The Fall: A Chronicle of the Financial Crisis

1. The Fall: A Chronicle of the Financial Crisis Joseph E. Stiglitz

2. The Crisis in Brief • Excess credit fed a housing bubble • Problems exacerbated by poorly designed mortgages (low doc “liar loans,” zero or negative amortization loans, variable rate mortgages, teaser rates)

3. The Crisis in Brief • Excess credit fed a housing bubble • Securitization meant that originator did not bear costs of flawed mortgage products • Based on the principle that a “fool is born every moment” • Globalization had opened up a global marketplace for fools • Rating agencies’ flawed incentives and flawed models made it all possible

4. The crisis was predictable, and predicted • The bubble was not sustainable • Savings rate had dropped to zero • House prices were soaring, while most people’s incomes were declining

5. The crisis was predictable, and predicted • When the bubble broke, it was inevitable that there would be long term consequences • Excessive leverage on the part of households and banks • Deleveraging is a slow process • Bankruptcies destroy organizational capital

6. This crisis is like many other crises around the world • Crises have marked capitalism since the beginning • The only period in which there were not crises is the short period after the Great Depression when there was good regulation

7. This crisis is like many other crises around the world • Since the deregulation movement began 30 years ago, there have been more than 100 crises, mostly in developing countries • Governments and the IMF came to the rescue • The wrong inference was made: markets worked, but only because they were rescued

8. Crisis is like a slow train wreck • First, the rate of increases in housing prices slowed down • Some mortgage products were designed to run into problems even then • Then housing prices crashed—with predictable consequences

9. Crisis is like a slow train wreck • Banks had created complex, non-transparent products—which they and investors did not fully understand—and engaged in off balance sheet activities • While some of the products were justified as helping to manage risk, they actually increased risk • Meant that banks didn’t know their own balance sheet • Couldn’t know that of others • Credit markets froze

10. Government to the rescue • Saved the banks, the bankers, their shareholders and bondholders • Ersatz Capitalism—new level of moral hazard (socializing losses, privatizing gains) • Repealing the ordinary rules of capitalism (entailing bankruptcy when debt obligations cannot be paid, putting banks into conservatorship) • Increased concentration in the banking system—increasing the problems of too-big-to-fail

11. Mortgages • Finally did something—but too little • Almost nothing about the underwater mortgages • Pace of foreclosures continues almost unabated

12. The Stimulus • Worked—but for the stimulus, the unemployment rate would probably have peaked at close to 12% • But it was too small, and not well designed • Based on the hypothesis that the economy had hit a small bump, repair the financial system, and everything would return to normal

13. Hypothesis was wrong • There were fundamental problems before the crisis—growth in America and around the world was largely supported by unsustainable American consumption • Even if America’s financial institutions were functioning perfectly, households unlikely to return profligate ways

14. What will fill the gap? • Government has been doing this temporarily • But ability and willingness to do this is limited • Growing fiscal pressures are leading to more contractionary policies around the world, especially in Europe after the Greek crisis • In US, states and localities are facing massive shortfalls of revenues—with balanced budget framework, negative stimulus to the economy

15. What will fill the gap? • Monetary policy has little power to stimulate the economy • Though it may succeed in creating bubbles in emerging markets • It has not succeeded in encouraging lending by banks in the US and Europe • Understandable, given their weak balance sheets

16. The Crisis Continues • As government came to the rescue, its fiscal positions worsened • In effect, debts were transferred to the government • Assumed that government could manage them better • Rescue policies did work—were it not for policies, there likely would have been a depression

17. Again, following historical pattern • Sovereign debt crises often follow financial crises • Hope that this time things would be different • Most crises are in developing countries, with limited ability to raise taxes and high debt to GDP ratios

18. Again, following historical pattern • Hope that this time things would be different • But European crisis shows that that is not the case • Greece had high debt and deficit • But many of the countries in Europe face similar problems • Explanation for the Trillion Dollar Bailout Program

19. Not Just a Matter of Profligacy • Spain had a budget surplus before the crisis • Spain had only a 60% debt/GDP ratio • Spain had better bank regulation (at least in some dimensions) than the US and most other countries

20. Not Just a Matter of Profligacy • Yet today, Spain stands at the precipice • Huge deficit • 20% unemployment • More than 40% youth unemployment

21. The world faces a dilemma • Response demanded of Spain and other countries with large deficits is to cut back spending (or raise taxes) • The effect could be massively contractionary

22. The world faces a dilemma • The improvement in the deficit will be minimal • Reminiscent of Argentinean death spiral • Disappointment with size of improvement in deficit/GDP will cause higher interest rates, worsening the problem, leading to further cutbacks • Even the rescue packages may not due the trick

23. Global Perspectives • One bright spot is growth in Asia • Partial decoupling—based on vast untapped domestic markets • But too small to lead to recovery of US and Europe • And there is limited spillover from their expansion

24. Global Perspectives • Problems of reserve accumulation (which weakens global aggregate demand) worsened • Those countries with large reserves fared better

25. But Europe’s problems will impact US • Irony: America exported its toxic mortgages and its recession to Europe • Now, Europe is likely to return favor

26. But Europe’s problems will impact US • One hope for American recovery was strong exports • Based on a weak dollar • US had been winning “negative beauty contest” • But it looks like Europe will take over, at least for a time • Prospects of strong exports with a weak euro (strong dollar) and a weak Europe are bleak

27. Prospects of a quick global recovery remain bleak • In U.S., problem is not that of a jobless recovery, but rather of an anemic recovery—too slow to create jobs for new entrants to the labor force, let alone to eliminate the job deficit • One out of six Americans who would like a full time job still can’t get one • Housing problems may impede recovery of labor market • Middle of decade (at earliest) before return to “normal”

28. Prospects of a quick global recovery remain bleak • In Europe, matters are even worse • Questions are raised: Will the euro survive? Will some European governments default? • Will countries be willing to take cutbacks required by “markets”? • Especially with prolonged high unemployment rates (including among the youth) • Uncertainties will play on investors, force higher interest rates, and exacerbate the problems

29. “Can it Happen Again?” • If history is our guide, not only can it happen again, it will happen again • Though it may take slightly different form • With slightly different instruments

30. “Can it Happen Again?” • Question is: have we “learned the lessons,” so that the likelihood is reduced, the consequences mitigated? • The answer is almost surely no: • We know that markets are not self-regulating • We know that perverse incentives give rise to perverse behavior • We know that regulations are required

31. “Can it happen again?” • But so far the responses to the crisis have been mixed—little has been done about underlying problems

32. “Can it happen again?” • And in some dimensions, matters are worse • A more concentrated banking system—giving rise to greater problems of “too big to fail” • The bailouts and the manner in which they were conducted exacerbated moral hazard problem

33. “Can it happen again?” • And in some dimensions, matters are worse • Prevalent incentive structures provide incentives for short sighted behavior and excessive risk taking. • Open question still about derivatives regulations • Some success in preventing worse mortgage abuses

34. Regulation and Creativity • In some quarters, there are worries about whether new regulations will stifle creativity • But much of the sectors’ creative energy was directed at regulatory, tax, and accounting arbitrage

35. Regulation and Creativity • This undermined the sector fulfilling its core functions of allocating capital (providing credit to small and medium sized enterprises) managing risk, running an efficient payments system, all at low transactions cost

36. Regulation and Creativity • A good regulatory system holds out the promise of directing innovative energies of the sector in ways more consonant with its role in our society • Creating not only a more stable economy, but a more prosperous one.