Tuesday, November 11, 2008

Granger Causality and the Financial Crisis

When the media, the public and politicians look for a cause of an economic event such as the recent severe stock market decline, the current economic slowdown, and the spate of financial institution failures, there is a strong tendency to look for some related event that happened before, such as the decline in home prices. The consensus becomes that since it happened prior, it must be the cause of the economic problems. These days there is a lot of talk about the nationwide decline of home values and about seeking solutions to stabilize home prices. The thinking is that stable home prices will restore economic growth and that the decline in home values precipitated many if not all of the economic problems.

Unfortunately, in economics, finding causes is not that easy. Economic agents and economic values respond to expectations about future events, such as the future value of assets and cash flows. Two economic events, A and B, can both respond to some future expected event, C, but A can reveal itself before B happens and both can happen before the expected C occurs. This is called Granger Causality. It looks like A caused B but both were simultaneously affected by the expectation of C. It is just that A is noticed before B happens. In the current economic environment, it is the change in some economic expectation that caused the decline in home values that is also causing the economic slowdown and many if not all of the other current economic problems, such as the credit tightening and freeze. It could be a host of factors. Some possibilities are the election of a Democratic Congress or President, an expected increase in taxes, a new war, a terrorist attack, or a change significantly affecting corporate profits to name a few but not all possibilities.

A simple, common example of Granger Causality is as follows. People wake up in the suburbs and commute to the city to work. When they wake, they listen to weather forecasts and if the weather person forecast rain later in the day, many of the commuters will take an umbrella with them to work. A person living in the city, who wakes up after the commuters start arriving in the city can look out the window and see if the commuters are carrying umbrellas. The city person will observe that when many commuters carry umbrellas, there is a good chance of rain later in the day. Statistically and through observation, the city person can conclude that commuters carrying umbrellas cause rain. This observation is known as Granger Causality since the commuters carrying umbrellas are caused by an expectation of rain later that day from the weather forecast and the umbrellas do not cause the later rain. Commuters carrying umbrellas happens before rain but does not cause the rain. Umbrellas are linked to rain because they are used for rain but they are not the cause.

Likewise, in the current economic environment, there was a change in an economic expectation that caused house prices to decline. (See my previous piece on Home Values Were Not In A Bubble.) This change in economic expectation also caused the increase in credit spreads, an increase in the risk of debt default by institutions, corporations and individuals. All are responding to the expected future economic event that will cause a decline in all asset values, including commodities, equity values and corporate cash flows and not just home values. It is just that the decline in home prices happened before or simultaneous with many of the other events. It does not show that house prices caused these other events. In fact, since houses are assets like many other assets, such as commodities and stocks, houses needed some expectation change for house values to decline.

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