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Why Are We in Are Cession
Transcript of Why Are We in Are Cession
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The Financial Crisis is the Symptom, not the Disease!
Ravi JagannathanKellogg School of ManagementNorthwestern University
Based on:Joint work with Mudit Kapoor and Ernst Schaumburg
2009 Ravi Jagannathan
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The Great Recession
US Corporate Equities. .
2008: $15.2 Trillion (1.1 GDP)
1999: $42.1 Trillion (4.4 GDP)
Peak Unemployment
. 2008: 7.2%
June 2009: 9.5%
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Folk Wisdom
What caused the Global Recession? A. Financial Crisis
What caused the Financial Crisis? B. Easy Credit & Lax Regulation
C. Savings Glut, Too much money chasing too few opportunities
What caused the Savings Glut? . oo muc sav ng n s a, an oo e n e
Why Too Much Saving in Asia? E. Asians like to save
So what can we do to get out of the recession? F. Asians should save less; Americans should save more
Is that all that is needed will it work?
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A Deeper Driving Force?
What is wron with this lo ic?
It is misleading to think that the causality is from Too much savings in Asia, E D C B Financial
Crisis A Global Recession
All these phenomena are closely interlinked and
causality flows both ways ere are eeper un er y ng r v ng orces
Changes in Geo-Political-Organization of Countries
Major Technological Innovations
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Global Perspective:
Major Shocks to World Economy
Geo-Political-Or anization
The opening of China The opening of India
Technolo ical Innovations Communication & Transportation in the 90s
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Impact on Developed Worlds Economy
Chinese factories can compete directly with USfactories
Workers from India can directly compete with workersin the US
Workers in Developing World can participate in the
Developed Worlds labor market without moving uge ncrease n e or s a or supp y n a very
short time period
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Impact on Developed Worlds Economy
Financial and Legal Institutions to cope with thischange is the reason for the recession
exports Inability to absorb savings through increased domestic investment and
consumption
Currency controls motivated by national objectives
Inability of US economy to adjust to perverse incentives caused byhuge money inflows
Institutional incentives, checks and balances in place turned out to beinadequate
Set the stage for the recession
The financial crisis was the first symptom
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Rest of the Talk
Global trade and the savings glut
Where did the savings go? US Household Behavior
Financial engineering and the housing bubble
What makes a housing bubble different The way forward
Final thoughts
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Global Trade in Goods and Capital Flows
Global Trade and Savings Glut
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Global Trade Benefits
Cheaper goods and services in the developed world Low inflation in developed world throughout 1982 2007
1982 2008: Emer in economies in Asia rowin at+7% pa
Global Trade and Savings Glut
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Global Trade Savings Glut
1997 Asian financial crisis
BRIC + NIAC (+ Middle East Oil exporters) Obsessed with building dollar reserves (through exports)
Dollar being the reserve currency
Huge Current Account Surplus (Savings)
Global Trade and Savings Glut
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Global Trade Savings Glut
Combined Current Account Balance of+ + on :
1996: + $ 42000: + $ 1492004: + $ 3182007: + $ 798
US Current Account Balance1996 - $ 1252000: - $ 4172004: - $ 640
2007: - 739 Huge US Current Account Deficit
US should have de reciated say, relative to Yuan
Global Trade and Savings Glut
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Yuan per US$ did not Rise!
Global Trade and Savings Glut
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Capital Flows
Hu e Ca ital Flows into the US durin the 21st centur
To balance the huge current account deficit Especially from China
Global Trade and Savings Glut
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Where did the money go?
Chinese holdings of US assets
$72 billion in Treasuries
$20 billion in Agencies ower ng n eres ra es on reasur es n par ue o ec n ng
deficits)
Subsequent Flow (2007 holdings)
$466 billion in Treasuries $376 billion in Agencies and some in corporate debt and
equities
(Treasuries + Agencies): 0.25GDP_China
Where did the money go?
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Change in China Holdings of US Assets
*
* Corporate = non-agency non-government debt
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Subsequent Flow into US
To accommodate the mone inflow investment banks
set up their own pools of private label non-conformingmortgages providing investors the desired higher yields
US Policy to promote increased home ownershipp aye a ma or ro e
That funneled the mone flow into US housin market Home mortgages (indebtedness) went up as Current Account
Deficit became large
Where did the money go?
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Current Account Deficit & Household Debt/HH
Current Account Balance and US Household Debt
Where did the money go?
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US Households
Wh did US households consume more leadin to the
huge increase in Current Account Deficit?
y ey ncrease e r orrow ng y so muc
I am oin to ar ue that US households behavedrationally!!
US Household
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Household Consumption & Wages
Private Consum tion to GDP Ratio 2000: 68.7%
2007: 70.3%
Wages, salaries, benefits, social security, andproprietors income to GDP Ratio .
2007: 64.2%
remained flat? Households felt wealthier!
US Household
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Stock and Housing Markets
Stock Market S&P500 Index remained flat 2000 Q
1: 1,499
2007 Q1: 1,421
Housing prices increased by 86%
S&P/Case Shiller Home Price Index 1 . 2007 Q1: 186.07
US Household
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Stocks: S&P 500 Index Values
US Household
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Housing: S&P/Case Shiller Index Q1 to Q1
200.00
140.00
160.00
180.00
100.00
120.00
40.00
60.00
.
0.00
20.00
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
US Household
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Home Values/Equity per Household
Household Real Estate Value (per household) 1980: $36,437
2000: $108,633
2007: $172,197
1980 to 2000: +$72,916
2000 to 2007: +$63,558
Household Home Equity (per household)
1980: $24,967 2000: $62,590
2007: $81,315
1980 to 2000: +$37,623 (52% of Household Real Estate Increase)
o : + , o ouse o ea s a e ncrease
So, they took out some of that wealth out to consume,
US Household
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Mortgage/Home Value (Leverage)
US Household
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After 2000: Sharp Rise in Household Debt
Financial Engineering
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A Model of Household Consumption Choice
(Journal of Monetary Economics, 2007)
ear to year c ange n ouse o consumpt on
= 683
+ 0.71(change in wages and salaries + proprietors income)+ 0.084(change in household home equity)
- 0.000($ change in other household assets) (almost no effect)
+ error
US households consume 71% of their salaries & in addition consume 8.4%of any increase in real estate wealth.
US Household
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Predicted vs Actual Change in Household Consumption
US Household
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Household Consumption: Recap
income during this 21st
century
ey so ecause t ey e t wea t er as ome pr ceswent up
That helped them borrow using home mortgage loans
o o ow: Why did home prices go up?
What is the relation to the current account deficit?
US Household
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CA Deficit and Capital Flows
$22 spent on imports
Underlying forces that trigger the $100 increase in,
$8 current account deficit
$8 flows back into the US as capital account flows (forconvenience sa from China
US Household
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CA Deficit Capital Flows Home Prices
In early years (late nineties and early this century,)
Made Treasury yields drop and less attractive Made Mortgage related debts more attractive
Subsequent capital account flows went to mortgagebacked debt
,easier availability of loans
Led to increased demand and higher housing
Feeds back through wealth effect leading to increasedconsumption, imports, and CA deficits
US Household
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Home Prices CA Deficit Feedback Effect
US Household
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Testing for Feedback Effect
When CA Deficit Increases
Pool of outstanding home mortgages shouldincrease (due to reduction in mortgage rates)
$ Change in pool of home mortgages
= +281. e c
- 0.26(Change in level of US Treasury Debt)
+ error
US Household
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Testing for Feedback Effect
Home values increase when Pool of outstandin home mort a es increase
Mortgage interest rate decreases
CA Deficit increases Other channels, viz. ease with which mortgage loans can be taken
$ Change in Household Real Estate Value
= -1,063- 181(Mortgage interest rate)
+ 1.21(Change in size of outstanding mortgage pool)
+ 2.91(CA Deficit)
+ error
US Household
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Back to Labor Supply Shock
What does labor supply shock have to do with all this?
Labor Supply Shock
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Back to Labor Supply Shock
attained that growth through exports Japan, Taiwan, S. Korea, Hong Kong, Singapore
More recently, Chinas, and to a lesser extent, India
However, population of China (and India) is huge
, , , Japan + Taiwan + S. Korea + Hong Kong +
Singapore: 212 million
Labor Supply Shock
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Back to Labor Supply Shock
most impressive, and export driven (Offshoring) Chinas share of World GDP : 0.5 for labor
employed using Ps technology by local firms)
Total output in R and P remains same at 1.41
20% unemployment in R and full employment in P Those in P working for R strictly better off
The 0.2 unem lo ed in P were em lo ed and received 0.18 those withcapital in R received 0.02 more.
Those unemployed (0.2 or 20%) lost 0.2
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A Stylized Model of Offshoring ..
This model does not seem to capture what happenedto the develo ed countries of the West when Ja anTaiwan, Korea developed through exports
Western economies also gained
What is wrong with the model?
We assumed that the 0.2 of labor in R replaced by 0.2 of laborin P will remain idle. But they can be redeployed in otherproductive activities That will increase output in R. A Win-Win situation.
be better off in real terms
Labor Supply Shock
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A Stylized Model of Offshoring
Redeployment of labor in R takes time
Can become an issue if the ma nitude of laborredeployment involved are large within a very shorttime
(offshoring) driven growth drive
,1) big increase in labor supply in the offshoring sector,
leading to surplus for P
(2) P has no financial market to save it in
,securities.
Labor Supply Shock
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Globalization and the US Recession
Wh did the recession not occur earlier? Financial Engineering plus easy money policy response channeled
the savings in developing countries into housing in the US That led to the Housing price bubble
Myopic US households felt wealthy and kept up their consumption
Hid the problems for a while
s n e s y ze mo e we exam ne
The labor employed by R in P saved 0.08 of their 0.18 wages andthose savings were invested in R to create a wealth effect to keepconsumption in R up
Some support for this view to follow
Labor Supply Shock
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China and India Exports (offshoring?)
China & India: Key Economic IndicatorsChina 1982 1992 2001 2002GDP US billions 221.5 454.6 1 167.1 1 232.7Gross domestic investment/GDP (%) 33.2 36.2 38.5 41.0Exports of goods & services/GDP (%) 8.9 19.5 25.5 29.5Gross domestic savings/GDP (%) 34.8 37.7 40.9 44.0
IndiaGDP (US$ billions) 194.8 244.2 478.5 510.2Gross domestic investment/GDP (%) 21.7 23.8 22.3 22.8Exports of goods & services/GDP (%) 6.1 9.0 13.5 15.2Gross domestic savin s/GDP % 18.3 21.8 23.5 24.2
Labor Supply Shock
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Some evidence for this view
Urban population in China increased by nearly 300 millionfrom 1990 to 2007
A large part of that migration of labor, presumably, was
facilitated by offshoring?
Labor Supply Shock
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Some evidence: Pressure on US Wages
Wages & Salaries 2000: 56.7% of GDP
2007: 53.7% of GDP
Change, 2000 to 2007: -3.0% of GDP
, ,increased Because of housing bubble and perceived increase in wealth
facilitated borrowing against that wealth
Next: More on Financial Engineering (FE)
Labor Supply Shock
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FE facilitated money flow to housing
Origination of non-prime mortgages rose from$500 bn in 2000 to $1500 bn in 2005
Mortgages Prior to 1990,
Conforming ( 80%LTV,..)
First lien mortgages
, Non conforming mortgages
Private label securitization
Asset Backed Securities market boom
50% market share by 2006
Financial Engineering
S f S ($/ )
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Share of Private Label ABS Increased ($/HH)
Financial Engineering
O i i ti f N P i M t T i l d ($B )
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Origination of Non Prime Mortgages Tripled ($Bn)
Financial Engineering
FE l d t th H i B bbl
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FE led to the Housing Bubble
Housing prices increased by 86%
S&P/Case Shiller Home Price Index
.2007 Q1: 186.07
Like all bubbles, housin bubble alsocollapsed
Wealth effect that kept up consumptionvanished
Recession followed
Financial Engineering
H i B bbl i Diff t f St k B bbl
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Housing Bubble is Different from Stock Bubble
Stock Bubble colla se Jul 2000/ Se 2001 NASDAQ: Over 60% drop
S&P500: Over 30% drop
Little wealth effect; Stock holdings of households not leveraged
Easy monetary policy temporarily helped:
Fed funds: 5.31% in 2001/3 to 2.09% in 2001/11 Housing Bubble collapse
A 25% drop in home values can wipe out entire home equity
Huge wealth effect => severe drop in consumer spending
Housing market transactions drop Job mobility severely affected
Inability to relocate affects speed of recovery
Housing Bubble
Home Ownership More Wide Spread & Levered
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Home Ownership More Wide Spread & Levered
Middle three wealth class quintiles, 2004 Principal residence: 66% of all assets
Corporate equities: 8% of all assets
Stock holdings 49% of families
Median value: $24,300
Primary residence 68% of families Median value: $131,000
Leverage Mort a e debt: 47% of real estate value
Other debt: 7% of other assets value Averages understate the severity of leverage
51% of loans ori inated in 2006 had CLTV > 80%
Source: E.N. Wolff, WP, New York University, 2007
Source: E.N. Wolff (2007) and A. Arora (2007)
Money Channeled into Housing: Bigger Price Effect
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Money Channeled into Housing: Bigger Price Effect
Consider a h othetical econom with 10 householdswith $100 in housing per household $100 in stocks per household
Sudden helicopter drop of $10 per household, that theyhave to bid up prices of stocks or housing
Total value of stocks before: $1,000
Total increase in money: $100
=,
Whether everyone invests their $10 or they lend their $10 to otherswho use it to bid up stock prices does not matter
Housing Bubble
Money Channeled into Housing: Bigger Price Effect
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Money Channeled into Housing: Bigger Price Effect
Housin Suppose 9 households give their money to a bank
Bank lends the $90 to one household That household uses that $90 plus own $10 to bid up the price of one
house
% price rise = $100/$100 = 100%
Other households will also think that the value of their homes have
in the US.)
Leverage more in housing, not as much in stocks
Even when individual households can take levered positions in stocks Financial Intermediaries that channel money to
, ,accentuates the leverage effects
Housing Bubble
Money Channeled into Housing: Bigger Price Effect
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Money Channeled into Housing: Bigger Price Effect
Financial sector that intermediates mone flow intohousing is also very highly levered
Housing Bubble
Why did the bubble collapse?
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Why did the bubble collapse?
households triggered defaults Feed back effect
Tightening of credit
Larger Financial Crisis
Collapse of housing price bubble
Bubble Collapse
PPI and CPI Changes
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PPI and CPI Changes
Bubble Collapse
PPI and CPI Changes
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PPI and CPI Changes
Pressure on dis osable income of some householdstriggered defaults PPI increased sharply from 2004 relative to CPI Even though PPI rose, did not get passed on to consumers
More reliance on outsourcing
Energy prices rise sharply
Pressure on manufacturing wages and disposable income Some households default on loans
Bank losses, Flight to safety and Tightening of credit
Real Activities Impaired
Great Recession
Bubble Collapse
Tightening of Credit TED Spread
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Tightening of Credit TED Spread
Jul 2006: 32 b
August 2007: 175 bp
October 2008: 457 bp
July 2009: 38 bp
Bubble Collapse
Tightening of Credit: Repo Haircuts
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Tightening of Credit: Repo Haircuts
Bubble Collapse
From Arvind Krishnamurthy, Debt Markets in the Crisis, 2009, Forthcoming JEPS
Tightening of Credit
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Tightening of Credit
Bubble Collapse
How much is the Lost Wealth Effect on Spending?
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p g
Residential RE/GDP in 2007: 1.45
Consumption is 8.4% of change in RE wealth
If RE value drops (permanent) by 25% mpac on consump on ~ . . . = .
We should expect a permanent drop of about 3% GPD
in consumption from 2007 level We should be able to move on and grow from there
Bubble Collapse
The US is not alone
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These arguments should hold for all countries That experience a significant CA deficit
CA surplus countries should behave differently
International Evidence
Countries: CA Balance as % of GDP
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International Evidence
Countries: Home price inflation relative to CPI
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International Evidence
Handling a large labor supply shock & Wealth Destruction:A Lesson From History
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End of World War II Defense production stopped overnight
60 million workers with 16 million returning soldiers
25% rise in workforce in a very short time A major part of physical capital of the world destroyed
US Department of Labor Forecast 12 to 15 million unemployed with severe recession
Those predictions did not materialize
Policy and Institutional Response Channeled labor and savings to productive activities
Led to Prosperity instead of Doom
Similar response now, Globally
Going Forward
Handling a large labor supply shock & Wealth Destruction:A Lesson From History
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We have to realize that a large part of the wealth we imaginedwere there are not really there, and move forward
Fiscal policy response is needed now as after WWII
eve opmen o ns u ons o c anne sav ngs w n na,India, into productive activities
ncourage sav ngs n e . . , an no su s ze ous ng
Going Forward