Title: The World Financial Crisis: Its Nature, Consequences, Causes and Resolutions
1The World Financial Crisis Its Nature,
Consequences, Causes and Resolutions
- Robert Mundell
- University Professor, Columbia University,
- Nobel Laureate in Economics, 1999
- Astana, Kazakhstan
- March 11. 2009
2Time of Great Crisis
- Today we are in the middle of a great crisis. The
governments of the world are in a state of shock.
All the major economies except China are in a
state of contraction expected to last at least
another full year. - Many banks around the world are insolvent and
unemployment is increasing rapidly. - It is imperative that we act with bold measures
quickly.
3Currency Areas after the Euro
Canada
Russia
Korea
Sweden
RMB
India
Taiwan
Indonesia
Hong Kong
Mexico
Brazil
Australia
Gulf Countries
Latin American Caribbean
CFA
4 The Crisis
5The 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.
6End 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.
7Six innovations Good or Bad?
- Investment Banking (end of
- Glass-Steagal)
- Securitization of mortgages
- Derivatives
- Credit-Default-Swaps
- Mark-to-Market Accounting Rules
- Variable Rate Mortgages
8Massive 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 fill (or
cover up!) the holes. - The scramble for liquidity was completely
unprecedented in the annals of finance. - A financial panic was about to occur.
9The Liquidity Crisis Aug 9-10, 2007
- 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.
10Injections by ECB and FRB in Billions of Dollars
in August 2007
11Solvency 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.
12Slowdown 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.
13The 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.
14Financial Blowout and Recession in 2008-II
- But instead of recovery in the last half of 2008
we got the greatest financial disasters in
American history and a an unambiguous recession
with two consecutive quarters of negative growth
in 2008 (3) and 2008(4).
15Lehmans 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.
16Credit 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.
17Two Questions
- Two questions arise
- 1. What put Lehman Bros in danger?
- 2. Why did the Fed and Treasury let Lehman fail?
18Lehmans 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.
19The 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?
20Currency Appreciation and Tight Money
- The dollar soared in July-September and the price
of gold fell. - These are two symbols of tight money.
- True, interest rates were low and monetary
expansion was enormous, but not enough to offset
the increase in the demand for money.
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22The price of gold plummeted.
Tue Feb 10 162109 2009
Tue Feb 10 162109 2009
23Low 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. -
24The Fed Screwed Up!
- The Federal Reserve cut off the economic recovery
in 2008(2) and tipped the economy into recession
and financial crisis.
25Joint Fed-Treasury Mistake
- This does not exonerate the Secretary of the
Treasury for the joint Fed-Treasury mistake in
letting Lehman Brothers failed. - The failure greatly increased the demand for
money further, creating the casualties that
followed.
26Crises and Tight Money, Appreciation
27Tight Money
- Crises are usually caused by unexpected tight
money or (not unrelated) currency appreciation. - Tight money always implies an excess demand for
money. - It can arise because demand increases or because
the supply decreases or both.
28Money Supply and Demand
- Central bankers dont always know when money is
tight or easy. - This is because while the money supply is easy to
measure, the demand for money is not. - So it turns out central bankers use many indirect
indicators.
29Variables Sometimes Used to Measure Tight Money
- 1. Interest rates (spot and forward)
- 2. Bank reserves (including free bank reserves)
and rates of change - 3. Rate of monetary expansion
- 4. Exchange rates (and rates of change)
- 5. Gold prices (and rates of change)
30Interest Rates and Money Supply
- Interest rates can reflect inflation or deflation
as well as the marginal productivity of capital
and not therefore a good measure of tightness. - Bank reserves mean nothing without consideration
of the demand for reserves. - Money supply expansion by itself can be
misleading because demand might be greater than
supply. Demand can increase because of economic
growth or because of uncertainty.
31Exchange Rates and Gold
- Currency appreciation under floating rates can
indicate relative tight monetary conditions
between two currencies. - A falling gold price (denominated in the domestic
currency) can reflect tight money because gold is
the most liquid commodity and widely used as a
hedge against inflation.
32Debt Crises and Deflation
- Debt crises typically arise because of an
exogenous event that suddenly changes
expectations from inflation to deflation. - In the late 1920s, it was the return to the gold
standard which ended the roaring twenties and
brought about high real interest rates and an
unexpected 35 deflation in all the major
countries (except the U.K. which the pound off
gold in 1931) in 1929-32.
33Debt Crises of the 1980s
- The debt crises of the early 1980s reflected
deflation (more precisely disinflation) and
dollar appreciation as the two-digit inflation
rates of 1979-81 were brought down toward 4. - The SL crisis came about when disinflationary
policies brought short-term interest rates
soaring above long term rates.
34Asian Crisis
- The Asian crisis of the 1990s cam about as a
result of the exchange rate instability of three
major countries. - Chinese Yuan, which devalued at the beginning of
1994, raising the dollar from C5.5 to C8.7. - The appreciation of the dollar against the yen,
from 78 in April 1995 to 148 in June 1998.
35Dollar Appreciation, Yen Depreciation
- The appreciation of the dollar against the yen
weakened Southeast Asian countries in a triple
way, by knocking them off their currency pegs, by
eliminating their markets in Japan, and by ending
Japans FDI to countries like Thailand, Malaysia,
and Indonesia.
36Consequences of the Crisis
37Events Associated with the Crisis
- Demoralization of markets in the United States
and all over the world. - Banks afraid to lend because they fear insolvency
of their clients. - Increasing recession and growing unemployment in
all the major countries. - Lack of confidence in governments ability to cope
with the crisis. - Failure of international coordination.
38EEMEA Currency Depreciation against USD yoy ,
as of 03/03/09
39LATAM Currency Depreciation against USD yoy ,
as of 03/03/09
40- Export yoy Latin American Countries
41 42Asia Currency Depreciation against USD yoy ,
as of 03/03/09
43 44International Reserves USD18.3bn
45CPI yoy 8.7
46PPI yoy -29.1
47CDS USD 5Y 1368.9 bps
48Stock Market Index 594.52
49Currency against USD 150.44 Tenge/USD
50KAZPRIME Interest rate 3M 15
51Monetary Systems and Crises
52Theories of the Crisis
- A crisis of capitalism.
- Global Imbalances
- Dollar as Reserve Currency
- Under-Regulation (IMF Theory)
- Unstable Exchange Rates
- Lack of a Global Currency
53No Systemic Failures until Floating Began
- No systemic banking failures under the gold
standard before World War I, nor under
bimetallism from 1815 to 1973, nor under the
Bretton Woods system from World War II until
1971. - Bretton Woods system broke down because of the
misalignment of gold, not a problem of fixed
exchange rates.
54Recessions, Crises or Policy Failures Under
Fluctuating Rates
- 1974-5 Recession
- 1979-81three years of two-digit inflation
- 1981-3recessionunemployment over 11
- 1982--- International Debt Crisis
- 1982-3 SL Crisis
- 1995Mexico-ArgentinaLatin America crisis
- 1997-8Asian crisis
- 2001-2Global Slowdown Dot-com crisis
- 2007-9The Great Financial Crisis
55Instability of Exchange Rates
- Instability of exchange rates has been culpable
as instigator or aggravator in each one of these
crises. - Reflects unfavorably on system of fluctuating
exchange rates.
56Historical Error Nixon and Roosevelt
- My general thesis, underlying this lecture, is
that the major problem lies with the failure to
restore the international monetary system. - President Roosevelt took the dollar off gold and
broke up the system in 1933 but he put it back
together again in 1934. - Likewise, President Nixon took the dollar off
gold and broke up the system, but failed to
establish a new price. - It was a mistake of leadership on his part, and a
mistake of his subordinates.
57Roosevelt Restored the System
- In March 1933 President Roosevelt in his first
week as president closed the banks and took the
dollar off gold at 20.57 an ounce. - The next year in 1934 he put the dollar back onto
gold at a higher price of 35 an ounce. - He restored what would later be called the
Bretton Woods System. - It lasted four decades without major banking
crises.
58Nixon Failed to Restore the System.
- President Nixon, like Roosevelt four decades
earlier, in August 1971, took the dollar off
gold, bringing to an end the Bretton Woods
international monetary system. - But Nixon failed to follow up with a restoration
of the system at a new price. - Probably Watergate got in the way.
- This left the world without am international
monetary system.
59In Retrospect, What Should Nixon have Done?
- Nixon should have established a new Gold-SDR
system. - The SDR was created in 1968 as an incipient world
currency with a gold-value guarantee. - In 1971 the dollar price of gold could have been
tripled to 100 an ounce and gold and SDRs (also
tripled) made the core of a revised international
monetary system alongside the dollar.
60POLICIES FOR DEALING WITH THE CRISIS
61Requirements
- A facility for increasing demand
- Restoring corporate competitiveness
- Restoring the banking system
- Stabilizing exchange rates Global Currencies
National Currencies - Cooperation and Policy Coordination
62A Facility for Increasing Demand Dated Spending
Vouchers
- Dated Spending Vouchers (DSVs) of 3 of a years
GDP 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 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.
632. Restoring Corporate Competitiveness Slash
Corporate Profits Taxes
- Cut the corporate tax rate 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 taking a large fraction of earnings
without adding any capital to the corporation or
share in any losses.
643. Restoring the Banking System Restructure and
Privatize Insolvent Banks
- Government should act aggressively to take over
and restructure insolvent banks and then
subsequently re-privatize them.
654. Stabilizing Exchange Rates Global Currencies
- The U.S. should work with Europeans to reduce
the instability of the dollar-euro rate. - It should help the dollar-euro (fixed between
margins) to be an anchor for non-global
currencies. - The Japanese yen and the Chinese yuan could also
be tied to the dollar-euro rate after it has been
stabilized.
664. Global Currencies, contd
- 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.
674. Stabilizing Exchange Rates National Currencies
- Other countries should seek, wherever possible,
to stabilize their currencies to either the
dollar or the euro or a basket of the two
currencies. - Then support plans that would internationalize
the global currencies into an international unit.
685. Cooperation and Policy Coordination An
International Macroeconomic Advisory Council
- Establish a global counterpart to the
Volcker-Chaired Obama Advisory Council. - Form a revolving committee to advise and evaluate
macroeconomic policy and make recommendations. . - Form on this basis an International Economic
Advisory Council to report to the G-20 and/or the
IMFC.
696. Project for a World Currency
- Propose to the G-20 the formation of an
international study group to propose alternative
routes to a global currency
70Guidelines for a World Currency
71Recent Phases of the International Monetary System
72Alternative Approaches
- Regionalization Approach
- Dominant Currency Approach
- Precious Metals Approach
- IMU Approach
73Regional Approach
- Basic model is to follow in Europes footsteps in
its creation of the euro. - Single currency requires security area (war-free
zone) and considerable degree of political
integration - Not easy to achieve in Latin America, Africa or
Asia.
74An Asian Currency by 2015?
India
Russia
15
RINGITT
Baht
YEN
WON
P-Peso
EURO
Africa
RMB
Rupiah
HK
Latin Dollar
Australia-NZ
Arab Bloc
75Dominant Currency Approach
- Likely to be the default position, if not plan
for an international currency can be negotiated. - Dominant Dollar Standard could be an efficient
standard if the U.S. maintained price stability. - But critics would maintain that it is not fair,
it gives too much power to the U.S. and is
unacceptable.
76Anchored Dollar Standard 1934-1971.
Gold
Soviet Union
U.K.
U.S.
Japan
China
France
Italy
Germany
77Gold Standard Approach
- Raise the price of gold to create enough gold
liquidity to serve as international reserves. - Would require a gold price of 7,000 the ounce to
replace For. Ex. Reserves. - Impossible to negotiate.
78The Gold Standard and Economic Powers, c.1890
(Inner circles represent gold stocks)
France
Japan
K
Cuba
Spain
British Empire
Puerto Rico
Russian Empire
U.S.
Ottoman Empire
German Empire
German Empire
Italy
Austria-Hungarian Empire
79INTOR APPROACH Alternative Names
- INTOR (Mundell, 1968) is one name for a world
currency. Other names are - BANCOR (Keynes, 1943)
- UNITAS (Harry Dexter White, 1943)
- MONDOR (Jacob Viner, 1944)
- SDR (IMF, 1967)
- IMU (International Money Units), Generic
80INTOR APPROACH
- Develop a small core basket of the top 2-5
currencies weighted by GDP. - Decide whether or not to include or exclude
commodities like gold or oil certificates in the
basket.
81 APEC Europe?
Euro Area
D E Y
India
Russia
RMB
Africa
Latin Dollar
Dinar Area
Indonesia
82Three Stages of Monetary Reform
- Stage I. Convergence of DEY (Dollar-Euro-Yen)
Exchange Rates and G-3 Monetary Policy - Use of DEY as platform, possibly with gold, for
world currency, the INTOR - Creation of INTOR and Ratification by the Board
of Governors of IMF.
83The INTOR What could we expect?
- A single unit for quoting prices.
- A common unit for denominating debts.
- A common rate of inflation for participating
countries. - A common interest rate on risk-free assets.
- A global business cycle.
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85Quotas in IMF
86Intor Sandwich
87World Map with the INTOR
India
RMB
Russia
Latin Dollar
Arab Bloc
Africa
88Thank You