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Tuesday, February 19, 2008

The Sub-Prime Crisis

Carmen M. Reinhart and Kenneth S. Rogoff in Is the 2007 U.S. Sub-Prime Financial Crisis So Different? An International Historical Comparison make the argument that the current financial crisis is in fact very much related to earlier ones all over the world. They try to show this through a comparison with data from eighteen crises ranging from 1977 to 1994. Their graphs generally speaking show developments from a point in time (t-4) four years before the onset of the crisis (T) to three years after its climax (t+3). The US crisis of course is different in the sense that we currently are at T. Rogoff and Reinhart then try to make the readers aware of how these other crises in general played out, and, yeah, it is not a pretty picture. In regard to housing prices, real GDP growth per capita, public debt and the current account balance as a percentage of GDP, developments between these eighteen financial crises (especially the so-called five big ones) are eerily similar. A fall in housing prices analogue to earlier cases would mean a loss in value of another 25%. Public debt (and thus really inter-generational borrowing) would in this case also increase significantly (as a side note, as much as I would vote for Democrat just because I abhor religion, xenophobic tendencies, and nationalism, what does an Obama (or Clinton) presidency coupled with Democratic majorities in both Houses mean for the American budget balance and free trade negotiations (see Obama's remarks on NAFTA in today's NY Times).

Finally, the only truly diverging statistic the authors show are real equity prices. Here, prices should have started falling already, yet instead have risen even from t-1 to T. What does this mean then? Rogoff and Reinhart propose as a reason that "the US Federal Reserve [has] pumped in an extraordinary amount of stimulus in the early part of the most recent episode." Whether this is true or not, the relevant question for me would be whether this just means that a decrease in value will occur later than expected (and possibly higher because the value is unnaturally high?) or whether it can be avoided through this stimulus (doubtful somehow, as the Fed cannot simply feeding 'the beast', right?).

Questions, over questions, the social sciences are just wonderful, we really have no clue what's going on, but are very eloquent at making educated guesses. That is why I love it I guess. In any case, it does not look good for the American economy (and by extension the next American president (less important) and the rest of the world (more important)).

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