From Crash to Recession

1. From Crash to Recession

2. Reinhart and Rogoff • “This time is different” is the common first impression with many financial crises, but this is wrong. • There are common elements among many incidents. • The subprime mortgage crisis of the late 2000’s is categorized as a “banking crisis”.

3. Banking crisis: Reinhart and Rogoff definition: 1. Bank runs that lead to the closure, merging, or takeover by the public sector of one or more financial institutions.

4. Banking crisis: 2. If there are no runs, the closure, merging, or takeover, or large scale government assistance of an important financial institution (or group of institutions) that marks the start of a string of similar outcomes for other financial institutions.

5. Banking crisis: • In the case of banking panics and bank runs, the problem is in the liability (deposits) side. • But more often, problems arise from the deteriotation in asset quality: collapse in real estate prices or increased bankruptcies in the nonfinancial sector.

6. Banking crises(Reinhart andRogoff) • Systemic (severe) • Financial distress (milder) • 18 banking crises in the developed world after World War II. • 5 are big (severe). • The largest is the current one. The second largest is Japan (1992).

7. Various comments on the current crisis • This is a severe financial crisis • A crisis of the Anglo-Saxon financial system (Martin Wolf) • First crisis of financial globalization and securitization (Roubini) • Due to financial innovation, the nature of systemic risk is changed

8. Indicators of risk of banking crises Before the crisis: • Rising asset prices • Slowing down of real economic activity • Large current account deficits • Sustained debt buildups

9. Aftermath of banking crises Indicators after the crisis: • Asset market collapses are deep and prolonged. • Profound declines in output and employment. • The value of government debt tends to explode.

10. Changing nature of systemic risk with financial innovation • In the old times (1960s-1980s): banks held the credit risk of their lending on balance sheet. “Originate and hold”model • When many bad loans/mortgage were made defaults would rise, a credit crunch would follow and then a recession

11. Changing nature of systemic risk with financial innovation • New model since 1980s: securitization “originate and distribute”model. • Banks not holding the credit risk but transferring to others. • Look in “Originate-to-distribute: The origin of it all,” MODELS & AGENTS January 26, 2008.

12. Changing nature of systemic risk with financial innovation The logic of this system: • Systemic risk should become lower as you slice and dice the risk because: • credit risk is spread out of the banks to capital markets and investors, domestic and abroad,

13. Changing nature of systemic risk with financial innovation Problem:systemic risk turned out to be now as high as in the past: • massive domestic financial contagion • massive global financial contagion • hard landing of the economy (recession or depression).

14. The Federal Reserve's strategy in the crisis (1) • Monetary easing: • Federal Open Market Committee (FOMC) has aggressively eased monetary policyto offset the effects of the crisis on credit conditions and the broader economy

15. The Federal Reserve's strategy in the crisis (2) • Support the functioning of credit markets and to reduce financial strains by providing liquidity to the private sector--that is, by lending cash or its equivalent secured with relatively illiquid assets. • (Look up the Financial Times interactive feature on Quantitative Easing)

16. The Federal Reserve's strategy in the crisis (3) the Fed collaborated with the Treasury, and sometimes with FDIC • for the acquisition of Bear Stearns by JPMorgan Chase • to stabilize the large insurer, American International Group (AIG). • put together a package of guarantees, liquidity access, and capital for Citigroup. • to support the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac • assist in the resolution of troubled depositories, such as Wachovia. • the failure of such institutions would risk the whole financial system

17. Monetary policy ineffectiveness Monetary injections by central banks to solve the liquidity/credit crunchare ineffective because there is: • Shadow banking system • Insolvency rather than illiquidity • Uncertainty rather than risk

18. Shadow banking system • The shadow banking system –unlike banks -does not have direct (or even indirect) access to the lender of last resort (LOLR) support of central banks • Non-bank players are subject to severe liquidity/rollover risk as they borrow short/liquid and invest/lend long/illiquid

19. Insolvency rather than just illiquidity • Millions of defaulting households • 200 mortgage lenders gone bankrupt • Many homebuilders gone bankrupt • Many highly leveraged institutions have gone bankrupt

20. Risk vs uncertainty • “Risk”is priceable while • “Uncertainty”cannot be measured or priced • lack of transparency • lack of information/disclosure

21. Two types of unmeasurable uncertainty: • Size of the losses is unknown. • Uncertainty on who is holding the toxic waste

22. Unmeasurable uncertainty Uncertainty leads to : • lack of trust, confidence, and • large counterparty risk; Everyone hoards liquidity and is unwilling to lend • Liquidity injections by central banks have been hoarded

23. Uncertainty affects portfolio decisions • Shift away from risky assets to riskless assets eg American Treasury bills. • Realisation that many new complex assets were much riskier • General worry about all risky assets, and about the balance-sheets of the institutions that hold them. • “Better safe than sorry” is the motto. • The motto is having catastrophic macroeconomic consequences for the world. • enormous spreads on risky assets, a credit crunch in advanced economies, and major capital outflows from emerging countries.

24. Tightness of credit

26. Uncertainty affects consumption and investment decisions • Fears ofdepression forces consumers to be careful and save and to wait and see how things turn out. • Buying a new house, a new car or a new laptop can be delayed a few months. • Firms: given the uncertainty, why build a new plant or introduce a new product now? • This is rational behaviour on the part of consumers and firms, but it has led to a collapse of demand, a collapse of output and to the current deep recession.

27. Lack of confidence Prevents • real investment spending by companies that are solvent • and spending by households that are sound

28. Viscious circle • Small, medium and large-sized solvent firms may fail because of the lack of credit, • The liquidity and credit crunch hurts even sound enterprises unable to roll over their debts.

29. Viscious circle Firms react to the falling demand by • investing less and • reducing production and employment • their goal is to survive the crisis by saving cash

30. Viscious circle • But the loss of jobs or the risk of becoming unemployed restrains the consumption of households • Banks that are under-capitalizedare forced to reduce their risks and thus provide even less credit.

31. Aftermath of the US subprime crisis: Unlike emerging market economies in crisis, US did not face: • An exchange rate crash • A “sudden stop” in capital inflows

32. The crisis hit the US hard: Crises have deep and lasting effects on • Output and Employment (second great contraction) • Asset prices • Value of government debt increases

33. “Hard landing” • There was discussion whether there would be “soft landing” or “hard landing”. • NBER: The recession started in December 2007.

34. US GDP growth rates (%)

35. Slowdown in 2007 • The U.S. economy slowed markedly to grow2.2 percent in 2007, down from almost 3 percentin 2006 . • Contraction of residential investment reduced growth in 2007. • Consumptionand business investment also decresed toward the end of the year, consumer confidence decreased and lending conditions tightenedsignificantly after the outbreak of financial turbulencein August, despite the Federal Reserve’saggressive turn to monetary easing.

37. Recession and depression • The popular definition for a recession: two consecutive quarters of falling GDP. • Before the 1930s all economic downturns were commonly called depressions. The term “recession” was coined later to avoid stirring up nasty memories. • Look in: “Diagnosing Depression,”The Economist, Dec 30th 2008

38. Depression • a decline in real GDP that exceeds 10%, or one that lasts more than three years. • America’s Great Depression qualifies on both counts, with GDP falling by around 30% between 1929 and 1933. Output also fell by 13% during 1937 and 1938.

39. Difference between a recession and a depression The cause of the downturn matters: • A standard recession usually follows a period of tight monetary policy, • A depression is the result of a bursting asset and credit bubble, a contraction in credit, and a decline in the general price level.

40. Policy action • A recession triggered by tight monetary policy can be cured by lower interest rates, but fiscal policy tends to be less effective because of the lags involved. • By contrast, in a depression caused by falling asset prices, a credit crunch and deflation, conventional monetary policy is much less potent than fiscal policy.

41. Recession There is dicussion about the duration of the recession: • V or U or Lshaped. • going on indefinitely: L-Shaped • long and protracted: U-shaped • short and shallow V-shaped

43. Index 2002=100

47. Policy Options: • Brad DeLong • Nouriel Roubini • Olivier Blanchard • Paul Krugman Have suggestions regarding the use of monetary and fiscal policy

48. Non depression economics • Short-run economic policy should be left in the hands of the central bank, • with the legislature and the executive focusing on the long run and keeping their noses out of year-to-year fluctuations in employment and prices; • Look in Depression Economicsby J. Bradford DeLong Project Syndicate, December 2008

49. Non depression economics • Central banks’ highest priority should be to maintain their credibility as guardians of price stability, • and only then turn their attention to keeping the economy near full employment, • which they should do by influencing asset prices – upward when unemployment threatens to rise, and downward when an inflationary spiral looms;

50. Non depression economics • Central banks should influence asset prices through normal open-market operations • by buying and selling short-term government securities for cash, • thus changing the “safe” interest rate and the price of longer-duration assets;