The Financial & Economic Crisis Jeffrey Frankel Harpel Professor of Capital Formation and Growth 2009 February 12, 2009

2 Origins of the crisis Well before 2007, there were danger signals in US: Well before 2007, there were danger signals in US: monetary policy too easy … monetary policy too easy … flawed corporate governance, flawed corporate governance, underestimation of risk, underestimation of risk, housing prices too high, housing prices too high, National Saving too low, National Saving too low, current account deficit, current account deficit, excess leverage, excess leverage, imprudent mortgages… imprudent mortgages…

3 Onset of the crisis Initial reaction to troubles: Initial reaction to troubles: Reassurance in mid-2007: “The subprime mortgage crisis is contained.” It wasn’t. Reassurance in mid-2007: “The subprime mortgage crisis is contained.” It wasn’t. Then, “The crisis will stay on Wall Street, sparing Main Street.” It didn’t. Then, “The crisis will stay on Wall Street, sparing Main Street.” It didn’t. Then de-coupling : “The US turmoil will have less effect on the rest of the world than in the past.” It hasn’t. Then de-coupling : “The US turmoil will have less effect on the rest of the world than in the past.” It hasn’t. By now it is clear that the crisis-turned-recession is as bad abroad as in the US. By now it is clear that the crisis-turned-recession is as bad abroad as in the US.

4 Five root causes of financial crisis Monetary policy was too loose during , Monetary policy was too loose during , accommodating fiscal expansion, reminiscent of the Vietnam era. accommodating fiscal expansion, reminiscent of the Vietnam era. Participants in financial markets during this period grossly underpriced risk (risks: housing crash, $ crash, oil prices, geopolitics…). Participants in financial markets during this period grossly underpriced risk (risks: housing crash, $ crash, oil prices, geopolitics…). US corporate governance falls short of its billing US corporate governance falls short of its billing as we should have learned in 2001 (Enron, Worldcom…). as we should have learned in 2001 (Enron, Worldcom…). E.g., rating agencies E.g., rating agencies executive compensation (options; golden parachutes…). executive compensation (options; golden parachutes…). US households save too little, borrow too much. US households save too little, borrow too much. Starting 2001, the federal budget was set on a reckless path Starting 2001, the federal budget was set on a reckless path Reminiscent of Reminiscent of

5 Monetary policy easy Federal budget deficits Underestimated risk in financial mkts Failures of corporate governance Households saving too little, borrowing too much Excessive leverage in financial institutions Stock market bubble Housin g bubble Stock market crash Housin g crash Financial crisis China’s growth Low national saving Lower long- term econ.growth Eventual loss of US global hegemony Recession Oil price spike Gulf insta- bility Foreig n debt Origins of the financial/economic crises Excessive complexity CDSs MBS s CDO s Predatory lending

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

7 Contribution of monetary policy to the crisis The origin of the crisis was an asset bubble collapse, loss of confidence, credit crunch. The origin of the crisis was an asset bubble collapse, loss of confidence, credit crunch. More like Keynes’ animal spirits or beauty contest than like Friedman-Schwarz. Add in Fisher’s “debt deflation,” von Hayek’s credit cycle and the “Minsky moment.” More like Keynes’ animal spirits or beauty contest than like Friedman-Schwarz. Add in Fisher’s “debt deflation,” von Hayek’s credit cycle and the “Minsky moment.” It was not a monetary contraction in response to inflation (as were or 1991). It was not a monetary contraction in response to inflation (as were or 1991). But, rather, a credit cycle: monetary expansion showed up only in asset prices. (Borio of BIS.) But, rather, a credit cycle: monetary expansion showed up only in asset prices. (Borio of BIS.)

8 US Recession In December 2008, NBER Business In December 2008, NBER Business Cycle Dating Committee proclaimed US recession had started in December Recovery quite unlikely before end Recovery quite unlikely before end => recession is already longest since 1930s. => recession is already longest since 1930s. Likely to be as severe as oil-shock recessions of 1974 and Likely to be as severe as oil-shock recessions of 1974 and

9 BUSINESS CYCLE REFERENCE DATES Source: NBER Source: NBER PeakTroughContraction 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 2001 December 2007 March 2001 December 2007 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) March 1991 November 2001 March 1991 November Average, all cycles: (32 cycles) (10 cycles) 17 10

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, 3.6 million jobs have been lost (2/6/09). Payroll employment series Source: Bureau of Labor Statistics

11 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…)

12 Recession was soon transmitted to rest of world: Contagion: Falling securities markets & contracting credit. Contagion: Falling securities markets & contracting credit. Especially in those countries with weak fundamentals: Iceland, Hungary & Ukraine… Especially in those countries with weak fundamentals: Iceland, Hungary & Ukraine… Or oil-exporters that relied heavily on high oil prices: Russia… Or oil-exporters that relied heavily on high oil prices: Russia… But even where fundamentals were relatively strong: Korea… But even where fundamentals were relatively strong: Korea… Some others experiencing their own housing crashes: Ireland, Spain… Some others experiencing their own housing crashes: Ireland, Spain… Recession in big countries will be transmitted to all trading partners through loss of exports. Recession in big countries will be transmitted to all trading partners through loss of exports.

13 Housing bubble burst

14 Housing permits falling almost everywhere

15 Forecasts

16 have now downgraded again (Jan.28, 2009)

17 The IMF has cut by half estimates for low- & middle-income countries. Jan.28, Rev. vs. Oct.08 projection

18 U.S. Policy Responses Monetary easing is unprecedented, appropriately. But it has largely run its course: Monetary easing is unprecedented, appropriately. But it has largely run its course: Policy interest rates ≈ 0. (graph) Policy interest rates ≈ 0. (graph) The famous liquidity trip is not mythical after all. The famous liquidity trip is not mythical after all. As Krugman & others warned us in re Japan in 90s. As Krugman & others warned us in re Japan in 90s. & lending, even inter-bank, builds in big spreads & lending, even inter-bank, builds in big spreads since mid-2007, not just since September (graph) since mid-2007, not just since September (graph) Now quantitative easing, as the Fed continues to purchase assets not previously dreamt of. Now quantitative easing, as the Fed continues to purchase assets not previously dreamt of.

19 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).

20 Corporate spreads between corporate & government benchmark bonds zoomed after Sept US €

21 Policy Responses, continued Obama policy of “financial repair”: Obama policy of “financial repair”: Infusion of funds will be more conditional, vs. Bush Administration’s no-strings-attached. vs. Bush Administration’s no-strings-attached. Some money goes to reduce foreclosures. Some money goes to reduce foreclosures. They may impose on banks that want help: They may impose on banks that want help: (1) no-dividends rule, (1) no-dividends rule, (2) more serious curbs on executive pay, (2) more serious curbs on executive pay, (3) no takeovers, unless at request of authorities & (3) no takeovers, unless at request of authorities & (4) more reporting of how funds are used. (4) more reporting of how funds are used. They won’t impose specific requirements to lend. They won’t impose specific requirements to lend.

22 Policy Responses, continued Repair of the financial system Repair of the financial system Mortgages Mortgages Consumer protection, incl. standards for mortgage brokers Consumer protection, incl. standards for mortgage brokers Fix “originate to distribute” model so lenders stay on the hook. Fix “originate to distribute” model so lenders stay on the hook. Banks: make Basle capital requirements countercyclical Banks: make Basle capital requirements countercyclical Extend bank regulation to “near banks.” Extend bank regulation to “near banks.” Regulatory agencies: Merge SEC and CFTC. Regulatory agencies: Merge SEC and CFTC. A central clearing house for CDSs. A central clearing house for CDSs. Credit ratings: Credit ratings: Reduce reliance on ratings. Reduce reliance on ratings. Reduce ratings agencies’ conflicts of interest. Reduce ratings agencies’ conflicts of interest.

23 Repair of the financial system, continued The TARP keeps evolving The TARP keeps evolving Paulson at first was unspecific; Paulson at first was unspecific; then TARP was to buy toxic loans, then TARP was to buy toxic loans, then to recapitalize banks. then to recapitalize banks. Now up in the air: Now up in the air: insure banks’ toxic assets rather than acquire them? insure banks’ toxic assets rather than acquire them? create “bad bank” as in “Swedish model”? create “bad bank” as in “Swedish model”? outright “nationalization” not under consideration in US. outright “nationalization” not under consideration in US. Obama Public Private Investment Fund Obama Public Private Investment Fund “co-investment”? “co-investment”? Or insure downside of bank assets purchased by investors, Or insure downside of bank assets purchased by investors, thus obviating unpopular labels & outlays, & need to value assets. thus obviating unpopular labels & outlays, & need to value assets.

24 Policy Responses, continued Unprecedented US fiscal expansion, most of which is still to come. Unprecedented US fiscal expansion, most of which is still to come. Obama proposed an $825 expansion Obama proposed an $825 expansion House passed a version. Senate will soon. House passed a version. Senate will soon. Good old-fashioned Keynesian stimulus Good old-fashioned Keynesian stimulus Even the belief that spending provides more stimulus than tax cuts has returned Even the belief that spending provides more stimulus than tax cuts has returned not just from Larry Summers, for example, not just from Larry Summers, for example, but also from Martin Feldstein. but also from Martin Feldstein. But tax-cut vs. spending distinction can be pernicious. But tax-cut vs. spending distinction can be pernicious.

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

26 It also includes Tax cuts Tax cuts Cut for lower-income workers Cut for lower-income workers EITC, EITC, child tax credit, child tax credit, payroll tax holiday. payroll tax holiday. Fix for the AMT (for the middle class). Fix for the AMT (for the middle class). Other tax cuts demanded by Republicans Other tax cuts demanded by Republicans But soon will need to return toward fiscal discipline But soon will need to return toward fiscal discipline E.g., let estate-tax-abolition expire in E.g., let estate-tax-abolition expire in Economists want to substitute energy taxes for others. Economists want to substitute energy taxes for others.

27 Motivation for macroeconomic intervention The view that Keynes stood for big government is not really right. 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 & 40s. He wanted to save market microeconomics from central planning, which had allure in the 30s & 40s. Some on the Left today reacted to the crisis & Obama’s election by hoping for a new New Deal. Some on the Left today reacted to the crisis & Obama’s 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; 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; Obama’s economics will be centrist, not far left. Obama’s economics will be centrist, not far left.