World Economy: Where have all the good times gone?

1. Painters’ Hall 14 October 2008 World Economy: Where have all the good times gone?

2. Professor Hélène Rey How did we get into the current financial crisis?

3. How did we get there?

4. Macro-economic environment • Macro-economic factors: • High liquidity due to loose monetary policy post 2001 • US government deficits due to tax cuts • Asian capital flows into dollar assets after Asian crisis • Symptoms: • Low savings rate in the US • Large US current account deficits: global imbalances • Housing bubble

5. Macro interacts with bad incentives • Abolition of Glass-Steagall in 1999 accelerates move of investment banks and shadow banks into risky business plans • Investment banking falls outside regulatory net • Credit rating agencies have conflicts of interest • This results in good and bad financial innovation • Securitisation and originate-to-distribute model • High leverage ratios

6. Macro interacts with bad incentives interacts with policy mistakes • No ex ante strategy, only ad hoc responses until recently • The Lehman Brothers fundamental error that spooked the market

7. Vicious spiral of deleveraging • Toxic assets spread around the system • Decline in equity value • Assets have to be sold • Everyone is selling assets • Price of assets drops • Decline in equity value • More fire sales of assets, etc... • Fear of counterparty risk: interbank and money market collapse

8. Powerful international crisis propagation mechanism • Contagion through balance sheets • US and European sales of assets reinforce the price drops and the deleveraging • Powerful effect because of large cross-border investments • As Paul Krugman puts it: There is an international financial multiplier

9. Professor Richard Portes What’s happening in the financial markets and what policies are required?

10. What was needed? • Urgency – as evidenced by banks desperately grasping liquidity, TED and Libor-OIS spreads, CDS spreads, volatilities • So needed to reduce perceived acute counterparty risk and stop ‘market runs’ as well as deposit runs • Key steps: reliquefy money markets through guarantees, recapitalise banks, extend deposit insurance • International coordination essential

11. What has been done? • UK plan (last Wednesday): bank recapitalisation, guarantees for new unsecured bank debt to deal with rollovers/refinancing • G7 statement (Friday): broad principles similar to UK • Euro Group (Sunday) – with UK ‘in attendance’: much more detailed, clearly following UK lead, adding proposals for modification of ‘marking to market’ • Implementation: • UK specific actions on bank recapitalisation yesterday • main euro area countries’ plans also announced yesterday • total European commitment put at € 1900 bn • US expected to announce government will take stakes in nine major banks, already will purchase commercial paper • central banks to provide unlimited dollar lending

12. What’s missing? • Blanket deposit guarantees • Explicit proposals for dealing with cross-border banks • Distinction between institutions that are systemically important and those that need not be supported – some banks will fail, which ones? • Creation of markets for impaired securities • Dealing with CDS market • Fiscal stimulus • Help for distressed mortgages • Longer term: lessons for regulation and for monetary policy, incentive problems

13. Will it work (short run)? • Key is to get lending guarantees in place a.s.a.p. • Restarting interbank lending should free up lending to non-financials – but still on tougher terms (though governments will push…) • Should avoid systemic meltdown – but… • Still concern about cross-border rescue operations, should they be needed • Some banks too big to rescue (not just Icelandics) • Possible contagion to various emerging market countries • But ‘good contagion’ too: laggard countries pushed to follow best-practice plans • Unsustainable fiscal burdens (longer term)?

14. The financial crisis and the real economic outlook Professor Lucrezia Reichlin

15. Three points • Large uncertainty in economic outlook • Comparison with other recession episodes point to a significant probability of a slowdown/recession in the US: we see similar housing deflation and credit patterns than previous recessions, but better financial positions of corporate sector (IMF) • This implies that the EA will follow: probability and timing depends on US developments

16. IMF forecast and their revisions

17. Uncertainty • Revisions downward, but a lot if uncertainty • US 2008 revised up from April forecast (fiscal package) • Large downward revision in the EA for 2009 (lagged effect with respect to the US)

18. US recession: what did we learnfromthe past? • Credit crunch + asset prices bust not always followed by a recession (IMF study on 28 credit crunches, 28 housing busts, 58 equity prices busts, 122 recessions in 21 advanced countries 1960-2007) • However ... Those recessions associated with financial crisis experienced larger output loss (IMF) • Credit ratios and asset prices similar than in past recessions, corporate financial positions better

19. Economic downturns tend to be more severe when preceded by financial stress... Preceded by financial stress Not preceded by financial stress Preceded by financial stress Not preceded by financial stress Slowdowns Recessions

20. US: house prices and credit as or worse than previous big recessions, not household and corporate finnancial position so far Median across financial stress episodes for six case studies Medianacross financial stress episodes followed by recessions United States (recent episode) House Prices (percent deviation from trend; quarters on the x-axis) Household Net Lending/Borrowing Ratio (deviation from trend; years on the x-axis) Nonfinancial Corporate Net Lending/Borrowing Ratio (deviation from trend; years on the x-axis) Credit (percent of GDP; percent deviation from trend; quarters on the x-axis)

21. What does this imply for the Euro Area? Facts (CEPR studies) Recessions in the EA follow US recessions, they are longer but less pronounced.

22. CEPR and NBER dating: Euro and US cycles since 1970

24. Scenario analysis for probabilities of recessions in the Euro Area

25. Background Slides GDP per capita: Euro Area and the US

27. Will the World be NICE again?Professor Andrew Scott

28. Recessions come and recessions go – we will see good times again • However, flavour of the next expansion will be different • Good chance we will look back on last decade like we do on the 1950s – a Golden Age, a NICE (non-inflationary consistently expansionary) decade • Inflation and macro risk have returned • Important to disentangle the financial (liquidity/regulation) from the macro (inflation, risk premia)

29. What next? • Might be at the beginning of the end for the financial crises • But probably at the end of the beginning for the macro economy • Economic bad news will start to deteriorate sharply as it becomes evident in a recession • Asset price deflation, deleveraging lead to longer than usual downturn

30. Looking further ahead… 1) Reregulation. Government action reclaimed its legitimacy – shift away from rules, institutional reform 2) Return of macro risk and equity risk premium 3) Rise in inflation expectations (longer term) 4) Continued growth of behavioural finance and strong influence on regulation/policy 5) Shift towards countercyclical leverage controls

31. Looking further ahead… 6) Less competitive banking system (higher spreads, lower volumes). End of mortgage only banks and financial institutions with high leverage/high short term borrowing model 7) Smaller financial system – scope for other sectors to grow, reduced emphasis on housing and focus on productive investment 8) Increase concentration in most industries – if credit markets cant be relied upon then larger conglomerates make sense 9) Potential for beginnings of end of US as international currency 10) Euro may have to weather some bond market tensions

32. Thank you