Could an early warning system have helped predict our current financial woes?

Much has been said about the causes of the financial crisis to which we are all held captive. Politicians blame each other for the mess, citing varying degrees of under (or over) regulation depending on wind directionality, Wall-Streeters blame avaricious mortgage lenders and profligate home-buyers, consumers blame greedy executives and the politicians beholden to them, and media pundits blame everyone. The interesting question, however, isn’t so much who was to blame, but more, what were the signposts along the way that, had they been identified beforehand, could have helped authorities avert the disaster. In other words, could a unified financial early warning system have helped predict and forestall our current financial woes?

To be fair, foreknowledge of the current crises would likely not have been enough to avert it (excessive systemic risk is purged from markets in one way or another) but surely paying attention to the warning signs (of which there were many) would have allowed governments to shore up soon-to-be faltering banking systems or at least ensure that adequate policy measures were in place that would help to guide the flailing, seemingly haphazard decisions that policy makers have made in the last few weeks.

So what, exactly, would the harbingers of a doomed economy look like, and where would one look to find them? Well for starters at least, historically speaking the major economic downturns have been preceded by a marked uptick in panicky investor behavior. In other words: volatility. Well, you may ask, by the time investors and policy-makers have noticed that volatility is on the upswing, isn’t it likely far too late to take decisive action? That depends upon your definition of too late. To be sure, the tell-tale signs of volatility began appearing as early as July and August of 2007. In fact, the Chicago Board of Trade’s Volatility Index or VIX (often referred to as the Fear Index), began a series of what should have been alarming spikes on mounting concerns about, what was at the time, a growing credit crisis. Granted, increased volatility does not necessarily mean a marked downturn, but had policy-makers created an integrated system of early warning indicators that included volatility monitoring, a VIX spike could have put them on alert.

Remember those Wall-Streeters and bankers who were looking for someone to blame? Well it turns out that they had advanced warning of what was going on in the credit markets and broader economy as well. How, you ask? As we’ve all come to know, inter-bank lending is in many ways the life-blood of our economy. When the credit markets freeze up, banks stop lending to one another (well technically they don’t stop lending, they simply charge prohibitive inter-bank rates which in and of itself is a measure of risk and uncertainty in the overall economy). Often referred to as the TED Spread, the difference between Treasury yields and the London Interbank Offered Rate measures the degree to which banks feel that their peers will default on inter-bank loans, or counter-party risk. In fact, that summer the TED Spread saw a spike to levels it hadn’t seen since the Black Monday crash of 1987. So how far back did banks begin panicking? You guessed it, the same exact time the VIX was spiking towards the end of summer 2007.

These are but two of several examples of potential indicators you are likely to hear about in the coming weeks and months. Again, while any one of these signals doesn’t necessarily mean that an economy is doomed, had the right people, armed with a list of triggers or indicators, been paying attention, policy-makers could have taken steps much sooner. When you think about the hysteria of the last few weeks, the speed with which Secretary Paulson tried to cram the Emergency Economic Stabilization Act of 2008 through congress, the ensuing equity market melt-down, and about the shape of things to come, think about how different things might have been if those who hold the public trust had done their jobs.

On second thought, the really interesting question isn’t what the early warning indicators might have looked like, it’s why our leaders weren’t looking for them to begin with. Truth be told, governments should have begun taking action to quash the mounting crisis more than a year ago.