Transcript Understanding the Root Causes Of The global financial crisis

Understanding the Root Causes Of The
global financial crisis
A fatal combination
• Financial globalization
– Great increase in (two-way) capital flows across national borders
– Net flows from emerging market economies to advanced economies
(especially, U.S.)
• Financial deregulation
– Blurring of lines between commercial and investment banking
– Free international capital mobility across as a norm
– Allowing big banks to use their own risk models in determining
leverage
– The rise of an unregulated “shadow banking system”
– Lack of regulation of new financial products
• “Financial innovation,” esp. securitization
• Colletarallized debt obligations (CDO), credit-default swaps (CDS)
Greater liquidity and lower returns on traditional investments spur
risk-taking and high leverage.
Financial globalization: United States
flows
Source: Maurice Obstfeld (2011)
Financial globalization: Iceland and Ireland
stocks
Source: Maurice Obstfeld (2011)
Historical relationship between capital mobility
and crises
Source: Reinhart and Rogoff (2008)
The U.S. as a borrower: twin deficits
Source: Econbrowser, http://www.econbrowser.com/archives/2011/09/lost_decades_th.html
The appeal of financial innovation in housing
Who wouldn’t want credit markets to serve the cause of home ownership? So:
•
•
•
introduce some real competition into the mortgage lending business by allowing
non-banks to make home loans
let them offer creative, more affordable mortgages to prospective homeowners
not well served by conventional lenders.
enable these loans to be pooled and packaged into securities that can be sold to
investors
– reducing risk in the process.
•
divvy up the stream of payments on these home loans further into tranches of
varying risk
– compensating holders of the riskier kind with higher interest rates
•
•
call on credit rating agencies to certify that the less risky of these mortgage-backed
securities are safe enough for pension funds and insurance companies to invest in
just in case anyone is still nervous, create derivatives that allow investors to
purchase insurance against default by issuers of those securities.
How did financial innovation work?
Source:
http://www.thedeal.com/news
weekly/features/chain-offools.php
The result: a housing “bubble”
250
1000
900
200
800
150
600
Home Prices
500
100
400
300
Building Costs
Population
50
200
Interest Rates
0
1880
1900
1920
1940
1960
Year
Source: Robert Shiller, http://www.irrationalexuberance.com/.
1980
2000
100
0
2020
Population in Millions
Index or Interest Rate
700
How the crisis plays out: the collapse of
confidence and contagion
The death spiral:
reduction in housing prices
defaults on mortgages
reduction in CDO values and loss of confidence
reduction collateral values
reduction in ability to borrow short-term
need to sell off assets (deleveraging)
further reduction in asset values
…
freezing of financial markets: no-one want to lend to
anyone else (“flight to safety”)
Who or what is the culprit? (1)
• unscrupulous mortgage lenders who devised credit terms?
– such as “teaser” interest rates and prepayment penalties
– perhaps, but these strategies would not have made sense for lenders unless
they believed house prices would keep on rising
• a housing bubble that developed in the late 1990s?
– and the reluctance of Alan Greenspan’s Fed to burst it?
– even so, the explosion in collateralized debt obligations (CDOs) and other
securities went far beyond what was needed to sustain mortgage lending
– especially true of credit default swaps, which became an instrument of
speculation instead of insurance
• Irresponsible financial institutions of all types leveraging themselves to the
hilt in pursuit of higher returns?
• credit rating agencies that fell asleep on the job?
Who or what is the culprit? (2)
• high-saving Asian households and dollar-hoarding foreign central banks
that produced a global savings “glut”?
– which pushed real interest rates into negative territory, in turn stoking the U.S.
housing bubble while sending financiers on ever-riskier ventures
• macroeconomic policy makers who failed to get their act together and
move in time to unwind large and unsustainable current-account
imbalances?
• the U.S. Treasury, which played its hand poorly as the crisis unfolded?
– bad as things were, what caused credit markets to seize up was Paulson’s
decision to make an example of Lehman Brothers by refusing to bail it out.
– might it have been better to do with Lehman what he had already done with
Bear Stearns and would have had to do in a few days with AIG: save them with
taxpayer money.
• all (or none) of the above?
The “deeper” causes of the crisis: hypotheses
• Ideas
– Economists’ ideas on market efficiency, the virtues
of deregulation, and ineffectiveness/inefficiency
of government regulation
Was it economists and their ideas? (1)
The myth of a self-regulating, self-correcting market.
• Example: securitization
– in principle, allows diversification and distribution of risk
(tranched CDOs)
– But requires good models of risk, full information, absence
of agency/incentive problems…
Alan Greenspan:
"I made a mistake in presuming that the self-interests of
organizations, specifically banks and others, were such
that they were best capable of protecting their own
shareholders and their equity in the firms.” (October
2008)
Was it economists and their ideas? (2)
But there was no shortage of research on departures from benign
view of financial markets.
Literatures on:
• emerging market financial crises
• agency theory
• asymmetric information
• financial market bubbles
• self-fulfilling runs (“bank runs”)
• systemic risk
• behavioral finance
• …
Why did economists focus on single model at the expense of these
alternatives and ignore the consequences of their own research?
The “deeper” causes of the crisis: hypotheses
• Interests
– The capture thesis: the role of banks and special
interests (Simon Johnson)
The financial capture thesis
• Pursuit of policies that advance banks’ interests, due to
– lobbying
– financial contributions
– the revolving door
• When things go wrong, banks’ influence ensure they get
bailed out
– “too big to fail”
• Key: “a belief system” that associates public interest with
banks’ interests (S. Johnson)
– Note role of ideas again
The “financialization” of the economy
Source: Johnson (2009)
The “deeper” causes of the crisis: hypotheses
• Interests
– The compensation thesis: the role of GSEs
(Frannie and Freddie) in providing cheap housing
finance (Raghuram Rajan)
Growing inequality…
Source: Mother Jones online. http://motherjones.com/politics/2011/02/income-inequality-in-americachart-graph
…pushes government to provide cheap housing
finance?
Share of Frannie and Freddie in total outstanding mortgage backed securities
Source: Econbrowser, http://www.econbrowser.com/archives/2008/07/did_fannie_and.html.
But much of the dramatic appreciation in house prices
came in the two years after the GSEs began to contract.
S&P/Case-Shiller Composite 10 home price index
Source: http://www.econbrowser.com/archives/2008/07/did_fannie_and.html
Questions for future Research
• What are the fundamental causes of the proclivity of
modern economies to financial crises?
– contribution of ideas versus interests
• What does each theory say about avenues of
reform?
• What is/should be the role of economic thought?