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In Search of Stability: The Economics and Politics of the Global Financial Crisis Mark Copelovitch Assistant Professor of Political Science & Public Affairs University of Wisconsin – Madison March 16, 2009. Overview. The economics of the crisis Causes Timeline Effects

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Overview

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  1. In Search of Stability:The Economics and Politics of the Global Financial CrisisMark CopelovitchAssistant Professor of Political Science & Public AffairsUniversity of Wisconsin – MadisonMarch 16, 2009

  2. Overview The economics of the crisis • Causes • Timeline • Effects The politics of financial stability • Policy responses • Difficult tradeoffs • The road ahead

  3. What Went Wrong? Three Faulty Assumptions About 21st Century Finance Securitization • Capital markets are so advanced that banks can lend more aggressively while off-loading risk through debt securities Credit agencies • Credit ratings agencies offer an easy and cheap “compass” for investors to assess the risk of these complex securities Risk and financial stability • The “slicing and dicing” of risk has made the financial system more stable and less crisis-prone

  4. The Initial Problem: Subprime Mortgage Lending SOURCE: BBC

  5. Subprime Borrowers “Subprime” borrowers • Borrowers with “bad” credit (<620 on 300-850 scale) • NINJAs (~20% of borrowers) What kind of loans do subprime borrowers get? • ARMs: Adjustable Rate Mortgages • “Teaser” rates to start…higher rates later on

  6. Mortgage-Backed Securities (CDOs) Ratings agencies play a key role SOURCE: NERA

  7. Subprime Mortgage Lending: Boom and Bust SOURCE: IMF, BBC

  8. Problems of uncertainty • No one knows how many “bad” mortgages are in the CDOs • No one wants to lend to banks and other institutions with heavy exposure to these securities • Results • “Flight to quality” (US Treasuries) • Spikes in market lending rates • Stock market crash • Frozen credit markets From Housing Crisis to Financial Crisis

  9. The Big Freeze SOURCE: Bloomberg

  10. The Big Freeze

  11. Case Study: Northern Rock (UK) UK’s 8th largest bank in 2007 (£113 billion in assets)

  12. Northern Rock’s Collapse Bank of England - steps in to bail out (£55 billion in loans/guarantees) and ultimately nationalize NR (2/22/08) once the “run” starts

  13. After Northern Rock, 2008-2009 SOURCE: BBC

  14. …the Financial Losses Mount… March 2009: $5.1 trillion in family net worth losses (9%) in Q4 2008

  15. GDP growth rates (%), 2008-2009 …and the Real Economic Impact is Severe SOURCE: BBC/IMF

  16. Policy Responses to Financial Crises: Two Phases Short-term (management/resolution) • Crisis lending, rate cuts, etc. • Preventing bank runs/collapses (“bailouts”) • Unfreezing credit markets (“toxic debt”) Long-term (prevention) • New regulation • New institutions • Domestic and international

  17. Liquidity (bailouts) • To money markets & directly to troubled banks (TARP) • Bank deposit guarantees • Extension of safety net to prevent bank runs • Dealing with toxic debt • A government-sponsored “bad bank” • Partial nationalization of banks • The “insurance” model (UK, January 2009) Short-Term Policy Responses: Crisis Management

  18. Why not let troubled financial institutions fail? • Why not bail out all firms? Who should be saved? • What should the government get in return? • Should non-financial firms get bailouts, too? Short-Term Policies: Key Questions

  19. Liquidity vs. moral hazard • Financial crisis vs. other goals • Aggregate welfare (“taxpayers”) vs. special interests • National policies vs. international cooperation How to Choose Policies? Difficult Tradeoffs

  20. “Bailouts” – Liquidity vs. Moral Hazard • Government/central bank credit (liquidity) helps banks pay their debts and may “unfreeze” credit markets • But, bailouts create moral hazard for borrowers and creditors How to choose? • A liquidity or solvency problem? • No clear economic answer  ultimately, a political question Greater moral hazard costs More money, fewer “strings” Less money, more “strings”

  21. Financial Stability & Stimulus vs. Other Goals • Economic stimulus package estimated to cost ~$800 billion • Full scale of toxic assets may be $3-4 billion SOURCE: New York Times

  22. Thus Far: Global Crisis, National Responses • Unilateral efforts unlikely to be successful • Threat of “beggar thy neighbor” policies SOURCE: BBC

  23. Strengthen international supervision and regulation • Bridge the gap between global markets and national regulation • Reform existing institutions • International Monetary Fund (IMF) • G-7 / G-20 • International policy coordination • Macroeconomic stimulus • Exchange rates / global imbalances • Trade policy The Global Reform Agenda: Consensus on Broad Goals…

  24. Strengthen international supervision and regulation • Which financial institutions and regulations? • What institutional form? • Reform existing global institutions • The IMF debate: resources, conditionality, votes • New “G” groups: who should be in/out? • International policy coordination • How much? For how long? • Sharp disagreements on trade and exchange rates …But Not on Specific Policies & Institutions

  25. IMF lending • Liquidity vs. moral hazard • Regulation/supervision • Confidence vs. competitiveness • Institutional reform • Accountability/legitimacy vs. effectiveness • Policy coordination • Domestic politics vs. international commitments Why No Agreement? Difficult Tradeoffs

  26. Tradeoffs: The Primacy of Politics No optimal economic solutions • Many possible policies, institutions, and regulations • Conflicts between “good economics” and “good politics” Key political factors • Domestic politics (interests, institutions) • Power and geopolitics • Collective action and bargaining problems • Ideology

  27. Example: Reforming the IMF • IMF needs ~ $750 billion - $1.75 trillion to be effective • Will new resources lead to governance reform? SOURCE: Financial Times

  28. TED Spread, March 2009 The Next Stage: Are the Bailouts Working?

  29. 9/-08 – 3/09: ~$50 billion in new IMF loans to Iceland, Pakistan, Ukraine, Belarus, Georgia, Serbia, Latvia, and Hungary The Next Stage: Crises in Emerging Markets SOURCE: Financial Times, IMF World Economic Outlook

  30. The Next Stage: World Trade Collapsing?

  31. Some Perspective: We’ve Been Here Before SOURCE: IMF, World Bank

  32. Some Perspective: The Great Depression, 1929-1933The Depression’s Effect on the US Economy SOURCE: Historical Statistics of the United States, pp. 235, 263, 1001, and 1007

  33. Some Perspective: Markets

  34. Some Perspective: Recession vs. Depression

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