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Financial Crises: Random Shocks or “Biological Regularities”?

Economists are notoriously bad at predicting recessions even as they are taking place. Or maybe they are too good. After all, “the stock market has predicted nine out of the last five recessions” as Paul Samuelson famously said back in 1982. This figure is now closer to 14 out of the last 8. Still, even if we cannot predict recessions, it is worthwhile to think about models that most accurately describe the business cycle to effectively guide economic policy.

The two central conceptual views on business cycles are as follows: First, the view that business cycles are primarily driven by exogenous shocks, and that absent these shocks, the oscillating pattern of the business cycle would largely disappear. The other view acknowledges these shocks but emphasises the significance of internal mechanisms of the economy that produce booms and busts regardless of exogenous shocks.

Economic historian Charles Kindleberger’s Manias, Panics, and Crashes argues that financial crises throughout history have shared many commonalities, most notably a ‘euphoria’ among investors during booms associated with pro-cyclical increases in the supply of credit and the subsequent indebtedness of investors. The willingness of investors to take on debt is enabled by the idea that asset prices will continue to rise forever. This mob mentality means that as soon as the increase in asset prices no longer exceeds the interest rates connected to the funds used to finance their asset purchases, a panic sets in and contagion and feedback effects can quickly spread waves of insolvency across the economy. Kindleberger concludes that although exogenous shocks such as the onset of war or bad harvests do take place, ultimately “the pattern [of financial crises] is biological in its regularity”.

In this regard, the business cycle is more like the ebb and flow of the tide. While a natural disaster may upset the natural rhythm of the crashing waves, they will inevitably return to their original flow. This also means that, although we are aware of the patterns of reckless trading, trying to stop such a crisis is as effective as casting a rock into the ocean to interrupt the currents. For this reason, Kindleberger stresses the importance of a lender of last resort to inject liquidity into a panic-stricken environment. This of course also lends itself to problems of moral hazard: private investors become more reckless in their extension of loans if they believe they will be supported during moments of financial distress.

Another view is that business cycles are driven by chance. The summation of random numbers such as the last digits of the Russian lottery (as Eugen Slutsky did back in 1937) reveals a pattern that closely resembles the oscillations of the business cycle. In other words, we can think of the business cycle as random shocks averaged over time. In practice, this means that it becomes increasingly difficult to predict downturns in the economy.

But say we can in fact predict recessions before they materialize. Just as Kindleberger concluded, this is not to say we can do anything to stop them, we may only be able to use economic policy to minimize the ensuing damage. Much like a car with loose brakes, we may not be able to stop the economic machine from driving off a cliff but perhaps we can steer it in the right direction to soften the landing.

The US Federal Reserve has recently pursued a series of rate hikes which are forecasted to reach as high as 5.6% before 2023 draws to a close. Fighting inflation with rate hikes inevitably slows the economy. According to Mark Zandi, chief economist at Moody’s Analytics, one of the ‘Big Three’ bond credit rating agencies in the US, “when inflation picks up and the Fed responds by pushing up interest rates, the economy ultimately caves under the weight of higher interest rates.” It is not surprising that this has convinced economists that a recession is on the horizon. Still, it has yet to precipitate. Despite low unemployment and steady job growth, inflation is actually dissipating. The economy has remained oddly resilient to the forces of monetary policy. For example, take 30-year fixed mortgage interest rates, which, despite having risen almost 4% in the past year and a half, seem to have weak impression on home ownership, likely due to the surge in housing demand when remote work became commonplace.

The consensus has been that a recession is imminent in the close future, but perhaps the growing pessimism is misplaced. In any case, the economy seems to be stubborn to the conventional forces of economic theory, or perhaps the worst is yet to come. Whether it be exogenous shocks or biological regularities, the tide must fall before it can rise again.

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