The Global Financial Crisis of 2008

1. The Global Financial Crisis of 2008 Chandra Athukorala Arndt-Corden Division of Economics Research School of Pacific and Asian Studies

2. Preview • Financial Crisis: A ‘hardy perennial’ - ‘[A] subject that does not appear to be going out of fashion’ (Robert M Solow, in the Foreword to Kindleberger and Aliber 2005)

3. Financial crisis results from the implosion of asset price bubbles (or from the sharp depreciation of national currencies) (A bubble; a non-sustainable pattern of price changes or cash flows) Bubbles are generally associated with a robust, prolong economic expansion : manias associated with growth euphoria rational behaviour morphs into irrational exuberance A certain event, perhaps a change in government policy, an unexplained failure of a firm/bank previously thought to have been successful leads to bursting of the bubble. Bubbles always implore, but this does not always lead to a crisis (a soft landing is possible) – depends very much on the money and capital market institutions of the time.

4. Financial crises have been more extensive and pervasive in the last four decades than in any previous period. (An outcome of ‘financial globalization’?) • We are now witnessing the third global crisis in a decade (1997-98 Asian crisis; dot-com crisis in 2001; the US housing market crisis 2007 - ) • The ‘mother of all crises’ (so far!) in recorded history has been the Great Depression following the crash of the stock market bubble in the US in the late 1920s. • The current unfolding crisis is similar in the source of origin (US, the largest economy) and global spread. The number of bank failures are going to be larger.

5. Could it usher in the Second Great Depression? Unlikely • The global economy is much more ‘diversified’ than in the thirties. • All major countries have central banks which are ready to act as ‘lenders of last resort’ • Floating exchange rate regimes (attempt to stick to the ‘gold standard’ was a major factor in deepening crisis in the 1930s)

6. The US Housing Boom and Bubble Three key factors provided the setting: • Surge in capital flows to the US (A reflection of the on-going process of financial globalization. implosion of the real state and stock bubble in Japan in the early 1990s, the Asian crisis 1997-98, China’s meteoric economic rise played a role) • Robust growth propelled by productivity growth since the mid- 1990. (productivity growth: 1974-95: 1.4%, 1996-2007 2.5% Rapid productivity growth means the economy could grow faster without exacerbating inflation) • Historically low interest rates in the aftermaths of the dot.com collapse and the terrorist attack of September 11, 2001, FED lowered federal fund rates to 1 percent and kept until June 2004. The subsequent hikes were marginal)

7. The house price inflation began to exceed consumption price inflation as early as 1998. (Shiller 2000) The rate of expansion of house prices began to exceed household income growth staring in 2004 (a clear sign of a bubble) (Harris 2008) Housing stock value increased from about 4% of GDP in the 1990s to 6% in 2006. Almost two thirds of house owners had a mortgage by 2007 (compared to 50% in the 1990s) Home-loans as percentage of consumption: 1990s: 26%; 2006: 36%

8. Signs of aggressive speculative behaviour • Surge in the use of hybrid (sub-prime) mortgages, which required no down payment, demanded little documentation of income or assts, or offered low initial ‘teaser’ rates of payments. (by 2006 sub prime mortgages accented for 15% of the mortgage market) • A surge in the number of buyers who were self identified speculators (‘flippers’) • Markets in ‘hot areas’ were getting hotter (home price increases: Metro areas: 5% in 2004 to 7% in 2006 Cities: 20% to 28%)

9. Linkages to the rest of the economy • Housing sector boom was accompanied by a stock market boon • New financial derivatives based on to mortgages contributed to massive expansion in overall financial systems • Thus, there was a high risk of a synchronized price declines across many speculative markets. • ‘regulatory failure’ amplified the potential risk. - There was no regulatory reforms to match new financial innovations - New innovations made it hard for regulators to keep track of firms’/banks’ exposure to credit risk.

10. Was Greenspan part of the problem? (Shiller 2000, Soros 2008, Harriss 2008, Rubin 2003) • Greenspan was an ‘easy-money dove’ (A an easy money dove tends to be soft on inflation and less inclined to hike interest rate. A hawk is tough on inflation and inclined to hike interest rates (and inflict pain on capital markets)) • He inadvertently encouraged the bubbles through talks of higher trend growth propelled by productivity growth and persistent low inflation 9in this he exaggerated the China factor. • He ignored the signs of housing bubble and kept short-term interest rates too low for too long.

11. Bursting of the Bubble and Onset of the Crisis Rumbling of the housing bubble from third quarter of 2007 Trigger: sub-prime credit defaults. Feedback loop in the housing sector) • The sharp pull back in lending to supreme borrows cased a sharp drop in demand for homes (over 1 million homes on sale by mid 2008) • Falling house prices • Negative household equity (i.e the value of the home is less than the value of the mortgage) creating an incentive for defaulting loans. • More houses are being sold at bargain prices, pushing home process lower.

12. Falling home construction and weaker demand, results in further contraction in demand for houses In addition • Economy wide concretionary effects arising from collapsing credit and share markets.

13. Unfolding crisis Nov/Dec 2007: The market for inter-bank lending tightened up dramatically January/February 2008: The auction rate market (where state and local governments borrowing is rolled over) ran into serious problems March 2008; Bear sterns, a major investment bank, was absorbed by JP Morgan September 2008: Lehman Brothers collapsed - a bellwether event which lead to virtual drying-up of the commercial papers market seized.

14. Policy Response Greenspan-style gradualism in 2006 and 2007: the FED continued to focus on inflation Gradualism ended in January 2008: Bernanke announced that recession, not inflation, was the main concern. Late January 2008: 125 basic point cuts in fund rate accompanied by array of new programs to directly add liquidity to credit market September 2008: 700 billion rescue package Recapitalization of back has become part of the policy package (following the British move in October)

15. Current state of the US economy The US economy may well be in recession already. Economic collapse is likely to continue well into 2009 (and beyond?) Retail sales dropped by 1.35% in 3rd quarter 2008 Almost a quarter of home owners with mortgages have zero or negative equity. Because of the collapse of the commercial paper market, companies are facing straining balance-sheet capacity

16. Global Spread • In the second half of 2007, banks and hedge funds around the world reported major losses from sub-prime mortgages • September 2007: Northern Rock, a major bank, was rescued by the UK government • Widespread bank failures in the second and third quarter of 2008 in a number of countries: UK, Belgium, Sweden, Iceland • In the 2nd week of October, Britain ‘nationalized’ much of its banking industry • The impact on Asian countries? No signs of significant ripple effects of the financial crisis, but bound to be affected by the second-round (real-sector contrition in the US and other developed countries) effects)

17. Reference Harris, Ethan S. (2008), Ben Bernanke’s FED: The Federal Reserve After Greemspan, Cambridge, AMS: Harvard Business Press. Hartcher, Peter (2006), Bubble Man: Allan Greenspan & the Missing 7 Trilliona Dollars, Melbourne: Black Ink. Kindleberger, Charls P. and Robert Aliber (2005), Manias, Panics, and Crashes: A History of the Financial Crises, Ney York: john Wiley and Sons. Rubin, Robert E. and Jacob Weisberg (2003), In a Uncertain World,New York: Random House. Shiller, Robert I. (2000), Irrational Exuberance, Priceton, NJ, Priceton University Press. Soros, George (2008), The Credit Crisis of 2008 and what it Means, New York: Foreign Affairs