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Reflections on Recent Financial Crisis
and the Pre-Crisis Situation
Prof. Julius Horvath, Ph.D.
Head of the Department of Economics
Central European University, Budapest
13-15 October 2010, Herľany
Technická Univerzita Košice
Národná a Regionálna Ekonomika VIII
Not To Be Quoted
Preliminary
Financial Crises Are Nothing New, But
− They come as surprise as they appear rarely
− The current crisis had partial effects similar to 1929
− There have been crises in the last few decades. These were studied with focus
on currency crises, not impact on banking and especially real economy
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A typical interpretation of financial crisis as of Hyman Minsky,
Charles Kindleberger, and others:
1. Boom driven by exogenous event (new profitable opportunities for investment)
2. Boom financed by bank money, by new credit instruments – innovation
3. Boom leads to an euphoria (difficult to distinguish sound from unsound prospects);
4. Euphoria leads to a bubble, i.e. asset prices independent from fundamentals;
5. Boom leads to over-indebtedness, i.e. insufficient cash flow to service liabilities;
6. Some unexpected event begins to change monetary ease to monetary tightening;
7. Sales of assets, declining net worths, bankruptcies, bank failures and recession;
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Ability to Predict
− The Blame on Economic Theory and Economic Model Building for not being able to
predict the crisis and especially its magnitude
− But also nobody predicted the Fall of the Soviet Union
− Friedman’ 1953 essay, “The Methodology of Positive Economics” : it is the ability of
models to predict what is important, not the realism of its assumptions what matters
− Prevailing macro concentrated on being dynamic, having stochastic elements and not
being partial equilibrium; none of these important for prediction of deep crisis;
Representative agent assumption: does not consider informational asymmetry,
redistribution, lending, bankruptcy;
− Important issue: to concentrate research on normal states of economy and assume
crisis away, or concentrate on conditions of crisis?
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Ability to Predict
Theory that diversification leads to lower risk, more stable economy; and in
practice an increase in overall systemic risk;
Is spreading risk necessarily increasing utility?
Maybe most behavior has to be represented as adaptive
Our ability to predict is inherently limited
The important task maybe not prediction but improving our understanding of
the conditions marking the boundaries between stable and unstable
situations in the economy
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Whom to Blame?
− Blame the Theory
− High innovation dynamics in the financial sector reflected the high innovation
dynamics of research programs at the Departments of Finance and Economics
across the world, but especially, in the US and England;
− These contributions were typically created without taking into consideration
the institutional, human, moral, traditional, and other factors.
− Blame the Wall Street
− It might seem unfair that mortgage brokers, investment bankers and others
got rich causing the current mess, and all the rest has to pay to fix it;
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Whom to Blame?
− Blame the Greed
− The fundamental cause, according to some commentators, was greed and corruption
on the Wall Street
− Eichengreen (2008) says “emphasising greed and corruption as causes of the crisis
leads to a bleak prognosis. We are not going to change human nature. We cannot
make investors less greedy.”
− Blaim the Hypocricy
− Joseph Stiglitz: This financial crisis is the fruit of a pattern of dishonesty on the part of
financial institutions, and incompetence on the part of policymakers;
− „We had become accustomed to the hypocricy. The banks reject any suggestion they
should face regulation, rebuff any move towards anti-trust measures – yet when
trouble strikes, all of a sudden they demand state intervention: they must be bailed
out; they are too big, too important to be allowed to fail.”
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Whom to Blame?
− Nobody to Blame:
− These Are the UnIntented Consequences of Right Decisions Eichengreen
(2008) two decisions in the US created the atmosphere for the crisis, but both
decisions the right ones;
− 1. In the 1970s: deregulated commissions paid to stockbrokers. when fixed
commissions investment banks make a comfortable living; deregulation
meant competition and thinner margins.
− 2. In the 1990s: removal of the Glass-Steagall Act; this allowed commercial
banks to enter on the investment banks' territory; in response, investment
banks into businesses of originating and distributing derivative securities. This
gave rise to the causes of the crisis: originate-and-distribute model of
securitization and extensive use of leverage.
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Comparison to the 1929
− Reaction of policy makers can be summarized by Bernanke’s comment that
government had to be aggressive in intervening during such crisis; this
aggressive government intervention is most likely behind the fact that panic
basically did not reach general population;
− Note that in the 1930s the Secretary of Treasury, who was also at the Federal
Reserve Board, Andrew William Mellon (1855-1937) who was a passionate
advocate of inaction;
− Similarly Schumpeter in his Viennese accent, “Chentlemen, you are worried
about the depression. You should not be. For capitalism, a depression is a
good cold douche.”
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Pre-Crisis Boom in Asset Prices
− From late 2002 until mid-2007, stock, credit and emerging markets all
witnessed a synchronized surge
− Less liquid markets like art, real estate and precious, industrial and agricultural
commodities saw even bigger appreciation
− In 2006 more than dozen equity markets registered gains of 40% of more,
with China in the lead on almost 100%
− The spread of the J. P. Morgan Emerging Bond Index over US Treasuries to just
150 basis points – a level not seen since before World War I
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Additional Pre-Crisis Atmosphere
− The US current account deficit from 3% of GDP to 7% between 1999-2006
− US failed to established stable democracies;
− High energy prices supported Iran, Venezuela, i.e. the political risk as
observed at the West increased
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Explanations of the Asset Price Boom
1. Excess Liquidity View
Interest rate cuts by the Federal Reserve afterwards the dot.com collapse and the 9/11
attacks flooded the world with cheap money
2. A Global Asset Shortage;
For example Rajan 2006a, Caballero (2006) and Caballero et al. (2007)
A shortage reflects the limited ability of emerging markets to generate financial
assets as a store of value at the same pace as their economies grow.
3. US is Simply Better
Cooper (2007) the US current account deficit reflects attractiveness to foreigners of
American securities; It is often said, foreigners need to “finance” the U.S. current
account deficit. It would be more correct to say that the desire of foreigners to invest
in the U.S. economy results in the U.S. current account deficit.
4. Fergusson and co-authors
An increase in the returns on capital (East Asian workforce into the global economy)
together with a decline in the cost of capital.
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Not an Excess Liquidity
− The idea that it has been excessive liquidity creation by central banks which
led to asset price bubble sounds plausible.
− What happened to the ratio of a narrow or broad monetary aggregates to
nominal GDP?
− A ‘liquidity bubble’ when the supply of money (as M3 growth) grows faster
than the demand for money (nominal GDP growth)
− But it was relatively stable, in the US, Europe, China, Latin America
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M3 to Nominal GDP;
Source OECD (2006)
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Not a Shortage of Financial Assets
− Caballero: emerging markets contribute to global growth and wealth, but
have only a limited capacity to create financial assets as a store of value
− In their search for financial assets, emerging markets turn to the Anglo-Saxon
world, creating global imbalances and driving up asset prices
− Financial assets from emerging market have grown at a rapid pace before
crisis. BIS: March 2005 and March 2007 the issuance of debt securities by
developing countries rose by 74% from $480 billion to $870 billion; Over the
same period, equity issuance increased by 250%;
− Thus no unusual divergence between GDP and asset issuance
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Net Issuance of Securities and the World GDP
Source: BIS (2007), IMF (2007)
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Increase in company profits around the globe.
− Company profits in the United States, Euroland, Japan and China at highest
level, both in absolute terms and relative to GDP (UBS 2007);
− Synchronous profit boom might be a consequence of the globalization
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US Corporate Profits, USD, billions
Source: BEA (2007)
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Corporate Profits to GDP 1990-2006
Source: Fersuson and Schularick (2007)
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Integration of the East and South Asia into the Global Economy
− The aggregate labour force of China, India, Vietnam, Indonesia and Pakistan, is
around 1.5 billion (World Bank 2006); of the OECD around 500 million
− Only a small portion of Asian labor force is integrated into the world economy
but still the global labor has increased twofold since 1990
− But the global capital stock has increased only little, because the capital stock
in the poor economies of China and India remains quite low.
− Freeman (2006a) estimates that the integration of China, India and the former
communist countries reduced the global capital labour ratio to roughly 60% of
what it was before these economies joined global markets
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Costs of Capital
− How about costs of capital?
− Use long-term nominal interest rates deflated by current consumer price
inflation to proxy the cost of capital in the world economy
− The cost of capital is exceptionally low by historical standards
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Global Costs of Capital: World Real Interest Rate
Source: Fergusson and Schularick (2007)
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Return and Costs of Capital
− Fergusson and Schularick (2007): global real interest rates do not reflect the
increase in the return on capital due to globalization.
− They calculate that because of the shift in the global capital–labour ratio,
returns on capital roughly 25% higher than before
− Global real interest rates should be about 25% above their previous average of
3.20%, namely at around 4%.
− The actual global cost of capital currently stands at a low of 2.25%, a little
more than half what it should be given the changes in the world economy.
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US 10 Year Government Bond Yield and Nominal GDP Growth
Source: Ferguson and Schularick (2007)
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If Profits High, Costs Low: Borrow and Buy
− Depressed cost of capital and huge corporate profitability; what follows that it
is smart to borrow money and buy earnings streams
− The world witnessed a golden age for private equity investment and leveraged
buyouts;
− Private equity investors were exploiting the wedge between returns on capital
and the cost of capital.
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Total Value of Global Leveraged Buyouts 1981–2006 (USD, bn)
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So Called ‘Fed’ Model
− The ‘Fed model’ compares the earnings yield of the S&P 500 with the nominal
ten-year bond yield.
− Over longer time horizons assumed extreme divergences should be corrected
− The Fed model correctly indicated stock market overvaluation ahead of the
crashes of 1987 and 2001
− What the Fed model has been telling investors since early 2003: buy stocks –
they are too cheap compared with bonds and sell bonds – they are too
expensive compared with equities
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10 Year Bond Yield – S&P 500 Earnings Yield
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China and the United States
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The US – China Economic Relationship
− „Let me be more positive: if I had an agreement with my tailor that whatever
money I pay him returns to me the very same day as a loan, I would have no
objection at all to ordering more suits from him.”
− Jacques Rueff (1965)
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U.S. Current Account Balance 1959-2006, %GDP
US Current Account Balance
2
1
20
05
19
97
19
99
20
01
20
03
19
89
19
91
19
93
19
95
19
81
19
83
19
85
19
87
19
73
19
75
19
77
19
79
19
65
19
67
19
69
19
71
19
59
19
61
19
63
0
(% of GDP)
-1
-2
-3
-4
-5
-6
-7
Current account balance (% of GDP)
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China and the United States
− China generate massive trade surpluses which they immediately lend back to
the United States
− By channelling surplus savings through government hands into U.S.
government paper, Chinese depress the long-term interest rate in the U.S.
− China does not allow private individuals to invest abroad, a substantial part of
China’s savings have been channelled by the State Administration for Foreign
Exchange into US government debt.
− The composition of Chinese foreign currency reserves not disclosed, assumed
a dollar share of 70% ;
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Chinese Reserve Increase and Issuance of US Treasury Debt
Source: Morgan Stanley (2007)
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Source of Chinese Savings
− China’s current account surplus increased from about 2% of GDP in 2000–
2003 to about 10% in the first half of 2007
− Where the sudden surge in savings came from?
− Chinese household savings rate falling quite significantly;
− The rapid surge in savings from Asia has not come from households but from
the Chinese corporate sector (profit surge, manufacturing and mining);
− Extraordinary profits, not the savings of households used to build-up China’s
foreign reserves as a cushion against any future financial crisis
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Corporate vs. household savings in China (% of GDP)
Source: Barnett and Brooks (2006), Kuijs (2005)
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Why do funds flow to the U.S. ?
− Under neoclassical assumptions, excess national savings should flow to
regions of the world where return to capital is highest, and those in turn are
assumed to be generally low-income regions with a low ratio of capital to
labor.
− Because of the size and institutional arrangements in the U.S. economy, many
marketable securities are much more liquid than in other financial markets;
the market offers a wide diversity of financial assets in terms of their risk
characteristics.
− In addition, property rights are secure in the United States, and dispute
settlement is relatively speedy and impartial
− Effective confiscations during the last decade in Argentina, Russia, Bolivia, and
Venezuela have reminded investors that foreign private investment in other
countries may not be secure.
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Why do funds flow to the U.S. ?
− In some years yields on U.S. debt instruments have been higher than
those in many other rich countries, as Japan and continental Europe
− Foreign investors in the United States face the risk that a weaker dollar
would hurt their rate of return measured in home currency,
− Trade-weighted index of the dollar: dollar depreciated in real terms from
the mid-1980s by 22 percent to a low in 1995, appreciated by 28 percent
(to its 1986 level) in 2002, and then depreciated by 21 percent to the
fourth quarter of 2007
− Foreign investors may believe that in the long run appreciations will
roughly balance depreciations
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