The Worst Financial Crisis in 75 Years: Origins, Magnitude, Response and Lessons

1. The Worst Financial Crisisin 75 Years: Origins, Magnitude, Response and LessonsJeffrey FrankelJames W. Harpel Professor of Capital Formation & GrowthHarvard Kennedy School Wellesley Country Club, March 26, 2009

2. 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…

3. 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 Tax-deductible mortgage interest; FannieMae; Allowing NINJA loans… Starting 2001, the federal budget was set on a reckless path Reminiscent of 1981-1990 Monetary policy was too loose during 2004-05, accommodating fiscal expansion,reminiscent of the Vietnam era. Financial market participants during this period grossly underpriced risk risks: housing crash, $ crash, oil prices, geopolitics….

4. 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 hegemony Homeownershipbias Predatory lending Excessive complexity MBSs Foreigndebt CDSs CDOs Gulf insta-bility Oil price spike 2007-08 Recession 2008-09

5. 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.

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

7. 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.)

8. 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.

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, 4 ½ million jobs have been lost (3/09). 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. Forecasts

14. downgraded again(Jan.28, 2009)

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

16. “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.

17. 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 aggressive quantitative easing, as the Fed continues to purchase assets not previously dreamt of.

18. 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).

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

20. 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 banks Policy Responses,continued

21. 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.  

22. 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.

23. The PPIP was attacked from both sidesin 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.

24. 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.

25. Policy Responses,continued Unprecedented 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.

26. 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.

27. 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.

28. 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.

29. Do we know this won’t be another GreatDepression? • 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 placebank 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

30. 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.

31. 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) Simulation predicts € may overtake $ as early as 2015 Tipping point in updated simulation: 2015 31

32. 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 whichBritain 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 2004at http://ksghome.harvard.edu/~jfrankel/FlubJ23M2004-.pdf 32

33. “Be careful what you wish for!”US politicians have not yet learned how dependent on Chinese financing we have become.

34. Jeffrey FrankelJames W. Harpel Professor of Capital Formation & GrowthHarvard Kennedy School http://ksghome.harvard.edu/~jfrankel/index.htm Blog: http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/