Tuesday, July 29, 2008

Not Following the Pattern

Brad Sester had an interesting post that looks at how U.S. economic imbalances have been affected by the subprime crisis. First, he notes what typically happens to countries running huge current account deficits like the United States when hit with a economic crisis like the subprime one:
Emerging market financial crises in the 1990s followed a fairly consistent pattern.

The country lost access to external financing.

The sector of the economy that had a large need for financing – firms in Asia, the government elsewhere – had to dramatically reduce its need for financing. Asian investment collapsed. Argentina swung from a fiscal deficit to a fiscal surplus (helped along by its default on its external debt). Turkey began to run large primary surpluses.

Financial balance sheets shrank; credit dried up.

The country’s currency fell sharply. And its current account swung into balance, if not a surplus.

That process was incredibly painful. Falls in GDP of 5% or more were not unknown. It also meant that after a year or so, most emerging markets had reached bottom. Their economies had adjusted, as had their currencies.
He then examines the U.S. experience since the subprime crisis erupted. Has it followed the typical currency crisis pattern?
A year – almost – after its crisis, the US economy hasn’t endured a similar period of adjustment. Economic activity has slumped, but not fallen off a cliff. US households are pinched (and unhappy), but spending hasn’t collapsed. The US current account deficit has fallen, but not by much – the rise in the oil deficit has offset the fall in the non-oil deficit. Banks have depleted their capital, but I don’t think that they have – in aggregate – shrank their balance sheets...
So no, the United States has not followed the pattern. And no matter how bad you think the U.S. economy has been hit, it could be far worse had external financing dried up.

Brad's point that the typical currency crisis pattern has not held up with the United States reminded me of something I heard about the Early Warning Systems (EWS) that were so popular a few yeas back. Before I mention what it was, let me review the purpose of the EWS by way of the IMF:
The IMF uses econometric models known as early warning system (EWS) models in its efforts to predict currency crises—defined as a sharp currency depreciation or loss of foreign exchange reserves or both—before they occur. These EWS models focus on external volatility and exploit systematic relationships apparent in historical data between variables associated with the buildup to crises and the actual incidence of crises. The variables include the ratio of short-term debt to foreign exchange reserves, the extent of real exchange rate appreciation relative to trend, and the external current account deficit. Both theory and evidence suggest that the higher the value of each of these variables, the greater the probability of a crisis. Extensive tests have been performed to determine which of these empirically based models best fits the data and is the most robust.

The IMF's EWS models focus on a relatively long prediction horizon of 12-24 months to provide countries with enough lead time to adopt corrective policies. The focus is, after all, on prevention. The IMF also keeps an eye on alternative EWS models developed by the private sector and explores variations on the central IMF model. The private sector models, produced chiefly by investment banks, have shorter time horizons because the aim is to guide short-term investment decisions. Among the IMF's alternative models, one focuses on balance sheet variables, notably for the financial and nonfinancial corporate sectors, and another (estimated with annual data) focuses on fiscal variables.
This comes from a 1999 paper, so the EWS models have evolved. Still, the basic premise behind the EWS remains: forecast currency crisis. So here is what I heard about these models. If you plug the United States into these models you find a major dollar crisis happened years ago. That has not happened though the dollar has already depreciated just over 25% over the last 3 years. Still, there are huge economic imbalances that will require further depreciation of the dollar. A sudden collapse of the Bretton Woods II system could turn this need for further dollar depreciation into a dollar crisis. I hope for a different outcome.

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