Anatomy of the Financial Crisis - Harvard Kennedy School

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					  Anatomy of the Financial Crisis
                  with comments on
               Acemoglu, Brunnermeier,
                  El-Erian, & Portes

                  Jeffrey Frankel
      Harpel Professor of Capital Formation & Growth
                 Harvard Kennedy School




Meeting of Commission on Growth & Development
     at Center for International Development, April 20-21, 2009
            Six root causes of financial crisis
   




1. US corporate governance falls short
      E.g., rating agencies;
      executive compensation
           options;
           golden parachutes…                           MSN Money & Forbes



2. US households save too little,
  borrow too much.
3. Politicians slant excessively
  toward homeownership
         Tax-deductible mortgage interest, cap.gains;
         FannieMae & Freddie Mac;
         Allowing teasers, NINJA loans, liar loans…
                                                                          2
              Six root causes of financial crisis,   cont.
    







4. Starting 2001, the federal budget
   was set on a reckless path,
            reminiscent of 1981-1990

5. Monetary policy was too loose during 2004-05,
          accommodating fiscal expansion,
           reminiscent of the Vietnam era.

6. Financial market participants during
   this period grossly underpriced risk
       risks:
          housing crash,
          $ crash,
          oil prices,
          geopolitics….
                                                             3
             Current account imbalances
   Richard Portes: “Global Imbalances caused crisis.”
            => low volatility and interest rates => leverage.
       I disagree.
   I view low US National Saving as main source of CA.
       I agree with Richard this crisis is not the feared US sudden stop
            That’s the next crisis.
   But then why interest rates low? Easy money.                        (Like 1960s.)

   Many disagree (My “9 Reasons…” for Growth Commission)
       Global savings glut hypothesis        (Bernanke…)
            But measured world saving did not rise in this decade.
       Bretton Woods II (Dooley, Garber…) .
            But BW I operated for only 14 years. We’re near the end.
       US offers the high-quality assets. (Forbes, Gourinchas, Caballero..)
            Not really. Was clear in 2001 (Enron…)
                                                                                        4
But I would think herd mentality – the opposite of
heterogeneous views -- would be the bigger problem.


Yes.
Note: time-varying variance itself gives fat tails.


                           Yes.    We thought
                           securitization of
                           mortgages would
                           “spread the risk.” But it
                           spread risk like a virus !
                                                 5
I would like to suggest a fourth “new” idea
in volatility:
When using Black-Scholes or other
formulas to price options (VIX) or bond
spreads (corporate bonds), analysts simply
plug in variance estimated
from the recent past.

During 2004-2006, lagged variance
was low, tho forward-looking risk was high.
                                              6
As Adrian & Brunnermeier point out                          (p.5),


   “After a string of good news, risk seems tamed, but,
    when a new tail event occurs, the estimated risk measure
    may sharply increase. This problem is most pronounced
    if the data samples are short. Hence, regulatory
    requirements that are naively based on estimated risk
    measures would be stringent during a crisis and lax
    during a boom. This introduces procyclicality –
    exactly the opposite of the goal of effective regulation.”
    I couldn’t agree more. But: (i) Does this require
    that tail events are asymmetrically negative?
    (ii) If so, could the causality run from a variance
    innovation, via the risk premium, to a fall in
    asset prices, instead of the other way?                 7
      Origins of the financial/economic crises
                         Underestimated    Failures of                 Households        Federal
  Monetary
                            risk in         corporate           saving too little,
  policy easy
                         financial mkts
                                                                                         budget
          2004-05
                                           governance            borrowing too
                                                                                         deficits
                                                 Homeownership bias much

                            Excessive leverage in          Predatory
                                                                                           Low
                                                            lending
                             financial institutions                                      national
          Stock                                                         Housin            saving
          market                                   Excessive              g
                                                  complexity
          bubble                                                MBS     bubble
                                                                                               Foreig
                                          CDSs                  s                              n debt
China’s                                                         CDO
growth
                       Stock                                    s            Housin
 Gulf
                       market              Financial                            g
insta-                 crash                 crisis                           crash
 bility
                                             2007-08
                                                                                       Lower long-
                                                                                          term
              Oil                                                                      econ.growth
             price
             spike
             2007-08
                                          Recession                               Eventual loss
                                             2008-09                             of US hegemony
                                                                                                    8
         The return of Keynes

   Keynesian truths abound today:
     Origins of the crisis
     The Liquidity Trap

     Fiscal response

     Motivation for macroeconomic intervention:
      to save market microeconomics
     International transmission

     Need for macroeconomic coordination
                                                   9
   The origin of the crisis was an asset bubble
    collapse, loss of confidence, credit crunch….
   like Keynes’ animal spirits or beauty contest .
       Add in von Hayek’s credit cycle,
       Kindleberger ’s “manias & panics”
                    78




       the “Minsky moment,” &
       Fisher’s “debt deflation.”


   It was not a monetary contraction
    in response to inflation as were 1980-82 or 1991.
   But, rather, a credit cycle: 2003-04 monetary expansion
    showed up only in asset prices. (Borio of BIS.)
                                                              10
    Financial regulation
Good for Daron !


True.
But if we don’t draw
up an informed list,
politicians will come
up with a worse one.


                           11
    Desirable longer-term financial reforms
   Executive compensation
             Compensation committee not under CEO. Maybe need Chairman of Board.
             Discourage golden parachutes & options, unless truly tied to performance.
   Securities                                                                    Heavy
        Regulatory agencies: In US, merge SEC & CFTC?
        Create a central clearing house for CDSs .                               overlap
        Credit ratings:                                                             with
             Reduce reliance on ratings. AAA does not mean no risk.
             Reduce ratings agencies’ conflicts of interest.                     Richard
   Lending                                                                       Portes’
        Mortgages
             Consumer protection, incl. standards for mortgage brokers             list,
             Fix “originate to distribute” model, so lenders stay on the hook.
        Banks:                                                                      FT,
             Regulators shouldn’t let banks use their own risk models (VAR);     11/11/08
             should make capital requirements less pro-cyclical .
        Extend bank-like regulation to “near banks.”                                 12
I always thought CoVar stood for Covariance.
But that is no more – nor less – confusing than VAR standing for
Value at Risk instead of either Variance or Vector AutoRegression.
In fact CoVaRiance rather captures the spirit of the idea.
Adrian & Brunnermeier make the sensible
point that regulators should worry about how
much a bank contributes to systemic risk
(CoVaR), more than just own risk (VaR).

Analogous to a CAPM for regulators.
                                                               13
Lehman Brothers, whose failure inflicted maximum adverse
effect on the financial system in Sept. 2008, shows up with
almost the highest risk rating by CoVaR, but also by VaR.




                                                         14
I would phrase it:
We have learned something we should
have already known --
financial markets need a lot of
regulation, but market capitalism
still works best in the real economy.
                                    15
Motivation for macroeconomic intervention
   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.
       Remember, Bretton Woods blessed
        capital controls and free trade.


   Some on the Left today reacted to the crisis & election by
    hoping a new New Deal would overhaul the economy.
       My view: faith in the 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.                 16
              transmission remains as
 International
 powerful as ever (no “de-coupling”)
     Consistent with old-fashioned Keynes-Meade-
      Mundell-Fleming transmission via trade balances.



                                                     17
             International coordination
                of fiscal expansion?
As in the classic Locomotive Theory
   Theory: in the Nash non-cooperative equilibrium
    each country holds back from fiscal expansion
    for fear of adverse trade deficits.
       Solution: A bargain where all expand together.

   In practice: example of Bonn Summit, 1978
       didn’t turn out so well,
       primarily because inflation turned out to be a bigger problem than
        realized (& the German world was non-Keynesian).
       Inflation is less a problem this time. The Germans are the same.     18
               Multilateral initiatives
   Hold the line against protectionism
   Attempts at multilateral reform
       More inclusion of developing countries
          Locus shifted from G7 to G20 at London meeting                       (April).

          The IMF and World Bank
                  Reallocation of shares
                  Break US-EU duopoly on MD & President
                  Tripling of size of IMF, incl. new SDR issue (a la Keynes)
       Regulatory reform.
            Reduce procyclical Basel capital requirements; FSF; ….
   Coordinated expansion? Failed at London G-20.
            As had cooperation in 1933 (London Monetary & Economic Conference)
                                                                                           19
                                                                    US
                                                                 fiscal
                                                              stimulus
                                                            looks the
                                                             largest of
                                                             the G-10.
But most others have larger automatic stabilizers than the US

                                                                          20
 Mohamed El-Elrian & Mike Spence,
 “Essential Task for G20 Leaders is a
Cinema Trip to See A Beautiful Mind”
               The Daily Telegraph, March 30, 2009
   Apparently Mohamed and Mike think
    the producers of that movie took the
    opportunity to teach the audience the
    simple principle of the prisoner’s dilemma.
    A reasonable inference.
   But that’s not how I remember the movie.
    Hollywood doubts the analytical aptitude/interests of the public.21
22
                         Appendices
   Origins of the crisis
   The US recession
   Transmission to rest of world
   Global forecast
   The US policy response
       Monetary easing
       Financial repair
       Fiscal expansion
   Global current account imbalances
       Implications of the crisis for the status of the dollar
       Adjustment in surplus countries
   End of the 3rd emerging markets capital boom
                                                                  23
               Origins of the crisis
   Well before 2007,
    there were danger signals in US:
     Real interest rates <0 , 2003-04 ;
     Early corporate scandals (Enron…);

     Risk was priced very low,

     housing prices very high,
     National Saving very low,

     current account deficit big,

     leverage high,

     mortgages imprudent…
                                           24
           US real interest rate < 0, 2003-04
Source: Benn Steil, CFR, March 2009




                                                25
                 Onset of the crisis
   Initial reaction to troubles:
     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 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
     the worst in 75 years,

     and is as bad abroad as in the US.                     26
                  US Recession
 In December 2008, NBER Business
Cycle Dating Committee proclaimed
US recession had started in December 2007.
   As of March 2009, the recession’s length ties the
    postwar record of 1981-82 (16 months).
     Recovery unlikely before late 2009
     => recession is already longest since 1930s.

   Likely also to be as severe as oil-shock recessions
    of 1974 and 1980-82.
                                                     27
      BUSINESS CYCLE REFERENCE DATES                          Source: NBER


          Peak                                       Trough   Contraction
                    Quarterly dates are in parentheses            Peak to Trough

August 1929 (III)                     March 1933 (I)                  43
May 1937 (II)                         June 1938 (II)                  13
February 1945 (I)                     October 1945 (IV)                8
November 1948 (IV)                    October 1949 (IV)               11
July 1953 (II)                        May 1954 (II)                   10
August 1957 (III)                     April 1958 (II)                  8
April 1960 (II)                       February 1961 (I)               10
December 1969 (IV)                    November 1970 (IV)              11
November 1973 (IV)                    March 1975 (I)                  16
January 1980 (I)                      July 1980 (III)                  6
July 1981 (III)                       November 1982 (IV)              16
July 1990 (III)                       March 1991 (I)                   8
March 2001 (I)                        November 2001 (IV)               8
December 2007 (IV)

Average, all cycles:
              1854-2001                   (32 cycles)                  17
           1945-2001 (10 cycles)                                     10            28
US employment peaked in Dec. 2007,
     which is the most important reason why
the NBER BCDC dated the peak from that month.
  Since then, 5 million jobs have been lost (4/3/09).




    Payroll employment series series Source: Bureau of Labor Statistics
         Payroll employment          Source: Bureau of Labor Statistics

                                                                          29
        My favorite monthly indicator:
      total hours worked in the economy




It confirms: US recession turned severe in September,
 when the worst of the financial crisis hit (Lehman bankruptcy…)
                                                           30
The US recession so far is deep
compared to past and to others’

                    Source: IMF, WEO, April 2009




                                                   31
        Recession was soon transmitted
                to rest of world:
   Contagion: Falling securities
    markets & contracting credit.
       Especially in those countries with weak fundamentals:
        Iceland, Hungary & Ukraine…
       Or oil-exporters that relied heavily on high oil prices: Russia…
       But even where fundamentals relatively strong: Korea, Brazil…

   Some others experiencing their own housing crashes:
    Ireland, Spain…

   Recession in big countries was soon transmitted
     to all trading partners through loss of exports.
                                                                      32
International Trade has Plummeted




        Source: OECD




                                    33
 The recession has hit more
countries than any in 60 years




                                 34
Forecasts




            35
Interim forecast   OECD 3/13/09




                         Forecast
                         for 2009 =
                           -3½%




                               36
                 “World Recession”
   No generally accepted definition.
     A sharp fall in China’s growth from 11% is a recession.
     Usually global growth < 2 % is considered a recession.



   The World Bank now (March) forecasts
    negative global growth in 2009,
       for the first time in 60 years.



                                                           37
Unemployment rates are rising everywhere




                                           38
Do we know this won’t be another Great Depression?

  One hopes we won’t repeat the mistakes of the 1930s.
     Monetary response: good this time

     Financial regulation: we already have bank regulation
      to prevent runs.      But it is clearly not enough.

     Fiscal response: OK, but : constrained
      by inherited debt. Also Europe was
      unwilling to match our fiscal stimulus at G-20 summit.

     Trade policy: Let’s not repeat Smoot-Hawley !
             E.g., the Buy America provision
             Mexican trucks                                   39
The Fed certainly hasn’t repeated the
  mistake of 1930s: letting M1 fall.




                   2008-09

                                     Source:
                             1930s    IMF,
                                     WEO,
                                      April
                                      2009
                                     Box 3.1



                                         40
                U.S. Policy Responses
    Monetary easing is unprecedented,
    appropriately. But it has largely run its course:
     Policy      interest rates ≈ 0.                 (graph)


        The     famous liquidity trip is not mythical after all.
               As Krugman & others warned us re Japan in 90s.

          & lending, even inter-bank, builds in big spreads
               since mid-2007, not just since September 2008.   (graph)



   Now aggressive quantitative easing, as the Fed
    continues to purchase assets not previously dreamt of.
                                                                           41
                                       Source: OECD
Major central banks have cut interest rates sharply.




                                                       42
   Bank spreads rose sharply
 when sub-prime mortgage crisis hit (Aug. 2007)
and up again when Lehman crisis hit (Sept. 2008).




 Source:
 OECD,
 Datastream




                                                    43
            Corporate spreads
between corporate & government benchmark bonds
         zoomed after Sept. 2008




               US




               €


                                             44
        Policy Responses,             continued


   Obama policy of “financial repair”:
Infusion of funds has been more conditional,
     vs. Bush Administration’s no-strings-attached.
     Some money goes to reduce foreclosures.

     Conditions imposed on banks that want help:
          (1) no-dividends rule,
          (2) curbs on executive pay,

          (3) no takeovers, unless at request of authorities &

          (4) more reporting of how funds are used.

       But so far they have avoided “nationalization” of banks
                                                              45
Policy Responses -- Financial Repair,            cont.




   Secretary Geithner announced PPIP 3/23/09:
    Public-Private Partnership Investment Program
     When       buying “toxic” or “legacy assets” from banks,
        theirprices 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.
                                                             46
Policy Responses -- Financial Repair,                   cont.



 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,
      butadmittedly bear all the downside risk.
   Nationalization could have been a lot more expensive.
                                                                47
The PPIP was attacked from both sides
      in part due to anger over AIG bonuses, etc.




       FT, Mar 25, 2009

   But the stock market reacted very
    positively, and some respected
    commentators are supportive.                    48
              Policy Responses, continued

 Unprecedented US               fiscal expansion.
  Obama proposed an $825 expansion
  Version passed by Congress was just a bit worse.

  Good old-fashioned Keynesian stimulus
         Even the belief that spending provides more
         stimulus than tax cuts has returned;
           not just from Larry Summers,
                              for example,
           but also from Martin Feldstein.

                                                        49
                 Fiscal response
“Timely, targeted and temporary.”

American Recovery & Reinvestment Plan includes:
   Aid to states:
     education,
     Medicaid…;

   Other spending.
       Unemployment benefits, food stamps,
       especially infrastructure, and
           Computerizing medical records,
           smarter electricity distribution grids, and
            high-speed Internet access.                  50
Fiscal stimulus also included

   Tax cuts
     for lower-income          workers (“Making Work Pay”)
           EITC,
           child tax credit.
     Fix for the AMT (for the middle class).
   But soon will need to return toward fiscal discipline
     Let Bush’s pro-capital tax cuts expire in 2011.
     Economists want to substitute energy taxes for others.



                                                          51
                        The next crisis

   The twin deficits:
       US budget deficit => current account deficit
   Until now, global investors have happily financed US deficits.
   The recent flight to quality paradoxically benefited the $,
       even though the international financial crisis originated in the US.
       For now, US TBills are still viewed as the most liquid & riskless.
   Sustainable?
       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.
                                                                         52
        The 2007-08 financial crisis has
       probably further undermined US
      monetary hegemony in the long run

   US financial institutions have lost credibility
   Expansionary fiscal and monetary policy may show
    up as $ depreciation in the long run.
   The long slow decline of the $ as an international
    reserve currency may accelerate.


                                                     53
Simulation of central banks’ of reserve currency holdings
 Scenario: accession countries join EMU in 2010. (UK stays out),
   but 20% of London turnover counts toward Euro financial depth,
  and currencies depreciate at the average 20-year rates up to 2007.

               From Chinn & Frankel (Int.Fin., 2008)

                     Simulation predicts € may overtake $ as early as 2015




                                            Tipping point in updated
                                            simulation: 2015
                                                                         54
                                                                         54
The 2001-2020 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.

    Historical precedent: £ (1914-1956)
   With a lag after US-UK reversal of ec. size & net
    debt, $ passed £ as #1 international currency.
   “Imperial over-reach:” the British Empire’s
    widening budget deficits and overly ambitious
    military adventures in the Muslim world.
                                                    55
         Precedent: The Suez crisis of 1956                                                                                  [i]


                    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.

[i] Frankel, “Could the Twin Deficits Jeopardize US Hegemony,”
           Journal of Policy Modeling, 28, no. 6, Sept. 2006.
          At http://ksghome.harvard.edu/~jfrankel/SalvatoreDeficitsHegemonJan26Jul+.pdf .
          Also “The Flubbed Opportunity for the US to Exercise Global Economic Leadership”;
          in The International Economy, XVIII, no. 2, Spring 2004 at http://ksghome.harvard.edu/~jfrankel/FlubJ23M2004-.pdf

                                                                                                                                    56
                                                                                                                                    56
     “Be careful what you wish for!”
US politicians have not yet learned how dependent
     on Chinese financing we have become.




                                              57
     In the short run, however, the financial
    crisis has caused a flight to quality which
      apparently still means a flight to US$.
   US Treasury bills are more in demand than ever,
    as reflected in very low interest rates.
   The $ appreciated in 2008, rather than depreciating as the
    “hard landing” scenario had predicted.
   => The day of reckoning had not yet arrived.
   Recent Chinese warnings may be a turning point:
        Premier Wen worried US T bills will lose value.
        PBoC Gov. Zhou proposed
         replacing $ as international currency.
                                                                 58
Global Current Account Imbalances
                 may now be forced to adjust

   US deficit will likely diminish,
       though adjustment requires $ depreciation.

   Who must take corresponding reduction in
    current account surpluses?
       Europe says: “Not us. Overall we are in balance.”
       Others say: Europe can expect to take a share, roughly
        proportionate to its share in world trade,
       IMF seems to think oil exporters will take all adjustment
                                                       (see graph)

                                                                     59
                Current account adjustment:
                 US vis-á-vis oil exporters

(as % of GWP;
 source: IMF)




                                              60
            The OECD sees the €-area
          bearing much of the adjustment.




Source: OECD Economic Outlook, Nov. 2008.   3/ as % of GDP   61
          But emerging markets
now have to spend some hard-earned reserves




                                         62
 3 cycles of net private capital flows
         to emerging markets, by region
          peaking in              1982, 1997 and                    2008




Source: Capital Flows to Emerging Market Economies, IIF, 1/27/09.

                                                                           63
Capital flows to emerging markets
          peaked in 2007




              from: EM Fund Flows, Citi, December 200864
Source: Benn Steil, Lessons of the Financial Crisis , CFR, March 2009




                                                                        65
BRIC growth has disappeared




                              66
                   Jeffrey Frankel
James W. Harpel Professor of Capital Formation & Growth
               Harvard Kennedy School




 http://ksghome.harvard.edu/~jfrankel/index.htm
 Blog: http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/

				
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