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Economics in Person – Understanding the Slow Recovery
Òscar Jordà, “Private Credit, Public Debt and Financial Crises”
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Okay, so let me give you the bottom line of my talk. The bottom
line is going to be this. The reason the recovery from the Great
Recession is low is that we had a financial crisis that we had not
seen in the last 70 years. And financial crises are quite different
from any other recession. And in particular when you have a
recession preceded by rather rapid growth of credit, then
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it takes time to deliver and it takes time to recover from that
deleveraging that Mark was mentioning earlier. And when you put
those elements together and think about how history can educate
us about whether this recession was different from the historical
experience of previous financial crises, the answer really is not
really. If you had taken the data from the last 140 years spanning
over 17 industrialized economies, you would’ve reached
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the conclusion that the recovery from this recession would be
pretty much on target from what we’ve seen in the data. So that’s
going to be my pitch. And to do that, let me take you through a
journey that’s going to take you, like I said, over a 140 years, 17
countries. This is part of a broad project of research that I have
started with a Research Associate here at the bank Early Elias,
Moritz Schularick, which is at the University of Bonn, and Alan
Taylor who is at the University of Virginia. I’d like to construct the
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talk into four broad areas. It’s not often that you get to see data
Economics in Person – Understanding the Slow Recovery
Òscar Jordà, “Private Credit, Public Debt and Financial Crises”
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that goes back 140 years, and it’s going to be very useful for me to
present you with some pictures that I think you’ll find interesting
in the sense that they, I think, reveal trends that are quite different
from what you’re used to. In a sense, when you get our outlook
from us you get almost the up-to-the-minute piece of news. And
sometimes you lose the forest for the trees. Let me show you longer
spans of data, and let me discuss really some, I would say,
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worrying trends in the sense that these are new elements that have
come into play in the last 20 to 30 years that we need to start
thinking about more seriously. That will serve me to motivate a
little bit why my emphasis on credit and the relationship between
financial crises, credit, and how we think about this recession in
particular. There’s also been another element to this recession and
perhaps, to almost any
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other recession which is how does the government play into this
picture? I’m going to give you a rather different perspective on the
perspective that Mark has given you. And that is to say, I’m going
to return to the beginning of the crisis and think about what was
the role of government before then. And how does that impact the
progress of the crisis as we move on from crisis to recovery. Okay,
and then I’d like to conclude by saying something
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about what are the potential lessons that we may have gleaned
Economics in Person – Understanding the Slow Recovery
Òscar Jordà, “Private Credit, Public Debt and Financial Crises”
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from this trip through history, economic history, okay? All right, so
what is the long view. Well the first thing to notice is that crises,
financial crises, are back. What you have in that slide that I have
in the projection is a plot for every year since 1870 up to today of
the number of countries that in any given year experienced a
financial crisis. And the one thing
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that strikes you in that picture is, well, we can identify global
events very easily. Obviously as you move your eyes to the right
hand side of that graph you will see the big spike that came about
in 2008 with the recent financial crisis. And if you move your eyes
back to the beginning of the axis you’ll clearly identify 1929. But
what is the other aspect of this graph that is eye-catching? Well,
the other aspect of that graph is that gap in there. That gap is a
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period of about 20 to 25 years where nobody experienced a crisis.
That’s a really long span of time. And if you were to play the odds
on this particular roulette, it would be very hard for you to get that
long a span of time with nothing happening. So what was going on
in that point in time? Well, this is the point in our economic
history when the Bretton Woods system was enforced. Just to give
you a little background, the Bretton Woods system
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came about because of the Great Depression. The war, in a sense,
interrupted a process that had been started at the end of the Great
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Òscar Jordà, “Private Credit, Public Debt and Financial Crises”
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Depression. And it was when all the architecture of the financial
system was being rewritten. So Bretton Woods in the large sense
encapsulated those ideas and encapsulated also the idea that you
wanted to restore international trade. You want to end policies of
beggar thy
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neighbor, which are so in vogue nowadays that the Bank of Japan
has started a different program of monetary stimulus. So in that
context, what are some of the ingredients of the Bretton Woods
period that perhaps we should think about. Well there are some
that are perhaps not as interesting. Capital controls, and fixed
exchange rates, exchange rate regimes, are possibly not the first
things that come to mind when we think about why that gap of
nothingness was there in the previous picture. But there are some
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other elements in the Bretton Woods System that do resonate with
one of the reasons that might have prevented that outbreak of
crises that we saw in that period. One of them is obviously low
leverage banking, regulation coming out of the Great Depression
and into Bretton Woods was much, much, much stricter than it
had previously been. As a result, what you see in the next bullet
point is that government securities were a part, or a much bigger
part, of portfolios at banks. And just to top it off
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basically there was – this was a period of really rapid growth in
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investment. So it didn’t seem like the delivery of finance at a very
primitive level was a hindrance to real economic growth. I’d like to
focus on those aspects of the Bretton Woods system and perhaps
leave aside the first two. And perhaps if you asked any European
nowadays they would tell you what a bad idea those two
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are. Okay? Well there are some other differences that came about
once the Bretton Woods system died off. And in this picture, you
have something that to me is very eye catching. So this picture,
displays, the ratio of bank assets to GDP, bank loans to GDP, and
the monetary base to GDP. Monetary base, by which I mean,
basically cash and broad money, and the deposits in checking
accounts. What you see there is that if you look at the
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ratio of money to GDP, it has been remarkably stable for a long
period of time. The two things that have not been stable are the
bank assets to GDP ratio, and the bank loans to GDP ratio. So
around the mid-70s those two ratios started to take off very, very
quickly. They’ve basically doubled in size in a very short period of
time. And this is going to be one of the longtime trends that I’d like
you to focus on as we move forward. It used to be in the
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Friedman and Schwartz days that if you knew the monetary base,
you had a pretty good idea of what the bank asset side was going
to be. And that is true for the period that pretty much predates
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World War II. Since then though, that has completely broken
down. As you can see in that picture that ratio of bank assets to
money and bank loans to money has just continued to increase
more and more over time. Okay well that is just the
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advent of modern finance and – and so we have this period of
innovation in finance. Which by the way, when we think about
financial crises, it’s amazing just how often we forget that people
will just find ways to get around regulation. It starts with
something as simple as backdating checks, as opening Euro dollar
accounts outside of the US when there’re restrictions. So people
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will always find ways to get around regulation. But it is really
unprecedented to see something so visible in the data in the last
30 to 40 years. Here’s something that nobody except you have
seen, you and Early because she put this graph together, have
seen before. So this is data that is part of this project I was telling
you about. And what we’ve done is go through a bunch of dusty
books and collected data and thought about well, okay, is all
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lending the same, and what has happened to lending at the bank
level? What you see here is a really striking evolution of what has
happened to lending. This is the ratio of total loans that is going to
real estate. That is the black line. And I’ve divided that black line
between the portion that is going to households so to speak, and
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the portion that is going to commercial real estate. And what you’ll
see in that graph, I think, is that the ratio that is being
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dedicated to real estate relative to other productive activities, what
I call here from nuts and bolts to bricks and mortar, is becoming
larger over time. And part of that increase is – is a big jump
obviously that happened before World War II, but also over time
just a big jump that commercial real estate lending has
experienced in the last 30 to 40 years. Okay, so this is a new
development also to keep in our bag of tricks. Now, here you
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have two interesting pictures that put these numbers in a different
light. You have here a picture that belongs to data in 1929 for 17
countries, and a picture for 2007. The year before each of the two
most recent global financial crises that we’ve experienced in the
last 140 years, so to speak. And the one thing that strikes you is
the switch in the mix of the liabilities. You look at 1928 and what
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you see is that government liabilities were just about as important,
if not more important, than the liabilities of the private sector. That
completely reversed in 2007. In 2007, private liabilities were much,
much, much more substantial than public liabilities. And that
starts to bring me to the topic of public debt and the role that
public debt plays into financial crisis, you’ll see in a minute. There
are also other developments to keep in mind that are
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perhaps somewhat unprecedented. In 1990’s we had the Asian
financial crisis. One of the lessons that especially Asian countries
took from that period was this, that if you have a big cushion of
foreign reserves it is a lot easier to handle a run on your currency.
There are anecdotes that during the financial crisis a country like
South Korea, which by almost any
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other measure was doing well economically, was faced with the
situation in which Nike would send a contract for sneakers to a
Korean factory and the Korean factory would be unable to secure a
loan from its local bank. Even with that contract in hand worth
multimillion dollars. So with that hard lesson learned, a lot of the
Asian economies have decided to engage in a really outstanding
accumulation of reserves. Much more than would have been
predicted
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by normal economic models. And it is not that economic theory
has left us behind here, what you still see is the normal flow of
private capital from developed economies into emerging economies.
What you see that is new is a flow that goes the other way from
official, basically the official side of the balance sheet in these
developing economies basically investing in
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our shores. So much so that they are basically undoing all the
private side of this investment equation. And in fact, when you
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look at the numbers they’re pretty staggering. So what I have there
is the period of this great reserve accumulation that has happened
in the last 20 years has – basically means there’s something of the
order of 10 trillion dollars officially held by emerging economies
somewhere perhaps at the level of 14 trillion dollars, if you’re
counting wealth sovereign funds. That is very
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impressive and that relates to some of the statements that
Chairman Bernanke made in 2005 regarding the savings glut. So
let’s keep in mind when you – when you look at the next slide. This
is one of the other emerging trends that is quite different from
what we’ve seen previously. Here’s what this graph tells you, this
graph tells you that the demographic trends are about to hit a
turning point in the next five years going forward into the next 30
to 40 years. What is that big switch in the demographic
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trend? What you see there is basically developed economies are
now aging and their dependency ratios are going up. They’re going
up because basically the retired population is growing larger and
larger relative to the working age population. It’s a complete
reversal of what has happened up to that point. Up to that point
what you saw in emerging economies was really young economies
with lots of children, lots of
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dependents. That has come down over time and now they’re
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Òscar Jordà, “Private Credit, Public Debt and Financial Crises”
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starting to look more like we did maybe 30 or 40 years ago. That
crossing of the lines there is telling you that soon enough
developed economies will not require the same level of investment
to keep the same level of development. The savings that we had
seen from the Boomer generation, they will start turning to these
savings and more consumption. Right at the time when some of
these emerging market economies have
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reached their transitions into new demographic steady states. So
what are the takeaways from looking at this long period of data?
Well there’re some new emerging trends. There’s a sense in which
this time is different, to paraphrase the title of Reinhart and
Rogoff’s new book. So what is new that perhaps we should be
paying more attention to? One is the unprecedented growth or
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expansion of credit. So what I have there is – is a couple numbers
to give you the flavor, but you’ve seen it from the graphs. So
something like financial assets to GDP in 1975 around 150 percent
to right before the financial crisis reaching something like 350
percent. That is a massive increase in financial liabilities. The
banks’ asset mix has also changed over time as regulation after
regulation has come down. So we have
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something like 60 to 70 percent of the portfolio being made up of
government securities. And now that has virtually disappeared
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from banks’ portfolios. There’s also been a switch to wholesale
funding. So the shadow banking system that Mark was alluding to
in his talk has basically exploded in the last 20 years. Unsecured
lending is the game of the day. Secured loans, or deposits which
are secured by the FDIC, now represent a much smaller
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piece of the pie. And then one other aspect that is a trend change
is the increasing weight of public debt on almost every country. Not
just in the US, and not just because of the financial crisis, but this
has been a trend that was coming at the heels of the end of Bretton
Woods. Coincidentally, not because of Bretton Woods necessarily,
and it has been growing up over the next 20 to 30 years and I will
show you a picture of this. Some of
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these are the broad trends that I want you to keep in mind
especially the ones that relate to the importance of credit. Okay,
so, how do we think about credit and financial crises? I’m going to
show you a bunch of these pictures so it’s perhaps useful for me to
spend a little bit of time telling you what’s going on in here. This is
a picture that displays the following exercise. It looks at all the
recessions that have happened in the US in the last 140
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years, puts them into different bins: normal and financial. And
then it takes the average in each case and it says, okay, let me
normalize so that in year zero when the recession stars I normalize
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at zero and then I see what happens, in this case to real GDP per
capita. Real GDP per capita falls in the first year and then starts
recuperating. That’s the usual pattern that we’ve seen in
recessions in the last 140 years. And by the way, the duration of
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recessions being one year, you can go back 140 years, that hasn’t
changed at all. Other things have changed, but not that. Financial
recessions, financial crises are much more longer lasting. As you
can see in the graph they last about two years and they take
much, much longer to recover from. Now, before we start drawing
too many conclusions, this is a little bit like the following
experiment. You ask a bunch of people whether they have a
headache or not. You then ask a bunch of people whether they
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have taken an aspirin. And then you look at the correlation and
you run the risk of concluding that aspirins cause headaches.
Okay we don’t want to do that, so we have to be a little bit more
sophisticated. This gives us a flavor, okay. This also gives us a
flavor of what is the typical pattern of financial crisis versus
normal recessions when you look at investment and when you look
at inflation. So the red line again is that monstrously negative
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line that shows you that investment really plummets in financial
crises and it takes a long time to recover. It also shows you that
prices tend to push the deflation boundaries rather than the
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inflation boundaries, okay. All right, well, this is great but we need
a little bit more analysis here to get a sense of what might be going
on. How can credit help us think about financial crises, is it
helpful to predict financial crises, are financial crises driven by the
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embarrassment of governments, as an early writer put it? The
answer is that financial crises are incredibly hard to predict, but
there is some predictive power in looking at how quickly credit
grows prior to a crisis event. You can put in public debt, you can
look at the external balance, none of those are going to help you
think about financial crises. But the one thing that does, not
majorly, but the one thing that does is the growth of credit. And if
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you look at that problem from this perspective, I know this is a
busy slide it’s meant to check your eyesight, what you’ll see is
basically again the same normal path for a recession and recovery
and then you see two groupings of lines. One that is closer to the
normal recession, one that’s farther away. The difference between
the two groupings is high versus low credit. Whether you have high
or low level of deficit accumulation prior to the financial crisis
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really doesn’t make a difference, okay. So again this is a story of
credit, it’s not a story of the government. Well what about the
government? These are some of the trends that I was describing
earlier in regard to what has happened to public debt in the last 40
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years. What I have displayed for you here is the ratio of public debt
to GDP and this included state, local, and federal debt for the US,
so it’s a litter higher than the numbers that you may have
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seen. But what you’ve seen are two things. Obviously you have the
big ramp up of World War II, the big pay down of that debt after
World War II all the way through the middle of the 70s. And then
basically the welfare state taking over in Europe and in the US and
those levels of public debt to GDP rising back again well before the
financial crisis hit again. So I don’t want to say that you shouldn’t
care about the level of public debt to GDP
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when thinking about recoveries from financial crises, that was not
the message. And in fact, let me tell you why that’s not the
message. Let me break this analysis down carefully for you. Now
we’re going to start moving away from aspirins cause headaches”
to now you have a scientist running a controlled experiment. Trust
me, this is the closest I can get to doing that. So this is what this
graph is showing you. It’s saying, okay, look at normal recessions
and look at financial recessions and think about the following
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counterfactual: everything stays the same, you control for all the
variables in the economy, you put the kitchen sink in there very
cleverly and then you say, okay, now let’s do the one experiment in
which prior to the outbreak of the recession, or prior to the
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Òscar Jordà, “Private Credit, Public Debt and Financial Crises”
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outbreak of the financial crisis, what you do is you have a higher
than normal accumulation of credit. What happens? Well it doesn’t
really matter whether you’re in a normal recession or you’re in a
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financial crisis, your recession is going to be deeper, your recovery
is going to be much slower, regardless. Okay so this is a graph of
real GDP per capita across all 17 economies to make everything
much more comparable. If you look, if you break down, and again
this is an eye check, I know. If you look at lending, if you look at
public debt, if you look at prices, what I’ve done is remove the
dashed line for the normal recession and just focused on the
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financial crisis. Lending goes down massively if you have a lot of
credit buildup before the expansion. Public debt grows massively
because of course you have to bail out a bunch of banks. So public
debt is going to explode in that respect. And of course prices are
going to be going down. There’s going to be deflation because
there’s going to be an immense shortage of demand as a
consequence, okay? Now I’m able to tell you what happens with
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the level of public debt. Well, if you have a financial crisis and you
have to bail out the private sector, mostly banks, and you’re going
to basically have your level of public debt to GDP explode, the more
precarious your balance sheet as a government is, the more the
sovereign falls under attack by markets. That’s easy to see and you
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can see it in Europe nowadays. Spain came into the recession with
a relatively benign, actually kind of the lowest level of debt to GDP
of the 17 countries that I showed you earlier. And look at Spain
now. You know, the level of debt to GDP is expected to go to 100
percent. It’s not there yet, but it’s going rapidly toward that
direction and look at the attacks on the sovereign debt for Spain in
the last year. You know, obviously with Cyprus things were a little
shaky,
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but well before then you saw attacks on Spanish debt. What
happens then if you come into the recession with a debt to GDP
level that’s about 50 percent, which is about average for the
sample versus an extreme which is 100 percent debt to GDP level.
Again your recession becomes so much more painful. Because, you
know, you start bailing out your private sector and at some point
the sovereign comes into attack. The sovereign comes into attack
that means ramp up the austerity. Ramp up the austerity means
stop
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the presses. Economic activity freezes, okay. And you can see that
in real GDP per capita, you can see massive deflation, you can see
massive freezing of lending, and of course you can see a massive
increase in public debt. And then that has to be undone. Okay, so
yes, public debt to GDP doesn’t predict financial crises, but it
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matters a lot for the purpose of thinking about what happens.
Now, let me retake what Mark said about the US economy. And
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let me retake the conclusion which I announced at the beginning of
the talk. If I look at the performance of the US economy, where
does the US economy rank? If I had taken the following
experiment, given my analysis of 140 years of data across 17
industrialized economies, take what I knew in 2007, run the model
forward, and then compare the prediction of my model with the
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actual data. And let me do that for the US and let me do that for
the UK, why? Because in the UK they had a slightly different
program. They had also slightly different constraints, they had a
slightly higher public debt to GDP level and we know that that
makes things harder, okay? On the left hand side you have the US
performance of real GDP per capita. On the right hand side you
have the UK’s. What is the performance of the US? As Mark
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anticipated the US has actually done better than I would have
expected from my model. I think we did clean balance sheets much
more quickly, I think we didn’t go the austeritypath quite as
quickly. We waited a little longer, we had a little bit more stimulus
at the beginning of the recession, and that helped us move the
path quite a bit. Okay, so now we’re doing, we would be expected
to be about 5 percentage points where we started in 2007 and
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we’re almost back to – to where we were in 2007. And compare
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that to the UK. The UK, my model actually does a very good job
predicting what would have happened for the first two years. I
mean, it’s uncanny how good a prediction it is. And like Mark, I
will confess to getting a prediction every now and then incorrectly,
despite my abilities with the data. But look at what happened . The
predicted path which said the UK ought to be now back to where it
was in 2007, but it’s not,
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it’s quite a bit lower than that. It’s almost like the mirror image of
the US, okay? And I don’t want to blame austerity in the UK for
this result. Like I said, they had different sets of constraints all of
which I’ve tried to put in my model, but, you know things are
different. So it may be austerity, may be something else. Okay, so I
got one minute left to tell you what should be the takeaway. And
since you have your policymaker hats on, so to speak, in your
function as directors of this bank, perhaps these are some of
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things that you should keep in mind for the longer run. And some
of the things that I think are worth mentioning are this: credit
plays a pivotal role in thinking about the business cycle and
thinking about the severity of recessions and thinking about the
likelihood of crises. So we ought to be doing a much better job at
monitoring credit. And we ought to keep our eyes on the ball much
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more thoroughly perhaps than we have, especially given the
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very rapid innovations in finance that happened in the last 25 to
30 years. It just makes the job of policymaking that much more
complicated but that much more important at the same time. And
what about excess public debt? We had a ramp up of public debt
in the last 30 to 40 years that is basically a trend changer from
what had happened World War II. Well there, too, I think we have
to keep our eye on the ball and perhaps not be
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too quick to do this, but perhaps at some point we need to get a
handle on public levels of debt relative to GDP. But there are two
other stories that I don’t really know how to qualify. And those are
what has happened in emerging economies and what has
happened to demographic transitions. And those suggest to me
that the savings glut that we experienced that was mentioned by
Chairman Bernanke in 2005 may be coming to
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an end at some point in the not too distant future. And those are
really long and strong forces that we need to think about. And with
that, I don’t know if it’s a high note or a low note, but I’ll leave it at
that.
[applause]
[End of Recording]