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. What Went Wrong? Three Faulty Assumptions About 21 st 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 300-850 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) SOURCE: NERA Ratings agencies play a key role

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. SOURCE: Bloomberg 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, 2008-2009 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 SOURCE: BBC/IMF GDP growth rates (%), 2008-2009

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 More money, fewer “strings” Less money, more “strings” Greater moral hazard costs

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

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

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

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