The Worst Financial Crisis in 75 Years: Origins, Magnitude, Response and Lessons Jeffrey Frankel James W. Harpel Professor of Capital Formation & Growth Harvard Kennedy School 2009 Wellesley Country Club, March 26, 2009

2 Origins of the crisis Well before 2007, there were danger signals in US: Well before 2007, there were danger signals in US: Low interest rates ; Low interest rates ; Early corporate scandals (Enron…); Early corporate scandals (Enron…); Risk was priced very low, Risk was priced very low, housing prices very high, housing prices very high, National Saving very low, National Saving very low, current account deficit big, current account deficit big, leverage high, leverage high, mortgages imprudent… mortgages imprudent…

3 Six root causes of financial crisis US corporate governance falls short of its billing US corporate governance falls short of its billing E.g., rating agencies; E.g., rating agencies; executive compensation (options; golden parachutes…). executive compensation (options; golden parachutes…). US households save too little, borrow too much. US households save too little, borrow too much. Politicians slant excessively toward homeownership Politicians slant excessively toward homeownership Tax-deductible mortgage interest; F annie M ae ; Allowing NINJA loans… Tax-deductible mortgage interest; F annie M ae ; Allowing NINJA loans… Starting 2001, the federal budget was set on a reckless path Starting 2001, the federal budget was set on a reckless path Reminiscent of Reminiscent of Monetary policy was too loose during , Monetary policy was too loose during , accommodating fiscal expansion, reminiscent of the Vietnam era. accommodating fiscal expansion, reminiscent of the Vietnam era. Financial market participants during this period grossly underpriced risk Financial market participants during this period grossly underpriced risk risks: housing crash, $ crash, oil prices, geopolitics…. risks: housing crash, $ crash, oil prices, geopolitics….

4 Monetary policy easy Federal budget deficits Underestimated risk in financial mkts Failures of corporate governance Households saving too little, borrowing too much Excessive leverage in financial institutions Stock market bubble Housin g bubble Stock market crash Housin g crash Financial crisis China’s growth Low national saving Lower long- term econ.growth Eventual loss of US hegemony Recession Oil price spike Gulf insta- bility Foreig n debt Origins of the financial/economic crises Excessive complexity CDSs MBS s CDO s Predatory lending Homeownership bias

5 Onset of the crisis Initial reaction to troubles: Initial reaction to troubles: Reassurance in mid-2007: “The subprime mortgage crisis is contained.” It wasn’t. Reassurance in mid-2007: “The subprime mortgage crisis is contained.” It wasn’t. Then, “The crisis is in Wall Street, sparing Main Street.” It didn’t. Then, “The crisis is in Wall Street, sparing Main Street.” It didn’t. Then de-coupling : “The US turmoil will have less effect on the rest of the world than in the past.” It hasn’t. Then de-coupling : “The US turmoil will have less effect on the rest of the world than in the past.” It hasn’t. By now it is clear that the crisis is By now it is clear that the crisis is the worst in 75 years, the worst in 75 years, and is as bad abroad as in the US. and is as bad abroad as in the US.

6 The return of Keynes Economists still shy away from using the name. Economists still shy away from using the name. But Keynesian truths abound today: But Keynesian truths abound today: Origins of the crisis Origins of the crisis The Liquidity Trap The Liquidity Trap Fiscal response Fiscal response Motivation for macroeconomic intervention: to save market microeconomics Motivation for macroeconomic intervention: to save market microeconomics International transmission International transmission

7 The origin of the crisis was an asset bubble collapse, loss of confidence, credit crunch. The origin of the crisis was an asset bubble collapse, loss of confidence, credit crunch. Like Keynes’ animal spirits or beauty contest. Add in Fisher’s “debt deflation,” the “Minsky moment,” and von Hayek’s credit cycle Like Keynes’ animal spirits or beauty contest. Add in Fisher’s “debt deflation,” the “Minsky moment,” and von Hayek’s credit cycle It was not a monetary contraction in response to inflation (as were or 1991). It was not a monetary contraction in response to inflation (as were or 1991). But, rather, a credit cycle: monetary expansion showed up only in asset prices. (Borio of BIS.) But, rather, a credit cycle: monetary expansion showed up only in asset prices. (Borio of BIS.)

8 US Recession In December 2008, NBER Business In December 2008, NBER Business Cycle Dating Committee proclaimed US recession had started in December As of March 2009, the recession’s length ties the postwar record of (16 months). As of March 2009, the recession’s length ties the postwar record of (16 months). Recovery unlikely before late 2009 Recovery unlikely before late 2009 => recession is already longest since 1930s. => recession is already longest since 1930s. Likely also to be as severe as oil-shock recessions of 1974 and Likely also to be as severe as oil-shock recessions of 1974 and

9 BUSINESS CYCLE REFERENCE DATES Source: NBER Source: NBER PeakTroughContraction Quarterly dates are in parentheses Peak to Trough August 1929 (III) May 1937 (II) February 1945 (I) November 1948 (IV) July 1953 (II) August 1957 (III) April 1960 (II) December 1969 (IV) November 1973 (IV) January 1980 (I) July 1981 (III) July 1990 (III) March 2001 (I) December 2007 (IV) March 2001 December 2007 March 2001 December 2007 March 1933 (I) June 1938 (II) October 1945 (IV) October 1949 (IV) May 1954 (II) April 1958 (II) February 1961 (I) November 1970 (IV) March 1975 (I) July 1980 (III) November 1982 (IV) March 1991 (I) November 2001 (IV) March 1991 November 2001 March 1991 November Average, all cycles: (32 cycles) (10 cycles) 17 10

10 US employment peaked in Dec. 2007, which is the most important reason why the NBER BCDC dated the peak from that month. Since then, 4 ½ million jobs have been lost (3/09). Payroll employment series Source: Bureau of Labor Statistics

11 My favorite monthly indicator is total hours worked in the economy It confirms: US recession turned severe in September, when the worst of the financial crisis hit (Lehman bankruptcy…)

12 Recession was soon transmitted to rest of world: Contagion: Falling securities markets & contracting credit. Contagion: Falling securities markets & contracting credit. Especially in those countries with weak fundamentals: Iceland, Hungary & Ukraine… Especially in those countries with weak fundamentals: Iceland, Hungary & Ukraine… Or oil-exporters that relied heavily on high oil prices: Russia… Or oil-exporters that relied heavily on high oil prices: Russia… But even where fundamentals were relatively strong: Korea… But even where fundamentals were relatively strong: Korea… Some others experiencing their own housing crashes: Ireland, Spain… Some others experiencing their own housing crashes: Ireland, Spain… Recession in big countries will be transmitted to all trading partners through loss of exports. Recession in big countries will be transmitted to all trading partners through loss of exports.

13 Forecasts

14 downgraded again (Jan.28, 2009)

15 The IMF has cut by half estimates for low- & middle-income countries. Jan.28, Rev. vs. Oct.08 projection

16 “World Recession?” No generally accepted definition. No generally accepted definition. A fall in China’s growth from 11% to 1%, e.g, is obviously a recession. A fall in China’s growth from 11% to 1%, e.g, is obviously a recession. Perhaps 6 ½ % is as well (World Bank forecast, Mar. 2009) Perhaps 6 ½ % is as well (World Bank forecast, Mar. 2009) Usually global growth < 2 % is considered a recession. Usually global growth < 2 % is considered a recession. The World Bank in March forecast that global growth would be negative in 2009, The World Bank in March forecast that global growth would be negative in 2009, for the first time since the 1930s. for the first time since the 1930s.

17 U.S. Policy Responses Monetary easing is unprecedented, appropriately. But it has largely run its course: Monetary easing is unprecedented, appropriately. But it has largely run its course: Policy interest rates ≈ 0. (graph) Policy interest rates ≈ 0. (graph) The famous liquidity trip is not mythical after all. The famous liquidity trip is not mythical after all. As Krugman & others warned us in re Japan in 90s. As Krugman & others warned us in re Japan in 90s. & lending, even inter-bank, builds in big spreads & lending, even inter-bank, builds in big spreads since mid-2007, not just since September (graph) since mid-2007, not just since September (graph) Now aggressive quantitative easing, as the Fed continues to purchase assets not previously dreamt of. Now aggressive quantitative easing, as the Fed continues to purchase assets not previously dreamt of.

18 Bank spreads rose sharply when sub-prime mortgage crisis hit (Aug. 2007) and up again when Lehman crisis hit (Sept. 2008). Source: OECD Economic Outlook (Nov. 2008).

19 Corporate spreads between corporate & government benchmark bonds zoomed after Sept US €

20 Policy Responses, continued Obama policy of “financial repair”: Obama policy of “financial repair”: Infusion of funds has been more conditional, vs. Bush Administration’s no-strings-attached. vs. Bush Administration’s no-strings-attached. Some money goes to reduce foreclosures. Some money goes to reduce foreclosures. Conditions imposed on banks that want help: Conditions imposed on banks that want help: (1) no-dividends rule, (1) no-dividends rule, (2) curbs on executive pay, (2) curbs on executive pay, (3) no takeovers, unless at request of authorities & (3) no takeovers, unless at request of authorities & (4) more reporting of how funds are used. (4) more reporting of how funds are used. But so far they have avoided “nationalization” of banks But so far they have avoided “nationalization” of banks

21 Secretary Geithner announced PPIP 3/23/09: Public-Private Partnership Investment Program Secretary Geithner announced PPIP 3/23/09: Public-Private Partnership Investment Program When buying “toxic” or “legacy assets” When buying “toxic” or “legacy assets” from banks, their prices are to be set by private bidding (from private equity, hedge funds, and others), rather than by an overworked Treasury official pulling a number out of the air and risking that taxpayers grossly overpay for the assets, as under TARP. Policy Responses -- Financial Repair, cont.

22 How much money is the government putting into the PPIP? designed to be enough to attract participants, but not more. From the Treasury (already set aside under TARP), leveraged courtesy of FDIC & Fed. Taxpayers share equally with new private investors in upside, but admittedly bear all the downside risk. Nationalization could have been a lot more expensive. Policy Responses -- Financial Repair, cont.

23 The PPIP was attacked from both sides in part due to anger over AIG bonuses, etc. But the stock market reacted very positively, and some respected commentators are supportive. FT, Mar 25, 2009

24 Desirable longer-term financial reforms Desirable longer-term financial reforms Mortgages Mortgages Consumer protection, incl. standards for mortgage brokers Consumer protection, incl. standards for mortgage brokers Fix “originate to distribute” model, so lenders stay on the hook. Fix “originate to distribute” model, so lenders stay on the hook. Banks: make Basle capital requirements less cyclical Banks: make Basle capital requirements less cyclical Extend bank regulation to “near banks.” Extend bank regulation to “near banks.” Regulatory agencies: Merge SEC & CFTC. Regulatory agencies: Merge SEC & CFTC. Create a central clearing house for CDSs. Create a central clearing house for CDSs. Credit ratings: Credit ratings: Reduce reliance on ratings. Reduce reliance on ratings. Reduce ratings agencies’ conflicts of interest. Reduce ratings agencies’ conflicts of interest.

25 Policy Responses, continued Unprecedented US fiscal expansion. Unprecedented US fiscal expansion. Obama proposed an $825 expansion Obama proposed an $825 expansion Version passed by Congress was just a bit worse. Version passed by Congress was just a bit worse. Good old-fashioned Keynesian stimulus Good old-fashioned Keynesian stimulus Even the belief that spending provides more stimulus than tax cuts has returned; Even the belief that spending provides more stimulus than tax cuts has returned; not just from Larry Summers, for example, not just from Larry Summers, for example, but also from Martin Feldstein. but also from Martin Feldstein.

26 Fiscal response “Timely, targeted and temporary.” American Recovery & Reinvestment Plan includes: Aid to states: Aid to states: education, education, Medicaid…; Medicaid…; Other spending. Other spending. Unemployment benefits, food stamps, Unemployment benefits, food stamps, especially infrastructure, and especially infrastructure, and Computerizing medical records, Computerizing medical records, smarter electricity distribution grids, and smarter electricity distribution grids, and high-speed Internet access. high-speed Internet access.

27 Proposed fiscal stimulus also included Tax cuts Tax cuts Cut for lower-income workers Cut for lower-income workers EITC, EITC, child tax credit. child tax credit. Fix for the AMT (for the middle class). Fix for the AMT (for the middle class). Other tax cuts demanded by Republicans Other tax cuts demanded by Republicans But soon will need to return toward fiscal discipline But soon will need to return toward fiscal discipline Let Bush’s pro-capital tax cuts expire in Let Bush’s pro-capital tax cuts expire in Economists want to substitute energy taxes for others. Economists want to substitute energy taxes for others.

28 Motivation for macroeconomic intervention The view that Keynes stood for big government is not really right. The view that Keynes stood for big government is not really right. He wanted to save market microeconomics from central planning, which had allure in the 30s & 40s. He wanted to save market microeconomics from central planning, which had allure in the 30s & 40s. Some on the Left today reacted to the crisis & Obama’s election by hoping for a new New Deal. Some on the Left today reacted to the crisis & Obama’s election by hoping for a new New Deal. My view: faith in unfettered capitalist system has been shaken with respect to financial markets, true; but not with respect to the rest of the economy; My view: faith in unfettered capitalist system has been shaken with respect to financial markets, true; but not with respect to the rest of the economy; Obama’s economics are centrist, not far left. Obama’s economics are centrist, not far left.

29 Do we know this won’t be an other Great Depression? True, the origins were similar. True, the origins were similar. But one hopes we won’t repeat the 1930s’ mistakes But one hopes we won’t repeat the 1930s’ mistakes Monetary response: good this time Monetary response: good this time Financial regulation: we already have in place bank regulation to prevent runs. But that is not enough. Financial regulation: we already have in place bank regulation to prevent runs. But that is not enough. Fiscal response : okay, but constrained by inherited debt (and politics) Fiscal response : okay, but constrained by inherited debt (and politics) Trade policy: Let’s not repeat Smoot-Hawley! Trade policy: Let’s not repeat Smoot-Hawley! E.g., the Buy America provision E.g., the Buy America provision Mexican trucks Mexican trucks

30 The next crisis The twin deficits: The twin deficits: US budget deficit => current account deficit US budget deficit => current account deficit Until now, global investors have happily financed US deficits. Until now, global investors have happily financed US deficits. The recent flight to quality paradoxically benefited the $, The recent flight to quality paradoxically benefited the $, even though the international financial crisis originated in the US. even though the international financial crisis originated in the US. For now, US TBills are still viewed as the most liquid & riskless. For now, US TBills are still viewed as the most liquid & riskless. Sustainable? Sustainable? How long will foreigners keep adding to their $ holdings? How long will foreigners keep adding to their $ holdings? The US can no longer necessarily rely on support of foreign central banks, either economically or politically. The US can no longer necessarily rely on support of foreign central banks, either economically or politically.

31 Simulation of central banks’ of reserve currency holdings Scenario: accession countries join EMU in (UK stays out), but 20% of London turnover counts toward Euro financial depth, and currencies depreciate at the average 20-year rates up to From Chinn & Frankel (Int.Fin., 2008) Tipping point in updated simulation: 2015 Simulation predicts € may overtake $ as early as 2015

32 The decline in international currency status for the $ would be only one small part of a loss of power on the part of the US. But: A loss of $’s role as #1 reserve currency could in itself have geopolitical implications. [i] A loss of $’s role as #1 reserve currency could in itself have geopolitical implications. [i] [i] Precedent: The Suez crisis of 1956 Precedent: The Suez crisis of 1956 is often recalled as the occasion on which Britain was forced under US pressure to abandon its remaining imperial designs. is often recalled as the occasion on which Britain was forced under US pressure to abandon its remaining imperial designs. But recall also the important role played by a simultaneous run on the £ and the American decision not to help the beleaguered currency. But recall also the important role played by a simultaneous run on the £ and the American decision not to help the beleaguered currency. [i][i] Frankel, “Could the Twin Deficits Jeopardize US Hegemony,” Journal of Policy Modeling, 28, no. 6, Sept At Also “The Flubbed Opportunity for the US to Exercise Global Economic Leadership”; in The International Economy, XVIII, no. 2, Spring 2004 at [i]

33 “Be careful what you wish for!” US politicians have not yet learned how dependent on Chinese financing we have become.

Jeffrey Frankel James W. Harpel Professor of Capital Formation & Growth Harvard Kennedy School Blog: