The Worst Crisis in 75 Years: Origins, Magnitude and Response Jeffrey Frankel Harpel Professor of Capital Formation

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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.

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Origins of the crisis

• Well before 2007, there were danger signals in
  US
• Real interest rates lt0 , 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

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US real interest rate lt 0, 2003-04
Source Benn Steil, CFR, March 2009
Real interest rates lt0
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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.wordpres
s.com/2008/05/
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Six root causes of financial crisis

• 1. US corporate 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
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Six root causes of financial crisis, cont.

• 4. Starting 2001, the federal budget was 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.

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Origins of the financial/economic crises
Homeownership bias
Predatory lending
Excessive complexity
MBSs
Foreign debt
CDSs
CDOs
Gulf insta-bility
Oil price spike 2007-08
Recession 2008-09
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Origins of the financial/economic crises
Homeownership bias
Predatory lending
Excessive complexity
MBSs
Foreign debt
CDSs
CDOs
Gulf insta-bility
Oil price spike 2007-08
Recession 2008-09
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Onset of the crisis

• Initial reaction to troubles
• Reassurance in mid-2007 The subprime mortgage
  crisis is contained. It
  wasnt.
• Then, The crisis is on Wall Street, sparing Main
  Street. It didnt.
• Then de-coupling The US turmoil will have
  less effect on the rest of the world than in the
  past. It hasnt.
• By now it is clear that the crisis is
• the worst in 75 years,
• and is as bad abroad as in the US.

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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).
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Corporate spreads between corporate government
benchmark bonds zoomed after Sept. 2008
US

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The return of Keynes

• Keynesian truths abound today
• Origins of the crisis
• The Liquidity Trap
• Fiscal response
• Motivation for macroeconomic interventionto
  save market microeconomics
• International transmission
• Need for coordinated expansion

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• 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 Hayeks credit cycle,
• Kindleberger78 s manias panics
• the Minsky moment,
• Fishers debt deflation.
• The origin this time was not a monetary
  contraction in response to inflation as were
  1980-82 or 1991.
• But, rather, a credit cycle 2003-04 monetary
  expansion showed up only in asset prices. (Borio
  of BIS.)

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US Recession

• The US recession started in December 2007
  according to the NBER Business Cycle Dating
  Committee (announcement of Dec. 2008) .
• As of May 2009, the recessions length broke the
  postwar 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.

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No, the fact that the recession is of record
length does not in itself imply we are near the
end.
kuya
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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
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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
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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.
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The US recession so far is deep,
and to others
compared to past
Source IMF, WEO, April 2009
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Job loss now cumulates to the worst since the
1940s.
Source BLS, May 8
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Prime-Age Male Unemployment Rateagain suggests
we have hit the record for post-war recessions.
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Recession was soon transmittedto 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.

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Source OECD
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World Recession

• No generally accepted definition.
• A fall in Chinas growth from 11 to 6, should
  probably be considered a recession.
• Usually global growth lt 2 is considered a
  recession.
• The World Bank forecasts that global growth
  would be negative in 2009,
• for the first time since the 1930s.

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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 wont repeat the mistakes
  we made then.

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• One hopes we wont 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 Lets not repeat Smoot-Hawley !
• E.g., the Buy America provision. China emulating.
• Mexican trucks

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U.S. Policy Responses

• Monetary easing 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.

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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
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Federal Reserve Assets ( billions)have
more-than-doubled, through new facilities, rather
than conventional T bill purchases
Source Federal Reserve H.4.1 report
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Major central banks have cut interest rates
sharply.
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Policy Responses, continued

• Obama policy of 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.

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• 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 shouldnt let banks use their own risk
  models
• should make capital requirements less
  pro-cyclical .
• Extend bank-like regulation to near banks.

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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.
• 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.

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Fiscal responseTimely, 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.

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• 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 Bushs 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
  gt 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?

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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
• Obamas economics are centrist, not far left.

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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 wont 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 ?

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The next crisis

• The twin deficits
• US budget deficit gt 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.

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Be careful what you wish for!US politicians
have not yet learned how dependent on Chinese
financing we have become.
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• Sustainable?
• 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.

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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
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Appendix As bad as the Great Depression?
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U.S. output loss unemployment risein 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
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but, by at least one measure, the world is on
track to match the 1930s !
Industrial production Source George Washingtons
blog
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Jeffrey FrankelJames W. Harpel Professor of
Capital Formation GrowthHarvard Kennedy School

• http//ksghome.harvard.edu/jfrankel/index.htm
• Blog http//content.ksg.harvard.edu/blog/jeff_fra
  nkels_weblog/