Download Financialization and the crisis

Financialization and the crisis
Marc Lavoie
University of Ottawa
Some background
A couple of years ago hardly any
economist knew about these terms
• ABS, MBS, RMBS, CMBS, ABCP, CDO, CDO2,
CMO, CLO, CDS, EDS, SPE, SPV, SIV
• asset-backed securities, mortgage-backed securities,
residential mortgage-backed securities, commercial
mortgage-backed securities, asset-backed commercial
paper, collaterized debt obligation, collaterized debt
obligation squared, collaterized mortgage obligation,
collaterized loan obligation, credit default swaps, equity
default swaps, special purpose entity, special purpose
vehicle, structured investment vehicle
Some warning signs
• 2005: High share of new mortgage loans that
were subprime;
• 2006: Risky mortgage formula (interest only,
2/28, negative amortization)
• Mid 2006: US Real estate prices stop rising
• Early 2007: the cost of insuring BBB mortgagebacked securities against default losses rose
briskly (MBX or ABX indices take a plunge)
Falling values of MBX, the reverse of the
cost of default insurance on MBS
A change of policy paradigm
A second Keynesian pragmatic
revolution
• In contrast to previous financial crises, the IMF
advocates low interest rates and government
stimulus packages with budget deficits;
• G20 leaders move away from unfettered
markets and uncontrolled capitalism;
• Gordon Brown (UK): “The Washington
consensus is out”;
• Financial Times: “The credit crunch has
destroyed faith in the free market ideology”.
Two opposite views back in favour
in the media
• Neo-Austrian theory (Hayek, von Mises) at
the forefront of the second counterrevolution;
• Post-Keynesian monetary theory
(Galbraith, Minsky) at the forefront of the
second Keynesian revolution;
The neo-Austrian view (not mine!)
of the crisis in a nutshell
• The US government (CRA) forced banks to
grant subprime loans.
• The Fed set short-term rates at too low a level
(from 2002 to 2004).
• The Chinese rigged the exchange rate and
flooded long-term bond markets, also leading to
overly low long-term rates.
• There would be no crises if government was
small and interest rates were always set at their
natural levels.
• The fiscal stimulus will make things worse!
The post-Keynesian view of the
crisis in a nutshell
• Western economies have moved towards a
financialization process over the last decades,
with deregulation of the regulated financial
system and growth of the unregulated financial
system.
• The current regime of accumulation (based on
low real wages and consumer debt) was
unsustainable.
• Financial crises are an endogenous feature of
unregulated capitalism.
• As a result, financial crises are more frequent
and more severe.
Financialization
Finance capitalism,
Stock market capitalism
Money manager capitalism
Rentier capitalism
Financialization: definition
• “Financialization means the increasing role
of financial motives, financial markets,
financial actors and financial institutions in
the operation of the domestic and
international economies” (Epstein 2006)
Financial institutions – stylized facts
• The GDP share of the finance, insurance and real estate
sectors has nearly doubled
• The profits of financial corporations relative to those of
non-financial corporations have doubled or tripled.
• The profits of banks as a percentage of their total assets
have nearly doubled.
• Compensation of employees in the financial sector as a
percentage of total compensation in the economy has
doubled.
• The turnover rate of shares on stock markets has
doubled.
Non-Financial corporations – stylized facts
• The percentage of financial assets held by non-financial
corporations relative to tangible assets has tripled, now
on par.
• Non-financial corporations, that used to issue new equity
to finance their investments, now often buy back their
shares instead.
• Non-financial corporations now raise a larger proportion
of their funds through bond issues.
• The interest and dividend income of non-financial
corporations as a percentage of their gross value added
has tripled.
• The interest payments of non-financial corporations as a
percentage of their gross value added has quadrupled.
• The dividend payout ratio (as a percentage of their cashflow) has doubled.
Distributional issues – stylized facts
• The wage share of income has gone down.
• The share of income going to rentiers has risen.
• Labour hourly productivity has grown much faster than
hourly earnings or even hourly total compensation of
production and non-supervisory workers.
• The income share of the lowest quintile has fallen.
• The income share of the highest quintile has risen.
• There has been an incredible rise in the income share of
the top centile.
Flow-of-funds – stylized facts
• The net accumulation of financial assets of corporations
is positive, meaning that they lend their surpluses to
households, with about half of these funds coming from
financial corporations.
• The net accumulation of financial assets of households
is negative, meaning that they borrow from corporations
to pay for their consumption, financial and real estate
investments.
• This has been made possible in particular by the use of
margin debt – the borrowing of money, collaterized by
equity in the stock market or equity in homes.
Some specificics of
financialization
Securitization and credit default
swaps
The advantages of securitization and its
derivatives, according to finance
• It reduces risk in the banking system
• It makes the payment system immune to
insolvency
• It spreads risk to those best able to handle
it
• It is a stabilizing factor
• It diversifies the supply of assets
• It reduces the cost of mortgages
The dangers of securitization
• Disconnects the risk of the defaulting borrower
from the bank granting the loan.
• Creates a chain of self-serving agents getting
bonuses (short-termism again):
– Mortgage broker, property appraiser, loan officer,
securitizer, bond rater, lawyer, underwriter, CDS
issuer, investment manager.
• With deregulation, more fraud incentives
(lender-induced liar loans)
Securitization according to Minsky 1987
• Securitization helps financial globalization
• Securitization will lead to credit-enhancing
mathematical techniques (AAA rated
securities at BBB yields)
• There will be “a thin market if price and
quality of the securities deteriorate”
• “Securitization implies that there is no limit
in creating credits for there is no recourse
to bank capital”
Credit default swaps according to
Wojnilower 1984
• “The recent entry of major insurance
companies into the business of insuring
banks and bond investors against loan
defaults represents another effort to
stretch the safety net. Now it can be
presumed, the authorities will have to
intervene to interdict a cascading of
defaults only if to save the insurance
industry” (Wojnilower 1985, p. 356).
Is this a Minsky crisis?
Financial markets blew up on their own
• This is not a true Minsky crisis.
• In the Minsky crisis, the problem starts with overindebtedness of non-financial firms, and
explodes because of rising interest rates.
• This was not really the case in 2007, and neither
was it in 1929.
• Both in 1929 and 2007, problems arose from
over-indebtedness of households, and, as in
Japan, a meltdown of the real estate market and
then the equity market.
US non-financial corporation debt
to equity ratio
Source: Wachovia Bank
Household debt to disposable income
ratio, US and Canada
debt / PDI
200
180
160
140
120
100
80
60
40
20
0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Canada
Source:
United States
Effect of a one-time increase in the flow of gross household
loans to personal income (Godley-Lavoie 2007 model)
Time
Effect of a one-time increase in the flow of
gross household loans to personal income
Time
Conclusion:
2009, the worse of two worlds
• The real estate market crashed before
these negative effects could really take
effect.
• But now we have two negative effects
operating at once on consumption:
– The long-run negative effects of a higher flow
of household borrowing relative to income
– The short-run negative effects of high saving
rates, directly from higher propensities to
save, and indirectly from a lower propensity to
take new debt