1. Harvard Kennedy School Belfer Center Economics Seminar Series, Harvard Kennedy School : 2009 Lessons from the Current Crisis Belfer Center Library, 3-4:30 p.m.,May 4, 2009 Jeffrey Frankel How do we know this will not be another Great Depression?

2. 2 Origins of the crisis Well before 2007, there were danger signals in US: Well before 2007, there were danger signals in US: Real interest rates <0, 2003-04 ; Real interest rates <0, 2003-04 ; Early corporate scandals (Enron 2001 …); Early corporate scandals (Enron 2001 …); Risk was priced very low, Risk was priced very low, housing prices very high, housing prices very high, National Saving very low, National Saving very low, current account deficit big, current account deficit big, leverage high, leverage high, mortgages imprudent… mortgages imprudent…

3. 3 US real interest rate < 0, 2003-04 Source: Benn Steil, CFR, March 2009 Real interest rates <0

4. 4 Six root causes of financial crisis 1. US corporate governance falls short E.g., rating agencies; E.g., rating agencies; executive compensation … executive compensation … options; options; golden parachutes… golden parachutes… 2. US households save too little, borrow too much. 3. Politicians slant excessively toward homeownership Tax-deductible mortgage interest, cap.gains; Tax-deductible mortgage interest, cap.gains; F annie M ae & Freddie Mac ; F annie M ae & Freddie Mac ; Allowing teasers, NINJA loans, liar loans… Allowing teasers, NINJA loans, liar loans… MSN Money & Forbes

5. 5 Six root causes of financial crisis, cont. 4. Starting 2001, the federal budget was set on a reckless path, reminiscent of 1981-1990 reminiscent of 1981-1990 5. Monetary policy was too loose during 2004-05, accommodating fiscal expansion, reminiscent of the Vietnam era. accommodating fiscal expansion, reminiscent of the Vietnam era. 6. Financial market participants during this period grossly underpriced risk. Possible risks were: Possible risks were: housing crash, housing crash, $ crash, $ crash, oil prices, oil prices, geopolitics…. geopolitics….

6. 6 Monetary policy easy 2004-05 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 2007-08 China’s growth Low national saving Lower long- term econ.growth Eventual loss of US hegemony Recession 2008-09 Oil price spike 2007-08 Gulf insta- bility Foreig n debt Origins of the financial/economic crises Excessive complexity CDSs MBS s CDO s Predatory lending Homeownership bias

7. 7 The return of Keynes Keynesian truths abound today : 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 International transmission Need for coordinated expansion Need for coordinated expansion

8. 8 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…. like Keynes’ animal spirits or beauty contest. like Keynes’ animal spirits or beauty contest. Add in von Hayek’s credit cycle, Add in von Hayek’s credit cycle, Kindleberger 78 ’s “manias & panics” Kindleberger 78 ’s “manias & panics” the “Minsky moment,” the “Minsky moment,” & Fisher’s “debt deflation.” & Fisher’s “debt deflation.” The origin this time was not a monetary contraction in response to inflation as were 1980-82 or 1991. The origin this time 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.) But, rather, a credit cycle: 2003-04 monetary expansion showed up only in asset prices. (Borio of BIS.)

9. 9 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 is on Wall Street; it may spare Main Street.” It didn’t. Then, “The crisis is on Wall Street; it may spare 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 is By now it is clear that the crisis is the worst in 75 years, the worst in 75 years, and is as bad abroad as in the US. and is as bad abroad as in the US.

10. 10 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).

11. 11 Corporate spreads between corporate & government benchmark bonds zoomed after Sept. 2008 US €

12. 12 US Recession The US recession started in December 2007 according to the NBER Business Cycle Dating Committee (announcement of Dec. 2008). The US recession started in December 2007 according to the NBER Business Cycle Dating Committee (announcement of Dec. 2008). As of April 29, 2009, the recession’s length tied the postwar records of 1973-75 & 1981-82 As of April 29, 2009, the recession’s length tied the postwar records of 1973-75 & 1981-82 = 4 quarters; 16 months = 4 quarters; 16 months One has to go back to 1929-33 for a longer downturn. One has to go back to 1929-33 for a longer downturn. Likely also to be also as severe as oil-shock recessions of 1973-75 and 1980-82, though not yet. Likely also to be also as severe as oil-shock recessions of 1973-75 and 1980-82, though not yet.

13. 13 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 2001 43 13 8 11 10 8 10 11 16 6 16 8 8 Average, all cycles: 1854-2001 (32 cycles) 1945-2001 (10 cycles) 17 10

14. 14 US employment peaked in Dec. 2007, which is the most important reason why the NBER BCDC dated the peak from that month. Since then, 5 million jobs have been lost (4/3/09). Payroll employment series Source: Bureau of Labor Statistics

15. 15 My favorite monthly indicator: total hours worked in the economy It confirms: US recession turned severe in September, when the worst of the financial crisis hit (Lehman bankruptcy…)

16. 16 The US recession so far is deep, Source: IMF, WEO, April 2009 compared to past and to others’

17. 17 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… & even where fundamentals were relatively strong: Brazil, Korea… & even where fundamentals were relatively strong: Brazil, Korea… Some others are experiencing their own housing crashes: Ireland, Spain… Some others are experiencing their own housing crashes: Ireland, Spain… Recession in big countries has been transmitted to all trading partners through loss of exports. Recession in big countries has been transmitted to all trading partners through loss of exports.

18. 18 Source: OECD International Trade has Plummeted

19. 19 The recession has hit more countries than any in 60 years

20. 20 Unemployment rates are rising everywhere

21. 21 Forecasts

22. 22 Interim forecast OECD 3/13/09 Forecast for 2009 = - 3 ½ %

23. 23 IMF, too, forecasts 2009 as sharpest downturn Source: WEO, April 2009

24. 24 “World Recession” No generally accepted definition. No generally accepted definition. A sharp fall in China’s growth from 11% is a recession. A sharp fall in China’s growth from 11% is a recession. Usually global growth < 2 % is considered a recession. Usually global growth < 2 % is considered a recession. The World Bank (March) now forecasts negative global growth in 2009, The World Bank (March) now forecasts negative global growth in 2009, for the first time in 60 years. for the first time in 60 years. So does the IMF (April) when GDPs compared at current exchange rates. So does the IMF (April) when GDPs compared at current exchange rates.

25. 25 U.S. output lost in the current downturn Source: Federal Reserve Bank of St. Louis would still have a very long way to go before reaching the depth of the 1930s...

26. 26 …but, by at least one measure, the world is on track to match the Great Depression ! Industrial production Source: George Washington’s blog

27. 27 especially considering that successive forecasts of the current episode have been repeatedly over-optimistic? especially considering that successive forecasts of the current episode have been repeatedly over-optimistic? How do we know this will not be another Great Depression? The usual answer: we learned important lessons from the 1930s, and we won’t repeat the mistakes we made then. The usual answer: we learned important lessons from the 1930s, and we won’t repeat the mistakes we made then.

28. 28 One hopes we won’t repeat the 1930s mistakes. One hopes we won’t repeat the 1930s mistakes. Monetary response: good this time Monetary response: good this time Financial regulation: we already have bank regulation to prevent runs. But it is clearly not enough. Financial regulation: we already have bank regulation to prevent runs. But it is clearly not enough. Fiscal response: OK, but : constrained by inherited debt. Also Europe was unwilling to match our fiscal stimulus at G-20 summit. Fiscal response: OK, but : constrained by inherited debt. Also Europe was unwilling to match our fiscal stimulus at G-20 summit. Trade policy: Let’s not repeat Smoot-Hawley ! Trade policy: Let’s not repeat Smoot-Hawley ! E.g., the Buy America provision E.g., the Buy America provision Mexican trucks Mexican trucks

29. 29 U.S. Policy Responses Monetary easing is unprecedented, appropriately avoiding the mistake of 1930s. (graph) But it has largely run its course: Monetary easing is unprecedented, appropriately avoiding the mistake of 1930s. (graph) 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. & lending, even inter-bank, builds in big spreads. & lending, even inter-bank, builds in big spreads. Now we have aggressive quantitative easing: the Fed continues to purchase assets not previously dreamt of. Now we have aggressive quantitative easing: the Fed continues to purchase assets not previously dreamt of.

30. 30 The Fed certainly has not repeated the mistake of 1930s: letting the money supply fall. Source: IMF, WEO, April 2009 Box 3.1 1930s 2008-09

31. 31 Source: OECD Major central banks have cut interest rates sharply.

32. 32 Policy Responses, continued Obama policy of “financial repair”: Obama policy of “financial repair”: Infusion of funds is 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. Conditions imposed on banks that get help: Conditions imposed on banks that get help: (1) no-dividends rule, (1) no-dividends rule, (2) curbs on executive pay, (2) 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. Enough to make some banks balk at keeping the funds. Enough to make some banks balk at keeping the funds. But so far we have avoided “nationalization” of banks But so far we have avoided “nationalization” of banks

33. 33 Secretary Geithner announced PPIP 3/23/09: Public-Private Partnership Investment Program Secretary Geithner announced PPIP 3/23/09: Public-Private Partnership Investment Program When buying “toxic” or “legacy assets” When buying “toxic” or “legacy assets” from banks, 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.

34. 34 The PPIP was attacked from both sides in part due to anger over AIG bonuses, etc. FT, Mar 25, 2009

35. 35 Desirable longer-term financial reforms Desirable longer-term financial reforms Executive compensation Executive compensation Compensation committee not under CEO. Maybe need Chairman of Board. Compensation committee not under CEO. Maybe need Chairman of Board. Discourage golden parachutes & options, unless truly tied to performance. Discourage golden parachutes & options, unless truly tied to performance. Securities Securities Regulatory agencies: M erge SEC & CFTC? Regulatory agencies: M erge SEC & CFTC? Create a central clearing house for CDSs. Create a central clearing house for CDSs. Credit ratings: Credit ratings: Reduce reliance on ratings: AAA does not mean no risk. Reduce reliance on ratings: AAA does not mean no risk. Reduce ratings agencies’ conflicts of interest. Reduce ratings agencies’ conflicts of interest. Lending Lending Mortgages Mortgages Consumer protection, including standards for mortgage brokers Consumer protection, including 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: Banks: Regulators shouldn’t let banks use their own risk models ; Regulators shouldn’t let banks use their own risk models ; should make capital requirements less pro-cyclical. should make capital requirements less pro-cyclical. Extend bank-like regulation to “near banks.” Extend bank-like regulation to “near banks.”

36. 36 Policy Responses, continued Unprecedented $800 b fiscal stimulus. Unprecedented $800 b fiscal stimulus. Good old-fashioned Keynesian stimulus Good old-fashioned Keynesian stimulus Even the principle that spending provides more stimulus than tax cuts has returned; Even the principle that spending provides more stimulus than tax cuts has returned; not just from Larry Summers, e.g., not just from Larry Summers, e.g., but also from Martin Feldstein. but also from Martin Feldstein. Is $800 billion too small? Too big? Is $800 billion too small? Too big? Yes: Too small to knock out recession ; Yes: Too small to knock out recession ; too big to keep global investors confident inUS debt. too big to keep global investors confident inUS debt. I.e., just about right. I.e., just about right.

37. 37 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.

38. 38 Fiscal stimulus also included tax cuts: Fiscal stimulus also included tax cuts: for lower-income workers (“Making Work Pay”) for lower-income workers (“Making Work Pay”) EITC, EITC, refundable child tax credit. refundable child tax credit. Fix for the AMT (for the middle class). Fix for the AMT (for the middle class). Soon we must return toward fiscal discipline. Soon we must return toward fiscal discipline. Let Bush’s pro-capital tax cuts expire in 2011. Let Bush’s pro-capital tax cuts expire in 2011. The budget passed by Congress omitted some of the best features proposed by Obama: The budget passed by Congress omitted some of the best features proposed by Obama: Cuts in farm subsidies for agribusiness & farmers > $250 million Cuts in farm subsidies for agribusiness & farmers > $250 million Auctioning of GHG emission permits in future, Auctioning of GHG emission permits in future, with revenue used, e.g., to cut taxes on low-income workers. with revenue used, e.g., to cut taxes on low-income workers.

39. 39 International coordination of fiscal expansion? As in the classic Locomotive Theory Theory: in the non-cooperative equilibrium, each country holds back fiscal expansion for fear of trade deficits. Theory: in the non-cooperative equilibrium, each country holds back fiscal expansion for fear of trade deficits. Classic prisoner’s dilemma of Nash Classic prisoner’s dilemma of Nash Solution: A bargain where all expand together. Solution: A bargain where all expand together.

40. 40 The Locomotive Theory in Practice The example of G-7 Bonn Summit, 1978 The example of G-7 Bonn Summit, 1978 didn’t turn out so well: didn’t turn out so well: inflation turned out to be a bigger problem than realized inflation turned out to be a bigger problem than realized & the German world was non-Keynesian. & the German world was non-Keynesian. Inflation is less a problem this time; Inflation is less a problem this time; the Germans are the same. the Germans are the same. Coordinated expansion failed at G-20 Summit in London, this April. Coordinated expansion failed at G-20 Summit in London, this April. As had cooperation in 1933 (London Monetary & Economic Conference) As had cooperation in 1933 (London Monetary & Economic Conference)

41. 41 US fiscal stimulus looks the largest of the G-10. than the US But others point out that they have larger automatic stabilizers

42. 42 Expansion of the IMF Expansion of the IMF Tripling of size of IMF quotas. Tripling of size of IMF quotas. New issue of SDRs (a la Keynes) New issue of SDRs (a la Keynes) More inclusion of developing countries More inclusion of developing countries Eventually: Eventually: Reallocation of voting shares in IMF and World Bank? Reallocation of voting shares in IMF and World Bank? Break US-EU duopoly on MD & President? Break US-EU duopoly on MD & President? Locus shifted from G7 to G20 at London meeting. Locus shifted from G7 to G20 at London meeting. Regulatory reform? Still to come. Regulatory reform? Still to come. Reduce procyclical Basel capital requirements; FSB; …. Reduce procyclical Basel capital requirements; FSB; …. Hold the line against protectionism? Not yet clear. Hold the line against protectionism? Not yet clear. But G-20 Summit did accomplish some things

43. 43 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 & election by hoping a new New Deal would overhaul the economy. Some on the Left today reacted to the crisis & election by hoping a new New Deal would overhaul the economy. My view: faith in the 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 the 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 are centrist, not far left. Obama’s economics are centrist, not far left.

44. 44 Bottom line of macroeconomic policy response: A good guess is that the monetary and fiscal response we have seen so far have been sufficient to halt the economic free-fall, so that the steep rate of decline will level off in the 2 nd half of this year. A good guess is that the monetary and fiscal response we have seen so far have been sufficient to halt the economic free-fall, so that the steep rate of decline will level off in the 2 nd half of this year. It won’t be enough to return us rapidly to full employment and potential output. It won’t be enough to return us rapidly to full employment and potential output. Given the path of debt that was inherited in 2009, it is unlikely that more could be done. Given the path of debt that was inherited in 2009, it is unlikely that more could be done.

45. 45 The next crisis The twin deficits: The twin deficits: US budget deficit => current account deficit US budget deficit => current account deficit Until now, global investors have happily financed US deficits. Until now, global investors have happily financed US deficits. The recent flight to quality paradoxically benefited the $, The recent flight to quality paradoxically benefited the $, even though the international financial crisis originated in the US. even though the international financial crisis originated in the US. For now, US TBills are still viewed as the most liquid & riskless. For now, US TBills are still viewed as the most liquid & riskless. Sustainable? Sustainable? Can the US rely on support of foreign central banks indefinitely ? Can the US rely on support of foreign central banks indefinitely ?

46. 46 The 2007-08 financial crisis probably further undermined US long run hegemony. US financial institutions have lost credibility. US financial institutions have lost credibility. Expansionary fiscal and monetary policy may show up as $ depreciation in the long run. Expansionary fiscal and monetary policy may show up as $ depreciation in the long run. The long slow descent of the $ as an international currency may accelerate. The long slow descent of the $ as an international currency may accelerate.

47. 47 “Be careful what you wish for!” US politicians have not yet learned how dependent on Chinese financing we have become.

48. 48 In the short run, the financial crisis has caused a flight to quality which apparently still means a flight to US $. US Treasury bills have been more in demand than ever, as reflected in very low interest rates. US Treasury bills have been more in demand than ever, as reflected in very low interest rates. The $ appreciated in 2008, rather than depreciating as the “hard landing” scenario had predicted. The $ appreciated in 2008, rather than depreciating as the “hard landing” scenario had predicted. => The day of reckoning had not yet arrived. => The day of reckoning had not yet arrived. Chinese officials’ warnings may be a turning point (April 2009) : Chinese officials’ warnings may be a turning point (April 2009) : Premier Wen worries US Treasury bills will lose value. Premier Wen worries US Treasury bills will lose value. PBoC Gov. Zhou proposes replacing $ as international currency. PBoC Gov. Zhou proposes replacing $ as international currency.

49. 49 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) Tipping point in updated simulation: 2015 Simulation predicts € may overtake $ as early as 2015

50. 50 Historical precedent: £ ( 1914-1956) With a lag after US-UK reversal of ec. size & net debt, $ passed £ as #1 international currency. With a lag after US-UK reversal of ec. size & net debt, $ passed £ as #1 international currency. “Imperial over-reach:” the British Empire’s widening budget deficits and overly ambitious military adventures in the Muslim world. “Imperial over-reach:” the British Empire’s widening budget deficits and overly ambitious military adventures in the Muslim world. 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.

51. 51 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] A loss of $’s role as #1 reserve currency could in itself have geopolitical implications. [i] [i] Precedent: The Suez crisis of 1956 Precedent: The Suez crisis of 1956 is often recalled as the occasion on which Britain was forced under US pressure to abandon its imperial designs. is often recalled as the occasion on which Britain was forced under US pressure to abandon its 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. But recall also the important role played by a simultaneous run on the £ and the American decision not to help the beleaguered currency. [i][i] Frankel, “Could the Twin Deficits Jeopardize US Hegemony,” Journal of Policy Modeling, 28, no. 6, Sept. 2006. At http://ksghome.harvard.edu/~jfrankel/SalvatoreDeficitsHegemonJan26Jul+.pdf. Also “The Flubbed Opportunity for the US to Exercise Global Economic Leadership”; in The International Economy, XVIII, no. 2, Spring 2004 at http://ksghome.harvard.edu/~jfrankel/FlubJ23M2004-.pdf http://ksghome.harvard.edu/~jfrankel/SalvatoreDeficitsHegemonJan26Jul+.pdf [i]http://ksghome.harvard.edu/~jfrankel/SalvatoreDeficitsHegemonJan26Jul+.pdf

52. Jeffrey Frankel James W. Harpel Professor of Capital Formation & Growth Harvard Kennedy School http://ksghome.harvard.edu/~jfrankel/index.htm Blog: http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/ http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/

53. 53 Emerging markets have been hit too; now have to spend some hard-earned reserves

54. 54 3 cycles of net private capital flows to emerging markets, by region peaking in 1982, 1997 and 2008 Source: Capital Flows to Emerging Market Economies, IIF, 1/27/09.

55. 55 Capital flows to emerging markets peaked in 2007 from: EM Fund Flows, Citi, December 2008

56. 56 BRIC growth has disappeared

57. 57 IMF forecasts, April 2009 IMF forecasts, April 2009