Anticipating the Next Crisis

• Author: Atish R. Ghosh/Jonathan D. Ostry/Natalia Tamirisa
• Position: Chief of the Systemic Issues Division. IMF’s Research Department/Jonathan D. Ostry is Deputy Director. IMF’s Research Department/Assistant to the Director. IMF’s Research Department
• Pages: 35-37

Page 35

What can early warning systems be expected to deliver?

“Often public officials have two unfortunate incentives: to give undue attention to worst-case scenarios and to pay no attention to them at all. Sometimes their electoral prospects, or their overall popularity, depend on one or the other.”

Cass R. Sunstein, Worst-Case Scenarios

The current global financial turmoil has rekindled the interest of both policymakers and the general public—after nearly a decade of calm since the emerging market crises of the 1990s—in early warning systems (eWS) to anticipate future financial crises. But what alarms can such systems realistically sound? how would they work? And would they be effective?

Experience with past crises suggests that, for both advanced and emerging economies, crises are very costly (see chart). Whereas each differs in its details, nearly all reflect a confluence of some underlying economic vulnerability and a specific crisis trigger. The underlying vulnerability is often a credit or asset price bubble, a balance sheet mismatch (excessive borrowing in foreign currency, at too-short maturities, or with inadequate capitalization), whereas the crisis trigger can be almost any event—political turmoil, terms of trade shocks, contagion from other countries, or, to take the example of the current crisis, the collapse of the subprime market (see table).

Costly crises

While crises are more common in emerging economies, advanced economies are not immune.

[GRAPHICS ARE NOT INCLUDED]

Page 36

This characterization of crises—as a specific trigger superimposed on an underlying vulnerability—leads to two conclusions. First, because the specific event that triggers the crisis is unpredictable, so are crises. Second, this unpredictability makes it difficult to persuade policymakers to take preventive measures, especially because the measures themselves are likely to be economically or politically costly. The corollary is that early warning efforts should be directed not so much at trying to call the next crisis as at identifying underlying vulnerabilities without which crises are unlikely to occur and then adopting policies to address those vulnerabilities.

What can an EWS realistically hope to accomplish?

Ideally, an early warning system would flag growing vulnerabilities sufficiently in advance—and sufficiently convincingly—that corrective actions can be taken to prevent even the risk of a crisis from developing. Pricking incipient asset price bubbles, restricting unhedged foreign currency exposure of banks or borrowers, limiting leverage, and requiring higher capital ratios are all examples of ways to reduce the buildup of vulnerabilities.

But such measures are hardly likely to be popular: homeowners would prefer to see a rapid increase in the value of their house, borrowers may be able to borrow more cheaply in foreign currency, and financial institutions do not like to have to hold more capital because it erodes their profitability. Therefore, a compelling case for policy action needs to explain how crises can propagate across sectors, markets, and countries. Finally, because it will never be possible...