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The Financial & Economic Crisis Jeffrey Frankel Harpel Professor of Capital Formation and Growth February 12, 2009 Origins of the crisis Well before 2007, there were danger signals in US: monetary policy too easy 2003-04… flawed corporate governance, underestimation of risk, housing prices too high, National Saving too low, current account deficit, excess leverage, imprudent mortgages… 2 Onset of the crisis Initial reaction to troubles: Reassurance in mid-2007: “The subprime mortgage crisis is contained.” It wasn’t. Then, “The crisis will stay 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-turned-recession is as bad abroad as in the US. 3 Five root causes of financial crisis Monetary policy was too loose during 2004-05, accommodating fiscal expansion, reminiscent of the Vietnam era. Participants in financial markets during this period grossly underpriced risk (risks: housing crash, $ crash, oil prices, geopolitics…). US corporate governance falls short of its billing as we should have learned in 2001 (Enron, Worldcom…). E.g., rating agencies executive compensation (options; golden parachutes…). US households save too little, borrow too much. Starting 2001, the federal budget was set on a reckless path Reminiscent of 1981-1991 4 Origins of the financial/economic crises Monetary policy easy 2004-05 Stock market bubble Underestimated risk in financial mkts Failures of corporate governance Excessive leverage in financial institutions MBS s CDO s Financial crisis 2007-08 Oil price spike 2007-08 Recession 2008-09 Federal budget deficits Low national saving Housin g bubble Excessive complexity Stock market crash Gulf instability saving too little, borrowing too much Predatory lending CDSs China’s growth Households Foreig n debt Housin g crash Lower longterm econ.growth Eventual loss of US global hegemony 5 The return of Keynes Economists still shy away from using the name. But Keynesian truths abound today: Origins of the crisis The Liquidity Trap Fiscal response Motivation for macroeconomic intervention: to save market microeconomics International transmission & coordination 6 Contribution of monetary policy to the crisis The origin of the crisis was an asset bubble collapse, loss of confidence, credit crunch. More like Keynes’ animal spirits or beauty contest than like Friedman-Schwarz. Add in Fisher’s “debt deflation,” von Hayek’s credit cycle and the “Minsky moment.” It 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.) 7 US Recession In December 2008, NBER Business Cycle Dating Committee proclaimed US recession had started in December 2007. Recovery quite unlikely before end-2009. => recession is already longest since 1930s. Likely to be as severe as oil-shock recessions of 1974 and 1980-82. 8 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 43 13 8 11 10 8 10 11 16 6 16 8 8 17 10 9 US employment peaked in Dec. 2007, which is the most important reason why the NBER BCDC dated the peak from that month. Since then, 3.6 million jobs have been lost (2/6/09). Payroll employment series Source: Bureau of Labor Statistics 10 My favorite monthly indicator is total hours worked in the economy It confirms: US recession turned severe in September, when the worst of the financial crisis hit (Lehman bankruptcy…) 11 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… 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. 12 Housing bubble burst 13 Housing permits falling almost everywhere 14 Forecasts 15 have now downgraded again (Jan.28, 2009) 16 The IMF has cut by half estimates for low& middle-income countries. 2009 Jan.28, 09 Rev. vs. Oct.08 projection 17 U.S. Policy Responses Monetary easing is unprecedented, appropriately. But it has largely run its course: Policy The (graph) famous liquidity trip is not mythical after all. As Krugman & others warned us in re Japan in 90s. & lending, even inter-bank, builds in big spreads interest rates ≈ 0. since mid-2007, not just since September 2008. (graph) Now quantitative easing, as the Fed continues to purchase assets not previously dreamt of. 18 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). 19 Corporate spreads between corporate & government benchmark bonds zoomed after Sept. 2008 US € 20 Policy Responses, continued Obama policy of “financial repair”: Infusion of funds will be more conditional, vs. Bush Administration’s no-strings-attached. Some money goes to reduce foreclosures. They may impose on banks that want help: (1) no-dividends rule, (2) more serious curbs on executive pay, (3) no takeovers, unless at request of authorities & (4) more reporting of how funds are used. They won’t impose specific requirements to lend. 21 Policy Responses, Repair continued of the financial system Mortgages Consumer protection, incl. standards for mortgage brokers Fix “originate to distribute” model so lenders stay on the hook . Banks: make Basle capital requirements countercyclical Extend bank regulation to “near banks.” Regulatory agencies: Merge SEC and CFTC. A central clearing house for CDSs . Credit ratings: Reduce reliance on ratings. Reduce ratings agencies’ conflicts of interest. 22 Repair of the financial system, The TARP keeps evolving continued Paulson at first was unspecific; then TARP was to buy toxic loans, then to recapitalize banks. Now up in the air: insure banks’ toxic assets rather than acquire them? create “bad bank” as in “Swedish model”? outright “nationalization” not under consideration in US. Obama Public Private Investment Fund “co-investment”? Or insure downside of bank assets purchased by investors, thus obviating unpopular labels & outlays, & need to value assets. 23 Policy Responses, Unprecedented continued US fiscal expansion, most of which is still to come. Obama proposed an $825 expansion House passed a version. Senate will soon. Good old-fashioned Keynesian stimulus Even the belief that spending provides more stimulus than tax cuts has returned not just from Larry Summers, for example, but also from Martin Feldstein. But tax-cut vs. spending distinction can be pernicious. 24 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. 25 It also includes Tax cuts Cut for lower-income workers EITC, child tax credit, payroll tax holiday. Fix for the AMT (for the middle class). Other tax cuts demanded by Republicans But soon will need to return toward fiscal discipline E.g., let estate-tax-abolition expire in 2011. Economists want to substitute energy taxes for others. 26 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 & Obama’s election by hoping for a new New Deal. My view: faith in 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 will be centrist, not far left. 27