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The Global Financial Crisis: Is It Like The Great Depression?

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Title: The Global Financial Crisis: Is It Like The Great Depression?


1
  • The Global Financial Crisis Is It Like The
    Great Depression?
  • Trento Economics Festival May 2009
  • Overview by Assaf Razin
  • Tel-Aviv University and Cornell University

2
Current Global Crisis 3 Acts
  • Act I Credit-fed Asset Bubble
  • Act II Financial Collapse after the Burst of the
    bubble
  • Act III spill overs to the real economy

3
Under currents
  • Financial innovation, globalization, and reduced
    transparency in the financial sector
  • Panicky in free fall of asset prices
  • Under capitalized banking system and credit crunch

4
Historical Precedents?
  • The great depression?
  • Japan in the 1990s?
  • Sweden in the 1980s?
  • The saving and loan crisis in the US in the 1980?

5
History
  • Carmen Reinhart of Maryland and Ken Rogoff of
    Harvard, have recently published an analysis of
    the current financial crisis in the context of
    what they identify as the previous 18 banking
    crises in industrial countries since the second
    world war. They find what they call "stunning
    qualitative and quantitative parallels across a
    number of standard financial crisis indicators" -
    the common themes that translate these individual
    dramas into the big-picture story of financial
    boom and bust. Their study is focused on the US,

5
6
Banking Crises
  • BANKING CRISES ARE PROTRACTED, THEY NOTE, WITH
    OUTPUT DECLINING, ON AVERAGE, FOR TWO YEARS.
    ASSET MARKET COLLAPSES ARE DEEP, WITH REAL HOUSE
    PRICES FALLING, AGAIN ON AVERAGE, BY 35 PER CENT
    OVER SIX YEARS AND EQUITY PRICES DECLINING BY 55
    PER CENT OVER 3½ YEARS. THE RATE OF UNEMPLOYMENT
    RISES, ON AVERAGE, BY 7 PERCENTAGE POINTS OVER
    FOUR YEARS, WHILE OUTPUT FALLS BY 9 PER CENT.

7
Banking crises follow ups
8
Two historical precedents
  • The Great Depression in the 1930s
  • The Japanese Deflation(Mid -90s)
  • The shocks that played a role in each (1)An
    asset price correction, in real estate and
    equities (reducing consumption through a wealth
    effect)
  • (2)Impairmaint of financial institutions balance
    sheets (reducing credit)

9
Great Depression
10
Tracking the Great Depression by months into the
Crisis
Eichengreen and ORourke point out that the
original Great Depression was most severe in
America, while this one is more severe in a
number of other countries.
11
Chronology of Crisis
  • May 2008 Bear Stearns crushed and forced to be
    sold to JP Morgan
  • Sept 15 2008Lehman Brothers went belly up.
  • Sept 16, 2008 A.I.G. is effectively nationalized
  • Sept 18, 2008Bank of America bought Merril
  • Lynch.
  • December 2008the Federal Reserve cuts interest
    rates virtually to zero

12
Understanding whats going on is Like shooting
at a moving target
  • Housing bubble.
  • Subprime mortgage crisis
  • Financial sectors toxic assets
  • Liquidity crisis
  • Zero interest rate.
  • Unconventional central banking
  • Liquidity trap?

13
The Current Crisis vs. the Great Depression
  • (1) Both crises followed asset bubbles.
  • (2) Both crises started in the financial sector
    and gradually spread to the real sector. During
    both crises many financial institutions either
    defaulted or had to be bailed out.
  • (3)In both cases the crisis appears to have
    started with the bursting of a bubble.
  • (4) In both cases banking credit dried up.
  • (5) In both cases the lower zero bound on the
    policy rate became effective.
  • (6) In both cases the crisis started in the US
    and then US and subsequently spread to other
    countries.

14
Key Differences
  • 1. Responses of both fiscal and monetary policies
    today are much swifter and vigorous than they
    were during the first three years of the great
    depression
  • The deficit declined in fiscal 1935 by roughly
    the same amount it had risen in 1934.
  • The US was on a gold standard throughout the
    Depression. In April 1933, Rosevelt temporaryily
    suspended the convertibility to gold and let
    Dollar depreciate substantially. When US went
    back on gold at the new higher price of gold,
    large quantities of gold flowed in and caused
    expansion of money supply. The expansion of
    money broke expectations of deflation. .

15
Budget Balance and Monetary Base
  • 2. Hoovers Federal budget was largely balanced
    budget deficit in the current crisis is 8-10
    percent of GDP.
  • Friedman and Schwartz (1963) claim that, during
    the first three years of the great depression,
    the Fed tolerated and even reinforced a
    substantial shrinkage of the money
  • The monetary base was flat during 1929-33 it
    was doubled during 2008.

16
Differences
  • 3. Unemployment in 1930 25
  • in May 2009 9.4
  • Change in output 1929-(peak) to 1933 (trough)
    -25
  • 2007 (peak) last qtr 2008 (before trough) 2
  • Change in prices 1929-1934 deflation 2008-9
    low inflation/deflation? See next slide

17
The graph, from the Cleveland Fed, shows
inflation as gauged by the consumer price index
and by a measure called the median CPI. As every
grade school student learns when the teacher
reports results of the latest test, the average
of any data set can be thrown off by a few
extreme outliers the median is a more robust
statistic to estimate the central tendency in the
data.
18
Monetary institutions
  • 4. There are two important differences in
    monetary institutions
  • First there was no banking deposit insurance at
    the time. As a matter of fact deposit insurance
    was introduced only after Roosevelt became
    president in March 1933. .

19
Gold Standard
  • the 5. US was in the great depression on the gold
    standard. The maintenance of a fixed parity with
    gold collided with the use of monetary policy to
    offset domestic unemployment during the first
    three years of the great depression. For this
    reason the US abandoned the gold standard under
    Roosevelt. Obviously, since the is floating
    vis-à-vis other major currencies, no such
    constraint operates in the current crisis.

20
Contractionary Policies under the Gold Standard
  • Central banks discount rates in the US, UK and
    Germany, in the late 1920s and early 1930s were
    pushed up to prevent gold leakages. The good news
    is that we donot have the Gold Standard now. But
    East European countries in crisis are now jacking
    up interest. Especially those who are trying to
    enter the Euro zone.

21
Informational capital
  • 5. Fourth, the fact that a relatively large
    number of banks disappeared during the great
    depression led to the destruction of banking
    informational capital about the credit
    worthiness of potential borrowers.

22
Tariff War
  • 6. The great depression was characterized by
    beggar thy neighbor policies. In mid 1930 the US
    Congress passed the Smoot-Hawley Tariff Act that
    raised tariffs on over 20,000 imported goods to
    record levels. Other countries retaliated by also
    imposing restrictions on imports and engaged in
    competitive devaluations. This led to a serious
    contraction of international trade.

23
The recession tracks the Great Depression
24
Irving Fishers debt deflation
  • As the great American economist Irving Fisher
    pointed out in the 1930s, the things people and
    companies do when they realize they have too much
    debt tend to be self defeating when every one
    tries to do them, AT THE SAME TIME, the attempts
    to sell assets and pay off debt deepen the plunge
    in asset prices. This further reduces a net
    worth and the process repeats itself.

25
Keynes Metaphor for a Bubble
  • Consider beauty competitions famously described
    by John Maynard Keynes, in which the winner was
    the contestant who chose the six faces most
    popular with all contestants. The result, Keynes
    observed, was that the task was not to choose the
    most beautiful face, but the face that average
    opinion would think that average opinion would
    find the most beautiful. In this way beliefs feed
    on themselves and become divorced from any
    underlying reality.

26
THE LENDER OF LAST RESORT
  • The role of lender of last resort was classically
    defined by Walter Bagehot. His great book Lombard
    Street was published in 1873, and set out what
    has become the guiding mantra for central banks
    in times of crisis ever since lend freely at
    high rates against good collateral. Lend freely,
    in his words, "to stay the panic". At high rates,
    so that "no one may borrow out of idle precaution
    without paying well for it". And lend on all good
    banking securities to an unlimited extent -
    because the "way to cause alarm is to refuse
    someone who has good security to offer".

26
27
Investment Banks
  • By forcing the fourth largest investment bank,
    Lehman Brothers, into bankruptcy and Merrill
    Lynch into a distressed sale to Bank of America,
    they helped to facilitate a badly needed
    consolidation in the financial services sector.
    However, at the 2008 juncture, the credit crisis
    radiated out into corporate, consumer and
    municipal debt. Regardless of the Fed and
    Treasurys most determined efforts, the political
    pressures for a much larger bail-out, and
    pressures from the continued volatility in
    financial markets, are going to be irresistible.

28
Bail Outs
  • the financial crisis has probably already added
    at most 200bn-300bn to net debt, taking into
    account the likely losses on nationalising the
    mortgage giants Freddie Mac and Fannie Mae, the
    costs of the 29bn March bail-out of investment
    bank Bear Stearns, the potential fallout from the
    various junk collateral the Federal Reserve has
    taken on to its balance sheet in the last few
    months, and finally, Wednesdays 85bn bail-out
    of the insurance giant AIG.

29
Repo market and liquidity
In repo agreements borrowers transfer securities
to lenders with an agreement to repurchase them
later, often the next day. They enable banks and
shadow banks to fund long-term, high-yield
investments with short-term low-cost loans
which they did enthusiastically during the credit
bubble by 2008 the top US investment banks
funded half their balance sheets in a repo market
exceeding 10,000bn.
30
What is a Bank?
Banks take peoples money, promise to give it
back on demand and lock it up in less liquid
investments. This works marvellously while few
enough lenders want their money back. It
collapses when all want to hoard their cash at
the same time. That is what happened to Lehman
Brothers the equivalent of a bank run in the
repo market.
31
Lehman as a Custodian
The panic was made worse, the Fed thinks, by the
custodians exposure to losses as Lehmans
lenders left it to its fate. Custodians also
faced conflicts of interest as counterparties to
the repo-funded banks in other markets.
32
Limited Liability
  • The core of the crisis lies in the legal
    provisions of limited liability creditors have
    no claims against the personal assets of the
    owners (shareholders). These liability
    constraints lead to a systematic disregard of
    systemic disaster risks-ocurrences only with a
    small probability about gigantic losses.

33
Risk taking bahavior
  • Investors that opt for high-risk projects with
    high potential gains and losses instead of safe
    projects with similar average profits, can expect
    to gain, since they only have to bear a portion
    of the possible losses. If things go well,
    investors reap the full profit. If things go
    badly, at worst their losses are limited by the
    stock of equity they invest.

34
Moral Hazard
  • A HOUSE INSURED FOR MORE THAN ITS VALUE IS ALWAYS
    CONSIDERED A FIRE RISK. BUT HOME INSURANCE IS
    REGULATED AND ARSON IS A CRIMINAL OFFENCE THAT
    KEEPS PEOPLE HONEST, MOST OF THE TIME

35
Bank recapitalization
  • A severe fall in the market value of a financial
    institution's assets raises the risk and lowers
    the market value of its debt, as well as its
    equity. Bringing in new equity capital produces
    an equal (dollar for dollar) increase in the
    market value of assets. This lowers the risk and
    raises the market value of the institution's
    debt. As a result, part of the new equity capital
    shows up not as equity but as a transfer to debt
    holders. (This is the debt overhang problem.)

36
Who pays for the transfer?
  • Not the new private stockholders. They will not
    invest unless they get stock with market value at
    least equal to the funds they provide. This means
    the transfer of wealth to the old debt holders
    must come from the old stockholders. They pay via
    the dilution of their ownership share (and the
    drop in the share price) caused by bringing in
    new equity.

37
Value of old stock
  • If the market value of the old stock before the
    equity issue is low, it may be insufficient to
    cover the transfer of wealth to debt holders that
    new equity capital produces. As a result, the
    market value of a stock issue would be less than
    the funds provided, and the financial
    institution's attempt to issue equity to meet its
    capital requirement will fail.

38
Subsidy
  • If the Treasury steps in when the private market
    refuses to provide equity capital to a financial
    institution, we are in subsidy land. Again, the
    subsidy arises because a large part of the equity
    injection by the government does not end up as
    government (taxpayer) equity but rather goes to
    prop up the financial institution's debt holders.

39
FDIC
  • If a bank cannot raise private equity to meet its
    FDIC capital requirement, the powers of the FDIC
    kick in. For example, the FDIC can seize the bank
    and auction it off. The bidders are typically
    other banks. Acquiring a seized bank is often an
    attractive option for a strong bank since it can
    be a cost effective way to expand deposits and
    acquire links to profitable borrowers.

40
Price of acquiring a bank
  • The maximum price the acquiring bank should be
    willing to pay is the market value of the seized
    bank's assets minus the seized bank's deposits.
    This net amount is then distributed to the bank's
    non-deposit liability holders, in order of
    priority. What this means is that the seized
    bank's stockholders and some of its lower
    priority debt often get nothing.

41
Credit Crunch 2008
42
Interbank Lendings Squeeze
42
43
Global Saving Glut
  • Behind this Global Saving Glut lie three
    phenomena
  • 1.excess of retained profits (corporate saving)
    over investment, of the corporate sectors of
    the advanced countries,
  • 2. --the persistent savings surpluses of a
    number of mature economies, particularly Japan
    and post-unification Germany.

43
44
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45
Global imbalances
46
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47
Currency reserves
48
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49
The US moves into debtor status, and vast
increase in cross-holdings.
  • In 1996, on the eve of the Asian crisis, the US
    had assets overseas equal to 52 percent of GDP,
    and liabilities equal 57 percent of GDP. By 2007,
    these numbers were up to 128 percent and 145
    percent, respectively.

50
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51
Risk sharing and globalization
  • This is change is supposes to reduce risk US
    investors held much of their assets abroad(less
    exposed to a slump in the US) foreign investors
    held much of their wealth in the US (they were
    less exposed to a slump in their domestic
    economies).
  • But, large parts of the increase in globalization
    came from investments in highly leveraged
    financial institutions (making various riskycross
    border bets).

52
Four vicious cycles
  • Four vicious cycles are simultaneously under
    way falling asset prices are forcing levered
    holders to sell, driving prices further down
    losses at financial institutions are reducing
    their ability to finance investment, which in
    turn reduces asset values, causing further
    losses the weakness of the financial system is
    reducing growth, which in turn weakens the
    financial system and falling output is hitting
    employment, which in turn leads to reduced demand
    for outputLarry Summers.

53
Debt accumulation and deflation in the US
  • The big US debt accumulations were not by
    non-financial corporations but by households and
    the financial sector. The gross debt of the
    financial sector rose from 22 percent of GDP in
    1981, to 117 percent of GDP in the third quarter
    of 2008 the debt of non financial corporations
    rose from 53 percent to 76 percent, in the same
    period. Thus, the desire of financial
    institutions to shrink balance sheet may be a
    cause of the recession.

54
Akerlofs Problem
  • When house prices started to decline, this has
    had bigger effect on some MBS than other MBSs,
    depending on the complexity of the mortgages that
    backed the securities. Owners of MBS have strong
    incentive to price each an every one of them.
    They have superior information over the market
    buyers. As in Akerlofs Lemmons Problem, the
    market for MBS will collapse.

55
Market illiquidity
  • The buyer hopes that the seller sells the
    security because he needs cash. But the buyer
    worries that the seller will unloads the most
    troubled securities. This makes the market
    illiquid.

56
Mortgage Finance
  • The common form of mortgage commits the household
    to make equal monthly payments for 30 years.
    These mortgages payy off with 10 years because
    households sell the property or does refinance.
  • New model The borrower applies to a mortgage
    broker, receives money from a wholesale lender,
    and make payments to a servicer. The servicer
    passes on each payment to a master servicer, who
    pays it out to holders of a mortgage-based-securit
    y (MBS), who pass it on to the adminstrator of a
    collateralized debt obligation (CDO), who passes
    it on to investors in CDOs.

57
Mortgage as option, not loan
  • This mortgage is therefore not a loan but an
    option it allowed for gains if house prices
    rose, but cost relatively little if prices fell.

58
Barriers to Lending
  • The Problem most banks no longer hold the loans
    they make, content to collect interest until the
    debt comes due. Instead, the loans are bundled
    into securities and sold to investors. But the
    securitization market broke. The result is a
    drastic contraction of credit available
    throughout the economy.
  • Banks have come to depend on selling mortgages
    and other loans to investors like hedge funds and
    insurance companies. This allows banks to make
    more loans and earn bigger profits.

59
Mortgage-backed Securities
  • How to value MBSs?
  • Imagine you bought a 100,000 house a year ago,
    with a 10,000 down payment.
  • If the value of the house rises, you are in the
    money.
  • If it falls, you can walk away. You loose the
    original 10,000 investment, but are safe in the
    knowledge that the lender cannot seize your other
    assets..

60
US Borrowings
61
US banks, undermine willingness to expand credit,
Destroy Confidence
62
House Price Bubble
63
US GDP
64
US Unemployment
65
counterparty risk 
  • DEFINITIONThe risk that the other party in an
    agreement will default. In an option contract,
    the risk to the option buyer that the writer will
    not buy or sell the underlying as agreed.
  • In general, counterparty risk can be reduced by
    having an financial organization with extremely
    good credit reputation which acts as an
    intermediary between the two parties.

66
Investors behavior in the asset bubble
-Disaster Myopia Equity markets lost by 2009
all the gains from the 1997-8 crises
  • A tendency to underestimate the probability of
    disastrous outcomes, especially for low-frequency
    events last experienced in the distant past.
  • The risk of falling victim to this syndrome was
    particularly acute in the recent period of
    unusual economic stability known as the great
    moderation. Investors were confronted by falling
    yields against a background of declining
    volatility in markets. Many concluded that a new
    era of low risk and high returns had dawned.

67
Investors in FX markets Carry Tradedepreciation
myopia
  • EQUALLY POPULAR WERE TRADING STRATEGIES SUCH AS
    CARRY TRADES, WHICH INVOLVED BORROWING AT LOW
    INTEREST RATES AND INVESTING AT HIGHER RATES,
    ESPECIALLY VIA THE CURRENCY MARKETS. FAVOURITE
    TRADES INCLUDED BORROWING IN JAPANESE YEN TO
    INVEST IN AUSTRALIA OR NEW ZEALAND, AND BORROWING
    IN SWISS FRANCS TO INVEST IN ICELANDIC ASSETS.

68
The danger in Carry Trade
  • Carry trade WAS DANGEROUS BECAUSE THE INTEREST
    RATE SPREAD COULD BE WIPED OUT IN SHORT ORDER BY
    VOLATILE CURRENCY MOVEMENTS. YET BECAUSE
    VOLATILITY REMAINED LOW FOR SO LONG, DISASTER
    MYOPIA PREVAILED. CARRY TRADERS WERE LULLED INTO
    A FALSE SENSE OF SECURITY, WHILE MORE SCEPTICAL
    COMPETITORS JOINED IN FOR FEAR OF UNDERPERFORMING.

69
The Credit Crunch
  • 1. Overnight credit is blocked by the asymmetric
    information held across banks regarding each
    others assets quality.
  • 2. Fear of the bank of being short of funds to
    meet creditor demands thus the bank is reluctant
    to lend.
  • 3. fear of the bank of being short of funds if
    investment opportunities get better.

70
Moral Hazard
  • Moral hazard, a situation in which one person
    makes
  • a decision about How much risk to take while
  • someone else bears the cost if things go
    badly
  • Treasury proposes to make low-interest,
    non-recourse, loans to private investors who buy
    bad assets this is a plan to drive up the prices
    of toxic assets by creating a lot of moral
    hazard.
  • By offering low interest non-recourse loans,
    these public-private entities can pay a higher
    than market price for the toxic assets (since
    there is no downside risk). This amounts to a
    direct subsidy from the taxpayers to the banks.

71
Four distinct economic mechanisms that played a
role in the liquidity and credit crunch
  • 1. . The effects of large quantities bad loan
    write-downs on borrowers' balance sheets caused
    two "liquidity spirals
  • 1a. As asset prices dropped, financial
    institutions not only had less capital
  • 1b. financial institutions also had harder time
    borrowing, because of tightened lending
    standards.
  • The two spirals forced financial institutions to
    shed assets and reduce their leverage. This led
    to fire sales, lower prices, and even tighter
    funding, amplifying the crisis beyond the
    mortgage market.

72
Mechanisms (continued)
  • 2. Lending channels dried up when banks,
    concerned about their future access to capital
    markets, hoarded funds from borrowers regardless
    of credit-worthiness.
  • 3. Runs on financial institutions, as occurred at
    Bear Stearns, Lehman Brothers, and others
    following the mortgage crisis, can and did
    suddenly erode bank capital.
  • 4. The mortgage crisis was amplified and became
    systemic through network effects, which can arise
    when financial institutions are lenders and
    borrowers at the same time. Because each party
    has to hold additional funds out of concern about
    counterparties' credit, liquidity gridlock can
    result.

73
The Geithner Public-private scheme to buy toxic
assets from banks
  • One or more giant investment fund will be created
    to buy up toxic assets.
  • Its balance sheet for every 1 of toxic assets
    they buy from banks, the FDIC will lend 85.7
    percent (6/7 th of 1), and the US treasury and
    private investors will each put 7.15 cents in
    equity to cover the remaining balance.

74
The Geithner Public-private scheme to buy toxic
assets from banks (continue)
  • The FDIC loan is non-recourse, meaning that if
    the toxic assets purchased by private investors
    fall in value below the amount of the FDIC loans,
    the investment fund will default, and the FDIC
    will end up holding the toxic assets.

75
Tax payer giveaway in the Geithner Plan
  • An Example (Jeff Sachs)
  • Consider a portfolio of toxic assets with a face
    value of 1 trillion. Assume that they have a 20
    percent chance of paying out their full face
    value (1 trillion) and an 80 percent chanceof
    paying out only 200 billion.
  • The market value of these assets is given by
    their expected payout (.2x10.8x.2)360 billion.
  • Because the FDIC is lending money at a low
    (bidding up the market value of toxic assets)
    interest rate on a non-recourse basis is likely
    to experience a massive default on the loan.
  • The FDIC subsidy subsidy shows up as a bid price
    for the toxic assets as it above 360 billion.

76
Over pricing the toxic assets through the
government non-recourse loan
  • Investor is prepared to bid 714, 000 for the the
    asset that a risk-neutral would pay 360,000
    only.
  • How is this number derived?
  • The investor uses 71,000 of her own money and
    643,000 of the government loan adding up to
    714, 000 bid.
  • If the asset pays in full, the investor repays
    the loan with a profit of 357,000 (1,000000-
    643,000) so that with 20 percent of the time,
    which bring an expected profit of 71,000.
  • The other 80 percent of the time the investor
    defaults on the loan, getting a profit of 0, and
    the government ends up with 200,000.
  • Summing up the investor just breaks even by
    bidding 714, 000, as would beexpected in
    competitive auction.

77
Price Discovery or Overpricing?
  • The idea of price discovery of the toxic asset
    would be genuine if the government loan has to be
    repaid whether or not the asset paid of in full
    or not. But, with the non-recourse loan it leads
    to overpricing of the toxic asset.

78
Gaming the System Jeff Sachs Example
  • Consider a toxic asset held by Citibank with a
    face value of 1 million, but with zero
    probability of any payout and therefore with a
    zero market value. An outside bidder would not
    pay anything for such an asset.

79
More..
  • Suppose, however, that Citibank itself sets up a
    Citibank Public-Private Investment Fund (CPPIF)
    under the Geithner-Summers plan. The CPPIF will
    bid the full face value of 1 million for the
    worthless asset, because it can borrow 850K from
    the FDIC, and get 75K from the Treasury, to make
    the purchase! Citibank will only have to put in
    75K of the total.

80
potential rip-off
  • Citibank thereby receives 1 million for the
    worthless asset, while the CPPIF ends up with an
    utterly worthless asset against 850K in debt to
    the FDIC. The CPPIF therefore quietly declares
    bankruptcy, while Citibank walks away with a cool
    1 million. Citibank's net profit on the
    transaction is 925K (remember that the bank
    invested 75K in the CPPIF) and the taxpayers
    lose 925K. Since the total of toxic assets in
    the banking system exceeds 1 trillion, and
    perhaps reaches 2-3 trillion, the amount of
    potential rip-off in the Geithner-Summers plan is
    unconscionably large.

81
the insider-bidding route
  • The earlier criticisms of the Geithner-Summers
    plan showed that even outside bidders generally
    have the incentive to bid far too much for the
    toxic assets, since they too get a free ride from
    the government loans. But once we acknowledge the
    insider-bidding route, the potential to game the
    plan at the cost of the taxpayers becomes
    extraordinary. And the gaming of the system
    doesn't have to be as crude as Citibank setting
    up its own CPPIF. There are lots of ways that it
    can do this indirectly, for example, buying
    assets of other banks which in turn buy Citi's
    assets. Or other stakeholders in Citi, such as
    groups of bondholders and shareholders, could do
    the same.

82
Ersatz Capitalism?
  • Ersatz is a German word meaning compensation or
    idemnity (or still, substitute). Ersatz
    capitalism is when the government in effect
    insure loses, so that loses are socialized but
    gains are privatized. The Geithner plan would
    not determine the fair price of toxic assets in
    the ailing banks. It sets a mechanism to price
    discovery on a put on the toxic asset but not
    on the value of the asset. Its success in
    helping capitalize the banks is negatively
    related to loses to tax payers.

83
Sources for charts Robert Shiller, Andrew
Smithers Thomson Datastream
84
Just under half of corporate debt in America was
rated as speculative (BB or below) at the end
of 2008
85
Global Trends
86
Financial crises over the history
87
Global Crisis
88
US CREDIT MARKET
89
Volume of asset backed securities
90
House price index
91
The Global Picture a la Krugman
  • we used to talk about the subprime crisis .
  • Today we know that subprime lending was only a
    small fraction of the problem.
  • Ben Barnanke (2005), The Global Saving Glut and
    the U.S. Current Account Deficit, offered a
    novel explanation for the rapid rise of the U.S.
    trade deficit in the early 21st century. The
    causes, argued Bernanke, lay not in America but
    in Asia.

92
Global Picture (Continued)
  • In the mid-1990s, Bernanke pointed out, the
    emerging economies of Asia had been major
    importers of capital, borrowing abroad to finance
    their development. But after the Asian financial
    crisis of 1997-98, these countries began
    protecting themselves by amassing huge war chests
    of foreign assets, in effect exporting capital to
    the rest of the world.

93
Global Picture (Continued)
  • Most of the Asia cheap money went to the United
    States hence our giant trade deficit, because a
    trade deficit is the flip side of capital
    inflows. But as Mr. Bernanke correctly pointed
    out, money surged into other nations as well. In
    particular, a number of smaller European
    economies experienced capital inflows that, while
    much smaller in dollar terms than the flows into
    the United States, were much larger compared with
    the size of their economies.

94
Global Picture (Continued)
  • wide-open, loosely regulated financial systems
    characterized the US shaddow banking system and
    mortgage institutions, as well as many of the
    other recipients of large capital inflows. This
    may explain the almost eerie correlation between
    conservative praise two or three years ago and
    economic disaster today. Reforms have made
    Iceland a Nordic tiger, declared a paper from
    the Cato Institute. How Ireland Became the
    Celtic Tiger was the title of one Heritage
    Foundation article The Estonian Economic
    Miracle was the title of another. All three
    nations are in deep crisis now.

95
Global Picture (Continued)
  • For a while, the inrush of capital created the
    illusion of wealth in these countries, just as it
    did for American homeowners asset prices were
    rising, currencies were strong, and everything
    looked fine. But bubbles always burst sooner or
    later, and yesterdays miracle economies have
    become todays basket cases, nations whose assets
    have evaporated but whose debts remain all too
    real. And these debts are an especially heavy
    burden because most of the loans were denominated
    in other countries currencies.

96
Global Picture (end)
  • Nor is the damage confined to the original
    borrowers. In America, the housing bubble mainly
    took place along the coasts, but when the bubble
    burst, demand for manufactured goods, especially
    cars, collapsed and that has taken a terrible
    toll on the industrial heartland. Similarly,
    Europes bubbles were mainly around the
    continents periphery, yet industrial production
    in Germany which never had a financial bubble
    but is Europes manufacturing core is falling
    rapidly, thanks to a plunge in exports.

97
Europe vs. the US
  • 27 EU countries lack ways of boosting their
    overall fiscal and monetary firepower by acting
    collectively.
  • Europe has fallen short in terms of both fiscal
    and monetary policy its facing at least as
    severe a slump as the United States, yet its
    doing far less to combat the downturn.
  • On the fiscal side, Americas actions dwarf
    anything the Europeans are doing.
  • Monetary policy The European Central Bank has
    been far less proactive than the Federal Reserve
    it has been slow to cut interest rates (it
    actually raised rates July 2008!), and it has
    shied away from any strong measures to unfreeze
    credit markets.
  • The only thing working in Europes favor is the
    very thing for which it takes the most criticism
    the size and generosity of its welfare states,
    which are cushioning the impact of the economic
    slump.

98
Stimulus packages
99
No two fiscal packages are ever launched amid the
same circumstances
It is wrong to extrapolate from the past!
Measuring the separate effect of any One-off
fiscal boost from the automatic Extra spending
that was anticipated Is hard.
100
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101
Fed Rate
102
Emerging stars buffeted by global storm
103
Triggers of credit bubbles and depression
Economics
1. Moral hazard, a situation in which one person
makes a decision about How much risk to take
while someone else bears the cost if things go
badly 2. Self fulfilling panics, as in bank runs.
104
Credit Market September 2008
  • financial institutions hold significant assets
    that are backed by mortgage payments. Two years
    ago, many of those mortgage-backed securities
    (MBS) were rated AAA, very likely to yield a
    steady stream of payments with minimal risk of
    default. This made the assets liquid. If a
    financial institution needed cash, it could
    quickly sell these securities at a fair market
    price, the present value of the stream of
    payments. A buyer did not have to worry about the
    exact composition of the assets it purchased,
    because the stream of payments was safe.

105
Libor-OIS spreads reached 200 basis points in
September 2008 when Congress failed to pass the
Paulson plan
106
Bank bailouts
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108
Japans 1990s
  • Japans experience in the 1990s is cautionary
    example of the peril of propping up banks after a
    real estate boom ends. The Japanese government
    helped keep many troubled banks afloat, hoping to
    avoid the pain of bank failures, only to extend
    the economic downturn as consumer spending and
    job growth fell.

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110
Japans Banks
  • THE 1990 COLLAPSE OF AN ASSET BUBBLE PROVOKED A
    SHARP FALL IN THE VALUE OF PROPERTY AND EQUITY
    THAT UNDERPINNED BANKS BALANCE SHEETS. BUT BANKS
    IGNORED THEIR PROBLEMS UNTIL 1997 WHEN SANYO
    SECURITIES, YAMAICHI SECURITIES AND HOKKAIDO
    TAKUSHOKU BANK ALL FAILED.

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112
Japans Current Account
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114
Reluctance to recapitalize by state funds
  • A RELUCTANCE TO ADMIT THE SCALE OF THE PROBLEM
    MEANT CAPITAL INJECTIONS TOOK PLACE IN THREE MAIN
    TRANCHES. THE FIRST CAME IN THE SPRING OF 1998,
    WHEN THE GOVERNMENT INJECTED Y1,800BN (18BN,
    11BN, 14BN) INTO 21 INSTITUTIONS. THE MONEY,
    WHICH CAME IN THE FORM OF PREFERENCE SHARES, HAD
    FEW STRINGS ATTACHED. THE SECOND FOLLOWED THE
    COLLAPSE IN 1998 OF NIPPON CREDIT BANK AND LONG
    TERM CREDIT BANK. A TIGHTENING OF RULES FORCED 32
    INSTITUTIONS TO RAISE CAPITAL AND IN 1999 TO
    ACCEPT GOVERNMENT FUNDS TOTALLING Y8,600BN.

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116
Conditions set by government
  • Conditions grew stricter. The first time, the
    government injections were very generous,
    depending on the banks own will. The second time
    was more forcible, says the former BoJ official.
    The first priority was that in a certain period
    they had to return from red to black, second was
    to lend to SMEs small and medium-sized
    enterprises and third was a host of conditions,
    such as cutting their payroll,

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118
Non performing loans
  • By March 2005, non-performing loans were at 2.9
    per cent of banks total assets from 8.4 per cent
    at the height of the crisis.

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120
Sweden in the 1990s
  • Sweden in the early 1990s took a middle
    pathswiftly taking over many of its troubled
    banks. The American bailout plan, economists say,
    takes a page from the Swedish example by making
    the government a shareholder in banks
    participating in the program. But, they add, the
    American banking system is so much larger and
    diverse than Swedens that the parallels are
    limited.

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122
Capital injection and tax payers
  • In exchange for the capital injection by the
    government, taxpayers might be protected through
    preferred shares (or warrants), giving them
    dividends in the future.

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124
Differences between bailout and government
spending
  • First, note that there is a major difference
    between a program to support the financial
    sector and 700bn in new outlays. No one is
    contemplating that the 700b in the Paulson plan
    will be given away. All of its proposed uses
    involve either purchasing assets, buying equity
    in financial institutions or making loans that
    earn interest.

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126
2nd difference
  • Second, the usual concern about GOVERNMENT
    BUDGET DEFICITS IS THAT THE NEED FOR GOVERNMENT
    BONDS TO BE HELD BY INVESTORS WILL CROWD OUT
    OTHER, MORE PRODUCTIVE, INVESTMENTS OR FORCE
    GREATER DEPENDENCE ON FOREIGN SUPPLIERS OF
    CAPITAL. TO THE EXTENT THAT THE GOVERNMENT
    PURCHASES ASSETS SUCH AS MORTGAGE-BACKED
    SECURITIES WITH INCREASED ISSUANCE OF GOVERNMENT
    DEBT, THERE IS NO SUCH EFFECT.

127
Whats Next?
  • Green Shoots?
  • Persistent and high unemployment?
  • Non functioning financial sector?
  • Debt overhang?
  • Inflation?
  • Prolong risk and volatility?

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129
The yield curve as a predictor of future growth
  • This graph shows the difference between the
    10-year and 2-year yield on Treasuries. In
    general, a steep yield curve--that is, a high
    value of this variable--is a positive indicator
    of future economic growth. In many ways, however,
    this is an unusual downturn, so it is not
    entirely clear to what extent historical
    relationships are a useful guide going forward

130
Treasuries (May 2009) sell-off
  • The sell-off may reflect fears of future
    inflation
  • The downgrade of treasuries in the presence of
    huge US government debt
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