1. Origins of the Current Crisis and Economic Policy of the NCM Philip Arestis Cambridge Centre for Economic and Public Policy Department of Land Economy University of Cambridge University of the Basque Country Department of Applied Economics V

2. Presentation 1. Introduction: The global financial system has been under enormous stress since August 2007, and has well spilled over to the global economy more broadly. Is it over now? 2. Origins of Current Financial Crisis: Five features: 2a. Distributional Effects 2b. Financial Liberalisation 2c. Financial Innovation 2d. International Imbalances 2e. Monetary Policy 3. Summary and Conclusions

3. Origins: Distributional Effects Feature 1: Distributional Effects We begin by referring to the first major feature of the origins of the ‘great recession’; We argue that it is the steady but sharp rise in inequality, especially in the US and the UK but elsewhere, too; The share of national output taken up by profits had reached close to a post World War II high before the onset of the recession; While real wages had fallen even behind productivity; The declining wage and rising profits share, were compounded by another long-term economic term: the increasing concentration of earnings at the top, especially in the financial sector; See relevant figures;

4. Origins: Distributional Effects Figure 1: UK Wages as Percentage of GDP

5. Origins: Distributional Effects Figure 2: UK Wages Relative to Productivity

6. Origins: Distributional Effects Figure 3: US and Rest of the World Profits as Percentage of GDP

7. Origins: Distributional Effects Similar observations can be made in Europe, excluding the UK; The rising profits share aped financial institutions thereby increasing leveraging (debt to assets ratio) and high risk-taking in financial institutions; This, along with financial liberalisation in the US, promoted the financial engineering based on the US subprime mortgages as we explain below.

8. Origins: Financial Liberalization Feature 2: Financial Liberalization; It is justified by the ‘efficient markets hypothesis’, which assumes that all unfettered markets clear continuously thereby making disequilibria, such as bubbles, highly unlikely; Economic policy designed to eliminate bubbles would lead to ‘financial repression’, a very bad outcome in this view; The experience with financial liberalization is that it caused a number of deep financial crises and problems unparalleled in world financial history in terms of their depth and frequency.

9. Origins: Financial Liberalization US financial liberalization did also begin in the 1970s; There was the deregulation of commissions for stock trading in the 1970s; The removal of Regulation Q in the 1980s, that is placing ceilings on interest rates on retail deposits; The repeal of the key regulation Glass-Steagall Act (of 1933) in 1999 (promoted by the US financial sector, complaining about the financial Bing Bank liberalisation of 1986 in the UK); And the Commodity Futures Modernisation Act (CFMA) of December 2000, which repealed the Shad-Johnson jurisdictional accord, which had banned single-stock futures in 1982 (the financial instrument that allows selling now but delivering in the future);

10. Origins: Financial Liberalisation When fixed commissions were in place, investment banks would book stock trades for their customers; deregulation meant greater competition, entry by low- cost brokers and thinner margins; Removing Regulation Q allowed the fluctuation in interest rates, thereby forcing commercial banks to compete for deposits on price, which led them to pursue new lines of business; Such new business emerged in response to the investment banks’ needs for short-term funding; It created, however, a financial crisis in the 1970s and 1980s when savings banks could not fund themselves in view of the narrowing of the margins of lending and borrowing rates;

11. Origins: Financial Liberalisation Investment banks proceeded into originating and distributing complex derivative securities, like collateralized bond obligations (normal investment bonds backed by pools of junk bonds); that was not a great success and collapsed in the second half of the 1980s;

12. Origins: Financial Liberalisation That originate-and-distribute failure was followed by a new initiative of asset-backed and mortgage-backed securities, which gained a clientele in the 1990s; We had in 1997 the Broad Index Secured Trust Offering (BISTRO), a buddle of credit derivatives based on pools of corporate bonds; And later the Collateralised Debt Obligations (CDOs), based on debt in general terms (including subprime mortgages), and Collateralised Mortgage Obligations (CMOs), based mainly on pools of subprime mortgages;

13. Origins: Financial Liberalisation BISTRO was not a great success in view of the corporate sector’s booms and recessions at that time; CDOs and CMOs became a success in view of the steady growth path of the housing market; That was the first cause of the crisis: the originate-and-distribute model of securitization and the extensive use of leverage (NB: leverage is the ratio debt/equity);

14. Origins: Financial Liberalisation This raises the issue of the difference between originate-and-distribute and originate-and-hold; In the originate-and-hold model bank loans are held in the banks’ own portfolios; In the originate-and- distribute (or originate-to- securitize) model bank loans are re-packaged and sold to other banks, foreign banks and the domestic and foreign personal sector; The latter model transfers the loan risk from the bank to whoever buys the Asset Backed Securities (ABS);

15. Origins: Financial Liberalisation Then came the Commodity Futures Modernization Act (CFMA) of December 2000, which deregulated single-stock futures trading, and provided certainty that products offered by banking institutions would not be regulated as futures contracts; CFMA enabled the creation and legitimisation of credit-default swaps (CDSs, credit derivative contracts between two parties, whereby there is guarantee in case of default); Thereby creating a potentially massive vector for the transmission of financial risk throughout the global system;

16. Origins: Financial Liberalisation The apotheosis of the financial liberalization in the US, however, had already come about with the repeal of the 1933 Glass-Steagall Act in 1999; Although it should be said that relaxing the 1933 Act began in 1987 (when the Fed allowed 5% of bank deposits to be used for investment banking, and further promoted in 1996 when 25% of deposits were allowed for the same purpose); The 1933 Glass-Steagall Act was designed to avoid the experience of the 1920s/1930s in terms of the conflict of interest between the commercial and the investment arms of large financial conglomerates (whereby the investment branch took high risk tolerance);

17. Origins: Financial Liberalisation The ultimate aim of the 1933 Glass-Steagall Act was to separate the activities of commercial banks and the risk-taking ‘investment or merchant’ banks along with strict regulation of the financial services industry; The goal was to avoid a repetition of the speculative, leveraged excesses of the 1920s/1930s; Without access to retail deposits and with money market instruments tightly regulated, investment banks funded themselves using their partners capital;

18. Origins: Financial Liberalisation The repeal of the Act in 1999 changed all that: It forced investment banks to branch into new activities; And it allowed commercial banks to encroach on the investment banks’ other traditional preserves Not just commercial banks but also insurance companies, like the American International Group (AIG), were also involved in the encroaching;

19. Origins: Financial Innovation Feature 3: Financial Innovation; The repeal of the Glass-Seagull Act in 1999 allowed the merging of commercial and investment banking, thereby enabling financial institutions to separate loan origination from loan portfolio; thus the originate- and-distribute model; Indeed financial institutions were able to use risk management in their attempt to dispose of their loan portfolio; This led to an important financial innovation;

20. Financial institutions can now provide risky loans without applying the three Cs: Collateral, Credit history and Character; This engineered a new activity that relied on interlinked securities mainly emerging from and closely related to the subprime mortgage market; Subprime mortgage is a financial innovation designed to enable home ownership to risky borrowers; Origins: Financial Innovation

21. The term subprime refers to borrowers who are perceived to be riskier than the average borrower because of a poor credit history; Rising home prices encouraged remortgaging, thereby expanding the subprime mortgage market substantially;

22. Origins: Financial Innovation The growth of loans in the subprime mortgage market was substantial: as a percentage of total mortgages: 1994: 5%;1996: 9%;1999:13%; 2006: 20%; 2007: 47%; Also, between 1998 and 2007 mortgage debt as a percentage of disposable income increased by more than 50% from 61% to 101%; In fact, by the first quarter of 2007 virtually all subprime originations were securitised, and subprime mortgage securities outstanding totalled more than $900bn;

23. Origins: Financial Innovation Banks set up trusts or limited liability companies with small capital base, i.e. separate legal entities, known as Structural Investment Vehicles (SIVs); Parallel banking is thereby created outside the control and the regulatory umbrella of the authorities; This SIVs operation is financed by borrowing from the short end of the capital markets at a rate linked to the inter-bank interest rate;

24. Origins: Financial Innovation The short-term capital thereby raised, is used by the SIVs to buy the risky segment of the loan portfolio of the mother company, mainly risky mortgages; The risky loan portfolio is then repackaged in the form of CDOs and CMOs, sold to other banks and personal sector; The securities purchased from the SIVs by the banks were combined with other asset-backed securities to form collateral for yet other securities: the structured finance collateralised debt obligations; These securities were issued in different tranches ranging from the AAA-rated super senior tranche that carried the lowest risk down to the unrated equity tranche that carried all the residual risk;

25. Origins: Financial Innovation At each stage of this slicing and dicing and transfer of credit risk, the banks took commission, as did the credit rating agencies that were paid not only for rating the credit products but also for helping the banks and their vehicles to structure these products; So long as the short-term rate of interest is lower than the long-term rate, big profits materialise, which helps the housing market to produce a bubble;

26. When the yield curve was inverted, that is long-term interest rates became lower than short-term rates, the subprime mortgage market simply collapsed; It occurred following a period of rising policy interest rates (mid-2004 to mid-August 2007) after a prolonged period of abnormally low interest rates (initially 1997-1998 but more aggressively after the internet bubble of March 2000); The collapse of the subprime mortgage market by early 2007, also meant the end of the housing boom and the burst of the housing bubble; Origins: Financial Innovation

27. Defaults on mortgages spread to investment banks and commercial banks in the US and across the world via the elaborate network of CDOs and CMOs; It should be noted that the complacency, the greed and even the outright corruption of the various financial institutions that created and distributed the structured credit products, were important contributory factors to the financial crisis;

28. Origins: Financial Innovation However, other factors were also important. The volume of these assets that had got into the global financial system grew to the point where the system could no longer cope; That critical mass was only reached because of the pressure of demand, and a principle source of that pressure was the large concentration of wealth ownership;

29. Origins: Financial Innovation The complex structure of the CDO and CMO markets complicated the task of credit rating institutions, which erroneously assigned AAA-status to many worthless papers; The overstated credit rating contributes to the growth of the CDO and CMO markets in the upswing but also to its downfall in the downswing; In fact in the aftermath of the subprime crisis in the US, credit rating agencies were blamed for their initial ratings of structured finance securities in that they did not reflect the true risks inherent on those securities;

30. Origins: Financial Innovation The sale of CDOs and CMOs to international investors made the US housing bubble a global problem and provided the transmission mechanism for the contagion to the rest of the world; The collapse of the subprime market spilled over into the real economy through the credit crunch and collapsing equity markets; And all this led to the freezing of the interbank lending market since August 2007; Although the first signs of the problem may be dated as March 2007, when major losses were announced by US subprime investors;

31. Origins: Financial Innovation A significant recession is well with us by now: the ‘great recession’! And with $4.1tr. losses in the world financial system, less than half of which has been formally written off; A policy debate has been triggered about the need to strengthen the regulatory framework for credit rate agencies; the G20 London agreement contains relevant regulatory provisions – see next lecture for a summary of the relevant issues;

32. Origins: International Imbalances Feature 4: International Imbalances; The process described so far was also accentuated by the international imbalances, which were built up over a decade or more; The rise of China and the decline of investment in many parts of Asia following the 1997 crisis there, created a great deal of savings; That amount of savings was channeled mainly into the US, encouraged and enabled by the ‘privilege’ enjoyed by the US dollar as the world’s currency; It helped to put downward pressure on US interest rates, which along with the Fed low interest rate policy pursued at the same time, enabled households there to live well beyond their means;

33. Origins: International Imbalances Also, the increasing allocation of manufacturing jobs to the relatively low wage areas of Asia, and China in particular, helped to keep down wages and hence low inflationary pressures in the US and elsewhere; This along with the channeling of savings into the US also enabled the US low-to-mid-income households to increasingly rely on credit as a means of survival; Low interest rates at the same time helped to push up asset prices, especially house prices, thereby enabling the financial sector to explode; The explosion of the banking sector enabled lending to households and businesses to expand substantially along with lending to other banks;

34. Origins: International Imbalances All these imbalances created a more buoyant market for financial institutions thereby feeding the originate-and-distribute culture and machine; The build up of household debt and asset holdings made household expenditure more sensitive to short-term interest rate changes; This helped to change the transmission mechanism of Monetary Policy as we examine in what follows.

35. Origins : NCM Monetary Policy Feature 5: NCM Monetary Policy; This feature springs from the monetary policy emphasis on frequent interest rate changes as a vehicle to controlling inflation; This type of monetary policy is based on the New Consensus Macroeconomics (NCM) model, which we have already discussed.

36. Origins: NCM Monetary Policy The impact of this policy has been the creation of enormous liquidity and household debt in the major economies, which reached unsustainable magnitudes and helped to promote the current crisis; Especially so after the collapse of the IT bubble (March 2000) when central banks, led by the Fed, pursued highly accommodative monetary policies to avoid a deep recession;

37. Origins: NCM Monetary Policy Looking at debt statistics (see, BIS Annual Report, June 2008, p. 29), we find the following: Between 1998 and 2002 outstanding household debt, including mortgage debt, in the UK was 72.0 percent of GDP; between 2003 and 2007 it shot to 94.3 percent of GDP; In the same periods, outstanding household debt jumped from 76.7 percent to GDP to 97.6 percent of GDP in the case of the US; And in the Euro Area from 48.5 to 56.6 respectively;

38. Origins: NCM Monetary Policy As a result of these developments, the transmission mechanism of Monetary Policy has changed: The build up of household debt and asset holdings has made household expenditure more sensitive to short-term interest rate changes; Furthermore, the current high debt levels, combined with the difficulties in the ‘real’ sector, imply that lenders and equity holders stay away from the market place; Not forgetting the presence and magnitude of toxic assets, which pose real problems that still need to be sorted out’;

39. Origins: NCM Monetary Policy We should remember, however, that ‘all debt is a bad thing’ under current circumstances may not be the solution; A sense of proportion is important; For if everybody started saving the economic situation can only get worse; Lack of aggregate demand is a serious problem at the moment; The following summary of GDP growth rate data make the point;

40. Origins: NCM Monetary Policy Eurostat annualized estimates for the OECD real GDP growth rate suggest that it plunged by 4.2% on average in 2008 (with the UK recording a decline by 4.1%, Germany by 6.9% and Japan by 9.1%); Also annualized Eurostat estimates, suggest that the UK contracted by 5 percent in 2009 but expected to return to a small positive number in 2010; Still in line with Eurostat estimates, the Euro Area GDP growth rate, on a quarter to quarter basis, was 0.4 percent in the third quarter of 2009, but only 0.1 in the fourth quarter;

41. Origins: NCM Monetary Policy ECB staff projections for the Euro Area GDP annual growth rate, expect it to be between 0.4 percent and 1.2 percent for 2010; According to IMF estimates the US economy contracted by 2.5 percent in 2009, which is expected to be followed by a modest revival in 2010; Current unemployment rates are: US: 9.7%; UK: 7.8%; Euro Area: 9.9%; Spain: 18.8%;

42. Origins: NCM Monetary Policy An important lesson from the NCM conduct of monetary policy is important; This is that there are serious dangers with the NCM type of conduct of monetary policy: frequent changes in interest rates can have serious effects; Low interest rates cause bubbles; high interest rates work through applying economic pressures on vulnerable social groups; There are, thus, severe distributional effects.

43. Final Comments This lecture should not end without a comment on the failures of policy makers to appreciate the coming of the August 2007 crisis; two quotes make the point; The first comes from the IMF: “..... this World Economic Outlook sees global economic risks as having declined since..... September 2006..... we actually see the continuation of strong global growth as the most likely scenario..... the overall U.S. economy is holding up well..... the signs elsewhere are very encouraging” (IMF, 2007, p. xii); Not merely did the IMF fail to appreciate the looming crisis but other monetary authorities now acknowledge the degree and depth of the problem;

44. Final Comments Greenspan (2010) readily admits as much very clearly: “In the growing state of high euphoria, risk managers, the Federal Reserve, and other regulators failed to fully comprehend the underlying size, length, and impact of the negative tail of the distribution of risk outcomes that was about to be revealed as the post-Lehman crisis played out. For decades, with little, to no, data, most analysts, in my experience, had conjectured a far more limited tail risk. This is arguably the major source of the critical risk management system failures” (p. 12).

45. Presentation 1. Introduction: The global financial system has been under enormous stress since August 2007, and has well spilled over to the global economy more broadly. Is it over now? 2. Origins of Current Financial Crisis: Five features: 2a. Distributional Effects 2b. Financial Liberalisation 2c. Financial Innovation 2d. International Imbalances 2e. Monetary Policy 3. Summary and Conclusions

46. Summary and Conclusions We have highlighted the origins of the current financial crisis; Five features have been highlighted: distributional effects; financial liberalization, financial innovation, international imbalances and current economic policy; The first three belong to the main cause of the crisis and the other two to the contributory factors to the crisis; A number of main conclusions follow, which we may summarise as follows:

47. Summary and Conclusions The first is that the distributional and financial liberalisation effects, examined above, led to the financial innovation, also discussed above, which have created huge risks; the latter have been mismanaged thereby creating enormous costs because of this failure; The second conclusion is that the deregulatory approach, which engineered the current financial crisis, does not have ‘healthy’ grounding in economic theory or historical experience. ‘Good’ economic theory, and historical experience, explain why the government should have an active role, especially in terms of regulating financial markets. It is true that good regulation promotes confidence in financial markets.

48. Summary and Conclusions The third conclusion is that we need to have a properly regulated and functioning banking system to allow economic activity to expand. The fourth conclusion is that although a well- functioning financial system is desirable, the interests of financial markets are not always compatible with those of others in the economy – workers, small business, etc. Regulation and proper institutional design are, thus, necessary.

49. Summary and Conclusions The fifth conclusion comes from Ben Bernanke who suggests that “although the subprime debacle triggered the crisis, the developments in the U.S. mortgage market were only one aspect of a much larger and more encompassing credit boom whose impact transcended the mortgage market to affect many other forms of credit. Aspects of this broader credit boom included widespread declines in underwriting standards, breakdowns in lending oversight by investors and rating agencies, increased reliance on complex and opaque credit instruments that proved fragile under stress, and unusually low compensation for risk-taking” (Stamp Lecture, London School of Economics, 13 January 2009);

50. Summary and Conclusions The sixth conclusion emerges from the type of monetary policy in place over the relevant period: the NCM type of monetary policy that is associated with gyrations in interest rates that creates enormous debts in the system with serious distributional effects as explained above; The seventh and final conclusion is that regulatory and prudential controls become very necessary. Indeed, more intervention on the policy front is desperately needed.