IP6001 Seminar 1 The Causes of, and Responses to, the Global Financial Crisis

1. IP6001 Seminar 1 The Causes of, and Responses to, the Global Financial Crisis

2. PART ONE – CAUSES OF & RESPONSES TO THE FINANCIAL CRISIS • Causes of the Credit Crisis • Causes of the Great Recession beyond the Credit Crisis • US Policy responses to the Economic Downturn

3. PART TWO – CAUSES OF & RESPONSES TO THE EUROZONE CRISIS • Causes of the Eurozone Crisis • Responses to the Eurozone Crisis

4. PART THREE – WHAT ELSE COULD HAVE BEEN DONE? • Should any other Policy Instruments have been implemented?

5. PART ONE

6. Main Causes of Credit Risk in 2008 • Policy Mistakes • Weak Regulatory and Supervisory Frameworks • Growth of Imbalances situation in US

7. Policy Mistakes • Glass-Steagall Act ‘33 - Separated commercial & investment banks • Established as a response bank failure during the Great Depression • Over the years, financial communities and lobbies lead to the eventual repeal of the Act in ’99 • US banks are allowed to take risky assets. • Moral hazard

8. Weak Regulatory & Supervisory Frameworks • The interconnected flow of the US mortgage market • Selling debt to large investment banks and GSEs (Fannie & Freddie). • Banks and GSEs pooled debt and sold to investors around the world (securitization) • Fall of housing prices and rising defaults on subprime mortgage in 2007  many individuals mortgages-holders did not make payments • “Underwater” - the amount of mortgage debt was greater than value of home. MBSs became “toxic assets”

9. Weak Regulatory & Supervisory Frameworks • Potential collapse of large financial institutions • Governments acted in some cases to prevent systematic collapse (AIG, etc.) • Other institutions were allowed to fail (Lehman Brothers) • Weak regulation of subprime mortgage • Limited or no oversight of “shadow banking system”

10. The Growing Imbalances in US • Asia, oil producing and other developing countries have large account surplus, while large deficit has occurred in US. • Imbalances situation leads to increased in saving rates in countries surpass domestic investment. • Surplus in Asia is channeled to purchasing activities of US treasuries , further causing credit boom in US .

11. Was the credit crisis the sole causes to the recession in 2009? BREAD PPT DESIGN

12. CONTENTS The high price of oil 1 Expectation of society: too optimistic economic forecast 2 Globalization 3

13. The Rising Price of Oil

14. The Rising Price of Oil

15. The Rising Price of Oil

16. The Rising Price of Oil • The percentage of wages is much higher than the percentage of GDP. • Most of the higher costs will eventually have to be paid for by individuals, through higher taxes or higher prices on goods or services.

17. The Rising Price of Oil Their salaries didn’t increase the same percentage as GDP, and in fact, the wage rose much slower than GDP.

18. The Rising Price of Oil • Then what will consumers do facing this situation ? • They had to cut down their expenditure, in order to save money to pay for their daily expenses, especially during the time of great recession when everyone feared about the future. Frustrating expectation. • CONSUMPTION DECLINED

19. The Rising Price of Oil

20. The Rising Price of Oil

21. The Rising Price of Oil A domino effect began

22. The Rising Price of Oil

23. The Rising Price of Oil The domino effect still went on Government spending

24. The Rising Price of Oil

25. The Rising Price of Oil • To sum up: • The rising price of oil led the prices of goods and services to go up, salary constant----consumption decreased. • Businesses had to lay off their workers or close their doors completely, which led to high unemployment rate and less investment. • Further, facing with the higher unemployment rate, the government had to pay more unemployment benefits and collect few taxes, which led to the decrease of government spending. • All these consequences helped cause the great recession.

26. Expectation of society: Too optimistic economic forecast

27. Too optimistic economic forecast • Early in February, 2007, New Century Financial Corporation issued a profit warning for the fourth quarter of 2006 and in April, it finally declared bankruptcy. • HSBC Holdings increased $1.8 billion of bad debts for the subprime mortgage business in United States.

28. Too optimistic economic forecast Lack of Government action

29. Too optimistic economic forecast • The government did not take action immediately until in August 2007. • Economists: In the middle of 2007, they estimated that financial institutions might lose a total of $150 billion on subprime mortgages, but they thought it was not a lot compared to the U.S. annual GDP of $14 trillion. • The optimistic economic forecast aggravated the financial crisis caused the great recession in 2009.

30. Globalization • “if the US sneezes, the rest of the world catches a cold”. • In terms of global financial system, before the financial crisis, the mortgage-backed financial instruments, like CDOS and MBS had been marketed globally to other countries

31. Globalization • As for global trade system, America is the important importer in the world. As the financial crisis happened, the consumption in U.S. went down dramatically, which led the government to decrease its import from other countries.

32. Globalization • In terms of the stock market, as the Dow Jones Index of stock prices plunged substantially, loads of stock markets around the world also experienced a sharp plunge.

33. What economic policies have been adopted in the main industrial countries to deal with the downturn?

34. International Response “…the overarching risk is that further delays in implementing policies to stabilize financial conditions will inevitably lead to an intensification of the negative feedback loops between the real economy and the financial system.” (IMF, 2009, G20 Global Economic Policies and Prospects) Need for coherent national, regional, and int’l strategies.

35. International Response Types of response: fiscal stimulus, tax cuts, and adjustments to government spending. G20 Countries Response: Implemented stimulus packages of 1.5% of world GDP in ‘09 and 1.25% of GDP in ’10 ½ cut personal income taxes 1/3 cut indirect taxes; excise and value added ¾ increased government expenditures on infrastructures

36. Asia Response TJ Pempel Seminar – August 7, 2013 Largely immune Avoided risky financial instruments & maintained regulatory control Regionalization focus of trade and finance China became #1 destination for regional exports

37. Asia Response Yet, Asia not completely immune, and many countries have implemented new policies. Japan - Abenomics 3 Arrows: 1 – Quantitative Easing 2 – Fiscal flexibility 3 – Structural reforms

38. US Response 4 Main Strategies: Bailouts Fiscal Stimulus Monetary Policy Regulatory/Legislative

39. US Response Bailouts: Emergency Economic Stabilization Act of 2008 Troubled Asset Relief Program (TARP) “Too big to fail”

40. US Response Major TARP Recipients: $70B committed to AIG $12.5B for “Asset Guarantee Program” >$80B for the auto industry >$420B total CNN-Money Bailout Tracker

41. US Response Response to Bailouts: “If they’re too big to fail, they’re too big.” -- Alan Greenspan “By any objective standards, the Troubled Asset Relief Program worked: it helped stop widespread financial panic, it helped prevent what could have been a devastating collapse of our financial system.” -- Says Who?

42. US Response Response to Bailouts: “If they’re too big to fail, they’re too big.” -- Alan Greenspan “By any objective standards, the Troubled Asset Relief Program worked: it helped stop widespread financial panic, it helped prevent what could have been a devastating collapse of our financial system.” -- US Treasury Dept

43. Response to Bailouts: As of July 2013: US taxpayers have recovered 95% of funds

44. US Response Fiscal Stimulus: American Recovery and Reinvestment Act of 2009 Goal: preserve jobs, increasing governmental investments, stabilize state and local budgets, assist those most impacted by the recession.

45. US Response Fiscal Stimulus: Transparency website: www.recovery.gov Initial $787B in stimulus promised later increased to $840B Three broad categories for funds: Tax benefits and cuts ($290.7B) Entitlement programs ($253.5B) Funding for grants and loans ($256.6B)

46. US Response Fiscal Stimulus: Keynesian strategy “…the government should actively stimulate aggregate demand when aggregate demand appeared insufficient to maintain production at its full-employment level.” (Mankiw, p. 794)

47. US Response Fiscal Stimulus Response: Political split – right vs. left Some say not enough stimulus! “…The centerpiece of Obama’s economic strategy, the American Recovery and Reinvestment Act, was the biggest job-creation program in U.S. history – but it was also woefully inadequate to the task.” (Krugman, “End This Depression Now!, 2012, p. 109)

48. US Response Monetary Policy: “Whatever it takes” – Ben Bernanke

49. US Response Monetary Policy – The Fed Duel mandate – maximizing employment and ensuring price stability Goal of “conventional” monetary policy - achieve low and stable inflation using the instrument of short-term interest rates to achieve target inflation.

50. US Response Monetary Policy – The Fed Interest Rate Policy Federal Fund Rate = the overnight rate banks can lend to other banks with deposits at the Federal Reserve. Discount Rate = the rate banks can borrow directly from the Fed Low Rates  cheaper for banks to borrow from each other and from the Fed  easier for banks to make more loans.