Download Mar. 26

The Worst Financial Crisis
in 75 Years: Origins, Magnitude,
Response and Lessons
Jeffrey Frankel
James W. Harpel Professor of Capital Formation & Growth
Harvard Kennedy School
Wellesley Country Club, March 26, 2009
Origins of the crisis

Well before 2007,
there were danger signals in US:
Low interest rates 2003-04 ;
 Early corporate scandals (Enron…);
 Risk was priced very low,

housing prices very high,
 National Saving very low,
 current account deficit big,
 leverage high,
 mortgages imprudent…

2
Six root causes of financial crisis


US corporate governance falls short of its billing


E.g., rating agencies;
executive compensation (options; golden parachutes…).

US households save too little, borrow too much.

Politicians slant excessively toward homeownership


Starting 2001, the federal budget was set on a reckless path


Reminiscent of 1981-1990
Monetary policy was too loose during 2004-05,


Tax-deductible mortgage interest; FannieMae; Allowing NINJA loans…
accommodating fiscal expansion, reminiscent of the Vietnam era.
Financial market participants during this period
grossly underpriced risk

risks:
housing crash, $ crash, oil prices, geopolitics….
3
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
4
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 in 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.
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

6

The origin of the crisis was an asset bubble collapse,
loss of confidence, credit crunch.

Like Keynes’ animal spirits
or beauty contest .
Add in Fisher’s “debt deflation,”
the “Minsky moment,”
and von Hayek’s credit cycle


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.


As of March 2009, the recession’s length ties the
postwar record of 1981-82 (16 months).
Recovery unlikely before late 2009
 => recession is already longest since 1930s.


Likely also 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, 4 ½ million jobs have been lost (3/09).
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
Forecasts
13
downgraded again
(Jan.28, 2009)
14
The IMF has cut by half estimates for low& middle-income countries.
2009
Jan.28, 09
Rev. vs.
Oct.08
projection
15
“World Recession?”

No generally accepted definition.

A fall in China’s growth from 11% to 1%, e.g, is
obviously a recession.



Perhaps 6 ½ % is as well (World Bank forecast, Mar. 2009)
Usually global growth < 2 % is considered a recession.
The World Bank in March forecast that
global growth would be negative in 2009,

for the first time since the 1930s.
16
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 aggressive quantitative easing, as the Fed
continues to purchase assets not previously dreamt of.
17
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).
18
Corporate spreads
between corporate & government benchmark bonds
zoomed after Sept. 2008
US
€
19
Policy Responses, continued

Obama policy of “financial repair”:
Infusion of funds has been more conditional,
vs. Bush Administration’s no-strings-attached.
 Some money goes to reduce foreclosures.
 Conditions imposed on banks that want 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.


But so far they have avoided “nationalization” of banks20
Policy Responses -- Financial Repair,

cont.
Secretary Geithner announced PPIP 3/23/09:
Public-Private Partnership Investment Program
 When
buying “toxic” or “legacy assets” from banks,
 their
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.
21
Policy Responses -- Financial Repair,
cont.
 How
much money is the government
putting into the PPIP?
 designed
to be enough to attract participants, but not more.
 From the Treasury (already set aside under TARP),
leveraged courtesy of FDIC & Fed.
 Taxpayers

share equally with new private investors in upside,
 but
admittedly bear all the downside risk.
 Nationalization could have been a lot more expensive.
22
The PPIP was attacked from both sides
in part due to anger over AIG bonuses, etc.
FT, Mar 25, 2009
But the stock market reacted very
positively, and some respected
commentators are supportive.
23
 Desirable

longer-term financial reforms
Mortgages


Consumer protection, incl. standards for mortgage brokers
Fix “originate to distribute” model, so lenders stay on the hook .
Banks: make Basle capital requirements less cyclical
 Extend bank regulation to “near banks.”
 Regulatory agencies: Merge SEC & CFTC.
 Create a central clearing house for CDSs .
 Credit ratings:

Reduce reliance on ratings.
 Reduce ratings agencies’ conflicts of interest.

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Policy Responses,
 Unprecedented
continued
US fiscal expansion.
Obama proposed an $825 expansion
 Version passed by Congress was just a bit worse.
 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.

25
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.
26
Proposed fiscal stimulus also included

Tax cuts
 Cut


for lower-income workers
EITC,
child tax credit.
 Fix

for the AMT (for the middle class).
 Other tax cuts demanded by Republicans
But soon will need to return toward fiscal discipline
Let Bush’s pro-capital tax cuts expire in 2011.
 Economists want to substitute energy taxes for others.

27
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 are centrist, not far left.
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Do we know this won’t be another Great Depression?

True, the origins were similar.

But one hopes we won’t repeat the 1930s’ mistakes

Monetary response: good this time

Financial regulation: we already have in place
bank regulation to prevent runs. But that is not enough.

Fiscal response: okay, but constrained
by inherited debt (and politics)

Trade policy: Let’s not repeat Smoot-Hawley!


E.g., the Buy America provision
Mexican trucks
29
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?


How long will foreigners keep adding to their $ holdings?
The US can no longer necessarily rely on support of foreign central
banks, either economically or politically.
30
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
31
1980
1990
2000
2010
2020
2030
31
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. [i]

Precedent: The Suez crisis of 1956
 is often recalled as the occasion on which
Britain was forced under US pressure to
abandon its remaining 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
32
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“Be careful what you wish for!”
US politicians have not yet learned how dependent
on Chinese financing we have become.
33
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/