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

The Global Financial Crisis and
the Slow Recovery
An Overview
by
Assaf Razin
Tel-Aviv University and Cornell University
January 1, 2010
1
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
2
Under currents

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Financial innovation, globalization, and
reduced transparency in the financial
sector
Panicky in free fall of asset prices
Under capitalized banking system and
credit crunch
3
Historical Precedents?


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
The great depression?
Japan in the 1990s?
Sweden in the 1980s?
The saving and loan crisis in the US in the
1980?
4
Percentage decline in
employment in recessions since
1970
5
History

6
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 financia
crisis indicators" - the common themes that
translate these individual dramas into the big6
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.
7
Banking crises: follow ups
8
US Bank Failures
9
in deep slumps monetary
expansion just piles up in
bank reserves
10
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”
11
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
12
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
13
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 “
14
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.
15
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.
16
Two historical precedents
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
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17
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)
US GDP: The Cycles
18
Great Depression
19
Japan’s Stock-Market Roller
Coaster
20
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.
21
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.



Sept 18, 2008—
Bank of America
bought Merril
Lynch.
December 2008—
the Federal
Reserve cuts
interest rates
virtually to zero
22
Understanding what’s going on is
Like shooting at a moving target



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Housing bubble.
Subprime
mortgage crisis
Financial sector’s
toxic assets
Liquidity crisis



Zero interest rate.
Unconventional
central banking
Liquidity trap?
23
The Current Crisis vs. the Great
Depression


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(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 .
24
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. .
25
Budget Balance and Monetary
Base



2. Hoover’s Federal budget was largely
balanced; budget deficit in the current crisis is 810 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 .
26
Differences


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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
27
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.
28
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
after Roosevelt became president in March
1933 . .
29
Gold Standard

the 5. 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 the US abandoned the gold standard
under Roosevelt. Obviously, since the $ is
floating vis-à-vis other major currencies, no such
constraint operates in the current crisis.
30
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.
31
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 .
32
Tariff War

6. The great depression was characterized
by beggar thy neighbor policies .In mid
1930 the US Congress passed the SmootHawley Tariff Act that raised tariffs on
over 20,000 imported goods to record
levels. Other countries retaliated by also
imposing restrictions on imports and
engaged in competitive devaluations. This
led to a serious contraction of
international trade .
33
The recession tracks the
Great Depression
34
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.
35
Keynes’ Metaphor for a Bubble

36
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
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
37
Liquidity crisis
Loans, bank run is possible. If a liquidity •
crisis erupts that can bring down other
banks by a collective movement of distrust
38
THE LENDER OF LAST
RESORT

39
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".
39
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.
40
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.
41
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 .
42
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.
43
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.
44
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 repofunded banks in other
markets.
45
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 risksocurrences only with a small probability
about gigantic losses.
46
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.
47
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
48
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.)
49
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.
50
Value of old stock

If the market value of the old stock before
the equity issue is low, it may be
insufficient to cover the transfer of wealth
to debt holders that new equity capital
produces. As a result, the market value of
a stock issue would be less than the funds
provided, and the financial institution's
attempt to issue equity to meet its capital
requirement will fail.
51
Subsidy

If the Treasury steps in when the private
market refuses to provide equity capital to
a financial institution, we are in subsidy
land. Again, the subsidy arises because a
large part of the equity injection by the
government does not end up as
government (taxpayer) equity but rather
goes to prop up the financial institution's
debt holders.
52
Determinants of Global
Imbalances

Among the favoured determinants are low
US savings (stressed especially by
Feldstein 2008, 2009), Asia’s export-led
growth strategy, reserve build-up, and
exchange rate policies (discussed by
many, including Bibow 2008, Obstfeld and
Rogoff 2009,), and Asian “savings glut”
(highlighted by Bernanke 2005, 2007,
2008, Bini Smaghi 2008, Wolf 2008,
Greenspan 2010).
53
US as the main Deficit country

Ben Bernanke (2005) argued that the US
became the main deficit nation because of
its service as global safe haven and
reserve currency issuer, and because of
the rapid growth in US household wealth
from stock market gains and housing
appreciation. The wealth effect kept
savings low, perpetuating foreign
borrowing.
54
Flows of money

The flow of money into housing rather
equipment or, say, software was linked to
regulatory and supervisory gaps in
mortgage underwriting and securitisation
(Johnson and Kwak 2009).
55
The Global Picture a la Krugman

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we used to talk about the “subprime crisis” .
Today we know that subprime lending was only
a small fraction of the problem.
Ben Barnanke (2005), “The Global Saving Glut
and the U.S. Current Account Deficit,” offered a
novel explanation for the rapid rise of the U.S.
trade deficit in the early 21st century. The
causes, argued Bernanke, lay not in America but
in Asia.
56
Global Picture (Continued)

In the mid-1990s, Bernanke pointed out,
the emerging economies of Asia had been
major importers of capital, borrowing
abroad to finance their development. But
after the Asian financial crisis of 1997-98,
these countries began protecting
themselves by amassing huge war chests
of foreign assets, in effect exporting
capital to the rest of the world.
57
Global Picture (Continued)

Most of the Asia cheap money went to the
United States — hence our giant trade deficit,
because a trade deficit is the flip side of capital
inflows. But as Mr. Bernanke correctly pointed
out, money surged into other nations as well. In
particular, a number of smaller European
economies experienced capital inflows that,
while much smaller in dollar terms than the
flows into the United States, were much larger
compared with the size of their economies.
58
Global Picture (Continued)

wide-open, loosely regulated financial systems
characterized the US shaddow banking system
and mortgage institutions, as well as many of
the other recipients of large capital inflows. This
may explain the almost eerie correlation
between conservative praise two or three years
ago and economic disaster today. “Reforms have
made Iceland a Nordic tiger,” declared a paper
from the Cato Institute. “How Ireland Became
the Celtic Tiger” was the title of one Heritage
Foundation article; “The Estonian Economic
Miracle” was the title of another. All three
nations are in deep crisis now.
59
Global Picture (Continued)

For a while, the inrush of capital created the
illusion of wealth in these countries, just as it did
for American homeowners: asset prices were
rising, currencies were strong, and everything
looked fine. But bubbles always burst sooner or
later, and yesterday’s miracle economies have
become today’s basket cases, nations whose
assets have evaporated but whose debts remain
all too real. And these debts are an especially
heavy burden because most of the loans were
denominated in other countries’ currencies.
60
Global Picture (end)

Nor is the damage confined to the original
borrowers. In America, the housing bubble
mainly took place along the coasts, but when
the bubble burst, demand for manufactured
goods, especially cars, collapsed — and that has
taken a terrible toll on the industrial heartland.
Similarly, Europe’s bubbles were mainly around
the continent’s periphery, yet industrial
production in Germany — which never had a
financial bubble but is Europe’s manufacturing
core — is falling rapidly, thanks to a plunge in
exports.
61
Imbalances and Crisis

Imbalances relaxed America’s credit
constraint and perpetuated low US real
interest rates that, in turn, stoked
borrowing and the housing bubble
Bernanke 2008, Caballero et al. 2008,
Dunaway 2009, Obstfeld and Rogoff 2009,
IMF 2009, Caballero and Krishnamurthy
2009, Blanchard and Milesi-Ferretti 2009,
Roubini 2009, Kohn 2010).
62
Global imbalances in 2010

With trade, credit, and commodity prices
recovering, the IMF (2010) recently
revised its projections of US currentaccount deficit to 3.3% of GDP in 2010
and 3.4% in 2011. Also UK, Canada,
Australia, India, Turkey, France, and
southern European nations are projected
to run steep trade deficits. The mirroring
surplus nations are the familiar China,
Japan, emerging East Asia, Germany, and
63
Europe vs. the US
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27 EU countries lack ways of boosting their overall fiscal and
monetary firepower by acting collectively.
Europe has fallen short in terms of both fiscal and monetary policy:
it’s facing at least as severe a slump as the United States, yet it’s
doing far less to combat the downturn.
On the fiscal side, America’s actions dwarf anything the Europeans
are doing.
Monetary policy: The European Central Bank has been far less
proactive than the Federal Reserve; it has been slow to cut interest
rates (it actually raised rates July 2008!), and it has shied away
from any strong measures to unfreeze credit markets.
The only thing working in Europe’s favor is the very thing for which
it takes the most criticism — the size and generosity of its welfare
states, which are cushioning the impact of the economic slump.
64
FDIC

If a bank cannot raise private equity to
meet its FDIC capital requirement, the
powers of the FDIC kick in. For example,
the FDIC can seize the bank and auction it
off. The bidders are typically other banks.
Acquiring a seized bank is often an
attractive option for a strong bank since it
can be a cost effective way to expand
deposits and acquire links to profitable
borrowers.
65
Price of acquiring a bank

The maximum price the acquiring bank
should be willing to pay is the market
value of the seized bank's assets minus
the seized bank's deposits. This net
amount is then distributed to the bank's
non-deposit liability holders, in order of
priority. What this means is that the
seized bank's stockholders and some of its
lower priority debt often get nothing.
66
Credit Crunch 2008
67
Interbank Lending’s Squeeze
68
68
Global Saving Glut



69
Behind this Global Saving Glut lie three
phenomena
1.–excess of retained profits (corporate
saving) over investment, of the corporate
sectors of the advanced countries,
2. --the persistent savings surpluses of a
number of mature economies, particularly
Japan and post-unification Germany.
69
Global imbalances
70
Currency reserves
71
The US moves into: debtor status,
and vast increase in crossholdings.

In 1996, on the eve of the Asian crisis, the
US had assets overseas equal to 52
percent of GDP, and liabilities equal 57
percent of GDP. By 2007, these numbers
were up to 128 percent and 145 percent,
respectively.
72
Risk sharing and globalization


This is change is supposes to reduce risk: US
investors held much of their assets abroad(less
exposed to a slump in the US); foreign investors
held much of their wealth in the US (they were
less exposed to a slump in their domestic
economies).
But, large parts of the increase in globalization
came from investments in highly leveraged
financial institutions (making various riskycross
border bets).
73
Four vicious cycles

74
“Four vicious cycles are simultaneously
under way: falling asset prices are forcing
levered holders to sell, driving prices further
down; losses at financial institutions are
reducing their ability to finance investment,
which in turn reduces asset values, causing
further losses; the weakness of the financial
system is reducing growth, which in turn
weakens the financial system; and falling
output is hitting employment, which in turn
leads to reduced demand for output”—Larry
Debt accumulation and deflation in
the US

The big US debt accumulations were not by nonfinancial corporations but by households and the
financial sector. The gross debt of the financial
sector rose from 22 percent of GDP in 1981, to
117 percent of GDP in the third quarter of 2008;
the debt of non financial corporations rose from
53 percent to 76 percent, in the same period.
Thus, the desire of financial institutions to shrink
balance sheet may be a cause of the recession.
75
Akerlof’s Problem

When house prices started to decline, this
has had bigger effect on some MBS than
other MBSs, depending on the complexity
of the mortgages that backed the
securities. Owners of MBS have strong
incentive to price each an every one of
them. They have superior information
over the market buyers. As in Akerlof’s
Lemmons Problem, the market for MBS
will collapse.
76
Market illiquidity

The buyer hopes that the seller sells the
security because he needs cash. But the
buyer worries that the seller will unloads
the most troubled securities. This makes
the market illiquid.
77
Mortgage Finance


The common form of mortgage commits the household
to make equal monthly payments for 30 years. These
mortgages payy off with 10 years because households
sell the property or does refinance.
New model: The borrower applies to a mortgage broker,
receives money from a wholesale lender, and make
payments to a servicer. The servicer passes on each
payment to a master servicer, who pays it out to holders
of a mortgage-based-security (MBS), who pass it on to
the adminstrator of a collateralized debt obligation
(CDO), who passes it on to investors in CDOs.
78
Mortgage as option, not loan

This mortgage is therefore not a loan but
an option: it allowed for gains if house
prices rose, but cost relatively little if
prices fell.
79
Barriers to Lending


The Problem: most banks no longer hold the loans
they make, content to collect interest until the
debt comes due. Instead, the loans are bundled
into securities and sold to investors. But the
securitization market broke. The result is a
drastic contraction of credit available throughout
the economy.
Banks have come to depend on selling mortgages
and other loans to investors like hedge funds and
insurance companies. This allows banks to make
more loans and earn bigger profits.
80
Mortgage-backed Securities




How to value MBSs?
Imagine you bought a $100,000 house a year
ago, with a $10,000 down payment.
If the value of the house rises, you are “in the
money”.
If it falls, you can walk away. You loose the
original $10,000 investment, but are safe in the
knowledge that the lender cannot seize your
other assets. .
81
US Borrowings
82
US banks, undermine willingness
to expand credit, Destroy
Confidence
83
House Price Bubble
84
US GDP
85
US Unemployment
86
counterparty risk


DEFINITION:The risk that the other party
in an agreement will default. In an option
contract, the risk to the option buyer that
the writer will not buy or sell the
underlying as agreed.
In general, counterparty risk can be
reduced by having an financial
organization with extremely good credit
reputation which acts as an intermediary
between the two parties.
87
Investors behavior in the asset
bubble -“Disaster” Myopia : Equity
markets lost by 2009 all the gains
from the 1997-8 crises


A tendency to underestimate the probability of
disastrous outcomes, especially for lowfrequency events last experienced in the distant
past.
The risk of falling victim to this syndrome was
particularly acute in the recent period of unusual
economic stability known as the “great
moderation”. Investors were confronted by
falling yields against a background of declining
volatility in markets. Many concluded that a new
88
era of low risk and high returns had dawned.
Investors in FX markets: Carry
Trade—”depreciation myopia”

EQUALLY POPULAR WERE TRADING
STRATEGIES SUCH AS CARRY TRADES,
WHICH INVOLVED BORROWING AT LOW
INTEREST RATES AND INVESTING AT
HIGHER RATES, ESPECIALLY VIA THE
CURRENCY MARKETS. FAVOURITE TRADES
INCLUDED BORROWING IN JAPANESE
YEN TO INVEST IN AUSTRALIA OR NEW
ZEALAND, AND BORROWING IN SWISS
FRANCS TO INVEST IN ICELANDIC
ASSETS.
89
The danger in Carry Trade

Carry trade WAS DANGEROUS BECAUSE
THE INTEREST RATE SPREAD COULD BE
WIPED OUT IN SHORT ORDER BY
VOLATILE CURRENCY MOVEMENTS. YET
BECAUSE VOLATILITY REMAINED LOW
FOR SO LONG, DISASTER MYOPIA
PREVAILED. CARRY TRADERS WERE
LULLED INTO A FALSE SENSE OF
SECURITY, WHILE MORE SCEPTICAL
COMPETITORS JOINED IN FOR FEAR OF
UNDERPERFORMING.
90
The Credit Crunch



1. Overnight credit is blocked by the
asymmetric information held across banks
regarding each other’s assets’ quality.
2. Fear of the bank of being short of funds
to meet creditor demands; thus the bank
is reluctant to lend.
3. fear of the bank of being short of funds
if investment opportunities get better.
91
Moral Hazard



Moral hazard, a situation in which one person makes
a decision about How much risk to take while
someone else bears the cost if things go badly;
Treasury proposes to make low-interest, non-recourse, loans to
private investors who buy bad assets —this is a plan to drive up the
prices of toxic assets by creating a lot of moral hazard.
By offering low interest non-recourse loans, these public-private
entities can pay a higher than market price for the toxic assets
(since there is no downside risk). This amounts to a direct subsidy
from the taxpayers to the banks.
92
Four distinct economic
mechanisms that played a role in
the liquidity and credit crunch




1. . The effects of large quantities bad loan writedowns on borrowers' balance sheets caused two
"liquidity spirals“:
1a. As asset prices dropped, financial institutions not
only had less capital;
1b. financial institutions also had harder time borrowing,
because of tightened lending standards.
The two spirals forced financial institutions to shed
assets and reduce their leverage. This led to fire sales,
lower prices, and even tighter funding, amplifying the
crisis beyond the mortgage market.
93
Mechanisms (continued)



2. Lending channels dried up when banks, concerned
about their future access to capital markets, hoarded
funds from borrowers regardless of credit-worthiness.
3. Runs on financial institutions, as occurred at Bear
Stearns, Lehman Brothers, and others following the
mortgage crisis, can and did suddenly erode bank
capital.
4. The mortgage crisis was amplified and became
systemic through network effects, which can arise when
financial institutions are lenders and borrowers at the
same time. Because each party has to hold additional
funds out of concern about counterparties' credit,
liquidity gridlock can result.
94
The Geithner Public-private
scheme to buy toxic assets from
banks


One or more giant investment fund will be
created to buy up toxic assets.
Its balance sheet: for every $1 of toxic
assets they buy from banks, the FDIC will
lend 85.7 percent (6/7 th of $1), and the
US treasury and private investors will each
put 7.15 cents in equity to cover the
remaining balance.
95
The Geithner Public-private
scheme to buy toxic assets from
banks (continue)

The FDIC loan is non-recourse, meaning
that if the toxic assets purchased by
private investors fall in value below the
amount of the FDIC loans, the investment
fund will default, and the FDIC will end up
holding the toxic assets.
96
Tax payer giveaway in the Geithner
Plan





An Example (Jeff Sachs):
Consider a portfolio of toxic assets with a face value of
$1 trillion. Assume that they have a 20 percent chance
of paying out their full face value ($1 trillion) and an 80
percent chanceof paying out only $200 billion.
The market value of these assets is given by their
expected payout (.2x1+0.8x.2)=$360 billion.
Because the FDIC is lending money at a low (bidding up
the market value of toxic assets) interest rate on a nonrecourse basis is likely to experience a massive default
on the loan.
The FDIC subsidy subsidy shows up as a bid price for
the toxic assets as it above $360 billion.
97
Over pricing the toxic assets
through the government nonrecourse loan






Investor is prepared to bid $714, 000 for the the asset that a riskneutral would pay $360,000 only.
How is this number derived?
The investor uses $71,000 of her own money and $643,000 of the
government loan– adding up to $714, 000 bid.
If the asset pays in full, the investor repays the loan with a profit of
$357,000 (=$1,000000- $643,000) so that with 20 percent of the
time, which bring an expected profit of $71,000.
The other 80 percent of the time the investor defaults on the loan,
getting a profit of 0, and the government ends up with $200,000.
Summing up: the investor just breaks even by bidding $714, 000, as
would beexpected in competitive auction.
98
Price Discovery or Overpricing?

The idea of “price discovery” of the toxic
asset would be genuine if the government
loan has to be repaid whether or not the
asset paid of in full or not. But, with the
non-recourse loan it leads to overpricing
of the toxic asset.
99
Gaming the System: Jeff Sachs
Example

Consider a toxic asset held by Citibank
with a face value of $1 million, but with
zero probability of any payout and
therefore with a zero market value. An
outside bidder would not pay anything for
such an asset.
100
More..

Suppose, however, that Citibank itself sets
up a Citibank Public-Private Investment
Fund (CPPIF) under the GeithnerSummers plan. The CPPIF will bid the full
face value of $1 million for the worthless
asset, because it can borrow $850K from
the FDIC, and get $75K from the
Treasury, to make the purchase! Citibank
will only have to put in $75K of the total.
101
potential rip-off

Citibank thereby receives $1 million for the
worthless asset, while the CPPIF ends up with
an utterly worthless asset against $850K in debt
to the FDIC. The CPPIF therefore quietly
declares bankruptcy, while Citibank walks away
with a cool $1 million. Citibank's net profit on
the transaction is $925K (remember that the
bank invested $75K in the CPPIF) and the
taxpayers lose $925K. Since the total of toxic
assets in the banking system exceeds $1 trillion,
and perhaps reaches $2-3 trillion, the amount of
potential rip-off in the Geithner-Summers plan is
unconscionably large.
102
the insider-bidding route

The earlier criticisms of the Geithner-Summers plan
showed that even outside bidders generally have the
incentive to bid far too much for the toxic assets, since
they too get a free ride from the government loans. But
once we acknowledge the insider-bidding route, the
potential to game the plan at the cost of the taxpayers
becomes extraordinary. And the gaming of the system
doesn't have to be as crude as Citibank setting up its
own CPPIF. There are lots of ways that it can do this
indirectly, for example, buying assets of other banks
which in turn buy Citi's assets. Or other stakeholders in
Citi, such as groups of bondholders and shareholders,
could do the same.
103
Ersatz Capitalism?

Ersatz is a German word meaning compensation
or idemnity (or still, substitute). Ersatz
capitalism is when the government in effect
insure loses, so that loses are socialized but
gains are privatized. The Geithner plan would
not determine the fair price of toxic assets in the
ailing banks. It sets a mechanism to price
discovery on a “ put” on the toxic asset but not
on the “value” of the asset. Its success in
helping capitalize the banks is negatively related
to loses to tax payers.
104
Sources for charts: Robert Shiller,
Andrew Smithers; Thomson
Datastream
105
Just under half of corporate debt in
America was rated as “speculative”
(BB or below) at the end of 2008
106
Global Trends
107
Financial crises over the history
108
Global Crisis
109
US CREDIT MARKET
110
Volume of asset backed securities
111
House price index
112
Stimulus packages
113
No two fiscal packages are ever
launched amid the same
circumstances
It is wrong
to extrapolate
from the past!
114
Measuring the separate effect of any
One-off fiscal boost from the automatic
Extra spending that was anticipated
Is hard.
115
Fed Rate
116
Emerging stars buffeted by
global storm
117
Triggers of credit bubbles and
depression Economics
1. Moral hazard, a situation in which one person makes
a decision about How much risk to take while
someone else bears the cost if things go badly;
2. Self fulfilling panics, as in bank runs.
118
Credit Market : September 2008

financial institutions hold significant assets that are
backed by mortgage payments. Two years ago, many of
those mortgage-backed securities (MBS) were rated
AAA, very likely to yield a steady stream of payments
with minimal risk of default. This made the assets liquid.
If a financial institution needed cash, it could quickly sell
these securities at a fair market price, the present value
of the stream of payments. A buyer did not have to
worry about the exact composition of the assets it
purchased, because the stream of payments was safe.
119
Libor-OIS spreads reached 200
basis points in September 2008
when Congress failed to pass the
Paulson plan
120
Bank bailouts
121
Japan’s 1990s

Japan’s experience in the 1990s is
cautionary example of the peril of
propping up banks after a real estate
boom ends. The Japanese government
helped keep many troubled banks afloat,
hoping to avoid the pain of bank failures,
only to extend the economic downturn as
consumer spending and job growth fell.
122
Japan’s Banks

THE 1990 COLLAPSE OF AN ASSET
BUBBLE PROVOKED A SHARP FALL IN
THE VALUE OF PROPERTY AND
EQUITY THAT UNDERPINNED BANKS’
BALANCE SHEETS. BUT BANKS
IGNORED THEIR PROBLEMS UNTIL
1997 WHEN SANYO SECURITIES,
YAMAICHI SECURITIES AND
HOKKAIDO TAKUSHOKU BANK ALL
FAILED.
123
Japan’s Current Account
124
Reluctance to recapitalize by state
funds

A RELUCTANCE TO ADMIT THE SCALE OF THE
PROBLEM MEANT CAPITAL INJECTIONS TOOK
PLACE IN THREE MAIN TRANCHES. THE FIRST
CAME IN THE SPRING OF 1998, WHEN THE
GOVERNMENT INJECTED Y1,800BN ($18BN,
£11BN, €14BN) INTO 21 INSTITUTIONS. THE
MONEY, WHICH CAME IN THE FORM OF
PREFERENCE SHARES, HAD FEW STRINGS
ATTACHED. THE SECOND FOLLOWED THE
COLLAPSE IN 1998 OF NIPPON CREDIT BANK
AND LONG TERM CREDIT BANK. A TIGHTENING
OF RULES FORCED 32 INSTITUTIONS TO RAISE
CAPITAL AND IN 1999 TO ACCEPT GOVERNMENT
FUNDS TOTALLING Y8,600BN.
125
Conditions set by government

Conditions grew stricter. “The first time,
the government injections were very
generous, depending on the banks’ own
will. The second time was more forcible,”
says the former BoJ official. “The first
priority was that in a certain period they
had to return from red to black, second
was to lend to SMEs [small and mediumsized enterprises] and third was a host of
conditions, such as cutting their payroll,”
126
Non performing loans

By March 2005, non-performing loans
were at 2.9 per cent of banks’ total assets
from 8.4 per cent at the height of the
crisis.
127
Sweden in the 1990s

Sweden in the early 1990s took a middle
pathswiftly taking over many of its troubled
banks. The American bailout plan, economists
say, takes a page from the Swedish example by
making the government a shareholder in banks
participating in the program. But, they add, the
American banking system is so much larger and
diverse than Sweden’s that the parallels are
limited.
128
Capital injection and tax payers

In exchange for the capital injection by
the government, taxpayers might be
protected through preferred shares (or
warrants), giving them dividends in the
future.
129
Differences between bailout and
government spending

First, note that there is a major difference
between a program to support the
financial sector and $700bn in new
outlays. No one is contemplating that the
$700b in the Paulson plan will be given
away. All of its proposed uses involve
either purchasing assets, buying equity in
financial institutions or making loans that
earn interest.
130
2nd difference

Second, the usual concern about GOVERNMENT
BUDGET DEFICITS IS THAT THE NEED FOR
GOVERNMENT BONDS TO BE HELD BY INVESTORS
WILL CROWD OUT OTHER, MORE PRODUCTIVE,
INVESTMENTS OR FORCE GREATER DEPENDENCE
ON FOREIGN SUPPLIERS OF CAPITAL. TO THE
EXTENT THAT THE GOVERNMENT PURCHASES
ASSETS SUCH AS MORTGAGE-BACKED
SECURITIES WITH INCREASED ISSUANCE OF
GOVERNMENT DEBT, THERE IS NO SUCH EFFECT.
131
What’s Next?






Green Shoots?
Persistent and high unemployment?
Non functioning financial sector?
Debt overhang?
Inflation?
Prolong risk and volatility?
132
133
long-term interest rates: 2009
treasuries

Peak of panic is June 2009
134
The yield curve as a predictor of
future growth

This graph shows the difference between
the 10-year and 2-year yield on
Treasuries. In general, a steep yield
curve--that is, a high value of this
variable--is a positive indicator of future
economic growth. In many ways,
however, this is an unusual downturn, so
it is not entirely clear to what extent
historical relationships are a useful guide
going forward
135
Treasuries (May 2009) sell-off


The sell-off may reflect fears of future
inflation
The downgrade of treasuries in the
presence of huge US government debt
136
Paul De Grauwe on
Mcroeconomics

Take government budget deficits, which
now exceed 10 per cent of gross domestic
product in countries such as the US and
the UK. One camp of macroeconomists
claims that, if not quickly reversed, such
deficits will lead to rising interest rates
and a crowding out of private investment.
Instead of stimulating the economy, the
deficits will lead to a new recession
coupled with a surge in inflation.
137
Budget Deficits

Wrong, says the other camp. There is no
danger of inflation. These large deficits
are necessary to avoid deflation. A
clampdown on deficits would intensify the
deflationary forces in the economy and
would lead to a new and more intense
recession.
138
Monetary Policy I

take monetary policy. One camp warns
that the build-up of massive amounts of
liquidity is the surest road to
hyperinflation and advises central banks to
prepare an “exit strategy”.
139
Monetary Policy II

Nonsense, the other camp retorts. The
build-up of liquidity just reflects the fact
that banks are hoarding funds to improve
their balance sheets. They sit on this pile
of cash but do not use it to increase
credit. Once the economy picks up, central
banks can withdraw the liquidity as fast as
they injected it. The risk of inflation is zero
140
Does it Matter?

Take the issue of government deficits. If
you want to forecast the long-term
interest rate, it matters a great deal which
of the two camps you believe. If you
believe the first one, you will fear future
inflation and you will sell long-term
government bonds. As a result, bond
prices will drop and rates will rise. You will
have made a reality of the fears of the
first camp.
141
But…

But if you believe the story told by the
second camp, you will happily buy longterm government bonds, allowing the
government to spend without a surge in
rates, thereby contributing to a recovery
that the second camp predicts will follow
from high budget deficits.
142
Evidence?

One day, when green shoots are popping
up here and there, they believe the story
warning about inflation; the next day,
when the shoots turn brownish, they
believe the other story. Disagreements
among economists take away the
intellectual anchors around which market
participants interpret events and forecast
the future.
143
Forecasts are ambigous

Ultimately, all our forecasts use a
particular economic model to interpret
data and to forecast their future course.
The existence of wildly different models
takes away this intellectual anchor and
this translates into more market volatility.
144
Policy making under uncertainty

The two camps of economists have wildly
different estimates of the effect of a 1 per
cent permanent increase in government
spending on real US GDP over the next
four years. According to the first camp,
the Ricardians, the multiplier is closer to
zero than to one, ie 1 per cent extra
spending generates much less than 1 per
cent of extra GDP, producing little extra
tax revenue. Thus budget deficits surge
and become unsustainable.
145
What to do?

By contrast, the second camp, the
Keynesians, predict that the same 1 per
cent of extra government spending
multiplies into significantly more than 1
per cent of extra GDP each year until the
end of 2012. This is the stuff of dreams
for governments, because such multiplier
effects are likely to generate additional tax
income so that budget deficits decline.
146
US Consumer Spending:
Summer 2009



In previous post-world war II recessions,
inventory rebuilding contributed a third of
economic growth 12 months after the
recessions ended.
Household debt was on average 60
percent of GDP in previous post-world war
II recessions, in 2009 it is 128 percent of
GDP.
Consumption growth at the end of
previous post-world war II recessions was
147
“Credit easing” vs. “Quantitative
easing"
“Credit easing” reflects a focus is on the •
assets’ side of the banks’ balance sheet
“Quantitative easing”, reflects a focus on
the liabilities’
side of the banks’ balance sheet
148
•
Money Growth vs Credit
Growth: The Fed
The FED stopped tracking the broadest
measure of money supply in 2006; no
figures for the US in 2009.
Outstanding consumer credit has been
contracting from May to June, 2009 by 5
percent on an annual basis.
149
ECB
ECB, in contrast to the US Fed, does •
indeed pay attention to the growth of
Money
In fact, ECB broad money growth began to •
accelerate in 2009
150
US Productivity
Productivity soared by a higher-than- •
expected 6.4 per cent in the non-farm
business sector in the second quarter, its
highest level since 2003, as hours worked
fell faster than output
151
Asia: early exit from the
Recession
152
Eurozone
Germany and France, partly •
helped by its neighbour’s
stimulus, exited recession in the
second quarter of 2009. Both
countries’ 0.3 per cent quarter-onquarter growth yanked up the
eurozone as a whole to a mere
0.1 per cent contraction.
153
Japan
154
Spain can’t devalue to restore
lost competitiveness
UK Can! •
155
China has the world’s fastestgrowing economy and largest
current account surplus
156
Greece
Greece accounts for less than •
3 per cent of the eurozone economy. •
There is also a precedent.
Hungary, Latvia and Romania •
have all won •
EU and International Monetary Fund •
backing, albeit with tough conditions
attached.
157
Fed Balance Sheet
Exit from •
unconventional •
monetary policy. •
158
Israel Growth
159
China in a Dilemma
Having set in motion a credit and •
investment-fuelled recovery to
manufacture strong growth in the 60th
anniversary year of the People’s Republic,
China is beginning to face the
consequences.
160
Renminbi exchange rate
161
Policy switch
China lifted its currency peg in July 2005. •
It allowed the renminbi to appreciate by 21
percent over three years to mid-2008
when the peg was reinstated: the
“emergency setting” of the renminbi/dollar
peg, reimposed in July 2008. May 2010’s
export surge of almost 50 per cent from a
year earlier, the biggest in six years,
restored China’s monthly trade surplus
comfortably above its five-year average.
The basket of 2005 to 2008 returned in
June 21 2010, along with the same daily
162
US Base Money
Fed now pays interest on
reserves. As long as the
interest rate on reserves is
high enough, banks should
be happy to hold onto
those excess reserves.
163
Both reserves and T-bills are
interest-paying obligations of
the Federal government
(including the Federal
Reserve). perfect substitutes.
The standard way of reducing the monetary base is open
market operations. The Fed sells Treasury bills, say,
and drains reserves from the banking system, reducing
the monetary base. But consider what this means in the
monetary current regime. An open market operation
merely removes interest-paying reserves from a bank's
balance sheet and replaces them with interest-paying Tbills. What difference does it make? None at all.
164
Global Imbalances
China’s accumulation of foreign reserves,
many of which were invested in American
bonds, was arguably doing US a favor by
keeping interest rates low — although what
US did with those low interest rates was
mainly to inflate a housing bubble. But right
now the world is awash in cheap money,
looking for someplace to go. Short-term
interest rates are close to zero; long-term
interest rates are higher, but only because
investors expect the zero-rate policy to end
some day. China’s bond purchases make
little or no difference.
165
If China were to start selling
dollars?
Right now the world is awash in cheap
money. So if China were to start selling
dollars, there’s no reason to think it would
significantly raise U.S. interest rates. It
would probably weaken the dollar against
other currencies — but that would be good,
not bad, for U.S. competitiveness and
employment. So if the Chinese do dump
dollars, US should send them a thank-you
note.
166
China’s Mercantilism
Under normal circumstances, the inflow of
dollars from trade surpluses would push
up the value of China’s currency, unless it
was offset by private investors heading
the other way. And private investors are
trying to get into China, not out of it. But
China’s government restricts capital
inflows, even as it buys up dollars and
parks them abroad, adding to a $2 trillionplus hoard of foreign exchange reserves.
China’s trade surplus drains
much-needed demand away
from a depressed world
economy.
167
China Mercantilism and US jobs
Paul Samuelson: “With employment
less than full ... all the debunked
mercantilistic arguments” — that is,
claims that nations who subsidize their
exports effectively steal jobs from other
countries — “turn out to be valid.” He
then went on argue that persistently
misaligned exchange rates create
“genuine problems for free-trade
apologetics.” The best answer to these
problems is getting exchange rates
back to where they ought to be. But
that’s exactly what China is refusing to
let happen.
168
A narrowing of China’s currentaccount surplus, from 11% of
GDP at its peak in 2007 to 6.1%
in 2009.
America’s huge trade deficit
with China sets it apart from
many other G20 members.
Japan has a surplus of $45.5
billion with China and South
Korea $59.1 billion. Even Brazil
can boast more than $14 billion.
In the past 12 months China has
run a trade deficit with the G20
excluding America (even
counting the entire European
Union as a member).
169
170