1. Lecture 10 – The global financial crisis 10.1 Introduction 10.2 Pre-crisis financial system 10.3 Upswing of the financial cycle 10.4 The crisis 10.5 Policy intervention in the crisis 10.6 Conclusion

2. 10.1 Introduction The Great Recession of 2008-09 was the most severe contraction the global economy has experienced since the Great Depression (1929) In the 1990’s and early 2000’s there were conditions of tranquility (low inflation and low levels of unemployment) of the the Great Moderation Under these conditions, levels of debt of households and banks increased dramatically, (see Fig 7.1 – rising debt in the US economy In the US, household debt rose by 8 percentage points between 1988 and 1998 and by 29 percentage points between 1998 and 2008, over the same periods financial sector debt rose by 30 percentage points and 48 percentage points) In Spain, households debt rose form 44% of GDP (1999) to 69% of GDP (2008) and in the UK from 88% (1999) to 105% (2008) In the main, this rise in debt did not set off alarm bells amongst macro economists at universities or at CB’s (See movie The Inside Job)

3. Debt leads to Asset price booms The rise in household and bank debt fueled booms in asset prices US house prices rose by 90% between 2000Q1 and 2006Q1 Two views amongst macro-economists: Predominant view – CB’s should not lean against asset price bubbles by raising interest rates, but instead should “focus on policies to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion” (Alan Greenspan 2002) Minority view – There have frequently been periods in history where low stable inflation has coincided with the build up of private sector debt that sowed the seeds for future banking crises (Borio and White 2004) – steps should be taken to regulate and prevent the housing bubble and related risky conduct by the financial sector

4. Figure 7.1

5. 10.2 Pre-crisis financial system Banks have an incentive to take on higher risks than is socially optimal They can ‘bank on the state’ in that they take advantage of the fact that banking sector gains are privatised (i.e. accrue to bank shareholders, managers and employees), but losses (at least partly) are socialised (i.e. the banking systems is insured / bailed- out by the state) A clear problems arises: Banks will choose too low a capital cushion i.e. they will choose leverage that is too high Note there are echoes of this problem as Barclays seeks to sell off ABSA in SA in 2016 – dangers of short- run private equity capital buying ABSA

6. In the period before the global financial crisis Incentives encouraged banks to adopt strategies that added to aggregate risk in the economy Regulators allowed banks to use their own models to assess risk There was lack of concern that the financial system was becoming a risk to the economy as a whole – investors believed that regulators and professional investors were managing risk The great moderation had the effect of persuading households and banks that aggregate risk in the economy had fallen

7. Financial Instruments There were three financial instruments at the center of the 2008-09 financial crisis: – The mortgage-backed security (MBS) – The collateralised debt obligation (CDO) – The credit default swap (CDS) Fig 7.2 shows how the innovation of these instruments evolved during the 2000’s

8. Figure 7.2

9. Mortgage-backed securities (MBS) An MBS is a financial product secured by a collection of mortgages and referred to as a securitised financial assets ( a bundle of mortgages) The coupon on payment on MBS’s is generated by homeowners paying their mortgage’s / bonds The risk on MBS’s is the credit risk on home owners not being able to pay their mortgage’s / bonds MBS’s mitigate risk through two channels: – Diversification e.g. from different regions around US – Division into tranches – lower junior tranches have higher risk and higher return, senior tranches – low risk, lower return

10. Collaterilised debt obligations (CBO’s) CDO’s are like MBS, but they were originally focused on corporate loans not housing loans Where the correlation of the underlying bundle of loans is low (e.g. loans made into different industrial sectors) then defaults are isolated events and only the junior tranche is at risk When the correlation is high, defaults are subject to clustering which can endanger the safer tranches of the CDO

11. Credit ratings agencies (CRA) The risk of financial products is assessed by the CRA’s using computer models and data on past correlations and asset performance The safest securities are rated triple A (AAA), which means the CRA assumes there is almost 0 probability of default The CRA’s rate many senior tranche CDO’s as AAA (when correlations of underlying debts are perceived to by very low)

12. CDO’s based on MBS’s When CDO’s came to be based on MBS they became dangerous (early 2000s) Evaluating correlation of underlying MBS’s was difficult as there was little historical data available on these financial products (only about 20 years back to 1980’s) The CRA’s decided the correlations were low and gave the senior tranches of the CDO’s based on MBS AAA ratings The AAA credit rating + the good returns on these CDO’s made them very popular with institutional investors globally But, paradoxically it was the geographical diversification of individual MBS’s that led to CDO’s based on MBS’s becoming homogenized and therefore highly correlated When house prices fell across the US it was not just some MBS’s that would suffer losses but all of them

13. Credit Default Swaps There was a ‘super senior’ tranche of the CDO’s based on MBS’s that was held mainly by banks (as it was not popular investors due to its low return), bank bought insurance on this ‘super senior’ tranche in the form of CDS’s US insurance giant AIG sold this insurance to banks in the form of CDS’s AIG received insurance premiums from the banks for these CDS’s and ito of these CDS’s AIG pledged to repay banks in full should the ‘super senior’ tranche of CDO’s default When CDO’s collapsed this led to staggering loses for AIG – leading to a USD180-bn government bailout of AIG (AIG’s bail out was much bigger than that given to any individual banks around USD25-bn)

14. Actors in 2008-09 Financial Crisis In the years before the crisis banks increased their return on equity and reduced their capital buffers, but regulators reported that risk had gone down Strategies to increase the return on equity was also called the ‘search for yield’ due to different regulatory frameworks: – in the US this meant banks lending into the ‘sub- prime’ (high risk) mortgage market, – in Europe banks shifted their activities to their ‘trading book’

15. Actors in 2008-09 Financial Crisis De-regulation of banks in US (1999) – Universal banks engage in retail, commercial, wholesale and investment banking activities – Europe had long had universal banks – In the US in 1999 the Glass-Steagall Act (of 1933) was repealed, this act had improved the safety of the banking system by separating retail and investment banking activities => Universal banks arose in the US

16. Incorrect rating of risk European banks had much higher leverage (See Fig 7.3) – poor regulation on European banks mean that could massively increase leverage – expand their assets relative to equity Under Basle II regulation – less capital cushion had to be held against high rated assets (e.g. 0 capital cushion was required to be held against a AAA-rated sovereign debt) and banks were allowed to use their own models to calculate their risk-weighted assets Risk weights were falling as a result of the proliferation of AAA- rated CDO’s (e.g. pre-crisis there were fewer than 10 companies with an AAA-rating, but there were over 50 000 CDO’s with AAA- rating) – effect of this banks could use CDO’s to increase their total assets without requiring additional equity to be held (intense leveraging) Contradiction due to regulatory failure: risk weights were falling due to proliferation of AAA-rated assets, while aggregate risk in the economy was rising

17. Figure 7.3

18. Concentration and interconnectedness of banks Concentration of banks saw the consolidation of national banking systems into the hands of a small number of “too big to fail” financial giants e.g. in UK 3 major banks held more than 70% of total UK banking assets just prior to crisis Interconnectedness saw banks across the globe became more intertwined and dependent on each other e.g. two thirds of expansion in bank balance sheets were a result of claims from within the financial system, rather than from non-financial agents. – This increases the chances of systemic liquidity crises when key institutions become distressed – Also homogeneity in the banking systems increases system wide risk – if all banks hold similar assets this may minimise their own risk of failure (considered in isolation), but can make the system more liable to collapse CB’s now more concerned with a macro-prudential regulatory framework that seeks to minimise the risk of the system as a whole, rather than for each bank individually (micro-prudential regulation)

19. 10.3 Upswing of the financial cycle (1) in the US and (2) globally The US govt promote home ownership – Clinton administration stated aim to “add as many as 8 million new families to America’s home ownership rolls by the year 2000” Rajan in 2010 showed how such policies helped to sustain AD in the US economy following the bursting of the dotcom bubble in 2000, where real wage growth for the majority workers had stagnated since the 1970’s Housing loans were extended to sections of society which were previously credit constrained – sub-prime lending e.g. ninja loans (no income no job or assets loans) As per the financial accelerator – more lending fuelled rising house prices and rising house prices in turn increased the willingness of banks to lend (as rising house prices increased bank collateral on loans they were giving), extrapolative price expectations meant that households also had an incentive to borrow more (i.e. increase their leverage) Households increased their leverage i.e. their debt to equity ratio increased (this happened as their mortgage (debt) increased relative to their equity (deposit/down payment on house)

20. Upswing of the financial cycle Households have an incentive to increase their leverage in order to increase their return on equity e.g. if a house price is USD200 000 and the deposit paid is 10% (USD20 000), the initial leverage ratio is 200/20 = 10, if the house price rises by 10% to USD220 000 then the return on the equity the household invested in 100% (increased from USD20 000 to USD 40 000) To get a high return households will seek to increase the leverage eg return on equity if the deposit is 5% or USD10 000 would mean an initial leverage of 200/10 = 20 and a return on equity from USD 10 000 to USD 40 000 = 300% But then all of the equity of households can be wiped out when house prices are falling – if leverage ratio is 10 then a fall in house prices of 10% (or USD 20 000) wipes out equity – If leverage ratio is 20 then a fall in house prices of 5% (or USD 10 000) wipes out equity (i.e. if house prices fall by more than 5% then house owners own an asset worth less then the amount they owe on it (USD 190 000) – called ‘negative equity’)

21. (2) Global financial upswing Due to cross border bank flows – the upswing effected more countries and by a larger magnitude than previously The financial boom had roots in the US subprime mortgage sector, factors that facilitated transmission from the US to other countries Post-2000: (1) US MBS began to be traded world- wide (2) growing domination of ‘too big to fail’ banks, (3) rise of importance and trust in ratings agencies, (4) incentives in banks for ‘search for yield’ behaviour rewarded by high bonuses

22. 10.4 The crisis Empirics: Fig 7.5 shows (1) the GDP performance across developed and developing countries, (2) the recession was not uniform as some emerging and developing countries managed to avoid recession Fig 7.6 shows key macro indicators for the US and other G7 economies – The recession was not-V shaped i.e. recovery in GDP was not faster than the pre-recession growth rate (in some countries like the UK it was L-shaped) – Consumption and Investment followed a similar pattern in the G7 economies – The Unemployment pattern in the US was different from other G7 economies as unemployment in the US was rising before the recession and rose much higher than in other G7 economies (unemployment doubled in the US as result of the recession) – As have seen in SA – GDP growth went negative, 1m jobs were lost, investment fell, govt debt rose

23. Figure 7.5

24. Figure 7.6

25. Figure 7.7 “Fear index” – volatility of the S&P stock index (VIX) peaked on 15 Sept 2008 when Lehman Brothers failed

26. Three stages of the credit crunch (1) Collapse of sub-prime housing market (2) Seizing up of the money market (3) Lehman Brothers collapse

27. (1) Collapse of sub-prime housing market US Fed started raising r in 2004 in response to inflation pressures as oil and commodity prices rose Rising r depressed housing market as it became more expensive to borrow and mortgage repayments rose Housing prices started to fall Borrowers struggled to make repayments and could no longer make use of rising property prices to make more loans (to help pay the mortgage) Negative financial accelerator came into effect (as housing prices fell => AD fell) MBS and CDS values fell (Feb 2007) By August 2007 – BNP Paribas stated that the value of the MBS assets it was holding was in doubt

28. (2) Seizing up of the money market Banks rely on two money markets to fund their need for s-r liquidity (regulated ratios) (1) Repo market – banks sell securities and agree to repurchase them at a particular repurchase (repo) rate, these loans are secured by collateral (2) commercial inter-bank markets – banks lend to each other overnight or for up to 2-3 months, these loans are unsecured (no collateral) Problem: – the value of MBS come to be included as collateral and when MBS started losing value this introduced increased risk into the system – in Aug 2007 interest rates in the inter-bank market started to rise as perceived risk rose (indicative of a rising risk premium) (e.g. Fig 7.8 shows the widening spread between the interest rate on inter-bank loans and the official bank rate in the UK) – In Sept 2007, Northern Rock UK bank experienced a bank-run and the bank was insolvent and had to be nationalised, event though Northern Rock was not directly involved in lending to the sub-prime market it relied too heavily on s-r debt to finance its operations, so when fears hit the money market it became impossible for Northern Rock fund its loans as these came due

29. Figure 7.8

30. (3) Lehman Brothers collapse Lehman Brothers declared bankruptcy on 15 Sept 2008 The US govt did not rescue Lehman Brothers and the ramifications of this were bigger than expected The collapse of Lehman Brothers has world-wide consequences for financial markets and for the real economy It was the key event that plunged the world economy into the Great Recession

31. The crisis and the 3 equation model The spread between the policy rate rp and the money market rate widened (as risk premium rose) (See Fig 7.8) The spread between the policy rate and the lending rate also widened (See Fig 7.9) The IS-PC-MR model would predict a rise in the mark- up of the lending rate as per r = (1 + μ B )r P due to higher credit risk and a loss of risk tolerance This widening between the policy rate and the lending rate leads to a breakdown of a key transmission mechanism of monetary policy in the IS-PC-MR model which relies on policy rate changes to change the lending rate used by firms and households

32. Figure 7.9

33. The crisis and the 3 equation model See Fig 7.10 where IS-PC_MR model is used to show the effects of the sub-prime crisis (which manifests as a –ve AD shock) (1) the IS curve shifts left due to fall in AD (2) the interest rate r rises due to the rising spread between the policy rate and lending rate (3) If Min rP is above the new stabilising rate of r’s the economy experiences a deflation trap In Fig 7.10, the interest rate spread means that the best y that can actually be achieved is at X As monetary policy is limited, What may be required is fiscal expansion and unconventional monetary policy (QE).

34. Figure 7.10

35. 10.5 Policy intervention in the crisis (1) Know your history in order not to repeat it – what was wrong with the policy response to the Great Depression (1929 - early 1930’s) (2) Monetary and Fiscal response in the teeth of the global financial crisis of 2008-09 (3) Policy response in the Great Recession that followed the global financial crisis

36. (1) What was wrong with the policy response to the Great Depression? Two key mistakes were made by policy makers in response to the Great Depression (1) contractionary monetary and fiscal policies – Money supply contracted by a third between 1929 and 1933 due to failing banks and bad Fed policy i.e. the Fed did increase money supply but not sufficiently to counteract the falling money multiplier (as the currency to deposit ratio rose and banks held excesses reserves) – Government increased tax rates on individuals and businesses (2) a rise in protectionism – President Hoover introduced the Tariff Act of 1930, which raised import tariffs on over 20 000 products. This was met by retaliatory measures from the US’s main trading partners and world trade plummeted.

37. Comparing 1929 and 2008 Fig 7.11 shows that the two downturns looked similar, but the bounce back was a lot more rapid following 2008-09 In 2008-09 Ben Bernanke was determined to avoid the mistakes of 1929: – Governments stepped in to support AD via fiscal stimulus packages – CB’s slashed interest rates and kept them at historical lows for an extended period – Expansionary monetary and fiscal policies were adopted more decisively and applied more consistently than in 1929

38. Figure 7.11

39. (2) Monetary and Fiscal response to global financial crisis of 2008-09 The 2008-09 policy response addressed three key problems: – The liquidity problem – CB took action to deal with seizing up of money markets and bank liquidity problems – The Bank Solvency problem – CB’s and govt’s took action to save failing banks and prevent contagion – The stabilisation of AD and expectations – CB’s used conventional and unconventional monetary policy and govt’s used expansionary fiscal policy

40. Liquidity problem Bank of England made USD10-bn reserves available for 3 month loans and widened acceptable collateral ECB injected Euro 95-bn in overnight credit into the interbank market Fed injected USD 24-bn While these interventions provided some respite and injected significant liquidity into the banking system, the spread remained high between lending rates (which stayed high) and the policy rate (which was lowered to historic lows)

41. Solvency problem Given bank high leverage the fall in the value of financial assets mean that they risked insolvency (where assets < liabilities) Banks needed capital urgently to plug the gaps in their balance sheets and avoid failure Private capital markets were not willing to provide additional capital (investment) so banks had not choice but to turn to their govt’s in the following forms: – Govt’s took equity / ownership stakes in financial institutions and in exchange provided capital (eg Citigroup and Bank of America in US) – Banks were nationalised i.e. govt’s took control of financial institutions by taking very high equity stakes (e.g. Northern Rock and RBS in UK and AIG in US) – MBS’s that had lost their value (had come to be called toxic assets) so CB’s agree to buy these toxic assets (in US Fed bought USD600-bn worth)

42. Stabilisation policy – prevent deflation Conventional monetary policy: – responded with sharp interest rate cuts, aimed at stimulating AD and preventing deflation (see Fig7.11 where interest rate cuts in 2008-09 were much sharper than in 1929) Unconventional monetary policy: – The zero bound of nominal interest rates restricted conventional monetary policy, so unconventional policies were used to stimulate AD and prop up inflation expectations – The main unconventional instrument used was QE (quantitative easing) where the CB used asset purchases (purchase govt bonds and financial assets) to try to boost asset prices and bring down long term interest rates (i.e. lower yields), – The aim of such unconventional policy was to boost AD by encouraging Consumption and Investment in the private sector by pushing down long term interest rates Note: conventional monetary policy seeks to reduce short-run interest rates unconventional monetary policy seeks to reduce long-run interest rates

43. Monetary policy and the yield curve The yield curve shows the relationship between the nominal interest rate of a bond and its time to maturity (i.e. the time remaining before the full value of the bond must be repaid) At Fig 7.12(a) yield curve is upward sloping (normal) as investors demand a higher rate for holding longer term bonds (iS<iL), this is due to: – uncertainty about the longer run future – uncertainty about inflation in the long-term as inflation impacts on the real return on bonds At 7.12(b) If there is a negative demand shock then CB undertakes conventional policy cuts short-run interest rate and assuming a constant spread, the the yield curve (YC) shifts down to YC’ and the long term interest rate falls to iL’ At Fig 7.12(c) the CB undertakes unconventional policy buys govt bonds in secondary markets, increases their prices reduces long-run rates, swivelling the slope of the yield curve to YC” and reducing long run rates to iL” Note: see an amazing 3D yield curve at this link: http://www.nytimes.com/interactive/2015/03/19/upshot/3d-yield-curve- economic-growth.html?_r=1&abt=0002&abg=0

44. Figure 7.12

45. Fiscal policy – automatic stabilisers and fiscal stimulus In Fig 7.10 policy makers need to use fiscal policy to try and boost output to that given by point C Fiscal policy shifts the IS curve up to the right based on the understanding that the real interest rate is at rx given the interplay of: – the zerobound on the nominal interest rate, – deflation and – the rising spread between the policy rate and the lending rate This fiscal policy response is made up of two components (1) automatic fiscal stabilisers and (2) discretionary fiscal policy (also called ‘fiscal stimulus packages’) IMF estimated that overall change in fiscal balances across G20 between 2007 and 2009 was 5.9% of GDP of which automatic stabilisers = 3.9% and fiscal stimulus = 2% This excludes fiscal resources allocated to bail out the banking sector, Studies show the sorting out the banking sector should be done first, as it is more costly in the long-run to have bad banks and zombie companies sucking the fiscus dry e.g. compare the relative success of Sweden in dealing with its banking crisis vs the stagnation of Japan

46. Fiscal Policy Fiscal Stimulus Packages took many forms – UK cut VAT from 17.5% to 15% – European countries introduced car scrapping schemes, paying consumers to scrap their cars and buy a new one – Australia gave tax bonuses, cash handouts to middle and low income earners The size of stimulus packages pre March 2009 relative to GDP are shown in Fig.7.13 – which shows how fiscal balances were negatively effected) made up of announced tax cuts and increases to spending Fiscal stimulus was coordinated across countries (eg at G20 summits) to avoid a situation where some countries would free ride on the stimulus of others e.g. benefit from increased exports without incurring the fiscal costs Note: monetary policy not so co-ordinated – where US has been criticized for not taking account of the costs of tapering its QE on other countries e.g. who experience exchange rate shocks (weakening) and / or interest rate shocks (eg US r up and Rand weakens and SA’s r must rise)

47. Figure 7.13

48. Under what conditions is fiscal stimulus likely to succeed When monetary policy supports expansionary fiscal policy by preventing interest rates from rising When it takes the form of a temporary rise in govt spending as this raises govt demand for goods and services directly (even if this is accompanied by higher taxation, as the first round effect is still stimulatory aka balanced budget multiplier) Even if govt borrows to fund extra spending there is a stimulatory first round effect (even if Ricardian equivalence means that rising saving (to prepare to pay tax for the borrowing) dampens second round effects Where there are temporary tax cuts and households are credit constrained, then the tax cut will lead to higher spending Conclusion: Fiscal stimulus, in response to a crisis which leads to fall in AD and excess capacity in the economy, should be timely, temporary and targeted (and co-ordinated across countries). The temporary nature of the intervention serves to shifts spending decision forward and reduces concerns about long-run implications for public debt.

49. Consolidation policies in the post- crisis recession In many countries fiscal stimulus was followed by discretionary contractionary fiscal policy even before they had exited the recession Why? The express aim was to reduce the debt to GDP ratio (which trumped the aim of stabilising AD) This process was called fiscal consolidation or austerity and has been much debated (eg see Paul Krugman’s criticism of austerity at: http://www.theguardian.com/business/ng- interactive/2015/apr/29/the-austerity-delusion http://www.theguardian.com/business/ng- interactive/2015/apr/29/the-austerity-delusion

50. Fiscal consolidation As per Fig7.14, shows that for the US, UK and other advanced countries: – In 2008-09 countries ran negative change in their structural balance (indicating discretionary expansion in their fiscal policies) – In 2009-10 the US and advanced countries continued to run (smaller) negative changes in their structural balances, but the UK began introducing a positive change to their structural balance (as they began a process of discretionary austerity) – From 2010-11 onwards – all countries had moved to positive change in their structural balances (discretionary austerity) in order to avoid a national debt trap In Fig 7.14 fiscal policy is tighter if the change to the structural balance is positive (even if a structural deficit remains)

51. Figure 7.14

52. Was austerity premature? Was it an error to attempt to deal with mounting govt debt via an early tightening of fiscal policy On the balance yes, as unlike an individual household where debt is reduced by saving more, the paradox of thrift implies that in an economy with spare capacity (y below ye) the decision by the govt to borrow less in the context where the private sector was still heavily indebted meant that at an aggregate level the decision to save more (pursue austerity) serves to reduce AD and reduce output Paradoxically, austerity may mean that the debt/GDP ratio rises – as the denominator (GDP) may fall as AD falls, and – as the numerator (debt) may rise if low AD / low growth and related low tax revenues and rising debt

53. 10.6 Conclusion The 2008-09 financial crisis highlighted the inadequacies of the pre-crisis policy framework that combined Inflation Targeting CB’s with light touch financial regulation A major theme of post-crisis policy debate is that measure should be put in place to prevent the upswing of a financial cycle with its pro-cyclical build up of debt and leverage and makes the economy vulnerable to financial crisis At the root of the problem is that banks take excessive risks when measured from a societal perspective – because banks do not internalise the impact of their actions on systemic risk and the are implicitly subsidised by the prospect of being bailed out As a result - How to better regulate banks is one of the key issues that is dealt with in policy discussion on how best to protect economies from costly financial crises