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In Search of Stability:
The Economics and Politics of the Global Financial Crisis
Mark Copelovitch
Assistant Professor of Political Science & Public Affairs
University of Wisconsin – Madison
March 16, 2009
Overview
The economics of the crisis
• Causes
• Timeline
• Effects
The politics of financial stability
• Policy responses
• Difficult tradeoffs
• The road ahead
What Went Wrong?
Three Faulty Assumptions About 21st Century Finance
Securitization
• Capital markets are so advanced that banks can lend more
aggressively while off-loading risk through debt securities
Credit agencies
• Credit ratings agencies offer an easy and cheap “compass” for
investors to assess the risk of these complex securities
Risk and financial stability
• The “slicing and dicing” of risk has made the financial system more
stable and less crisis-prone
The Initial Problem: Subprime Mortgage Lending
SOURCE: BBC
Subprime Borrowers
“Subprime” borrowers
• Borrowers with “bad” credit (<620 on 300-850 scale)
• NINJAs (~20% of borrowers)
What kind of loans do subprime borrowers get?
• ARMs: Adjustable Rate Mortgages
• “Teaser” rates to start…higher rates later on
Mortgage-Backed Securities (CDOs)
Ratings agencies play a key role
SOURCE: NERA
Subprime Mortgage Lending: Boom and Bust
SOURCE: IMF, BBC
From Housing Crisis to Financial Crisis
Problems of uncertainty
• No one knows how many “bad” mortgages are in the CDOs
• No one wants to lend to banks and other institutions with
heavy exposure to these securities
Results
• “Flight to quality” (US Treasuries)
• Spikes in market lending rates
• Stock market crash
• Frozen credit markets
The Big Freeze
SOURCE: Bloomberg
The Big Freeze
Case Study: Northern Rock (UK)
UK’s 8th largest bank in 2007 (£113 billion in assets)
Northern Rock’s Collapse
Bank of England - steps in to bail out (£55 billion in loans/guarantees)
and ultimately nationalize NR (2/22/08) once the “run” starts
After Northern Rock, 2008-2009
SOURCE: BBC
…the Financial Losses Mount…
March 2009: $5.1 trillion in family net worth losses (9%) in Q4 2008
…and the Real Economic Impact is Severe
GDP growth rates (%), 2008-2009
SOURCE: BBC/IMF
Policy Responses to Financial Crises: Two Phases
Short-term (management/resolution)
• Crisis lending, rate cuts, etc.
• Preventing bank runs/collapses (“bailouts”)
• Unfreezing credit markets (“toxic debt”)
Long-term (prevention)
• New regulation
• New institutions
• Domestic and international
Short-Term Policy Responses: Crisis Management
Liquidity (bailouts)
• To money markets & directly to troubled banks (TARP)
Bank deposit guarantees
• Extension of safety net to prevent bank runs
Dealing with toxic debt
• A government-sponsored “bad bank”
• Partial nationalization of banks
• The “insurance” model (UK, January 2009)
Short-Term Policies: Key Questions
• Why not let troubled financial institutions fail?
• Why not bail out all firms? Who should be saved?
• What should the government get in return?
• Should non-financial firms get bailouts, too?
How to Choose Policies? Difficult Tradeoffs
• Liquidity vs. moral hazard
• Financial crisis vs. other goals
• Aggregate welfare (“taxpayers”) vs. special interests
• National policies vs. international cooperation
“Bailouts” – Liquidity vs. Moral Hazard
• Government/central bank credit (liquidity) helps banks pay their
debts and may “unfreeze” credit markets
• But, bailouts create moral hazard for borrowers and creditors
Greater moral hazard costs
More money,
fewer “strings”
Less money,
more “strings”
How to choose?
• A liquidity or solvency problem?
• No clear economic answer  ultimately, a political question
Financial Stability & Stimulus vs. Other Goals
• Economic stimulus package estimated to cost ~$800 billion
• Full scale of toxic assets may be $3-4 billion
SOURCE: New York Times
Thus Far: Global Crisis, National Responses
• Unilateral efforts unlikely to be successful
• Threat of “beggar thy neighbor” policies
SOURCE: BBC
The Global Reform Agenda: Consensus on Broad Goals…
Strengthen international supervision and regulation
• Bridge the gap between global markets and national regulation
Reform existing institutions
• International Monetary Fund (IMF)
• G-7 / G-20
International policy coordination
• Macroeconomic stimulus
• Exchange rates / global imbalances
• Trade policy
…But Not on Specific Policies & Institutions
Strengthen international supervision and regulation
• Which financial institutions and regulations?
• What institutional form?
Reform existing global institutions
• The IMF debate: resources, conditionality, votes
• New “G” groups: who should be in/out?
International policy coordination
• How much? For how long?
• Sharp disagreements on trade and exchange rates
Why No Agreement? Difficult Tradeoffs
IMF lending
• Liquidity vs. moral hazard
Regulation/supervision
• Confidence vs. competitiveness
Institutional reform
• Accountability/legitimacy vs. effectiveness
Policy coordination
• Domestic politics vs. international commitments
Tradeoffs: The Primacy of Politics
No optimal economic solutions
• Many possible policies, institutions, and regulations
• Conflicts between “good economics” and “good politics”
Key political factors
• Domestic politics (interests, institutions)
• Power and geopolitics
• Collective action and bargaining problems
• Ideology
Example: Reforming the IMF
•
IMF needs ~ $750 billion - $1.75 trillion to be effective
•
Will new resources lead to governance reform?
SOURCE: Financial Times
The Next Stage: Are the Bailouts Working?
TED Spread, March 2009
The Next Stage: Crises in Emerging Markets
9/-08 – 3/09:
~$50 billion in new
IMF loans to Iceland,
Pakistan, Ukraine,
Belarus, Georgia,
Serbia, Latvia, and
Hungary
SOURCE: Financial Times, IMF World Economic Outlook
The Next Stage: World Trade Collapsing?
Some Perspective: We’ve Been Here Before
SOURCE: IMF, World Bank
Some Perspective: The Great Depression, 1929-1933
The Depression’s Effect on the US Economy
SOURCE: Historical Statistics of the United States, pp. 235, 263, 1001, and 1007
Some Perspective: Markets
Some Perspective: Recession vs. Depression