The Financial Crisis and the Global Outlook

1
The Financial Crisis and the Global Outlook

• Robert Mundell
• Columbia University
• Sao Paulo, Brazil
• May 11, 2011

2
Outline

• 1.Origins of the Crisis
• 2.What Reversed the Recovery?
• 3. Five Goats of the Crisis
• 4. Policies for Future Recessions
• 5. Conclusions

3
1. Origins of the Crisis
4
Federal Reserve Policies

• The Federal Reserve policies used to cope with
  the global slowdown of 2001-2.
• Low interest rates and a low dollar in the
  recovery created the housing boom.
• Rising house prices created an artificial cushion
  of safety between mortgages and house values.
• Leverage soared with low down payments based on
  rising house prices.

5
Governments supported the AmericanDream of Home
Ownership.
5
6
Five Trouble-Makers

• Securitization of mortgages
• Derivatives and Leverage
• Credit-Default-Swaps
• Mark-to-Market Accounting Rules
• Variable Rate Mortgages

7
Rotten Balance Sheets

• When the house prices peaked the boom ended.
• When prices fell below mortgage values,
  homeowners walked away.
• The banks were left holding the bag.
• Failing sub-prime mortgage assets created holes
  in balance sheets.

8
Massive Liquidity Crisis

• The scramble for liquidity was completely
  unprecedented in the annals of finance.
• A financial panic was about to occur.

9
The ECB Solved the Liquidity Crisis Aug 9-10,
2007

• The panic was averted by prompt action by the
  ECB. It offered unlimited credit at 4 on August
  9.
• 95 billion in euros were lent at that rate
• More came from the Fed and other central banks
  when their markets opened later and the next day
  the lending continued.

10
Injections by ECB and FRB in Billions of Dollars
in August 2007
11
Solvency Problems Remained

• The prompt actions of the ECB and FED and others
  in August 2007 solved the liquidity problem at
  the time.
• What remained was the solvency problem of those
  institutions with big holdings of these
  defaulting assets.

12
Phony Crisis?

• After the resolution of the liquidity crisis
  there was relative quiet for 13 Months.
• Why did it take 13 months for the financial
  collapse?

13
The Real Economy

• The great expansion of 2002-2007 came to an end
  in 2007 (4).
• Two quarters of near recession 2007(4) and 2008
  (1).
• Then expansion in 2008 (2) with growth of 2.8.
• A recovery was coming.

14
Recovery in 2008(2)

• In the spring of 2008 it looked as if the U.S.
  economy was recovering. There was 2.8 growth in
  the second quarter of 2008.
• Bear Stearns was a problem the biggest bailout
  since LTCM in Sept 1998 - but it seemed to be
  settled with its absorption into J.P. Morgan in
  May 2008.
• In June 2008 it looked as though the US economy
  was recovering.

15
The Financial Blowout

• Instead of recovery came the biggest financial
  blowout in US history.
• Massive bank failures
• A contraction lasting at least three quarters.

16
Lehmans Collapse

• Lehmans demise was the biggest failure in world
  history.
• Previously, Enron in 2002 had been the biggest.
• But the Lehman failure was six times bigger than
  Enron.

17
Credit Dried Up

• The Lehman crash caused a surge in the demand for
  dollars and banks in their scramble for liquidity
  stopped lending.
• Money became even tighter. Credit became
  unavailable except for super-solvent firms.
  Credit for ordinary enterprises dried up.

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Lehmans Collapse

• Lehman was too big to fail BUT THE FED AND
  TREASURY LET IT FAIL.
• It was a mind-boggling mistake.
• It put other institutions at risk and made the
  take-over of AIG, at a cost of 78 billion
  inevitable.

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2. What Reversed the Recovery and Caused the
Blowout?
20
Tell-Tale Signs of Tight Money

• Two tell-tale signs of tight money in the U.S.
  are dollar appreciation combined with falling
  gold prices.
• The dollar soared in the third quarter by 30.
• The price of gold tumbled by 200.

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The Taylor Rule

• The Fed follows something like the Taylor Rule.
• The Taylor Rule ignores the exchange rate and the
  price of gold.
• The Taylor Rule is not even valid in a closed
  economy.
• But it is hopeless in an open economy.

22
The Dollar Surge

• The best measure of the dollar now is its price
  in terms of euros.
• On July 15, the dollar was .63 Euros
• Three months later, on October 27, it had soared
  to .80 euros.
• This was a dollar surge of 27 in 13 weeks!
• The largest rate of dollar appreciation in
  history!

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(No Transcript)
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The price of gold plummeted.
Tue Feb 10 162109 2009                      
                                                  
                                                  
                     
Tue Feb 10 162109 2009                      
                                                  
                                                  
                     
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Could Have Avoided the Crisis

• Buying government bonds or foreign exchange could
  have avoided the crisis entirely.
• Instead, the dollar appreciation overvalued US
  dollar assets including all fixed income
  securities and mortgages, tipping Lehman Bros and
  other banks over the edge and the economy into
  recession.

26
The Joint Fed-Treasury Mistake

• The Fed mistake does not exonerate the Secretary
  of the Treasury from blame for the joint
  Fed-Treasury mistake in letting Lehman Brothers
  fail.
• The failure increased the demand for money
  further, causing bank lending to dry up even to
  normally solvent firms.

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3. Five Goats of the Crisis
28
Five Goats Who Contributed to the Financial Crisis

• Ranieri
• Greenspan
• Greenberg
• Bernanke
• Paulsen

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Lewis RanieriJulia Finch Guardian.co.uk
(26/01/09)

• The bond trader who turned home loans into
  tradable securities
• The father of securitized mortgages
• Pioneered mortgage-backed bonds in 1980s
• Mortgages are math
• Created collateralized pools of mortgages
• Lost connection between original borrowers and
  lenders
• But ranked by Business Week with Bill Gates and
  Steve Jobs as one of the greatest innovators of
  the past 75 years.

30
Alan Greenspan Julia Finch Guardian.co.uk
(26/01/09)

• Kept interest rates too low, dollar too week, for
  too long, led the housing bubble to develop
• Supported sub-prime lending
• Advocated variable rate mortgages
• Defended derivatives Derivatives have been an
  extraordinarily useful vehicle to transfer risk
  from those who shouldnt be taking it to those
  who are willing to and are capable of doing so.
  Senate Banking Committee, 2003

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Maurice Hank Greenberg

• The founder of AIG, the biggest insurance company
  in the world.
• Conducted a vast business in credit default swaps
  (CDS).
• Insured mortgage assets for a regular premium for
  people/institutions that didnt own them.
• Similar to insurance, but different because the
  buyer of a CDS does not need to own the mortgage
  asset or even suffer a loss from a default event.
• Allowed mass multiples of derivatives.

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Ben Bernanke

• Allowed dollar to soar as the euro fell from
  above 1.60 in July to below 1.25 in October
  2008.
• Failed to realize this appreciation surge
  signaled the freezing of credit markets and
  extreme shortage of dollar liquidity.
• Failure to act brought on the recession in last
  half of 2008 and the financial crisis with Fanny
  Mae, Freddy Mac and Lehman and AIG, Goldman
  Sachs, etc. all involved.

33
Hank Paulsen

• Bailed out Bear-Stearns but allowed Lehman Bros.
  to fail.
• Failure of Lehman Bros. made it necessary to save
  AIG.
• Failed to recognize significance of dollar
  appreciation in third quarter of 2008

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3. International Considerations
35
Two Periods

• Ever since 1934, when the U.S. devalued the
  dollar, raising the price of gold to 35 an
  ounce, the Federal Reserve has followed a
  monetary policy based on national interests.
• The period since 1934 needs to be broken into two
  parts 1934-1971 (or 1973), when the rest of the
  world fixed their currencies to the dollar
  exchange rate and
• The period 1973-2009, under flexible exchange
  rates.

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Fixed Rates

• In both periods the U.S. used the interest rate
  as its key variable and symbol of monetary policy
  to achieve targets of internal stability which
  could mean full employment or price stability.
• The Federal Reserve Policy was the same in the
  two periods.

37
US Sterilization

• In the period of fixed rates, the rest of the
  world fixed exchange rates, while the U.S.
  theoretically bought and sold gold freely as
  was required under IMF Articles of Agreement.
• But the U.S. always sterilized the monetary
  effects of any gold sales or purchases.
• This policy shifted the burden of balance of
  payments adjustment onto the rest of the world.

38
Fed Policy the same Under Fixed and Flexible Rates

• US monetary policy ignored the balance of
  payments under fixed exchange rates and
• It ignored the dollar cycle under flexible
  exchange rates.
• Monetary policy, from the standpoint of the
  Federal Reserve, was the same under the system of
  fixed as under flexible exchange rates.
• The Taylor Rule. Or some variant of it.

39
The Taylor Rule

• The Taylor Rule relates interest rate policy to
  the inflation gap and the output gap.
• In a closed economy the rule has some merit.
• But the only closed economy is the world economy.
  
• So it is not relevant for monetary policy in any
  country in the real world.

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Not Relevant in the Real World

• It doesnt work under a fixed exchange rate
  system because it ignores the balance of
  payments.
• It doesnt work under a flexible exchange rate
  system because it ignores the exchange rate.

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Crisis-Prone Systems

• The fixed exchange rate system of 1934-71 broke
  down because US monetary policy did not adjust to
  the balance of payments.
• There was no mechanism for keeping the price
  level in line with the gold price.

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4. Alternative Policies(for the next time?)
43
Five Alternative Policies

• 1. Dated Spending Vouchers
• 2. Cut in Corporate Profit Taxes
• 3. Dollar-Euro Anchor
• 4. Global Macroeconomic Advisory Council
• 5. International Reserve Currency

44
1. Dated Spending Vouchers

• Dated Spending Vouchers (DSVs) of 500 billion
  (divided up among individuals) that expire after
  three months. Retailers would use the executed
  vouchers as tax credits.
• This would amount to stimulus in one quarter that
  would represent a potential 12.5 increase in
  spending in the quarter's income.
• It is superior to a tax change because it is
  temporary and flexible it doesn't change the tax
  structure and it can be repeated as needed.

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Proposal 1, Contd

• Given the fact that there is great uncertainty
  about the needed amount that is necessary, a tool
  that targets spending per quarter is flexible is
  superior to a one-shot guess. 
• It would involve a once-for-all redistribution
  that benefits lower income groups and maximizes
  the proportion of it that will be spent. 

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2. Slash Corporate Profits Taxes

• Cut the corporate tax rate from 35 to 15 to
  recapitalize banks and corporations and spur
  investment.
• This measure takes account of the fact that the
  government is already a non-voting shareholder in
  corporations with 35 of the stock without
  adding any capital to the corporation or share in
  any losses.
• Instead of the government buying stock in
  corporations to recapitalize them, the tax cut
  would let the corporations recapitalize
  themselves.
• (Note that Germany recently cut its corporation
  tax from 25 to 15, and its overall taxes on
  corporations from 38.7 to about 30.) 

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Corporation Tax Cut, contd

• Economists have been behind the curve on the
  impact of the corporate profits tax on investment
  and growth and employment. It is usually looked
  upon as an instrument for redistribution from the
  rich to the poor, ignoring the negative effects
  on the allocation of resources.
•  
• Elimination of the corporation tax has long ben a
  project of tax experts like the late William
  Vickrey, Nobel-prize-winning tax expert who,
  although a left-leaning liberal, regarded the
  corporation income tax as an "abomination"
  because of its harmful effects on output, growth
  and efficiency.
• A large cut in the corporate tax rate would make
  the stock market soar and restore the health of
  ailing corporations and banks and together with
  the DSVs jump-start investment and recovery.

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3. Dollar-Euro Anchor

• 3. Stabilize the dollar-euro rate and let the
  dollar-euro be the new anchor for the
  international monetary system around which an
  international currency can be based.
• The stabilization can be done gradually by
  creating a band of fluctuation at the margins of
  which the banks intervene and then narrow the
  band as the FRB and ECB get more comfortable at
  coordinating monetary policies.
• The Treasury/FRB can start by putting a floor to
  the euro (and a ceiling for the dollar) at 1.20
  and the ECB put a floor to the dollar (and a
  ceiling for the euro) at 1.40.

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- Anchor, contd

• The Federal Reserve should modify its policy of
  sterilizing automatically all foreign exchange
  intervention.
• Japan and China could also be invited to take
  part in the stabilization program as could the
  United Kingdom

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4. Global Macroeconomic Advisory Council

• Work to establish for the world as a whole an
  International Macroeconomic Advisory Council as a
  counterpart to the Volcker-chaired Obama Advisory
  Council.
• Form a committee of 10-15 wise people from around
  the world to advise and evaluate economic
  strategy and make recommendations.
• These could raw materials for an International
  Economic Advisory Council for policy at the
  Global Level.

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5. International Reserve Currency

• SDRs were created because of the need to find a
  solution to dollar deficits.
• SDRs were gold-value guaranteed.
• But the gold-value guarantee was stripped away in
  1974.
• The amount 9.5 billion SDRs issued in 1970-72
  would now be worth 270 billion.
• A massive issue of SDRs would go far to avert the
  collapse of the banking systems in the rest of
  the world.

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Conclusions
53
Emerging Market Countries

• Unstable Dollar-Euro Rate a major source of
  instability.
• Not much chance that the U.S. and Europe will
  back a world currency.
• Important for the emerging market countries to
  take a stand on this issue.
• Countries like China and Brazil have a big stake
  in the future of the international system.
• They should collaborate with other emerging
  market countries to rebuild the international
  system.

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The Outlook

• The recession in the U.S. is in the process of
  bottoming out, either in the current second
  quarter or early in the third quarter.
• Fiscal and monetary easing has helped.
• The recession in Europe has not reached bottom,
  but recent easing by the ECB is helpful.
• There are encouraging signs in German export
  markets for machine tools.

55
Japan

• Japanese economic growth is negative and the
  profit outlook for manufacturing companies looks
  bad.
• Outlook is for continued weakness of Japanese
  manufacturing, with heavy losses in major
  companies.

56
Emerging Market Economies

• Emerging markets, like Nigeria and Brazil and
  Russia have suffered less than the U.S. and
  Europe.
• Growth in the Chinese economy has plummeted from
  nearly 12 to below 8.
• PMI index is above 50 for the first time in
  months. Outlook for orders is good.
• Probability is for growth of 7 in 2009.

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US Economy Locomotive?

• Optimism about US recovery and growth has to be
  modest. Government sector expanding.
• Most likely US recovery will not be strong and
  sustained.
• Housing is slowly recovering but will not be the
  sparkplug for strong growth.
• Automobile markets not enough for strong growth
  amid rival firms.
• Investment required for strong recovery in the
  U.S.

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Investment in U.S.

• Investment outlook is poor.
• Problem is deficiency of profits.
• Major problem because of expectations of Obama
  tax increases.
• A strong recovery would require slashing
  corporation taxes to rebuild capital positions.
• Obama administration going in the wrong direction
  with taxes. Biggest flaw in the recovery program.

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Thank You