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How do we know this will not be
another Great Depression?
Jeffrey Frankel
Belfer Center Economics Seminar Series, Harvard Kennedy School :
Lessons from the Current Crisis
Belfer Center Library, 3-4:30 p.m.,May 4, 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
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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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
7

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.”
78
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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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;
it may spare 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.
9
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
€
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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 April 29, 2009, the recession’s length tied
the postwar records of 1973-75 & 1981-82
= 4 quarters; 16 months
 One has to go back to 1929-33 for a longer downturn.


Likely also to be also as severe as oil-shock recessions
of 1973-75 and 1980-82, though not yet.
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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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US employment peaked in Dec. 2007,
which is the most important reason why
the NBER BCDC dated the peak from that month.
Since then, 5 million jobs have been lost (4/3/09).
employment
Source: Bureau of Labor Statistics
PayrollPayroll
employment
series series Source:
Bureau of Labor Statistics
14
My favorite monthly indicator:
total hours worked in the economy
It confirms: US recession turned severe in September,
when the worst of the financial crisis hit (Lehman bankruptcy…)
15
The US recession so far is deep,
compared to past and to others’
Source: IMF, WEO, April 2009
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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…
Or oil-exporters that relied heavily on high oil prices: Russia…
& even where fundamentals were relatively strong: Brazil, Korea…
Some others are experiencing their own housing crashes:
Ireland, Spain…

Recession in big countries has been transmitted to all
trading partners through loss of exports.
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International Trade has Plummeted
Source: OECD
18
The recession has hit more
countries than any in 60 years
19
Unemployment rates are rising everywhere
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Forecasts
21
Interim forecast
OECD 3/13/09
Forecast
for 2009 =
-3½%
22
IMF, too, forecasts 2009 as sharpest downturn
Source: WEO,
April 2009
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“World Recession”

No generally accepted definition.
A sharp fall in China’s growth from 11% is a recession.
 Usually global growth < 2 % is considered a recession.


The World Bank (March) now forecasts
negative global growth in 2009,
for the first time in 60 years.
 So does the IMF (April) when GDPs compared at current exchange rates.

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U.S. output lost 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 Great Depression !
Industrial production
Source: George Washington’s blog
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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
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.
29
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
30
Source: OECD
Major central banks have cut interest rates sharply.
31
Policy Responses, continued

Obama policy of “financial repair”:
Infusion of funds is more conditional,
vs. Bush Administration’s no-strings-attached.
 Some money goes to reduce foreclosures.
 Conditions imposed on banks that get help:





(1) no-dividends rule,
(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.
 But so far we have avoided “nationalization” of banks

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Policy Responses -- Financial Repair,

cont.
Secretary Geithner announced PPIP 3/23/09:
Public-Private Partnership Investment Program
 When
 their
buying “toxic” or “legacy assets” from banks,
prices are to be set by private bidding
(from private equity, hedge funds, and others),
 rather
than by an overworked Treasury official pulling
a number out of the air and risking that taxpayers
grossly overpay for the assets, as under TARP.
33
The PPIP was attacked from both sides
in part due to anger over AIG bonuses, etc.
FT, Mar 25, 2009
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Desirable longer-term financial reforms

Executive compensation



Securities



Regulatory agencies: Merge SEC & CFTC?
Create a central clearing house for CDSs .
Credit ratings:



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.

 Is
$800 billion too small? Too big?
 Yes:
Too small to knock out recession ;
 too big to keep global investors confident inUS debt.
 I.e., just about right.
36
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.
37

Fiscal stimulus also included tax cuts:

for lower-income workers (“Making Work Pay”)




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.
The budget passed by Congress omitted
some of the best 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.
38
International coordination
of fiscal expansion?
As in the classic Locomotive Theory
 Theory:
in the non-cooperative equilibrium, each country
holds back fiscal expansion for fear of trade deficits.
Classic prisoner’s dilemma of Nash
 Solution:
A bargain where all expand together.

39
The Locomotive Theory in Practice

The example of G-7 Bonn Summit, 1978

didn’t turn out so well:
inflation turned out to be a bigger problem than realized
 & the German world was non-Keynesian.


Inflation is less a problem this time;


the Germans are the same.
Coordinated expansion failed
at G-20 Summit in London, this April.

As had cooperation in 1933 (London Monetary & Economic Conference)
40
US
fiscal
stimulus
looks the
largest of
But others point out
the G-10.
that they have larger automatic stabilizers than the US
41
But G-20 Summit did accomplish some things

Expansion of the IMF
Tripling of size of IMF quotas.
 New issue of SDRs (a la Keynes)


More inclusion of developing countries

Eventually:




Locus shifted from G7 to G20 at London meeting.
Regulatory reform? Still to come.


Reallocation of voting shares in IMF and World Bank?
Break US-EU duopoly on MD & President?
Reduce procyclical Basel capital requirements; FSB; ….
Hold the line against protectionism? Not yet clear.
42
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.
43
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.
44
The next crisis

The twin deficits:

US budget deficit => current account deficit

Until now, global investors have happily financed US deficits.

The recent flight to quality paradoxically benefited the $,



even though the international financial crisis originated in the US.
For now, US TBills are still viewed as the most liquid & riskless.
Sustainable?

Can the US rely on support of foreign central banks indefinitely ?
45
The 2007-08 financial crisis
probably further undermined
US long run hegemony.



US financial institutions have lost credibility.
Expansionary fiscal and monetary policy
may show up as $ depreciation in the long run.
The long slow descent of the $ as an international
currency may accelerate.
46
“Be careful what you wish for!”
US politicians have not yet learned how dependent
on Chinese financing we have become.
47
In the short run, the financial crisis
has caused a flight to quality
which apparently still means a flight to US $.

US Treasury bills have been more in demand than ever,
as reflected in very low interest rates.

The $ appreciated in 2008, rather than depreciating
as the “hard landing” scenario had predicted.

=> The day of reckoning had not yet arrived.

Chinese officials’ warnings may be a turning point (April 2009):


Premier Wen worries US Treasury bills will lose value.
PBoC Gov. Zhou proposes replacing $ as international currency.
48
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
49
1980
1990
2000
2010
2020
2030
49
2040
The 2001-2020 decline in international currency
status for the $ would be only one small part of
a loss of power on the part of the US. But:
A loss of $’s role as #1 reserve currency could in
itself have geopolitical implications.
Historical precedent: £ (1914-1956)


With a lag after US-UK reversal of ec. size &
net debt, $ passed £ as #1 international
currency.
“Imperial over-reach:” the British Empire’s
widening budget deficits and overly ambitious
50
The 2001-2020 decline in international currency
status for the $ would be only one small part of
a loss of power on the part of the US.
But:

A loss of $’s role as #1 reserve currency could in itself
have geopolitical implications. [i]

Precedent: The Suez crisis of 1956
 is often recalled as the occasion on which
Britain was forced under US pressure to
abandon its imperial designs.
 But recall also the important role
played by a simultaneous run on the £
and the American decision not to help
the beleaguered currency.
[i] Frankel, “Could the Twin Deficits Jeopardize US Hegemony,”
Journal of Policy Modeling, 28, no. 6, Sept. 2006.
At http://ksghome.harvard.edu/~jfrankel/SalvatoreDeficitsHegemonJan26Jul+.pdf .
Also “The Flubbed Opportunity for the US to Exercise Global Economic Leadership”;
in The International Economy, XVIII, no. 2, Spring 2004 at http://ksghome.harvard.edu/~jfrankel/FlubJ23M2004-.pdf
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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/
Emerging markets have been hit too;
now have to spend some hard-earned reserves
53
3 cycles of net private capital flows
to emerging markets, by region
peaking in 1982, 1997 and
2008
Source: Capital Flows to Emerging Market Economies, IIF, 1/27/09.
54
Capital flows to emerging markets
peaked in 2007
from: EM Fund Flows, Citi, December 200855
BRIC growth has disappeared
56
IMF forecasts, April 2009
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