The Worst Financial Crisis in 75 Years: Origins, Magnitude, Response and Lessons Jeffrey Frankel James W. Harpel Professor of Capital Formation & Growth.

The Worst Financial CrisisThe Worst Financial Crisisin 75 Years: Origins, in 75 Years: Origins,

Magnitude, Response and Magnitude, Response and LessonsLessons

Jeffrey FrankelJeffrey FrankelJames W. Harpel Professor of Capital James W. Harpel Professor of Capital

Formation & GrowthFormation & GrowthHarvard Kennedy SchoolHarvard Kennedy School

Wellesley Country Club, March 26, 20092009

2

Origins of the crisisOrigins of the crisis Well before 2007, Well before 2007,

there were danger there were danger signals in US:signals in US: Low interest rates 2003-Low interest rates 2003-

04 ; 04 ; Early corporate scandals Early corporate scandals

(Enron…);(Enron…);

Risk was priced very low, Risk was priced very low,

housing prices very high, housing prices very high, National Saving very low,National Saving very low, current account deficit big,current account deficit big, leverage high,leverage high, mortgages imprudent…mortgages imprudent…

3

Six root causes of financial Six root causes of financial crisiscrisis

US US corporate governance falls shortcorporate governance falls short of its billing of its billing E.g., rating agencies; E.g., rating agencies; executive compensationexecutive compensation (options; golden parachutes…).(options; golden parachutes…).

US households save too little,US households save too little, borrow too much. borrow too much.

Politicians slant excessively toward Politicians slant excessively toward homeownershiphomeownership Tax-deductible mortgage interest; FTax-deductible mortgage interest; FannieannieMMaeae; Allowing NINJA ; Allowing NINJA

loans… loans…

Starting 2001, the Starting 2001, the federal budgetfederal budget was set on a was set on a reckless pathreckless path

Reminiscent of 1981-1990 Reminiscent of 1981-1990

Monetary policy was too loose during 2004-05,Monetary policy was too loose during 2004-05, accommodating fiscal expansion,accommodating fiscal expansion, reminiscent of the Vietnam era.reminiscent of the Vietnam era.

Financial market participants during this period Financial market participants during this period grossly grossly underpriced riskunderpriced risk risks: housing crash, $ crash, oil prices, geopolitics….risks: housing crash, $ crash, oil prices, geopolitics….

4

Monetary policy easy

2004-05

Federal budget deficits

Underestimated

risk in financial mkts

Failures of corporate

governance

Households saving too little, borrowing too

much

Excessive leverage in financial institutions

Stockmarketbubble

Housing

bubble

Stock marketcrash

HousingcrashFinancial

crisis2007-08

China’s growth

Low national saving

Lower long-term

econ.growth

Eventual loss of US hegemony

Recession2008-09

Oil price spike2007-08

Gulfinsta-bility

Foreign debt

Origins of the financial/economic Origins of the financial/economic crisescrises

Excessive complexity

CDSsMBSs

CDOs

Predatory lending

Homeownership bias

5

Onset of the crisisOnset of the crisis Initial reaction to troubles:Initial reaction to troubles:

Reassurance in mid-2007: “The subprime Reassurance in mid-2007: “The subprime mortgage crisis mortgage crisis is contained.” is contained.” It wasn’t.It wasn’t.

Then, “The crisis is in Wall Street, sparing Then, “The crisis is in Wall Street, sparing Main Street.” Main Street.” It didn’t.It didn’t.

Then Then de-couplingde-coupling : : “The US turmoil will have less effect on the “The US turmoil will have less effect on the rest rest of the world than in the past.” of the world than in the past.” It hasn’t.It hasn’t.

By now it is clear that the crisis is By now it is clear that the crisis is the worst in 75 years, the worst in 75 years, and is as bad abroad as in the US.and is as bad abroad as in the US.

6

The return of KeynesThe return of Keynes

Economists still shy away Economists still shy away from using the name.from using the name.

But Keynesian truths abound today:But Keynesian truths abound today: Origins of the crisisOrigins of the crisis The Liquidity TrapThe Liquidity Trap Fiscal responseFiscal response Motivation for macroeconomic Motivation for macroeconomic

intervention:intervention:to save market microeconomicsto save market microeconomics

International transmissionInternational transmission

7

The origin of the crisis was an asset bubble The origin of the crisis was an asset bubble collapse, loss of confidence, credit crunch.collapse, loss of confidence, credit crunch.

Like Keynes’ animal spirits Like Keynes’ animal spirits or beauty contestor beauty contest . .Add in Fisher’s “debt deflation,” Add in Fisher’s “debt deflation,” the “Minsky moment,” the “Minsky moment,” and von Hayek’s credit cycle and von Hayek’s credit cycle

It was not a monetary contraction It was not a monetary contraction in response to inflationin response to inflation (as were 1980-82 or 1991).(as were 1980-82 or 1991).

But, rather, a credit cycle: 2003-04 But, rather, a credit cycle: 2003-04 monetary expansion showed up only in asset monetary expansion showed up only in asset prices. prices. (Borio of BIS.)(Borio of BIS.)

8

US RecessionUS Recession

In December 2008, NBER Business In December 2008, NBER Business Cycle Dating Committee proclaimed Cycle Dating Committee proclaimed US recession had started in December US recession had started in December

2007.2007.

As of March 2009, the recession’s length As of March 2009, the recession’s length ties the postwar record of 1981-82 ties the postwar record of 1981-82 (16 (16 months).months). Recovery unlikely before late 2009Recovery unlikely before late 2009 => recession is already longest since 1930s.=> recession is already longest since 1930s.

Likely also to be as severe as oil-shock Likely also to be as severe as oil-shock recessions of 1974 and 1980-82.recessions of 1974 and 1980-82.

9

BUSINESS CYCLE REFERENCE DATESBUSINESS CYCLE REFERENCE DATES   Source: NBERSource: NBER

PeakPeak TroughTrough ContractioContractionn

Quarterly dates are in parenthesesQuarterly dates are in parentheses Peak to TroughPeak to Trough

August 1929 (III)August 1929 (III)May 1937 (II)May 1937 (II)February 1945 (I)February 1945 (I)November 1948 (IV)November 1948 (IV)July 1953 (II)July 1953 (II)August 1957 (III)August 1957 (III)April 1960 (II)April 1960 (II)December 1969 (IV)December 1969 (IV)November 1973 (IV)November 1973 (IV)January 1980 (I)January 1980 (I)July 1981 (III)July 1981 (III)July 1990 (III)July 1990 (III)March 2001March 2001 (I) (I)December 2007December 2007 (IV) (IV)

March 1933 (I)March 1933 (I)June 1938 (II)June 1938 (II)October 1945 (IV)October 1945 (IV)October 1949 (IV)October 1949 (IV)May 1954 (II)May 1954 (II)April 1958 (II)April 1958 (II)February 1961 (I)February 1961 (I)November 1970 (IV)November 1970 (IV)March 1975 (I)March 1975 (I)July 1980 (III)July 1980 (III)November 1982 (IV)November 1982 (IV)March 1991March 1991 (I) (I)November 2001November 2001 (IV) (IV)

434313138811111010881010111116166616168888

Average, all cycles:Average, all cycles: 1854-2001 (32 cycles) 1854-2001 (32 cycles)

1945-2001 (10 cycles)1945-2001 (10 cycles)

1717

1010

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 My favorite monthly indicator is total hours indicator is total hours worked in the economyworked 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 Recession was soon transmittedtransmitted

to rest of world: to rest of world: Contagion: Falling securities Contagion: Falling securities

markets & contracting credit.markets & contracting credit. Especially in those countries with weak fundamentals: Especially in those countries with weak fundamentals:

Iceland, Hungary & Ukraine…Iceland, Hungary & Ukraine… Or oil-exporters that relied heavily on high oil prices: Or oil-exporters that relied heavily on high oil prices:

Russia…Russia… But even where fundamentals were relatively strong: Korea…But even where fundamentals were relatively strong: Korea…

Some others experiencing their own housing Some others experiencing their own housing crashes:crashes: Ireland, Spain…Ireland, Spain…

Recession in big countries will be transmitted to Recession in big countries will be transmitted to all trading partners through loss of exports.all trading partners through loss of exports.

13

Forecasts

14

downgraded againdowngraded again (Jan.28, 2009)(Jan.28, 2009)

15

The IMF has cut by half estimates for low- & middle-income countries.

Jan.28, 09Jan.28, 09 2009

Rev. vs. Oct.08

projection

16

““World Recession?”World Recession?”

No generally accepted definition.No generally accepted definition. A fall in China’s growth from 11% to 1%, e.g, is A fall in China’s growth from 11% to 1%, e.g, is

obviously a recession. obviously a recession. Perhaps 6 ½ % is as well Perhaps 6 ½ % is as well (World Bank forecast, Mar. 2009)(World Bank forecast, Mar. 2009)

Usually global growth < 2 % is considered a Usually global growth < 2 % is considered a recession.recession.

The World Bank in March forecast that The World Bank in March forecast that global growth would be negative in 2009,global growth would be negative in 2009, for the first time since the 1930s.for the first time since the 1930s.

17

U.S. Policy U.S. Policy ResponsesResponses

MonetaryMonetary easing is unprecedented, easing is unprecedented, appropriately. But it has largely run its appropriately. But it has largely run its course:course:

Policy interest rates ≈ 0.Policy interest rates ≈ 0. (graph)(graph)

The famous liquidity trip is not mythical after all.The famous liquidity trip is not mythical after all. As Krugman & others warned us in re Japan in 90s.As Krugman & others warned us in re Japan in 90s.

& lending, even inter-bank, builds in big spreads& lending, even inter-bank, builds in big spreads since mid-2007, not just since September 2008.since mid-2007, not just since September 2008. (graph)(graph)

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

18

Bank spreads rose sharplyBank spreads rose sharplywhen sub-prime mortgage crisis hit (Aug. when sub-prime mortgage crisis hit (Aug.

2007) 2007) and up again when Lehman crisis hit (Sept. and up again when Lehman crisis hit (Sept.

2008).2008).

Source: OECD Economic Outlook

(Nov. 2008).

19

Corporate spreadsCorporate spreads between corporate & government between corporate & government

benchmark bondsbenchmark bonds zoomed after zoomed after Sept. 2008Sept. 2008

US

€

20

Policy Responses,Policy Responses, continuedcontinued

Obama policy of Obama policy of “financial repair”:“financial repair”:Infusion of funds has been more conditional,Infusion of funds has been more conditional,

vs. Bush Administration’s no-strings-attached. vs. Bush Administration’s no-strings-attached. Some money goes to reduce foreclosures.Some money goes to reduce foreclosures. Conditions imposed on banks that want help:Conditions imposed on banks that want help:

(1) no-dividends rule,(1) no-dividends rule, (2) curbs on executive pay, (2) curbs on executive pay, (3) no takeovers, unless at request of authorities &(3) no takeovers, unless at request of authorities & (4) more reporting of how funds are used.(4) more reporting of how funds are used.

But so far they have avoided “nationalization” But so far they have avoided “nationalization” of banksof banks

21

Secretary Geithner announced PPIP 3/23/09: Secretary Geithner announced PPIP 3/23/09: Public-Private Partnership Investment Public-Private Partnership Investment ProgramProgram When buying “toxic” or “legacy assets” 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.  

Policy Responses -- Financial Policy Responses -- Financial

Repair,Repair, cont.cont.

22

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.

Policy Responses -- Financial Policy Responses -- Financial

Repair,Repair, cont.cont.

23

The PPIP was attacked from The PPIP was attacked from both sidesboth sides

in part due to anger over AIG bonuses, etc.in part due to anger over AIG bonuses, etc.

But the stock market reacted But the stock market reacted very positively, and some very positively, and some

respected commentators are respected commentators are supportive.supportive.

FT, Mar 25, 2009

24

Desirable longer-term financial Desirable longer-term financial reformsreforms MortgagesMortgages

Consumer protection, incl. standards for mortgage brokersConsumer protection, incl. standards for mortgage brokers Fix “originate to distribute” model, so lenders stay on the hook .Fix “originate to distribute” model, so lenders stay on the hook .

Banks: make Basle capital requirements less Banks: make Basle capital requirements less cyclicalcyclical

Extend bank regulation to “near banks.”Extend bank regulation to “near banks.” Regulatory agencies: Merge SEC & CFTC.Regulatory agencies: Merge SEC & CFTC. Create a central clearing house for CDSs .Create a central clearing house for CDSs . Credit ratings: Credit ratings:

Reduce reliance on ratings.Reduce reliance on ratings. Reduce ratings agencies’ conflicts of interest.Reduce ratings agencies’ conflicts of interest.

25

Policy Responses,Policy Responses, continuedcontinued

Unprecedented US Unprecedented US fiscalfiscal expansionexpansion.. Obama proposed an $825 expansion Obama proposed an $825 expansion Version passed by Congress was just a Version passed by Congress was just a

bit worse. bit worse. Good old-fashioned Keynesian stimulusGood old-fashioned Keynesian stimulus

Even the belief that spending provides Even the belief that spending provides more stimulus than tax cuts has more stimulus than tax cuts has returned;returned;

not just from Larry Summers, not just from Larry Summers, for example, for example,

but also from Martin Feldstein.but also from Martin Feldstein.

26

Fiscal responseFiscal response“Timely, targeted and “Timely, targeted and

temporary.”temporary.”

American Recovery & Reinvestment Plan American Recovery & Reinvestment Plan includes:includes:

Aid to states: Aid to states: education, education, Medicaid…; Medicaid…;

Other spending.Other spending. Unemployment benefits, food stamps,Unemployment benefits, food stamps, especially infrastructureespecially infrastructure, and, and

Computerizing medical records, Computerizing medical records, smarter electricity distribution grids, andsmarter electricity distribution grids, and high-speed Internet access.high-speed Internet access.

27

Proposed fiscal stimulus also Proposed fiscal stimulus also includedincluded Tax cuts Tax cuts

Cut for lower-income workersCut for lower-income workers EITC, EITC, child tax credit.child tax credit.

Fix for the AMT Fix for the AMT (for the middle class).(for the middle class). Other tax cuts demanded by RepublicansOther tax cuts demanded by Republicans

But soon will need to return toward fiscal But soon will need to return toward fiscal disciplinediscipline Let Bush’s pro-capital tax cuts expire in 2011.Let Bush’s pro-capital tax cuts expire in 2011. Economists want to substitute energy taxes for Economists want to substitute energy taxes for

others.others.

28

Motivation for macroeconomic Motivation for macroeconomic interventionintervention

The view that Keynes stood for The view that Keynes stood for big government is not really right.big government is not really right. He wanted to save market microeconomics from He wanted to save market microeconomics from

central planning, which had allure in the 30s & 40s.central planning, which had allure in the 30s & 40s.

Some on the Left today reacted to the crisis & Some on the Left today reacted to the crisis & Obama’s election by hoping for a new New Deal.Obama’s election by hoping for a new New Deal. My view: faith in unfettered capitalist system has been My view: faith in unfettered capitalist system has been

shaken shaken with respect to financial markets, true; with respect to financial markets, true; but not with respect to the rest of the economy; but not with respect to the rest of the economy;

Obama’s economics are centrist, not far left.Obama’s economics are centrist, not far left.

29

Do Do we knowwe know this won’t this won’t be anbe anotherother Great Great

Depression?Depression? True, the origins were similar.True, the origins were similar.

But one hopes we won’t repeat the 1930s’ But one hopes we won’t repeat the 1930s’ mistakesmistakes

Monetary responseMonetary response:: good this time good this time

Financial regulationFinancial regulation:: we already have in place we already have in placebank regulation to prevent runs. But that is not bank regulation to prevent runs. But that is not enough.enough.

Fiscal responseFiscal response:: okay, but constrained okay, but constrained by inherited debt (and politics)by inherited debt (and politics)

Trade policy: Let’s not repeat Smoot-Hawley!Trade policy: Let’s not repeat Smoot-Hawley! E.g., the Buy America provisionE.g., the Buy America provision Mexican trucksMexican trucks

30

The The nextnext crisis crisis

The twin deficits:The twin deficits: US budget deficit => current account deficitUS budget deficit => current account deficit

Until now, global investors have happily financed US Until now, global investors have happily financed US deficits.deficits.

The recent flight to quality paradoxically benefited the The recent flight to quality paradoxically benefited the $,$, even though the international financial crisis originated in the US.even though the international financial crisis originated in the US. For now, US TBills are still viewed as the most liquid & riskless.For now, US TBills are still viewed as the most liquid & riskless.

Sustainable?Sustainable? How long will foreigners keep adding to their $ holdings?How long will foreigners keep adding to their $ holdings? The US can no longer necessarily rely on support of foreign The US can no longer necessarily rely on support of foreign

central banks, either economically or politically.central banks, either economically or politically.

3131

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)

.0

.1

.2

.3

.4

.5

.6

.7

.8

1980 1990 2000 2010 2020 2030 2040

USD

DEM/EUR

USD forecast

EURforecast

Tipping point in updated simulation: 2015

Simulation predicts € may overtake $ as early as 2015

3232

The 2001-2020 decline in The 2001-2020 decline in international currency status for the international currency status for the

$ would be only one small part of $ would be only one small part of a loss of power on the part of the US. a loss of power on the part of the US.

But: But: A loss of $’s role as #1 reserve currency A loss of $’s role as #1 reserve currency could in itself have could in itself have geopolitical geopolitical implicationsimplications. . [i][i]

Precedent: The Precedent: The Suez crisis of 1956Suez crisis of 1956 is often recalled as the occasion on whichis often recalled as the occasion on which

Britain was forced under US pressure to Britain was forced under US pressure to abandon its remaining imperial designs. abandon its remaining imperial designs.

But recall also the important role But recall also the important role played by a simultaneous run on the played by a simultaneous run on the ££ and the American decision not to help and the American decision not to help the beleaguered currency. the beleaguered currency.

[i][i] Frankel, “Could the Twin Deficits Jeopardize US Hegemony,” Frankel, “Could the Twin Deficits Jeopardize US Hegemony,” Journal of Policy ModelingJournal of Policy Modeling, 28, no. 6, Sept. 2006.  , 28, no. 6, Sept. 2006.  At At http://ksghome.harvard.edu/~jfrankel/SalvatoreDeficitsHegemonJan26Jul+.pdfhttp://ksghome.harvard.edu/~jfrankel/SalvatoreDeficitsHegemonJan26Jul+.pdf . .

Also “The Flubbed Opportunity for the US to Exercise Global Economic Leadership”;  Also “The Flubbed Opportunity for the US to Exercise Global Economic Leadership”;  in in The International Economy, The International Economy, XVIII, no. 2, Spring 2004XVIII, no. 2, Spring 2004 at http://ksghome.harvard.edu/~jfrankel/FlubJ23M2004-.pdfat http://ksghome.harvard.edu/~jfrankel/FlubJ23M2004-.pdf

33

““Be careful what you wish for!”Be careful what you wish for!”US politicians have not yet learned US politicians have not yet learned

how dependent on Chinese financing how dependent on Chinese financing we have become.we have become.

Jeffrey FrankelJeffrey FrankelJames W. Harpel Professor of Capital James W. Harpel Professor of Capital

Formation & GrowthFormation & GrowthHarvard Kennedy SchoolHarvard Kennedy School

http://ksghome.harvard.edu/~jfrankel/ihttp://ksghome.harvard.edu/~jfrankel/index.htmndex.htm

Blog: Blog: http://content.ksg.harvard.edu/blog/jeff_frankels_whttp://content.ksg.harvard.edu/blog/jeff_frankels_weblog/eblog/