Early Warning Indicator Model of Financial Developments Using an Ordered Logit – Literature on Money, Credit and Asset Price Developments

Gerdesmeier, Reimers and Roffia mention that evidence that money and credit could be important for the analysis of asset price developments is not new. Already at the beginning of the 20th century, Fisher had analysed the reasons for various booms and depressions, emphasising, among other things, the role of the debt structure and, in particular, the debt contracted to leverage the acquisition of speculative assets for subsequent resale as possible sources of financial instabilities. Moreover, he stressed the role of monetary factors by pointing to the fact that, basically, in all cases, real interest rates had been too low and thus monetary factors had been “fuelling the flames”. Forty years later, Kindleberger (1978) provided a comprehensive history of financial crises. He started with the South Sea bubble, to illustrate common threads. His work is illustrative of the idea that historically booms and bursts in asset markets had been strongly associated with large movements in monetary and, especially, credit aggregates.
The view that credit developments may contain useful indications in times of sharp asset price fluctuations was further explored by Borio, Kennedy and Prowse. On the basis of an aggregate asset price index for several industrialised countries (based on the combination of residential property, commercial property and share prices), the authors examined the factors (inter alia credit and money) behind the observed movements in the index over the 1970s and 1980s. They concluded that ratio of private credit to nominal GDP contains useful incremental information to predict movements in the real asset price index, in addition to more standard determinants such as real profits, nominal GDP growth and the long-term nominal interest rates, possibly reflecting the impact of the relaxation of credit constraints on the aggregate price index developments during the 1980s.
Moreover, Vogel (2010) presents a summary of the results of some studies regarding bubbles of the last three centuries. First, it seems that the availability of money and credit beyond what is needed to finance real GDP growth tends to stimulate speculative activity, which might end into an asset price bubble. Second, crashes seem to occur when there is an insufficient amount of cash or additional credit available to service the debt incurred. Third, crashes are characterized by relatively rapid price changes whereas a bubble, from a behavioural perspective, seems to be characterised by a longer build-up period. A bubble coincides with a period of euphoria while a crash is linked to fears. Hence, Vogel (2010) stresses the difference between booms and busts. Prechter states that hope tends to build slowly while fear often crystalizes swiftly. This argumentation is also put forward by Greenspan (2009). In particular, the latter states that bubbles seem to be connected with periods of prosperity, moderate inflation and moderate long-term interest rates which feed euphoria, thereby driving a bubble. By contrast, a contraction phase of credit and business cycles, driven by fear, have historically been far shorter and for more abrupt than expansion phases.
Regarding the definition of bubbles, Brunnermeier defines them as episodes when asset prices exceed an asset’s fundamental value due to the fact that current owners believe that they can resell the asset at an even higher price in the future, whereas Grantham states that bubbles are definable events when the prices exceed a threshold marked by a two standard deviations away from a long-term trend.
More recently, a new strand of the literature (including work by several international organizations such as the BIS, the ECB and the IMF) has started investigating in a systematic manner episodes of asset price misalignments and/or financial crises with the aim to derive common stylized facts across the different episodes and, more specifically, to identify possible early indicators that could provide warning signals to policy makers. Yucel (2011) gives a survey of early warning models. An overview is also given by Gerdesmeier, Reimers and Roffia. Early warning model approaches are applied to analyse bubbles on stock markets as in Herwartz and Kholodilin (2011), whereas Angello and Schuknecht and Dreger and Kholodilin concentrate on house markets. Both markets are investigated by Borio and Lowe or Helbling and Terrones or as a composite asset constructed from these markets by Alessi and Detken, Borio et al. or Gerdesmeier et al. Gerdesmeier et al conclude that the identification and quantification of asset price imbalances represents an extremely difficult task, both ex ante and ex post. Many studies also confirm that – among other variables -monetary and credit developments represent useful leading indicators of financial imbalances. In particular, one robust finding across the different studies is that measures of excessive credit creation are very good leading indicators of the building up of financial imbalances in the economy.