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Great Depression and Great Recession A comparison between an old and a modern global systemic risk Abstract Several studies find evidence that the economic downturn after a financial crisis tends to be more severe than a normal ending business cycle. Financial stability therefore is crucial for a stable economy. The speculative bubble and the financial collapse at the roots of the Great Depression changed the vision in the United States about the desired role of federal authorities in the life of citizens. Next to poverty relief programs, a far reaching framework for banking regulation and supervision was developed and implemented ever since. Also in the 1930s, the foundations were laid for macroeconomic theory to guide policymakers to achieve full employment. For over 70 years, no banking panic occurred in the United States significantly contributing to a more stable economic environment. For the first time since, the recent financial panics and the credit crunch brought back into life the danger of an international systemic risk with potential dramatic consequences for the real economy. To avoid a new depression, policymakers immediately intervened to safeguard the financial system but the rules of the game have changed. For the stabilization policies to be sustainable, lessons from the 1930s in combination with more recent insights must reshape an adequate theoretical and regulatory framework. Angela Maria Caboni 0111880 March, 11, 2010 Master Thesis Supervisor: Dr. M. Giuliodori Second Reviewer: Prof. Dr. C. Van Ewijk Universiteit van Amsterdam 1 Acknowledgments This thesis was my way to combine my never ending passion for history with all that I learned during my years of study. Besides the fear and uncertainty for the future, the recent financial crisis had the small benefit of renewing my interest for the economic science. It made me realize this highly theoretical study may still be helpful to understand the world we live in and that we are certainly not at a dead end as was thought just before or during the crisis. I must admit it was not easy for me to distill a valid ‘crisis’ comparison from the enormous quantity of historic elements, which of course caught my eye much more than the economic aspects did. Therefore I thank my supervisor, prof. Giuliodori, who gave me the possibility to write about this topic in the first place, and who helped me find the right path in the labyrinth of the Great Depression. I also would like to express my gratitude to my family, in particular my parents and my sister, for their loving support during all these years. They always believed in me through all the ups and downs, giving me the strength to keep on going and believe in myself. Last but not least, a special thanks to all my most dear friends for the encouragement, the good advice, the times together at the library, at work, the many laughs and so much more. To all, you shallowed every recession during this ‘Depressing’ thesis and make my fears for the future disappear as long as we have each other, our love and our friendship. 2 3 Table of Contents 1. INTRODUCTION............................................................................................................................................. 5 2. THE DAWN OF THE GREAT DEPRESSION ............................................................................................. 7 2.1 HISTORICAL BACKGROUND ........................................................................................................................... 7 2.2 INSTITUTIONAL FRAMEWORK........................................................................................................................ 9 2.2.1 Central Bank......................................................................................................................................... 9 2.2.2 Gold Exchange Standard.................................................................................................................... 10 2.3 MACROECONOMIC BACKGROUND ............................................................................................................... 11 2.3.1 Stabilization of the Currencies ........................................................................................................... 11 2.3.2 Economic and Credit Boom................................................................................................................ 12 2.3.3 Structural Changes and the Agricultural Depression ........................................................................ 14 2.3.4 Global Imbalances.............................................................................................................................. 16 2.4 FINANCIAL CRISIS IN THE UNITED STATES .................................................................................................. 16 2.4.1 Initiation of Financial Crisis .............................................................................................................. 17 2.4.2 Banking Crisis .................................................................................................................................... 18 2.4.3 Debt Deflation .................................................................................................................................... 20 2.5 REPERCUSSIONS ON EUROPE ....................................................................................................................... 20 2.6 RECOVERY .................................................................................................................................................. 21 3. FINANCIAL CRISES 2007 AND 2008 ......................................................................................................... 23 3.1 HISTORICAL BACKGROUND ......................................................................................................................... 23 3.2 INSTITUTIONAL FRAMEWORK ...................................................................................................................... 24 3.2.1 Independent Central Banks................................................................................................................. 25 3.2.2 Banking Regulation and Supervision.................................................................................................. 25 3.2.3 Basel Capital Accord.......................................................................................................................... 26 3.3 MACROECONOMIC BACKGROUND ............................................................................................................... 28 3.3.1 Great Moderation ............................................................................................................................... 28 3.3.2 Loose Monetary Policy....................................................................................................................... 29 3.3.3 Global Imbalances.............................................................................................................................. 30 3.4 CREDIT BOOM ............................................................................................................................................. 31 3.4.1 Securitization of Debts........................................................................................................................ 31 3.4.2 Rising Complexity of Derivatives ....................................................................................................... 34 3.4.3 Subprime Deals .................................................................................................................................. 35 3.4.4 Subprime Bubble ................................................................................................................................ 36 3.5 FINANCIAL CRISES 2007-2008 .................................................................................................................... 37 3.5.1 Financial Panic 2007 ‘Subprime Crisis’ ............................................................................................ 37 3.5.2 Financial Panic of 2008 ‘The Perfect Storm’..................................................................................... 41 3.6 RECOVERY .................................................................................................................................................. 44 4. CONCLUSION................................................................................................................................................ 46 5. REFERENCES................................................................................................................................................ 49 4 1. Introduction The dramatic decade of economic depression that hit the United States in the 1930s, put an end to the laissez-faire mentality that ruled the banking and business life of the country at that time. The severe impact of the financial crises of 1929-1933 finally made the policymakers understand the importance of sound banking systems for the whole economy, and the mass poverty of the population changed the feelings towards the desired role of the government in people’s life. Social programs, banking regulation and supervision were implemented already during the Depression and a new field of study, macroeconomics, continued to develop ever since serving as a guideline to policymakers to achieve full employment and stability. Successfully, no banking panic has occurred in the United States for more than 70 years. In the meantime financial panics throughout the world continued to pop up every now and then, their impact more or less contained by prompt (inter) national fiscal and monetary actions with the help of experiences learned from each past crisis. In addition, from the 1980s a long and stable period of growth called the Great Moderation made many believe the key to permanent growth and stability was found forever. Some of the pillars of this infallible economic environment were liberalization, deregulation, privatization and globalization. In other words, the ideological ‘invisible hand’ that self regulates the economy was back. Financial markets are very vulnerable to market failures in the absence of adequate regulation. In the recent years, the financial system was permitted to become overleveraged feeding a housing boom in the United States that reached enormous proportions before its collapse in 2007. Ironically, every financial crisis exhibits a general pattern of excessive optimism that transforms a sound period of growth into a speculative bubble. When the bubble bursts, the optimism suddenly turns into excessive pessimism and hysteric panic reactions on the stock and the financial markets. What is different this time with the financial crises of 2007-2008, is the fact that it was the first systemic risk in the United States since the Great Depression years. The aim of this thesis is to draw a comparison between the Great Depression and the present crisis. The first part will discuss the Great Depression starting with the historical, institutional and macroeconomic background, followed by the triggers for the crisis and the policy responses. The second part will be a similar description of the 2007-2008 crises. In the conclusion some lessons for the future will be accompanied by the answers to the following questions: Is it sustainable to compare the events preceding the Great Depression to the situation prior to the financial crisis of 2007-2008? Could the present crisis have been prevented on the basis of our knowledge about the Great 5 Depression? And, comparing the policy actions of that time with now, what have we learned and will we succeed in mitigating the negative effects of the severe crisis? This thesis will describe how mismanaged technological innovations in the 1920s and financial innovations in the 1990s resulted in an unsustainable credit boom. In both periods the lagging behind of regulations in the banking sector led to an overexposure to credit and market risk of these institutions, which were the source of panic and banking runs once uncertainty about future profits was revealed by declining asset prices. Both periods marked drastic structural changes in the United States on the way to progress; from agriculture to industry in the 1920s in the real economy, and now in the financial markets from the traditional originate-to-hold to the originate-to-distribute model. The financial crises were on the retail level in 1920s and on the wholesale level now, nevertheless both systemic. The Great Depression set the example of how dramatic the impact of a financial collapse may be for the real economy as well. Even if insecurity is still ongoing on the financial markets and we do not have the knowledge about the full effects, provisional lessons at this point are essential to minimize the risk that this greatest global economic recession since the 1930s turns into a new depression. A combination of lessons learned from past and recent events, is essential to stabilize the present insecurity on financial markets and set the stage for a new theoretical and regulatory framework that is more adequate to cope with market failures deriving from modern financial markets, just like the regulations during the Great Depression helped to foster stability in the decades that followed. 6 2. The Dawn of the Great Depression Banking panics and financial crises certainly were not a unique phenomenon in the United States. What distinguishes crises in 1929-1933 from the earlier episodes is that they occurred after the placement of the Federal Reserve System in 1914 and more importantly, they were followed by a decade of economic depression. Disagreement still exists on the true causes of the Great Depression despite academic efforts of the most prominent economists since. Broadly two views prevail. The ‘monetarists’ basically blame the failure of the Federal Reserve to prevent banking panics. According to them, had the Fed intervened adequately as a lender of last resort, the monetary contraction would have been less severe, and so would its negative effects on the aggregate economy. This view however is considered too narrow because it solely concentrates on the monetary factors. In contrast, a broader view considers financial crises to be the result of a series of causes, varying from sharp declines in asset prices, failures of both financial and non-financial firms, deflations and uncertainty in foreign exchange markets (Mishkin, 1990, p. 2). This view helps explaining why Europe was experiencing banking problems prior to the financial panics in America, but is too broadly defined to create a useful theoretical framework. To understand the Great Depression is the Holy Grail of macroeconomics; it gave birth to macroeconomics as a distinct field of study and it continues to influence macroeconomic beliefs, policy recommendations and research agendas (Bernanke, 2000, p. 5). Prior to the Depression, authorities were facing a series of problems they did not know how to cope with. Especially in the beginning, they worsened the matter by sticking to an old set of instruments which resulted in excessively restrictive policies. To better understand the decisions in the United States of that time, we must first take a look at what happened in Europe after the First World War and in particular the German hyperinflation of 1922. 2.1 Historical Background While the general interest remains the fact that the Great Depression led almost directly to the World War II, interestingly large part of the causes that led to the Depression find their roots in the aftermath of the First World War (1914-1918). In Table 1 a short overview of some important events illustrates how especially Germany was afflicted in the first half of the twenties. In addition to normal post-war economic disruptions, the country was characterized by hyperinflation in 1922-1923 and was saddled with war reparations. 7 In January 1923, international tensions again were high when French and Belgian troops entered the Ruhr Valley to ensure Germany paid the due reparations in goods, such as coal from the Ruhr, because the mark was practically worthless due to hyperinflation. To put an end to these tensions, a commission was appointed to help Germany stabilize its currency and set a new schedule for war reparations. The Dawes Plan, launched in 1924, included a loan of 800 million marks that was to be floated in various financial capitals against the collateral of German railroads securities, as Germany had no gold to back its currency. Confidence was restored and the hyperinflation resolved quickly, although the memory of its dramatic effects would echo in Germany and beyond for many years to come. Table 1: Overview Turbulent Twenties 1918 End First World War 1922 German Hyperinflation 1923 Invasion Ruhr Valley 1924 Dawes Plan 1925 Restoration British Gold Standard 1927 Credit and Stock Market Boom 1928 Fed increases interest rate 1929 Stock Market Crash The Dawes loan not only solved the hyperinflation, it was also the spark that ignited foreign lending from New York giving rise to a boom on the international capital markets. Together with the restoration of the pre-war Gold Standard in 1925 that stabilized the currencies, the stage was set for an economic boom to take place once the recovery from the war was over. This economic growth had the dark shade of leading to excess supply on the primary goods markets. In fact, during the war the production in Europe stood still and other countries had to quickly gain productivity to fill in the gap. When Europe resumed the production, however, this resulted in an excess supply that led to worldwide deflationary pressures, protectionist measures and competitive depreciations. Especially in the United States, where the agricultural sector was still very large in the 1920s, the negative effects of this agricultural depression on the rural banking sector played a major role in the financial panics that would start in 1930 as will be explained in greater detail later. 8 The excessive fear in the United States for hyperinflation like happened in Europe, justified all the restrictive monetary and fiscal policies that aimed at preventing high inflation at all costs and held back the expansionary policies needed at that time to fight off the negative effects of this structural deflation on the primary goods market and the rural banking sector. Despite the existence of the Federal Reserve System, the institutional framework lacked regulations and expertise to foster financial stability. In addition, many central banks were limited in their actions by their dependency from (national) political goals and the commitment to the Gold Standard. 2.2 Institutional Framework The Federal Reserve System was institutionalized through the Federal Reserve Act in 1913, with the aim to put an end to the long history of regular banking panics. Still, this young institution was not able to prevent the most severe economic contraction in U.S. history and its severe repercussions on the rest of the world furthermore revealed other the weaknesses in the international institutional framework. The lacking regulation of banks, the gold standard and the absence of a safety net all contributed to a vulnerable banking system that eventually would become pray of asymmetric information problems and runs once the conditions of the real economy started deteriorating. 2.2.1 Central Bank By the 1920s most countries had central banks for the management of their gold and foreign reserves and for the provision of currency and credit. These institutions were very different from how we know them now. First of all, they were not independent from their national governments, subjecting monetary policy to domestic goals and their destabilizing effects. Second, there was a lack in regulation and supervision of the banking sector. In the United States for example, chartering of banks and capital requirements were very poor or fragmented. 1 In general the importance of a sound banking system for the real economy was underestimated during the Federal Reserve meetings. The only exception was the Federal Reserve of New York who had more knowledge about international finance and repeatedly tried to convince other members of the Board into more extensive open market operations, but to no avail. Banks were systematically allowed to fail under the ‘laissez-faire’ ideology 1 Mitchener (2004, pp. 2-4) finds evidence that state regulatory and supervisory regimes help account for the regional variation in financial distress during the Depression. For example, counties located in states that permitted branching, adopted higher capital requirements and where supervisors had more power to liquidate banks, experienced lower bank rate suspensions during the Great Contraction years 1929-1933 as the contagion and credit-channel dislocations were minimal. On the contrary the suspension rates were higher in states where branching was not allowed, reserve requirements were elevated and where supervisors were appointed for longer terms with unlimited authority to charter banks, as this increased the incentives for banking lobbyists to influence supervisory decisions. 9 that markets would regulate themselves through the invisible hand, despite the possibility of the Federal Reserve to act as a lender of last resort having plenty of gold reserves. A crucial difference with modern banking regulation is the absence prior to the Great Depression of a safety net to protect deposit holders. Banks are particularly subject to market failures due to asymmetric information problems that make them vulnerable to deposit withdrawals. In the absence of government guarantees, a banking run certainly becomes rational behaviour even if everyone knows not all the deposits are in cash, because the first to arrive have more chance to get their money back while the last ones will not receive a penny. The possibility to engage in expansionary policy helping out banks in trouble or guaranteeing deposits however was not a luxury permitted to every central bank. Another important factor that tight the hand of both monetary and fiscal policymakers was the commitment to the Gold Exchange Standard. 2.2.2 Gold Exchange Standard Prior to the Great War, the City of London successfully managed the international Gold Standard fostering some kind stability on the financial markets. After its suspension during war, one of the major national objectives was its restoration to put an end to widespread high inflation and monetary chaos. However, the price level had increased in the meantime and there was not enough gold available. With the solution of a gold-exchange standard in which convertible foreign exchange reserves as well as gold could be used to back national money supplies, most countries could return to gold (Bernanke, 1990, p. 5). The most debated example remains the restoration of the pound at par in 1925 that led to a significantly overvalued currency. The impact on the British economy turned out to be disastrous through its repercussions on British exports, unemployment and speculative attacks on the gold reserves. The weakness of the standard increased because of the rising accumulation of gold in the United States and France, which continued their restrictive monetary policies imposing deflation to the rest of the world through the interlinkages of the exchange system. The automatic mechanism prior to the war, with countries with more gold inflating and countries with gold outflow deflating was disrupted and the presuppositions for British dominance on the financial markets were changing rapidly. Eventually Britain abandoned the gold standard in 1931 after it became impossible to maintain the fixed exchange with the pound without putting the economy through further restrictive measures. 10 Summarizing, central banks were still very inexpert in fostering stable financial markets for several reasons. They lacked knowledge about the importance of prudential banking regulation and supervision and they had limited liberty of action. The gold standard on one side linked them to (gold) reserve flows to be materially in the position to inflate or deflate, while on the other side their dependency on national political goals further constrained their decision-making. A typical example is perhaps the Bank of France which was not permitted to engage in open market operations despite its large gold reserves, to prevent an undesired appreciation of the French franc as the French government did not want to reverse the positive effects of the devaluated franc on exports and national output. The system that worked so well prior to the War now was dysfunctional, revealing a lack of international coordination on the financial markets which would worldwide spread deflation and financial distress. Central banks and governments together, underestimated the impact of a systemic risk to the real economy and banks were allowed to work themselves into overleveraged positions during the credit boom, becoming extremely vulnerable to asymmetric information problems. 2.3 Macroeconomic Background The post-war reparations, the foreign lending, the excess supply of primary goods and the gold exchange standard all gave rise to a fragmented economic boom. This section will provide a short description of the macroeconomic environment of the second half of the twenties. 2.3.1 Stabilization of the Currencies Following the British example of a return to gold, many other countries restored the commitment to a fixed exchange with gold albeit not at the pre-war level. France for example stabilized its currency gradually over 1926 at an undervalued level, which permitted the country to attract large gold inflows through the positive effects for the French exports. The stabilization of the German currency after the hyperinflation also was successful. Although Germany did not have large gold reserves the confidence was maintained through the real estate collateral to back up the Reichsmark. This further alimented large short term lending flows from the U.S., in addition to the initial Dawes loan. Figure 1 illustrates the rising U.S. and British foreign lending to Europe that started around 1926, and anticipates the sudden lending stop in 1928. 11 Figure 1: U.S. and British Foreign Lending to Europe (in millions of dollars) Source: Kindleberger, 1986, p. 40. But before going too much ahead in this story, let us first see how for the United States the stable currencies together with domestic technological and financial innovations led to an economic and credit boom that extended beyond the U.S. border. 2.3.2 Economic and Credit Boom Although not general and often interrupted, many countries experienced economic growth in the twenties. Especially around 1925-1926, once the recovery from the Great War was over and currencies were stabilized, the way was paved for an economic boom to arise. Important exceptions were Britain, Italy and Japan while amongst the most booming countries were France and the United States. Figure 2 shows how the GNP in the United States rose steadily from 1921 to 1929 then started falling. Growth in the United States was built around the automobile. This included the manufacture of vehicles, tires and other components, roads, gasoline stations, oil refineries, garages and suburbs. Also, the combustion engine spread into transport with the use of trucks and to the farm where the horses were replaced by tractors (Kindleberger, 1986, p. 44). Structural changes that were underway affected farming productivity, which considering the high percentage of agriculture in the United States, contributed to the agricultural depression. 12 Figure 2: U.S. GNP Per Capita Source: EH.Net Encyclopedia (2009). The modernization of the economy also resulted in booming electrical appliances like radios, refrigerators and vacuum cleaners. Practically unknown at the beginning of the 1920s, these luxury goods were commonplace by 1929 also due to the financial innovation of instalment credit which facilitated sales to a larger public. In the period from 1925 to 1929, the volume of instalment paper outstanding more than doubled. Figure 3: Short Term Interest Rates in the U.S. Source: Homer S. and R. Sylla, 2005, pp. 396-404. 13 From July to September 1927 the Federal Reserve System implemented an expansionary policy in response to a recession and rapidly declining commodity prices. The open market purchases and the cut in the discount rate shaped an environment of easy money that added to the credit boom and probably stimulated the rise in the stock market that began in the spring of 1928 (Kindleberger, 1986, p. 53). Figure 3 shows the short term interest rates in the United States for the period 1910 to 1940, with the rediscount rate of the Federal Reserve Bank of New York starting from 1914. The positive effects on the stock market are represented in Figure 4. Figure 4: New York Stock Exchange Sales and Securities Issued Source: EH.Net Encyclopedia (2009). In general the declining short term rates from 1921 to 1927, with the exception of call loans, reflect the expansionary policy and the favourable environment for foreign long term lending and the start of a stock market boom. 2.3.3 Structural Changes and the Agricultural Depression Problems in the agricultural sector started well before the Great Depression years. The technological innovations had improved the agricultural productivity and the European production of primary goods had recovered quickly after the War. This resulted in strong deflationary pressures with declining output. In Figure 5 evidence for this agricultural depression is provided by the steady declining rate of employment. 14 Figure 5: Farm Population and Unemployment in the United States Source: EH.Net Encyclopedia (2009). For the United States, where the agricultural sector was very important, this significantly added to the general level of unemployment and financial distress. The many fractioned small banks in rural areas started having difficulties quite early, as in some states up to 85 percent of the farms were mortgaged. Foreclosures started rising, as represented in Figure 6, and did not stop until 1927, when the interest rates were cut and the stock market started booming. Figure 6: U.S. Farm Mortgage Foreclosure Rate Source: EH.Net Encyclopedia (2009). 15 The Federal Reserve was not interested in helping out small banks with liquidity and solvability issues even if they could have done so. Often these banks were not even members of the Fed. With these financial institutions particularly vulnerable to panics and bankruptcies once they were hit by a run, the systemic risk was very high and it was only a matter of time until panic spread also to the city banks despite their flourishing activities. 2.3.4 Global Imbalances The final macroeconomic aspect that will be discussed is the rising global imbalance that contributed to the worldwide monetary contraction and the contagion of financial problems. The scarcity of gold and the linkages of the Gold Standard were a perfect transmission channel for international deflation as in a scramble for gold, countries tried to attract inflows competing with high interest rates. In addition, the two countries with most gold reserves, United States and France, accumulated gold without inflating. Hence, structural deflation was further exacerbated by these voluntary or imposed restrictive monetary and fiscal policies. Probably for fear of a repetition of hyperinflation scenario’s, countries preferred to respond to the declining output by depreciating their currencies and imposing tariffs on imports in order to help their exporting sectors, rather than pursuing a more expansionary policy. Therefore, given all countries were trying to protect their exports and were facing the same excess supply and deflation problems, these depreciations only led to more deflation, triggering further depreciations. The result was a spiralling deflation that was, in the end, the major explanation for the Great Depression. Concluding, despite its negative effects on spreading deflation, the Gold Standard had the initial positive result of stabilizing the currencies, contributing to the economic growth. However, like often happens in a rising business cycle, irrational over optimism led to a credit boom and excessive risk taking. With weak regulation on financial institutions on the background and the negative effects of the agricultural depression on their balance sheets, the stage was set for financial crises to occur once uncertainty about the future triggered panics. 2.4 Financial Crisis in the United States The chronological overview of some important events reported in Table 2 starts with the Great Crash in 1929, which would definitively put an end to the dreams and illusions that dominated the positive 16 wind of the twenties. So although it was not the direct trigger, it significantly contributed to the first banking panic of 1930. Table 2: Diary of the Great Depression 1929 Stock Market Crash 1930 First U.S. Banking Panic Smoot-Hawley Tariff Act 1931 Second U.S. Banking Panic Banking Panic in Europe Britain abandons Gold Standard 1932 Start Large-Scale Open Market Purchases Reconstruction Finance Corporation (RFC) Glass-Steagall Act Roosevelt wins Presidential Elections 1933 Third U.S. Banking Panic Emergency Banking Act Bank Holiday Agricultural Adjustment Act (AAA) 1934 Securities and Exchange Commission (SEC) Federal Deposit Insurance Corporation (FDIC) 1939 Start Second World War The financial crisis that initiated the decade of depression is very similar to more recent financial crises. Not every crisis however leads to a depression. What follows is an explanation of why particularly the episodes in beginning of the 1930s had such a worldwide devastating impact. 2.4.1 Initiation of Financial Crisis In Figure 7 below, a general pattern is represented of how financial unrest develops into a banking crisis and how this further creates severe economic disruptions. In the first stage the economy is situated in the peak of a business cycle. At this point markets start becoming nervous and in trying to maintain the high profit level, moral hazard and adverse selection problems arise. In the specific case of the 1930s, these problems were the result of several factors. First, there was the deterioration of the balance sheets of financial institutions, as the negative effects of the agricultural depression in rural areas started affecting city banks through the withdrawals of rural banks’ deposits. Second, the increase of interest rates of the Fed in 1928 not only added to the 17 difficulties for banks through its contractionary effect on money supply, it also set in motion an asset price decline that found its climax when the New York Stock Market crashed in October 1929. Figure 7: The Evolution of Financial Crises Source: Mishkin, 2010, p. 203. The dramatic welfare effects of this crash for the United States reached far beyond the purpose of the policymakers at that time, namely to put an end to the stock market speculation. Finally, everything led to general uncertainty about the future typical of every ending business cycle. In the attempt to keep up the high level of profits that seemed sustainable during the boom, adverse selection and moral hazard problems increase, and in the absence of an adequate regulatory framework, these asymmetric information problems may lead to banking panics. 2.4.2 Banking Crisis In the second stage of the crisis, the initial moral hazard and adverse selection problems are translated to a real economic decline because the dysfunctional financial system is not allocating capital efficiently. The declining asset prices force banks to write down and the losses on loans begin to affect 18 their solvability and liquidity; banks start deleveraging. At this point lending is cut down abruptly for fear of lemons and deteriorating capital positions. The economic decline in turn increases the uncertainty about soundness of financial institutions and fear spreads among the depositors, inducing them to withdraw their money. Banking runs of course increase moral hazard and adverse selection problems and are very contagious due to more or less irrational fears. Figure 8: Stock Prices and the Interest Rate Spread Source: Mishkin, 1990, p. 22. In Figure 8 some important stages in the U.S. financial panic are indicated by RC- the Stock Market Crash, P1- the first banking panic of November 1930, P2- the second banking panic of March 1931, P3- Britain’s abandonment of the Gold Standard in September 1931 and PH- the bank holiday of March 1933. According to Mishkin (1990, p. 23) it is remarkable that the level of the interest rate spread before October 1930 remained so low despite the sharp economic contraction up to that point and the decline in the value of stocks. This low spread indicates that asymmetric information problems had not yet become severe in financial markets, probably because of lagged negative market sentiments. During the first banking crisis in October 1930, the United States experienced an extraordinary rise in the deposits suspended by banks. In November 1930, 256 banks failed with $180 million of deposits, followed by 352 failed banks in December 1930 with over $370 million deposits. According to Friedman and Schwartz, the failure of the Bank of United States on December 11, which alone 19 accounted for $200 million deposits, was of particular importance because it was the largest commercial bank ever to have failed up to that time in the U.S. history and its name led many at home and abroad to regard it as an official bank. Also being a member of the Federal System, the failure was a serious blow to the System’s prestige (2008, pp. 25-27). As banks reacted each seeking to strengthen their own liquidity position, this led to an even worse second panic in March 1931. 2.4.3 Debt Deflation What made the Great Depression the worst economic contraction in U.S. history was not the structural deflation or the stock market crash. A process called debt deflation is what distinguished this period. Essentially, an additional unexpected price level decline led to an increased burden of indebtedness at the firm level, which negatively affected the net worth of firms (Mishkin, 2010, p. 206). Debt deflation, probably caused by the lacking quick and substantial expansionary policy response at that time, caused longer lasting and more severe moral hazard problems and adverse selection problems. Their negative impact on lending and investment opportunities kept the economy far below its full potential for a decade, with unemployment in the United States reaching peaks of 25 percent. In Europe, where the negative impact of the American depression accrued to the own difficult economic and financial positions, the situation was not much better. 2.5 Repercussions on Europe The scope of this thesis is to compare the two major financial crises in the United States. Therefore, not much attention has been given so far to the financial distress in Europe although this was almost simultaneous to the American. The increase of the interest rates around 1928 that contributed to a stop in foreign lending from the United States, as shown in Figure 1, led to an abrupt stop of the credit boom in Europe. Especially for Germany, which was very dependent on these funds for monetary purposes as it could not rely on gold reserves, the effects on the banking system were dramatic. With the failure in May 1931 of the Austrian bank Creditanstalt that triggered banking panics Austria, the contagion to Germany and the rest of Europe was almost immediate. Only France was temporarily saved by its large gold reserves. On the contrary, the situation was particularly tensed in Britain which was constrained to abandon the gold standard in September 1931. It however turned out to be a relief because of the immediate devaluation of the pound and the benefits for the exports, in addition to the stop of restrictive commitments to the gold standard. Interestingly, the spreading of panic across the Atlantic region is an 20 important element that returns in both the Great Depression period and the more recent financial panics. 2.6 Recovery At long last, in April 1932, the System embarked on large scale open market purchases and more legislation was implemented to stabilize the financial system. Two examples are the Reconstruction Finance Corporation (RFC), chartered to provide loans to different financial institutions and other businesses, and the Glass-Steagall Act, which was mainly designed to broaden the collateral the Reserve System could hold against Federal Reserve notes. In the meantime Franklin Delano Roosevelt won the presidential elections but this was not sufficient to stop a third banking panic in 1933. This last flow of banking runs was counteracted with the proclamation of a nationwide banking holiday, made possible by the Emergency Banking Act passed during a special session at the Congress. This Act confirmed the powers assumed by the President in declaring the holiday and facilitated the closing down of insolvent banks and the reorganization and opening of stronger institutions. Finally in 1934, the Securities and Exchange Commission (SEC) and the Federal Deposit Insurance Corporation (FDIC) were institutionalized. The unprecedented emergency legislation under Roosevelt, better known as the New Deal, not only regulated banking. It also aimed at alleviating the economic disease through programs that reduced unemployment and assisted business and agriculture; security was provided for the weaker segments of the population, as half the population was living below the minimum subsistence level. Although the U.S. gross debt increased from $22.5 billion in 1933 to $40.44 billion in 1939, Roosevelt was reluctant to accept anymore deficit spending than the absolutely necessary to prevent mass suffering. The United States finally abandoned the Gold Standard in 1933. This account of the Great Depression cannot be concluded without mentioning John Maynard Keynes and his General Theory of Employment, Interest and Money, published in 1936, in which he provided a convincing theoretical framework in justification of counter-cyclical fiscal and monetary policies, needed to shallow business cycles and correct market failures. According to him, to put an end to the Depression, massive government spending was needed to compensate the hoarding behavior of people and fill the consumption gap that kept the economy below its potential equilibrium. His ‘interventionist’ theory was an attack to the neo-classical ‘laissez-faire’ paradigm that was founded rational behavior of economic agents and on the free market’s natural achievement of full employment. 21 However, it was not until the U.S. government was forced to large defense expenditures by the imminent Second World War that the Depression in fact ended, and that the Keynesian theory would be implemented by Western policymakers. Mainstream macroeconomics based on the General Theory continued to develop ever since, successfully preventing depressions, but losing popularity after the high volatility of economic fundamentals in the seventies. Starting from the eighties, a new flow of deregulations and liberalizations increased market efficiency and contributed to the Great Moderation. The ideology of free markets that take care of themselves was gaining absolute popularity again. Unfortunately, the positive effects were not general, as the dramatic financial panics of 2007-2008 illustrate. What happened is that in the absence of adequate regulations in the financial sector, market failures arose again, feeding an American house price bubble that continued to expand thanks to financial innovations and excessive liquidity. Chapter 3 will describe what went wrong in the financial markets in more detail. 22 3. Financial Crises 2007 and 2008 In the long period from the Great Depression to now the world has completely changed. The lessons learned from past mistakes helped improving regulation, supervision, monetary policies and international cooperation in such a way that financial crises so far, had a limited impact on the world’s financial stability and real economy. Besides, the absence of significant financial disruptions was also beneficial for a very stable economic environment, better known as the Great Moderation. The events of 2007 and 2008 pulled the United States and Europe abruptly out of the illusion that a systemic risk on the financial market belonged to the black and white history of the 1930s. This chapter aims at explaining why the 2007-2008 panics are different from other recent crises and why these differences makes them more similar to those that preceded the Great Depression, despite the completely different settings. What follows is an overview of the recent history, institutional framework and macroeconomic antecedents that contributed to the environment of excess liquidity, one of the major causes of the rise of the new bubble. 3.1 Historical Background The Second World War put a definitive end to the economic depression of the 1930s, when it forced the massive spending that was required to restore the economy to its full employment level. Nevertheless, economic instability persisted long after the war, predominantly in the form of high inflation. Things gradually changed from the early eighties, when a happy period of stable output growth and prices called the Great Moderation, made us believe we had found the key to eternal economic equilibrium. This dream shattered with the burst of the house price bubble in the United States, and worsened a year later when panic persisted. Some historical events represented in Table 3 may help understanding the prerequisites for this bubble to occur despite the stable environment. First, there is the structural deflation that hit Japan in the 1990s. Among the factors that contributed to the deflation was the burst of the equities and real estate bubble in 1989, which had a double impact on the prices through its negative effect on the money supply and the general price level, and in the form of restricted credit conditions, due to the solvency problems at many companies and banks that had invested in real estate. In addition, deflation was imported from China and other upcoming Asian countries with lower prices. The government and the Bank of Japan responded reducing interest rates with a zero-rate policy but did not succeed in reanimating the economy, the country was stuck in a liquidity trap. 23 Table 3: Early Nineties and 2000 1990 Deflation Japan 1992 Implementation Basel Accord (1988) 2000 ‘New Economy’ bubble bursts 2001 Twin Tower attack The second event was the burst of the New Economy bubble in early 2000, after the growth of technology and internet possibilities in the 1990s led to over valuated stock prices. Central banks responded with massive interest rate reductions in line with the lesson learned from the Japanese economical downturn, which was to act quickly and aggressively in order to shallow the recession after the burst. Successfully the fall in asset prices had no important effect on the real economy and no deep recession occurred. Finally, another important monetary event was the massive injection of liquidity on the capital markets after the attack on the World Trade Centre in 2001. Similarly here, policymakers succeeded in keeping the system stable and around 2003 the real economy had recovered. The unstoppable deflationary forces in Japan were the scary evidence that the kind of structural deflation that left policymakers powerless during the Great Depression could still be active in our modern days. The expansionary influence on monetary policies worldwide, i.e. the continued large amount of money on the market and the low interest rates, stimulated the beginning of a new credit cycle, that fed by new possibilities in the form of financial innovations would lead again to a speculative bubble. The better regulated and supervised banking sector through the independency of central banks, deposit guarantee schemes and international capital requirements were not enough to stop financial panic. 3.2 Institutional framework Ever since the importance of a sound financial system was acknowledged after the Depression, authorities worldwide started developing a better institutional framework in order to foster financial stability and prevent systemic risk. Importantly, legislative changes protected deposit holders, reshaped the role of governments and central banks, subjected the banking sector to stricter regulation and supervision rules, and increased international coordination through the establishment of institutions like the Bank for International Settlements (BIS) in 1930 and the International Monetary Fund (IMF) in 1944. With the scope of increasing efficiency on the capital markets, deregulation and 24 liberalization started in the 1980s, changing for good the rules of the game in the global financial markets. 3.2.1 Independent Central Banks In general central banks in industrialized countries now are independent institutions who received mandates from their government to implement monetary policy. Although decisions at the central bank are bounded by the specific mandate, predominantly price stability, their discretionary power remains large. More decision power is also due to the flexible exchange rates, in contrast with the tight hands for the maintenance of a fixed exchange rate regime as was the case during the Gold Standard and later the Bretton Woods System. In their role as the lender of last resort, central banks also are granted much liberty. Through the possibility of helping financial institutions in liquidity problems, they significantly may contribute to stable financial systems. Central banks also have supervisory and regulatory powers of the banking sector, albeit in combination with the governments and other national institutions designed to mitigate asymmetric information problems on the financial markets. 3.2.2 Banking Regulation and Supervision The rationale for authorities’ intervention is to reduce the negative effects of market failures to which the financial system is extremely vulnerable to. The most important, asymmetric information, at the same time makes banks uniquely important for a good functioning market economy. Banks contribute to an efficient allocation of capital through their knowledge advantage about assessing risks of investments, permitting also non-financial agents to invest without having to gather this costly information themselves. On the banks’ balance sheet, long term loans on the asset side are financed trough short term deposits and other securities on the liabilities’ side. According to standard economic theory, banks have every incentive to monitor and produce information about the borrower to minimize the risk of losses in case of default, while making large profits from interest and amortizations. Through deposits and securities banks create informationinsensitive debt; deposit-holders need not to be concerned about the value of the check and bonds are not subject to adverse selection because to produce private information for speculation purposes it is not profitable (Gorton, 2009, p. 7). 25 The disturbances caused by asymmetric information however cannot be ignored by regulators. Banks are vulnerable to solvency risks due to the mismatch in the maturity transformation. For example, the depositors’ lack of knowledge about the quality of banking activities and their assets can lead to banking panics. Also the lack of knowledge about risk taking activities of banks makes agents reluctant to trust their funds to the banks, as in the event of a failure they risk losing their money. Chartering, bank examination, bank disclosure and capital requirements are just some elements of prudential supervision central banks implement in addition to their lender of last resort role. Governments also may intervene directly in the functioning of financial markets through injections of liquidity, nationalisations and deposit insurance. Deregulation and liberalization of financial markets, together with the differences in national regulations, called for international rules to create a level playing field on global financial markets. The Basel Capital Accord of 1988 was developed to respond to this need. 3.2.3 Basel Capital Accord Prudential supervision is nation-bound and may differ significantly from country to country. Due to increased deregulation and globalization that started in the 1980s it was necessary to come with international rules to address the rising complexity of financial markets. To mitigate the vulnerability to solvency risk that could come forth from the rising transaction activities of banks, the emphasis was on capital regulations. In 1988 the Basel Accord was published by the Basel Committee. This set of minimal capital requirements would be first implemented in 1992 by a group of ten countries and continued to spread since. In a nutshell, banks with international presence were required to hold capital equal to a minimum of 8 percent of their risk-weighted assets. These assets were classified in four categories according to their credit risk; 0 percent risk-weight for reserves and sovereign debt of OECD countries, 20 percent for claims on banks of OECD countries, 50 percent on municipal bonds and residential mortgages and 100 percent risk-weight for corporate and household debt. This emphasis on credit risk, that is the risk of losses due to the debtor’s nonpayment of the loan, whether further specified in sovereign risk and counterparty risk, soon was being thought of as outdated in light of the shortcomings of this construction to deal with increasing complexity of the financial products, the financial markets and the intrinsic incentives for capital arbitrage. 2 An amendment to the Capital Accord of 1988 introduced the computation of market risk in 2 Excessive risk taking could not be prevented with these capital requirements as no distinctions were made between AAA rated bonds and CCC rated bonds. Also, country risk of OECD members was treated with an equal weight when in fact, given different macroeconomic conditions, the sovereign risk of different OECD member counties may differ significantly. As with higher risk comes higher profit, banks were tempted into more risky business while still meeting the capital requirements. 26 1996, responding to possible losses due to changes in the value of investments resulting from changes in the market. 3 In 2004 the New Basel Capital Accord (Basel II) was endorsed by the banking supervisory authorities of the G10 countries, in response to the need for better risk control. The challenge of Basel II was to achieve this through the introduction of operational and market risk in addition to credit risk assessments and the incentive to develop and improve tailored risk management functions within individual banking organisations (first pillar), a more active role for supervisory authorities to encourage banks to improve their risk management (second pillar) and improved market discipline through disclosure of banks, in order to provide all market participants sufficient information for assessing risks and performances of the financial institutions (third pillar) (ECB Monthly Bulletin, 2005, p. 49). Two important differences with the previous Accord reside in the first pillar. The first, although the minimum capital requirement of 8 percent of risk-weighted assets remained unchanged, is the inclusion of operational risk; the risk of a loss resulting from failures in the part internal processes (for example people or systems) or from external events. The second is the introduction of sophisticated and risk-sensitive options for the calculations of credit and operational risk. Where under Basel I the risk weight depended on the category of the borrower, now risks were tailored using a credit rating provided by a recognised external credit assessment institution (ECAI) that met supervisory eligibility standards (ECB Monthly Bulletin, 2005, p. 50). With this comes an important point of critique on the Basel rules in light of the current financial crises, the role rating agencies played in the risk assessment of smaller banks. Smaller banks could in fact choose to rely on rating agencies instead of making complicated internal calculations. In other words, they could ‘outsource’ the mere thing a good bank should be about: risk management. This fundamental flaw took away the responsibility out the bank for its actions, and later proved even more disastrous once the ratings given to certain types of assets came under fire. Another point of discussion is the procyclical effect of Basel that has been already witnessed in this period of deleveraging. To conclude, the focus on capital requirements of the traditional segment of banking, created an incentive to find loopholes in the regulations. Through the construction of larger financial conglomerates and separate vehicles that fell out of the supervision scope, the financial system became overleveraged taking excessive risks. If it is true that regulations lag behind, however, macroeconomic 3 Examples of changes in the market conditions that may affect the value of investments are movements in the exchange rate (currency risk), interest rates, and equity and commodity prices. 27 policy also was dormant and did not recognize in time the overheating economy. Reassured by the Great Moderation period, not enough was done to fight the unsustainable inflation in the asset markets. 3.3 Macroeconomic Background Beyond any doubt the current recession finds its roots in the dysfunctions on the financial markets but a closer look at the macroeconomic antecedents also is essential for understanding how the credit bubble was initiated and more importantly, how the crisis propagated. What follows is a brief discussion of the Great Moderation, the loose monetary policy and the global imbalances that contributed to the credit boom. 3.3.1 Great Moderation The Great Inflation of 1970s was a period of high macroeconomic imbalance in which price regulations, trade restrictions, oil shocks and the Bretton Woods system of fixed-exchange rates all contributed to price volatility. In addition, the benchmark used for monetary policy was a long-term trade-off between unemployment and inflation. Since the early 1980s this volatility in the industrialized countries declined and was replaced by a period of stable growth that lasted 25 years, the Great Moderation. Explanations for this change include globalization, as it outsourced production to cheaper production countries and increased the competition on world trade markets. Also, the domestic output gap which is an important determinant for monetary policy became less important because positive gaps could be flattened with exports and negative gaps could be filled with imports. Another explanation is the mitigating impact of structural changes on the macroeconomic effect of positive or negative shocks. Some examples are the increased competition in labour and product markets, the shift from manufacturing to services and the improved inventory management that attenuated the inventory cycle. Furthermore, these shocks were lowered by innovations in financial markets that facilitated the greater spreading of risk and enabled economic agents to smooth spending (Bean, 2009, p. 4). The Great Moderation may also be the result of better monetary policy. In the past, central banks were often not entirely independent from their governments making their monetary decisions sensible to their government’s desired level of output. The trade-off between inflation and output consequently resulted in the incentive to create a higher ‘surprise’ inflation to get lower real wages, stimulate production in the short-term and lower unemployment. The problem is that economic agents soon understand this time inconsistency problem the policymakers face and surprise inflation will cease to 28 have the desired effects once households start anticipating higher inflation. From the early 1980s the experience was that through a mandate of price stability and other stability-oriented policies, a credible central bank may successfully anchor low inflation expectations and pursue both a stable output and stable prices goal at the same time. In light of the current crisis more people are sceptical about the true benefits of the 25 years of equilibrium. Cornerstones like the liberalization of the goods and capital market, further reaching deregulation of especially the financial markets and the benefits of globalization, all are under scrutiny again. Some people go as far as to believe it was all just a matter of good luck due to less severe shocks in these years. In my opinion, it would be an exaggeration to ascribe the Great Moderation solely to good luck because there have been important shocks in those years. Also the importance of independent, credible central banks has been proved in many studies. Nevertheless, we are forced again to reconsider what determines stability and growth equilibrium, and especially how to stay there. 3.3.2 Loose Monetary Policy The previous account provided ‘better monetary policy’ as one of the explanations for stable economic fundamentals. Despite the formation of the bubble and the subsequent collapse of the financial market, this does not mean this explanation should be rejected a priori. Evidence suggests that especially in the United States monetary policy has been too loose in the past years, implicating it was not necessarily the policy framework that was bad, rather it was badly implemented. According to Taylor (2007, p. 2), during the period from 2003 to 2006 ‘the federal funds rate was well below what experience during the previous two decades of good economic macroeconomic performance - the Great Moderation – would have predicted’. The low interest rates and the provision of large amounts of liquidity that continued even after the recovery from the asset bubble of 2000 helped the extraordinary rise in demand for housing, which in turn led to further house price inflation. Related to this problem of interest rates below sustainable levels, is the view that the central banks underestimated the inflation rates they based their policy decisions on. High inflation was often addressed as a problem of ‘global inflation’ about which national monetary authorities had no power. However, if inflation is imported from other countries while the whole world is experiencing inflation, are we then importing inflation from another planet? The Fed’s focus on ‘core inflation’ since start of the new millennium has been criticized a lot. Core inflation eliminates the more variable prices from the headline inflation, and is therefore a good predictor of future headline inflation. The impact of globalization on world prices is ambiguous, as it 29 may also drive up the inflation through the increased demand for goods from booming countries. In the past years emerging markets persistently entered the global economy as demanders of non-core commodities and suppliers of core goods. Considering core goods are subject to price rigidities, while non-core goods have flexible prices, a continued upward movement in the relative price of non-core goods to core goods may cause a temporary increase of the headline inflation, and at the same time a temporary reduction of the core inflation (Buiter, 2008, pp. 66-68). For this reason, the medium-term inflationary pressures may have been higher than the Fed thought they were, keeping the interest rates below the reasonable framework levels. 3.3.3 Global Imbalances The rapid growth in the last decade of emerging market economies like China, India and Brazil should have led to inflow of capital from advanced countries according to standard economic theory. This is because capital in growing economies is needed to provide the investment necessary to equip the extra workers. Instead, we saw the opposite happen as especially China was exporting capital to the United States and the United Kingdom (Bean, 2009, p. 6). Among the explanations for this phenomenon we find the ‘savings glut’ hypothesis advanced by Bernanke. According to him, the fact that surplus countries engage in attracting even more capital may be a reflection of their wish to accumulate precautionary holdings of international reserves and on the micro level, the outcome of a lacking household safety net. It is possible that global imbalances contributed to the credit boom through the decline in long term interest rates in advanced countries, linked to the ‘savings glut’. For example, the low level of real returns on government bonds may have encouraged financial institutions to shift investment into riskier assets areas like the ABS market, in search for yield. In summary, the Great Moderation and the easy monetary policy all contributed to the bubble in several ways. First, the low rates meant the return on risk-free assets was very low, making it more attractive for people to invest in riskier assets. This ‘search for yield’ was further enforced by the excess liquidity on the markets, in part imported from emerging economies, and the financial innovations that made these investments possible. A second contribution is through the cheaper credit possibilities which created situations of over lending and over consumption. Third, there is the persistent underestimation of future risks to which the long period of prosperity contributed. Finally, the low rates made it very unattractive to save money. A problem that maybe was not considered when everything went well because banks financed themselves with liquid short term assets, but that created serious problems at banks once the short term assets markets froze. At this point, to complete the 30 puzzle that reconstructs the onset of the credit boom, we will turn in greater detail to the contribution of the financial innovations. 3.4 Credit Boom Similar to the technological innovations in the past like electricity, railroads and internet that increased productivity and gave rise to new credit cycles, also this time it were innovations that started the new cycle albeit in the financial sector. Also similarly, the beginning was very positive through the creation of new opportunities. What follows is a simplistic example of how banks moved from the originate-tohold model to an originate-to-distribute model applying the technique of securitization, enabling the shadow banking to reach enormous proportions. 3.4.1 Securitization of Debts Although they started flourishing after 2003, innovations in the financial markets already existed in the 1990s. For example the use of derivatives was a way financial institutions found to hedge all kinds of risks in response to the high interest rate volatility of the 1970s and 1980s. Encouraged and sometimes sponsored by the government, securitization of debt started to play an important role in the U.S. housing market. Residential and commercial mortgages were not the only type of debt that could be securitized, also student loans, credit card receivables and loans to businesses could be used as collateral for Asset Backed Securities (ABSs). To explain how securitization works, let us start with the balance sheet of an imaginary traditional mortgage bank as shown in Table 4. On the asset side the bank has ‘issued mortgages’, on the liabilities’ side the bank has deposits and capital. To meet the capital requirements, there is a limit to the mortgage lending the bank may offer its clients. Also because of the short term liabilities versus the long term mortgage annuities, the banks has every incentive to screen and monitor potential lenders in order to minimise default and credit risks. This is the classical example of a distribute-tohold model, or in other words, a relationship oriented banking model with incentives on both sides to invest in mutual trust and long term business relations. The mortgage owner in most cases holds all his financial business at the same bank. Now let us turn to the innovation of securitization. The bank may sell the finished mortgage products in bundles to a separate institution, for example a Structured Investment Vehicle (SIV) in return for cash. This institution was not physically present but rather a legal construction, a Master Trust, set up by the bank who wanted to apply the technique of securitization. Importantly, it was thought to be 31 completely independent from the bank. Table 4 illustrates how cash is received in turn for the bundle of mortgages and the debt risk is swept away from the official balance sheet. In case the capital requirements in this example are 10 percent of the total assets, the bank now may create another package of mortgages that can be sold on. Securitization enables the bank to generate mortgages and issue all other kinds of debt moving it off-balance without ever having to raise its capital in order to meet the capital requirements. In this originate-to-distribute model banks became transaction oriented and acted more as financial intermediaries. The cash flows emanated from assets are sold on to the SIVs and the bank loses the incentives to monitor the loans. The risks are removed from the bank’s balance, at least in theory. Table 4: Balance Sheet Mortgage Bank Mortgage Bank Before securitization Assets Liabilities Mortgages 100 Deposits Capital 90 10 Total 100 Total 100 Cash After securitization 100 Deposits Capital 90 10 Total 100 Total 100 Table 5: Balance Sheet Special Investment Vehicle Special Investment Vehicle Assets Liabilities MBS 100 ABCP Capital 95 5 Total 100 Total 100 32 To complete the story, in Table 5 the balance sheet of an imaginary SIV is represented. It shows how the purchase of the long term assets was financed through issuance of short term securities to investors in the form of asset-backed commercial paper (ABCP). Figure 9 below is a scheme of how this worked in practice. The general characteristic of ABSs is that their payment relies upon cash flows from a specific pool of assets rather than on the general credit of the issuing corporation (Gorton, 2009, p. 8). The mortgage ‘pools’ were subdivided according to the priority of cash flow payments into senior, mezzanine tranches and so on. The highest rating was for senior tranches, AAA, who had the lowest risk of loss because they were the first to be paid out of the incoming cash flows. Figure 9: Securitization of Assets Source: Gorton, 2009, p. 8. Banks, whether or not related to these SIVs, received fees from these mortgages. This is a classical example of regulatory arbitrage, because banks acted like SIVs were independent when in fact, as would become very clear later, they were not. When the SIV got into liquidity problems after ABCP was pulled back, banks injected liquidity through credit lines in such amounts that finally transmitted liquidity problems to the banks as well. 33 A problem that returns in cycles is that markets are one step ahead of regulators and there is always an incentive to find loopholes in the regulation (Hoogduin, 2009). SIVs did not have to meet any regulators capital requirements and supervisors did not look at these off-balance sheets focussing instead on the capital positions of banks which were of course always solvent. The levels of leveraging in the financial sector were increasing to dangerous levels under the nose of authorities as the capital risk in the shadow banking was taking large proportions. However, as long as the access to liquidity functioned well there were no serious problems. 3.4.2 Rising Complexity of Derivatives The expansion of the issuance of debt continued rising as banks could create loans to businesses and households and sell these to the conduits, thus shifting the risk off their balance sheet. Not only housing benefited from the low interest rates and the innovations, also M&A sectors of banks and companies increasingly used the credit markets to fund their activities, rather than relying on more traditional mediums like deposits and stock issuances respectively. The demand for collateral rose together with the markets for structured products, and new products came into life to meet the demand. Collaterized Debt Obligations (CDOs) 4 became very popular providing lots of new opportunities and Credit Default Swaps (CDSs) allowed investors to hedge themselves against a wider range of default risk (Bean, 2009, p. 3). Risks could be sliced and diced, made tradable and be redistributed towards those in better positions to bear them according to the rating of these products, resulting in a more flexible and efficient credit market. What happened in time is that the difficulty to assess risks rose as the complexity of the products increased. In addition, the explosion of credit was not associated with an even expansion in demand for goods, leading to a dangerous build-up of household and business debt to GDP (Bean, 2009, p. 3). The price of the assets was becoming dangerously high in comparison to the real value of the underlying collateral, especially in the U.S. housing sector. At some point it became possible to allow riskier borrowers access to mortgage finance through the financial innovation of ‘subprime mortgages’. This innovation was warmly welcomed in the beginning not only by banks; it was on the U.S. political agenda to allow every American to own a house. This adds to the idea that financial innovations also offered great opportunities in the beginning, but fact remains the panic started in the subprime sector so it is worth to go into these products in more detail. 4 A cash CDO is a special purpose vehicle, which buys a portfolio of fixed income assets and finances the purchase of the portfolio via issuing different tranches of risk in the capital market. For example, ABS CDOs have underlying portfolios consisting of asset-backed securities (ABS), including residential mortgage-backed securities (RMBS), and commercial mortgage-backed securities (CMBS) (Gorton, 2008, p. 34). 34 3.4.3 Subprime Deals Subprime mortgages and their financing structures were designed in a way as to respond to the need to deal with riskier borrowers and therefore they significantly differed from traditional ‘prime’ contracts. Gorton (2008, p. 12) pins the defining feature of subprime lending as the idea that the counterparties can benefit from house price appreciation over short horizons, mostly two or three years. Most subprime mortgages are adjustable-rate mortgages (ARMs) with 30-years amortizations in a hybrid structure ‘2/28’ or ‘3/27’. 5 The first number stands for the initial period of two or three years in which the rate is fixed, often a lower ‘teaser’ rate, while the remaining 28 or 27 years will have a floating interest rate. Despite its name, however, the teaser rate was not much lower than the average 8.5 percent rate used in prime mortgages. After the initial period, on the ‘step-up date’, the floating rate regime came into force. Usually this was calculated as the benchmark LIBOR plus 6.1 percent on average and updated every six months. Intuitively, if the LIBOR rate would float significantly this was transmitted to the flexible mortgage rate, but even if the LIBOR remained constant the resulting rate was very high. Borrowers were essentially forced after the reset date to go back to the lenders and ask for a refinance, which in most cases was possible due to the house value increase, because of the impossibly high mortgage fees. In some cases even an equity extraction could be obtained from the increased house value that could be used for other types of consumption. The risk of losses for the lenders was thought to be very low as they ultimately had the decision power to refinance or not, and in the worst case of a default on the mortgage they would get the house. 6 Between 1998 and 2006, when house prices were still steadily moving upwards, subprime mortgages were working quite well (Gorton, 2008, p. 18). The security design of subprime bonds reflected the particular construction of their collateral, the subprime mortgages. The difference with other types of collateral, like credit card receivables and prime mortgages, was that these were not very sensitive to price changes. In the meantime these investments were thought to be low risk bearing. When finally CDOs started purchasing significant amounts of subprime RMBS bonds, the complexity of the products rose as well as ‘subprime’ fraction of the booming financial markets. 5 ‘Hybrid’ stands for the combination of both a fixed and a floating rate-element. This form of lending is sometimes called ‘predatory lending’ because the borrower is tempted to engage in the mortgage without realising that in the end the lender had every power not to refinance and basically put the borrower on the street. 6 35 3.4.4 Subprime Bubble The difficulty is that with hindsight the dangers of rising asset prices are very clear, but while its happening increased efficiency and cheaper credit in financial markets is a good thing, especially when it can provide houses to more people. In these times over optimism makes it difficult to distinguish ‘real progress’ from the formation of bubbles and overexposure to risk in the financial sector. Fact remains that at some point the best deals were made and mortgages started being sold to very risky borrowers. Table 6: The Unstoppable Subprime Market 2004 Implementation New Basel Accord (1996) Fed increases interest rate 2005 ECB increases interest rate 2006 Exponential growth subprime derivatives By 2006 the extremely low perceived risks in financial markets by no means reflected the true risks coming from the highly leveraged banking system. Nonetheless, economic fundamentals were better than ever, asset and house prices were increasing and when everything goes well, people tend to believe it cannot go wrong. For policymakers also it is not easy to take action in this stage. When you know there is a bubble you are basically too late; even if interest rates are raised, the profits would still be higher and trading could not be stopped. The gradual rise in interest rates implemented by the Fed in 2004 and the ECB in 2005 shown in Table 6 illustrate this impotence. The subprime issues boomed in 2006. Incentive distortions intrinsic to the transactions oriented banking model also contributed to the boom, as banks leveraged up to high levels without increasing their monitoring and screening. They could have felt protected by their ‘too big’ or ‘too interconnected’ to fail position, their good liquidity options, the knowledge that house prices in the U.S. did not decline nationwide since the Second World War and of course, the considerable movement of risk to the conduits. They however misjudged their true risk position first because of the credit lines these ‘independent’ SIVs had with their supporting banks through which liquidity problems could be transferred directly back ‘on balance’. Secondly, the debt securities issued by one bank were often bought by the propriety trading desks of other banks instead of being sold on to investors outside the banking system, leading to a crossholding of underlying loans of which the risk remained widely in the banking system instead of being distributed (Bean, 2009, p. 8). 36 Incentive distortions on the level of the rating agencies also played a significant role, as they could make high profits from giving high ratings to these products. Even once the risk is perceived, however, it is not easy to get out. Managers could get fired if they refused to trade options because they would miss lots of profits and the reason is also psychological, similar to the first to jump from the Titanic. ‘As long as the music plays, we are still dancing’ said the former CEO of the Citygroup Chuck Prince in the summer of 2007. The music would stop playing shortly afterwards when housing inflation halted and the dark shadow of fundamental uncertainty spread panic among financial markets. 3.5 Financial Crises 2007-2008 Despite the completely different settings, the mechanisms that gave rise to the recent financial crises resemble a lot those of the 1929-1933 represented in Figure 7. The interest rates were increasing, the asset prices declining and the balance sheets of financial institutions deteriorating. The general uncertainty that accompanies every ending business cycle was now extremely dangerous due to the immeasurable non-regulated shadow banking. After the first panic in the fall of 2007, policymakers worldwide acted promptly but could not prevent the even more dramatic panic attack that would take place a year later. 3.5.1 Financial Panic 2007 ‘Subprime Crisis’ The simple chronological overview of events in Table 7, reports how the feeling of uncertainty came rather late considering what was happening on the markets since 2003. Table 7: The Subprime Crises of 2007 February Subprime defaults increase July U.S. house prices decrease August BNP Paribas announcement Run on SIVs and drying up ABCP market ECB and Fed injections on the money markets Fed starts cutting interest rates September Bank run at Northern Rock December Term Auction Facility (TAF) 37 The trouble only started in 2006 after the house price peak was reached and then worsened quickly after February 2007, when defaults in subprime mortgages started increasing. Owners were not able or willing to pay back a debt that was becoming higher than the house value and the assessment of the value of subprime related products became very problematic. The ABX index (see Figure 10) played a crucial role in revealing the information to the public that the risk on subprime derivatives could be higher than expected. The index was based on the price of CDSs; a decline of this rate represents the higher costs of insuring a basket of mortgages against default (Brunnermeier, 2008, p. 8). Figure 10: Decline in Mortgage Credit Swap ABX Indices Source: Brunnermeier, 2008, p. 9. The first financial institutions started suffering from subprime-related losses and rating agencies immediately proceeded downgrading tranches. This had a negative impact on the prices of mortgagerelated products, further triggering downgrades of other tranches and preoccupation in the credit markets. The turning point came in July 2007 when house prices in the United States were decreasing nationwide like did not happen for a long time. The risks of derivatives now were impossible to calculate given the lack of information on what would happen next. All existing models for risk assessment were based on some form of increasing prices. This fundamental uncertainty produced a new kind of panic on the financial markets; instead of a lack of confidence from the private citizens towards credit institutions on a ‘retail’ level, the lack of trust was among financial institutions on the ‘wholesale’ level of which funding was largely based on collateral. 38 The blow came on August 9, 2007, when the hedge fund of one of the largest European banks, the French BNP Paribas, announced they would not repay asset holders because of what was happening in the United States. It became clear that the troubles with U.S. housing had spilled over the underlying assets and the inability to value structurized products triggered a run on the SIVs. This resulted in the drying up of the ABCP market as can be seen from Figure 11 and the related banks had to fill in the liquidity gap through credit lines. Figure 11: Outstanding Asset-Backed Commercial Paper (ABCP) and Unsecured Commercial Paper Source: Brunnermeier, 2008, p. 11. The higher perceived liquidity and default risk of banks dried up other short term funding markets as well. Uncertainty about the exposure to risk of other banks froze interbank lending and the LIBOR shifted upwards. Banks desperately in need for liquidity started selling stocks, even at much lower prices but nobody wanted to buy MBS anymore. Other stock prices went down as well and so contagion spread even to banks that did not have MBS. In Figure 12 the trouble on the liquidity markets is revealed by the peaking interest rate spreads. The beginning of the credit crunch coincides with the announcement of BNP Paribas on August 9, 2007, but if we already look forward to the spikes of the ‘Great Panic’ of 2008 it is clear that the worse had yet to come. For now the focus remains on the ‘little’ subprime panic of 2007. 39 Figure 12: Interest Rates Spreads Source: Brunnermeier, 2008, p. 13. The LIBOR-OIS spread is the difference between the London Interbank Offered Rate, the rate at which banks make unsecured short term loans (mostly overnight to three months) to each other, and the Overnight Indexed Swap, which in the U.S. is based on the federal funds rate. The credit crunch is indicated by a higher spread, which reflects the unwillingness of banks to lend money to each other. The contraction in the T-Bill-OIS spread reflects the popularity of Treasury bills as collateral, while the spread between mortgage-backed repos and general collateral repos on the lower panel, indicate the opposite sentiment towards MBS as collateral. 7 Finally, the ‘agency spread’ between 30-year agency bonds issued by government-sponsored enterprises (Fannie Mae and Freddie Mac) and 30-year Treasury bonds, reveal the mortgage-related panic. The ECB and the Fed injected respectively €95 billion and $24 billion into the interbank market. To alleviate the liquidity crunch, the Fed also reduced the discount rate to 5.75 percent and extended both the type of collateral that banks could post and the horizon for lending facilities on August 17. All the same, banks were reluctant to borrow at the Fed’s discount window because of the negative signals about their creditworthiness on the interbank market. This fear for a stigma was not a new phenomenon as it already existed at the times of the Great Depression. On September 18, the federal 7 Repos, are repurchase agreements that allow market participants to obtain collateralized funding by selling securities with the agreement to repurchase them when the loan matures. 40 funds rate was reduced to 4.75 percent and the discount rate set on 5.25 percent. Meanwhile, the ECB chose not to change its rates in light of the high inflation forecasts showing strong commitment to its price stability mandate, but government interventions in Britain and Germany were required to save respectively Northern Rock and IKB from closing down. While downgrading of conduits continued, banks succeeded in cleaning their books through writedowns of mortgage-related securities. The relief was only temporary; in November 2007 it became clear that the total estimated loss in the mortgage sector of $200 billion was too low, forcing additional larger write-downs on banks’ balance sheets. Interest rate spreads peaked again in December (see Figure 12). The Fed responded with a further cut in the funds rate of 0.25 percentage points but it was clear lower rates alone were not effective in helping banks out of the liquidity crunch. The Term Auction Facility (TAF) was announced, through which commercial banks could bid anonymously for loans against a broad range of collateral, including some MBSs (Brunnermeier, 2008, p. 14). Although the lending effect was basically the same as the use of the discount window, the ‘anonymous’ aspect of the TAF made it more successful in reanimating the interbank lending. In summary, uncertainty about the subprime collateral triggered runs on the SIVs, seriously affecting the liquidity and solvability of banks through the use of credit lines. The first writing-downs of 2007 further decreased asset prices and liquidity problems spilled over to other financial companies like insurers, pension funds and hedge funds. Financial institutions stopped trusting each other, leading to a halt in the functioning of the money markets and worldwide crashes on the stock exchange. Central banks addressed it like a liquidity problem but matters would worsen even beyond the completely stop of the credit markets’ functionality and the thousands of people that lost their homes and their jobs. In 2008 an even more dangerous systemic collapse forced central banks to rapidly reinvent themselves as ‘market-maker of last resort’, providing help to banks in the form of the new liquidity that is used in modern financial markets, the collateral based assets. 3.5.2 Financial Panic of 2008 ‘The Perfect Storm’ House prices continued declining, defaults continued rising and banks were deleveraging and dumping their assets to meet capital requirements. Given the inability to get funding from the distressed money markets, central banks tried to help but they did not accept all collateral and could attach conditions. Also uncertainty about the exact valuation of derivatives remained as there was no history available about declining house prices; the existing accounting models were not accurate anymore. In this environment the ‘subprime panic’ contaminated other products, markets and countries. 41 Table 8: The Perfect Storm of 2008 January Fed 'Emergency Cut' March Run on Bear Stearns September Conservatorship Fannie and Freddie Bank of America takes over Merrill Lynch Lehman Brothers files for bankruptcy AIG receives financial support October 700 billion rescue package U.S. (Troubled Asset Relief Program TARP) ECB starts cutting interest rates Commercial Paper Funding Facility (CPFF) Europe increases deposit guarantees and capital injections Obama wins Presidential Elections G-20 December Federal Funds Rate at 0,25 percent Early 2008 the worries of investors shifted to the insurance sector, after the rating agency Fitch downgraded one of the ‘monoline insures’. Monoline insures were specified in insuring one product against default, mostly municipal bonds, in order to guarantee AAA-ratings. In the past years they also extended guarantees to MBSs and other structured products. Fitch, Moody’s and Standards Poor put monoline insurers on downgrade reviews when the losses in the mortgage sector increased, implying the loss of AAA-rating for a wide range of bonds (including low risk municipal and corporate bonds). Besides the obvious negative effects for the bondholders, these funds promise to maintain the value of every dollar invested (or never to ‘break the buck’), and so they could ask underwriters of assets to buy back the assets if needed. An important condition for this is the AAA-rating of these assets. Intuitively, the downgrade would have triggered an enormous asset sell-off by money market funds (Brunnermeier, 2008, p. 18). This danger induced the Fed to an ‘emergency cut’ of 0.75 percentage point in its funds rate on January 22. Due to the persistent drops in equity markets around the world, the funds rate was again reduced during the regular FOMC on January 30, to 3 percent. Early March the investment bank Bear Stearns was hit by a run and being considered too interconnected to fail, everything was done by the Fed to minimize counterparty risk. In the end, JPMorgan Chase acquired the bank paying $10 for shares that just a year before were worth about $150, and agreed to assume the first $1 billion of losses. Equity holders of Bear Stearns lost almost everything, but the debt-holders were saved from losses. 42 Mortgage delinquencies continued rising in the subsequent months causing even problems for the government-sponsored, publicly traded enterprises. Fannie Mae and Freddie Mac, who were institutions that securitized a large fraction of U.S. mortgages, saw their stock prices fall until they had to be put in federal conservatorship on September 7. Given the $1.5 trillion in bonds outstanding this government intervention also resulted in a ‘credit event’, for a large number of people that had bought CDSs now were receiving the payments (Brunnermeier, 2008, p. 16). This liquidity increase not only was not able to prevent the panic that would follow in the fall of 2008, it probably even intensified it, because in the meantime the unsustainability of the financial situation was not yet acknowledged and the risky business continued. At some point, the government and the Fed could not bail-out or help troubled institutions anymore. Even if they wanted to, it required exaggerated amounts of money and the range of institutions that fell under the scope of systemic risk reached far beyond the mere commercial bank sector. If the Fed still wanted to be a credible guardian of price stability, a halt was necessary. When Lehman Brothers filed for bankruptcy on September 15, after the failed tentative of rescue, it triggered a ‘perfect storm’ that materialized the true risk of a global financial collapse like was not seen since the Great Depression years. Lehman had narrowly survived the trouble in March that was fatal for Bear Stearns, but did not succeed in strengthening its balance sheet enough in the meantime to face future critical moments. When Lehman’s share price plunged, no other bank was willing to take it over without a form of government guarantee. The government decided not to offer a guarantee because Lehman and its relations, clients and counterparties, had had enough time to protect themselves from liquidity problems. This loaded decision probably was driven by future moral hazard and market discipline problems, but it generated panic on the global financial markets and a run on repos. Meanwhile, Merrill Lynch had sold itself to Bank of America in anticipation of problems of the Lehman sort, and AIG revealed having serious liquidity shortage problems. Being a large internationally operating insurance company highly active in the credit derivatives, the Federal Reserve organized a bailout of $85 billion that would be extended further in October and November with $37 billion and $40 billion respectively. In exchange the Fed’s would retain 80 percent of the AIG shares. According to Brunnermeier (2008, p. 19) the effects of Lehman’s demise worldwide were first, large losses at money market funds; second, a surge in prices of CDSs as banks tried to protect themselves against counterparty risk; third, a sharp fall in financial non asset-backed commercial paper. To this the Fed responded with the introduction of the Commercial Paper Funding Facility, while the U.S. Treasury set aside $ 80 billion to guarantee brokers’ money market funds. 43 On September 19, 2008, a $700 billion financial industry bail-out plan was proposed by the U.S. Treasury. Among other things it purchased mortgage assets, helped foreclosing homeowners and coordinated recapitalization of banks. In Europe similar government guarantees on interbank lending were introduced, additional government capital injections for troubled financial institutions were given and deposit guarantee schemes were raised to prevent people from withdrawing their savings from banks. Also the ECB gradually cut its interest rates. If the Fed’s funds rate now ranges between 0 and 0.5 percent, also the ECB reached its historically lowest level of 1 percent. Nevertheless, credit markets continued to deteriorate in the following weeks and panic on the stock markets persisted, pulling the world in a recession. Although the traditional banking crises now were not the element bringing systemic risk, the systemic risk was on the interbank lending through the run on SIVS and later on the repo markets. In order to avoid the last similarity with the financial crises that preceded the Great Depression, policymakers are focussing on preventing debt deflation. 3.6 Recovery Table 9 gives a simplified chronology of the past year. Starting from January 2009 the world was officially in a recession as the negative effects of the crisis affected the real sector through several channels. For example through the credit channel, as the process of deleveraging of banks restricts credit conditions to households and firms; through welfare effects, due to stock related losses and decreasing asset prices (especially house values); and the expectations channel as over optimism turned into over pessimism. These were some of the reasons for monetary authorities and governments to quickly pass laws aimed at stabilizing the economy as much as possible despite potential dangerous consequences for the future. Table 9: The Path to Recovery 2009 January World in recession May ECB rate at 1 percent June ECB lends 442 billion euro to banks Obama announces financial reforms, more power to the Fed November Basel announces stricter rules for 2012 December House approves Reform Bill 44 In response to the crisis also central banks have not handled conventionally by applying both credit and quantitative easing. With credit easing the central bank starts to buy long term government bonds to push up the prices and influence long term yields. For example the Fed is buying commercial paper for his purpose. The downward pressure on the interest rate is intended as an incentive to economic growth and credit issuing, but these actions may turn into losses for the central bank that in the end will come to the taxpayer. The semi-fiscal central bank actions furthermore, endanger its independent position and its credibility in fostering price stability on the long run. With quantitative easing, central banks simply provide more liquidity to oil markets and help banks in giving more credit to private agents. To conclude, both expansionary fiscal and monetary policies helped preventing deflation and the total collapse of the financial system. In this, policymakers were helped by more advanced macroeconomic models and tools that estimated the impact of the credit crunch in order to understand what funds were needed to restore the economy to its full potential level. A central issue however remains the exit strategy and prevention of a future crisis. Once the markets are stable again, the expansionary policy needs to be pulled back or else we will again incur the danger of new bubbles arising from excess liquidity. Despite the critics and the room for improvements, like the liquidity risk and counterparty risk assessments that were embarrassingly inadequate in the ‘perfect storm’ of 2008, the regulatory framework remains an important and necessary element for international coordination on the global financial markets. The Basel Committee is already working on more adequate rules to deal with the changed financial world. The other form of prevention could come from macroeconomic perspective. As we have witnessed counter-cyclical policy alone may not be a sufficiently strong tool to mitigate irrational price increases. In their book Animal Spirits, Akerlof and Shiller describe how the current and past crises were the result of psychological and social factors rather than rational behaviour. According to them, a positive economic boom may transform itself in a speculative bubble because of several feedback mechanisms, more or less driven by animal spirits. For example the price-to-price feedback, which is the movement of price in the same direction due to future price expectations creating a vicious cycle, and the feedback between the asset prices in the bubble and the real economy (2009, pp. 134-135). The new frontiers of macro prudential regulation are on studying and controlling both positive and negative feedbacks. A greater role for psychology and behavioural economics at this point can no longer be postponed. 45 4. Conclusion All financial crises follow a similar path in which different stages can be distinguished. They usually start with a mismanaged innovation and credit boom that turns into a speculative bubble which eventually will explode when a negative shock hits the real economy, for example the end of a business cycle. In an environment of over optimism and overvalued assets, people tend to forget past bubbles and do not rationally weigh the true risk attached to their investment decisions. When uncertainty arises and the true risk is acknowledged, over optimism suddenly turns into over pessimism and panic reactions. Asset prices decline and bank’s balance sheets worsen, possibly triggering bank runs and further fire sales in order to solve liquidity and solvability issues. The deleveraging financial system and the increasing interest rates then reverse the credit boom into a credit crunch, further aggravating the problems in the real economy. Both positive and negative feedback mechanism move the stock and financial markets, rather than rational behavior. If authorities do not intervene to solve these market failures, deflationary pressures (or declining prices) turn into a recession (declining output) and in the worst case a depression, like happened in the 1930s. The Great Depression laid the foundations for macroeconomic theory and the regulatory framework for the financial sector. Their continued development through the years improved monetary and fiscal policy to such an extent that it became possible to effectively safeguard economic equilibrium and financial stability, peaking in the Great Moderation. The present credit crunch has been for many an unexpected awaking from a nice dream, namely the belief the key to stable growth was found forever just by letting markets work freely. The truth is, these theories are based on rational behavior of economic agents and do not take into account the fact that market imperfections are always behind the corner. In this case, the financial innovations led to shadow banking which largely exposed the financial sector to excessive risk taking and asymmetric information problems. By finding loopholes in the regulation, banks were able to bypass the supervisor’s credit requirements and provide supply for the growing, irrational demand for collateralized debt products. The historical, institutional and macroeconomic backgrounds of the 1930s and the recent years are very different from each other and for some aspects even the opposite. Interestingly, the fear for hyperinflation of the 1920 versus the fear for deflation around the new millennium shaped an environment of respectively hidden structural deflation and structural inflation which policymakers did not counteract sufficiently. Another difference is the turbulent political and economic environment of the 1920s in comparison to the political stability and the Great Moderation of the recent years. Last but not least, the banking system has changed a lot from the traditional originate-to-hold model into 46 the more modern originate-to-distribute model. The screen and monitor incentives are very different, nevertheless, in both periods the world experienced a substantial credit boom that turned into a financial panic with systemic risk, and in the case of the Great Depression due to inadequate intervention, the financial system was allowed to collapse. Although counter-cyclical policies now still form the base of the most prominent responses to the recession, the Keynesian framework is confronted with big flaws; the absence of the consequences of dysfunctional financial markets for the general equilibrium and the understanding of business cycle movements. We must bear in mind that bubbles in the future cannot be completely prevented because they are intrinsic to the irrational human behavior that drives markets. Another fundamental problem is that regulation lags behind. More knowledge about how financial markets move could be found by studying the psychological and social reasons behind investment decisions. Especially now securitization made funding liquidity more and more based on collateral, understanding further the price movements of these underlying assets has become essential to safeguard future financial stability. It is too early to fully understand all the effects of the 2007-2008 financial panics and to evaluate the related policy decisions. The financial sector and the real economy are still far away from the stable equilibrium and we are not out of the danger zone yet. For now however, it is possible to draw a few lessons. First, the focus should not be on eliminating the financial innovations, which furthermore have the beneficial side of increasing efficiency on the capital markets, but enriching our science about asset price movements and adjusting the regulatory framework to the vast, modern financial markets. Like happened in the 1920s, we are facing again important structural changes albeit in the financial sector this time. If before the Great Depression the boom was fed by mass consumption of durables, now the boom was fed by mass consumption of debt products. Like then, the solution is not the elimination of the innovations that led to economic boom, but to revise and update theories and regulations to safeguard the financial system and to foster future stability. Secondly, regulation and supervision must be extended in order to comprise all aspects of financial markets, not merely traditional banks and deposits, which now are only a minimal part of the financial business. Securitization gave rise to a new form of liquidity, collateralized debt products, of which the shortage could not be solved by central banks with existing instruments. Also, different (non-bank) financial institutions operate without having to meet credit requirements, while they seriously may destabilize the system due to their interconnections. Working in this direction, central banks updated their ‘lender of last resort’ role during becoming also ‘market makers of last resort’, while the Basel Committee is already working on higher capital requirements for the future and probably other changes as well. For example, SIVs should also meet capital requirements and incentives to screen and monitor must be restored. The role of rating agencies must also be reconsidered given their 47 responsibility in this crisis; models that calculate risk must again include the systemic event, and risk management of banks cannot be outsourced to external firms. A third lesson is to apply the exit strategy on time. This is a delicate step however because of the negative effects a premature stop of economic recovery may have, before the stabilization phase is complete. On the other hand, the exit strategy is also crucial to minimize future moral hazard problems in the financial sector. A final lesson from the Great Depression, is when the United States had sufficient gold reserves to implement the expansionary policy needed to get out of the depression and drag along the rest of the world, but instead waited too long for Britain to act as financial stabilizator. Now, the ‘surplus’ countries have the sufficient reserves but continue to play a minor role on the international decision making process. The United States are expected to solve the global recession, but the country already is indebted and may not be able to supply the funds needed. To safeguard macroeconomic stability we should recognize in time, the shifting global economic and political powers. In summary, the Great Depression provided useful lessons because it permitted to avoid a collapse and will hopefully prevent a depression. The actual crisis could not have been prevented exclusively on the basis of what we learned from the 1930s because of the underlying features of speculative bubbles, namely the irrational investment decisions and the lagging behind of even the most sophisticated regulations. The positive results of the institutional improvements of 1933 and 1934 for the banking stability however, give hope for the future stability which actual regulations for a broader range of financial institutions may have. 48 5. References Akerlof, G.A. and R.J. Shiller (2009). Animal Spirits. How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism. Princeton: Princeton University Press. Bean, C. (2009). 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