In Search of Stability: The Economics and Politics of the Global Financial Crisis Mark Copelovitch A

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In Search of StabilityThe Economics and
Politics of the Global Financial CrisisMark
CopelovitchAssistant Professor of Political
Science Public AffairsUniversity of Wisconsin
MadisonMarch 16, 2009
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Overview

• The economics of the crisis
• Causes
• Timeline
• Effects
• The politics of financial stability
• Policy responses
• Difficult tradeoffs
• The road ahead

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What Went Wrong? Three Faulty Assumptions About
21st Century Finance

• Securitization
• Capital markets are so advanced that banks can
  lend more aggressively while off-loading risk
  through debt securities
• Credit agencies
• Credit ratings agencies offer an easy and cheap
  compass for investors to assess the risk of
  these complex securities
• Risk and financial stability
• The slicing and dicing of risk has made the
  financial system more stable and less crisis-prone

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The Initial Problem Subprime Mortgage Lending
SOURCE BBC
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Subprime Borrowers

• Subprime borrowers
• Borrowers with bad credit (lt620 on 300-850
  scale)
• NINJAs (20 of borrowers)
• What kind of loans do subprime borrowers get?
• ARMs Adjustable Rate Mortgages
• Teaser rates to starthigher rates later on

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Mortgage-Backed Securities (CDOs)
Ratings agencies play a key role
SOURCE NERA
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Subprime Mortgage Lending Boom and Bust
SOURCE IMF, BBC
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From Housing Crisis to Financial Crisis

• Problems of uncertainty
• No one knows how many bad mortgages are in the
  CDOs
• No one wants to lend to banks and other
  institutions with heavy exposure to these
  securities
• Results
• Flight to quality (US Treasuries)
• Spikes in market lending rates
• Stock market crash
• Frozen credit markets

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The Big Freeze
SOURCE Bloomberg
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The Big Freeze
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Case Study Northern Rock (UK)
UKs 8th largest bank in 2007 (113 billion in
assets)
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Northern Rocks Collapse
Bank of England - steps in to bail out (55
billion in loans/guarantees) and ultimately
nationalize NR (2/22/08) once the run starts
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After Northern Rock, 2008-2009
SOURCE BBC
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the Financial Losses Mount
March 2009 5.1 trillion in family net worth
losses (9) in Q4 2008
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and the Real Economic Impact is Severe
GDP growth rates (), 2008-2009
SOURCE BBC/IMF
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Policy Responses to Financial Crises Two Phases

• Short-term (management/resolution)
• Crisis lending, rate cuts, etc.
• Preventing bank runs/collapses (bailouts)
• Unfreezing credit markets (toxic debt)
• Long-term (prevention)
• New regulation
• New institutions
• Domestic and international

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Short-Term Policy Responses Crisis Management

• Liquidity (bailouts)
• To money markets directly to troubled banks
  (TARP)
• Bank deposit guarantees
• Extension of safety net to prevent bank runs
• Dealing with toxic debt
• A government-sponsored bad bank
• Partial nationalization of banks
• The insurance model (UK, January 2009)

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Short-Term Policies Key Questions

• Why not let troubled financial institutions fail?
• Why not bail out all firms? Who should be saved?
• What should the government get in return?
• Should non-financial firms get bailouts, too?

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How to Choose Policies? Difficult Tradeoffs

• Liquidity vs. moral hazard
• Financial crisis vs. other goals
• Aggregate welfare (taxpayers) vs. special
  interests
• National policies vs. international cooperation

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Bailouts Liquidity vs. Moral Hazard

• Government/central bank credit (liquidity) helps
  banks pay their debts and may unfreeze credit
  markets
• But, bailouts create moral hazard for borrowers
  and creditors
• How to choose?
• A liquidity or solvency problem?
• No clear economic answer ? ultimately, a
  political question

Greater moral hazard costs
More money, fewer strings
Less money, more strings
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Financial Stability Stimulus vs. Other Goals

• Economic stimulus package estimated to cost
  800 billion
• Full scale of toxic assets may be 3-4 billion

SOURCE New York Times
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Thus Far Global Crisis, National Responses

• Unilateral efforts unlikely to be successful
• Threat of beggar thy neighbor policies

SOURCE BBC
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The Global Reform Agenda Consensus on Broad
Goals

• Strengthen international supervision and
  regulation
• Bridge the gap between global markets and
  national regulation
• Reform existing institutions
• International Monetary Fund (IMF)
• G-7 / G-20
• International policy coordination
• Macroeconomic stimulus
• Exchange rates / global imbalances
• Trade policy

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But Not on Specific Policies Institutions

• Strengthen international supervision and
  regulation
• Which financial institutions and regulations?
• What institutional form?
• Reform existing global institutions
• The IMF debate resources, conditionality, votes
• New G groups who should be in/out?
• International policy coordination
• How much? For how long?
• Sharp disagreements on trade and exchange rates

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Why No Agreement? Difficult Tradeoffs

• IMF lending
• Liquidity vs. moral hazard
• Regulation/supervision
• Confidence vs. competitiveness
• Institutional reform
• Accountability/legitimacy vs. effectiveness
• Policy coordination
• Domestic politics vs. international commitments

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Tradeoffs The Primacy of Politics

• No optimal economic solutions
• Many possible policies, institutions, and
  regulations
• Conflicts between good economics and good
  politics
• Key political factors
• Domestic politics (interests, institutions)
• Power and geopolitics
• Collective action and bargaining problems
• Ideology

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Example Reforming the IMF

• IMF needs 750 billion - 1.75 trillion to be
  effective
• Will new resources lead to governance reform?

SOURCE Financial Times
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The Next Stage Are the Bailouts Working?
TED Spread, March 2009
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The Next Stage Crises in Emerging Markets
9/-08 3/09 50 billion in new IMF loans to
Iceland, Pakistan, Ukraine, Belarus, Georgia,
Serbia, Latvia, and Hungary
SOURCE Financial Times, IMF World Economic
Outlook
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The Next Stage World Trade Collapsing?
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Some Perspective Weve Been Here Before
SOURCE IMF, World Bank
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Some Perspective The Great Depression,
1929-1933The Depressions Effect on the US
Economy
SOURCE Historical Statistics of the United
States, pp. 235, 263, 1001, and 1007
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Some Perspective Markets
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Some Perspective Recession vs. Depression
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