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The Worst Crisis in 75 Years:
Origins, Magnitude and Response
Jeffrey Frankel
Harpel Professor of Capital Formation & Growth
Harvard University
The Boston Security Analysts Society
Thursday, June 25, 2009.
Origins of the crisis

Well before 2007,
there were danger signals in US:
Real interest rates <0 , 2003-04 ;
 Early corporate scandals (Enron 2001…);
 Risk was priced very low,

housing prices very high,
 National Saving very low,
 current account deficit big,
 leverage high,
 mortgages imprudent…

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US real interest rate < 0, 2003-04
Source: Benn Steil, CFR, March 2009
Real interest rates <0
3
In 2003-07, market-perceived
volatility, as measured by
options (VIX), plummeted.
So did spreads on US junk
& emerging market bonds.
In 2008, it all reversed.
Source: “The EMBI in the Global Village,”
Javier Gomez, May 18, 2008
juanpablofernandez.wordpress.com/2008/05/
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Six root causes of financial crisis

1. US corporate governance falls short


E.g., rating agencies;
executive compensation …


options;
golden parachutes…
MSN Money & Forbes
2. US households save too little,
borrow too much.
3. Politicians slant excessively
toward homeownership
 Tax-deductible
mortgage interest, cap.gains;
 FannieMae & Freddie Mac;
 Allowing teasers, NINJA loans, liar loans…
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Six root causes of financial crisis,
cont.


4. Starting 2001, the federal budget
was set on a reckless path,

reminiscent of 1981-1990
5. Monetary policy was too loose during 2004-05,
 accommodating fiscal expansion,
reminiscent of the Vietnam era.
6. Financial market participants during
this period grossly underpriced risk.

Possible risks were:
housing crash,
 $ crash,
 oil prices,
 geopolitics….

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Origins of the financial/economic crises
Monetary
policy easy
2004-05
Stock
market
bubble
Underestimated
risk in
financial mkts
Failures of
corporate
governance
saving too little,
borrowing too
much
Homeownership bias
Excessive leverage in
financial institutions
Predatory
lending
Stock
market
crash
Gulf
instability
MBS
s
CDO
s
Financial
crisis
2007-08
Oil
price
spike
2007-08
Federal
budget
deficits
Low
national
saving
Housin
g
bubble
Excessive
complexity
CDSs
China’s
growth
Households
Recession
2008-09
Foreig
n debt
Housin
g
crash
Lower longterm
econ.growth
Eventual loss
of US hegemony
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Origins of the financial/economic crises
Monetary
policy easy
2004-05
Stock
market
bubble
Underestimated
risk in
financial mkts
Failures of
corporate
governance
saving too little,
borrowing too
much
Homeownership bias
Excessive leverage in
financial institutions
Predatory
lending
Excessive
complexity
MBS
s
CDSs
China’s
growth
Stock
market
crash
Gulf
instability
CDO
s
Financial
crisis
2007-08
Oil
price
spike
2007-08
Households
Recession
2008-09
Federal
budget
deficits
Low
national
saving
Housin
g
bubble
Foreig
n debt
Housin
g
crash
Lower longterm
econ.growth
Eventual loss
of US hegemony
8
Onset of the crisis

Initial reaction to troubles:
Reassurance in mid-2007: “The subprime mortgage crisis
is contained.”
It wasn’t.
 Then, “The crisis is on Wall Street, sparing Main Street.”
It didn’t.
 Then de-coupling :
“The US turmoil will have less effect on the rest
of the world than in the past.”
It hasn’t.


By now it is clear that the crisis is
 the worst in 75 years,
 and is as bad abroad as in the US.
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Bank spreads rose sharply
when sub-prime mortgage crisis hit (Aug. 2007)
and up again when Lehman crisis hit (Sept. 2008).
Source:
OECD Economic Outlook
(Nov. 2008).
10
Corporate spreads
between corporate & government benchmark bonds
zoomed after Sept. 2008
US
€
11
The return of Keynes

Keynesian truths abound today:
 Origins
of the crisis
 The Liquidity Trap
 Fiscal response
 Motivation for macroeconomic intervention:
to save market microeconomics
 International transmission
 Need for coordinated expansion
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
The origin of the crisis was an asset bubble
collapse, loss of confidence, credit crunch….

like Keynes’ animal spirits or beauty contest .






Add in von Hayek’s credit cycle,
Kindleberger ’s “manias & panics”
the “Minsky moment,”
& Fisher’s “debt deflation.”
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The origin this time was not a monetary contraction
in response to inflation as were 1980-82 or 1991.
But, rather, a credit cycle: 2003-04 monetary expansion
showed up only in asset prices.
(Borio of BIS.)
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US Recession

The US recession started in December 2007
according to the NBER Business Cycle Dating
Committee (announcement of Dec. 2008) .

As of May 2009, the recession’s length broke
the postwar records of 1973-75 & 1981-82
= 4 quarters; 16 months
 One has to go back to 1929-33 for a longer downturn.


Probably also as severe as recession of 1982.
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BUSINESS CYCLE REFERENCE DATES
Peak
Trough
Quarterly dates are in parentheses
August 1929 (III)
May 1937 (II)
February 1945 (I)
November 1948 (IV)
July 1953 (II)
August 1957 (III)
April 1960 (II)
December 1969 (IV)
November 1973 (IV)
January 1980 (I)
July 1981 (III)
July 1990 (III)
March 2001 (I)
December 2007 (IV)
Average, all cycles:
1854-2001
March 1933 (I)
June 1938 (II)
October 1945 (IV)
October 1949 (IV)
May 1954 (II)
April 1958 (II)
February 1961 (I)
November 1970 (IV)
March 1975 (I)
July 1980 (III)
November 1982 (IV)
March 1991 (I)
November 2001 (IV)
(32 cycles)
1945-2001 (10 cycles)
Source: NBER
Contraction
Peak to Trough
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13
8
11
10
8
10
11
16
6
16
8
8
17
10
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No, the fact that the recession is of record length
does not in itself imply we are near the end.
kuya
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US employment peaked in Dec. 2007,
which is the most important single reason why
the NBER BCDC dated the peak from that month.
Since then, 6 million jobs have been lost (5/09).
Payroll employment series Source: Bureau of Labor Statistics
17
On June 5, commentators were encouraged
when BLS reported a sharp moderation in
the rate of jobs decline in May.
Payroll employment series Source: Bureau of Labor Statistics
18
My favorite monthly indicator is total
hours worked in the economy
It confirms: US recession turned severe in September;
but hours worked has not yet shown any sign of moderating.
19
The US recession so far is deep,
compared to past and to others’
Source: IMF, WEO, April 2009
20
Job loss now cumulates to the worst since
the 1940s.
Source: BLS, May 8
21
Prime-Age Male Unemployment Rate
again suggests we have hit the record
for post-war recessions.
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Recession was soon transmitted
to rest of world:

Contagion: Falling securities
markets & contracting credit.




Especially in those countries with weak fundamentals:
Iceland, Hungary, Ukraine, Latvia…
Or oil-exporters that relied heavily on high oil prices: Russia…
But even where fundamentals were relatively strong: Korea…
Some others experiencing their own housing crashes:
Ireland, Spain…

Recession in big countries will be transmitted to all
trading partners through loss of exports.
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Source: OECD
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“World Recession”

No generally accepted definition.
A fall in China’s growth from 11% to 6%, should
probably be considered a recession.
 Usually global growth < 2 % is considered a recession.


The World Bank forecasts that
global growth would be negative in 2009,

for the first time since the 1930s.
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How do we know this will
not be another Great Depression?

especially considering that
successive forecasts of the
current episode have been
repeatedly over-optimistic?

The usual answer: we learned
important lessons from the 1930s,
and we won’t repeat the mistakes
we made then.
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One hopes we won’t repeat the 1930s mistakes.

Monetary response: good this time

Financial regulation: we already have bank regulation
to prevent runs.
But it is clearly not enough.

Fiscal response: OK, but : constrained
by inherited debt. Also Europe was
unwilling to match our fiscal stimulus at G-20 summit.

Trade policy: Let’s not repeat Smoot-Hawley !


E.g., the Buy America provision. China emulating.
Mexican trucks
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U.S. Policy Responses

Monetary easing is unprecedented,
appropriately avoiding the mistake of 1930s.
But it has largely run its course:
 Policy



interest rates ≈ 0.
(graph)
(graph)
The famous liquidity trip is not mythical after all.
& lending, even inter-bank, builds in big spreads.
Now we have aggressive quantitative easing: the Fed
continues to purchase assets not previously dreamt of.
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The Fed certainly has not repeated the
mistake of 1930s: letting the money supply
fall.
2008-09
1930s
Source:
IMF,
WEO,
April
2009
Box 3.1
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Federal Reserve Assets ($ billions)
have more-than-doubled, through new
facilities, rather than conventional T bill purchases
Source: Federal Reserve H.4.1 report
31
Major central banks have cut interest rates sharply.
32
Policy Responses, continued

Obama policy of “financial repair”:
Infusion of funds is more conditional,

Conditions imposed on banks that get help:




(1) no dividends,
(2) curbs on executive pay,
(3) no takeovers, unless at request of authorities &
(4) more reporting of how funds are used.
Enough to make some banks balk at keeping the funds.
 The “stress tests” achieved the drawing of a (dotted) line
between “good banks” and “bad banks.”
 So far we have avoided nationalization.

33
Desirable longer-term financial reforms

Executive compensation



Securities
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Regulatory agencies: Merge SEC & CFTC?
Create a central clearing house for CDSs .
Credit ratings:


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Compensation committee not under CEO. Maybe need Chairman of Board.
Discourage golden parachutes & options, unless truly tied to performance.
Reduce reliance on ratings: AAA does not mean no risk.
Reduce ratings agencies’ conflicts of interest.
Lending

Mortgages



Banks:



Consumer protection, including standards for mortgage brokers
Fix “originate to distribute” model, so lenders stay on the hook.
Regulators shouldn’t let banks use their own risk models;
should make capital requirements less pro-cyclical .
Extend bank-like regulation to “near banks.”
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Policy Responses,
 Unprecedented

continued
$800 b fiscal stimulus.
Good old-fashioned Keynesian stimulus

Even the principle that spending provides more
stimulus than tax cuts has returned;
not just from Larry Summers, e.g.,
 but also from Martin Feldstein.

 Was
$800 too small? Too large?
 Yes:
Too small to knock out recession ;
 too small to reassure global investors re US debt.
 I.e., just about right.
35
Fiscal response
“Timely, targeted and temporary.”
American Recovery & Reinvestment Plan includes:

Aid to states:
education,
 Medicaid…;


Other spending.


Unemployment benefits, food stamps,
especially infrastructure, and



Computerizing medical records,
smarter electricity distribution grids, and
high-speed Internet access.
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
Fiscal stimulus also included tax cuts:

for lower-income workers (“Making Work Pay”)



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Fix for the AMT (for the middle class).
Soon we must return toward fiscal discipline.


EITC,
refundable child tax credit.
Let Bush’s pro-capital tax cuts expire in 2011.
But the budget passed by Congress omitted some of the
newly-responsible features proposed by Obama:


Cuts in farm subsidies for agribusiness & farmers > $250 million
Auctioning of GHG emission permits in future,


with revenue used, e.g., to cut taxes on low-income workers.
Will Secy. Gates’ attempt to cut unwanted weapons systems (such as the
F22 fighter) meet the same fate?
37
Motivation for macroeconomic intervention

The view that Keynes stood for
big government is not really right.


He wanted to save market microeconomics from
central planning, which had allure in the 30s & 40s.
Some on the Left today reacted to the crisis & election by
hoping a new New Deal would overhaul the economy.


My view: faith in the unfettered capitalist system has been shaken
with respect to financial markets, true;
but not with respect to the rest of the economy;
Obama’s economics are centrist, not far left.
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Bottom line of macroeconomic
policy response:



A good guess is that the monetary and fiscal response
we have seen so far have been sufficient to halt
the economic free-fall, so that the steep rate of decline
will level off in the 2nd half of this year.
It won’t be enough to return us rapidly
to full employment and potential output.
Given the path of debt that was inherited in 2009, it is
unlikely that more could be done.




Chinese officials already questioning our creditworthiness
US could lose AAA rating, according to David Walker (GAO, Petersen).
US long-term interest rates have risen lately
Hard landing for the $ ?
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The next crisis

The twin deficits:

US budget deficit => current account deficit

Until now, global investors have happily financed US
deficits.

The flight to quality paradoxically benefited the $,
even though the financial crisis originated in the US.
 In 2008, US TBills were still viewed as the most liquid &
riskless.

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“Be careful what you wish for!”
US politicians have not yet learned how dependent
on Chinese financing we have become.
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
Sustainable?
Can the US rely on foreign central banks indefinitely ?
 Especially if we keep telling China to stop buying $?


Although the day of reckoning did not arrive in 2008,

Chinese warnings in the spring of 2009
may have been a turning point:

PM Wen worried US T bills will lose value.

PBoC Gov. Zhou proposed
replacing $ as international
currency with the SDR.
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Simulation of central banks’ of reserve currency holdings
Scenario: accession countries join EMU in 2010. (UK stays out),
but 20% of London turnover counts toward Euro financial depth,
and currencies depreciate at the average 20-year rates up to 2007.
From Chinn & Frankel (Int.Fin., 2008)
.8
Simulation predicts € may overtake $ as early as 2015
.7
USD
.6
EUR
forecast
.5
USD forecast
.4
.3
DEM/EUR
.2
Tipping point in updated
simulation: 2015
.1
.0
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1980
1990
2000
2010
2020
2030
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2040
Appendix:
As bad as the Great Depression?
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U.S. output loss & unemployment rise
in the current downturn
would still have a very long way to go
before reaching the depth of the 1930s...
Source: Federal Reserve Bank of St. Louis
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…but, by at least one measure,
the world is on track to match the 1930s !
Industrial production
Source: George Washington’s blog
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Jeffrey Frankel
James W. Harpel Professor of Capital Formation & Growth
Harvard Kennedy School
http://ksghome.harvard.edu/~jfrankel/index.htm
Blog: http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/