The Worst Financial Crisis in 75 Years: Origins, Magnitude,

8/14/2019 The Worst Financial Crisis in 75 Years: Origins, Magnitude,

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The Worst Financial Crisisin 75 Years: Origins, Magnitude,

Response and Lessons

Jeffrey Frankel

James W. Harpel Professor of Capital Formation & GrowthHarvard Kennedy School

Wellesley Country Club, March 26, 2009

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Origins of the crisis

Well before 2007,there were danger signals in US:

Low interest rates 2003-04 ;

Early corporate scandals (Enron);

Risk was priced very low, housing prices very high,

National Saving very low,

current account deficit big,

leverage high,

mortgages imprudent


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Six root causes of financial crisis US corporate governance falls short of its billing

E.g., rating agencies;

executive compensation(options; golden parachutes).

US households save too little, borrow too much.

Politicians slant excessively toward homeownershipTax-deductible mortgage interest; FannieMae; Allowing NINJA loans

Starting 2001, the federal budget was set on a reckless path Reminiscent of 1981-1990

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

Financial market participants during this periodgrosslyunderpriced risk risks: housing crash, $ crash, oil prices, geopolitics.

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Monetarypolicy easy

2004-05

Federal

budget

deficits

Underestimated

riskinfinancial mkts

Failures of

corporate

governance

Householdssaving too little,

borrowing too

much

Excessive leverage in

financial institutionsStock

market

bubble

Housing

bubble

Stock

market

crash

Housing

crashFinancial crisis2007-08

Chinas

growth

Lownational

saving

Lower long-

term

econ.growth

Eventual loss

of US hegemony

Recession2008-09

Oil

price

spike2007-08

Gulf

insta-

bility

Foreign

debt

Origins of the financial/economic crises

Excessive

complexity

CDSsMBSs

CDOs

Predatory

lending

Homeownership bias


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Onset of the crisis Initial reaction to troubles:

Reassurance in mid-2007: The subprime mortgage crisisis contained. It wasnt.

Then, The crisis is in Wall Street, sparing Main Street.It didnt.

Then de-coupling:

The US turmoil will have less effect on the restof the world than in the past. It hasnt.

By now it is clear that the crisis is

the worst in 75 years,

and is as bad abroad as in the US.

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The return of Keynes

Economists still shy awayfrom using the name.

But Keynesian truths abound today:

Origins of the crisis

The Liquidity Trap

Fiscal response

Motivation for macroeconomic intervention:to save market microeconomics

International transmission


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

Like Keynes animal spiritsor beauty contest .

Add in Fishers debt deflation,the Minsky moment,and von Hayeks credit cycle

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

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

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US Recession

In December 2008, NBER Business

Cycle Dating Committee proclaimed

US recession had started in December 2007.

As of March 2009, the recessions length ties thepostwar record of 1981-82 (16 months). Recovery unlikely before late 2009

=> recession is already longest since 1930s.

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


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BUSINESS CYCLE REFERENCE DATES Source: NBER

Peak Trough ContractionQuarterly dates are in parentheses Peak to Trough

August 1929 (III)May 1937 (II)February 1945 (I)November 1948 (IV)July 1953 (II)August 1957 (III)

April 1960 (II)December 1969 (IV)November 1973 (IV)

January 1980 (I)July 1981 (III)July 1990 (III)March 2001 (I)December 2007 (IV)

March 1933 (I)June 1938 (II)October 1945 (IV)October 1949 (IV)May 1954 (II)April 1958 (II)

February 1961 (I)November 1970 (IV)March 1975 (I)

July 1980 (III)November 1982 (IV)March 1991 (I)November 2001 (IV)

4313811108

101116

61688

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

1945-2001 (10 cycles)17

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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 million jobs have been lost (3/09).

Payroll employment series Source: Bureau of Labor Statistics


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My favorite monthly indicator is totalhours worked in the economy

It confirms: US recession turned severe in September,

when the worst of the financial crisis hit(Lehman bankruptcy)

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Recession was soon transmitted

to rest of world:

Contagion: Falling securitiesmarkets & contracting credit. Especially in those countries with weak fundamentals:

Iceland, Hungary & Ukraine

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 alltrading partners through loss of exports.


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Forecasts

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downgraded again (Jan.28, 2009)


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The IMF has cut by half estimates for low-

& middle-income countries.

Jan.28, 09

2009Rev. vs.Oct.08

projection

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World Recession?

No generally accepted definition.

A fall in Chinas growth from 11% to 1%, e.g, is

obviously a recession.

Perhaps 6 % is as well (World Bank forecast, Mar. 2009)

Usually global growth < 2 % is considered a recession.

The World Bank in March forecast thatglobal growth would be negative in 2009,

for the first time since the 1930s.


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U.S. Policy Responses

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

Policy interest rates 0. (graph)

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

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

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

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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).


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Corporate spreadsbetween corporate & government benchmark bondszoomed after Sept. 2008

US

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Policy Responses,continued

Obama policy offinancial repair:

Infusion of funds has been more conditional,

vs. Bush Administrations no-strings-attached.

Some money goes to reduce foreclosures. Conditions imposed on banks that want help:

(1) no-dividends rule,

(2) curbs on executive pay,

(3) no takeovers, unless at request of authorities &

(4) more reporting of how funds are used.

But so far they have avoided nationalization of banks


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Secretary Geithner announced PPIP 3/23/09:Public-Private Partnership Investment Program

When buying toxic or legacy assets from banks,

their prices are to be set byprivate bidding(from private equity, hedge funds, and others),

rather than by an overworkedTreasury official pullinga number out of the air and risking that taxpayersgrossly overpay for the assets, as under TARP.

Policy Responses -- Financial Repair,cont.

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How much money is the governmentputting 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 Repair,cont.


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The PPIP was attacked from both sidesin part due to anger over AIG bonuses, etc.

But the stock market reacted very

positively, and some respected

commentators are supportive.

FT, Mar 25, 2009

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Desirable longer-term financial reforms Mortgages

Consumer protection, incl. standards for mortgage brokers

Fix originate to distribute model, so lenders stay on the hook .

Banks: make Basle capital requirements less cyclical

Extend bank regulation to near banks. Regulatory agencies: Merge SEC & CFTC.

Create a central clearing house for CDSs .

Credit ratings:

Reduce reliance on ratings.

Reduce ratings agencies conflicts of interest.


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Policy Responses,continued

Unprecedented US fiscal expansion. Obama proposed an $825 expansion

Version passed by Congress was just a bit worse.

Good old-fashioned Keynesian stimulus

Even the belief that spending provides more

stimulus than tax cuts has returned;

not just from Larry Summers,

for example,

but also from Martin Feldstein.

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Fiscal responseTimely, 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.


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Proposed fiscal stimulus also included

Tax cuts

Cut for lower-income workers

EITC,

child tax credit.

Fix for the AMT (for the middle class).

Other tax cuts demanded by Republicans But soon will need to return toward fiscal discipline

Let Bushs pro-capital tax cuts expire in 2011.

Economists want to substitute energy taxes for others.

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Motivation for macroeconomic intervention

The view that Keynes stood forbig 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 & Obamaselection by hoping for a new New Deal.

My view: faith in unfettered capitalist system has been shaken

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

Obamas economics are centrist, not far left.


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Dowe knowthis wont be another GreatDepression?

True, the origins were similar.

But one hopes we wont repeat the 1930s mistakes

Monetary response: good this time

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

Fiscal response: okay, but constrainedby inherited debt (and politics)

Trade policy: Lets not repeat Smoot-Hawley! E.g., the Buy America provision

Mexican trucks

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The next crisis

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

Until now, global investors have happily financed US deficits.

The recent flight to quality paradoxically benefited the $, even though the international financial crisis originated in the US.

For now, US TBills are still viewed as the most liquid & riskless.

Sustainable? How long will foreigners keep adding to their $ holdings?

The US can no longer necessarily rely on support of foreign centralbanks, either economically or politically.


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Simulation of central banks of reserve cur r ency hol di ngsScenario: 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)

Tipping point in updated

simulation: 2015

Simulation predicts may overtake $ as early as 2015

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The 2001-2020 decline in international currency

status for the $ would be only one small part of

a loss of power on the part of the US. But:

A loss of $s role as #1 reserve currency could in itselfhave geopolitical implications. [i]

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

Britain was forced under US pressure toabandon its remaining imperial designs.

But recall also the important roleplayed by a simultaneous run on the and the American decision not to helpthe beleaguered currency.

[i] Frankel, Could the Twin Deficits Jeopardize US Hegemony,Journal of Policy Modeling, 28, no. 6, Sept. 2006.

At http://ksghome.harvard.edu/~jfrankel/SalvatoreDeficitsHegemonJan26Jul+.pdf .

Also The Flubbed Opportunity for the US to Exercise Global Economic Leadership;

in The International Economy, XVIII, no. 2, Spring 2004 at http://ksghome.harvard.edu/~jfrankel/FlubJ23M2004-.pdf


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Be careful what you wish for!US politicians have not yet learned how dependenton Chinese financing we have become.

Jeffrey FrankelJames W. Harpel Professor of Capital Formation & Growth

Harvard Kennedy School

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

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

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