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