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Causes and Consequences of the 2008 Crisis Andrew K. Rose April 24, 2010 Leading Through Innovation The “Great Recession” Crisis of 2008: the Defining Event of the Decade ● Downturn unusual in Many Respects Affected Most Countries Essentially Simultaneous Unusually Deep Recession Unusually Long Recession Financial Crisis has lead to Policy Challenges ● Most Dramatic: Policy Reform, including: New Capital Requirements (“macro-prudential”) Dissolution of Institutions “too big to fail” New Regulatory Reforms Organization of Derivatives Limits on Executive Compensation/Bonuses Development of Early Warning Systems But What do We Know about Actual Causes of the Crisis? ● The Crisis hit all rich countries, many developing But not all countries affected equally East Asia and (especially) Central Europe affected particularly severely ● Can we learn about causes of crisis from varying intensity across countries? ● Relevant because policy prescriptions depend on crisis diagnosis Can Investigate by Economic Modeling ● Many manifestations of crisis are easily measurable across countries and time ● Similarly, many potential causes of the crisis can be quantified ● Can compare cross-country incidence of crisis to its cross-country manifestations Interpreting this International “Cross-Section” For 2008 crisis we know lots of information inadmissible to actual policy makers: 1. 2. 3. 4. There was a crisis (many false signals in reality) The timing of the crisis (ditto) The countries involved Crisis involved banks, security markets, (at least some) housing markets, and (at least some) exchange rates IMF: each of these is different • Mix probably not comparable/predictable from history! Use Data for a Large Number of Countries ● Sample is cross-section of 107 countries All countries >$10,000 per capita GDP All countries >$4,000 per capita GDP, plus population > 1 million ● Separate dates Data on Crisis Manifestations from 2008 Data on Crisis Causes from 2006 or earlier Critical Crisis Manifestations: Straightforward ● Numerous Indicators of 2008 Crisis ● Real: Economic Growth (2008 GDP growth) ● Financial Markets: Stocks: use 2008 equity market collapse FX: use 2008 exchange rate devaluation Bonds: use 2008 change in Institutional Investor creditworthiness • Also use Euromoney as robustness check Crisis Manifestations Bottom quartile Upper quartile % Changes, 2008: Iceland Ukraine Estonia Argentina Latvia Ireland Korea New Zealand UK Hungary Luxembourg Denmark Singapore Swaziland Finland Japan France Netherlands Thailand Poland Real GDP II Rating -4.7 2.1 -2.8 6 -4.6 -2.8 2.6 -.9 .7 .4 .6 -.9 1.2 2.7 1.4 -.5 .7 2 3 4.8 -32.5 -12.1 -9.4 -13.6 -8.3 -7.8 -7.3 -5.4 -5.5 -7.6 -2.6 -2.6 -3.8 -2.6 -2.6 -5.7 -2.6 -2.5 -3.5 -1.5 Stock Market -90.0 -74.3 -63.0 -49.8 -55.1 -66.1 -40.7 -37.4 -31.5 -53.2 -59.5 -48.6 -48.9 3.9 -53.4 -42.1 -42.7 -52.3 -47.6 -51.1 Price of SDR 90.0 48.6 1.7 6.9 -.3 3.1 30.9 30.4 33.9 6.1 3.1 1.5 -2.7 33.2 3.1 -22.4 3.1 3.1 1.3 18.6 Potential Crisis Causes: Problematic ● Considerable disagreement concerning underlying causes of 2008 Crisis Potential Causes 1: Financial Policies • Crisis widely perceived as demonstrating regulatory flaws, e.g. Bernanke (2009) – Improper incentives within institutions • Basel capital requirements – Contributed to lending pro-cyclicality – Codified role for rating agencies – Encouraged opaqueness through securitization and moving assets off balance sheets Many Measures of Financial Policies • Economic Freedom of the World data base – Private Bank Ownership – Foreign Bank Competition – Interest Rate Controls – Quality of Credit Market Regulation • World Bank Central Bank data set – Overall Capital Stringency – Ability to Take Prompt Corrective Action – Capital Regulatory Index – Official Supervisory Power – Restructuring Power – Power to Declare Insolvency Potential Causes 2: Financial Conditions ● Degree of maturity mismatch, due to short-term debt obligations, e.g. Cecchetti (2008) ● Risky lending practices Feldstein (2009): Appraised value of US mortgage contracts grew from 70-80 % to 90-100 % Community Reinvestment Act encouraged lending to broader set of borrowers ● Exploding leverage of firms and households Measures ● ● ● ● ● ● ● Private Sector Domestic Credit as share of GDP Domestic Bank Credit as share of GDP Share of domestic credit consumed by Private Sector Bank Liquid Reserves as a share of assets Share of Non-Performing Loans Bank Capital as a share of assets Bank Claims as a share of deposits Potential Causes 3: Asset Price Appreciation • Widely cited as a source of fragility, in US and elsewhere, e.g. Feldstein (2009) • Buiter (2009): Investment diverted to real estate from “productive uses” • US mortgage delinquencies highest in areas that experienced highest amount of appreciation • U.S. areas with high latent housing demand had highest decreases in denials – Sub-prime lending fed appreciation • Real estate appreciation mirrored in other financial markets, particularly equity markets Measures ● Real estate Percentage Change in Real Estate Prices • Based on data from the BIS and augmented by an Asia-specific study by Glindro, et al (2008). ● Equity market appreciation Market Capitalization as a share of GDP Value of Stocks Traded relative to GDP Stock Market Growth. Potential Causes 4: International Imbalances • Many countries built up deficit international financial positions over boom • Arguments over source of “global imbalances” – Asian and other country efforts to build up foreign exchange reserves – Lax policies in West? • Countries with high CA deficits had larger exchange rate depreciations – High exposure to U.S. also led to depreciation Measures • Measures of the external balance position – Net External Position as % of GDP – Current Account as % of GDP – External Debt as % of GNI – Gross Financing in Capital Markets as % of GDP – Real Effective Exchange Rate • Measures of adequacy of foreign reserve holdings – Total Reserves as % of external debt – Short-Term Debt as % of Reserves – Total Reserves over value of a Month of Imports – M2 as % of Total Reserves minus Gold – M2 as % of Central Bank Foreign Assets Potential Causes 5: Macroeconomic Policies ● Easy monetary policy Taylor-rule indicated Fed Funds rate below levels consistent with 2% inf. target 2003-2006 “Greenspan put” exacerbated asset appreciation ● Lax fiscal policy Countries pursued unsustainable deficits Poor fiscal positions hindered counter-cyclical policies during crisis Fiscal and Macro Measures • Fiscal policy – Government Budget Surplus/Deficit as % of GDP – Central Government Debt as % of GDP – Total Debt as % of GDP – Debt Service Burden as % of GDP. • Macro conditions – CPI inflation – GDP growth Monetary Measures • Monetary policy – Currency Union dummy – Aggregate GDP of Monetary Zone – EU, but not EMU dummy – Inflation Targeter – M2 as % of GDP – M3 as % of GDP Potential Causes 6: Contagion ● Exposure to “Center” Country (US?) can hurt ● “Trade Channel” Downturn in US hurts foreign exports ● “Financial Channel” Deterioration of US assets (mortgages?) hurts foreigners that hold American assets Measures ● Exports to USA (as proportion of all exports) Also consider other epi-centers Also consider 2-way trade (not just exports) ● Share of US assets (proportion of wealth) Also consider other potential epi-centers Also consider debt, long-term debt Also consider BIS Consolidated banking data Even more (only for American exposure): US TIC assets (as proportion of national GDP) • Also consider American equity/long debt/debt/treasuries/long treasuries Also consider $PPG debt denominated in yen/$ Results ● Strong Result: Richer Countries more dramatically affected by crisis No effect of country size (population) Richer Countries Hit Worse: Combined Crisis Manifestations and real GDP p/c 2 2 Papua Ne Kyrgyz R 0 Qatar Slovakia Peru Barbados Libya El Colombia Salva Oman Panama Trinidad Costa Venezuel Bahamas Morocco Egypt IranRi Lebanon China Tunisia Bahrain Saudi Ar Kuwait Sri Lank Mauritiu Israel Brazil Slovenia Indonesi Macedoni Switzerl Malaysia Cyprus Ecuador Botswana Malta Taiwan Chile Czech Re Jamaica Hong Kon Germany, United A Poland Netherla France Japan Swazilan Finland Singapor Denmark Namibia Thailand CroatiaPortugalSpain Belgium United S Luxembou Mexico Greece Canada Romania Austria Norway Italy Sweden Bulgaria South Turkey AfRussia Australi Lithuani Kazakhst Hungary UK New Zeal Korea Ireland Latvia Argentin Estonia 0 Ukraine -2 -2 -4 Iceland -6 -4 7 9 11 7 Default 9 11 Euromoney, not II 2 0 0 -5 -2 -4 -10 7 9 Drop Exchange Rate 11 7 9 Maximum Likelihood, not PF Factors (y) against log real GDP per capita (x) 11 Unfortunately, no Strong Consistent Crisis Causes • Few potential causes are robustly significant across countries • In particular, real estate appreciation cause insignificant – Widely cited as a principal “cause of crisis” in US • Same is true for almost all other causal variables Absence of Correlations: Robust 2008 Crisis Manifestations against Capital Regulatory Index Depreciation against SDR -50 -100 0 -50 50 0 100 Stock Market Change 2 4 6 8 2 6 8 GDP Growth Rate -5 -30 5 -10 15 10 Country Credit Rating Change 4 2 4 6 8 2 4 6 Barth, Caprio and Levine 2003 Capital Regulatory Index 8 Stock Market Run-up Does Best 2008 Crisis Manifestations against Stock Market Runup Depreciation against SDR -50 -100 0 -50 50 0 100 Stock Market Change 0 200 400 600 0 400 600 GDP Growth Rate -5 -30 5 -10 15 10 Country Credit Rating Change 200 0 200 400 600 0 200 2003-06 Change in Market Capital (%GDP), WDI 400 600 Domestic Credit Growth Insignificant 2008 Crisis Manifestations against Domestic Credit Growth Depreciation against SDR -50 -100 0 -50 50 0 100 Stock Market Change -100 0 100 200 300 -100 100 200 300 GDP Growth Rate -5 -30 5 -10 15 10 Country Credit Rating Change 0 -100 0 100 200 300 -100 0 100 2006 Domestic Bank Credit (%GDP), WDI 200 300 Bank Claim/Deposits 2008 Crisis Manifestations against Bank Claim/Deposit Ratio Depreciation against SDR -50 -100 0 -50 50 0 100 Stock Market Change 0 1 2 3 4 0 2 3 4 GDP Growth Rate -5 -30 5 -10 15 10 Country Credit Rating Change 1 0 1 2 3 4 0 1 2006 Bank Claims (%Deposits), IFS 2 3 4 Real Estate Appreciation Insignificant 2008 Crisis Manifestations against Real Estate Price Runup Depreciation against SDR -50 -100 0 -50 50 0 100 Stock Market Change 0 50 100 150 0 100 150 GDP Growth Rate -5 -30 5 -10 15 10 Country Credit Rating Change 50 0 50 100 150 0 50 2003-06 Change in Real Real Estate Prices 100 150 Bank Leverage Insignificant 2008 Crisis Manifestations against Bank Capital Adequacy Depreciation against SDR -50 -100 0 -50 50 0 100 Stock Market Change 5 10 15 20 25 5 15 20 25 GDP Growth Rate -5 -30 5 -10 15 10 Country Credit Rating Change 10 5 10 15 20 25 5 10 2006 Bank Capital (%Assets), WDI 15 20 25 Current Account 2008 Crisis Manifestations against Current Account Depreciation against SDR -50 -100 0 -50 50 0 100 Stock Market Change -40 -20 0 20 40 60 -40 0 20 40 60 GDP Growth Rate -5 -30 5 -10 15 10 Country Credit Rating Change -20 -40 -20 0 20 40 60 -40 -20 0 2006 Current Account (%GDP), WDI 20 40 60 Budget Deficits 2008 Crisis Manifestations against Government Budget Depreciation against SDR -50 -100 0 -50 50 0 100 Stock Market Change -10 0 10 20 -10 10 20 GDP Growth Rate -5 -30 5 -10 15 10 Country Credit Rating Change 0 -10 0 10 20 -10 0 2006 Budget Surplus/Deficit (%GDP), WDI 10 20 Results suggest that Measurable Pre-existing Conditions had Little Common Impact • Few potential causes have robust effects on crisis intensity • That is, can’t easily align causes and consequences of 2008 crisis across countries Results Disappointing for Policy Reform/Modelers ● Can model incidence of crisis well, but not link it to observable causes ● Not an artifact of econometric methodology Scatter plots yield similar results ● Disappointing, given voluminous analysis of causes of observed crisis ● Ex ante for future crises: much harder! Even then, we’re ignoring the problem of timing Why are Results so Weak? • Data limitations – Will it improve as crisis recedes? • Focus mostly on national characteristics – Inappropriate if crisis international due to contagion or common shock – but few sensible signs of contagion when included (American exposure helps!) – Vulnerability to common shocks typically viewed as dependent on national fundamentals • Causes may differ across countries – Japan: little financial exposure, but trade downturn So Caution is Warranted ● Economists should be Humble ● Difficult to engage in Policy Reform if Crisis Causes are uncertain ● Much motivation for ongoing research