Is the 2007 U.S. Sub-Prime Financial Crisis So Different?

February 9, 2008 12:48 PM

Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard University have compared the recent US subprime mortgage crisis with five downturns in industrialized economies in the past 30 years in their brief paper, Is the 2007 U.S. Sub-Prime Financial Crisis So Different? (pdf). Their conclusion: “given the severity of most crisis indicators in the run-up to its 2007 financial crisis, the United States should consider itself quite fortunate if its downturn ends up being a relatively short and mild one.” Summarized, with some data and charts, here. Via.
posted by ibmcginty (19 comments total)

Just a quick thought: the current crisis reminds me a great deal of the follies of genetically engineered crops. While creating homogenous, super-output crops obviously lowers costs and increases output, it increases your downside risk as well. One particularly bad strain of virus could wipe out an entire crop because the genetic structures are all the same.

The same applies to the globalization of financial institutions, methods, and investors. As the world gets smaller, and financial techniques are more homogenized and widely used (CDOs using RMBS and securitized receivables, credit card debt, etc. and CLOs using similarly appraised bank debt), the upside potential becomes great, and leads to new heights of wealth and glory. But once again, the downside risk is magnified because the financial system lacks the diversity necessary to keeps various asset values non-correlated.

It's a fascinating time we live in. I hope that enough people pay attention to prevent it from happening again.
posted by SeizeTheDay at 1:16 PM on February 9, 2008 [1 favorite]

The same applies to the globalization of financial institutions, methods, and investors. As the world gets smaller, and financial techniques are more homogenized and widely used (CDOs using RMBS and securitized receivables, credit card debt, etc. and CLOs using similarly appraised bank debt), the upside potential becomes great, and leads to new heights of wealth and glory. But once again, the downside risk is magnified because the financial system lacks the diversity necessary to keeps various asset values non-correlated.

Except the magnitude of financial crises has been going down not up. We've never had another depression, for example.
posted by delmoi at 1:20 PM on February 9, 2008

Except the magnitude of financial crises has been going down not up.

I think you're missing my point. This particular crisis started because investors and institutions all used the same methodology to value their structured products, relied upon an incestuous mess of ratings agencies, and using derivatives, artificially increased liquidity, amplifying their bets. And this isn't JUST a US problem; banks in Europe engaged in similar practices. It was a herd mentality that flooded the US with cash, much like Argentina back in the day. And now that the herd is spooked, asset values with high correlations are dropping like flies.
posted by SeizeTheDay at 1:29 PM on February 9, 2008

Allow me to summarize: we've run out of suckers.
posted by telstar at 1:32 PM on February 9, 2008 [3 favorites]

Nordic part of the "Big Five" crises had quite clear cause: the fall of Soviet Union. Finland lost 20% of its exports in very short period. The problem was obvious, many of the old trades just wouldn't work anymore and overall there would be less money to go around, so the cures were also obvious. Bailing out the banks was horribly expensive (10 billion euros, where the whole budget currently is 40 billion). New trade partners and new strong sectors were found, and welfare system tightened (huge unemployment costs anyway, re-education and structural unemployment). Slowly things got better.

Now I'm wondering what exactly is the problem with U.S. economy. There isn't one clear sector or trade partner that is crashing and consequently there is no clear way to circumvent it. What is the sector you have to learn to live without?
posted by Free word order! at 1:46 PM on February 9, 2008

^ Retail.
posted by panamax at 1:57 PM on February 9, 2008 [1 favorite]

One factor of the subprime mess that hasn't been addressed yet is the impact on property tax revenues. There's no bailout for that mess either, and no "one time write-down" of losses; it could be problematic for several years.
posted by yesster at 2:08 PM on February 9, 2008

One particularly bad strain of virus could wipe out an entire crop because the genetic structures are all the same.

But can't GM also introduce unprecedented genetic diversity - much greater than nature provides? The fact of the matter is that, as a result of derivatives, there is an unprecedented diversity in investment vehicles. Today's market is less sensitive than ever before to particular strains of virus.

This just proves Taleb's hypothesis that anyone who thinks they understand market trends knows nothing at all.

Randomness rules and only the lucky win.
posted by three blind mice at 2:14 PM on February 9, 2008

only the lucky win

only the lucky, OR CORRUPT, win

Corruption is the one ring that rules them all.
posted by three blind mice at 2:16 PM on February 9, 2008

Kidding aside, I found these charts from the St Louis Fed to be interesting reading.

Specifically, US GDP, Total US Savings Deposits, Federal Receipts, 1890-.

I like the last one because it's the first time I've seen all the recessions of 1890-now plotted. . . 1890 through 1930 was quite a mixed bag, economically speaking, and also I got an appreciation for how good I've had it . . . I entered the workforce in 1986 (more or less), and there have only been two piddling recessions since then, 1991 and 2001.

Here we see that the Fed has "monetized" around $300B of debt since 2001. This is pure money printing to my limited understanding.

Here is one driver of this post-2001 growth, national debt not counting the FICA surplus. This is the money we as a nation have to pay interest on, which is also charted here.

But here is the money shot, Total Household Debt; and here is the household debt service as a percentage of income.

This has been a very interesting economy 2001-2007. I have no idea where it's going, really. I suspect we'll see Japan-style belt-tightening and deflation, but there's a lot of dynamics -- peak oil, medicare crisis, lack of savings, GINI imbalance, that make it hard to see the future.
posted by panamax at 2:17 PM on February 9, 2008 [1 favorite]

What I find interesting is the chart that shows that the average minimum real GDP growth per capita for their "Big 5" crises is -1%. You can interpret that figure two ways: that -1% is not very much at all and so we make a bigger deal out of these crises than we ought to or that -1% is a big deal and so we have a ridiculous economic system that treats a relatively short period of slight contraction as a major problem.
posted by ssg at 2:42 PM on February 9, 2008

ssg: if you switch my US GDP chart above to log seems to highlight the tough economic patches a bit. We live in an exponential world apparently.

Plus 1% of a $15T economy divided by $50,000/job is . . . three million jobs that go poof.
posted by panamax at 3:27 PM on February 9, 2008

panamax: I think you have illustrated my point exactly: if the effect of a 1% contraction (per capita, mind) is that 1% of jobs are eliminated, then clearly the system isn't working very well. I don't think that this would be the case, but that you would even think that all economic contraction would play out as loss of jobs is indicative of the problem.
posted by ssg at 3:38 PM on February 9, 2008

three blind mice: "One particularly bad strain of virus could wipe out an entire crop because the genetic structures are all the same.

But can't GM also introduce unprecedented genetic diversity - much greater than nature provides? The fact of the matter is that, as a result of derivatives, there is an unprecedented diversity in investment vehicles. Today's market is less sensitive than ever before to particular strains of virus.

This just proves Taleb's hypothesis that anyone who thinks they understand market trends knows nothing at all.

Randomness rules and only the lucky win."

Exactly. It's not genetic engineering, per se, that results in loss of genetic diversity, but rather industrialized farming. Whether you're crossing hybrids a la mendel or in vitro, the result is the same, and it's the ends to which you put your engineering that need to be examined.

It's the same old story - people are getting theirs and getting out before things collapse as all speculative bubbles must. The smart people have already found the next leading edge to milk and they're not too worried about long term consequences because they figure they'll either be rich or dead by the time they run out of suckers. There will always be people who think this way.
posted by Mr. Gunn at 5:16 PM on February 9, 2008

Randomness rules and only the lucky win.

Yeah, just like in poker.

There are a limitless supply of suckers. You can start with everyone who has swallowed the "subprime meltdown" meme as the alpha and omega of problems with the market. Buffet nailed it years ago when he started talking about derivatives. It is a systemic problem (or maybe "feature"), subprimes are only a part of it.

Before last fall, I never saw anyone beyond the trading sites I follow that had a clue. We had been b1tching about this problem for years, but there was nothing we could do. Any top-callers that got antsy and went short ended up taking big losses, and the bulls laughed in their faces. Now the bulls are whining about interest rates (a red herring) and I see "subprime meltdown" posts everywhere.

The scary part to me is that the federal government uses demand for credit to create money instead of running a printing press. Since a large demand for credit, namely real estate loans, has essentially been turned almost completely off, what mechanism is the government going to use to finance its profligate spending? The Fed cannot push on a string.

Maybe Helicopter Ben Bernanke will earn his name before this is over. For now he is busy putting the market through obedience training, since they assumed he was just going to be a more easy-to-parse version of Greenspan.
posted by b1ff at 10:05 PM on February 9, 2008

"...the United States should consider itself quite fortunate if its downturn ends up being a relatively short and mild one."

IF
posted by Civil_Disobedient at 3:30 AM on February 10, 2008

The lack of error bars on the graphs in the paper is pretty shitty.
posted by afu at 6:04 AM on February 10, 2008

We live in an exponential world apparently.

Where humans should aim for a logarithmic growth, ie. one that flattens out, we have exponential growth.

Our population, instead of leveling, continues to go exponential. Instead of a sustainable population, we overpopulate.

The concentration of wealth, instead of leveling, goes exponential: instead of many people being well-off, we have a very few people incredibly well-off and very many people at subsistence level.

And so on.
posted by five fresh fish at 9:45 AM on February 10, 2008

At the TED conference, Marine biologist Tierney Thys talks about the rise of jellyfish, and the weird immense animal the giant ocean sunfish. Very interesting.
posted by shavenwarthog at 2:01 PM on February 10, 2008