The Boston Security Analysts Society Thursday, June 25, 2009.

1. The Worst Crisis in 75 Years: Origins, Magnitude and ResponseJeffrey FrankelHarpel Professor of Capital Formation & GrowthHarvard University The Boston Security Analysts Society Thursday, June 25, 2009.

2. Origins of the crisis Well before 2007, there were danger signals in US: Real interest rates <0 , 2003-04 ; Early corporate scandals (Enron 2001…); Risk was priced very low, • housing prices very high, • National Saving very low, • current account deficit big, • leverage high, • mortgages imprudent…

3. US real interest rate < 0, 2003-04 Source: Benn Steil, CFR, March 2009 Real interest rates <0

4. In 2003-07, market-perceived volatility, as measured by options (VIX), plummeted. So did spreads on US junk & emerging market bonds. In 2008, it all reversed. Source: “The EMBI in the Global Village,” Javier Gomez, May 18, 2008 juanpablofernandez.wordpress.com/2008/05/

5. Six root causes of financial crisis 1. UScorporate governance falls short E.g., rating agencies; executive compensation … options; golden parachutes… 2. US households save too little,borrow too much. 3. Politicians slant excessively toward homeownership Tax-deductible mortgage interest, cap.gains; FannieMae & Freddie Mac; Allowing teasers, NINJA loans, liar loans… MSN Money & Forbes

6. Six root causes of financial crisis,cont. 4. Starting 2001, the federal budgetwas set on a reckless path, reminiscent of 1981-1990 5. Monetary policy was too loose during 2004-05, accommodating fiscal expansion,reminiscent of the Vietnam era. 6. Financial market participants during this period grossly underpriced risk. Possible risks were: housing crash, $ crash, oil prices, geopolitics….

7. 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

8. 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

9. 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 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 is the worst in 75 years, and is as bad abroad as in the US.

10. 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).

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

12. The return of Keynes • Keynesian truths abound today: • Origins of the crisis • The Liquidity Trap • Fiscal response • Motivation for macroeconomic intervention:to save market microeconomics • International transmission • Need for coordinated expansion

13. The origin of the crisis was an asset bubble collapse, loss of confidence, credit crunch…. • like Keynes’ animal spirits or beauty contest . • Add in von Hayek’s credit cycle, • Kindleberger78 ’s “manias & panics” • the “Minsky moment,” • & Fisher’s “debt deflation.” • The origin this time was not a monetary contraction in response to inflationas were 1980-82 or 1991. • But, rather, a credit cycle: 2003-04 monetary expansion showed up only in asset prices. (Borio of BIS.)

14. US Recession The US recession started in December 2007 according to the NBER Business Cycle Dating Committee (announcement of Dec. 2008) . As of May 2009, the recession’s length broke thepostwar records of 1973-75 & 1981-82 = 4 quarters; 16 months One has to go back to 1929-33 for a longer downturn. Probably also as severe as recession of 1982.

16. No, the fact that the recession is of record length does not in itself imply we are near the end. kuya

17. US employment peaked in Dec. 2007,which is the most important single reason why the NBER BCDC dated the peak from that month. Since then, 6 million jobs have been lost (5/09). Payroll employment series Source: Bureau of Labor Statistics

18. On June 5, commentators were encouraged when BLS reported a sharp moderation in the rate of jobs decline in May. Payroll employment series Source: Bureau of Labor Statistics

19. My favorite monthly indicator is total hours worked in the economy It confirms:US recession turned severe in September; but hours worked has not yet shown any sign of moderating.

20. The US recession so far is deep, and to others’ compared to past Source: IMF, WEO, April 2009

21. Job loss now cumulates to the worst since the 1940s. Source: BLS, May 8

22. Prime-Age Male Unemployment Rateagain suggests we have hit the record for post-war recessions.

23. Recession was soon transmittedto rest of world: Contagion: Falling securities markets & contracting credit. Especially in those countries with weak fundamentals: Iceland, Hungary, Ukraine, Latvia… 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.

25. Source: OECD

26. “World Recession” • No generally accepted definition. • A fall in China’s growth from 11% to 6%, should probably be considered a recession. • Usually global growth < 2 % is considered a recession. • The World Bank forecasts that global growth would be negative in 2009, • for the first time since the 1930s.

27. How do we know this will not be another Great Depression? • especially considering that successive forecasts of the current episode have been repeatedly over-optimistic? • The usual answer: we learned important lessons from the 1930s, and we won’t repeat the mistakes we made then.

28. One hopes we won’t repeat the 1930s mistakes. • Monetary response: good this time • Financial regulation: we already have bank regulation to prevent runs. But it is clearly not enough. • Fiscal response: OK, but : constrained by inherited debt. Also Europe wasunwilling to match our fiscal stimulus at G-20 summit. • Trade policy: Let’s not repeat Smoot-Hawley ! • E.g., the Buy America provision. China emulating. • Mexican trucks

29. U.S. Policy Responses Monetaryeasing is unprecedented, appropriately avoiding the mistake of 1930s. (graph)But it has largely run its course: Policy interest rates ≈ 0.(graph) The famous liquidity trip is not mythical after all. & lending, even inter-bank, builds in big spreads. Now we have aggressive quantitative easing: the Fed continues to purchase assets not previously dreamt of.

30. The Fed certainly has not repeated the mistake of 1930s: letting the money supply fall. 2008-09 Source: IMF, WEO, April 2009Box 3.1 1930s

31. Federal Reserve Assets($ billions)have more-than-doubled, through new facilities, rather than conventional T bill purchases Source: Federal Reserve H.4.1 report

32. Major central banks have cut interest rates sharply.

33. Obama policy of “financial repair”: Infusion of funds is more conditional, Conditions imposed on banks that get help: (1) no dividends, (2) curbs on executive pay, (3) no takeovers, unless at request of authorities & (4) more reporting of how funds are used. Enough to make some banks balk at keeping the funds. The “stress tests” achieved the drawing of a (dotted) line between “good banks” and “bad banks.” So far we have avoided nationalization. Policy Responses,continued

34. Desirable longer-term financial reforms • Executive compensation • Compensation committee not under CEO. Maybe need Chairman of Board. • Discourage golden parachutes & options, unless truly tied to performance. • Securities • Regulatory agencies: Merge SEC & CFTC? • Create a central clearing house for CDSs . • Credit ratings: • Reduce reliance on ratings: AAA does not mean no risk. • Reduce ratings agencies’ conflicts of interest. • Lending • Mortgages • Consumer protection, including standards for mortgage brokers • Fix “originate to distribute” model, so lenders stay on the hook. • Banks: • Regulators shouldn’t let banks use their own risk models; • should make capital requirements less pro-cyclical . • Extend bank-like regulation to “near banks.”

35. Policy Responses,continued Unprecedented $800 b fiscal stimulus. Good old-fashioned Keynesian stimulus Even the principle that spending provides more stimulus than tax cuts has returned; not just from Larry Summers, e.g., but also from Martin Feldstein. Was $800 too small? Too large? Yes: Too small to knock out recession ; too small to reassure global investors re US debt. I.e., just about right.

36. 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.

37. Fiscal stimulus also included tax cuts: • for lower-income workers (“Making Work Pay”) • EITC, • refundable child tax credit. • Fix for the AMT (for the middle class). • Soon we must return toward fiscal discipline. • Let Bush’s pro-capital tax cuts expire in 2011. • But the budget passed by Congress omitted some of the newly-responsible features proposed by Obama: • Cuts in farm subsidies for agribusiness & farmers > $250 million • Auctioning of GHG emission permits in future, • with revenue used, e.g., to cut taxes on low-income workers. • Will Secy. Gates’ attempt to cut unwanted weapons systems (such as the F22 fighter) meet the same fate?

38. 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 & election by hoping a new New Deal would overhaul the economy. • My view: faith in the 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.

39. Bottom line of macroeconomic policy response: • A good guess is that the monetary and fiscal response we have seen so far have been sufficient to halt the economic free-fall, so that the steep rate of decline will level off in the 2nd half of this year. • It won’t be enough to return us rapidly to full employment and potential output. • Given the path of debt that was inherited in 2009, it is unlikely that more could be done. • Chinese officials already questioning our creditworthiness • US could lose AAA rating, according to David Walker(GAO, Petersen). • US long-term interest rates have risen lately • Hard landing for the $ ?

40. The next crisis • The twin deficits: • US budget deficit => current account deficit • Until now, global investors have happily financed US deficits. • The flight to quality paradoxically benefited the $, • even though the financial crisis originated in the US. • In 2008, US TBills were still viewed as the most liquid & riskless.

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

42. Sustainable? • Can the US rely on foreign central banks indefinitely ? • Especially if we keep telling China to stop buying $? • Although the day of reckoning did not arrive in 2008, • Chinese warnings in the spring of 2009 may have been a turning point: • PM Wen worried US T bills will lose value. • PBoC Gov. Zhou proposed replacing $ as international currency with the SDR.

43. 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 43

44. Appendix: As bad as the Great Depression?

45. U.S. output loss & unemployment risein the current downturn would still have a very long way to gobefore reaching the depth of the 1930s... Source: Federal Reserve Bank of St. Louis

46. …but, by at least one measure, the world is on track to match the 1930s ! Industrial production Source: George Washington’s blog

47. 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/