The Financial & Economic Crisis Jeffrey Frankel Harpel Professor of Capital Formation and Growth

1. The Financial & Economic CrisisJeffrey FrankelHarpel Professor of Capital Formation and Growth February 12, 2009

2. 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…

3. 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.

4. 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

5. Origins of the financial/economic crises Underestimated riskin financial mkts Failures of corporate governance Households saving too little, borrowing too much Federal budget deficits Monetary policy easy 2004-05 Excessive leverage in financial institutions Housing bubble Low national saving Stock market bubble Stock market crash Housing crash China’s growth Financial crisis 2007-08 Lower long-term econ.growth Eventual loss of US global hegemony Predatory lending Excessive complexity MBSs Foreigndebt CDSs CDOs Gulf insta-bility Oil price spike 2007-08 Recession 2008-09

6. 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

7. 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 contestthan 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.)

8. 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.

10. 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

11. 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…)

12. Recession was soon transmittedto 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.

13. Housing bubble burst

14. Housing permits falling almost everywhere

15. Forecasts

16. have now downgraded again(Jan.28, 2009)

17. The IMF has cut by half estimates for low- & middle-income countries. Jan.28, 09 Rev. vs. Oct.08 projection 2009

18. U.S. Policy Responses Monetary easing is unprecedented, appropriately. But it has largely run its course: Policy interest rates ≈ 0. (graph) The 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 since mid-2007, not just since September 2008. (graph) Now quantitative easing, as the Fed continues to purchase assets not previously dreamt of.

19. Bank spreads rose sharplywhen sub-prime mortgage crisis hit (Aug. 2007) and up again when Lehman crisis hit (Sept. 2008). Source: OECD Economic Outlook (Nov. 2008).

20. Corporate spreadsbetween corporate & government benchmark bonds zoomed after Sept. 2008 US €

21. 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. Policy Responses,continued

22. Policy Responses,continued • Repair 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.

23. Repair of the financial system,continued The TARP keeps evolving 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.

24. Policy Responses,continued Unprecedented 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.

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. 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.

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 will be centrist, not far left.