The Global Financial Crisis The Global Financial Crisis and the Slow Recoveryand the Slow Recovery

An OverviewAn Overview by by

Assaf RazinAssaf Razin Tel-Aviv University and Cornell Tel-Aviv University and Cornell

UniversityUniversity

January 1, 2010January 1, 2010

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Current Global Crisis: 3 Acts

Act I: Credit-fed Asset Bubble Act II: Financial Collapse after the

Burst of the bubble Act III: spill overs to the real

economy

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Under currents

Financial innovation, globalization, and reduced transparency in the financial sector

Panicky in free fall of asset prices Under capitalized banking system

and credit crunch

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Historical Precedents?

The great depression? Japan in the 1990s? Sweden in the 1980s? The saving and loan crisis in the US

in the 1980?

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Percentage decline in Percentage decline in employment in recessions since employment in recessions since

1970 1970

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HistoryHistory

Carmen Reinhart of Maryland and Ken Carmen Reinhart of Maryland and Ken Rogoff of Harvard, have recently Rogoff of Harvard, have recently published an analysis of the current published an analysis of the current financial crisis in the context of what they financial crisis in the context of what they identify as the previous 18 banking crises identify as the previous 18 banking crises in industrial countries since the second in industrial countries since the second world war. They find what they call world war. They find what they call "stunning qualitative and quantitative "stunning qualitative and quantitative parallels across a number of standard parallels across a number of standard financial crisis indicators" - the common financial crisis indicators" - the common themes that translate these individual themes that translate these individual dramas into the big-picture story of dramas into the big-picture story of financial boom and bust. Their study is financial boom and bust. Their study is focused on the US,focused on the US,

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Banking Crises BANKING CRISES ARE PROTRACTED,

THEY NOTE, WITH OUTPUT DECLINING, ON AVERAGE, FOR TWO YEARS. ASSET MARKET COLLAPSES ARE DEEP, WITH REAL HOUSE PRICES FALLING, AGAIN ON AVERAGE, BY 35 PER CENT OVER SIX YEARS AND EQUITY PRICES DECLINING BY 55 PER CENT OVER 3½ YEARS. THE RATE OF UNEMPLOYMENT RISES, ON AVERAGE, BY 7 PERCENTAGE POINTS OVER FOUR YEARS, WHILE OUTPUT FALLS BY 9 PER CENT.

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Banking crises: follow ups

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US Bank Failures

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in deep slumps monetary expansion just piles up in

bank reserves

Monetary Policy and Asset Prices

•During the past quarter century, monetary authorities in developed countries have remarkably successful in reducing and stabilizing inflation.

•This phenomenon is coined” the great moderation ”

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Irrational exuberance

•A common view was that asset prices are driven by exogenous shocks to investor beliefs or preferences that have little to do

with underlying macro fundamentals .•Greenspan, famously used the phrase

irrational exuberance

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Asset prices reflect expectations about economic growth

•An alternative view is that asset markets

•Reflect evolving beliefs about the long term prospects for the economy, particularly trends about growth, rather than Irrational exuberance, which describe an exogenous shock to investor beliefs

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Fluctuations in asset markets

•The same period, however, has seen major fluctuations in asset markets .

•The equity bull markets during the 1980s and the 1990s ,

• the boom and bust in technology stocks during the late 1990s and early 2000s,

•And the dramatic rise in hose prices that busted into the “great recession“

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Early Warning

•In 2006 there were warning predictions: from a few studies:

•Ceccheti, in an empirical study, finds strong linkages between housing markets and the macroeconomy. Housing booms predict strong economic growth in the near term, weak economic growth in the longer term, and relatively high inflation.

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Financial accelerator and inflation targeting

•Gilchrist and Saito , use in the model the financial accelerator model : high asset prices increase the collateral of entrepreneurs and lower the external cost of funds for investment.

•They find, using standard loss function, that a policy of aggressive inflation targeting is less than ideal because, while stabilizing inflation, it allows the financial accelerator to destabilize

output .16

Two historical precedentsTwo historical precedents

The Great Depression in the 1930sThe Great Depression in the 1930s The Japanese Deflation(Mid -90s)The Japanese Deflation(Mid -90s) The shocks that played a role in each: The shocks that played a role in each:

(1)An asset price correction, in real (1)An asset price correction, in real estate and equities (reducing estate and equities (reducing consumption through a “wealth effect”)consumption through a “wealth effect”)

(2)Impairmaint of financial institutions’ (2)Impairmaint of financial institutions’ balance sheets (reducing credit)balance sheets (reducing credit)

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US GDP: The CyclesUS GDP: The Cycles

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Great Depression

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Japan’s Stock-Market Roller Japan’s Stock-Market Roller CoasterCoaster

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Tracking the Great Depression Tracking the Great Depression by months into the Crisisby months into the Crisis

Eichengreen and O’Rourke point out that the original Great Depression was most severe in America, while this one is more severe in a number of other countries.

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Chronology of Crisis Summer of 2007 Distress in financial

markets from the subprime problem

May 2008 Bear Stearns crushed and forced to be sold to JP Morgan

Sept 15 2008—Lehman Brothers went belly up.

Sept 16, 2008: A.I.G. is effectively nationalized

Sept 18, 2008—Bank of America bought Merril

Lynch. December 2008

—the Federal Reserve cuts interest rates virtually to zero

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Understanding what’s going on is Like shooting at a moving target

Housing bubble. Subprime

mortgage crisis Financial

sector’s toxic assets

Liquidity crisis

Zero interest rate.

Unconventional central banking

Liquidity trap?

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The Current Crisis vs. the Great Depression

(1) Both crises followed asset bubbles. (2) Both crises started in the financial sector and

gradually spread to the real sector. During both crises many financial institutions either defaulted or had to be bailed out.

(3)In both cases the crisis appears to have started with the bursting of a bubble.

(4) In both cases banking credit dried up. (5) In both cases the lower zero bound on the

policy rate became effective.

(6) In both cases the crisis started in the US and then US and subsequently spread to other countries.

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Key Differences 1. Responses of both fiscal and monetary policies

today are much swifter and vigorous than they were during the first three years of the great depression

The deficit declined in fiscal 1935 by roughly the same amount it had risen in 1934.

The US was on a gold standard throughout the Depression. In April 1933, Rosevelt temporaryily suspended the convertibility to gold and let Dollar depreciate substantially. When US went back on gold at the new higher price of gold, large quantities of gold flowed in and caused expansion of money supply. The expansion of money broke expectations of deflation. .

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Budget Balance and Monetary Base

2. Hoover’s Federal budget was largely balanced; budget deficit in the current crisis is 8-10 percent of GDP.

Friedman and Schwartz (1963) claim that, during the first three years of the great depression, the Fed tolerated and even reinforced a substantial shrinkage of the money

The monetary base was flat during 1929-33; it was doubled during 2008.

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Differences

3. Unemployment: in 1930: 25 %; in May 2009 9.4% Change in output: 1929-(peak) to 1933

(trough) -25%; 2007 (peak) last qtr 2008 (before

trough) – 2% Change in prices: 1929-1934:

deflation; 2008-9: low inflation/deflation? See next slide

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The graph, from the Cleveland Fed, shows inflation as gauged by the consumer price index and by a measure called the median CPI. As every grade school student learns when the teacher reports results of the latest test, the average of any data set can be thrown off by a few extreme outliers; the median is a more robust statistic to estimate the central tendency in the data.

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Monetary institutions

4. There are two important differences in monetary institutions:

First there was no banking deposit insurance at the time. As a matter of fact deposit insurance was introduced only after Roosevelt became president in March 1933. .

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Gold Standard

the 5. US was in the great depression on the gold standard. The maintenance of a fixed parity with gold collided with the use of monetary policy to offset domestic unemployment during the first three years of the great depression. For this reason the US abandoned the gold standard under Roosevelt. Obviously, since the $ is floating vis-à-vis other major currencies, no such constraint operates in the current crisis.

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Contractionary Policies under the Gold Standard

Central banks discount rates in the US, UK and Germany, in the late 1920s and early 1930s were pushed up to prevent gold leakages. The good news is that we donot have the Gold Standard now. But East European countries in crisis are now jacking up interest. Especially those who are trying to enter the Euro zone.

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Informational capital

5. Fourth, the fact that a relatively large number of banks disappeared during the great depression led to the destruction of banking “informational capital” about the credit worthiness of potential borrowers.

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Tariff War

6. The great depression was characterized by beggar thy neighbor policies. In mid 1930 the US Congress passed the Smoot-Hawley Tariff Act that raised tariffs on over 20,000 imported goods to record levels. Other countries retaliated by also imposing restrictions on imports and engaged in competitive devaluations. This led to a serious contraction of international trade.

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The recession tracks the Great Depression

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Irving Fisher’s debt deflation

As the great American economist Irving Fisher pointed out in the 1930s, the things people and companies do when they realize they have too much debt tend to be self defeating: when every one tries to do them, AT THE SAME TIME, the attempts to sell assets and pay off debt deepen the plunge in asset prices. This further reduces a net worth and the process repeats itself.

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Keynes’ Metaphor for a BubbleKeynes’ Metaphor for a Bubble

Consider beauty competitions famously Consider beauty competitions famously described by John Maynard Keynes, in which described by John Maynard Keynes, in which the winner was the contestant who chose the the winner was the contestant who chose the six faces most popular with all contestants. six faces most popular with all contestants. The result, Keynes observed, was that the The result, Keynes observed, was that the task was not to choose the most beautiful task was not to choose the most beautiful face, but the face that average opinion face, but the face that average opinion would think that average opinion would find would think that average opinion would find the most beautiful. In this way beliefs feed the most beautiful. In this way beliefs feed on themselves and become divorced from on themselves and become divorced from any underlying reality.any underlying reality.

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The Basics of Banks

•Banks are in the business of borrowing short and lending long

•They create credit that allows the real economy grow

•When one or more banks experience a solvency problem due to non performing

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Liquidity crisis

•Loans, bank run is possible. If a liquidity crisis erupts that can bring down other banks by a collective movement of distrust

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THE LENDER OF LAST THE LENDER OF LAST RESORTRESORT

The role of lender of last resort was classically The role of lender of last resort was classically defined by Walter Bagehot. His great book defined by Walter Bagehot. His great book Lombard Street was published in 1873, and set Lombard Street was published in 1873, and set out what has become the guiding mantra for out what has become the guiding mantra for central banks in times of crisis ever since: lend central banks in times of crisis ever since: lend freely at high rates against good collateral. Lend freely at high rates against good collateral. Lend freely, in his words, "to stay the panic". At high freely, in his words, "to stay the panic". At high rates, so that "no one may borrow out of idle rates, so that "no one may borrow out of idle precaution without paying well for it". And lend on precaution without paying well for it". And lend on all good banking securities to an unlimited extent all good banking securities to an unlimited extent - because the "way to cause alarm is to refuse - because the "way to cause alarm is to refuse someone who has good security to offer".someone who has good security to offer".

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Moral Hazard

•Large systematically important banks are able to obtain cash at near zero interest rate and engage in risky arbitrage activities. They know that the “invisible wallet” of the taxpayer stands behind them, to bail the banks out in case of a crisis.

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Investment BanksInvestment Banks By forcing the fourth largest investment By forcing the fourth largest investment

bank, bank, Lehman BrothersLehman Brothers, into , into bankruptcybankruptcy and and Merrill Lynch Merrill Lynch into a distressed sale to into a distressed sale to Bank of AmericaBank of America, they helped to facilitate , they helped to facilitate a badly needed consolidation in the financial a badly needed consolidation in the financial services sector. However, at the 2008 services sector. However, at the 2008 juncture, the credit crisis radiated out into juncture, the credit crisis radiated out into corporate, consumer and municipal debt. corporate, consumer and municipal debt. Regardless of the Fed and Treasury’s most Regardless of the Fed and Treasury’s most determined efforts, the political pressures determined efforts, the political pressures for a much larger bail-out, and pressures for a much larger bail-out, and pressures from the continued volatility in financial from the continued volatility in financial markets, are going to be irresistible. markets, are going to be irresistible.

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Bail OutsBail Outs the financial crisis has probably already the financial crisis has probably already

added at most $200bn-$300bn to net added at most $200bn-$300bn to net debt, taking into account the likely losses debt, taking into account the likely losses on nationalising the mortgage giants on nationalising the mortgage giants Freddie MacFreddie Mac and and Fannie MaeFannie Mae, the , the costs of the $29bn March bail-out of costs of the $29bn March bail-out of investment bank investment bank Bear StearnsBear Stearns, the , the potential fallout from the various junk potential fallout from the various junk collateral the Federal Reserve has taken collateral the Federal Reserve has taken on to its balance sheet in the last few on to its balance sheet in the last few months, and finally, Wednesday’s $85bn months, and finally, Wednesday’s $85bn bail-outbail-out of the insurance giant of the insurance giant AIGAIG. .

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In repo agreements borrowers transfer securities to lenders with an agreement to repurchase them later, often the next day. They enable banks and shadow banks to fund long-term, high-yield investments with short-term low-cost loans – which they did enthusiastically during the credit bubble: by 2008 the top US investment banks funded half their balance sheets in a repo market

exceeding $10,000bn .

Repo market and liquidity

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Banks take people’s money, promise to give it back on demand – and lock it up in less liquid investments. This works marvellously while few enough lenders want their money back. It collapses when all want to hoard their cash at the same time. That is what happened to Lehman Brothers: the equivalent of a bank run in the repo market.

What is a Bank?

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The panic was made worse, the Fed thinks, by the custodians’ exposure to losses as Lehman’s lenders left it to its fate. Custodians also faced conflicts of interest as counterparties to the repo-funded banks in other markets.

Lehman as a Custodian

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Limited Liability

The core of the crisis lies in the legal provisions of limited liability: creditors have no claims against the personal assets of the owners (shareholders). These liability constraints lead to a systematic disregard of systemic disaster risks-ocurrences only with a small probability about gigantic losses.

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Risk taking bahaviorRisk taking bahavior

Investors that opt for high-risk projects Investors that opt for high-risk projects with high potential gains and losses with high potential gains and losses instead of safe projects with similar instead of safe projects with similar average profits, can expect to gain, average profits, can expect to gain, since they only have to bear a portion since they only have to bear a portion of the possible losses. If things go well, of the possible losses. If things go well, investors reap the full profit. If things investors reap the full profit. If things go badly, at worst their losses are go badly, at worst their losses are limited by the stock of equity they limited by the stock of equity they invest. invest.

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Moral HazardMoral Hazard

A HOUSE INSURED FOR MORE A HOUSE INSURED FOR MORE THAN ITS VALUE IS ALWAYS THAN ITS VALUE IS ALWAYS CONSIDERED A FIRE RISK. BUT CONSIDERED A FIRE RISK. BUT HOME INSURANCE IS REGULATED HOME INSURANCE IS REGULATED AND ARSON IS A CRIMINAL AND ARSON IS A CRIMINAL OFFENCE THAT KEEPS PEOPLE OFFENCE THAT KEEPS PEOPLE HONEST, MOST OF THE TIMEHONEST, MOST OF THE TIME

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Bank recapitalization

A severe fall in the market value of a financial institution's assets raises the risk and lowers the market value of its debt, as well as its equity. Bringing in new equity capital produces an equal (dollar for dollar) increase in the market value of assets. This lowers the risk and raises the market value of the institution's debt. As a result, part of the new equity capital shows up not as equity but as a transfer to debt holders. (This is the debt overhang problem.)

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Who pays for the transfer?

Not the new private stockholders. They will not invest unless they get stock with market value at least equal to the funds they provide. This means the transfer of wealth to the old debt holders must come from the old stockholders. They pay via the dilution of their ownership share (and the drop in the share price) caused by bringing in new equity.

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Value of old stock

If the market value of the old stock before the equity issue is low, it may be insufficient to cover the transfer of wealth to debt holders that new equity capital produces. As a result, the market value of a stock issue would be less than the funds provided, and the financial institution's attempt to issue equity to meet its capital requirement will fail.

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Subsidy

If the Treasury steps in when the private market refuses to provide equity capital to a financial institution, we are in subsidy land. Again, the subsidy arises because a large part of the equity injection by the government does not end up as government (taxpayer) equity but rather goes to prop up the financial institution's debt holders.

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Determinants of Global Determinants of Global ImbalancesImbalances

Among the favoured determinants are Among the favoured determinants are low US savings (stressed especially by low US savings (stressed especially by Feldstein 2008, 2009), Asia’s export-led Feldstein 2008, 2009), Asia’s export-led growth strategy, reserve build-up, and growth strategy, reserve build-up, and exchange rate policies (discussed by exchange rate policies (discussed by many, including Bibow 2008, Obstfeld many, including Bibow 2008, Obstfeld and Rogoff 2009,), and Asian “savings and Rogoff 2009,), and Asian “savings glut” (highlighted by Bernanke 2005, glut” (highlighted by Bernanke 2005, 2007, 2008, Bini Smaghi 2008, Wolf 2007, 2008, Bini Smaghi 2008, Wolf 2008, Greenspan 2010).2008, Greenspan 2010).

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US as the main Deficit countryUS as the main Deficit country

Ben Bernanke (2005) argued that the Ben Bernanke (2005) argued that the US became the main deficit nation US became the main deficit nation because of its service as global safe because of its service as global safe haven and reserve currency issuer, haven and reserve currency issuer, and because of the rapid growth in US and because of the rapid growth in US household wealth from stock market household wealth from stock market gains and housing appreciation. The gains and housing appreciation. The wealth effect kept savings low, wealth effect kept savings low, perpetuating foreign borrowing. perpetuating foreign borrowing.

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Flows of moneyFlows of money

The flow of money into housing The flow of money into housing rather equipment or, say, software rather equipment or, say, software was linked to regulatory and was linked to regulatory and supervisory gaps in mortgage supervisory gaps in mortgage underwriting and securitisation underwriting and securitisation (Johnson and Kwak 2009).(Johnson and Kwak 2009).

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The Global Picture a la Krugman

we used to talk about the “subprime crisis” .

Today we know that subprime lending was only a small fraction of the problem.

Ben Barnanke (2005), “The Global Saving Glut and the U.S. Current Account Deficit,” offered a novel explanation for the rapid rise of the U.S. trade deficit in the early 21st century. The causes, argued Bernanke, lay not in America but in Asia.

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Global Picture (Continued)

In the mid-1990s, Bernanke pointed out, the emerging economies of Asia had been major importers of capital, borrowing abroad to finance their development. But after the Asian financial crisis of 1997-98, these countries began protecting themselves by amassing huge war chests of foreign assets, in effect exporting capital to the rest of the world.

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Global Picture (Continued)

Most of the Asia cheap money went to the United States — hence our giant trade deficit, because a trade deficit is the flip side of capital inflows. But as Mr. Bernanke correctly pointed out, money surged into other nations as well. In particular, a number of smaller European economies experienced capital inflows that, while much smaller in dollar terms than the flows into the United States, were much larger compared with the size of their economies.

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Global Picture (Continued) wide-open, loosely regulated financial

systems characterized the US shaddow banking system and mortgage institutions, as well as many of the other recipients of large capital inflows. This may explain the almost eerie correlation between conservative praise two or three years ago and economic disaster today. “Reforms have made Iceland a Nordic tiger,” declared a paper from the Cato Institute. “How Ireland Became the Celtic Tiger” was the title of one Heritage Foundation article; “The Estonian Economic Miracle” was the title of another. All three nations are in deep crisis now.

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Global Picture (Continued)

For a while, the inrush of capital created the illusion of wealth in these countries, just as it did for American homeowners: asset prices were rising, currencies were strong, and everything looked fine. But bubbles always burst sooner or later, and yesterday’s miracle economies have become today’s basket cases, nations whose assets have evaporated but whose debts remain all too real. And these debts are an especially heavy burden because most of the loans were denominated in other countries’ currencies.

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Global Picture (end) Nor is the damage confined to the original

borrowers. In America, the housing bubble mainly took place along the coasts, but when the bubble burst, demand for manufactured goods, especially cars, collapsed — and that has taken a terrible toll on the industrial heartland. Similarly, Europe’s bubbles were mainly around the continent’s periphery, yet industrial production in Germany — which never had a financial bubble but is Europe’s manufacturing core — is falling rapidly, thanks to a plunge in exports.

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Imbalances and CrisisImbalances and Crisis

Imbalances relaxed America’s credit Imbalances relaxed America’s credit constraint and perpetuated low US real constraint and perpetuated low US real interest rates that, in turn, stoked interest rates that, in turn, stoked borrowing and the housing bubble borrowing and the housing bubble Bernanke 2008, Caballero et al. 2008, Bernanke 2008, Caballero et al. 2008, Dunaway 2009, Obstfeld and Rogoff Dunaway 2009, Obstfeld and Rogoff 2009, IMF 2009, Caballero and 2009, IMF 2009, Caballero and Krishnamurthy 2009, Blanchard and Krishnamurthy 2009, Blanchard and Milesi-Ferretti 2009, Roubini 2009, Kohn Milesi-Ferretti 2009, Roubini 2009, Kohn 2010).2010).

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Global imbalances in 2010Global imbalances in 2010

With trade, credit, and commodity prices With trade, credit, and commodity prices recovering, the IMF (2010) recently revised recovering, the IMF (2010) recently revised its projections of US current-account deficit its projections of US current-account deficit to 3.3% of GDP in 2010 and 3.4% in 2011. to 3.3% of GDP in 2010 and 3.4% in 2011. Also UK, Canada, Australia, India, Turkey, Also UK, Canada, Australia, India, Turkey, France, and southern European nations are France, and southern European nations are projected to run steep trade deficits. The projected to run steep trade deficits. The mirroring surplus nations are the familiar mirroring surplus nations are the familiar China, Japan, emerging East Asia, China, Japan, emerging East Asia, Germany, and oil producing nations.Germany, and oil producing nations.

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Europe vs. the US 27 EU countries lack ways of boosting their overall fiscal

and monetary firepower by acting collectively. Europe has fallen short in terms of both fiscal and monetary

policy: it’s facing at least as severe a slump as the United States, yet it’s doing far less to combat the downturn.

On the fiscal side, America’s actions dwarf anything the Europeans are doing.

Monetary policy: The European Central Bank has been far less proactive than the Federal Reserve; it has been slow to cut interest rates (it actually raised rates July 2008!), and it has shied away from any strong measures to unfreeze credit markets.

The only thing working in Europe’s favor is the very thing for which it takes the most criticism — the size and generosity of its welfare states, which are cushioning the impact of the economic slump.

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FDIC

If a bank cannot raise private equity to meet its FDIC capital requirement, the powers of the FDIC kick in. For example, the FDIC can seize the bank and auction it off. The bidders are typically other banks. Acquiring a seized bank is often an attractive option for a strong bank since it can be a cost effective way to expand deposits and acquire links to profitable borrowers.

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Price of acquiring a bank

The maximum price the acquiring bank should be willing to pay is the market value of the seized bank's assets minus the seized bank's deposits. This net amount is then distributed to the bank's non-deposit liability holders, in order of priority. What this means is that the seized bank's stockholders and some of its lower priority debt often get nothing.

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Credit Crunch 2008Credit Crunch 2008

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Interbank Lending’s SqueezeInterbank Lending’s Squeeze

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Global Saving GlutGlobal Saving Glut

Behind this Global Saving Glut lie three Behind this Global Saving Glut lie three phenomena phenomena

1.–excess of retained profits (corporate 1.–excess of retained profits (corporate saving) over investment, of the saving) over investment, of the corporate sectors of the advanced corporate sectors of the advanced countries, countries,

2. --the persistent savings surpluses of 2. --the persistent savings surpluses of a number of mature economies, a number of mature economies, particularly Japan and post-unification particularly Japan and post-unification Germany.Germany.69 69

Global imbalances

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Currency reserves

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The US moves into: debtor status, and vast increase in cross-

holdings. In 1996, on the eve of the Asian

crisis, the US had assets overseas equal to 52 percent of GDP, and liabilities equal 57 percent of GDP. By 2007, these numbers were up to 128 percent and 145 percent, respectively.

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Risk sharing and globalization

This is change is supposes to reduce risk: US investors held much of their assets abroad(less exposed to a slump in the US); foreign investors held much of their wealth in the US (they were less exposed to a slump in their domestic economies).

But, large parts of the increase in globalization came from investments in highly leveraged financial institutions (making various riskycross border bets).

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Four vicious cyclesFour vicious cycles ““Four vicious cycles are simultaneously Four vicious cycles are simultaneously

under way: falling asset prices are forcing under way: falling asset prices are forcing levered holders to sell, driving prices levered holders to sell, driving prices further down; losses at financial further down; losses at financial institutions are reducing their ability to institutions are reducing their ability to finance investment, which in turn reduces finance investment, which in turn reduces asset values, causing further losses; the asset values, causing further losses; the weakness of the financial system is weakness of the financial system is reducing growth, which in turn weakens reducing growth, which in turn weakens the financial system; and falling output is the financial system; and falling output is hitting employment, which in turn leads to hitting employment, which in turn leads to reduced demand for output”—Larry reduced demand for output”—Larry Summers.Summers.

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Debt accumulation and deflation in the US

The big US debt accumulations were not by non-financial corporations but by households and the financial sector. The gross debt of the financial sector rose from 22 percent of GDP in 1981, to 117 percent of GDP in the third quarter of 2008; the debt of non financial corporations rose from 53 percent to 76 percent, in the same period. Thus, the desire of financial institutions to shrink balance sheet may be a cause of the recession.

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Akerlof’s ProblemAkerlof’s Problem

When house prices started to decline, When house prices started to decline, this has had bigger effect on some MBS this has had bigger effect on some MBS than other MBSs, depending on the than other MBSs, depending on the complexity of the mortgages that backed complexity of the mortgages that backed the securities. Owners of MBS have the securities. Owners of MBS have strong incentive to price each an every strong incentive to price each an every one of them. They have superior one of them. They have superior information over the market buyers. As information over the market buyers. As in Akerlof’s Lemmons Problem, the in Akerlof’s Lemmons Problem, the market for MBS will collapse.market for MBS will collapse.

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Market illiquidityMarket illiquidity

The buyer hopes that the seller sells The buyer hopes that the seller sells the security because he needs cash. the security because he needs cash. But the buyer worries that the seller But the buyer worries that the seller will unloads the most troubled will unloads the most troubled securities. This makes the market securities. This makes the market illiquid. illiquid.

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Mortgage FinanceMortgage Finance The common form of mortgage commits the The common form of mortgage commits the

household to make equal monthly payments for household to make equal monthly payments for 30 years. These mortgages payy off with 10 years 30 years. These mortgages payy off with 10 years because households sell the property or does because households sell the property or does refinance.refinance.

New model: The borrower applies to a mortgage New model: The borrower applies to a mortgage broker, receives money from a wholesale lender, broker, receives money from a wholesale lender, and make payments to a servicer. The servicer and make payments to a servicer. The servicer passes on each payment to a master servicer, passes on each payment to a master servicer, who pays it out to holders of a mortgage-based-who pays it out to holders of a mortgage-based-security (MBS), who pass it on to the adminstrator security (MBS), who pass it on to the adminstrator of a collateralized debt obligation (CDO), who of a collateralized debt obligation (CDO), who passes it on to investors in CDOs. passes it on to investors in CDOs.

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Mortgage as option, not loanMortgage as option, not loan

This mortgage is therefore not a loan This mortgage is therefore not a loan but an option: it allowed for gains if but an option: it allowed for gains if house prices rose, but cost relatively house prices rose, but cost relatively little if prices fell.little if prices fell.

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Barriers to Lending

The Problem: most banks no longer hold the loans they make, content to collect interest until the debt comes due. Instead, the loans are bundled into securities and sold to investors. But the securitization market broke. The result is a drastic contraction of credit available throughout the economy.

Banks have come to depend on selling mortgages and other loans to investors like hedge funds and insurance companies. This allows banks to make more loans and earn bigger profits.

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Mortgage-backed SecuritiesMortgage-backed Securities

How to value MBSs?How to value MBSs? Imagine you bought a $100,000 house a Imagine you bought a $100,000 house a

year ago, with a $10,000 down payment.year ago, with a $10,000 down payment. If the value of the house rises, you are “in If the value of the house rises, you are “in

the money”.the money”. If it falls, you can walk away. You loose the If it falls, you can walk away. You loose the

original $10,000 investment, but are safe original $10,000 investment, but are safe in the knowledge that the lender cannot in the knowledge that the lender cannot seize your other assets.seize your other assets.. .

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US Borrowings

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US banks, undermine willingness to expand credit, Destroy Confidence

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House Price Bubble

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US GDP

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US Unemployment

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counterparty risk 

DEFINITION:The risk that the other party in an agreement will default. In an option contract, the risk to the option buyer that the writer will not buy or sell the underlying as agreed.

In general, counterparty risk can be reduced by having an financial organization with extremely good credit reputation which acts as an intermediary between the two parties.

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Investors behavior in the asset bubble -“Disaster” Myopia : Equity markets lost by 2009 all the gains

from the 1997-8 crises A tendency to underestimate the probability

of disastrous outcomes, especially for low-frequency events last experienced in the distant past.

The risk of falling victim to this syndrome was particularly acute in the recent period of unusual economic stability known as the “great moderation”. Investors were confronted by falling yields against a background of declining volatility in markets. Many concluded that a new era of low risk and high returns had dawned.

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Investors in FX markets: Carry Trade—”depreciation myopia”

EQUALLY POPULAR WERE TRADING STRATEGIES SUCH AS CARRY TRADES, WHICH INVOLVED BORROWING AT LOW INTEREST RATES AND INVESTING AT HIGHER RATES, ESPECIALLY VIA THE CURRENCY MARKETS. FAVOURITE TRADES INCLUDED BORROWING IN JAPANESE YEN TO INVEST IN AUSTRALIA OR NEW ZEALAND, AND BORROWING IN SWISS FRANCS TO INVEST IN ICELANDIC ASSETS.

89

The danger in Carry Trade

Carry trade WAS DANGEROUS BECAUSE THE INTEREST RATE SPREAD COULD BE WIPED OUT IN SHORT ORDER BY VOLATILE CURRENCY MOVEMENTS. YET BECAUSE VOLATILITY REMAINED LOW FOR SO LONG, DISASTER MYOPIA PREVAILED. CARRY TRADERS WERE LULLED INTO A FALSE SENSE OF SECURITY, WHILE MORE SCEPTICAL COMPETITORS JOINED IN FOR FEAR OF UNDERPERFORMING.

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The Credit Crunch

1. Overnight credit is blocked by the asymmetric information held across banks regarding each other’s assets’ quality.

2. Fear of the bank of being short of funds to meet creditor demands; thus the bank is reluctant to lend.

3. fear of the bank of being short of funds if investment opportunities get better.

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Moral Hazard Moral hazard, a situation in which one person makes a decision about How much risk to take while someone else bears the cost if things go badly;

Treasury proposes to make low-interest, non-recourse, loans to private investors who buy bad assets —this is a plan to drive up the prices of toxic assets by creating a lot of moral hazard.

By offering low interest non-recourse loans, these public-private entities can pay a higher than market price for the toxic assets (since there is no downside risk). This amounts to a direct subsidy from the taxpayers to the banks.

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Four distinct economic mechanisms that played a role in

the liquidity and credit crunch 1. . The effects of large quantities bad loan

write-downs on borrowers' balance sheets caused two "liquidity spirals“:

1a. As asset prices dropped, financial institutions not only had less capital;

1b. financial institutions also had harder time borrowing, because of tightened lending standards.

The two spirals forced financial institutions to shed assets and reduce their leverage. This led to fire sales, lower prices, and even tighter funding, amplifying the crisis beyond the mortgage market.

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Mechanisms (continued) 2. Lending channels dried up when banks,

concerned about their future access to capital markets, hoarded funds from borrowers regardless of credit-worthiness.

3. Runs on financial institutions, as occurred at Bear Stearns, Lehman Brothers, and others following the mortgage crisis, can and did suddenly erode bank capital.

4. The mortgage crisis was amplified and became systemic through network effects, which can arise when financial institutions are lenders and borrowers at the same time. Because each party has to hold additional funds out of concern about counterparties' credit, liquidity gridlock can result.

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The Geithner Public-private scheme to buy toxic assets from

banks One or more giant investment fund will

be created to buy up toxic assets. Its balance sheet: for every $1 of toxic

assets they buy from banks, the FDIC will lend 85.7 percent (6/7 th of $1), and the US treasury and private investors will each put 7.15 cents in equity to cover the remaining balance.

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The Geithner Public-private scheme to buy toxic assets from

banks (continue) The FDIC loan is non-recourse,

meaning that if the toxic assets purchased by private investors fall in value below the amount of the FDIC loans, the investment fund will default, and the FDIC will end up holding the toxic assets.

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Tax payer giveaway in the Geithner Plan

An Example (Jeff Sachs): Consider a portfolio of toxic assets with a face

value of $1 trillion. Assume that they have a 20 percent chance of paying out their full face value ($1 trillion) and an 80 percent chanceof paying out only $200 billion.

The market value of these assets is given by their expected payout (.2x1+0.8x.2)=$360 billion.

Because the FDIC is lending money at a low (bidding up the market value of toxic assets) interest rate on a non-recourse basis is likely to experience a massive default on the loan.

The FDIC subsidy subsidy shows up as a bid price for the toxic assets as it above $360 billion.

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Over pricing the toxic assets through the government non-

recourse loan Investor is prepared to bid $714, 000 for the the asset that

a risk-neutral would pay $360,000 only. How is this number derived? The investor uses $71,000 of her own money and $643,000

of the government loan– adding up to $714, 000 bid. If the asset pays in full, the investor repays the loan with a

profit of $357,000 (=$1,000000- $643,000) so that with 20 percent of the time, which bring an expected profit of $71,000.

The other 80 percent of the time the investor defaults on the loan, getting a profit of 0, and the government ends up with $200,000.

Summing up: the investor just breaks even by bidding $714, 000, as would beexpected in competitive auction.

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Price Discovery or Overpricing?

The idea of “price discovery” of the toxic asset would be genuine if the government loan has to be repaid whether or not the asset paid of in full or not. But, with the non-recourse loan it leads to overpricing of the toxic asset.

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Gaming the System: Jeff Sachs Example

Consider a toxic asset held by Citibank with a face value of $1 million, but with zero probability of any payout and therefore with a zero market value. An outside bidder would not pay anything for such an asset.

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More..

Suppose, however, that Citibank itself sets up a Citibank Public-Private Investment Fund (CPPIF) under the Geithner-Summers plan. The CPPIF will bid the full face value of $1 million for the worthless asset, because it can borrow $850K from the FDIC, and get $75K from the Treasury, to make the purchase! Citibank will only have to put in $75K of the total.

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potential rip-off Citibank thereby receives $1 million for the

worthless asset, while the CPPIF ends up with an utterly worthless asset against $850K in debt to the FDIC. The CPPIF therefore quietly declares bankruptcy, while Citibank walks away with a cool $1 million. Citibank's net profit on the transaction is $925K (remember that the bank invested $75K in the CPPIF) and the taxpayers lose $925K. Since the total of toxic assets in the banking system exceeds $1 trillion, and perhaps reaches $2-3 trillion, the amount of potential rip-off in the Geithner-Summers plan is unconscionably large.

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the insider-bidding route The earlier criticisms of the Geithner-Summers plan

showed that even outside bidders generally have the incentive to bid far too much for the toxic assets, since they too get a free ride from the government loans. But once we acknowledge the insider-bidding route, the potential to game the plan at the cost of the taxpayers becomes extraordinary. And the gaming of the system doesn't have to be as crude as Citibank setting up its own CPPIF. There are lots of ways that it can do this indirectly, for example, buying assets of other banks which in turn buy Citi's assets. Or other stakeholders in Citi, such as groups of bondholders and shareholders, could do the same.

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Ersatz Capitalism?

Ersatz is a German word meaning compensation or idemnity (or still, substitute). Ersatz capitalism is when the government in effect insure loses, so that loses are socialized but gains are privatized. The Geithner plan would not determine the fair price of toxic assets in the ailing banks. It sets a mechanism to price discovery on a “ put” on the toxic asset but not on the “value” of the asset. Its success in helping capitalize the banks is negatively related to loses to tax payers.

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Sources for charts: Robert Shiller, Sources for charts: Robert Shiller, Andrew Smithers; Thomson Andrew Smithers; Thomson

DatastreamDatastream

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Just under half of corporate debt in America was rated as “speculative”

(BB or below) at the end of 2008

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Global Trends

107

Financial crises over the history

108

Global CrisisGlobal Crisis

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US CREDIT MARKET

110

Volume of asset backed securities

111

House price index

112

Stimulus packages

113

No two fiscal packages are ever launched amid the same

circumstances

It is wrong to extrapolate

from the past!

Measuring the separate effect of anyOne-off fiscal boost from the automaticExtra spending that was anticipatedIs hard.114

115

Fed RateFed Rate

116

Emerging stars buffeted by Emerging stars buffeted by global stormglobal storm

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Triggers of credit bubbles and depression EconomicsEconomics

1 .Moral hazard, a situation in which one person makesa decision about How much risk to take while someone else bears the cost if things go badly;

2 .Self fulfilling panics, as in bank runs.

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Credit Market : September 2008Credit Market : September 2008 financial institutions hold significant assets that financial institutions hold significant assets that

are backed by mortgage payments. Two years are backed by mortgage payments. Two years ago, many of those mortgage-backed securities ago, many of those mortgage-backed securities (MBS) were rated AAA, very likely to yield a (MBS) were rated AAA, very likely to yield a steady stream of payments with minimal risk of steady stream of payments with minimal risk of default. This made the assets liquid. If a financial default. This made the assets liquid. If a financial institution needed cash, it could quickly sell these institution needed cash, it could quickly sell these securities at a fair market price, the present value securities at a fair market price, the present value of the stream of payments. A buyer did not have of the stream of payments. A buyer did not have to worry about the exact composition of the to worry about the exact composition of the assets it purchased, because the stream of assets it purchased, because the stream of payments was safe. payments was safe.

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Libor-OIS spreads reached 200 Libor-OIS spreads reached 200 basis points in September 2008 basis points in September 2008

when Congress failed to pass the when Congress failed to pass the Paulson planPaulson plan

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Bank bailoutsBank bailouts

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Japan’s 1990sJapan’s 1990s

Japan’s experience in the 1990s is Japan’s experience in the 1990s is cautionary example of the peril of cautionary example of the peril of propping up banks after a real estate propping up banks after a real estate boom ends. The Japanese government boom ends. The Japanese government helped keep many troubled banks helped keep many troubled banks afloat, hoping to avoid the pain of afloat, hoping to avoid the pain of bank failures, only to extend the bank failures, only to extend the economic downturn as consumer economic downturn as consumer spending and job growth fell. spending and job growth fell.

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Japan’s BanksJapan’s Banks

THE 1990 COLLAPSE OF AN ASSET THE 1990 COLLAPSE OF AN ASSET BUBBLE PROVOKED A SHARP BUBBLE PROVOKED A SHARP FALL IN THE VALUE OF PROPERTY FALL IN THE VALUE OF PROPERTY AND EQUITY THAT UNDERPINNED AND EQUITY THAT UNDERPINNED BANKS’ BALANCE SHEETS. BUT BANKS’ BALANCE SHEETS. BUT BANKS IGNORED THEIR BANKS IGNORED THEIR PROBLEMS UNTIL 1997 WHEN PROBLEMS UNTIL 1997 WHEN SANYO SECURITIES, YAMAICHI SANYO SECURITIES, YAMAICHI SECURITIES AND HOKKAIDO SECURITIES AND HOKKAIDO TAKUSHOKU BANK ALL FAILED.TAKUSHOKU BANK ALL FAILED.

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Japan’s Current Account

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Reluctance to recapitalize by state Reluctance to recapitalize by state fundsfunds

A RELUCTANCE TO ADMIT THE SCALE OF THE A RELUCTANCE TO ADMIT THE SCALE OF THE PROBLEM MEANT CAPITAL INJECTIONS TOOK PROBLEM MEANT CAPITAL INJECTIONS TOOK PLACE IN THREE MAIN TRANCHES. THE PLACE IN THREE MAIN TRANCHES. THE FIRST CAME IN THE SPRING OF 1998, WHEN FIRST CAME IN THE SPRING OF 1998, WHEN THE GOVERNMENT INJECTED Y1,800BN THE GOVERNMENT INJECTED Y1,800BN ($18BN, £11BN, €14BN) INTO 21 ($18BN, £11BN, €14BN) INTO 21 INSTITUTIONS. THE MONEY, WHICH CAME IN INSTITUTIONS. THE MONEY, WHICH CAME IN THE FORM OF PREFERENCE SHARES, HAD THE FORM OF PREFERENCE SHARES, HAD FEW STRINGS ATTACHED. THE SECOND FEW STRINGS ATTACHED. THE SECOND FOLLOWED THE COLLAPSE IN 1998 OF FOLLOWED THE COLLAPSE IN 1998 OF NIPPON CREDIT BANK AND LONG TERM NIPPON CREDIT BANK AND LONG TERM CREDIT BANK. A TIGHTENING OF RULES CREDIT BANK. A TIGHTENING OF RULES FORCED 32 INSTITUTIONS TO RAISE CAPITAL FORCED 32 INSTITUTIONS TO RAISE CAPITAL AND IN 1999 TO ACCEPT GOVERNMENT AND IN 1999 TO ACCEPT GOVERNMENT FUNDS TOTALLING Y8,600BN.FUNDS TOTALLING Y8,600BN.

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Conditions set by governmentConditions set by government

Conditions grew stricter. “The first time, Conditions grew stricter. “The first time, the government injections were very the government injections were very generous, depending on the banks’ own generous, depending on the banks’ own will. The second time was more will. The second time was more forcible,” says the former BoJ official. forcible,” says the former BoJ official. “The first priority was that in a certain “The first priority was that in a certain period they had to return from red to period they had to return from red to black, second was to lend to SMEs [small black, second was to lend to SMEs [small and medium-sized enterprises] and third and medium-sized enterprises] and third was a host of conditions, such as cutting was a host of conditions, such as cutting their payroll,” their payroll,”

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Non performing loansNon performing loans

By March 2005, non-performing loans By March 2005, non-performing loans were at 2.9 per cent of banks’ total were at 2.9 per cent of banks’ total assets from 8.4 per cent at the assets from 8.4 per cent at the height of the crisis. height of the crisis.

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Sweden in the 1990sSweden in the 1990s

Sweden in the early 1990s took a middle Sweden in the early 1990s took a middle pathpathswiftly taking over many of its swiftly taking over many of its troubled banks. The American bailout plan, troubled banks. The American bailout plan, economists say, takes a page from the economists say, takes a page from the Swedish example by making the Swedish example by making the government a shareholder in banks government a shareholder in banks participating in the program. But, they participating in the program. But, they add, the American banking system is so add, the American banking system is so much larger and diverse than Sweden’s much larger and diverse than Sweden’s that the parallels are limited.that the parallels are limited.

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Capital injection and tax payersCapital injection and tax payers

In exchange for the capital injection In exchange for the capital injection by the government, taxpayers might by the government, taxpayers might be protected through preferred be protected through preferred shares (or warrants), giving them shares (or warrants), giving them dividends in the future.dividends in the future.

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Differences between bailout and Differences between bailout and government spendinggovernment spending

First, note that there is a major First, note that there is a major difference between a difference between a program to program to support the financial sector support the financial sector and $700bn and $700bn in new outlays. No one is contemplating in new outlays. No one is contemplating that the $700bthat the $700b in the Paulson plan will in the Paulson plan will be be given away. All of its proposed uses given away. All of its proposed uses involve either purchasing assets, involve either purchasing assets, buying equity in financial institutions or buying equity in financial institutions or making loans that earn interest. making loans that earn interest.

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22ndnd difference difference Second, the usual concern about Second, the usual concern about

GOVERNMENT BUDGET DEFICITS IS THAT GOVERNMENT BUDGET DEFICITS IS THAT THE NEED FOR GOVERNMENT BONDS TO BE THE NEED FOR GOVERNMENT BONDS TO BE HELD BY INVESTORS WILL CROWD OUT HELD BY INVESTORS WILL CROWD OUT OTHER, MORE PRODUCTIVE, INVESTMENTS OTHER, MORE PRODUCTIVE, INVESTMENTS OR FORCE GREATER DEPENDENCE ON OR FORCE GREATER DEPENDENCE ON FOREIGN SUPPLIERS OF CAPITAL. TO THE FOREIGN SUPPLIERS OF CAPITAL. TO THE EXTENT THAT THE GOVERNMENT EXTENT THAT THE GOVERNMENT PURCHASES ASSETS SUCH AS MORTGAGE-PURCHASES ASSETS SUCH AS MORTGAGE-BACKED SECURITIES WITH INCREASED BACKED SECURITIES WITH INCREASED ISSUANCE OF GOVERNMENT DEBT, THERE IS ISSUANCE OF GOVERNMENT DEBT, THERE IS NO SUCH EFFECT.NO SUCH EFFECT.

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What’s Next?

Green Shoots? Persistent and high unemployment? Non functioning financial sector? Debt overhang? Inflation? Prolong risk and volatility?

132

133

long-term interest rates: 2009 long-term interest rates: 2009 treasuriestreasuries

Peak of panic is June 2009Peak of panic is June 2009

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The yield curve as a predictor of future growth

This graph shows the difference between the 10-year and 2-year yield on Treasuries. In general, a steep yield curve--that is, a high value of this variable--is a positive indicator of future economic growth. In many ways, however, this is an unusual downturn, so it is not entirely clear to what extent historical relationships are a useful guide going forward

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Treasuries (May 2009) sell-off

The sell-off may reflect fears of future inflation

The downgrade of treasuries in the presence of huge US government debt

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Paul De Grauwe on Paul De Grauwe on McroeconomicsMcroeconomics

Take government budget deficits, which Take government budget deficits, which now exceed 10 per cent of gross domestic now exceed 10 per cent of gross domestic product in countries such as the US and product in countries such as the US and the UK. One camp of macroeconomists the UK. One camp of macroeconomists claims that, if not quickly reversed, such claims that, if not quickly reversed, such deficits will lead to rising interest rates deficits will lead to rising interest rates and a crowding out of private investment. and a crowding out of private investment. Instead of stimulating the economy, the Instead of stimulating the economy, the deficits will lead to a new recession deficits will lead to a new recession coupled with a surge in inflation. coupled with a surge in inflation.

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Budget DeficitsBudget Deficits

Wrong, says the other camp. There is Wrong, says the other camp. There is no danger of inflation. These large no danger of inflation. These large deficits are necessary to avoid deficits are necessary to avoid deflation. A clampdown on deficits deflation. A clampdown on deficits would intensify the deflationary would intensify the deflationary forces in the economy and would forces in the economy and would lead to a new and more intense lead to a new and more intense recession.recession.

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Monetary Policy IMonetary Policy I

take monetary policy. One camp take monetary policy. One camp warns that the build-up of massive warns that the build-up of massive amounts of liquidity is the surest amounts of liquidity is the surest road to hyperinflation and advises road to hyperinflation and advises central banks to prepare an “exit central banks to prepare an “exit strategy”. strategy”.

139

Monetary Policy IIMonetary Policy II

Nonsense, the other camp retorts. Nonsense, the other camp retorts. The build-up of liquidity just reflects The build-up of liquidity just reflects the fact that banks are hoarding funds the fact that banks are hoarding funds to improve their balance sheets. They to improve their balance sheets. They sit on this pile of cash but do not use sit on this pile of cash but do not use it to increase credit. Once the it to increase credit. Once the economy picks up, central banks can economy picks up, central banks can withdraw the liquidity as fast as they withdraw the liquidity as fast as they injected it. The risk of inflation is zeroinjected it. The risk of inflation is zero

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Does it Matter?Does it Matter?

Take the issue of government deficits. If Take the issue of government deficits. If you want to forecast the long-term you want to forecast the long-term interest rate, it matters a great deal interest rate, it matters a great deal which of the two camps you believe. If which of the two camps you believe. If you believe the first one, you will fear you believe the first one, you will fear future inflation and you will sell long-future inflation and you will sell long-term government bonds. As a result, term government bonds. As a result, bond prices will drop and rates will rise. bond prices will drop and rates will rise. You will have made a reality of the fears You will have made a reality of the fears of the first camp. of the first camp.

141

But…But…

But if you believe the story told by But if you believe the story told by the second camp, you will happily the second camp, you will happily buy long-term government bonds, buy long-term government bonds, allowing the government to spend allowing the government to spend without a surge in rates, thereby without a surge in rates, thereby contributing to a recovery that the contributing to a recovery that the second camp predicts will follow from second camp predicts will follow from high budget deficits.high budget deficits.

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Evidence?Evidence?

One day, when green shoots are One day, when green shoots are popping up here and there, they popping up here and there, they believe the story warning about believe the story warning about inflation; the next day, when the shoots inflation; the next day, when the shoots turn brownish, they believe the other turn brownish, they believe the other story. Disagreements among story. Disagreements among economists take away the intellectual economists take away the intellectual anchors around which market anchors around which market participants interpret events and participants interpret events and forecast the future. forecast the future.

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Forecasts are ambigousForecasts are ambigous

Ultimately, all our forecasts use a Ultimately, all our forecasts use a particular economic model to particular economic model to interpret data and to forecast their interpret data and to forecast their future course. The existence of wildly future course. The existence of wildly different models takes away this different models takes away this intellectual anchor and this intellectual anchor and this translates into more market translates into more market volatility.volatility.

144

Policy making under uncertaintyPolicy making under uncertainty The two camps of economists have wildly The two camps of economists have wildly

different estimates of the effect of a 1 per different estimates of the effect of a 1 per cent permanent increase in government cent permanent increase in government spending on real US GDP over the next four spending on real US GDP over the next four years. According to the first camp, the years. According to the first camp, the Ricardians, the multiplier is closer to zero Ricardians, the multiplier is closer to zero than to one, ie 1 per cent extra spending than to one, ie 1 per cent extra spending generates much less than 1 per cent of extra generates much less than 1 per cent of extra GDP, producing little extra tax revenue. Thus GDP, producing little extra tax revenue. Thus budget deficits surge and become budget deficits surge and become unsustainable.unsustainable.

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What to do?What to do?

By contrast, the second camp, the By contrast, the second camp, the Keynesians, predict that the same 1 per Keynesians, predict that the same 1 per cent of extra government spending cent of extra government spending multiplies into significantly more than 1 multiplies into significantly more than 1 per cent of extra GDP each year until the per cent of extra GDP each year until the end of 2012. This is the stuff of dreams end of 2012. This is the stuff of dreams for governments, because such for governments, because such multiplier effects are likely to generate multiplier effects are likely to generate additional tax income so that budget additional tax income so that budget deficits decline.deficits decline.

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US Consumer Spending: US Consumer Spending: Summer 2009Summer 2009

In previous post-world war II recessions, In previous post-world war II recessions, inventory rebuilding contributed a third of inventory rebuilding contributed a third of economic growth 12 months after the economic growth 12 months after the recessions ended.recessions ended.

Household debt was on average 60 percent Household debt was on average 60 percent of GDP in previous post-world war II of GDP in previous post-world war II recessions, in 2009 it is 128 percent of GDP.recessions, in 2009 it is 128 percent of GDP.

Consumption growth at the end of previous Consumption growth at the end of previous post-world war II recessions was significantly post-world war II recessions was significantly larger than in the 2007-2009 recession.larger than in the 2007-2009 recession.

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“Credit easing” vs. “Quantitative "easing

•“Credit easing” reflects a focus is on the assets’ side of the banks’ balance sheet

•“Quantitative easing”, reflects a focus on the liabilities’

side of the banks’ balance sheet

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Money Growth vs Credit Growth: The Fed

The FED stopped tracking the broadest measure of money supply in 2006; no figures for the US in 2009. Outstanding consumer credit has been contracting from May to June, 2009 by 5 percent on an annual basis .

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ECB

•ECB, in contrast to the US Fed, does indeed pay attention to the growth of

Money•In fact, ECB broad money growth began to

accelerate in 2009

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US Productivity

•Productivity soared by a higher-than-expected 6.4 per cent in the non-farm business sector in the second quarter, its highest level since 2003, as hours worked fell faster than output

151

Asia: early exit from the Recession

152

Eurozone

•Germany and France, partly helped by its neighbour’s stimulus, exited recession in the second quarter of 2009. Both countries’ 0.3 per cent quarter-on-quarter growth yanked up the eurozone as a whole to a mere 0.1 per cent contraction.

153

Japan

154

Spain can’t devalue to restore lost competitiveness

•UK Can!

155

China has the world’s fastest-growing economy and largest

current account surplus

156

Greece

•Greece accounts for less than

• 3 per cent of the eurozone economy. There is also a precedent.

• Hungary, Latvia and Romania

• have all won •EU and International Monetary Fund

backing, albeit with tough conditions attached .

157

Fed Balance Sheet

•Exit from

• unconventional •monetary policy.

158

Israel Growth

159

China in a Dilemma

•Having set in motion a credit and investment-fuelled recovery to manufacture strong growth in the 60th anniversary year of the People’s Republic, China is beginning to face the consequences.

160

Renminbi exchange rate

161

Policy switch•China lifted its currency peg in July 2005. It

allowed the renminbi to appreciate by 21 percent over three years to mid-2008 when the peg was reinstated: the “emergency setting” of the renminbi/dollar peg, reimposed in July 2008. May 2010’s export surge of almost 50 per cent from a year earlier, the biggest in six years, restored China’s monthly trade surplus comfortably above its five-year average. The basket of 2005 to 2008 returned in June 21 2010, along with the same daily trading band .

162

US Base MoneyUS Base Money

163

Fed now pays interest on reserves.  As long as the

interest rate on reserves is high enough, banks should

be happy to hold onto those excess reserves  .

Both reserves and T-bills are Both reserves and T-bills are interest-paying obligations of interest-paying obligations of

the Federal government the Federal government (including the Federal (including the Federal

Reserve).  perfect substitutes.  Reserve).  perfect substitutes. 

164

The standard way of reducing the monetary base is open market operations.  The Fed sells Treasury bills, say, and drains reserves from the banking system, reducing the monetary base.  But consider what this means in the monetary current regime.  An open market operation merely removes interest-paying reserves from a bank's balance sheet and replaces them with interest-paying T-bills.  What difference does it make?  None at all.

Global ImbalancesGlobal Imbalances

165

China’s accumulation of foreign reserves, many of which were invested in American bonds, was arguably doing US a favor by keeping interest rates low — although what US did with those low interest rates was mainly to inflate a housing bubble. But right now the world is awash in cheap money, looking for someplace to go. Short-term interest rates are close to zero; long-term interest rates are higher, but only because investors expect the zero-rate policy to end some day. China’s bond purchases make little or no difference.

If China were to start selling If China were to start selling dollars?dollars?

166

Right now the world is awash in cheap money. So if China were to start selling dollars, there’s no reason to think it would significantly raise U.S. interest rates. It would probably weaken the dollar against other currencies — but that would be good, not bad, for U.S. competitiveness and employment. So if the Chinese do dump dollars, US should send them a thank-you note.

China’s MercantilismChina’s Mercantilism

167

China’s trade surplus drains much-needed demand away from a depressed world economy.

Under normal circumstances, the inflow of dollars from trade surpluses would push up the value of China’s currency, unless it was offset by private investors heading the other way. And private investors are trying to get into China, not out of it. But China’s government restricts capital inflows, even as it buys up dollars and parks them abroad, adding to a $2 trillion-plus hoard of foreign exchange reserves.

China Mercantilism and US jobsChina Mercantilism and US jobs

168

Paul Samuelson: “With employment less than full ... all the debunked mercantilistic arguments” — that is, claims that nations who subsidize their exports effectively steal jobs from other countries — “turn out to be valid.” He then went on argue that persistently misaligned exchange rates create “genuine problems for free-trade apologetics.” The best answer to these problems is getting exchange rates back to where they ought to be. But that’s exactly what China is refusing to let happen.

A narrowing of China’s current-A narrowing of China’s current-account surplus, from 11% of account surplus, from 11% of

GDP at its peak in 2007 to 6.1% GDP at its peak in 2007 to 6.1% in 2009.in 2009.

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America’s huge trade deficit with China sets it apart from many other G20 members. Japan has a surplus of $45.5 billion with China and South Korea $59.1 billion. Even Brazil can boast more than $14 billion. In the past 12 months China has run a trade deficit with the G20 excluding America (even counting the entire European

Union as a member) .

170