15. THE GREAT MODERATION AND THE GLOBAL FINANCIAL CRISIS 1. The Great Moderation 2. The Global Financial Crisis: Causes and consequences 3. The Global.

1

15. THE GREAT MODERATION AND THE GLOBAL FINANCIAL CRISIS

1. The Great Moderation

2. The Global Financial Crisis: Causes and consequences

3. The Global Financial Crisis: Policies and Lessons

2

1. The Great Moderation

• A reduction in the volatility of the business cycle started to be visible starting in the mid-1980s

• The reasons, it was thought, might include structural changes: like better inventory management made possible by ITC , the shift from manufacturing to services, the increased sophistication of financial markets …

• But avobe all: the great moderation was seen as a triumph of independent central banking geared to inflation targetting

• Robert Lucas in 2003 declared that ”the central problem of depression-prevention has been solved, for all practical purposes”

• Question: Has the great moderation come to its end because of the Global Financial Crisis or are we on our way back to the great moderation?

3

The Great Moderation

4

The policy consensus (associated with the great moderation) as it used to be before the global financial crisis

Monetary policy is focussed on price stability or low inflation in the medium term, the overriding or only objective of the monetary policy run by politically independent central banks, using the short-term interest rate as the main instrument (the short-term market rate of interest being strongly influenced by the policy rates and open market operations of the central bank);

price stability was expected to further output stability as well, as can be expected at least if demand shocks dominate

Fiscal policy and particularly discretionary policy would play a more limited role, but the automatic stabilizers should be allowed to operate fully, and it would therefore be important to keep public debt at a reasonable level and aim at a balanced budget over the cycle

Discretionary fiscal policy action risked being ’too late’, overly politicised and less effective than monetary policy (partly becuase of ’Ricardian equivalence’)

Structural reform should aim at improving the functioning of the market economy (incentives, competition, no heavy regulation), thereby enhancing allocative efficiency

Also, financial regulation was not seen as part of the macroeconomic policy framework, it was concerned with regulation and supervision of individual financial institutions without any focus on ’systemic risks’ to the financial system or the economy as a whole

5

2. The Global Financial Crisis: Causes and Consequences

Question: who is to blame for the global financial crisis?

Answer: Deng Xiao Ping!

Or perhaps:

1) the ’savings glut’ (global financial imbalances)

2) financial innovations like subprime mortgages

3) lax monetary policies (Alan Greenspan)

6

The ’savings glut’

• China and other ’emerging market’ countries were running large current account surpluses (from the late 1990s onwards), reflecting very high national saving rates

• NB that the current account surplus = national saving – national investment

• Many western countries, notably the US, were at the same time running large current account deficits, reflecting budget deficits and low household saving

• As a consequence of the current account surpluses, the central bank of China invested heavily in foreign assets, notably in US treasury bills and bonds, which made it easy for the US to finance its current account deficit

• The high savings rate in Asia and the associated large-scale asset buying of the central bank of China contributed to keep the level of global interest rates low

• In all, due to the savings glut there was a lot of money going around and searching for safe and liquid financial assets (+ with a good return) to be invested in

• US is the world’s deepest and most sophisticated financial market, a lot of the excess saving of China and oher BRICs ended up in the US

7

China had a huge national investment and particularly savings rate, the difference constituting its external surplus (surplus of current account)

8

One counterpart to the Chinese surpluses was the current account deficit of the United States

9

The current account surplus of one country is the deficit of some other country (the global current account is in balance by definition)

10

Personal saving declined in the US from the 1990s until 2008 and household debt increased rapidly

11

Subprime lending and the subprime mortgage crisis

• Subprime lending = mortgage loans to people with potential difficulties to manage repayment

• Subprime loans had high interest rates but often ’teasers’ in the form of low rates in the early phase; they often had poor quality collatera (if any)

• The borrowers were often young, members of discriminated minorities, people with weak and uncertain incomes. Politicians were pleased that such groups would have access to mortgages for buying homes and gave legislative support for this

• Earlier banks used to hold mortgage loans on their books, but not so any more: New loans were increasingly sold to financial institutions that would package them together into mortgage-backed securities (MBS) to be placed on the market and therefore reducing the need of capital of banks (or giving additional scope for financial intermediation)

• the packaging was often done by investment banks and then sold to government-sponsord insitutions such as Fanny Mae of Freddie Mac (originally set up to sponsor home buying by giving quarantees for mortgage loans)

• All of this was asso ciated with rapid growth of ’shadow banking’ or non-traditional banks or financial institutions: investment banks, hedge funds, money market funds etc.

12

Cont.

• Some of the MBS-instruments were collateralized debt obligations CDO, which would consist of tranches with different rights to repayment in case of trouble: the most senior tranches were best protected and would therefore be rated AAA by rating agencies, while junior tranches would be risky and receive lower rating

• It was assumed that repayments of the underlying loans would be uncorrelated, which, if true, would substantially reduce the risk of the asset

• However, when the crisis started with declines in home prices, these occured widely in the US, and lack of confidence quickly caused dramatic declines in the market value of these securities, the underlying value of which was difficult to evaluate

• The outcome was a ’bank run’ on the shadow banking system, giving rise to acute liquidity shortages and ’fire-price sales’ of assets at great loss for the shadow banks

• While the US authorities allowed the failure of Lehman Brothers 15.9.2008, they did not dare allow more failures, given the dramatic consequences in the form of a generalized panic that the fall of Lehman Brothers gave rise to

• Some of the shaky institutions had issued large amounts of credit default swaps (CDS), a kind of insurance against losses of holding financial assets. Such institutions risked bankruptcy as a consequence of the financial crisis, forcing authorities to act to stop the crisis, because these institutions could not possibly have honoured all the CDS-contracts in a situation with wide-spread default

13

Lax monetary policy (Greenspan)

• Central banks were in the first decade of this millenium pursuing monetary policies with quite low interest rates without running into inflationary problems, partly because China and other BRICs were incrreasingly supplying world markets with cheap manufacturing goods

• Also, the US Fed reacted to occasional declines in the stock market by aggressive easing of monetary policy. Alan Greenspan thought central banks should not worry about the build-up of bubbles (in housing or in the stock exchange) but should instead concentrate on softening the conseuences if the bubble burst. This, however, created an expansionary bias in monetary policy, which supported borrowing and lending and highly leveraged investments (providing incentives for high leverage)

• Central bankers, including Greenspan, more or less neglected the role of financial regulation and supervision and did not consider the possibility that financial fragility and disturbances could give rise to problems for the financial system and the economy as a whole: no consideration was given to the possible need for ’macroprudential supervision’.

14

The global financial crisis: consequences

In the end the housing bubble burst, first in the USA, later elsewhere

The stock market turned down

Risk premia in money markets and financial markets more generally rose

Investment and consumption declined abruptly, GDP fell dramatically

Unemployment increased fast

The whole world economy was hit by pessimism: gloom and doom

15

16

17

18

19

20

21

2222

23

The global financial crisis: policies

The collapse of the world economy starting gradually in 2007, escalating in 2008 (15.9.2008 Lehman Brothers bankruptcy!) was dramatic and did trigger large-scale macroeconomic action widely in the world, with key discussion taking place within the IMF and notably G20

Monetary policy was eased fast in all major countries, notably in the US and in the euro area; later many central bansk would also resort to quantitative easing as well as to negative interest rates on central bank deposits (+ ’policy guidance’, talking interest rates down) Fiscal expansion was strong notably in 2009, thereafter fiscal polices became cautious and in many cases at least mildly contractionary, but public debt was allowed to increase

Forcecul policy action prevented the repeat of the great depression of the 1930s, but economic growth after the global financial crisis has nevertheless been very weak for a long sequence of years

As emphasized by Reinhart and Rogoff (’This time is different’), it is a typical historical experience that a financial crisis, associated with excessive debt, will have long-lasting negative consequences for economic growth; unemployment and public debt will be at a high level for a long time to come

Central banks took down policy rates to the zero level

24

Both the US Fed and the ECB did the same, later first the US Fed and recently the ECB have also embarked upon ’quantitative easing’ , buying bonds in large amounts in the market

25

Fiscal policy2007 2008 2009 2010 2011 2012 2013

Gen.gov.financial deficitOECD 1,5 3,5 8,3 7,9 6,5 5,7 4,3 USA 3,7 7,2 12,8 12,2 10,7 9,0 5,7Euro area 0,6 2,1 6,2 6,1 4,1 3,6 2,9

Gen.gov.cyclically adj.deficitOECD 2,9 4,5 7,5 7,2 6,0 5,0 3,5 USA 4,7 7,3 11,0 10,3 8,9 7,4 4,4Euro area 2,2 3,5 5,3 5,2 3,6 2,7 1,3

Public debt in the US (% of GDP): 2007 = 64,3, 2014 = 109,7Public debt in the euro area (%): 2007 = 72,8, 2014 = 108,2

In sum, fiscal policy was more expansionary in the US (as seen when looking at the change in the cyclically adjusted balance from, SAY, 2007 to 20109, also monetary policy was more forceful (as was action to put the banking system on a sound footing)

26

The Global Financial Crisis: Lessons

Monetary policy cannot just focus on price stability; it needs to be concerned about the risk of financial instability, it must consider the risk of a very deep slump with deflation etc

Monetary policy may run into the zero lower bound, which then calls for negative interest rates (possible within some limits) or large-scale quantitative easing to push down the risk-free interest rate and push investors into more risky assets (like equity)

Fiscal policy made a (temporary?) comeback: there may be a need for fiscal expansion if monetary policy is ineffective because of a liquidity trap or the zero lower bound of interest rates

There is a need not only for supervision of individual banks or financial institutions but for macroprudential supervision of the system as a whole; the authorities should also have some instruments to enhance financial stability when excessive leverage is feared

Financial regulation and supervision needs strenthening and action is called for to deal with the ’too big to fail’ syndrome of large, systemically important financial institutions

However, the lessons to be drawn are still a matter of discussion and dispute

27