Download Origins and Initial Years of The Global Economic Crisis

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Fall Term 2016
Origins of The
Global Economic Crisis
Overview
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Economic Crisis and Security Threats
“The global recession is America’s primary near-term security
concern.”
Admiral Blair – Director of National Intelligence
(February 2009)
“The single biggest threat to national security is the national
debt.”
Admiral Mullen, Chairman of the Joint Chiefs of Staff
(August 2010)
“I have to confess, I paid no attention to this (economics) as a
cadet and have done nothing to increase my awareness of
economics issues between age 22 and 59. I should have
paid attention.”
General Dempsey, Chairman of the Joint Chiefs of Staff
(October 2011)
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The World Economic Crisis
• The current crisis while severe, shares many
characteristics and patterns associated with past crisis
• Its origins and underlying causes follow a familiar pattern
--- with several unique twists
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Characteristics of Financial Crisis
• All financial crisis share the same core elements:
• Some type of shock
• Its propagation (how it spreads – contagion)
• The broader impact
• The Underlying Causes
• Primarily microeconomic (e.g. bad banking)
• Primarily macroeconomic (e.g. recession)
• Primarily institutional (e,g. poor infrastructure or inadequate
supervision)
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Crisis Overview: Vulnerabilities and Triggers
• U.S. Vulnerabilities
• Monetary and fiscal policies too loose to long
• Innovation and regulatory failure
• Excessive household debt and bank leverage
• Global Vulnerabilities
• Demand boom and inflationary pressures
• Housing and asset price boom
• Large and widening imbalances
• Triggers
• Subprime securities collapse
• Lehman failure
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Causes of the Current Crisis I
Over the years the stage being set for the current crisis. Four initial
conditions critical.
• 1. Assets were created, bought and sold that appeared much less
risky than they truly were.
• Early 2000s environment stable in most of world with sustained growth
and low interest rates.
• Investors expected housing prices to continue their rapid increase.
•
2. Development of securitization led to complex assets on the
balance sheets of financial institutions
• Major improvements in risk allocation,
• But harder to assess values than the case of simple mortgages
• Worries about the original mortgages translated into a large degree of
uncertainty about the value of derived securities
• The fact that the securities were held by a large set of financial
institutions implied that this considerable uncertainty affected a large
number of balance sheets in the economy.
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Causes of the Current Crisis II
Initial conditions contd.
• 3. Securitization and globalization led to increasing
interconnection of financial institutions, both within and across
countries.
• Foreign claims by banks from the five major advanced economies
increased from $6.3 trillion in 2000 to $22 trillion by June 2008
•
• Claims by these banks on emerging market countries alone exceeded
$4 trillion.
4. Leverage increased within the financial system
• Financial institutions increased their portfolios with less and less capital
thus increasing the rate of return on that capital.
• Optimism and the underestimation of risk key factors.
•
• Numerous regulatory holes
Implications: if for any reason the value of the assets became
lower and more uncertain, then the higher the leverage the higher
the probability capital would be wiped out and the institutions
would become insolvent – exactly what happened.
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Crisis Timetable
The economic crisis has evolved through several stages:
• Summer 2007 – initial phase
•
•
Subprime mortgage crisis,
Beginning of collapse of stock exchange
• Early 2008 – growing stress in advanced countries
•
•
•
Systemic crisis of financial intuitions in US
Economic slowing down in U.S. EU and Japan, but
Overheating inmost emerging markets (high commodity prices,
weak US dollar accelerating inflation
• Summer 2008 – breaking point
•
•
•
Bursting commodity and other bubbles
Global crisis of financial institutions (bankruptcy of Lehman)
Recession in developed countries
• Fall 2008 – crisis hits emerging market economies.
•
Effects of the crisis world-wide and more severe than in past
modern recessions – severe because of wide-spread financial
institution’s holding of bad paper.
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Economic Growth Rates
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Global Financial Crisis: Potential Security Threats
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Four Early Economic/Security Scenarios
In late 2008, early 2009 four economic crisis/security
scenarios were getting considerable attention –
• The Vulnerability Effect – terrorists seeing the U.S. economy
melting down calculate that a strike could have a force
multiplier because of the already skittish stock market.
• The China Syndrome – Chinese own more than $500 billion
in US. Treasury bonds, and billions more in other U.S. debt.
While they would not dump them on the market to disrupt
the U.S. economy, they have leverage over U.S. decisions on
interest rates, exchange rate decisions.
• A Japanese “Lost Decade” – U.S. economy flat in the water
for a decade or so – government runs up debt with no
stimulating effect on the economy
• The Alternative-Dollar Nightmare – countries refuse to hold
dollar reserves. Dollar crashes and U.S economy along with
it.
• None happened – Lesson – Much More Stability in Global
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System than Commonly Believed
Factors Contributing to Stability
Why didn’t the global system collapse when many in late 2008 were
predicting its immediate demise?
• Revival did not happen because markets managed to stabilize
themselves on their own
• Governments learning from the great depression responded quickly
through central banks and treasuries
•
• The extensive social safety nets across the industrialized world
cushioned the pain
Global system is simply more resilient than we imagined – three
major reinforcing elements producing stability
• Spread of great power peace – relatively little friction between major
nations – rare in history – true global economy
• Relatively low rates of inflation – can plan for the future
• Technological connectivity – information revolution crated a deeply
connected global system – most nations have benefitted greatly from
the system – cautious about appeals to nationalism or acts that would
jeopardize the current system.
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Crisis: Potential U.S. Growth
The crisis will have a marked impact on U.S. potential
growth:
• The recession, the rising U.S. debt levels and tighter
financial conditions will hurt investment, keeping
capital formation well below rates in pre-crisis years
• Resulting high and more-persistent-than-usual unemployment
will lower potential growth
• IMF estimates that U..S. potential output will average about
1.5% over the next five years.
• This compares with an estimated 2.0 percent anticipated
average in the absence of the crisis
• By 2014 the potential output expected to be abut 6 percent
below what it would have been in the absence of a crisis
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Crisis Transmission and Responses
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Crisis Response
• Not much coordinated activity in responding to crisis,
because of incompatible conceptual frameworks for
understanding its root causes
• U.S. policy makers believe that trade surplus countries pursued
policies that created global imbalances – excess savings in
China – fixed exchange rate
• Europeans believed that the root cause of the crisis was
excessively deregulated financial systems
• China feels reserve status of dollar created the imbalances to
develop to unsustainable levels
• Therefore responses not coordinated
• Fiscal stimulus in some countries
• Expansive monetary policy, central bank asset purchases
• Support (IMF) to vulnerable countries
• Attempts through WTO at preempting protectionism
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Overview: Divergent Growth Recovery
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Crisis Recovery: Type I Countries
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Crisis Recovery: Type II Countries
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Crisis Recovery: Type III Countries
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Crisis Assessment October 2010
• Despite encouraging signs, still much uncertainty in the
world economy
• Currently, the global recovery is looking like a U – but that could
change quickly – several distinctive recovery patterns
• Economic repair is still incomplete and fragilities remain.
• Will private sector demand be strong when stimulus over?
• Will exit from stimulus policies be well timed and orderly?
• Premature retreat can kill the recovery; delayed retreat can raise
inflationary likelihood
• Medium term growth for the world might be subdued
• Fiscal viability of the rich economies in in question
• Financial systems in rich countries are still impaired
• A slow expansion of world trade is likely in the context of
rebalancing
• Possible adverse impact on developed country investment due to
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regulatory uncertainty.
• Martin Wolf Assessment
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Crisis Impacts I
International Relations:
• Potential effects on the U.S. leadership position in the
world
• Enhanced role for the International Monetary Fund,
and Multilateral Development Banks – decline in U.S.
influence in IMF policy.
• The rise of China as a player in international financial
issues and the co-mingling of U.S. and Chinese
financial interests
• Additional pressures on European unity and policy
discord between the United States and
Germany/France.
• Possible economic and political crisis in Eastern
Europe and a tug-of-war for influence there between
Russia and the EU/US.
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Crisis Impacts II
Fundamental Philosophies
• Rise of state capitalism and a questioning of the Western
economic model of deregulated, market-based decisionmaking
• Risk of rising trade protectionism and intensified antiglobalization efforts.
• Potential for more authoritarianism in countries such as
China and Russia and or rise in authoritarian models of
governance in the developing world.
Security
• Rising poverty and potential political instability in
developing countries – fertile ground for recruits for
extremism
• Budgetary pressures in Western nations could constrain
international security and diplomatic efforts.
• More instability in poor countries -- Estimates are that the
risk of conflict goes up 1 percentage point for each percentage26
point decline in economic growth rates.
Crisis Impacts III
Financial and Economic Fallout
• Possible reduced U.S. financial primacy in the world
and importance of dollar as a reserve currency
• Diminished flows of economic assistance, capital and
remittances to developing nations
• For developing nations, declines in export earnings
from low prices for commodities and from shrinking
world trade.
• Increased likelihood of espionage against both private
corporations and U.S. government agencies –
increased employee vulnerability
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Roubini Q3 2010 Assessment
Going into Q3 2010 global recovery remains in grip of
extreme economic uncertainty and unprecedented
financial volatility. Four main scenarios:
• V-Shaped global recovery (4% probability) imbalances
increase as both surplus and deficit G10 and EM
countries get back to business as usual.
• W-Shaped double dip (35%) with collapsing financing of
imbalances precipitating cascading defaults around the
world damaging both creditor and net debtor economies.
• U-Shaped anemic G10 and semi V-shaped EM recovery
(52%) in which protracted balance sheet repair allows for
gradual rebalancing/reduction of global macro
imbalances.
• L-Shaped stagnation (9%) in advanced economies and Ushaped below potential EM growth due to a lack of
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adjustment among both debtor and creditor nations.
IMF Scenarios I
•
Scenario 1: Global Cooperation to Rebalance World Output and
Demand – Not much evidence of this
• Refocus of citizens and governments on sustainable domestic
production and consumption
• Sustainability refers to patterns of work, investment and spending that
do not rely on persistent, large international transfers of economic and
financial resources.
•
• At the international level it means that international trade and financial
balances should not be far from zero in either direction over long
periods of time
Scenario 2: Lack of Coordinated policy Adjustments – Global
Imbalances Return – Seems to be playing out now
• Continuation of export led growth, especially in Asia could frustrate
attempts by US to shift its economy away from excessive consumer and
government borrowing and spending toward business investment and
exports
• If we attempted this sift and the surplus countries continued export-led
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growth – U.S. would have at best a weak recovery
IMF Scenarios II
• Scenario 3: No Policy Adjustments and Premature
Withdrawal of Macroeconomic Support– Global Slump
Returns – not widespread – Eurozone?
• Assumes no progress toward economic restructuring while
policymakers misjudge the strength of economic recovery
• If government policies that have resulted in large budget deficits
and near-zero short-term interest rates – which probably kept the
global economy out of a depression are reversed – and if private
sector spending slows unexpectedly, economies could fall back
into a slump as bad as 2008-09
• Result in a double-dip global recession with policy responses
even more drastic than the first downturn.
• Further long-lasting economic damage in form of long term
unemployment and financial defaults would occur.
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Global Recovery Consensus
Despite diverging interpretations over the pattern of
recovery, most analysts agree that:
• The global economy has been significantly affected by
the financial crisis
• Emerging economies will outpace growth of the
advanced economies. This disparity in growth has only
been exacerbated by the financial crisis.
• Commodity prices are also set to rise, which could
further frustrate gains in GDP as well as affect security.
• Debt will rise and revenues will fall for the governments
of the advanced economies, while emerging economies
will be more financially sound.
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Crisis Impact on Defense Spending
Global financial crisis and the subsequent recession in most
European countries has created a new dynamic for defense
spending
• Even before the crisis punishing demands of operations on
armed forces revealed shortfalls in capabilities
• In addition the cost of new equipment was rising at a rate of 510% per year.
• As both trends continue, European governments now
struggling to control public deficits have launched a series of
austerity measures across the board.
• In the overall scheme of government priorities, defense
spending has become discretionary and many defense
ministers have already been asked to make do with less money
• Two basic options in light of these developments
• Accept that reduced financial resources will lead to reduced capabilities
• Use the budget crunch as an opportunity to do things differently
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Defense and Austerity
• Most elements of defense policy are likely to experience major
changes.
• UK government has suggested defense expenditures might be
cut between 10% and 25% over the next few years
• France is considering cuts of $2.6-$6.6 billion over the next three
years.
• Germany – Finance Ministry has demanded reductions totaling
4.3 billion Euros for the period 2011-14.
• Italy and Span have slashed budgets as have a range of smaller
EU member states.
• So far these cuts have not been coordinated on the European
level which increases the likelihood that an overall reduction of
European capability will be the result
• In late July 2010 France and Germany were first countries to
announce coordinated discussions about cuts.
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Patterns of Military Expenditures
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Projected Changes in Defense Budgets: 2010-2015
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Spending Cuts Hit Foreign Aid
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CBO Defense Budget Estimates
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Is Health Care the Worst Threat to U.S. National Security?
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Implications for U.S. Security
One key outcome of the Crisis – Lower Growth and Higher debt –
Greater Threat to Security than Concerns at Start of Crisis
• Financial constraints will play a considerable role in structuring
U.S. policy in the foreseeable future
• When debt levels reach 90% or more of GDP, the U.S. may find
that its rate of growth slows by 1% per year (ring of fire
diagram)
• The fiscal squeeze that the U.S. and other advanced economies
may experience can have the ability to crowd out discretionary
spending – defense budgets under considerable stress.
• As a result the ability for advanced countries such as the U.S.
to spend increasing shares of GDP on defense and security
may ---- even to respond to threats may be extremely limited.
• In the longer term the U.S. is likely to find that its traditional
allies are declining in relative economic and military strength.
• Similarly, the U.S. will find it has to deal more and more with
countries that it traditionally has not had shared common
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interests
Summing Up
Key Points
• The global economy has been significantly affected by the
financial crisis
• Emerging economies will outpace the growth of the
advanced economies. This disparity in growth has only been
exacerbated by the financial crisis
• If commodity prices increase over the next several years it
would further reduce slow DMs and perhaps some EMs
• Debt will rise and revenues will fall for the governments of
advanced economies while emerging economies will be
more fiscally sound
• U.S. and other DM countries will most likely experience a
lower rate economic growth than it has in the past creating
greater fiscal stresses
• The fiscal stress in the advanced economies may
significantly reduce defense expenditures and other
discretionary items.
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