1. In Search of Stability: The Economics and Politics of the Global Financial Crisis Mark Copelovitch Assistant Professor of Political Science & Public Affairs University of Wisconsin – Madison March 16, 2009

2. Overview The economics of the crisis Causes Timeline Effects
The politics of financial stability
Policy responses
Difficult tradeoffs
The road ahead

3. Three Faulty Assumptions About 21st Century Finance
What Went Wrong?
Three Faulty Assumptions About 21st Century Finance
Securitization
Capital markets are so advanced that banks can lend more aggressively while off-loading risk through debt securities
Credit agencies
Credit ratings agencies offer an easy and cheap “compass” for investors to assess the risk of these complex securities
Risk and financial stability
The “slicing and dicing” of risk has made the financial system more stable and less crisis-prone

4. The Initial Problem: Subprime Mortgage Lending
SOURCE: BBC

5. Subprime Borrowers “Subprime” borrowers
Borrowers with “bad” credit (<620 on scale)
NINJAs (~20% of borrowers)
What kind of loans do subprime borrowers get?
ARMs: Adjustable Rate Mortgages
“Teaser” rates to start…higher rates later on

6. Mortgage-Backed Securities (CDOs)
Ratings agencies play a key role
SOURCE: NERA

7. Subprime Mortgage Lending: Boom and Bust
SOURCE: IMF, BBC

8. From Housing Crisis to Financial Crisis
Problems of uncertainty
No one knows how many “bad” mortgages are in the CDOs
No one wants to lend to banks and other institutions with heavy exposure to these securities
Results
“Flight to quality” (US Treasuries)
Spikes in market lending rates
Stock market crash
Frozen credit markets

9. The Big Freeze
SOURCE: Bloomberg

10. The Big Freeze

11. Case Study: Northern Rock (UK)
UK’s 8th largest bank in 2007 (£113 billion in assets)

12. Northern Rock’s Collapse
Bank of England - steps in to bail out (£55 billion in loans/guarantees) and ultimately nationalize NR (2/22/08) once the “run” starts

14. After Northern Rock,
SOURCE: BBC

15. …the Financial Losses Mount…
March 2009: $5.1 trillion in family net worth losses (9%) in Q4 2008

16. …and the Real Economic Impact is Severe
GDP growth rates (%),
SOURCE: BBC/IMF

17. Policy Responses to Financial Crises: Two Phases
Short-term (management/resolution)
Crisis lending, rate cuts, etc.
Preventing bank runs/collapses (“bailouts”)
Unfreezing credit markets (“toxic debt”)
Long-term (prevention)
New regulation
New institutions
Domestic and international

18. Short-Term Policy Responses: Crisis Management
Liquidity (bailouts)
To money markets & directly to troubled banks (TARP)
Bank deposit guarantees
Extension of safety net to prevent bank runs
Dealing with toxic debt
A government-sponsored “bad bank”
Partial nationalization of banks
The “insurance” model (UK, January 2009)

19. Short-Term Policies: Key Questions
Why not let troubled financial institutions fail?
Why not bail out all firms? Who should be saved?
What should the government get in return?
Should non-financial firms get bailouts, too?

20. How to Choose Policies? Difficult Tradeoffs
Liquidity vs. moral hazard
Financial crisis vs. other goals
Aggregate welfare (“taxpayers”) vs. special interests
National policies vs. international cooperation

21. “Bailouts” – Liquidity vs. Moral Hazard
Government/central bank credit (liquidity) helps banks pay their debts and may “unfreeze” credit markets
But, bailouts create moral hazard for borrowers and creditors
How to choose?
A liquidity or solvency problem?
No clear economic answer  ultimately, a political question
Greater moral hazard costs
More money,
fewer “strings”
Less money,
more “strings”

22. Financial Stability & Stimulus vs. Other Goals
Economic stimulus package estimated to cost ~$800 billion
Full scale of toxic assets may be $3-4 billion
SOURCE: New York Times

23. Thus Far: Global Crisis, National Responses
Unilateral efforts unlikely to be successful
Threat of “beggar thy neighbor” policies
SOURCE: BBC

24. The Global Reform Agenda: Consensus on Broad Goals…
Strengthen international supervision and regulation
Bridge the gap between global markets and national regulation
Reform existing institutions
International Monetary Fund (IMF)
G-7 / G-20
International policy coordination
Macroeconomic stimulus
Exchange rates / global imbalances
Trade policy

25. …But Not on Specific Policies & Institutions
Strengthen international supervision and regulation
Which financial institutions and regulations?
What institutional form?
Reform existing global institutions
The IMF debate: resources, conditionality, votes
New “G” groups: who should be in/out?
International policy coordination
How much? For how long?
Sharp disagreements on trade and exchange rates

26. Why No Agreement? Difficult Tradeoffs
IMF lending
Liquidity vs. moral hazard
Regulation/supervision
Confidence vs. competitiveness
Institutional reform
Accountability/legitimacy vs. effectiveness
Policy coordination
Domestic politics vs. international commitments

27. Tradeoffs: The Primacy of Politics
No optimal economic solutions
Many possible policies, institutions, and regulations
Conflicts between “good economics” and “good politics”
Key political factors
Domestic politics (interests, institutions)
Power and geopolitics
Collective action and bargaining problems
Ideology

28. Example: Reforming the IMF
IMF needs ~ $750 billion - $1.75 trillion to be effective
Will new resources lead to governance reform?
SOURCE: Financial Times

29. The Next Stage: Are the Bailouts Working?
TED Spread, March 2009

30. The Next Stage: Crises in Emerging Markets
9/-08 – 3/09:
~$50 billion in new IMF loans to Iceland, Pakistan, Ukraine, Belarus, Georgia, Serbia, Latvia, and Hungary
SOURCE: Financial Times, IMF World Economic Outlook

31. The Next Stage: World Trade Collapsing?

32. Some Perspective: We’ve Been Here Before
SOURCE: IMF, World Bank

33. Some Perspective: The Great Depression, 1929-1933 The Depression’s Effect on the US Economy
SOURCE: Historical Statistics of the United States, pp. 235, 263, 1001, and 1007

34. Some Perspective: Markets

35. Some Perspective: Recession vs. Depression