The global financial crisis Jeffrey Frankel Harpel Professor of Capital Formation & Growth

1. The global financial crisisJeffrey FrankelHarpel Professor of Capital Formation & Growth Boston Committee on Foreign Relations Union Club, Boston, May 12, 2009

2. Outline • The international financial crisis of 2007-2009 • Root causes in the US • Transmission to rest of world • Forecasts • Multilateral Cooperation: • The G-20 meeting • The locomotive theory of fiscal policy • The next crisis: Hard landing for the $ ? • China’s dollar purchases • Emerging Markets • The 3rd capital inflow boom 2003-2007 and its end in 2008 • Are the 1994-2002 lessons on how to avoid crises holding up? • Appendices

3. Six root causes of US 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 MSN Money & Forbes

4. Six root causes of financial crisis,cont. 4. Starting 2001, the federal budgetwas set on a reckless path, 5. Real interest rates were too low during 2004-05 --mostly due to Fed policy,tho some point to high Asian saving. 6. Financial market participantsduring this period grossly underpriced risk.

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

6. The 2003-06 underpricing of risk • showed up everywhere: • in options prices (e.g., VIX) • in bond spreads (e.g., “high yield” corporate bonds) • in emerging markets (low sovereign spreads) • as low in 2006 as it had been high in 1998 • Explanations? • Estimated variances (e.g., in Black-Scholes formula) • backward-looking, rather than forward looking. • Option-implied volatility seems to follow US fed funds interest rate (with a lag): e.g., low in 1993 & 2004

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. 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… & even where fundamentals were relatively strong: Brazil, Korea… Some others are experiencing their own housing crashes:Ireland, Spain… Recession in big countries has been transmitted to all trading partners through loss of exports.

10. The Financial Crisis Hit Emerging Markets in Late 2008:Stock markets plunged and sovereign spreads roseSource: IMF WEO, Oct. 2008

11. International Trade has Plummeted Source: OECD

12. Asian exports are especially hard-hit via RGE Monitor 2009 Global Outlook

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

14. Unemployment rates are rising everywhere

15. Forecasts

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

17. IMF, too, forecasts 2009 as sharpest downturn Source: WEO,April 2009

18. “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 (March) now forecasts negative global growth in 2009, • for the first time in 60 years. • So does the IMF (April) when GDPs compared at current exchange rates.

19. IMF forecasts, April 2009

20. BRIC growth has disappeared

21. 2009 April

22. Multilateral initiatives • E.g., G-20, • which met in London • in April 2009.

23. International coordination of fiscal expansion? As in the classic Locomotive Theory • Theory:in the non-cooperative equilibrium, each country holds back fiscal expansion for fear of trade deficits. • Classic prisoner’s dilemma of Nash • Solution: A bargain where all expand together.

24. The Locomotive Theory in Practice • The example of G-7 Bonn Summit, 1978 • didn’t turn out so well: • 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. • Coordinated expansion failed at G-20 Summit in London, this April. • As had cooperation in 1933(London Monetary & Economic Conference)

25. USfiscal stimulus looks the largest of the G-10. But others point out that they have larger automatic stabilizers than the US

26. But G-20 Summit did accomplish some things • Expansion of the IMF • Tripling of size of IMF quotas. • New issue of SDRs (a la Keynes) • More inclusion of developing countries • Eventually: • Reallocation of voting shares in IMF and World Bank? • Break US-EU duopoly on MD & President? • Locus shifted from G7 to G20 at London meeting. • Regulatory reform? Still to come. • Reduce procyclical Basel capital requirements; FSB; …. • Hold the line against protectionism? Not yet clear.

27. The next crisis • The twin deficits: • US budget deficit => current account deficit • Until now, global investors have happily financed US deficits. • The recent flight to quality paradoxically benefited the $, • even though the international financial crisis originated in the US. • For now, US TBills are still viewed as the most liquid & riskless. • Sustainable? • How long will foreigners keep adding to their $ holdings? • The US can no longer necessarily rely on support of foreign central banks, either economically or politically.

28. The 2007-08 financial crisisprobably further underminedUS long run hegemony. • US financial institutions have lost credibility. • Expansionary fiscal and monetary policy may show up as $ depreciation in the long run. • The slow descent of the $ as an international currency may accelerate.

29. Simulation of central banks’ of reserve currency holdings Scenario: accession countries join EMU in 2010. (UK stays out), but 20% of London turnover counts toward Euro financial depth, and currencies depreciate at the average 20-year rates up to 2007. From Chinn & Frankel (Int.Fin., 2008) Simulation predicts € may overtake $ as early as 2015 Tipping point in updated simulation: 2015 29

30. “Be careful what you wish for!”US politicians have not yet learned how dependent on Chinese financing we have become.

31. If China gave US politicians what they say they want... • we’d regret it. • especially if it included reserve shift to match switch in basket weights. • As of early 2009, a floating yuan might not even appreciate ! • Even if RMB did appreciate, US TB & employment might not rise: • fall in US bilateral trade deficit with Chinawould be offset by rise in US bilateral deficit with other cheap-labor countries, • What if all Asian currencies appreciated together? • Yes, that would help US TB; • but US interest rates probably would rise: • possible hard landing for the $.

32. What about China’s currency reform announced in July 2005? China did not fully do what it implied, • i.e., basket peg (with cumulatable +/- .3% band). • Frankel & Wei(2007) & Frankel (2009) estimates: • De facto weight on $ still very high in 2005-06. • Little appreciation against the implicit basket, • but appreciation against $ in 2007, as the basket gave substantial weight to the € which appreciated against $. • Beijing responded to pressure on exporters in 2008 by switching back to a dollar peg. Just in time to ride the $ up in its year of reverse-trend appreciation !

33. In the short run, however, the financial crisis has caused a flight to quality which apparently still means a flight to US$. • US Treasury bills are more in demand than ever, as reflected in very low interest rates. • The $ appreciated in 2008, rather than depreciating as the “hard landing” scenario had predicted. • => The day of reckoning had not yet arrived. • Recent Chinese warnings may be a turning point: • Premier Wen worried US T bills will lose value. • PBoC Gov. Zhou proposed replacing $ as international currency.

34. Historical precedent: £ (1914-1956) The 2001-2020 decline in international currency status for the $ would be only one small part of a loss of power on the part of the US. But: • With a lag after US-UK reversal of ec. size & net debt, $ passed £ as #1 international currency. • “Imperial over-reach:” the British Empire’s widening budget deficits and overly ambitious military adventures in the Muslim world. A loss of $’s role as #1 reserve currency could in itself have geopolitical implications.

35. The 2001-2020 decline in international currency status for the $ would be only one small part of a loss of power on the part of the US. But: A loss of $’s role as #1 reserve currency could in itself have geopolitical implications. [i] Precedent: The Suez crisis of 1956 is often recalled as the occasion on whichBritain was forced under US pressure to abandon its imperial designs. But recall also the important role played by a simultaneous run on the £and the American decision not to help the beleaguered currency. [i]Frankel, “Could the Twin Deficits Jeopardize US Hegemony,” Journal of Policy Modeling, 28, no. 6, Sept. 2006.  At http://ksghome.harvard.edu/~jfrankel/SalvatoreDeficitsHegemonJan26Jul+.pdf . Also “The Flubbed Opportunity for the US to Exercise Global Economic Leadership”;  in The International Economy, XVIII, no. 2, Spring 2004at http://ksghome.harvard.edu/~jfrankel/FlubJ23M2004-.pdf 35

36. Emerging markets

37. Real interest rates in the US, when low, have sent capital flowing into developing countries: • 1st boom -- recycling petrodollars, 1974- Ended with the international debt crisis of 1982- • 2nd boom -- emerging market bonanza: 1990- Ended, for Mexico, in 1994. Perhaps precipitated -- as predicted by Calvo, Leiderman & Reinhart – by increase in US interest rates. • 3rd boom -- the search for yield: 2003- • e.g., carry trade from ¥, CHF & $, into NZ, Iceland, S.Africa.… • Convergence play from € into Hungary, Baltics… Ended in the fall of 2008.

38. Capital Inflows to Developing Countries as % of Total GDP (Low and Middle Income) 5.00 4.50 4.00 3.50 Net Total Private Capital Flows 3.00 2.50 2.00 1.50 1.00 ct 0.50 - 1988 1990 1992 1994 2000 2002 2004 1998 1996 1984 1986 1982 1972 1974 1970 1976 1978 1980 Source: World Development Indicators Capital flow cycle International debt crisis of 1982 East Asiacrisis of 1997 3rd boom: 2004- 1st boom: 1975-81 2nd boom: 1990-1996

39. 3 peaks in net private capital flow cyclesto emerging markets, by regionpeaking in 1982, 1997 and 2008 Source:Capital Flows to Emerging Market Economies, IIF, 1/27/09.

40. Cycle in capital flows to emerging markets • 1st developing country lending boom (“recycling petro dollars”): 1975-1981 • Ended in international debt crisis 1982 • Lean years (“Lost Decade”): 1982-1989 • 2nd lending boom (“emerging markets”): 1990-96 • Ended in East Asia crisis 1997 • Lean years: 1997-2003 • 3rd boom (incl. China & India this time): 2003-2008

41. The latest emerging market boom began in 2003, and surpassed the 1990s boom. Source: IMF WEO, 2007

42. This time, many countries used the inflowsto build upforex reserves, rather thanto finance Current Account deficits 2003-07boom 1991-97 boom

43. As a result, reserves reached extreme levels.... As a result, reserves in developing countries soon reached high levels....

44. …, especially in Asia Traditional denominator for reserves: imports

45. New denominator: short-term debt. After 2000, many brought their reserves above the level of short-term debt (the Guidotti rule).

46. Source: IMF WEO, 2007 This time, China and India shared in major inflows. But, again, capital inflows financed only reserve accumulation, not current account deficits as in the past. By 2007, reserves in some countries seemed grossly excessive.

47. Capital flows to emerging marketspeaked in 2007, fell in 2008 from: EM Fund Flows, Citi,December 2008

48. All decoupling ended in September 2008 Source: Benn Steil, Lessons of the Financial Crisis, CFR, March 2009

49. What characteristics have helped emerging markets resist financial contagion in the past? • High FX reserves and/or floating currency • Low foreign-denominated debt (currency mismatch) • Low short-term debt (maturity mis-match) • High Foreign Direct Investment • Strong initial budget, allowing room to ease. • High export/GDP ratio, • Sachs (1985); Eaton & Gersovitz(1981),Rose (2002) Calvo, Izquierdo & Talvi (2003); Cavallo & Frankel (2008); • but openness might not be helpful resisting a global recession

50. Are big current account deficits dangerous? Neoclassical theory – if a country has a low capital/labor ratio or transitory negative shock, a large CAD can be optimal. In practice – Developing countries with big CADs often get into trouble.Traditional rule of thumb: “CAD > approx. 4% GDP” is a danger signal. “Lawson Fallacy” – CAD not dangerous if government budget is balanced, so borrowing goes to finance private sector, rather than BD. Amendment after 1994 Mexico crisis – CAD not dangerous if BD=0andS is high, so the borrowing goes to finance private I, rather than BD or C. Amendment after 1997 East Asia crisis –CAD not dangerous if BD=0, S is high, and I is well-allocated, so the borrowing goes to finance high-return I, rather than BD or Cor empty beach-front condos (Thailand) & unneeded steel companies (Korea). Amendment after 2008 financial crisis – CAD dangerous (?).