Are Financial Crises Predictable?

Behavioral economists at Harvard say the answer might be "yes"

By: Greg Obenshain & Eldar Safarov

The consensus wisdom among academics and practitioners alike is that crises are inherently unpredictable. But Harvard’s famed behavioral economics group has recently produced a new paper suggesting the consensus wisdom on predicting crises might be wrong—at least on a time horizon of three years or longer. Instead, they argue that rapid expansions of credit can drive asset price booms, which are followed by credit busts.

Building off earlier academic research, the authors combine data from 42 countries between 1950 and 2016 to study financial crises in the context of business and household credit growth as well as equity and home price growth. They define crises as declines in bank equities by greater than 30% or banking panics, which capture events such as the Great Recession (2007) and the Savings and Loan Crisis (1990), but not the bust of the dot-com bubble. In line with the theories of Hyman Minsky and Charles Kindleberger, the authors find that financial crises tend to follow periods that feature both elevated debt and asset price growth. The authors define periods when three-year debt growth has been in the top 20% of historical increases and three-year asset price growth has been in the top third of historical increases as the “Red Zone,” shown in the upper right-hand corner of the figure below.

Figure 1: Financial Crises Follow Periods of Elevated Debt and Asset Price Growth

Source: Greenwood et al. Dots placed based on the highest debt and price growth in the previous three years.

Businesses and households are analyzed separately, meaning a country can enter the Red Zone either because household debt and equity prices have jointly risen or because business debt and equity prices have jointly risen. It turns out that businesses and households rarely overheat together. The few crises preceded by both high business and household debt growth tend to be notable, including Japan in 1988-89, Spain in 2005-07, and Iceland in 2005-07.

The table below shows the probability of entering a financial crisis once the Red Zone has been breached, broken down by the type of Red Zone event: business, household or both.

Figure 2: Probability of Entering Financial Crisis after Red Zone Breached

Source: Greenwood et al.

The probability of experiencing a financial crisis within one year of entering the Red Zone is over 13%, compared to a 4% probability in the entire dataset. Remarkably, the probability of entering a financial crisis within three years of entering the Business Red Zone is 45% and an astounding 69% in the rare instances when both the household and business Red Zones are breached. The authors note that crises do not immediately follow high debt and asset price growth, suggesting they take time to develop.

As a leading indicator, the Red Zone would appear to be effective. 64% of crises were preceded by either the business or household Red Zone warning within the prior three years. When the authors expand their three-year debt growth to include the top 40% of historical increases and the three-year price growth to be in the top two-thirds of historical increases, the Yellow Zone precedes 82% of crises within the prior three years. But like most leading indicators, their presence does not necessarily result in the event. Red Zones and Yellow Zones were followed by crises only 36% and 20% of the time. To give a sense of what this data looks like, we show the Red and Yellow Zone indicators for the US housing sector along with the real housing price index.

Figure 3: US Housing Red and Yellow Zones and Housing Prices

Source: Bank for International Settlements, Macrohistory Database, Verdad Analysis. Methodology follows Greenwood et al.

The data fit well. The Yellow and Red Zones precede subsequent falls in home prices, most notably in the late 1980s and ahead of the 2008 financial crisis.

Ideally, we’d show the same chart for US businesses debt and asset price growth. However, there were no business Red Zones in the United States in the authors’ dataset. But while the authors needed to study 42 countries across 60 years so that they could get statistically significant results, we are not similarly constrained. We can use their insights to see what happens if we use US data alone. Specifically, rather than global cut-off values for Red and Yellow Zones, we can use only the US data to define the Yellow and Red Zones. The results are shown below.

Figure 4: US Business Red and Yellow Zones and Equity Prices

Source: Bank for International Settlements, Macrohistory Database, Verdad Analysis. Methodology follows Greenwood et al., except that cutoffs are US data alone and only use data available as of that date.

The Yellow and Red Zones capture the late 1980’s leveraged buyout boom and the dot-com bust. And most interestingly, we have just entered a Red Zone as of the end of 2020. This is driven by the rise of debt-to-GDP and the equity market rally. Even if debt-to-GDP is calculated using the pre-COVID GDP level, this result holds. So, if crises are by-products of credit and asset price growth cycles, as the authors’ evidence strongly suggests, then the US may have just entered the danger zone. This does not mean that we need to worry about the sky falling just yet. The authors show clearly that crises take time to develop, and only materialize 36% of the time after a Red Zone has been entered.

Credit and asset booms are what predict busts. In part, the authors argue, because investors tend to extrapolate these booms into the future, taking more risks than they should. Investors feel an inevitable desire to “reach for yield” in low-yielding environments, spurring credit growth that drives asset growth until the inevitable reckoning when some portion of the assets and some portion of the debt go bad.

Acknowledgment: Eldar Safarov interned with Verdad this summer. He will be graduating from Georgetown in 2022 with a BA and an MS in mathematics and statistics, and an economics minor with a 3.9/4.0 GPA. He is passionate about technology, financial history, and microeconomics. He is looking for full-time opportunities in private or public market investing. I’d be delighted to introduce you to him if you’re hiring.