The Worst Financial Crisis in 75 Years: Origins, Magnitude, Response and Lessons Jeffrey Frankel James W. Harpel Professor of Capital Formation - PowerPoint PPT Presentation


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The Worst Financial Crisis in 75 Years: Origins, Magnitude, Response and Lessons Jeffrey Frankel James W. Harpel Professor of Capital Formation


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Title: The Worst Financial Crisis in 75 Years: Origins, Magnitude, Response and Lessons Jeffrey Frankel James W. Harpel Professor of Capital Formation

The Worst Financial Crisis in 75 Years
Origins, Magnitude, Response and
Lessons Jeffrey Frankel James W. Harpel
Professor of Capital Formation Growth Harvard
Kennedy School
  • Wellesley Country Club, March 26, 2009

Origins of the crisis
  • Well before 2007, there were danger signals in
  • Low interest rates 2003-04
  • Early corporate scandals (Enron)
  • Risk was priced very low,
  • housing prices very high,
  • National Saving very low,
  • current account deficit big,
  • leverage high,
  • mortgages imprudent

Six root causes of financial crisis
  • US corporate governance falls short of its
  • E.g., rating agencies
  • executive compensation (options golden
  • US households save too little, borrow too much.
  • Politicians slant excessively toward
  • Tax-deductible mortgage interest FannieMae
    Allowing NINJA loans
  • Starting 2001, the federal budget was set on a
    reckless path
  • Reminiscent of 1981-1990
  • Monetary policy was too loose during 2004-05,
  • accommodating fiscal expansion, reminiscent of
    the Vietnam era.
  • Financial market participants during this period
    grossly underpriced risk
  • risks housing crash, crash, oil prices,

Origins of the financial/economic crises
Homeownership bias
Predatory lending
Excessive complexity
Foreign debt
Gulf insta-bility
Oil price spike 2007-08
Recession 2008-09
Onset of the crisis
  • Initial reaction to troubles
  • Reassurance in mid-2007 The subprime mortgage
    crisis is contained. It
  • Then, The crisis is in Wall Street, sparing Main
    Street. It didnt.
  • Then de-coupling The US turmoil will have
    less effect on the rest of the world than in the
    past. It hasnt.
  • By now it is clear that the crisis is
  • the worst in 75 years,
  • and is as bad abroad as in the US.

The return of Keynes
  • Economists still shy away from using the name.
  • But Keynesian truths abound today
  • Origins of the crisis
  • The Liquidity Trap
  • Fiscal response
  • Motivation for macroeconomic intervention to
    save market microeconomics
  • International transmission

  • The origin of the crisis was an asset bubble
    collapse, loss of confidence, credit crunch.
  • Like Keynes animal spirits or beauty contest
    . Add in Fishers debt deflation, the Minsky
    moment, and von Hayeks credit cycle
  • It was not a monetary contraction in response to
    inflation (as were 1980-82 or 1991).
  • But, rather, a credit cycle 2003-04 monetary
    expansion showed up only in asset prices. (Borio
    of BIS.)

US Recession
  • In December 2008, NBER Business
  • Cycle Dating Committee proclaimed
  • US recession had started in December 2007.
  • As of March 2009, the recessions length ties the
    postwar record of 1981-82 (16 months).
  • Recovery unlikely before late 2009
  • gt recession is already longest since 1930s.
  • Likely also to be as severe as oil-shock
    recessions of 1974 and 1980-82.

Peak Trough Contraction
Quarterly dates are in parentheses Quarterly dates are in parentheses Peak to Trough
August 1929 (III) May 1937 (II) February 1945 (I) November 1948 (IV) July 1953 (II) August 1957 (III) April 1960 (II) December 1969 (IV) November 1973 (IV) January 1980 (I) July 1981 (III) July 1990 (III) March 2001 (I) December 2007 (IV) March 1933 (I) June 1938 (II) October 1945 (IV) October 1949 (IV) May 1954 (II) April 1958 (II) February 1961 (I) November 1970 (IV) March 1975 (I) July 1980 (III) November 1982 (IV) March 1991 (I) November 2001 (IV) 43 13 8 11 10 8 10 11 16 6 16 8 8
Average, all cycles 1854-2001 (32 cycles) 1945-2001 (10 cycles) Average, all cycles 1854-2001 (32 cycles) 1945-2001 (10 cycles)   17 10
US employment peaked in Dec. 2007, which is the
most important reason why the NBER BCDC dated
the peak from that month. Since then, 4 ½
million jobs have been lost (3/09).
Payroll employment series Source Bureau of Labor
My favorite monthly indicator is total hours
worked in the economy
It confirms US recession turned severe in
September, when the worst of the financial
crisis hit (Lehman bankruptcy)
Recession was soon transmitted to rest of world
  • Contagion Falling securities markets
    contracting credit.
  • Especially in those countries with weak
    fundamentals Iceland, Hungary Ukraine
  • Or oil-exporters that relied heavily on high oil
    prices Russia
  • But even where fundamentals were relatively
    strong Korea
  • Some others experiencing their own housing
    crashes Ireland, Spain
  • Recession in big countries will be transmitted to
    all trading partners through loss of exports.

downgraded again (Jan.28, 2009)
Jan.28, 09
The IMF has cut by half estimates for
low- middle-income countries.
Rev. vs. Oct.08 projection
World Recession?
  • No generally accepted definition.
  • A fall in Chinas growth from 11 to 1, e.g, is
    obviously a recession.
  • Perhaps 6 ½ is as well (World Bank forecast,
    Mar. 2009)
  • Usually global growth lt 2 is considered a
  • The World Bank in March forecast that global
    growth would be negative in 2009,
  • for the first time since the 1930s.

U.S. Policy Responses
  • Monetary easing is unprecedented,
    appropriately. But it has largely run its
  • Policy interest rates 0. (graph)
  • The famous liquidity trip is not mythical after
  • As Krugman others warned us in re Japan in
  • lending, even inter-bank, builds in big
  • since mid-2007, not just since September 2008.
  • Now aggressive quantitative easing, as the Fed
    continues to purchase assets not previously
    dreamt of.

Bank spreads rose sharply when sub-prime mortgage
crisis hit (Aug. 2007) and up again when Lehman
crisis hit (Sept. 2008).
Source OECD Economic Outlook (Nov. 2008).
Corporate spreads between corporate government
benchmark bonds zoomed after Sept. 2008

Policy Responses, continued
  • Obama policy of financial repair
  • Infusion of funds has been more conditional,
  • vs. Bush Administrations no-strings-attached.
  • Some money goes to reduce foreclosures.
  • Conditions imposed on banks that want help
  • (1) no-dividends rule,
  • (2) curbs on executive pay,
  • (3) no takeovers, unless at request of
  • (4) more reporting of how funds are used.
  • But so far they have avoided nationalization of

Policy Responses -- Financial Repair, cont.
  • Secretary Geithner announced PPIP 3/23/09
    Public-Private Partnership Investment Program
  • When buying toxic or legacy assets from
  • their prices are to be set by private bidding
    (from  private equity, hedge funds, and others),
  • rather than by an overworked Treasury official
    pulling a number out of the air and risking that
    taxpayers grossly overpay for the assets, as
    under TARP.  

Policy Responses -- Financial Repair, cont.
  • How much money is the government putting into
    the PPIP?
  • designed to be enough to attract participants,
    but not more.
  • From the Treasury (already set aside under TARP),
    leveraged courtesy of FDIC Fed.
  • Taxpayers
  • share equally with new private investors in
  • but admittedly bear all the downside risk.
  • Nationalization could have been a lot more

The PPIP was attacked from both sides in part due
to anger over AIG bonuses, etc.
FT, Mar 25, 2009
But the stock market reacted very positively, and
some respected commentators are supportive.
  • Desirable longer-term financial reforms
  • Mortgages
  • Consumer protection, incl. standards for mortgage
  • Fix originate to distribute model, so lenders
    stay on the hook .
  • Banks make Basle capital requirements less
  • Extend bank regulation to near banks.
  • Regulatory agencies Merge SEC CFTC.
  • Create a central clearing house for CDSs .
  • Credit ratings
  • Reduce reliance on ratings.
  • Reduce ratings agencies conflicts of interest.

Policy Responses, continued
  • Unprecedented US fiscal expansion.
  • Obama proposed an 825 expansion
  • Version passed by Congress was just a bit worse.
  • Good old-fashioned Keynesian stimulus
  • Even the belief that spending provides more
    stimulus than tax cuts has returned
  • not just from Larry Summers,
    for example,
  • but also from Martin Feldstein.

Fiscal response Timely, targeted and temporary.
  • American Recovery Reinvestment Plan includes
  • Aid to states
  • education,
  • Medicaid
  • Other spending.
  • Unemployment benefits, food stamps,
  • especially infrastructure, and
  • Computerizing medical records,
  • smarter electricity distribution grids, and
  • high-speed Internet access.

Proposed fiscal stimulus also included
  • Tax cuts
  • Cut for lower-income workers
  • EITC,
  • child tax credit.
  • Fix for the AMT (for the middle class).
  • Other tax cuts demanded by Republicans
  • But soon will need to return toward fiscal
  • Let Bushs pro-capital tax cuts expire in 2011.
  • Economists want to substitute energy taxes for

Motivation for macroeconomic intervention
  • The view that Keynes stood for big government is
    not really right.
  • He wanted to save market microeconomics from
    central planning, which had allure in the 30s
  • Some on the Left today reacted to the crisis
    Obamas election by hoping for a new New Deal.
  • My view faith in unfettered capitalist system
    has been shaken with
    respect to financial markets, true but
    not with respect to the rest of the economy
  • Obamas economics are centrist, not far left.

Do we know this wont be another Great Depression?
  • True, the origins were similar.
  • But one hopes we wont repeat the 1930s
  • Monetary response good this time
  • Financial regulation we already have in
    place bank regulation to prevent runs. But that
    is not enough.
  • Fiscal response okay, but constrained by
    inherited debt (and politics)
  • Trade policy Lets not repeat Smoot-Hawley!
  • E.g., the Buy America provision
  • Mexican trucks

The next crisis
  • The twin deficits
  • US budget deficit gt current account deficit
  • Until now, global investors have happily financed
    US deficits.
  • The recent flight to quality paradoxically
    benefited the ,
  • even though the international financial crisis
    originated in the US.
  • For now, US TBills are still viewed as the most
    liquid riskless.
  • Sustainable?
  • How long will foreigners keep adding to their
  • The US can no longer necessarily rely on support
    of foreign central banks, either economically or

Simulation of central banks of reserve currency
holdings Scenario accession countries
join EMU in 2010. (UK stays out),
but 20 of London turnover counts toward Euro
financial depth, and currencies
depreciate at the average 20-year rates up to
2007. From Chinn Frankel (Int.Fin., 2008)
Simulation predicts may overtake as early as
Tipping point in updated simulation 2015
The 2001-2020 decline in international currency
status for the would be only one small part of
a loss of power on the part of the US. But
  • A loss of s role as 1 reserve currency could
    in itself have geopolitical implications. i
  • Precedent The Suez crisis of 1956
  • is often recalled as the occasion on
    which Britain was forced under US pressure to
    abandon its remaining imperial designs.
  • But recall also the important role played by a
    simultaneous run on the and the American
    decision not to help the beleaguered currency.
  • i Frankel, Could the Twin Deficits Jeopardize
    US Hegemony, Journal of Policy Modeling, 28,
    no. 6, Sept. 2006.  At http//ksghome.harvard.e
    . Also The Flubbed Opportunity for the
    US to Exercise Global Economic Leadership  in
    The International Economy, XVIII, no. 2, Spring
    2004 at http//

Be careful what you wish for! US politicians
have not yet learned how dependent on Chinese
financing we have become.
Jeffrey Frankel James W. Harpel Professor of
Capital Formation Growth Harvard Kennedy School
  • http//
  • Blog http//