Belfer Center Economics Seminar Series, Harvard Kennedy School :

1. How do we know this will not be another Great Depression? Jeffrey Frankel Belfer Center Economics Seminar Series, Harvard Kennedy School : Lessons from the Current CrisisBelfer Center Library,3-4:30 p.m.,May 4, 2009

2. Origins of the crisis Well before 2007, there were danger signals in US: Real interest rates <0 , 2003-04 ; Early corporate scandals (Enron 2001…); Risk was priced very low, • housing prices very high, • National Saving very low, • current account deficit big, • leverage high, • mortgages imprudent…

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

4. 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

5. 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. Possible risks were: housing crash, $ crash, oil prices, geopolitics….

6. 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

7. 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 coordinated expansion

8. 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.” • The origin this time 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.)

9. 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 on Wall Street; it may spare 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.

10. Bank spreads rose sharplywhen sub-prime mortgage crisis hit (Aug. 2007) and up again when Lehman crisis hit (Sept. 2008). Source: OECD Economic Outlook (Nov. 2008).

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

12. US Recession The US recession started in December 2007 according to the NBER Business Cycle Dating Committee (announcement of Dec. 2008) . As of April 29, 2009, the recession’s length tied thepostwar records of 1973-75 & 1981-82 = 4 quarters; 16 months One has to go back to 1929-33 for a longer downturn. Likely also to be also as severe as oil-shock recessions of 1973-75 and 1980-82, though not yet.

14. 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

15. 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…)

16. The US recession so far is deep, and to others’ compared to past Source: IMF, WEO, April 2009

17. 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.

18. International Trade has Plummeted Source: OECD

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

20. Unemployment rates are rising everywhere

21. Forecasts

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

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

24. “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.

25. U.S. output lost in the current downturn would still have a very long way to gobefore reaching the depth of the 1930s... Source: Federal Reserve Bank of St. Louis

26. …but, by at least one measure, the world is on track to match the Great Depression ! Industrial production Source: George Washington’s blog

27. How do we know this will not be another Great Depression? • especially considering that successive forecasts of the current episode have been repeatedly over-optimistic? • The usual answer: we learned important lessons from the 1930s, and we won’t repeat the mistakes we made then.

28. One hopes we won’t repeat the 1930s mistakes. • 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 wasunwilling 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

29. U.S. Policy Responses Monetaryeasing is unprecedented, appropriately avoiding the mistake of 1930s. (graph)But it has largely run its course: Policy interest rates ≈ 0.(graph) The famous liquidity trip is not mythical after all. & lending, even inter-bank, builds in big spreads. Now we have aggressive quantitative easing: the Fed continues to purchase assets not previously dreamt of.

30. The Fed certainly has not repeated the mistake of 1930s: letting the money supply fall. 2008-09 Source: IMF, WEO, April 2009Box 3.1 1930s

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

32. Obama policy of “financial repair”: Infusion of funds is more conditional, vs. Bush Administration’s no-strings-attached. Some money goes to reduce foreclosures. Conditions imposed on banks that get 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. Enough to make some banks balk at keeping the funds. But so far we have avoided “nationalization” of banks Policy Responses,continued

33. 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.  

34. The PPIP was attacked from both sidesin part due to anger over AIG bonuses, etc. FT, Mar 25, 2009

35. 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: 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, including 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; • should make capital requirements less pro-cyclical . • Extend bank-like regulation to “near banks.”

36. Policy Responses,continued Unprecedented $800 b fiscal stimulus. Good old-fashioned Keynesian stimulus Even the principle that spending provides more stimulus than tax cuts has returned; not just from Larry Summers, e.g., but also from Martin Feldstein. Is $800 billion too small? Too big? Yes: Too small to knock out recession ; too big to keep global investors confident inUS debt. I.e., just about right.

37. 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.

38. Fiscal stimulus also included tax cuts: • for lower-income workers (“Making Work Pay”) • EITC, • refundable child tax credit. • Fix for the AMT (for the middle class). • Soon we must return toward fiscal discipline. • Let Bush’s pro-capital tax cuts expire in 2011. • The budget passed by Congress omitted some of the best features proposed by Obama: • Cuts in farm subsidies for agribusiness & farmers > $250 million • Auctioning of GHG emission permits in future, • with revenue used, e.g., to cut taxes on low-income workers.

39. 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.

40. 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)

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

42. 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.

43. 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. • 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.

44. Bottom line of macroeconomic policy response: • A good guess is that the monetary and fiscal response we have seen so far have been sufficient to halt the economic free-fall, so that the steep rate of decline will level off in the 2nd half of this year. • It won’t be enough to return us rapidly to full employment and potential output. • Given the path of debt that was inherited in 2009, it is unlikely that more could be done.

45. 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? • Can the US rely on support of foreign central banks indefinitely ?

46. 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 long slow descent of the $ as an international currency may accelerate.

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

48. In the short run, the financial crisis has caused a flight to quality which apparently still means a flight to US $. • US Treasury bills have been 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. • Chinese officials’ warnings may be a turning point (April 2009): • Premier Wen worries US Treasury bills will lose value. • PBoC Gov. Zhou proposes replacing $ as international currency.

49. 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 49

50. 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.