Our starting point is the real0life situation of a policymaker aiming to identify and collect economic data, evaluate competing models of the intensity of financial crisis, and make policy decisions with a view to preventing and mitigating financial crises. The policymaker may be interpreted as either the IMF or the World Bank aiming to determine which crisis indicators to employ in their new role of assessing financial vulnerability. The tools available are a set of multiple, overlapping theories of financial crises emphasizing different channels (e.g., foreign exchange liquidity, bad banks) and a large set of economic data that encompasses potentially useful indicators of crisis shocks and channels, but may be costly to collect. In this context, it seems sensible for the policymaker to extract useful crisis indicators from the data by imposing priors based on the literature, choosing indicators that explain the intensity of historical financial crises, and paying the costs of collecting these data. Uncertainty over which policy to recommend follows from a number of sources of uncertainty, including theory and measurement uncertainty. In this study we assume that the policy maker wants to evaluate policies unconditionally with respect to a potentially large number of alternate models of financial crisis intensity.
The assessment of post crisis dynamics involves estimation of the intensity of a crisis in terms of its impact on the real sector. Intensity can be thought of as the distance that the economy travels from the pre0crisis equilibrium measured along the output dimension. This definition is useful for policy because governments care most about the welfare costs of financial crises, and welfare costs have a higher correlation with real GDP than with financial sector indicators. In addition, accurate financial indicators of crisis intensity are problematic, especially indicators meant to capture aggregate bank distress. Empirically, crisis intensity is gauged by the change in real GDP relative to the precrisis trend, conditional on the occurrence of a crisis.
This paper examines the intensity of financial crises during the 1990s with a view to improving crisis prevention and mitigation policies. The motivation is the new mandate for the IMF and World Bank to undertake comprehensive assessments of the vulnerability of the financial sectors of member countries. We address a number of fundamental problems posed by empirical analysis of financial crises. These problems are the lack of a single true underlying model, the combination of a large number of candidate indicators (many of which represent different measures of the same underlying construct), small sample size, and missing data. Our methodology recognises that in many instances the evolving body of theory and available crisis data do not support a single model, and in this regard it is important to provide some measure of the degree of uncertainty surrounding the process of indicator selection. To do this we calculate a set of data0based weights which we use as a metric to evaluate the degree of support for both specific models and individual indicators. We demonstrate that these weights are easy to calculate and contrast them with alternative measures of model uncertainty.
We note that this paper takes a different tack than the high frequency early warning system (EWS) literature (Berg, Borensztein, Milesi0Ferretti, and Pattillo (1999) and Mulder, Perrelli, and Rocha (2001)). An increasing number of studies are developing EWS's, typically with monthly data. These EWS's aim to identify a small number of leading crisis indicators or composite measures of vulnerability to provide relatively quick warning signals of impending crises to trigger countervailing adjustments in macroeconomic policies. The goal of this paper, rather, is to enhance the effectiveness of annual or even less frequent assessments of crisis vulnerability. These assessments can be used to ameliorate crisis vulnerability by motivating structural reforms. The paper makes two contributions to the literature.
This paper is organized as follows. The theoretical and empirical literature on crisis intensity is reviewed in section two. The empirical methodology used in this paper is described in section three, and in section four we discuss the data and specification issues. Crisis intensity results are presented in section five. Section six concludes with a summary of the results and their policy implications.
