EC 450 - Global crisis 2008-09

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EC 450 - Global crisis 2008-09

  1. 1. EC 450 The current global financial crisis: causes and dynamics 1. It’s too soon for anyone to have applied rigorous economic modeling to the current crisis; there’s too much missing data at this point. On the other hand, the crisis did not strike economists as a bolt from the blue. Few predicted its exact timing, but most thought that very disruptive corrections were due – and indeed, were a surprisingly long time coming. So my lecture today will appeal to analyses that were already being worked out before September 2009. I rely most heavily on the work of Robert Schiller, Paul Krugman, and Simon Johnson – plus my own sense as an economist of what’s going on and why, based on the indicators on which I’ve learned to concentrate. (In September, I estimated that probable losses by US financial institutions would turn out to be in the region of $10 trillion. That now looks to have been about right.) 2. The immediate source of the crisis is that large banks in Europe and America hold assets, many based on home mortgages, that are worth far less than what they paid for them. If they sold these assets at their present market values, the markdowns in corporate worth they’d be forced to declare would bankrupt them. In the meantime, they need all the cash they can hoard, so they’ll lend only under the least risky circumstances. A major source of that problem is that they won’t lend to one another (since they themselves are high risk debtors). Thus when a solid investment opportunity appears, an individual bank can’t raise short-run finance by relying on the power of the banking network. Thus potentially profitable businesses can’t raise finance to expand, or, in many cases, cover temporary liquidity gaps. In the latter circumstances, healthy businesses often go under. Frozen and collapsing businesses lead to mass job losses. This puts steady downward pressure on consumer spending,
  2. 2. which exacerbates the business crisis. This is the classic pattern of a major recession rooted in a crisis for financial institutions. Its dynamics are indeed quite similar to those that brought on the Great Depression of 1929-1939. 3. How bad could it get? The most dire situation arises if the economy falls into general price and wage deflation. This increases the value of money, thus increasing the value of debt held by households, businesses and government. More of them become insolvent. Meanwhile wages and corporate receipts fall. This leads to further contraction, which leads to further deflation, and so on in a self-driving spiral. Such a spiral occurred on a global scale in 1929-1932, and wiped out about 70% of world wealth. Countries in the grip of panic responded by erecting trade barriers that severely reduced the efficiency of international markets. This ultimately led the two industrial powers most dependent on trade, Germany and Japan, to make war on the rest of the world. 70 million people were killed. But massive government spending on military supplies reversed the prevailing deflationary pressures, and ended the depression. 4. So how did the financial institutions get into such trouble? I believe there were two deep causes, both ultimately institutional: (i) China has no legal labour unions. Its unelected government, uneasy about its legitimacy, has been determined to deliver very high and consistent growth to its people, and is under no direct pressure to allow growth to be naturally moderated by transfers from investment capital to the wage bill. In consequence, while China grew at annual rates of 8-11% for almost twenty years – the highest sustained rate in the history of the world – it
  3. 3. invested a very high proportion of the profits from this growth. Much of this investment went into domestic infrastructure. But then China had another problem: a very primitive banking system that was inefficient as an allocator of capital. So China used the US banking system instead. It poured money into American assets, creating a huge capital surplus. Some of this found its way back to China as FDI in Chinese businesses. Much more of it passed through the hands of American consumers and returned to China as payment for exported goods. Finally, to add fuel to this fire, the Chinese prevented their currency from appreciating to the extent that was natural given the levels of national savings. This made Chinese export goods cheaper and inflowing US dollars more productive. A direct consequence of this was a huge glut of capital in America that wasn’t based on any increases in US productivity. (US productivity slightly fell during 2002-2008.) This meant that at least one bubble had to form in at least one asset market, unless the Fed set interest rates high or sterilized all the incoming money (by buying their own bonds). Not wanting to rain on the party Americans were enjoying, the Fed did neither of these things. So several bubbles formed: in bonds, in equities, in returns on leveraged mergers – and especially, massively, in residential property. Starting in 2007, and then with accelerating force through 2008, this bubble burst, as, sooner or later, all bubbles do. (ii) The financial sector underwent profound institutional changes during the period 1990-2009. The emergence of the global communications network enormously increased the capacity of holders of assets to hedge and diversify. This brought huge new efficiencies that put ever higher proportions of capital to work in multiplying investments. At the same time, a steadily higher share of global capital was controlled by institutional investors, such as pension funds, mutual fund
  4. 4. manufacturers and sovereign wealth funds. Many institutions such as insurance companies and casinos started acting as de facto investment banks. This loosened relationships between shareholders in companies and the companies in which their funds were invested. (A pension fund with investments in thousands of companies would tend to be an inactive shareholder in all of them.) This in turn freed executives and their tame directors to maximize their own interests. They did this by linking their compensation to the future share prices of their companies through huge option bonuses and other devices. This in turn incentivized them to relentlessly push up share values by engaging in mega-deals, especially mergers and acquisitions financed by hedge funds, investment banks and private equity investors. The rule of thumb was: the larger in financial terms the better. Protected by guarantees of highly generous severance terms if strategies failed, executives acquired prospects for massive personal profits when risky investments paid off, and limited personal damage when risky investments went bad. Thus executives, especially in banks, massively inflated the property bubble by combining mortgages into securities, especially derivatives, and selling them to third parties. Adding (a lot of) fuel to the fire, AIG took advantage of a failure of coordination between US and EU regulations to insure purchases of mortgage-based securities by European banks through credit-default swaps. Thus the bubble built on Chinese and other emerging-market capital inflows was blown up to mighty proportions. Worse, when the bubble burst, it was the financial sector that was positioned closest to the explosion. In late 2008 and early 2009 it became evident that all of the large American and European investment banks, and a majority of large commercial banks, plus AIG, were insolvent the moment they had to reveal their losses by marking down their so-called ‘toxic assets’ – mainly securities built out of bets on mortgages.
  5. 5. 5. What about other causal influences regularly mentioned in the media and by economists? Congress’s encouragement of Fannie Mae and Freddie Mac to guarantee millions of poorly supported mortgages certainly compounded the bubble, and dragged huge numbers of less wealthy Americans directly into personal ruin when it burst. But without the forces that inflated the bubble in the first place, the damage that Fannie and Freddie could have done would have been strictly circumscribed. As for deregulation of the financial services industry under Presidents Clinton and Bush, I am unconvinced that this was an unambiguous contributor at all. On the hand, it made it easier for executives to engineer bubble-inflating transactions, and it allowed commercial banks to act like investment banks, thus allowing the entire US financial industry to become imperiled, instead of only part of it. (Canadian banks, barred by regulations from playing dangerous games, remain blue-chip investments.) On the other hand, deregulation facilitated the rise of hedge funds, which, by genuinely diversifying and efficiently allocating risk, made the world genuinely richer. This richer world is correspondingly better equipped than it otherwise would be to weather the current storm. Hedge funds now provide the lever with which the Obama administration will try to rescue the banks (by guaranteeing hedge fund purchases of ‘toxic assets’). Clearer culprits than financial deregulation, in my view, were failure by the Securities Exchange Commission to adequately oversee such regulations as remained, and failure by the Department of Commerce to regulate corporate governance so as to encourage active oversight of executives by independent directors. 6. How do I see the prospects for recovery? If the administration can free the banks to resume lending, recovery in the US could
  6. 6. be underway as early as mid-2010. Standing in the way of this are (a) political spoiler interests that may sabotage the bank rescue effort; (b) precipitate collapse of manufacturing, which could in turn trigger falling wages and deflation; (c) a rise in economic nationalism and protectionism around the world (including in the US itself), which could shut off the export markets on which any US recovery must depend. 7. The situation in most of the world is worse than in the US. Spain, Ireland and the UK had bigger property bubbles. Large European banks were more exposed on average to mortgage- backed debt than US ones. Countries that depend on export of manufactured goods to America and Europe, such as Japan, South Korea and Taiwan, are suffering through substantially worse recessions (so far) than America. Countries that depend on commodity exports, such as Russia, Brazil, Australia and South Africa, along with most LDCs, have suffered collapsing world prices for their sources of Dollars. Along with reducing revenue, this has eroded their currency reserves – which could be deadly for those, such as South Africa, Hungary, Turkey and others, that have current account deficits or thin foreign reserves. Such countries could suffer currency collapses, and we might have deflation in rich countries at the same time as runaway inflation in some poor and developing ones. An outbreak of general protectionism would be catastrophic for many emerging markets. 8. The last time the world suffered so strongly coordinated a recession was 1929-39. That one ended in global war and genocide because, almost everywhere, populism swept aside sound economics. The small minority of economically literate people in the world may be the resource needed to save us from repeating this fate, if they can politically coordinate.

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