The Great Recession, How Does it Differ From Others? FCCC 7 This ‘great’ vs. “normal” recession How Different; How Similar ?

5 years after Lehman … economy/Markets economy/Markets

Savings Glut ? Different? savings glut flowed into poorly regulated shadow banking system In USA, housing prices rose 30% in five years preceding crisis. Housing booms also in UK, Spain, Eastern Europe (earlier scandanavian, japan) Similar to previous in e.g. debt build up

Goods Market Eqbm (Closed) S d = I d S d = I d so: Y – C d – G = I d => (C d + I d + G) = Y If unsold goods: I > I d diseqbm, but expenditure approach still true Y = C + I + G At r 0, I 0 > S 0 : amount firms wish to invest > amount savers want to lend so in closed economy, r ↑

(assume NFP = 0, so NX = CA) Open Economy Goods Market Eqbm What can be done with national savings ? I: lend to domestic firms buying new capital goods CA surplus: lend to foreigners who want to purchase your goods (more than you want to buy their’s)

Assume nation too small to have any influence on world interest rate Small Open Economy Model r IS r ROW

Assume 2 nations in world r WORLD adjusts until int’l lending = int’l borrowing (eqbm r) Nation with relatively high I D has high r AUTARKY Nation with relatively low I D has low r AUTARKY Eqbm r WORLD rate lies between 2 autarky rates Large Open Economy Model r IS r ROW

Similar 1: Asset Price Boom Agnello, Schuknecht (2011) 1971

Similar 2. Credit Boom Boom: Y, C & I rise above trend in build-up phase (then fall below in bust phase) Higher P House Real exchange rate appreciates CA deficit

Similar 3: Marginal Loans & Systemic Risk Households bought marginal assets requiring excellent conditions to pay off Subprime => debt servicing sensitive to recessions & changes in credit/monetary conditions Housing loans sensitive to P House declines (indeed, became non-performing loans with falling P House ) Many foreign currency denominated loans In good times required lower interest payments In crisis, more difficult for borrowers to repay with depreciated currency

Similar 4: Regulation & Supervision Previous post-liberalization credit booms led into crises due to lack of reforms Underdeveloped financial systems unable to handle large capital inflows In recent crisis, shadow banking system (finance companies, investment banks, off-balance sheet entities) not subject to bank regulation Regulators underestimated conflicts of interest of “originate to distribute” model

Different 1: Increased Opaqueness Mortgage securitization: greater lender-borrower distance No monitoring of loan ‘originators’ who sought greater volumes (not quality) Assessing risk difficult so investors had to rely heavily on ratings Collateral but value fell limiting security

Different 2: Financial Integration Benefits of greater financial openness (and more foreign banks) GDP growth Develop financial sector Discipline macro policies Expose local firms to int’l competition for efficiency gains But intensifies cross-border spillovers: Liquidity pressure Asset prices Depletion of bank capital (US financial assets represent 31% of world financial assets, USD represent ca 62% of all reserve assets) Most believed US financial assets offered safety and liquidity

Different 3: Leverage Greater leverage In commercial banks Also in shadow banking sector Cut ability to absorb even small losses (high LTV => P fall pushed household’s equity negative) Led to loss of confidence & greater counterparty risk

Different 4: Households 2008: households heavily in debt, especially in subprime Yet aggregate credit growth more moderate than in previous recessions (previous crises due to gov’t or corporations’ debt) Low interest rates makes easier to service debt Household debt to income also rose in UK, Spain & Ireland

Different 5: Old & New Combined Vicious cycle: Rising foreclosures Falling home values Securitization markets thinned (fewer mortgages so sped up P declines) Reinforced by tighter mortgage standards Rising rates & falling home P limited households’ ability to refinance mortgages Securitized assets’ value unknown (mix of subprime + prime) MBS less valued as collateral Higher counterparty risk (didn’t know if counterparty healthy so stopped trading => freeze in interbank markets)