The Global Financial Crisis and the Slow Recovery An Overview by Assaf Razin

1. The Global Financial Crisis and the Slow Recovery An Overview by AssafRazin Tel-Aviv University and Cornell University January 1, 2010

2. Current Global Crisis: 3 Acts • Act I: Credit-fed Asset Bubble • Act II: Financial Collapse after the Burst of the bubble • Act III: spill overs to the real economy

3. Under currents • Financial innovation, globalization, and reduced transparency in the financial sector • Panicky in free fall of asset prices • Under capitalized banking system and credit crunch

4. Historical Precedents? • The great depression? • Japan in the 1990s? • Sweden in the 1980s? • The saving and loan crisis in the US in the 1980?

5. Percentage decline in employment in recessions since 1970

6. History Carmen Reinhart of Maryland and Ken Rogoff of Harvard, have recently published an analysis of the current financial crisis in the context of what they identify as the previous 18 banking crises in industrial countries since the second world war. They find what they call "stunning qualitative and quantitative parallels across a number of standard financial crisis indicators" - the common themes that translate these individual dramas into the big-picture story of financial boom and bust. Their study is focused on the US, 6

7. Banking Crises BANKING CRISES ARE PROTRACTED, THEY NOTE, WITH OUTPUT DECLINING, ON AVERAGE, FOR TWO YEARS. ASSET MARKET COLLAPSES ARE DEEP, WITH REAL HOUSE PRICES FALLING, AGAIN ON AVERAGE, BY 35 PER CENT OVER SIX YEARS AND EQUITY PRICES DECLINING BY 55 PER CENT OVER 3½ YEARS. THE RATE OF UNEMPLOYMENT RISES, ON AVERAGE, BY 7 PERCENTAGE POINTS OVER FOUR YEARS, WHILE OUTPUT FALLS BY 9 PER CENT.

8. Banking crises: follow ups

9. US Bank Failures

10. in deep slumps monetary expansion just piles up in bank reserves

11. Monetary Policy and Asset Prices • During the past quarter century, monetary authorities in developed countries have remarkably successful in reducing and stabilizing inflation. • This phenomenon is coined” the great moderation”

12. Irrational exuberance • A common view was that asset prices are driven by exogenous shocks to investor beliefs or preferences that have little to do with underlying macro fundamentals. • Greenspan, famously used the phrase irrational exuberance

13. Asset prices reflect expectations about economic growth • An alternative view is that asset markets • Reflect evolving beliefs about the long term prospects for the economy, particularly trends about growth, rather than Irrational exuberance, which describe an exogenous shock to investor beliefs

14. Fluctuations in asset markets • The same period, however, has seen major fluctuations in asset markets. • The equity bull markets during the 1980s and the 1990s, • the boom and bust in technology stocks during the late 1990s and early 2000s, • And the dramatic rise in hose prices that busted into the “great recession “

15. Early Warning • In 2006 there were warning predictions: from a few studies : • Ceccheti, in an empirical study, finds strong linkages between housing markets and the macroeconomy. Housing booms predict strong economic growth in the near term, weak economic growth in the longer term, and relatively high inflation.

16. Financial accelerator and inflation targeting • Gilchrist and Saito , use in the model the financial accelerator model : high asset prices increase the collateral of entrepreneurs and lower the external cost of funds for investment. • They find, using standard loss function, that a policy of aggressive inflation targeting is less than ideal because, while stabilizing inflation, it allows the financial accelerator to destabilize output.

17. Two historical precedents The Great Depression in the 1930s The Japanese Deflation(Mid -90s) The shocks that played a role in each: (1)An asset price correction, in real estate and equities (reducing consumption through a “wealth effect”) (2)Impairmaint of financial institutions’ balance sheets (reducing credit)

18. US GDP: The Cycles

19. Great Depression

20. Japan’s Stock-Market Roller Coaster

21. Tracking the Great Depression by months into the Crisis Eichengreen and O’Rourke point out that the original Great Depression was most severe in America, while this one is more severe in a number of other countries.

22. Chronology of Crisis Summer of 2007 Distress in financial markets from the subprime problem May 2008 Bear Stearns crushed and forced to be sold to JP Morgan Sept 15 2008—Lehman Brothers went belly up. Sept 16, 2008: A.I.G. is effectively nationalized Sept 18, 2008—Bank of America bought Merril Lynch. December 2008—the Federal Reserve cuts interest rates virtually to zero

23. Understanding what’s going on is Like shooting at a moving target Housing bubble. Subprime mortgage crisis Financial sector’s toxic assets Liquidity crisis Zero interest rate. Unconventional central banking Liquidity trap?

24. The Current Crisis vs. the Great Depression (1) Both crises followed asset bubbles. (2) Both crises started in the financial sector and gradually spread to the real sector. During both crises many financial institutions either defaulted or had to be bailed out. (3)In both cases the crisis appears to have started with the bursting of a bubble. (4) In both cases banking credit dried up. (5) In both cases the lower zero bound on the policy rate became effective. (6) In both cases the crisis started in the US and then US and subsequently spread to other countries.

25. Key Differences 1. Responses of both fiscal and monetary policies today are much swifter and vigorous than they were during the first three years of the great depression The deficit declined in fiscal 1935 by roughly the same amount it had risen in 1934. The US was on a gold standard throughout the Depression. In April 1933, Rosevelt temporaryily suspended the convertibility to gold and let Dollar depreciate substantially. When US went back on gold at the new higher price of gold, large quantities of gold flowed in and caused expansion of money supply. The expansion of money broke expectations of deflation. .

26. Budget Balance and Monetary Base 2. Hoover’s Federal budget was largely balanced; budget deficit in the current crisis is 8-10 percent of GDP. Friedman and Schwartz (1963) claim that, during the first three years of the great depression, the Fed tolerated and even reinforced a substantial shrinkage of the money The monetary base was flat during 1929-33; it was doubled during 2008.

27. Differences 3. Unemployment: in 1930: 25 %; in May 2009 9.4% Change in output: 1929-(peak) to 1933 (trough) -25%; 2007 (peak) last qtr 2008 (before trough) – 2% Change in prices: 1929-1934: deflation; 2008-9: low inflation/deflation? See next slide

28. The graph, from the Cleveland Fed, shows inflation as gauged by the consumer price index and by a measure called the median CPI. As every grade school student learns when the teacher reports results of the latest test, the average of any data set can be thrown off by a few extreme outliers; the median is a more robust statistic to estimate the central tendency in the data.

29. Monetary institutions 4. There are two important differences in monetary institutions: First there was no banking deposit insurance at the time. As a matter of fact deposit insurance was introduced only afterRoosevelt became president in March 1933. .

30. Gold Standard the5. US was in the great depression on the gold standard. The maintenance of a fixed parity with gold collided with the use of monetary policy to offset domestic unemployment during the first three years of the great depression. For this reason theUS abandoned the gold standard underRoosevelt. Obviously, since the $ is floating vis-à-vis other major currencies, no such constraint operates in the current crisis.

31. Contractionary Policies under the Gold Standard Central banks discount rates in the US, UK and Germany, in the late 1920s and early 1930s were pushed up to prevent gold leakages. The good news is that we donot have the Gold Standard now. But East European countries in crisis are now jacking up interest. Especially those who are trying to enter the Euro zone.

32. Informational capital 5. Fourth, the fact that a relatively large number of banks disappeared during the great depression led to the destruction of banking “informational capital” about the credit worthiness of potential borrowers.

33. Tariff War 6. The great depression was characterized by beggar thy neighbor policies. In mid 1930 the US Congress passedthe Smoot-Hawley Tariff Act that raised tariffs on over 20,000 imported goods to record levels. Othercountries retaliated by also imposing restrictions on imports and engaged in competitive devaluations. This led to a serious contraction of international trade.

34. The recession tracks the Great Depression

35. Irving Fisher’s debt deflation • As the great American economist Irving Fisher pointed out in the 1930s, the things people and companies do when they realize they have too much debt tend to be self defeating: when every one tries to do them, AT THE SAME TIME, the attempts to sell assets and pay off debt deepen the plunge in asset prices. This further reduces a net worth and the process repeats itself.

36. Keynes’ Metaphor for a Bubble Consider beauty competitions famously described by John Maynard Keynes, in which the winner was the contestant who chose the six faces most popular with all contestants. The result, Keynes observed, was that the task was not to choose the most beautiful face, but the face that average opinion would think that average opinion would find the most beautiful. In this way beliefs feed on themselves and become divorced from any underlying reality.

37. The Basics of Banks • Banks are in the business of borrowing short and lending long • They create credit that allows the real economy grow • When one or more banks experience a solvency problem due to non performing

38. Liquidity crisis • Loans, bank run is possible. If a liquidity crisis erupts that can bring down other banks by a collective movement of distrust

39. THE LENDER OF LAST RESORT The role of lender of last resort was classically defined by Walter Bagehot. His great book Lombard Street was published in 1873, and set out what has become the guiding mantra for central banks in times of crisis ever since: lend freely at high rates against good collateral. Lend freely, in his words, "to stay the panic". At high rates, so that "no one may borrow out of idle precaution without paying well for it". And lend on all good banking securities to an unlimited extent - because the "way to cause alarm is to refuse someone who has good security to offer". 39

40. Moral Hazard • Large systematically important banks are able to obtain cash at near zero interest rate and engage in risky arbitrage activities. They know that the “invisible wallet” of the taxpayer stands behind them, to bail the banks out in case of a crisis.

41. Investment Banks By forcing the fourth largest investment bank, Lehman Brothers, into bankruptcy and Merrill Lynch into a distressed sale to Bank of America, they helped to facilitate a badly needed consolidation in the financial services sector. However, at the 2008 juncture, the credit crisis radiated out into corporate, consumer and municipal debt. Regardless of the Fed and Treasury’s most determined efforts, the political pressures for a much larger bail-out, and pressures from the continued volatility in financial markets, are going to be irresistible.

42. Bail Outs the financial crisis has probably already added at most $200bn-$300bn to net debt, taking into account the likely losses on nationalising the mortgage giants Freddie Mac and Fannie Mae, the costs of the $29bn March bail-out of investment bank Bear Stearns, the potential fallout from the various junk collateral the Federal Reserve has taken on to its balance sheet in the last few months, and finally, Wednesday’s $85bn bail-out of the insurance giant AIG.

43. Repo market and liquidity In repo agreements borrowers transfer securities to lenders with an agreement to repurchase them later, often the next day. They enable banks and shadow banks to fund long-term, high-yield investments with short-term low-cost loans – which they did enthusiastically during the credit bubble: by 2008 the top US investment banks funded half their balance sheets in a repo market exceeding $10,000bn.

44. What is a Bank? Banks take people’s money, promise to give it back on demand – and lock it up in less liquid investments. This works marvellously while few enough lenders want their money back. It collapses when all want to hoard their cash at the same time. That is what happened to Lehman Brothers: the equivalent of a bank run in the repo market.

45. Lehman as a Custodian The panic was made worse, the Fed thinks, by the custodians’ exposure to losses as Lehman’s lenders left it to its fate. Custodians also faced conflicts of interest as counterparties to the repo-funded banks in other markets.

46. Limited Liability • The core of the crisis lies in the legal provisions of limited liability: creditors have no claims against the personal assets of the owners (shareholders). These liability constraints lead to a systematic disregard of systemic disaster risks-ocurrences only with a small probability about gigantic losses.

47. Risk taking bahavior • Investors that opt for high-risk projects with high potential gains and losses instead of safe projects with similar average profits, can expect to gain, since they only have to bear a portion of the possible losses. If things go well, investors reap the full profit. If things go badly, at worst their losses are limited by the stock of equity they invest.

48. Moral Hazard A HOUSE INSURED FOR MORE THAN ITS VALUE IS ALWAYS CONSIDERED A FIRE RISK. BUT HOME INSURANCE IS REGULATED AND ARSON IS A CRIMINAL OFFENCE THAT KEEPS PEOPLE HONEST, MOST OF THE TIME

49. Bank recapitalization A severe fall in the market value of a financial institution's assets raises the risk and lowers the market value of its debt, as well as its equity. Bringing in new equity capital produces an equal (dollar for dollar) increase in the market value of assets. This lowers the risk and raises the market value of the institution's debt. As a result, part of the new equity capital shows up not as equity but as a transfer to debt holders. (This is the debt overhang problem.)

50. Who pays for the transfer? Not the new private stockholders. They will not invest unless they get stock with market value at least equal to the funds they provide. This means the transfer of wealth to the old debt holders must come from the old stockholders. They pay via the dilution of their ownership share (and the drop in the share price) caused by bringing in new equity.