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The Worst Crisis in 75 Years: Origins, Magnitude and Response Jeffrey Frankel Harpel Professor of Capital Formation & Growth Harvard University. The Boston Security Analysts Society Thursday, June 25, 2009. Origins of the crisis. Well before 2007, there were danger signals in US:

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The boston security analysts society thursday june 25 2009

The Worst Crisis in 75 Years: Origins, Magnitude and ResponseJeffrey FrankelHarpel Professor of Capital Formation & GrowthHarvard University

The Boston Security Analysts Society

Thursday, June 25, 2009.


Origins of the crisis
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…


Us real interest rate 0 2003 04
US real interest rate < 0, 2003-04

Source: Benn Steil, CFR, March 2009

Real interest rates <0


In 2003-07, market-perceived volatility, as measured by options (VIX), plummeted.

So did spreads on US junk & emerging market bonds.

In 2008, it all reversed.

Source: “The EMBI in the Global Village,” Javier Gomez, May 18, 2008 juanpablofernandez.wordpress.com/2008/05/


Six root causes of financial crisis
Six root causes of financial crisis options (VIX), plummeted.

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


Six root causes of financial crisis cont
Six root causes of financial crisis, options (VIX), plummeted.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….


Origins of the financial economic crises
Origins of the financial/economic crises options (VIX), plummeted.

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


Origins of the financial economic crises1
Origins of the financial/economic crises options (VIX), plummeted.

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


Onset of the crisis
Onset of the crisis options (VIX), plummeted.

Initial reaction to troubles:

Reassurance in mid-2007: “The subprime mortgage crisis is contained.” It wasn’t.

Then, “The crisis is on 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.


Bank spreads rose sharply options (VIX), plummeted.when sub-prime mortgage crisis hit (Aug. 2007) and up again when Lehman crisis hit (Sept. 2008).

Source:

OECD Economic Outlook

(Nov. 2008).


Corporate spreads between corporate government benchmark bonds zoomed after sept 2008
Corporate spreads options (VIX), plummeted.between corporate & government benchmark bonds zoomed after Sept. 2008

US


The return of keynes
The return of Keynes options (VIX), plummeted.

  • 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


  • The origin of the crisis was an asset bubble options (VIX), plummeted.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.)


Us recession
US Recession options (VIX), plummeted.

The US recession started in December 2007 according to the NBER Business Cycle Dating Committee (announcement of Dec. 2008) .

As of May 2009, the recession’s length broke thepostwar records of 1973-75 & 1981-82

= 4 quarters; 16 months

One has to go back to 1929-33 for a longer downturn.

Probably also as severe as recession of 1982.


No the fact that the recession is of record length does not in itself imply we are near the end
No, the fact that the recession is of record length does not in itself imply we are near the end.

kuya


US employment peaked in Dec. 2007, which is the most important single reason why the NBER BCDC dated the peak from that month.

Since then, 6 million jobs have been lost (5/09).

Payroll employment series Source: Bureau of Labor Statistics


On June 5, commentators were encouraged when BLS reported a sharp moderation in the rate of jobs decline in May.

Payroll employment series Source: Bureau of Labor Statistics


My favorite monthly indicator is total hours worked in the economy
My favorite monthly indicator is total hours worked in the economy

It confirms:US recession turned severe in September;

but hours worked has not yet shown any sign of moderating.


The us recession so far is deep
The economyUS recession so far is deep,

and to others’

compared to past

Source: IMF, WEO, April 2009



Prime age male unemployment rate again suggests we have hit the record for post war recessions
Prime-Age Male Unemployment Rate economyagain suggests we have hit the record for post-war recessions.


Recession was soon transmitted to rest of world
Recession was soon transmitted economyto rest of world:

Contagion: Falling securities markets & contracting credit.

Especially in those countries with weak fundamentals: Iceland, Hungary, Ukraine, Latvia…

Or oil-exporters that relied heavily on high oil prices: Russia…

But even where fundamentals were relatively strong: Korea…

Some others experiencing their own housing crashes:Ireland, Spain…

Recession in big countries will be transmitted to all trading partners through loss of exports.


Source: OECD economy


World recession
“World Recession” economy

  • No generally accepted definition.

    • A fall in China’s growth from 11% to 6%, should probably be considered a recession.

    • Usually global growth < 2 % is considered a recession.

  • The World Bank forecasts that global growth would be negative in 2009,

    • for the first time since the 1930s.


How do we know this will not be another great depression
How do we know this will economynot 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.


One economyhopes 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. China emulating.

    • Mexican trucks


U s policy responses
U.S. Policy Responses economy

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.


The fed certainly has not repeated the mistake of 1930s letting the money supply fall
The Fed certainly has economynot repeated the mistake of 1930s: letting the money supply fall.

2008-09

Source: IMF, WEO, April 2009Box 3.1

1930s


Federal Reserve Assets economy($ billions)have more-than-doubled, through new facilities, rather than conventional T bill purchases

Source: Federal Reserve H.4.1 report



Obama policy of economy“financial repair”:

Infusion of funds is more conditional,

Conditions imposed on banks that get help:

(1) no dividends,

(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.

The “stress tests” achieved the drawing of a (dotted) line between “good banks” and “bad banks.”

So far we have avoided nationalization.

Policy Responses,continued


Desirable longer-term financial reforms economy

  • 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.”


  • Policy responses continued
    Policy Responses, economycontinued

    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.

    Was $800 too small? Too large?

    Yes: Too small to knock out recession ;

    too small to reassure global investors re US debt.

    I.e., just about right.


    Fiscal response timely targeted and temporary
    Fiscal response economy“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.


    • Fiscal stimulus also included tax cuts: economy

      • 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.

    • But the budget passed by Congress omitted some of the newly-responsible 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.

      • Will Secy. Gates’ attempt to cut unwanted weapons systems (such as the F22 fighter) meet the same fate?


    Motivation for macroeconomic intervention
    Motivation for macroeconomic intervention economy

    • 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.


    Bottom line of macroeconomic policy response
    Bottom line of macroeconomic policy response: economy

    • 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.

      • Chinese officials already questioning our creditworthiness

      • US could lose AAA rating, according to David Walker(GAO, Petersen).

      • US long-term interest rates have risen lately

      • Hard landing for the $ ?


    The next crisis
    The economynext crisis

    • The twin deficits:

      • US budget deficit => current account deficit

    • Until now, global investors have happily financed US deficits.

    • The flight to quality paradoxically benefited the $,

      • even though the financial crisis originated in the US.

      • In 2008, US TBills were still viewed as the most liquid & riskless.


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


    • Sustainable? economy

      • Can the US rely on foreign central banks indefinitely ?

      • Especially if we keep telling China to stop buying $?

    • Although the day of reckoning did not arrive in 2008,

    • Chinese warnings in the spring of 2009 may have been a turning point:

      • PM Wen worried US T bills will lose value.

      • PBoC Gov. Zhou proposed replacing $ as international currency with the SDR.


    Simulation of central banks’ of reserve economycurrency 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

    43


    Appendix as bad as the great depression
    Appendix: economyAs bad as the Great Depression?


    U s output loss unemployment rise in the current downturn
    U.S. output loss & unemployment rise economyin 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


    But by at least one measure the world is on track to match the 1930s
    …but, by at least one measure, economythe world is on track to match the 1930s !

    Industrial production

    Source: George Washington’s blog


    Jeffrey frankel james w harpel professor of capital formation growth harvard kennedy school

    Jeffrey Frankel economyJames W. Harpel Professor of Capital Formation & GrowthHarvard Kennedy School

    http://ksghome.harvard.edu/~jfrankel/index.htm

    Blog: http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/


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