Thursday, May 8, 2008

A statistical look at the credit crisis: Is it the result of bad decisions or tough conditions?

Here are two figures full of great data. Let's look at them separately and then together, because they paint a picture of the conditions -- some say, decisions -- that led to the current credit crisis.

The first graph shows the functional importance of credit to the continuation of economic growth. What I mean by 'functional importance' is this: as the decades pass from the 60s to today, this graph shows that credit becomes 2-3 times more important as a factor of economic growth. In other words, economic growth today is much more dependent on credit in a way it wasn't as recently as the 1970s. A final thing to note about the first graph is that the functional importance of credit has begun to rise even more dramatically during the current decade.

That point brings us to the second figure, which compares actual Fed interest rates vs. the conventional economic wisdom of what interest rates should be for the 2000s (based on the 'Taylor Rule'). Note that the Fed had rates significantly lower throughout the early 2000s than conventional wisdom suggested should be the case. This is the best statistical representation of a criticism often thrown at Former Fed Chairman Greenspan -- not that he was wrong to drop rates following 9/11 and the 2001/2002 recession but that he was too slow bringing them back up. As a result, some people pin the current crisis on the inflation-creating policies of Mr. Greenspan, who left the Fed in 2005.

But these two pieces of data point to a reason to somewhat exonerate Mr. Greenspan. The lower interest rates of the 2000s can be explained by the increase in the 'functional importance' of credit. If Greenspan had not kept the rates low, a fairly dramatic recession could have been the consequence.

So what, some say. We have a recession now, don't we? This criticism has merit. Today's recession faces an environment in which inflation is a far greater problem than it might have been had the recession proceeded in 2003, 2004, and 2005. As a result, current Chairman Ben Bernanke has a more challenging context with which to work.

So what is next? Two alternatives stand out. Either American capitalism finds a way to ease the 'functional importance' of credit so that the economy can grow without needing to expand credit, or American capitalism finds new, innovative ways to begin freely lending and investing again. At least until they burst too.

Bottom line: These data suggest that Greenspan's "bad decisions" were actually reasonable responses to "tough conditions" -- namely, the economy had to expand credit or the economy would contract. Greenspan chose to expand credit and keep growing the economy. Make no mistake his mandate was to do just that.

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