Academic journal article Review of Business

Centennial Repeat of History: Testing the Veracity of Reinhart and Rogoff Model

Academic journal article Review of Business

Centennial Repeat of History: Testing the Veracity of Reinhart and Rogoff Model

Article excerpt

Executive Summary

Financial crisis seems to be an intrinsic part of an economic cycle and system. When one occurs, it cuts deeply into the gains previously secured. If anticipated, perhaps proper protective measures could be taken to soften the impact. Reinhart and Rogoff (2008) have developed a Five Element Model (FEM) as a predictor of financial crisis. The five variables are housing prices, equity prices, current account balance as a percentage of gross domestic product (GDP), real GDP growth per capita and public debt. The objective of this paper is to test whether the FEM could have been able to predict the 1907 financial crisis, which occurred in a pre-Federal Reserve environment. This is a unique application since Reinhart and Rogoff's FEM was only tested on post-Federal Reserve crises. This analysis shows compelling parallels in conditions leading up to the 1907 crisis to those of other crises, suggesting a reasonable conclusion that the FEM has effectiveness that is also relevant in the pre-Federal Reserve era.

I. Introduction

Financial crisis as a study has commanded much attention throughout the years, both in academic and business circles. To capture the economic pattern displayed by these financial trends, Reinhart and Rogoff have developed a five element model using:

1. Housing prices.

2. Equity prices.

3. Current account balance as a percentage of GDP.

4. Real GDP growth per capita.

5. Public debt to predict financial crises.

The FEM looked at 18 financial crises that have occurred since World War II in developed countries. The big five are Spain (1977), Norway (1987), Finland (1991), Sweden (1991) and Japan (1992), and a second group of thirteen other banking crises that occurred at different times in the following countries: Australia (1989), Canada (1983), Denmark (1987), France (1994), Germany (1977), Greece (1991), Iceland (1985), Italy (1990), New Zealand (1987), United Kingdom (1974, 1991, 1995) and the United States (1984). These crises were also compared to the 2007 U.S. Sub-Prime Crisis. The model holds that the crises studied "share striking similarities" (Reinhart and Rogoff, 2008 p.10) leading up to each crisis and in the aftermath of each event.

The objective of this paper is to validate or negate the veracity of the FEM model when applied to a pre-Federal Reserve period. We have chosen to test the FEM in 1907 since all of the crises that were tested by Reinhart and Rogoff took place after the establishment of the Federal Reserve. The crisis of 1907 was the actual impetus for the Federal Reserve. It is of research significance to determine how similar or dissimilar a crisis that occurred during the developmental stages of the U.S. economy is to those crises that occurred after economic maturation.

This paper is organized in the following format:

* Section II presents the literature review of the various economic thinking and models that seek to predict financial crises, along with those specifically related to the 1907 crisis. It concludes with the seeming similarity that the 1907 crisis had with the financial crisis of 2007.

* Section III introduces the research methodology used in this study to explore whether the FEM could have predicted a financial crisis in a pre-Federal Reserve environment.

* Section IV provides the analysis and conclusion gleaned from studying the dataset.

II. Literature Review

A body of literature has developed that says financial crises are cyclical in nature and follow rather naturally and predictably after a period of rapid economic growth, in an economic environment that is more or less overloaded with the extremes of the growth. Gieve (2008) contends that an upward momentum increases asset prices leading to overconfidence, which then translates into imprudent lending at the top of the business cycle. This is followed by a downward movement in prices, increasing default and contraction in lending. …

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