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King’s College, Cambridge May 23 rd 2009

Learning the lessons of the financial crisis Martin Wolf, Associate Editor & Chief Economics Commentator, Financial Times. King’s College, Cambridge May 23 rd 2009. Learning the lessons of the financial crisis.

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King’s College, Cambridge May 23 rd 2009

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  1. Learning the lessons of the financial crisis Martin Wolf, Associate Editor & Chief Economics Commentator, Financial Times King’s College, Cambridge May 23rd 2009

  2. Learning the lessons of the financial crisis “Simply stated, the bright new financial system – for all its talented participants, for all its rich rewards – failed the test of the market place.” Paul Volcker, April 8th 2008

  3. 1. What has just happened? • A global financial and economic crisis, triggered by a re-rating of risk in the core economies • This re-rating revealed the under-capitalisation of the financial system and that in turn generated a panic • This panic triggered a collapse in credit and consumer demand, which spread the crisis worldwide • Those worst affected were exporters of manufactures and emerging economies dependent on foreign capital inflow

  4. 2. What is the underlying story? • The story: • Long build-up of imbalances and leverage; • Excessive risk-tolerance; • Then financial and economic crisis; • Unprecedented monetary and fiscal stimulus; and now • “Green shoots” or a decline in the rate of decline • So are we on the way to sustainable recovery or to a relapse?

  5. 3. Path to a disaster • The late Hyman Minsky produced a canonical model of financial instability, based on a simple idea: • Confidence, then euphoria, then the “Ponzi game” and, finally, revulsion; • We are now in the revulsion stage – flight to quality and dramatic increases in spreads • Asset values, credit and, at worst, financial institutions collapse • Success breeds excess and excess breeds collapse

  6. 3. Path to a disaster GREAT US DEBT BOOM

  7. 3. Path to a disaster US PRIVATE DEBT BOOM

  8. 3. Path to a disaster HOUSE PRICE BUBBLE AND COLLAPSE

  9. 3. Path to a disaster • So why did huge credit and housing bubbles occur? • The “Great Moderation” and resulting complacency among policymakers and investors • Emergence of huge global imbalances and extraordinary reserve accumulations in the late 1990s and early 2000s; • Low real and nominal interest rates and the “reach for yield”; • Accommodative monetary policy aimed at targeting inflation; • Innovation in the financial sector, to provide apparently safe, high-yielding assets; and • De-regulation and mal-regulation of financial system

  10. 4. Crisis • Action of G7 governments has probably saved core banking institutions. • But the recessionary forces are overwhelming: • Dysfunctional credit markets and implosion of the shadow banking system; • Ongoing asset price collapses in housing and equities across the globe; • Need for higher savings in US, UK and other low-saving countries; and • Cut off of funding to all risky borrowers everywhere

  11. 4. Crisis RISK AVERSION SPREAD, AS BANKS DREW BACK

  12. 4. Crisis • Actions of G7 governments in October saved core banking institutions • Confidence is returning • But recessionary forces are powerful: • IMF estimates financial sector write-downs at $4.1 trillion • Asset price falls in housing are continuing; and • Consumers have cut back spending, with a chance of further rises in savings in big indebted countries

  13. 4. Crisis DEATH OF SAFE MORTGAGE-BACKED SECURITIES

  14. 4. Crisis FINANCIAL SECTOR LOSSES EXPLODE

  15. 4. Crisis THE GREAT BEAR MARKET

  16. 4. Crisis EXPORT-ORIENTED ECONOMIES ARE HARD-HIT

  17. 4. Crisis • Why is it so bad? • The scale of the bubbles; • Dispersion of risk, which means that nobody knows who holds the bad assets – and so radical uncertainty; • Failed distribution of bad paper generated much bigger write-downs than expected Inadequate capitalisation of the banking system; • Totally inadequate capitalisation of the shadow banking system; • Mistakes by US treasury (over Lehman) and other authorities

  18. 5. Green shoots • Stimulus applied has been massive, both fiscal and monetary; • The biggest fiscal stimulus is in the countries with external deficits; • Rate of economic decline has slowed; and • Forward-looking signs of recovery have emerged

  19. 5. Green shoots FISCAL STIMULUS IS MASSIVE

  20. 5. Green shoots CONFIDENCE BEGINS TO RETURN

  21. 5. Green shoots BUT CONFIDENCE BEGINS TO RETURN

  22. 5. Green shoots BUT CONFIDENCE BEGINS TO RETURN

  23. 5. Green shoots STOCK MARKET BOUNCE

  24. 5. Green shoots BUT CONFIDENCE BEGINS TO RETURN

  25. 5. Green shoots BUT CONFIDENCE BEGINS TO RETURN

  26. 6. Scenarios • Deep recessions are certain this year; • But what sort of recovery can we expect? • The big questions are three: • First, how long can governments maintain such massive stimulus, before risk-aversion spreads to sovereign debt and panic about inflation grows? • Second, does de-leveraging in countries with high levels of private indebtedness need to occur before final demand recovers? • Third, might private demand grow strongly elsewhere?

  27. 6. Scenarios THE GRIM FUTURE – BUT IS IT GRIM ENOUGH?

  28. 6. Scenarios THE GRIM FUTURE – BUT IS IT GRIM ENOUGH?

  29. 6. Scenarios • Scenario 1: Swift recovery: • Massive stimulus delivers quick restoration of demand in the big deficit countries and return to business as usual; • But big further increases in private debt • Little rebalancing of the world economy • and so increased vulnerability for the future • Also risk of oil price spike • This would be a V-shaped recession, but with real danger of a relapse some years in the future • What worries me is that this would be unsustainable

  30. 6. Scenarios • Scenario 2: Muddling through: • Modest pick-up of private spending; and • Weak recovery in US followed by other deficit high-income countries in 2011, which would pull export-oriented economies • This would be an extended “U-shaped” recession • This seems a likely outcome. • But it would also leave huge challenges of de-leveraging and re-balancing ahead

  31. 6. Scenarios • Scenario 3: Full adjustment • Strong pick up of demand in surplus countries • Export- and investment-led growth in deficit countries • De-leveraging in deficit countries, as well • This also would be an extended “U-shaped” recession • This seems a highly unlikely outcome. • But it would leave more stable growth in the years ahead

  32. 7. Lessons • Far too soon to tell. • The first lesson - fragility of the financial system: • Term transformation; and • Pervasive asymmetric information • Such systems are prone to serious errors • They are also “run-prone” • Securitisation did not make this better, but worse • This has been an age of financial crises

  33. 7. Lessons • Second Lesson - Global Macroeconomics: • We need a different global monetary system; • The present one is too vulnerable to the “Triffin problem” • Countries that do not issue internationally acceptable currencies find it very dangerous to borrow substantially abroad • So deficits end up in countries with internationally acceptable currencies • This is inefficient and undesirable • The solution is either a global currency or development of local currency finance or an international insurance arrangement on a much bigger scale

  34. 7. Lessons • Third Lesson - Macroeconomic Policy • Inflation Targeting is not enough; • Need to “lean against the wind”; • Run large fiscal surpluses in normal times; • Adopt “macro-prudential” countercyclical capital requirements

  35. 7. Lessons • Fourth Lesson - Microeconomic Policy • Case for separating utility banking from the “casino”; • Need to charge properly for guarantees, explicit and implicitly; • Need to tax term transformation through liquidity requirements; • Need to rethink the “shadow banking system”, which is a banking system, after all; • Need to raise capital requirements against all activities; • Need to reconsider risk weighting and abandon trust in risk models

  36. 7. Lessons • Big issues outstanding: • What are the regulatory and economic implications of the new “mega-banks”? • Is there a future for the shadow financial system? • If so, how do we manage and control it? • If so, how do we regulate the utility and the casino? • Should banks be prohibited from engaging in markets? • Should casinos be prohibited from term-transformation? • How do we limit risks to the state? • What do we do about “too big to fail”? • What do we do about foreign assets and liabilities of domestic institutions and domestic assets and liabilities of foreign institutions? • Should we regulate household access to credit directly? • If so, how do we do so fairly? • Do we control total borrowing or the leverage of households?

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