Regional Economist - April 2009

8/9/2019 Regional Economist - April 2009

1/28

This Is NotYour Fathers

Recession... or Is It?

The Regional

Economist

A Quarterly Reviewof Business andEconomic Conditions

Vol. 17, No. 2

April 2009

The Volcker EraActions by Todays FedHarken Back to 1979

Social ResponsibilityCorporations Can ProftFrom Taking on a Cause

The Federal reserve Bank oF sT. louis

C e n T r a l t o a m e r i C a s e C n m yTm


2/28

3 P n t M g

4 Corporate Social

Responsibility

By Rubn Hernndez-Murillo

and Christopher J. Martinek

Businesses have ound that it

can pay o to engage in social

stewardship, such as donating

to charity, protecting the

environment and nurturing a

diverse and sae workplace.

13 The Financial Crisis

in S, M and L

By Rajeev Bhaskar and Yadav Gopalan

An examination o what Iceland,

the United Kingdom and the United

States went through last September

and October during the fnancial

crisis reveals some important

dierences and similarities.

c o n t n t

This Is Not Your Fathers Recession ...By Charles S. Gascon

The current recession is the seventh since 1969. Todaysdeclines in employment and income are consistent withthe past. Unique this time are the major drop in home

prices and the proactive response by policymakers.

6

The Regional Economistis published

quarerly by he esearh ad Publi

ffairs deparmes f he Federal

eserve Bak f . Luis. addresses

he aial, ieraial ad reial

emi issues f he day, pariularly

as hey apply saes i he ihh

Federal eserve isri. Views

expressed are eessarily hsef he . Luis Fed r f he Federal

eserve ysem.

Please dire yur mmes

Mihael . Pakk a 314-444-8564 r

by e-mail a [email protected]. Yu a

als wrie him a he address belw.

ubmissi f a leer he edir

ives us he rih ps i ur web

sie ad/r publish i i The Regional

Economistuless he wrier saes

herwise. We reserve he rih edi

leers fr lariy ad leh.

Director of Research

ber H. ashe

Deputy Director of Research

cleus c. cuhli

Director of Public Affairs

ber J. hek

EditorMihael . Pakk

Managing Editor

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Art Director

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ile-py subsripis are free.

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als wrie The Regional Economist,

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Mo 63166.

The Eighth Federal Reserve District

iludes all f rkasas, easer

Missuri, suher lliis ad diaa,

weser Keuky ad teessee, ad

rher Mississippi. the ihh isri

fes are i Lile k, Luisville,

Memphis ad . Luis.

The Regional

EconomistAPRIL 2009 | VoL. 17, no. 2



THE REGIONAL

ECONOMIST

AQuarterlyReviewofBusinessandEconomicCond itions

Vol.17,No.2

April2009

TheVolckerEraActionsbyTodaysFedHarkenBackto 1979

SocialResponsibilityCorporationsCanProftFromTakingona Cause

THE FEDERAL RESERVE BANK OF ST. LOUIS

CENTRAL to AMERICAS ECONOMYTM

19 c o M M n t Y P o F L

Elizabethtown, Ky.

By Susan C. Thomson

Now, more than ever, Fort Knox

looms golden to this small city

in western Kentucky. The Army

base, just 15 miles away, is in

the midst o a buildi ng boom

that will add to the thousands o

jobs already flled by residents o

Elizabethtown and its environs.

22 c o n o M Y t gL nc

23 nt o n L o V V W

Nearing the Bottom?

By Kevin L. Kliesen

Policymakers and fscal authori-

ties have already taken drastic

measures to prevent the hole that

the economy is in rom getting

any deeper. Whether these

measures can be economically

justifed in either the short term

or long term is uncertain.

24 t c t o V V W

Revisions to Jobs Data

By Thomas A. Garrett and

Michael R. Pakko

Employment data undergo

signifcant updating every

March. Oten, major changes

result, particularly in timeslike these. However, the latest

revision yielded little change

in the data or metro areas in

the Eighth District.

26 c H ng

2 The Regional Economist | April 2009


3/28

important dierence is that U.S. ination

and long-term interest rates are currently

very low. In act, market-based indicators

o ination expectations may be driting

toward deation. Still, there is a clear atmo-

sphere o crisis. Financial turmoil continues

to impact a wide range o fnancial markets

and institutions around the globe. The Fed

has lost its usual ability to signal to the pri-

vate sector via nominal interest rates as the

policy rate has reached the zero bound.As in October 1979, the Fed has reacted to

the crisis situation with an aggressive change

in policy. Like the Federal Reserve in Vol-

ckers time, todays Fed has taken unprece-

dented actions, departing rom its traditional

approach to monetary policyinterest-rate

targetingand ocusing on quantitative

measures instead. Beginning in December

o last year, the FOMC shited its ocus or

uture policy to the Feds balance sheet.

In some ways, our current environment

parallels the Japanese experience ater 1990.

Jim Bullard, Preside ad co

Federal eserve Bak f . Luis

Elsewhere in this issue, you will fnd anarticle titled This is not your athersrecession ... or is it? It compares todays

recession with those o the past 40 years.

In the same spirit, I would like to compare

todays Fed, and the challenges we ace, with

the Volcker Fed o 1979.1

During the 1970s, monetary policy had

ollowed a gradualist approach: fne-tuning

interest rate moves in an eort to avert

economic slowdowns. By 1979, it hadbecome apparent that such a strategy was

inadequate as ination and ination expec-

tations continued to march upward and the

real economy deteriorated. Ination rose

steadily rom about 2 percent through

much o the 60s to more than 13 percent

in December 1979. The Federal Reserve

was not seen by the public as credibly fght-

ing ination.

A drastic change in the approach to mon-

etary policy was needed by the Fed in order

to regain its credibility, tame ination andrestore confdence in fnancial markets. The

plan had to allow or substantial increases in

short-term interest rates while, at the same

time, reassuring fnancial markets that this

new policy approach would be eective and

the cost o disination would be minimized.

On Oct. 6, 1979, the Fed, under Paul

Volckers leadership, shited its ocus rom

targeting nominal interest rates to targeting

non-borrowed reserves to control the money

supply. Volckers monetarist experiment

was ultimately successul in stabilizingination and anchoring ination expecta-

tions. The economy experienced a sharp

recession, but was then set or a long period

o stable growth. For more than two-and-

a-hal decades ollowing the monetarist

experiment, the economy grew in long

stretches, punctuated by just two relatively

mild recessions.

The situation we ace today is not that

aced by the Volcker Fed in 1979. One

Feds Bold Actions Harken Back to Volcker Era

P n t M g

1 See Reections on Monetary Policy: 25 Years Ater Octo-

ber 1979, Federal Reserve Bank o St. Louis Review March

April 2005, or a compilation o the conerence proceeding

as well as personal reections commemorating Oct. 6,

1979. Go to http: //research.stlouised.org/publ ications/

review/05/03/part2/MarchApril2005Part2.pd.

The Japanese banking system encountereddifculties with troubled assets, and the

intermediation system broke down. Even-

tually, persistent year-over-year deation

was observed in core measures o ination,

and average economic growth stagnated. In

Japan, policy rates have been below 1 percent

or 14 years, and deation was observed or

more than a decade. An outcome o sus-

tained deation and extremely low nominal

interest rates, as happened in Japan, is some-

times reerred to as a deationary trap.

To avoid the Japanese experience, theFed will need to provide enough sustained

growth in the monetary base to oset down-

ward pressure on ination coming rom the

very sharp recession. At the same time, the

Fed cannot provide such a sustained high

level o monetary growth that medium-run

ination takes hold. Either way, the signals

that the Fed sends about its uture intentions

have to come rom quantitative measures o

policy and not rom interest rate movements

This is a very dierent mode o operation

than what the Fed and the fnancial marketshave been used to over the past two decades.

By acting aggressively, the Fed may be able

to replicate the success o Volckers Fed 30

years ago.

this is a very differe mde

f perai ha wha

he Fed ad he aial

markes have bee used

ver he pas w deades.By ai aressively, he

Fed may be able repliae

he suess f Vlkers Fed

30 years a.

The Regional Economist | www.stlouisfed.org 3


4/28

Corporate social responsibility (CSR)is a doctrine that promotes expandedsocial stewardship by businesses and orga-

nizations. CSR suggests that corporations

embrace responsibilities toward a broader

group o stakeholders (customers, employ-

ees and the community at large) in additionto their customary fnancial obligations to

stockholders. A ew examples o CSR include

charitable giving to community programs,

commitment to environmental sustainability

projects, and eorts to nurture a diverse and

sae workplace.1

As more attention is being paid by out-

siders to the social impact o businesses,

corporations have acknowledged the need or

transparency regarding their social eorts.

In a recent survey, 74 percent o the top 100

U.S. companies by revenue published CSRreports last year, up rom 37 percent in 2005.

Globally, 80 percent o the worlds 250 largest

companies issued CSR reports last year.2

Is CSR Socially Desirable?

Despite the apparent acceptance o CSR

by businesses, many economists have taken

a skeptical view o CSR and its viability in a

competitive environment. Milton Fried-

man, in particular, doubted that CSR was

social ly desirable at all. He maintained that

the only social responsibility o a businessis to maximize profts (conducting business

in open and ree competition without raud

or deception).3 He argued that the corpo-

rate executive is the agent o the owners

o the frm and said that any action by the

executive toward a general social purpose

amounts to spending someone elses money,

be it reducing returns to the stockholders,

increasing the price to consumers or lower-

ing the wages o some employees. Friedman

pointed out that the stockholders, the custo-

mers or the employees could separately

spend their own money on social activities

i they wished to do so.

Friedman, however, also noted that there

are many circumstances in which a frms

manager may engage in actions that servethe long-run interest o the frms owners

and that also have indirectly a positive social

impact. Examples are: investments in the

community that can improve the quality

o potential employees, or contributions to

charitable organizations to take advantage

o tax deductions. Such actions are justifed

in terms o the frms sel-interest, but they

happen to generate corporate goodwill as a

byproduct. Furthermore, this goodwill can

serve to dierentiate a company rom its

competitors, providing an opportunity togenerate additional economic profts.

Friedmans argument provoked econo-

mists to explore the conditions under which

CSR can be economically justifed. Econo-

mists Bryan Husted and Jos de Jesus Salazar,

or example, recently examined an environ-

ment where it is possible or investment in

CSR to be integrated into the operations o

a proft-maximizing frm. The authors con-

sidered three types o motivation that frms

consider beore investing in social activities:

altruistic, where the frms objective isto produce a desired level o CSR with no

regard or maximizing its social profts, i.e.,

the net private benefts captured by the frm

as a consequence o its involvement in social

activities;

egoistic, where the frm is coerced into

CSR by outside entities scrutinizing its social

impact; and

strategic, where the frm identifes social

activities that consumers, employees or

investors value and integrates those activities

into its proft-maximizing objectives.

In agreement with Friedman, Husted and

Salazar conclude that the potential benefts

to both the frm and society are greater in

the strategic case: when the frms socially

responsible activities are aligned with thefrms sel-interest.

Strategic CSR

Similarly, economists Donald Siegel and

Donald Vitaliano examined the theory

that frms strategically engage in proft-

maximizing CSR. Their analysis highlights

the specifc attributes o business and types

o CSR activities that make it more likely

that socially responsible actions actually

contribute to proft maximization. They

conclude that high-profle CSR activities(e.g., voluntary eorts to reduce pollution or

to improve working conditions or employ-

ees) are more likely undertaken when such

activities can be more easily integrated into

a frms dierentiation strategy.

Siegel and Vitaliano studied a large sample

o publicly traded frms and classifed them

using the North American Industry Classif-

cation System codes into fve categories. The

fve categories were:

search goods, whose quality can be readily

evaluated beore purchase, e.g., clothing,ootwear and urniture;

nondurable experience goods, whose qual-

ity is experienced over multiple uses and

requent purchases, e.g., ood, health and

beauty products;

durable experience goods, which must

be consumed beore their true value can

be determined, permit less learning rom

repeated purchases and require a longer

period or the products characteristics to

B n

Corporate Social Responsibility

Can Be ProftableBy Rubn Hernndez-Murillo and Christopher J. Martinek



5/28

be ully known, e.g., automobiles and

appliances; and fnally

experience services and credence services,

which oten involve strong inormation

asymmetries between sellers and buy-

ers, who may fnd it difcult to assess the

services value even over a long period,

e.g., banking, fnancial counseling, auto

repairs and weight-loss programs.

Siegel and Vitaliano ound, using an

aggregate measure o CSR involvement,

that frms selling experience goods and

experience and credence services are

more likely to engage in CSR than those

selling search goods. The dierence in

the intensity o CSR involvement across

types o goods, they argued, is explained

by the consumers perception o a frms

involvement in CSR (even when the frms

product does not directly include a social

component) as a valuable signal o thefrms reliability and its commitment to

quality and honesty.

Using the same classifcation o frms as

Siegel and Vitaliano did, the accompany-

ing chart shows the proportion o frms

in each classifcation that demonstrated

relative strength in seven dierent social

issues related to CSR as rated in 2007 by

Kinder, Lyndenberg and Domini (KLD),

an independent research frm that rates

the social perormance o corporations.4

The chart reveals that the level o relativestrength in the seven individual areas o

CSR rated by KLD varies among the fve

classifcations o frms.5 In other words,

frms choose to invest in dierent types

o CSR when catering to dierent groups

o stakeholders.

A greater proportion o goods-produc-

ing frms showed strength in the environ-

ment issue areas. This result is perhaps not

surprising. Stakeholders in service frms

are not likely to value CSR eorts related

to the environment, since services prob-ably have lower perceived environmental

impact than manuacturing frms do.

In the community issue areawhere

strengths include giving programs,

volunteer programs and support or

local organizationsfrms providing

experience services perormed quite well.

Devoting resources to CSR activities in

community relations can bolster reputa-

tion, on which frms that are classifed in

E N D N O T E S

1 See General Mills Inc. or detai led examples

o corporate CSR eorts.2 See KPMG.3 See Friedman (1962, 1970).4 A frm is considered to have a relative

strength in an issue area when the raction

o strengths identifed divided by the number

o strengths considered exceeds the raction

o areas o concern identifed divided by the

number o concerns considered.5 The ratings in the seven social issue areas are

provided by Kinder, Lyndenberg and Domini

(KLD) rom the 2008 KLD STATS database.

KLD rates the largest 3,000 publicly traded U.S

companies in several categories o strengths

and concerns in each issue area. The classifca

tion o frms by product or service provided

used a listing o primary industry (NAICS)

codes provided by the Center or Research in

Security Prices (CRSP) database. Since some

frms received no ratings rom KLD or did not

have a primary NAICS code listed in the CRSP

database, the total number o frms considered

is slightly ewer than 3,000.

R E F E R E N C E S

Friedman, Milton. Capitalism and Freedom.

Chicago: University o Chicago Press, 1962.

Friedman, Milton. The Social Responsibility

o Business Is To Increase Its Profts, The

New York Times Magazine, Sept. 13, 1970,

No. 33, pp. 122-26. See www.colorado.edu/

studentgroups/libertarians/issues/riedman-

soc-resp-business.html.

General Mills Inc. Corporate Social Responsibil-

ity Report, 2008. See www.generalmills.com/

corporate/commitment/NEW_CSR_2008.pd

Husted, Bryan W.; and Salazar, Jos de Jesus. Tak

ing Friedman Seriously: Maximizing Profts and

Social Perormance. Journal of Management

Studies, January 2006, Vol. 43, No. 1, pp. 75-91.

KPMG, International Survey of Corporate Respon-

sibility Reporting of 2008, October 2008. See

www.kpmg.com/Global/IssuesAndInsights/

ArticlesAndPublications/Pages/Sustainability

corporate-responsibility-reporting-2008.aspx.

Siegel, Donald S.; and Vital iano, Donald F. An

Empirical Analysis o t he Strategic Use o

Corporate Social Responsibility. Journal

of Economics and Management Strategy, Fall

2007, Vol. 16, No. 3, pp. 773-92.

Search Goods122 rms

NondurableExperience Goods

269 rms

DurableExperience Goods

1,250 rms

Experience Services701 rms

Credence Services414 rms

60

50

40

30

20

10

0

Diversity Corporate Governance Community Employee Relations

Environment Human Rights Product

PERCENT

OF

TOTAL

Proportion of the 3,000 Largest Publicly Traded U.S. Firms

Demonstrating Strength in Social Issue Areas

the experience services category typically rely

as a orm o brand dierentiation. Banks,

which constitute a large portion o the frms

in the experience services category, can also

excel in this area o CSR by committing a

portion o their commercial loan portolio to

community development initiatives.

In the human rights issue area, the fve

categories o businesses have ew, i any, frms

that demonstrated relative strength. The only

category with a sizeable proportion o frms

was the search goods category. This is also

understandable, as frms in this category ace

higher pressures rom activists concerned

about the working conditions o unskilled

labor employed (usually in developing coun-

tries) in the production process.

Being Responsibleand Protable

Modern theoretical and empirical analyses

indicate that frms can strategically engage

in socially responsible activities to increase

private profts. Given that the frms stake-

holders may value the frms social eorts,

the frm can obtain additional benefts rom

these activities, including: enhancing the

frms reputation and the ability to generate

profts by dierentiating its product, the

ability to attract more highly qualifed per-

sonnel or the ability to extract a premium

or its products.

Rubn Hernndez-Murillo is an economist at

the Federal Reserve Bank of St. Louis. Christo-

pher J. Martinek is a research associate there.

SOURCE: KLD SS 2008



6/28

By Charles S. Gascon

Recessions are a common occurrencein any economy, part o the pattern oexpansion and contraction known as the

business cycle. For most Americans, the cur-

rent recession is, by ar, the worst recession in

their adult lietime. Not since 1981 has the

economy contracted or more than a single

year. Heightening economic insecurity, this

particular recession is also associated with a

fnancial crisis, as many news stories recall

the turmoil o the Great Depression.

Although there is a strong correlation

between fnancial crises and severe economicdownturns, not all fnancial crises result in

a depression or even a recession: The U.S.

economy never slipped into recession ater

the 1987 fnancial crisis.

Every recession and fnancial crisis has

certain characteristics in common; at the

same time, each event is unique. Similari-

ties across recessions are generally related

to declines in employment, production

and ination. Financial crises tend to be

associated with an increased demand orgovernment-backed assets and a decline in

demand or private assetsa eature known

as ight to quality.

The unique characteristics o the current

recession are a signifcant decline in home

prices and the resulting fnancial crisis.

Surprising to many, the recent declines in

employment and income, so ar, have been

consistent with past recessions. One eature

o the current environment that stands out

as a stark departure rom past fnancial

crisesparticularly compared with theJapanese fnancial crisis or with the Great

Depressionis a proactive response by

policymakers.

Comparing U.S. Recessions

Since 1978, economists and policymakers

have accepted the judgment o the National

Bureau o Economic Research (NBER) Busi-

ness Cycle Dating Committee on the start

and end o a recession, or business cycle

c o n o M Y

very reessi ad

aial risis has erai

haraerisis i mm;

a he same ime, eah

eve is uique.





7/28

turning points. The NBER is a nonproftorganization, and the committee consists o

well-respected economists rom around the

country. This group defnes a recession as

a signifcant decline in economic activity

spread across the economy, lasting more

than a ew months. The committee does

not use the popular defnition o a reces-

sion as two consecutive quarters o negative

growth in real gross domestic product (real

GDP). Because o this, dating o recessions is

sometimes conusing. The committee dated

the start o the current recession as Decem-ber 2007, even though real GDP actually

increased by an average annual rate o 1.9

percent during the frst two quarters o 2008.

According to the committee, the U.S.

economy has experienced six periods o

recession during the past 40 years.1 On

average, these past recessions have lasted

10.8 months. The longest recessions

beginning in November 1973 and July

1981each lasted 16 months. The shortest

recessionbeginning in January 1980lasted six months. Although the end o the

current recession is unclear, some economists

expect it to extend into mid-to-late 2009, a

duration o about 18 to 24 months.

In its December 2007 report, the commit-

tee ocused on our indicators: industrial

production, total nonarm employment, real

personal income less transer payments, and

wholesale and retail sales. Many economists

ollow these indicators to gauge the state o

the economy.2 Surprising to many non-

economists, the unemployment rate is notincluded. (See Figure 1.) The rate tends to

reach its minimum ater the recession has

begun. This occurs because the unemploy-

ment rate measures the share o the popula-

tion not employed but actively seekingwork.

As the economy moves into recession, many

people stop looking or work and are omitted

rom the index. Cushioning the unemploy-

ment rates decline, when the economy

improves people will once again seek work.

Three popular leading economic indica-tors that tend to move prior to business cycles

are stock price indices, housing starts and

interest rate spreads.3 In particular, stock

price indices normally increase about three

months prior to the end o a recession.

Figure 2 displays a broad collection o indi-

cators used to assess the state o the economy

The series were selected because they exhibit

trends generally unique to the current

recession. Other important indicators have

exhibited normal recessionary declines. The

fgure compares the declines throughout thecurrent recession (red lines) to the average

decline over the past six recessions (solid blue

lines). Each series reports the percent change

rom the business cycle peak. The horizontal

axis reports the months beore and ater the

peak. For example, the datum on the red line

at month one reports the percentage decline

rom December 2007 to January 2008, while

the datum on the solid blue line at month

one reports the average decline during the



8/28

frst month o the past six recessions. The

variability in each series is captured by the

two dashed lines, which report the highest

and lowest values recorded across the past

six recessions.

The two charts on the top row describe

the general state o the economy through

data on total nonarm employment and real

personal income less transer payments.

Percentage decreases in these series, thus ar,

Business cycle indicators can be classifed as leading,

lagging or coincident based on their turning points

relative to the business cycle. For example, the S&P500 is a leading indicator because it generally turns

down beore the onset o a recession and up beore the

recession ends. ( here are always exceptions.) While

the unemployment rate is a lagging indicator, totalemployment is a coincident indicatorits peaks and

troughs generally occur in the same month as businesscycle peaks and troughs. he gray bars represent thecurrent and past six recessions.

Fu 1 Leading, Lagging and Coincident Indicators

Jan.

68

Jan.

74

Jan.

80

Jan.

86

Jan.

92

Jan.

98

Jan.

04

1800

1600

1400

1200

1000800

600

400

200

0

A V E R A G E 1 9 4 1 - 4 3 = 1 0

S&P 500 Stock Price Index

Jan.

68

Jan.

74

Jan.

80

Jan.

86

Jan.

92

Jan.

98

Jan.

04

12

10

8

6

4

2

0

% , S E A S O N A L L Y A D J U S T E D

Civilian Unemployment Rate

160

140

120

100

80

60

40

20

M I L L I O N S , S E A S O N A L L Y A D J U S T E D

Total Nonfarm Employment

have been within the range exhibited by pas

recessions. In December 2008 (month 12

on the chart), employment was 2.2 percent

lower than a year ago, while real incomes

declined by less than 1 percent. Although

simple charts alone cannot suggest reasons

or these declines, low ination has likely

assisted in stabilizing real incomes, and

active monetary and fscal policies have

mitigated the spillover eects rom turmoil

in fnancial markets into these broad mea-

sures o economic well-being.

In the second row are two series that

describe the current fnancial crisis: home

prices, measured by the median sales price

o existing amily homes, and stock prices,

measured by the S&P 500 index. The

decrease in home prices started months

beore the current recession, dropping

12 percent in the six months beore the

recession and another 15 percent in the 12months ater the recession began. During

past recessions, home prices tended to be

relatively stable. Only during the 1990-1991

recession did home prices decline by more

than 3 percent. Falling home prices erased

over $3 trillion in home equity rom the

wealth o American households in 2008.

The problems in the housing market have

also taken a signifcant toll on equity prices

particularly the equities o fnancial institu-

tions highly exposed to real-estate-related

securities. Over the frst 13 months o therecession, the S&P 500 lost over 40 percent

o its value.

Trends in real consumption are reported

in the third row o the fgure. Consump-

tion is separated into two components:

consumption o durable goods and con-

sumption o nondurable goods and services

Consumption o durable goods can be

thought o as a type o household spend-

ing on big ticket items (e.g., rerigerators

and automobiles), which are more likely

dependent on fnancing. Consumption onondurable goods and services tends to be

smaller purchases that households buy with

cash. The fgure indicates that these two

types o consumption have dierent cyclica

properties. On the one hand, consumption

o durables declined during past recessions;

on the other hand, consumption o nondu-

rables and services remained stable or even

grew during past recessions. It is likely,

continued on Page 11



9/28

Comparison of Business Cycle Indicators Fu 2

6 4 2 0 2 4 6 8 10 12

1.5%

1.0%

0.5%

0.0%

0.5%1.0%

1.5%

2.0%

2.5%

3.0%

6 4 2 0 2 4 6 8 10 12

15%

10%

5%

0%

5%

10%

6 4 2 0 2 4 6 8 10 12

2.0%

1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6 4 2 0 2 4 6 8 10 12

60%

40%

20%

0%

20%

40%

60%

80%

100%

120%

6 4 2 0 2 4 6 8 10 12

20%

15%

10%

5%

0%

5%

10%

15%

20%

6 4 2 0 2 4 6 8 10 12

30%

20%

10%

0%

10%

20%

30%

40%

50%

6 4 2 0 2 4 6 8 10 12

5%

4%

3%

2%

1%

0%

1%

2%

3%

E M P L O Y M E N T R E A L I N C O M E

C O N S U M E R P R I C E I N D E X F E D E R A L F U N D S R A T E

S & P 5 0 0

R E A L C O N S U M P T I O N : D U R A B L E G O O D S REAL CONSUMPTION: NONDURABLES AND SERVICES

6 4 2 0 2 4 6 8 10 12

15%

10%

5%

0%

5%

10%

15%

20%

M E D I A N H O M E P R I C E

Current LowestAverage Highest Lowest

SOURCES: Employment and the Consumer Price Index are rom the Bureau o Labor Statistics; real income and real consumption are rom

Bureau o Economic nalysis; S&P 500 is rom The Wall Street Journal; ederal unds rate is rom the Federal Reserve Board H.15.

he current recession is dierent, but how

dierent? he charts to the let put things into

perspective. he red lines represent the percentchange in each series rom the start o the current

recession, December 2007. s a benchmark, the

blue lines report the average (solid line), highest

(gold dotted lines) and lowest levels (purple dot-ted lines) experienced over the past six recessions.

(hey do not represent data or a particular reces-sion.) I the red line remains close to the average,or at least above the lowest, the decline can be

interpreted as a normal recessionary one. he

numbers on the horizontal axes represent monthsbeore and ater the business cycle peak.



10/28

The Great Depression (1929-1939) beganabout August 1929 with a severe reces-sion, which lasted for 43 months. Between

1933 and 1937, the economy expanded, actu-

ally reaching its 1929 level of output. In May

1937, the economy again slipped into reces-

sion, although one that was much less severe

and that lasted only through June 1938. Most

historians agree that the Great Depression

ended sometime in 1939, although the worst

year of the Depression was probably 1933.

One popular phrase in recent months has

been the worst decline since the Great

Depression. Fortunately, the difference

between the worst since and as worse as

the Great Depression is vast. Some events are

similar: The failure of major investment banks

and the largest commercial bank, as well as

a sharp decline in consumer spending, have

been the main points of comparison between

these episodes. Contrary to the Depression-

era references, institutions designed to pre-

vent banking collapses and substantial action

by policymakers make these two episodes

very different.

The current recession would have to last

another 2.5 years before reaching the length

of the 1929-33 recession. Investment banks

have failed during the current crisis, but

depositors condence in their banks has

remained rm. Between 1930 and 1933, an

average of 9.2 percent of all banks failed every

year. The FDIC reported last year that only 30

of over 7,000 banks failed or received assis-

tance. This is less than 0.5 percent.10

The accompanying table compares recent

declines in income, employment and stock

prices with those experienced during the

1929-33 recession. The column on the left

reports the percentage declines during the

rst year of the current recession, the center

column shows the percentage declines over

the rst year of the Great Depression and the

column on the right shows the total declines

over the entire 1929-33 recession.11

The S&P 500 lost more value in the rst

12 months of the current recession than in the

rst 12 months of the Great Depression. But

broader economic indicators have been much

stronger of late. Per capita income declined

by over 10 percent during the rst year of the

Depression, while current per capita incomes

(before adjusting for ination) have remained

stable. Similarly, employment declined by

5.6 percent during the rst year of the Great

Depression, but declined by 2.2 percent in

the rst year of the current recession.

While it cannot be directly inferred from the

chart, differences in government policy likely

exacerbated the Depression-eras declines in

income and employment while mitigating the

current declines. During the Depression, the

Revenue Act of 1932 raised taxes to meet

budget shortfalls, and the Federal Reserve

failed to sufciently expand the money supply

to offset the effect of the elevated demand

for currency. In contrast, in 2008, the Federal

Reserve greatly increased the money supply,

and the federal government implementedincreased spending and tax reductions.

A nal point of interesting information: In

the year after the 1929-33 recession, the

stock market rallied, increasing 72 percent in

one year. However, it took another 20 years

until the S&P 500 reached its 1929 levels. In

more recent times, stock prices fell 40 percent

between 1999 and 2002, and only ve years

were needed to recover the losses.

Are Great Depression Fears Warranted?

RECESSIN VS. DEPRESSIN

Percentage declines between dates

Dec. 2007to Dec. 2008

1929 to 1930 1929 to 1933

Per capita personal incomeless transer payments

0.7 11.7 48.0

otal nonarm employment 2.2 5.6 15.8

S&P 500 stock price index* 40.8 30.9 79.3

SOURCES: uthors calculations using data rom: Historical Statistics of the United States, Bureau o Economic nalysis,and The Wall Street Journal. * Changes are rom ugust 1929 to ugust 1930 and ugust 1929 to March 1933.



11/28

continued from Page 8

because real incomes have remained stable,

that recent declines in wealth and/or liquid-

ity constraints have suppressed both orms

o consumption. Consumption o durables

declined 11 percent in the frst 12 months o

the recession. Consumption o nondurables

and services, while remaining relatively

stable, declined about 1 percent over the

same time period.

Losses in wealth associated with home

and stock prices have reduced consumer

spending. Economic theory suggests that

consumption is primarily driven by lietime

wealth. In response to short-term declines

in income, households will smooth their

consumption by borrowing. That means

that consumption spending will uctuate less

over business cycles than household income

or wealth will uctuate. This theoretical

result must be amended to account orliquidity constraints, that is, some house-

holds will fnd it difcult to borrow money

as their income alls because lenders will

be uncertain o uture earnings and, hence,

prospects or repayment. The current

fnancial crisis has reportedly increased the

difculty o individuals and businesses to

borrow. The result has been the largest reces-

sionary decline in real consumption in the

past 40 years.

The bottom row reports the trend in

ination, measured by the Consumer PriceIndex, and the trend in the eective ederal

unds rate. Slowing ination has allowed the

Federal Reserve to act in a proactive ashion

when dealing with the current recession.

Not only have reductions in the ederal unds

rate been larger than in past recessions, but

the reductions actually started three months

beore the onset o the latest recession. The

ederal unds target decreased rom 5.25

percent on Sept. 17, 2007, to 2 percent on

April 30, 2008. By the spring o 2008, when

the fnancial crisis was airly certain, theFederal Reserve began to aggressively reduce

its target, ultimately to between 0 and 0.25

percent on Dec. 16, 2008.

Comparing Financial Crises

Tightening o credit, declines in asset

prices, and banking runs or ailures tend to

characterize fnancial crises.4 Tightening

o credit occurs because banks, institutions

and individuals ear that borrowers will be

unable to repay a loan or investment. The

inability o investors to evaluate the credit-

worthiness o borrowers causes

them to move away rom private assets

(i.e., stocks or corporate bonds) and toward

government-issued (or guaranteed) debt

(i.e., Treasuries, bank deposits or currency).

The shit rom private to government-issued

debt may reduce the demand or private

assets, such as houses or equities, which,

in turn, pushes down their prices.

Prior to the creation o the Federal Deposit

Insurance Corp. (FDIC), bank runs were a

eature o crises. Depositors who were wor-

ried about their ability to access cash that was

held at their bank would run to the bank to

withdraw their money. As depositors with-

drew unds, banks would be orced to quickly

liquidate assets, possibly at a loss, resulting at

times in the ailure o the bank.

In the current recession, bank runs atFDIC-insured institutions have not occurred.

Worried investors, however, did withdraw

large amounts rom money market mutual

unds ater a major und broke the buck in

September 2008.5 In response, the Treasury

and Federal Reserve instituted ederal guar-

antees or all money market und shares held

as o Sept. 18, 2008. Similarly, some hedge

unds have been orced to halt redemptions

due to attempted runs.

Many have studied the Japanese fnancial

crisis or lessons on how to handle the cur-

rent U.S. fnancial crisis. The Japanese crisis,

which lasted through the 1990s, is similar

in many ways.6 In the decade preceding

the crisis, deregulation allowed banks totransorm their balance sheets, exposing

them to more risk. Over this same period,

the percentage o loans that banks extended

to real estate doubled. During the fnancial

crisis and subsequent recession, home prices

in Japan declined over 35 percent and equity

prices declined by roughly 60 percent. For

many, the U.S. declines in home and equity

prices are all too similar. (See Figure 2.)

The Japanese crisis was unique, on the other

the Japaese risis, whih lased hruh he 1990s,is similar i may ways. he deade preedi he

risis, dereulai allwed baks rasfrm heir

balae shees, expsi hem mre risk.



12/28

hand, because o its longevity (lasting over

a decade), but with only modest declines in

output (close to 1 percent) and low unem-

ployment (under 5 percent).

Many economists have been quite critical

o how Japanese policymakers handled the

crisis. Economist Benjamin Friedman sug-

gested in 2000 that the Japanese government

incorrectly pursued a policy o orbearance,

wherein weak supervision standards allowed

banks to postpone the correct classifcation

o nonperorming assets. Friedman also

suggested that Japan should have applied

more-expansionary monetary and fscal

policies. In response to the crisis, the Bank

o Japan did, in act, lower its key interest

rate to virtually zero percent. Many have

suggested, however, that the Bank o Japan

could have gone urther and was mistaken

to assume that zero interest rates ended its

ability to stimulate the economy throughmonetary policy.7 U.S. policymakers have

learned rom this experience and pursued

expansionary policy even with target inter-

est rates close to zero percent.

In a recent study, economists Carmen

Rienhart and Kenneth Rogo compare the

recent declines in major economic indica-

tors with the declines experienced during

15 previous fnancial crises associated with

recessions in the U.S. and elsewhere.8 Three

common eatures o the data are: (1) a col-

lapse in asset prices, (2) proound declinesin output and employment and (3) explod-

ing government debt.

As expected, collapses in asset prices tend

to be severe during fnancial crises. Rein-

hart and Rogo report that, on average, real

equity prices declined by 55.9 percent, while

home prices declined by an average o 35.5

percent. The duration o these declines was

particularly long: Equity declines lasted,

on average, 3.4 years, and home prices

slid or six years. While the durations are

unknown, the declines reported in Figure 2are generally consistent with these averages.

The reported declines in output and

employment are smaller than decreases in

asset prices. The average decline in real

GDP per capita lasted just under two years,

exhibiting a total decline o 9.3 percent, or an

average quarterly decline o about 1 percent.

In 2008, the average quarterly decline in

real GDP per capita was 0.75 percent. At its

highest, the unemployment rate across these

countries averaged 7 percent, which is only

about 1 percentage point above the 40-year

average U.S. unemployment rate. A useul

comparison is the Great Depression, during

which the real GDP per capita declined by

almost 30 percent and the unemployment

rate increased to 23 percent. (See sidebar

on Great Depression comparison.)

Exploding government debt is possi-

bly the most astounding characteristic o

fnancial crises. In the major post-WWII

crises that Reinhart and Rogo studied, the

average increase in real government debt

was 86 percent. The outlook or the U.S.

national debt was ominous even beore the

current fnancial crisis, increasing roughly

60 percent between 2000 and 2007.9 Never-

theless, the debt had increased another 8.5

percent between January and September

2008. Reinhardt and Rogo note that while

antirecessionary government spending surelyincreases the national debt, the primary

actor tends to be declining tax revenue rom

a slowing economy. This fnding is possibly

at odds with some criticism that govern-

ment stimulus programs may raise the debt

burden. Absent o its eect, government

spending will increase the debt burden, but

successul government stimulus programs

could actually reduce the debt by growing the

economy and, thus, increasing tax revenue.

Look Beyond the Headlines

Much o the ear surrounding the current

recession has stemmed rom the collapse in

home prices and subsequent turmoil in

fnancial markets. The historic undertone

in the reporting o most economic data has

heightened economic insecurity. As unique

as the current recession may be, the policy

response has been very proactive. So ar, this

has mitigated the impact o the fnancial

crisis on broader measures o economic

health. By understanding the parallels

among recessions, it is possible to disen-tangle the typical recession-period bad news

rom the truly unexpected bad news that

might signal unusual problems.

Charles S. Gascon is a research associate at theFederal Reserve Bank of St. Louis.

E N D N O T E S

1

According to the NBER, the past si x reces-

sions began in December 1969 (lasting 11

months), November 1973 (16), January 1980

(6), July 1981 (16), July 1990 (8) and March

2001 (8).

2

See the Federal Reserve Bank o St. Louis

Tracking the Recession at http://research.

stlouised.org/recession.

3

Interest rate spreads are the di erence

between a long-term interest rate (10-year

Treasury bond) and a short-term interest rate

(ederal unds rate). Interest rate spreads hav

been negative beore every recession in the

past 40 years.

4

Tightening o credit is not necessarily unique

to fnancial crises; it occurs during most, i

not all, economic downturns.

5

Breaking the buck means that the unds

asset value alls below $1 per share.

6

Freidman provides parallels between Japans

fnancial crisis and t he U.S. savings and loan

crisis o the late 1980s and early 1990s. This

section is based on Friedmans interpretation

o the Japanese experience and data reported

in Reinhart and Rogo.

7

Bernanke (2000) is oten credited or this

critique.

8

The crises are: Norway (1899), U.S. (1929),

Spain (1977), Norway (1987), Finland (1991),

Sweden (1991), Japan (1992), Hong Kong

(1997), Indonesia (1997), South Korea (1997),

Thailand (1997), Malaysia (1997), Philip-

pines (1997), Colombia (1998) and Argentina

(2001).

9

See Pakko or a complete discussion.

10

Depression-era ailures are reported in Ber-

nanke (1983). Current ailures are reported

in FDIC table BF01, total institutions in FDIC

table CB01.11

According to the NBER, the business cycle

peak occurred in August 1929. Only annual

data are available during this time period;

1929 is used as the recession start. The mag-

nitudes o the declines are modestly increased

when using the 1930 to 1931 percent change.

R E F E R E N C E S

Bernanke, Ben S. Nonmonetary Eects o

the Financial Crisis in the Propagation o

the Great Depression,American Economic

Review, 1983, Vol. 73, No. 3, pp. 257-276.

Bernanke, Ben S. Japanese Monetary Policy:

A Case o Sel-Induced Paralysis, in Ryoichi

Mikitani and Adam S. Posen eds.,Japans

Banking Crisis and Its Parallels to U.S. Experi-

ence, pp 149-166. Washi ngton: Insti tute or

International Economics, 2000.

Friedman, Benjamin M. Japan Now and the

United States Then: Lessons rom the Paral-

lels, in Ryoichi Mikitani and Adam S. Posen

eds.,Japans Banking Crisis and Its Parallels to

U.S. Experience, pp 37-56. Washington: Insti

tute or International Economics, 2000.

Pakko, Michael. Defcits, Debt and Looming

Disaster. The Regional Economist, January

2009, Vol. 17. No. 1, pp. 4-9.

Reinhart, Carmen M.; a nd Rogo, Kenneth S.

The Atermath o Financia l Crises, paper

presented at the 2009 American E conomic

Association meetings. American Economic

Review, orthcoming.



13/28

Last September and October were criticalor the United States in the ongoingfnancial crisis. Almost daily, there were

announcements o mergersand ailures

o major fnancial institutions, and huge

corporations across many industries pleaded

or government help. In response, ederal

lending and other assistance programs

popped up like mushrooms ater a down-

pour, oering hundreds o billions

o dollars in aid.

While many Americans were shaken

by the problems in the private sector, they

were just as anxious about the response

rom the ederal government. Although the

response was unprecedented in many ways,

its important to know that the U.S. wasnt

taking such action in a vacuum. At the

same time that the crisis was snowballing inthe United States, it was spreading around

the world. And government leaders in other

countries were responding with similarly

bold and unprecedented actions.

This article examines the crisis and

response last all in a sampling o countries

a small one (Iceland,) a medium one

(the United Kingdom) and a large one (the

United States). While each country had

somewhat dierent problems and dierent

institutions to deal with those problems, all

responded with orceul action and majorintervention to keep their fnancial systems

rom a complete collapse.

THE U.S. SITUATIN

The U.S. economy is the largest in the

world. In 2007, GDP was $13.8 trill ion,

approximately fve times larger than that o

the U.K. and 708 times larger than that o Ice-

land. The U.S. fnancial sector represented

8.9 percent o the tota l economy in 2007.

The turbulent fnancial market condi-

tions in the all o 2008, along with the

ongoing fnancial crisis, have their roots in

the subprime crisis dating back to mid-

2007. When fnancial institutions suered

signifcant losses to their subprime mort-

gage portolios, investor confdence in the

credit markets was shaken. The ensuing

year-long credit and liquidity crisis over-

owed onto the global arena in September

2008. This period can be characterized by

severe liquidity contraction in the credit

markets, mounting losses and ailures o

fnancial institutions, as well as the threat

o insolvency to many other fnancial

institutions.

Fannie Mae and Freddie Mac, the two

housing government-sponsored enterprises

(GSEs), were among the frst o the largetroubled institutions that the government

aided. Falling house prices and rising

oreclosures led to signifcant losses. The

two GSEs saw their stock prices plummet

more than 90 percent over the year. More

bad news came when Lehman Brothers fled

or bankruptcy protection Sept. 15, rattling

the markets across the globe. AIG (Ameri-

can International Group) was the next large

fnancial services company in trouble. On

Sept. 16, credit rating agencies downgraded

AIG, requiring it to post collateral on itscredit deault swaps. This led to a liquidity

crisis or AIG; it was unable to generate the

billions o dollars in cash required to meet

its obligations. Next was the ailure on Sept.

26 o the largest thrit in the U.S., Washing-

ton Mutual, which had assets o more than

$300 billion.

The U.S. has a complex and diverse

fnancial regulatory structure, consisting o

numerous ederal and state agencies with

dierent roles, jurisdictions and objec-

tives. Though many government agencies

have played some role in the response to

the fnancial crisis, there have been ourmajor players: the Federal Housing Finance

Agency (FHFA), the Federal Deposit Insur-

ance Corp. (FDIC), the Federal Reserve and

the Treasury.

The Response

FHFA

The FHFA was created July 30, 2008, by the

merger o the Federal Housing Finance Board

(FHFB) and the Ofce o Federal Housing

Enterprise Oversight (OFHEO). The new

agency oversees the secondary mortgagemarkets. Soon ater its ormation, the FHFA

nationalized the two housing giants Fannie

Mae and Freddie Mac. The government, in

eect, invested in them, took control o their

boards and managements, and restricted

their activities. These actions reassured

market participants that Fannie and Freddie

still had the necessary unds to buy mortgage

loans and would continue to play an impor-

tant role in providing liquidity to the U.S.

mortgage market.

The FDIC

The FDIC is an independent agency o

the ederal government that has a mandate

to maintain fnancial stability by insur-

ing deposits, examining and supervis-

ing fnancial institutions, and managing

receiverships. Through legislative action,

the FDICs deposit insurance limit was

raised to $250,000 rom $100,000 through

December 2009 in order to provide security

The Financial Crisis in S, M and L

Three Very Different Countries Respond Similarly

n t n t o n L

By Rajeev Bhaskar and Yadav Gopalan



14/28

to depositors and small businesses during

the fnancial crisis. The FDIC, through its

rule-making powers, initiated a temporary

liquidity guarantee program that guarantees

newly issued senior unsecured debt o banks,

thrits and certain holding companies and

that provides insurance coverage o noninter-

est bearing deposit transaction accounts.

The Fed

The Federal Reserve, the central bank o

the United States, is independent rom the

fscal authority (the Treasury). The role o

the central bank is to oster a sound banking

system and a healthy economy. The Fed is

dierent rom the central banks o Iceland

and the U.K. in that the U.S. central bank

is the only one that is also a regulator and

supervisor o banks.

As early as August 2007, when the mar-kets began showing fnancial strain, the

Fed lowered its discount rate by 50 basis

points. This was ollowed by a rapid easing

o monetary policy. The target ed unds

rate was lowered rom 5.25 percent in

September 2007 to a range o 0-0.25 percent

in December 2008. The easing helped in

lowering short-term lending rates, yet activ-

ity in the credit and securitization markets

remained clogged.

The Fed has also provided an enormous

amount o liquidity (close to $1 trillion) to

private institutions to restore the normal

unctioning o credit. The Feds actions have

included direct lending to banks and primary

security dealers, and have provided liquidity

directly to borrowers and investors in key

credit markets. At the height o the crisis,the Fed provided an initial loan o up to $85

billion to the beleaguered AIG to meet its

short-term needs. To help maintain liquidity

in worldwide fnancial marketswhich are

largely denominated in dollarsthe Fed

has initiated swap lines with several central

banks around the world.

The Treasury

The Treasury Department is the executive

agency o the government responsible or

promoting economic prosperity and ensur-ing the fnancial security o the United States

Through its bureaus (the Ofce o the

Comptroller o the Currency and the Ofce

o Thrit Supervision), the Treasury regulates

and supervises depository institutions.

Among the most ar-reaching actions

taken by the government last all was the

Treasurys $700 billion fnancial services

stabilization package, ormally known as

TARP (Troubled Asset Relie Program).

A Timeline of the Events of Fall 2008for U.S., U.K. and Iceland

Fannie Mae and Freddie Macnationalized.

Lehman Brothers les forbankruptcy protection.

Sept. 15

Robin Radaetz holds a sign in ront o the Lehman

Brothers headquarters Sept. 15 in New York. Lehman

Brothers, a 158-year-old investment bank choked by

the credit crisis and alling real estate values, fled or

Chapter 11 protection in the biggest bankruptcy fling

ever and said it was trying to sell o key business units.

reasury Secretary Henry Paulson Jr.

speaks during a news conerence

in Washington on Sept. 7 on the

nationalization o mortgage giants

Fannie Mae and Freddie Mac.

Sept. 16

Federal Reserveaids AIG with$85 billion loan.

In a bid to save fnancial

markets and economy rom

urther turmoil, the Federal

Reserve said Sept. 16 it would

provide up to $85 billion in

an emergency, two-year loan

to rescue the New York-based

insurance corporation.

(P PHOO/SUSN WLSH)

Sept. 14

Bank of America buys MerrillLynch for $50 billion.

Bank o merica bought Merrill Lynch in

a $50 billion deal that created a bank

oering everything rom fxed-income

trading to credit-card lending.

(P PHOO/MRY LFFER)

Sept. 7



15/28

This package was designed to buy troubled

assets, especially mortgage backed securi-

ties (MBS), and to provide capital to banks

that had severe liquidity needs. Between

the creation o TARP and its implementa-

tion, however, the thrust o the program

morphed into one o recapitalizing fnancial

institutions. As o Jan. 6, 2009, the Trea-sury had invested a total o $187.5 bill ion

in senior preerred shares in 214 fnancial

institutions; $40 billion to AIG under the

Signifcant Failing Institutions Program;

$19.4 billion to the auto industry; $20 bil-

lion to Citigroup as part o the Targeted

Investment Program; and $20 billion or a

Federal Reserve consumer-fnance program.

The grand total was $282.9 billion.

THE SITUATIN IN ICELAND

Until airly recently, Icelands two majorindustries had been fshing and tourism. The

government had tight control over many sec-

tors, including banking. Earlier this decade,

Icelands government privatized many sec-

tors o the economy by selling o state assets,

including its banking institutions.

Following privatization between 2001

and 2003, Icelands commercial banks grew

tremendously. In addition, some banks

used debt, primarily denominated in euros,

to fnance aggressive expansion overseas.

Figure 1 (on the next page) shows the speed

at which Icelands banks issued credit and

marketable securities; it also shows the

growth in their deposits.

The sector was dominated by three main

banks: Glitnir, Landsbanki and Kaupthing.

All three institutions expanded internation-ally and had become savings havens or

Europeans who wanted to take advantage o

Icelands high interest rates.

Right beore the crisis, the sectors col-

lective assets had ballooned to roughly

eight times the countrys overall GDP.1

Furthermore, the banks stocks had risen

to comprise roughly 75 percent o Icelands

stock market value.2

Glitnir, the third largest fnancial institu-

tion in Iceland, had borrowed heavily or

aggressive expansion abroad. On Oct. 15, thebank had roughly600 million in maturing

debt; in addition, it needed to pay out 150

million as part o a loan it arranged with

Bayerische Landesbank, a German bank.

Due to a precipitous drop in the value o the

currency, as well as the central banks insu-

fcient oreign reserves, Glitnir did not have

the cash necessary to pay down its debt, as

well as to pay its loan to Bayerische Landes-

bank. (The German government eventually

structured a rescue package or Bayerische

Landesbank.)

Landsbanki, the second largest bank,

was a particular magnet or oreign savers,

especially or British savers. In the wake

o Glitnirs collapse, British depositors

withdrew roughly $272 million in deposits

rom Landsbanki over one weekend, causingsevere liquidity problems or the bank.

For Kaupthing, Icelands largest bank,

problems arose when the Icelandic govern-

ment guaranteed a higher level o deposits

or Icelanders but not or oreigners. As

a result, the U.K. government invoked

anti-terror laws to reeze Kaupthings or-

eign assets.

Institutional Structure

and Policy Responses

The main organizations that orches-trated Icelands response to its crisis were

its central bank (Sedlabanki Islands), its

fscal authority (the Finance Ministry) and

its fnancial regulatory body (the Finan-

cial Supervisory Authority, also known as

FME, a derivation rom its Icelandic name).

Unlike in the United States, Icelands banks,

as well as its fnancial markets as a whole,

are regulated by a single authority, the FME

Its authorities and responsibilities are

Morgan Stanley and GoldmSachs become bank holdincompanies.

Sept. 21

Britains biggest mortgage lender,HBOS, is taken over by Lloyds TSBin a 12 billion deal.

Sept. 17

Haliax Bank o Scotland Chie Executive ndy Hornby,

et, shakes hands with Lloyds SB Chie Executive

Eric Daniels, right, while Lloyds Chairman Victor Blank

ooks on ater the merger was agreed to Sept. 17 in

London. Blank said that the prime minister had told

him the day beore that competition rules would be set

aside to make way or the merger.

Sept. 19

U.S. Treasury secretary announces $700 stabilization plan.

Senate Majority Leader Harry Reid, D-Nev., speaks to reporters ater members o Congress

met with SEC Chairman Chris Cox, second rom let, and reasury Secretary Henry Paulson,

third rom let, House Speaker Nancy Pelosi, and Federal Reserve Board Chairman Ben Ber-

nanke, right, on Sept. 18 in Washington. Democrat s began the week by blaming President

Bush or the fnancial crisis and said it was his job to fx it. But as the disarray became ameltdown and the entire U.S. economy was at stake, they pledged to work with Republicans

on a rescue that could cost taxpayers hundreds o billions o dollars.

Late Sunday, Sept. 21, the Federal Reserv

granted Goldman Sachs and Morgan Stan

the countrys last two major investment

banks, approval to change their status to

bank holding companies.

P PHOO / JOHN SILLWELL, POOL)

(P PHOO/LUREN VICORI BURKE)



16/28

much broader than any single agency in the

United States.3

Icelands central bank is primarily

charged with price stability. It achieves this

by controlling its interbank policy interest

rate to aect the cost o borrowing. The

central bank also promotes fnancial stabil-

ity, maintains Icelands oreign reserves,manages public debt, and serves as public

repository o economic data and statistics.4

Because o its small size and its isolated

location, Icelands central bank kept inter-

est rates high in an eort to support the

exchange value o its currency.

The Icelandic Finance Ministry is a

department within the national govern-

ment. The fnance minister is usually

an elected Member o Parliament. The

ministrys objectives are to promote a stable

economy, collect revenue on behal o thegovernment, administer the public debt

and manage national fnances. Unlike its

analogous department in the United States,

the Treasury, the Icelandic Finance Ministry

is not involved with any supervisory tasks.

The central bank, the FME and the

Finance Ministry were all central to stabiliz-

ing Icelands banks. Icelands currency lost

tremendous value over the course o two

months. From September through October,

the krona lost 20 percent versus the U.S.

dollar and 17 percent versus the euro. Thus,

Glitnirs krona-denominated assets made it

difcult or the institution to pay o its debt.

To compound the issue, the central bank

could not properly unction as the lender

o last resort because o insufcient oreign

currency reserves. On Sept. 29, the FMEhelped resolve the issue with Glitnir Bank by

acquiring a 75 percent stake in the bank, a

stake valued at roughly $782 million.5

One week later, on Oct.6, the government

passed emergency laws enabling the FME to

take over banks. Through this legislation,

Icelandic ofcials ormally nationalized

Landsbanki and Glitnir.

In the midst o the Landsbanki takeover,

U.K. and Icelandic ofcials debated the ate

o the British deposits at Icelandic banks.

As a result o Iceland not being able toguarantee oreign deposits beyond set Euro-

pean limits, the U.K. invoked anti-terror

legislation to reeze assets associated with

Icelandic banks and transer them to ING,

a Dutch bank. Due to the exodus o these

deposits, Kaupthing was orced to submit to

government takeover as well.

The FME then created three new banks

to continue regular banking operation,

while the old banks were kept in existence

Icelandic Banking and GDP Growth, 2000-2007

Y E A R 2 0 0 0 = 1

2001 2002 2003 2004 2005 2006 2007

10

9

8

7

65

4

3

2

1

INDEXED

PERCENT

AGE

GROWTH

Credit and Marketable Securities

Total Deposits

GDP

YEAR

Fu 1

Oct. 3

Congress passes stabilizationpackage, called the TroubledAssets Relief Program (TARP)

Financial crisis spreadswidely across Europe.

Oct. 1

In this video image rom PN, the fnal vote

tally is displayed ater the Senate passed the

Economic Stabilization ct by a vote o 74-25on Oct. 1. he House passed it on Oct. 3 and

President Bush signed it within hours.

Sept. 29

(P PHOO/PN)

French President Nicolas Sarkozy, center,

gestures while speaking during a media

conerence at an emergency fnancial

summit at the Elysee Palace in Paris on

Oct. 4. he global fnancial crisis is orcing

the leaders o France, Britain, Germany and

Italy to come together or an emergency

summit in Paris. Seated at let is German

Chancellor ngela Merkel, and at right isBritish Prime Minister Gordon Brown.

Sept. 26

Washington Mutual, with$307 billion in assets,becomes largest thrift failure.

In this pril 8, 2008, photo, a closure notice hangs

in the window o a Washington Mutual home loan

center in Salt Lake City. On Sept. 26, Washington

Mutual, one o the nations largest banks, was

seized by the Federal Deposit Insurance Corp. andthen sold to JPMorgan Chase & Co.

(P PHOO/DOUGLS C. PIZC, FILE)

(P PHOO/VIRGINI MYO)

Iceland takescontrol of Glitnir,the countrysthird largest bank.

U.K. nationalizesmortgage lenderBradford & Bingley.



17/28

as a mechanism to handle oreign deposits

and assets, as well as any complex securi-

ties. This marked the beginning o a period

o recovery or Icelands banking system.

Iceland also secured $2.07 billion in loans

rom Denmark, Norway, the Faroe Islands

and Poland. In addition, Iceland and the

International Monetary Fund structured a$2.1 billion economic stabilization program,

centered upon preventing urther depre-

ciation o the Icelandic krona, developing

a plan to restructure its banks as well as

putting the country back on sound fscal

ooting in the medium term.

THE U.K. SITUATIN

Like the quick rise o Icelands bank-

ing sector, the United Kingdom had also

experienced an unprecedented growth in

its fnancial sector, to the point at whichit rivaled New York and Tokyo as a major

center or fnance. By the time the U.K.

economy started showing signs o weakness,

in the summer o 2007, the fnancial services

sector contributed roughly 32 percent

toward the U.K. GDP.6

The U.K.s fnancial institutions began

to show signs o strain much earlier than

such institutions in Iceland or even in the

United States. In the all o 2007, the U.K.

experienced its frst bank run in 141 years,

with the ight o deposits rom lender

Northern Rock. Compounding the issue,

U.K. authorities resolved to take care o

another institution, Bradord & Bingley.

The nationalization o Northern Rock in

early 2008 and o Bradord & Bingleys

mortgages in the all o 2008 shook Brit-ish markets. This was compounded by

the weak market reaction to the takeover

by U.K. bank Lloyds TSB o another bank,

HBOS.

In addition, spillovers rom the turmoil

in the U.S. markets aected the fnancial

sector in London. Many U.S. banks, broker-

ages and investment frms, including Bear

Stearns and Lehman Brothers, had large

operations in London.

Institutional Structure

and Policy Responses

The United Kingdoms eorts to pro-

mote fnancial stability are anchored by

three important institutions: the Bank o

England, the Treasury and the Financial

Services Authority (FSA). The U.K.s insti-

tutional structure is similar to Icelands.

The Bank o England sets monetary policy

by controlling its main interbank policy

interest rate. In addition, it has a mandate

to promote fnancial stability. The Bank o

England also serves as a lender o last resort

to the nations fnancial institutions. The

U.K. Treasury coordinates fscal and eco-

nomic policy on behal o the government as

a whole. It carries out its fscal policy objec-

tives by collecting tax revenue and manag-

ing government debt. Through its goal ocoordinating economic policy, the Treasury

helps support broad economic growth.

Unlike in the United States, the U.K.s Trea-

sury is not involved in bank supervision.

Despite their di ering unctions within

the fnancial sector, the U.K. Treasury and

the Bank o England worked closely together

in orging a policy response. On Oct. 8, the

British government and the Bank o Eng-

land unveiled a three-part plan estimated to

cost 500 billion to help stabilize the fnan-

cial system.7

The frst part o the plan calledor a 50 billion recapitalization o Tier 1

capital in the countrys fnancial institu-

tions. An aggregated 25 billion would frst

be injected into the eight largest institu-

tions, and an additional 25 billion would

be used to recapitalize all other institutions.

The government would buy preerred stock

or preerred interest bearing shares (PIBS)

in these entities. As a part o this package,

the Treasury would assist in equity oerings

U.S., U.K. and other countriescut interest rates.

Oct. 8

Icelandic bank Kaupthingis nationalized.

Oct. 8Oct. 7 Oct. 10

U.K. government announces 500billion bank rescue package.

Demonstrators gather outside the Bank o England in

London on Oct. 10 to protest against the governments

bank rescue plan. Earlier in the week, the government

announced it would provide debt guarantees o 250

billion, short- term loans o 200 billion and a reasuryinjection o 50 billion.

journalist in London reporting on the fnancial crisis holds up

a newspaper with the headline oo little, too late and too much

afng, say the traders. (Fafng is slang in the U.K. or

wasting time.) On Oct. 8, six major central banks cut interes t

rates in a coordinated move to try to ease the eects o the

global economic crisis. he banks were those o the U.K., U.S.,

European Union, Canada, Switzerland and Sweden.

(P PHOO/LEFERIS PIRKIS)

(P PHOO/SNG N)

protester speaks to the crowd outside

the Central Bank o Iceland in Reykjavik

Oct. 10 during a demonstration demand

the resignation o the chairman, David

Oddsson. Iceland suspended trading on

its stock exchange or two days and took

control o the countrys largest bank

the third to be placed under its protectiv

custody as Iceland struggles to bring itseconomy back rom the brink.

elandic bankandsbankiationalized.

(P PHOO/RNI ORFSON)



18/28

by these institutions. Institutions, on their

part, have to submit to the government

proposals on executive compensation and

dividend payouts, as well as saeguards to

ensure that the government investments

would go toward lending.

The second part o this plan committed

250 billion to guarantee short- to medium-

term debt issuance by fnancial institutions.

For those institutions that do raise a su-

fcient amount o Tier 1 capital, the govern-

ment would use this guarantee program to

help refnance any prior debt or fnancing

obligations that may be maturing. The aim

o this part o the plan is to make unding

costs cheaper to banks.

The third part o this plan involved the

Bank o Englands increase in unds avail-

able through its Special Liquidity Scheme

(SLS) to 200 billion. Designed by the Bank

o England, the SLS enables British fnancialinstitutions to swap illiquid assets in return

or Treasury bills, which are generally more-

liquid assets. Through the amended SLS

program, the Bank o England would swap

British pounds or three months and U.S.

dollars or one week against the collateral

that fnancial institutions put orward.

An additional element in the U.K.s regu-

latory structure is the Financial Supervisory

Authority (FSA). Set up in the late 1990s,

the FSA is an independent agency in charge

o regulating all fnancial services frms.Like Icelands FME, the FSA has a mandate

to supervise all fnancial services frms and

fnancial markets as a whole. The Financial

Services Compensation Scheme (FSCS) is

an independent body set up by the British

government in 2000 to cover deposits o an

insolvent fnancial institution. Similar to

the FDIC in the U.S., it guarantees consum-

ers up to 100 percent o the frst 50,000,

as well as guarantees or some investments

and insurance.

Despite handling claims rom lost depositsin Icelandic banks, the FSCS did not create

broad guarantees or unding instruments as

did its American counterpart, the FDIC. Nor

did legislators expand the scope o deposit

guarantees, as was the case in the U.S.

Conclusion

In terms o size, scope and regulatory

structure, the three countries described in

this article are very dierent. Yet one

common actor is the decentralized nature

o fnancial regulation. A number o

separate institutions exist to carry out

specifc unctions. Yet in the ace o crisis,

these organizations were able to work

together to orm cohesive national

responses. The fnancial crisis in each

country, though disproportionate in size

relatively speaking, was national in scope

or all three. This required, and got, all

signifcant government entities to work

together to produce a swit and strong

response. As policymakers around the

world consider fnancial market reorms,

these experiences should be kept in mind.

Rajeev Bhaskar and Yadav Gopalan are researchassociates at the Federal Reserve Bank ofSt. Louis.

E N D N O T E S

1

See Iceland Review Magazine.

2

See Forelle.3

The FME oversees operations o banks,

investment banks, securities companies, secu

rities brokerages, insurance companies, insur

ance brokers, the stock exchange (and more

broadly, capital markets), central securities

depositories, as well as depository activities

o any cooperative institution. See Financial

Supervisory AuthorityIceland at www.me

is/?PageID=157.

4

See Central Bank o Iceland.5

See Federal Reserve Bank o St. Louis time-

line or complete perspective on the chain

o events.

6

OECD (Organization or Economic Coopera-

tion and Development) country data. See

http://stats.oecd.org/WBOS/index.aspx.

7

U.K. Treasurys rescue plan can be ound at

www.hm-treasury.gov.uk/press_100_08.htm

See, too, www.hm-treasury.gov.uk/fn_

support_lending.htm.

R E F E R E N C E S

Bank o England inormation and that on the

U.K.s fnancial regulatory agency can be

ound at ww w.bankoengland.co.uk/index.

htm and www.sa.gov.uk/Pages/About/Aims/

index.shtml.

Bernanke, Ben. The Crisis and the Policy

Response. Presented at the Stamp Lecture,

London School o Economics, London, Eng-

land, Jan. 13, 2009. See www.ederalreserve.

gov/newsevents/speech/bernanke20090113a.

htm.

Central Bank o Iceland. Objectives and Roles.

See www.sedlabanki.is/?PageID=188.

Central Bank o Iceland inormation and that on

Icelands Financial Regulatory Agency can be

ound at www.sedlabanki.is /?PageID=188, at

www.me.is/?PageID=157 and at www.me.

is/?PageID=867.

Federal Deposit Insura nce Corp.s inormation

on Temporary Liquidity Guarantee Pro-

gram can be ound at www.dic.gov/regula-

tions/resources/tlgp/index.html.

Federal Reserve Bank o St. L ouis The Finan-

cial Crisis: A Timeline o Events and Policy

Actions. See www.stlouised.org/timeline.

Forelle, Charles. The Isle That Rattled the

World. The Wall Street Journal, Dec. 27,

2008, Page 1. See http://online.wsj.com/

article/SB123032660060735767.html?mod

=testMod#CX.

Iceland Review Magazine. Vol. 46, No. 1. March

2008. Interview with Prime Minister Geir

Haarde. See www.icelandreview.com/

icelandreview/search/news/Deault.

asp?ew_0_a_id=303247.

Treasury Departments Emergency Economic

Stabilization Act can be ound at www.treas.

gov/initiatives/eesa/.

World Bank. Gross Domestic Product 2007.

See http://siteresources.worldbank.org/

DATASTATISTICS/Resources/GDP.pd.



19/28

Elizabethtown by he umbers

POPUATION

City of Elizabethtown ................... ............... 23,777

Hardin County ................... ..................... ..... 97,949

ABOR FORCE

County .................. .................... ................... 46,639

UNEMPOMENT RATE

County ..................................................7.3 percent

PER CAPITA INCOME

County .................. .................... ................. $31,875

TP FIVE EMPLYERS

Hardin Memorial Hospital .................. ................. 1,600

Akebono Brake Systems. ................... .................... 825

Wal-Mart Stores Inc. .................... .................... ....... 600

Dana Corp. .................... ..................... .................... 500

AGC Automotive Americas ............... .................... 350

Self-reported, February 2009

SOURCE: Elizabethtown/Hardin County Industrial

Foundation, February 2009

**

**

*

*

* U.S. Bureau of the Census, estimate 2007

** HAVER/BS, December 2008

*** BEA/HAVER, 2006

***

By Susan C. Thomson

Helps Pre my f lizabehw, Ky.

Through the og o the current recession,Fort Knox looms golden to Elizabeth-town, Ky.

The Army base, next to the U.S. bullion

depository o the same name, came through

the base realignment and closure exercise

in 2005 with an enhanced mission. Over

the next three years, it will bulk up into a

bastion o 20,000 jobs, 5,500 o them new.

The biggest share o the additions will comewith the Armys human resources com-

mand, to be consolidated at the ort rom

sites around the country. By one estimate,

allowing or slots taken by current soldiers

or Army employees, 1,500 to 1,800 o those

new jobs will remain or civilians either in

the Fort Knox area or recruited to it. These

will be permanent jobs o the corporate-

headquarters sortmanagerial and techni-

cal included, all white-collar.

Although 15 miles outside o Elizabeth-

town and only partly in Hardin County, Fort

Knox has long been the economic elephant in

the area. More county residents2,166 civi l

ians, by the Armys countwork at the post

than or any other employer.

In addition, hundreds o local trades

people have ound temporary work on the

orts many expansion-related construction

projects, says B. Keith Johnson, presidento Elizabethtowns First Federal Savings

Bank. O these projects, the centerpiece is

an ofce building o about 900,000 square

eetequal to the playing area o 15 ootbal

felds. In all, the Armys investment in the

bases expansion is projected to approach

$1 billion.

Larry Hayes, Kentuckys acting economic

development secretary, describes the bases

buildup as one o the most signifcant

c o M M n t Y P o F L

A bilding boom at nearby Fort Knox is music to the ears o those who live in Elizabethtown and elsewhere in HardinCounty. he ort employs more county residents than any other employer. Workers toil on the new human resources

command center, a 900,000-square-oot building set or completion in June 2010.



20/28

economic development projects in the state

since the late 1980s, when Toyota opened

its assembly plant in Georgetown, 85 miles

rom Elizabethtown.

Auto Plants Are Still Key

Toyota gave Elizabethtown its biggest

shot o business adrenalin pre-Fort Knox.

Over the ollowing decade, parts makers

Akebono Brake Corp. (auto brake systems),

AGC Automotive Americas (automotivesaety glass) and Dana Corp. (truck rames)

built new plants in town. Tokyo-based

Akebono took the extra step o moving its

North American headquarters to Elizabeth-

town rom Michigan in 2007.

Incentives helped attract the three plants.

Elizabethtown Mayor David Willmoth says

the city agreed to return to the plants, or

fve years, three-quarters o the 0.8 percent

in taxes it collected on their employees

earnings. In some cases, the city also issued

industrial revenue bonds.We are always willing to work with

clients to make their project work in our

area, especially in todays slack economy,

says Rick Games, president o the Elizabeth/

Hardin County Industrial Foundation.

The oundation markets Elizabethtown

as something o an incentive in itsel, given

its location, where two our-lane Kentucky

parkways meet up with Interstate 65, which

itsel connects the Gul Coast and suburban

Chicago. From Elizabethtown, the new

par

Regional Economist - April 2009

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