The World Economy in Crisis: International Monetary Reform

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The World Economy in Crisis International
Monetary Reform

• Robert Mundell
• Columbia University
• June 27, 2009
• Tbilisi State University
• Tblisi, Georgia

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Outline

• 1. Origins of the Financial Crisis
• 2. What Caused the Crisis of 2008?
• 3. The International Monetary System
• 4. Chinas Economy
• 5. Five Goats of the Crisis
• 6. What Should We Do?
• 7. Policies for Rest of the World
• 8. Conclusions

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1. Origins of the Financial Crisis
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The Financial Crisis

• The financial crisis started in the summer of
  2007.
• It was reflected in the great liquidity crisis
  that developed on August 9-10 when awareness of
  the troubles associated with sub-prime mortgage
  assets became general.
• It exploded in the summer and fall of 2008 with
  the insolvency of Fannie Mae and Freddie Mac and
  the failure of Lehman Bros.

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The Origins

• The early origins go back to the Federal Reserve
  policies used to cope with the global slowdown of
  2001-2.
• With very low interest rates and a low dollar in
  the recovery, a housing boom developed.
• As long as house prices were rising there was a
  cushion of safety between mortgages and house
  values.

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Five Flies in the Ointment

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

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Financial Innovations

• Securitization of mortgages cut link between
  issuers and holders.
• Derivatives created new systemic risks.
• Credit default swaps enabled insurance without
  ownership.
• Mark-to-market accounting in investment accounts
  created intertemporal instability in balance
  sheets.

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End of the Boom

• When the house prices stopped rising and began to
  fall, the boom ended.
• When house prices fell below mortgage values,
  homeowners walked away from their mortgages.
• Sub-prime mortgage assets became toxic, creating
  a devastating hole in balance sheets.

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Massive Liquidity Crisis

• Sudden awareness of the problem in the summer of
  2007 created a massive balance sheet problem for
  banks amounting to hundreds of billions of
  dollars.
• Mark-to-market accounting forced them to cover
  the holes.
• The scramble for liquidity was completely
  unprecedented in the annals of finance.
• A financial panic was about to occur.

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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.

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Injections by ECB and FRB in Billions of Dollars
in August 2007
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Solvency Problem

• 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.

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Slowdown and then Recovery?

• After the resolution of the liquidity crisis
  there was relative quiet for 13 Months.
• The great expansion of 2002-2007 came to an end
  in the U.S. with the great slowdown in 2007 (4)
  and 2008 (1) and a near recession.
• But then expansion came in 2008 (2) with growth
  of 2.8.
• A recovery seemed to be coming.

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Financial Blowout and Recession in 2008-II

• But instead of recovery in the last half of 2008
  we got the greatest financial disasters in
  Americaqn history and a an unambiguous recession
  with two consecutive quarters of negative growth
  in 2008 (3) and 2008(4).

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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.

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Credit Dried Up

• The most serious cost of the failure of Lehman
  was a colossal increase in the demand for money
  on the part of both banks and the public.
• Money became even tighter. Credit became
  unavailable except for super-solvent firms.
  Credit for ordinary enterprises dried up.

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Two Questions

• Two questions arise
• 1. What put Lehman Bros in danger?
• 2. Why did the Fed and Treasury let Lehman fail?

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Lehmans Collapse

• Lehman was too big to fail BUT THE FED AND
  TREASURY LET IT FAIL.
• A colossal 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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The Spring Recovery

• 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.

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The Big Question

• Why did the financial crisis occur and why did it
  happen to come about in August and September
  2008?
• What caused the debacle that September?

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The price of gold plummeted.
Tue Feb 10 162109 2009                      
                                                  
                                                  
                     
Tue Feb 10 162109 2009                      
                                                  
                                                  
                     
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The FED Mistake

• The soaring dollar and falling gold price were
  symptoms of a shortage of dollar liquidity.
• Had the FED recognized this shortage and bought
  foreign exchange to prevent the appreciation,
  there would probably have been no financial
  crisis in the fall.
• Instead, the dollar appreciation overvalued US
  dollar assets including all fixed income
  securities and mortgages, tipping Lehman Bros and
  other banks over the edge.

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Low Gold, Strong Dollar

• The soaring dollar and falling gold price were
  symptoms of a shortage of dollar liquidity.
• Had the FED recognized this shortage and bought
  foreign exchange to prevent the appreciation,
  there would probably have been no financial
  crisis in the fall.
• Instead, the dollar appreciation overvalued US
  dollar assets including all fixed income
  securities and mortgages, tipping Lehman Bros and
  other banks over the edge.

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Conclusion

• The Federal Reserve cut off the economic recovery
  in 2008(2) and tipped the economy into recession
  and financial crisis.

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Like the early 1980s

• In 1979 oil prices nearly tripled to 34/bbl,
  gold soared and the dollar tumbled, while
  inflation in 1980 registered 13.
• The Reagan administration lowered tax rates and
  increased defense spending, while the Federal
  Reserve Board tightened, creating a policy shock
  that made the dollar soar, gold prices fall, the
  recession of 1982, the savings and loan debacle
  and the international debt crisis.

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Flight to the Dollar

• The tight money of summer 2008 reflected in the
  strong dollar and low gold price panic all over
  the world and a flight to the dollar that brought
  a halt to bank lending.
• Similarities are great because of oil prices,
  exchange rates, gold prices, and massive fiscal
  policies.

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3. The International Monetary System
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Intl Gold
Standard 1873 - 1914 Bretton Woods System
1945 1971Flexible Exchange Rates 1973
1999Dollar-Euro 1999
Phases of the International Monetary Arrangements
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Gold Standard

• No major banking crises under gold standard or
  Bretton Woods System
• Barings Crisis of 1890s
• Knickerbocker Crisis of 1908
• Rather anecdotal by comparison

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The Gold Standard and the Great Powers, c.1910
Ottoman Empire
China
Gold
U.S.
Russian Empire
Mexico
Japanese Empire
British Empire
British Empire
French Empire
Italian Empire
Austria-Hungarian Empire
German Empire
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Dollar Standard II. 1934-1971. A.K.A. the Bretton
Woods System
Gold
Soviet Union
U.K.
U.S.
Japan
China
France
Italy
Germany
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No Major Banking Crisis

• No major banking crises under either the gold
  standard before 1914 or under the Bretton Woods
  system of fixed exchange rates.
• Four crises under floating.

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Flexible Rates 1973-99

Canada
Soviet Union
Sweden

Korea

RMB
DM
France

Hong Kong
Gulf Countries
India
CFA
Italy
Mexico
Latin American Caribbean
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Four Crises Under Floating

• Four major banking crises under floating rates
• 1982International Debt Crisis
• 1982-3 Savings and Loan Ass. Crisis
• 1997-8 Asian Crisis
• 2007-9 Financial Meltdown

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Exchange Rate Instability

• All of these crises were associated with swings
  in exchange rates of big currencies, mainly
  dollar-euro (or ECU) and dollar-yen.

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The International Monetary System after the
Euro 2008

Russia
Canada

Korea
Sweden



RMB

India
Malaysia

Taiwan
Indonesia
Hong Kong
Malaysia
Mexico
Brazil
Australia
Gulf Countries
Latin American Caribbean
CFA
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EUROS PER DOLLAR
1985
2001
Trend?
1971
1992
1980
2008
2008
1970
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Harmful Effect of Big Swings in Exchange Rates

• Huge redistributions of wealth because currencies
  denominate debts
• Dollar system benefits U.S. in short run, hurts
  it in long run
• Dollar weakens with easy monetary policy during
  recessions and strengthens during booms
• Harmful to Europe and Other Countries

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6. Policies
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Global Macroeconomic Policy Council

• Establish an international counterpart to the
  Volcker-Chaired Advisory Committee
• Stabilize exchange rates were feasible

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Outlook

• US economy is reaching a bottom.
• But recovery is likely to be slow.
• Major barrier to recovery is instability of oil
  prices and exchange rates, particularly
  dollar-euro rate.
• Smaller countries need to support an agenda of
  major monetary reform.

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Policy Shift Needed

• Big cut in Corporate Profits Tax
• Stabilization of major exchange rates.
• Creation of a Global Reserve Currency

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• thank you