Anatomy of the Financial Crisis: Root Causes and Impact

1. Anatomy of the Financial Crisiswith comments onAcemoglu, Brunnermeier, El-Erian, & PortesJeffrey FrankelHarpel Professor of Capital Formation & GrowthHarvard Kennedy School Meeting of Commission on Growth & Development at Center for International Development, April 20-21, 2009

2. Six root causes of financial crisis 1. UScorporate governance falls short E.g., rating agencies; executive compensation options; golden parachutes… 2. US households save too little,borrow too much. 3. Politicians slant excessively toward homeownership Tax-deductible mortgage interest, cap.gains; FannieMae & Freddie Mac; Allowing teasers, NINJA loans, liar loans… MSN Money & Forbes

3. Six root causes of financial crisis,cont. 4. Starting 2001, the federal budgetwas set on a reckless path, reminiscent of 1981-1990 5. Monetary policy was too loose during 2004-05, accommodating fiscal expansion,reminiscent of the Vietnam era. 6. Financial market participants during this period grossly underpriced risk risks: housing crash, $ crash, oil prices, geopolitics….

4. Current account imbalances • Richard Portes: “Global Imbalances caused crisis.” • => low volatility and interest rates => leverage. • I disagree. • I view low US National Saving as main source of CA. • I agree with Richard this crisis is not the feared US sudden stop • That’s the next crisis. • But then why interest rates low? Easy money. (Like 1960s.) • Many disagree (My “9 Reasons…” for Growth Commission) • Global savings glut hypothesis (Bernanke…) • But measured world saving did not rise in this decade. • Bretton Woods II (Dooley, Garber…) . • But BW I operated for only 14 years. We’re near the end. • US offers the high-quality assets. (Forbes, Gourinchas, Caballero..) • Not really. Was clear in 2001 (Enron…)

5. But I would think herd mentality – the opposite of heterogeneous views -- would be the bigger problem. Yes. Note: time-varying variance itself gives fat tails. Yes. We thought securitization of mortgages would “spread the risk.” But it spread risk like a virus !

6. I would like to suggest a fourth “new” idea in volatility: When using Black-Scholes or other formulas to price options (VIX) or bond spreads (corporate bonds), analysts simply plug in variance estimated from the recent past. During 2004-2006, lagged variance was low, tho forward-looking risk was high.

7. As Adrian & Brunnermeier point out(p.5), • “After a string of good news, risk seems tamed, but, when a new tail event occurs, the estimated risk measure may sharply increase. This problem is most pronounced if the data samples are short. Hence, regulatory requirements that are naively based on estimated risk measures would be stringent during a crisis and lax during a boom. This introduces procyclicality – exactly the opposite of the goal of effective regulation.” I couldn’t agree more. But: (i) Does this require that tail events are asymmetrically negative? (ii) If so, could the causality run from a variance innovation, via the risk premium, to a fall in asset prices, instead of the other way?

8. Origins of the financial/economic crises Underestimated riskin financial mkts Failures of corporate governance Households saving too little, borrowing too much Federal budget deficits Monetary policy easy 2004-05 Excessive leverage in financial institutions Housing bubble Low national saving Stock market bubble Stock market crash Housing crash China’s growth Financial crisis 2007-08 Lower long-term econ.growth Eventual loss of US hegemony Homeownershipbias Predatory lending Excessive complexity MBSs Foreigndebt CDSs CDOs Gulf insta-bility Oil price spike 2007-08 Recession 2008-09

9. The return of Keynes • Keynesian truths abound today: • Origins of the crisis • The Liquidity Trap • Fiscal response • Motivation for macroeconomic intervention:to save market microeconomics • International transmission • Need for macroeconomic coordination

10. The origin of the crisis was an asset bubble collapse, loss of confidence, credit crunch…. • like Keynes’ animal spirits or beauty contest . • Add in von Hayek’s credit cycle, • Kindleberger78 ’s “manias & panics” • the “Minsky moment,” & • Fisher’s “debt deflation.” • It was not a monetary contraction in response to inflationas were 1980-82 or 1991. • But, rather, a credit cycle: 2003-04 monetary expansion showed up only in asset prices. (Borio of BIS.)

11. Financial regulation Good for Daron ! True. But if we don’t draw up an informed list, politicians will come up with a worse one.

12. Desirable longer-term financial reforms • Executive compensation • Compensation committee not under CEO. Maybe need Chairman of Board. • Discourage golden parachutes & options, unless truly tied to performance. • Securities • Regulatory agencies: In US, merge SEC & CFTC? • Create a central clearing house for CDSs . • Credit ratings: • Reduce reliance on ratings. AAA does not mean no risk. • Reduce ratings agencies’ conflicts of interest. • Lending • Mortgages • Consumer protection, incl. standards for mortgage brokers • Fix “originate to distribute” model, so lenders stay on the hook. • Banks: • Regulators shouldn’t let banks use their own risk models (VAR); • should make capital requirements less pro-cyclical . • Extend bank-like regulation to “near banks.” Heavy overlap withRichard Portes’ list,FT, 11/11/08

13. I always thought CoVar stood for Covariance. But that is no more – nor less – confusing than VAR standing for Value at Risk instead of either Variance or Vector AutoRegression. In fact CoVaRiance rather captures the spirit of the idea. Adrian & Brunnermeier make the sensible point that regulators should worry about how much a bank contributes to systemic risk (CoVaR), more than just own risk (VaR). Analogous to a CAPM for regulators.

14. Lehman Brothers, whose failure inflicted maximum adverse effect on the financial system in Sept. 2008, shows up with almost the highest risk rating by CoVaR, but also by VaR.

15. I would phrase it: We have learned something we should have already known -- financial markets need a lot of regulation, but market capitalism still works best in the real economy.

16. Motivation for macroeconomic intervention • The view that Keynes stood for big government is not really right. • He wanted to save market microeconomics from central planning, which had allure in the 30s & 40s. • Remember, Bretton Woods blessed capital controls and free trade. • Some on the Left today reacted to the crisis & election by hoping a new New Deal would overhaul the economy. • My view: faith in the unfettered capitalist system has been shaken with respect to financial markets, true; but not with respect to the rest of the economy; • Obama’s economics are centrist, not far left.

17. International transmission remains as powerful as ever (no “de-coupling”) • Consistent with old-fashioned Keynes-Meade-Mundell-Fleming transmission via trade balances.

18. International coordinationof fiscal expansion? As in the classic Locomotive Theory • Theory:in the Nash non-cooperative equilibriumeach country holds back from fiscal expansionfor fear of adverse trade deficits. • Solution: A bargain where all expand together. • In practice:example of Bonn Summit, 1978 • didn’t turn out so well, • primarily because inflation turned out to be a bigger problem than realized (& the German world was non-Keynesian). • Inflation is less a problem this time. The Germans are the same.

19. Multilateral initiatives • Hold the line against protectionism • Attempts at multilateral reform • More inclusion of developing countries • Locus shifted from G7 to G20 at London meeting (April). • The IMF and World Bank • Reallocation of shares • Break US-EU duopoly on MD & President • Tripling of size of IMF, incl. new SDR issue (a la Keynes) • Regulatory reform. • Reduce procyclical Basel capital requirements; FSF; …. • Coordinated expansion? Failed at London G-20. • As had cooperation in 1933 (London Monetary & Economic Conference)

20. USfiscal stimulus looks the largest of the G-10. But most others have larger automatic stabilizers than the US

21. Mohamed El-Elrian & Mike Spence,“Essential Task for G20 Leaders is a Cinema Trip to See A Beautiful Mind”The Daily Telegraph, March 30, 2009 • Apparently Mohamed and Mike think the producers of that movie took the opportunity to teach the audience the simple principle of the prisoner’s dilemma. A reasonable inference. • But that’s not how I remember the movie.Hollywood doubts the analytical aptitude/interests of the public.

23. Appendices • Origins of the crisis • The US recession • Transmission to rest of world • Global forecast • The US policy response • Monetary easing • Financial repair • Fiscal expansion • Global current account imbalances • Implications of the crisis for the status of the dollar • Adjustment in surplus countries • End of the 3rd emerging markets capital boom

24. Origins of the crisis Well before 2007, there were danger signals in US: Real interest rates <0 , 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…

25. US real interest rate < 0, 2003-04 Source: Benn Steil, CFR, March 2009

26. Onset of the crisis Initial reaction to troubles: Reassurance in mid-2007: “The subprime mortgage crisis is contained.” It wasn’t. Then, “The crisis is in Wall Street, sparing Main Street.” It didn’t. Then de-coupling : “The US turmoil will have less effect on the rest of the world than in the past.” It hasn’t. By now it is clear that the crisis is the worst in 75 years, and is as bad abroad as in the US.

27. US Recession In December 2008, NBER Business Cycle Dating Committee proclaimed US recession had started in December 2007. As of March 2009, the recession’s length ties the postwar 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 recessions of 1974 and 1980-82.

29. US employment peaked in Dec. 2007,which is the most important reason why the NBER BCDC dated the peak from that month. Since then, 5 million jobs have been lost (4/3/09). Payroll employment series Source: Bureau of Labor Statistics Payroll employment series Source: Bureau of Labor Statistics

30. My favorite monthly indicator:total hours worked in the economy It confirms:US recession turned severe in September, when the worst of the financial crisis hit(Lehman bankruptcy…)

31. The US recession so far is deepcompared to past and to others’ Source: IMF, WEO, April 2009

32. Recession was soon transmittedto rest of world: Contagion: Falling securities markets & 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 relatively strong: Korea, Brazil… Some others experiencing their own housing crashes:Ireland, Spain… Recession in big countries was soon transmitted to all trading partners through loss of exports.

33. International Trade has Plummeted Source: OECD

34. The recession has hit more countries than any in 60 years

35. Forecasts

36. Interim forecast OECD 3/13/09 Forecast for 2009 = - 3 ½ %

37. “World Recession” • No generally accepted definition. • A sharp fall in China’s growth from 11% is a recession. • Usually global growth < 2 % is considered a recession. • The World Bank now (March) forecasts negative global growth in 2009, • for the first time in 60 years.

38. Unemployment rates are rising everywhere

39. Do we know this won’t be another GreatDepression? One hopes we won’t repeat the mistakes of the 1930s. • Monetary response: good this time • Financial regulation: we already have bank regulation to prevent runs. But it is clearly not enough. • Fiscal response: OK, but : constrained by inherited debt. Also Europe was unwilling to match our fiscal stimulus at G-20 summit. • Trade policy: Let’s not repeat Smoot-Hawley ! • E.g., the Buy America provision • Mexican trucks

40. The Fed certainly hasn’t repeated the mistake of 1930s: letting M1 fall. 2008-09 Source: IMF, WEO, April 2009Box 3.1 1930s

41. 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 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 Fed continues to purchase assets not previously dreamt of.

42. Major central banks have cut interest rates sharply. Source: OECD

43. Bank spreads rose sharplywhen sub-prime mortgage crisis hit (Aug. 2007) and up again when Lehman crisis hit (Sept. 2008). Source: OECD, Datastream

44. Corporate spreadsbetween corporate & government benchmark bonds zoomed after Sept. 2008 US €

45. Obama policy of “financial repair”: Infusion of funds has been more conditional, vs. Bush Administration’s 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 Policy Responses,continued

46. Policy Responses -- Financial Repair,cont. • 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 by private bidding (from  private equity, hedge funds, and others), • rather than by an overworked Treasury official pulling a number out of the air and risking that taxpayers grossly overpay for the assets, as under TARP.  

47. Policy Responses -- Financial Repair,cont. • How much money is the government putting 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.

48. The PPIP was attacked from both sidesin part due to anger over AIG bonuses, etc. FT, Mar 25, 2009 But the stock market reacted very positively, and some respected commentators are supportive.

49. 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.

50. Fiscal response“Timely, 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.