The subprime financial crisis: Reflections from a post-Keynesian viewpoint

1. The subprime financial crisis: Reflections from a post-Keynesian viewpoint Marc Lavoie

2. Outline Some historical background A change of paradigm, in policy, in theory? Presuppositions in economic analysis Financialization Securitization A Minsky crisis? A new Great Depression? Click View then Header and Footer to change this text

3. Some recent historical background Click View then Header and Footer to change this text

4. A couple of years ago, hardly any economist knew about these terms ABS, MBS, RMBS, CMBS, ABCP, CDO, CDO2, CMO, CLO, CDS, EDS, SPE, SPV, SIV asset-backed securities, mortgage-backed securities, residential mortgage-backed securities, commercial mortgage-backed securities, asset-backed commercial paper, collaterized debt obligation, collaterized debt obligation squared, collaterized mortgage obligation, collaterized loan obligation, credit default swaps, equity default swaps, special purpose entity, special purpose vehicle, structured investment vehicle Click View then Header and Footer to change this text

5. Some warning signs 2005: High share of new mortgage loans that were subprime; 2006: Risky mortgage formula (interest only, 2/28, negative amortization) Mid 2006: US Real estate prices stop rising Early 2007: the cost of insuring BBB mortgage-backed securities against default losses rose briskly (MBX or ABX indices take a plunge) Click View then Header and Footer to change this text

6. Flow of US subprime mortgages Click View then Header and Footer to change this text

7. The real estate bubble bursts, first in the US (mid 2006) and then in the UK Click View then Header and Footer to change this text

8. Falling values of MBX, the reverse of the cost of default insurance on MBS Click View then Header and Footer to change this text

9. The beginning of the end, all related to MBS August 2007: confidence crisis: Near gridlock on the European interbank market; September 2007: Bank run on Northern Rock; AAA and BBB MBX indices plunge; March 2008: Bear Stearns collapses and is bailed out; September 2008: Freddie Mac, Fanny Mae; Large Wall Street banks collapse and are bailed out, except for Lehman Brothers; stock markets plunge; Big commercial banks collapse in the US and Europe; AIG is nationalized; The entire Islandic banking system is nationalized. Click View then Header and Footer to change this text

10. Asset-backed short-term paper market in Canada shuts down in August 2007 Click View then Header and Footer to change this text

11. Stock markets finally plunge for good in September 2008 Click View then Header and Footer to change this text

12. A change of policy paradigm ? Click View then Header and Footer to change this text

13. A second Keynesian pragmatic revolution In contrast to previous financial crises, the IMF advocates low interest rates and government stimulus packages with budget deficits; G20 leaders move away from unfettered markets and uncontrolled capitalism; Gordon Brown (UK): “The Washington consensus is out”; Financial Times: “The credit crunch has destroyed faith in the free market ideology”. Click View then Header and Footer to change this text

14. Is there also a second Keynesian academic revolution? A rather negative answer: “These changes in ideology among world politicians create a different environment for economists. But as yet there are no strong shifts of opinion or practice among academic leaders of our profession. We search in vain for similar conversions or recantations. The signs are business as usual” (Hodgson, CJE 2009) Click View then Header and Footer to change this text Brazilian Keynesian Association, Porto Alegre, September 2009

15. But there are indeed some academic leaders that reject current mainstream macro theory Willem H. Buiter 2009, LSE professor, former member of the Monetary Policy Committee of the Bank of England: « The typical graduate macroeconomics and monetary economics training received at Anglo-American universities during the past 30 years or so [Lucas,Prescott, Sargent, Barro, Woodford], may have set back by decades serious investigations of aggregate economic behaviour and economic policy-relevant understanding. » « Most of the profession continued to swallow the EMH [efficient market hypothesis] hook, line and sinker, although there were influential advocates of reason throughout, including James Tobin, Robert Shiller, George Akerlof, Hyman Minsky, Joseph Stiglitz and behaviourist approaches to finance. » Click View then Header and Footer to change this text Brazilian Keynesian Association, Porto Alegre, September 2009

16. Two opposite views back in favour in the media Neo-Austrian theory (Hayek, von Mises), backed by new classical theory (Barro, John Taylor) at the forefront of the second counter-revolution; Post-Keynesian monetary theory (Galbraith, Minsky) at the forefront of the second Keynesian revolution; Click View then Header and Footer to change this text

17. The neo-Austrian view (not mine!) of the crisis in a nutshell Government intervention and bad regulation are the causes of the crisis. Free-market capitalism is essentially perfect and stable. The US government would have forced banks to grant subprime loans. The Fed set short-term rates at too low a level (from 2002 to 2004). The Chinese rigged the exchange rate and flooded long-term bond markets, also leading to overly low long-term rates. There would be no crises if government was small and interest rates were always set at their natural levels. Expansionary fiscal policy and low interest rates will prolong the crisis, as it did in the 1930s. Click View then Header and Footer to change this text Brazilian Keynesian Association, Porto Alegre, September 2009

18. The post-Keynesian view of the crisis in a nutshell Western economies have moved towards a financialization process over the last decades, with deregulation of the regulated financial system and growth of the unregulated financial system. The current regime of accumulation (based on low real wages and consumer debt) was unsustainable. Financial crises are an endogenous feature of unregulated capitalism. As a result, financial crises are ever more frequent and more severe. Click View then Header and Footer to change this text

19. Presuppositions in economics Click View then Header and Footer to change this text

20. KEYNES Click View then Header and Footer to change this text

21. Mainstream economics Click View then Header and Footer to change this text

22. Variety of Heterodox Keynesians Click View then Header and Footer to change this text

23. Presuppositions of the heterodox programme vs those of the mainstream (1989) Click View then Header and Footer to change this text

24. Example of instrumentalism The use of the parameters of the Cobb-Douglas function to estimate the production elasticities when we know that these parameters only estimate the shares of wages and profits. The use of the Gaussian copula function to estimate default correlation and thus the prices of CDO – the synthetic MBS. These were based on recent MBX prices, the prices of credit default swaps on MBS, on the assumption that markets price risk correctly, instead of being based on the default records of actual borrowers. For instrumentalists, “It is better to be precisely wrong than roughly right”. Click View then Header and Footer to change this text

25. Model-consistent vs reasonable rationality Model-consistent, rational, expectations Agents know all contingencies Agents all assume the same model Agents can do the most complicated computations vs Reasonable rationality Ecological rationality: simple rules Reaction to a discrepancy wrt some norm Traders, chartists, trends Click View then Header and Footer to change this text

26. Holism: Some crisis-related macro paradoxes Click View then Header and Footer to change this text

27. Tranquillity, liquidity, risk As time goes on, the risk level as computed by engineering models of finance (Value at Risk), appears to get smaller because the last recession is just one remote observation among a series of more recent successful years. A financial innovation that leads to both new ways to finance business and new substitutes for cash assets, decrease the volume of liquidity available to redeem the debts incurred …In the process of financial expansion the financial system contrary to appearances, becomes progressively illiquid” (Nesvetailova 2007) The “supposed immunity to financial risk always turns out to be illusory, and the risks and costs of shattering the illusion may be considerable” (Wojnilower 1980) Click View then Header and Footer to change this text

28. Scarcity vs abundance Credit is not a scarce resource: “We may have as much, or as little, credit as we want: credit is created whenever we accept the liabilities of someone who desires more purchasing power” (Wray 1994) Click View then Header and Footer to change this text

29. Unfettered vs regulated markets “I have said that we fall into two main groups. What is it that makes the cleavage which thus divides us? On the one side are those who believe that the existing economic system is, in the long run, a self-adjusting system, through which creaks and groans and jerks, and interrupted by time lags, outside interferences and mistakes…. On the other side of the gulf are those who reject that idea that the existing economic system is, in any significant sense, self-adjusting. (Keynes speech 1934) Click View then Header and Footer to change this text

30. FinancializationFinance capitalism Stock-market capitalismMoney manager capitalismRentier capitalism Click View then Header and Footer to change this text

31. Financialization: definition “Financialization means the increasing role of financial motives, financial markets, financial actors and financial institutions in the operation of the domestic and international economies” (Epstein 2006) Click View then Header and Footer to change this text

32. Financial institutions – stylized facts The importance of the financial, insurance and real estate sector has doubled GDP share Profits relative to those of non-financial corporations Profits of banks as a percentage of their total assets Compensation of employees in the financial sector as a percentage of total compensation Click View then Header and Footer to change this text

33. Non-Financial corporations – stylized facts Non-financial corporations now hold as many financial assets as they hold tangible assets. Hence the interest and dividend income of non-financial corporations as a percentage of their gross value added had tripled. Non-financial corporations, that used to issue new equity to finance their investments, now often buy back their shares instead. Non-financial corporations now raise a larger proportion of their funds through bond issues. The interest payments of non-financial corporations as a percentage of their gross value added has quadrupled. The dividend payout ratio (as a percentage of their cash-flow) has doubled. Click View then Header and Footer to change this text

34. Distributional issues – stylized facts The wage share of income has gone down. The share of income going to rentiers has risen. Labour hourly productivity has grown much faster than hourly earnings or even hourly total compensation of production and non-supervisory workers. There has been an incredible rise in the income share of the top centile. Click View then Header and Footer to change this text

35. Flow-of-funds – stylized facts The net accumulation of financial assets of corporations is positive, meaning that they lend their surpluses to households, with about half of these funds coming from financial corporations. The net accumulation of financial assets of households is negative, meaning that they borrow from corporations to pay for their consumption, financial and real estate investments. This has been made possible in particular by the use of margin debt – the borrowing of money, collaterized by equity in the stock market or equity in homes. Click View then Header and Footer to change this text

36. The net financial accumulation of Canadian households was negative 2000-7! Click View then Header and Footer to change this text Click View then Header and Footer to change this footer

37. Top Decile (10%) Income Share, USA, including capital gains (Saez 2009) Click View then Header and Footer to change this text

38. Top .01% Income Share, USA, including capital gains (Saez 2009) Click View then Header and Footer to change this text

39. Flow-of-funds – stylized facts The net accumulation of financial assets of corporations is positive, meaning that they lend their surpluses to households, with about half of these funds coming from financial corporations. The net accumulation of financial assets of households is negative, meaning that they borrow from corporations to pay for their consumption, financial and real estate investments. This has been made possible in particular by the use of margin debt – the borrowing of money, collaterized by equity in the stock market or equity in homes. Click View then Header and Footer to change this text

40. The net financial accumulation of Canadian households was negative 2000-2007 ! Click View then Header and Footer to change this text Click View then Header and Footer to change this footer

41. Fordist regime of accumulation (1950-1975) High real wages relative to labour productivity Low real rates of interest High investment expenditures High public infrastructure expenditures Click View then Header and Footer to change this text

42. New regime – finance driven Low median real wages High real interest rates and dividend payments (for most of the period) Rising debt to personal income ratios High propensities to consume, based on equity in the stock market and in real estate The regime is not sustainable Click View then Header and Footer to change this text

43. Household debt to disposable income ratio, US and Canada USA Canada Click View then Header and Footer to change this text

44. Simulating current changes in financial flows Click View then Header and Footer to change this text

45. Effect of a one-time increase in the flow of gross household loans to personal income Click View then Header and Footer to change this text

46. Effect of a one-time increase in the flow of gross household loans to personal income Click View then Header and Footer to change this text

47. Effect of a one-time decrease in the flow of gross household loans to personal income ratio, with a decrease in the propensity to consume out of personal income Click View then Header and Footer to change this text

48. Effect of a one-time decrease in the flow of gross household loans to personal income ratio, with a decrease in the propensity to consume out of personal income Click View then Header and Footer to change this text

49. 2009: the worse of two worlds The real estate market crashed before these negative effects could really take effect. But now we have two negative effects operating at once on consumption: The long-run negative effects of high household debt The short-run negative effects of high saving rates, directly from higher propensities to save, and indirectly from a lower propensity to take new debt Click View then Header and Footer to change this text

50. The boxed-in worker Finance Central bank Globalization Environment Government Corporations Click View then Header and Footer to change this text