The Global Financial Crisis Of 2008


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The Global Financial Crisis Of 2008

  1. 1. The Global Financial Crisis of 2008 Chandra Athukorala Arndt-Corden Division of Economics Research School of Pacific and Asian Studies
  2. 2. Preview <ul><li>Financial Crisis: A ‘hardy perennial’ </li></ul><ul><li>- ‘[A] subject that does not appear to be going out of fashion’ </li></ul><ul><li>(Robert M Solow, in the Foreword to Kindleberger and Aliber 2005)‏ </li></ul>
  3. 3. <ul><li>Financial crisis results from the implosion of asset price bubbles (or from the sharp depreciation of national currencies)‏ </li></ul><ul><li>(A bubble; a non-sustainable pattern of price changes or cash flows)‏ </li></ul><ul><li>Bubbles are generally associated with a robust, prolong economic expansion : </li></ul><ul><li>manias associated with growth euphoria </li></ul><ul><li>rational behaviour morphs into irrational exuberance </li></ul><ul><li>A certain event, perhaps a change in government policy, an unexplained failure of a firm/bank previously thought to have been successful leads to bursting of the bubble. </li></ul><ul><li>Bubbles always implore, but this does not always lead to a crisis (a soft landing is possible) – depends very much on the money and capital market institutions of the time. </li></ul>
  4. 4. <ul><li>Financial crises have been more extensive and pervasive in the last four decades than in any previous period. (An outcome of ‘financial globalization’?)‏ </li></ul><ul><li>We are now witnessing the third global crisis in a decade (1997-98 Asian crisis; dot-com crisis in 2001; the US housing market crisis 2007 - ) </li></ul><ul><li>The ‘mother of all crises’ (so far!) in recorded history has been the Great Depression following the crash of the stock market bubble in the US in the late 1920s. </li></ul><ul><li>The current unfolding crisis is similar in the source of origin (US, the largest economy) and global spread. </li></ul><ul><li>The number of bank failures are going to be larger. </li></ul><ul><li> </li></ul>
  5. 5. <ul><li>Could it usher in the Second Great Depression? </li></ul><ul><li>Unlikely </li></ul><ul><li>The global economy is much more ‘diversified’ than in the thirties. </li></ul><ul><li>All major countries have central banks which are ready to act as ‘lenders of last resort’ </li></ul><ul><li>Floating exchange rate regimes (attempt to stick to the ‘gold standard’ was a major factor in deepening crisis in the 1930s)‏ </li></ul>
  6. 6. The US Housing Boom and Bubble <ul><li>Three key factors provided the setting: </li></ul><ul><li>Surge in capital flows to the US </li></ul><ul><ul><li>(A reflection of the on-going process of financial globalization. </li></ul></ul><ul><ul><li>implosion of the real state and stock bubble in Japan in the early 1990s, the Asian crisis 1997-98, China’s meteoric economic rise played a role)‏ </li></ul></ul><ul><li>Robust growth propelled by productivity growth since the mid- 1990. </li></ul><ul><li>(productivity growth: 1974-95: 1.4%, 1996-2007 2.5% Rapid productivity growth means the economy could grow faster without exacerbating inflation) </li></ul><ul><li>Historically low interest rates </li></ul><ul><li>in the aftermaths of the collapse and the terrorist attack of September 11, 2001, FED lowered federal fund rates to 1 percent and kept until June 2004. The subsequent hikes were marginal)‏ </li></ul>
  7. 7. <ul><li>The house price inflation began to exceed consumption price inflation as early as 1998. </li></ul><ul><li>(Shiller 2000)‏ </li></ul><ul><li>The rate of expansion of house prices began to exceed household income growth staring in 2004 (a clear sign of a bubble) (Harris 2008)‏ </li></ul><ul><li>Housing stock value increased from about 4% of GDP in the 1990s to 6% in 2006. </li></ul><ul><li>Almost two thirds of house owners had a mortgage by 2007 (compared to 50% in the 1990s)‏ </li></ul><ul><li>Home-loans as percentage of consumption: 1990s: 26%; 2006: 36% </li></ul>
  8. 8. <ul><li>Signs of aggressive speculative behaviour </li></ul><ul><li>Surge in the use of hybrid (sub-prime) mortgages, which required no down payment, demanded little documentation of income or assts, or offered low initial ‘teaser’ rates of payments. </li></ul><ul><li>(by 2006 sub prime mortgages accented for 15% of the mortgage market)‏ </li></ul><ul><li>A surge in the number of buyers who were self identified speculators (‘flippers’)‏ </li></ul><ul><li>Markets in ‘hot areas’ were getting hotter </li></ul><ul><li>(home price increases: Metro areas: 5% in 2004 to 7% in 2006 Cities: 20% to 28%)‏ </li></ul>
  9. 9. <ul><li>Linkages to the rest of the economy </li></ul><ul><li>Housing sector boom was accompanied by a stock market boon </li></ul><ul><li>New financial derivatives based on to mortgages contributed to massive expansion in overall financial systems </li></ul><ul><li>Thus, there was a high risk of a synchronized price declines across many speculative markets. </li></ul><ul><li>‘ regulatory failure’ amplified the potential risk. </li></ul><ul><li>- There was no regulatory reforms to match new financial innovations </li></ul><ul><li>- New innovations made it hard for regulators to keep track of firms’/banks’ exposure to credit risk. </li></ul>
  10. 10. <ul><li>Was Greenspan part of the problem? </li></ul><ul><li>(Shiller 2000, Soros 2008, Harriss 2008, Rubin 2003)‏ </li></ul><ul><li>Greenspan was an ‘easy-money dove’ </li></ul><ul><li>(A an easy money dove tends to be soft on inflation and less inclined to hike interest rate. </li></ul><ul><li>A hawk is tough on inflation and inclined to hike interest rates (and inflict pain on capital markets)) </li></ul><ul><li>He inadvertently encouraged the bubbles through talks of higher trend growth propelled by productivity growth and persistent low inflation 9in this he exaggerated the China factor. </li></ul><ul><li>He ignored the signs of housing bubble and kept short-term interest rates too low for too long. </li></ul>
  11. 11. Bursting of the Bubble and Onset of the Crisis <ul><li>Rumbling of the housing bubble from third quarter of 2007 </li></ul><ul><li>Trigger: sub-prime credit defaults. </li></ul><ul><li>Feedback loop in the housing sector)‏ </li></ul><ul><li>The sharp pull back in lending to supreme borrows cased a sharp drop in demand for homes (over 1 million homes on sale by mid 2008)‏ </li></ul><ul><li>Falling house prices </li></ul><ul><li>Negative household equity (i.e the value of the home is less than the value of the mortgage) creating an incentive for defaulting loans. </li></ul><ul><li>More houses are being sold at bargain prices, pushing home process lower. </li></ul>
  12. 12. <ul><li>Falling home construction and weaker demand, results in further contraction in demand for houses </li></ul><ul><li>In addition </li></ul><ul><li>Economy wide concretionary effects arising from collapsing credit and share markets. </li></ul>
  13. 13. <ul><li>Unfolding crisis </li></ul><ul><li>Nov/Dec 2007: The market for inter-bank lending tightened up dramatically </li></ul><ul><li>January/February 2008: The auction rate market (where state and local governments borrowing is rolled over) ran into serious problems </li></ul><ul><li>March 2008; Bear sterns, a major investment bank, was absorbed by JP Morgan </li></ul><ul><li>September 2008: Lehman Brothers collapsed - a bellwether event which lead to virtual drying-up of the commercial papers market seized. </li></ul>
  14. 14. Policy Response <ul><li>Greenspan-style gradualism in 2006 and 2007: the FED continued to focus on inflation </li></ul><ul><li>Gradualism ended in January 2008: Bernanke announced that recession, not inflation, was the main concern. </li></ul><ul><li>Late January 2008: 125 basic point cuts in fund rate accompanied by array of new programs to directly add liquidity to credit market </li></ul><ul><li>September 2008: 700 billion rescue package </li></ul><ul><li>Recapitalization of back has become part of the policy package (following the British move in October)‏ </li></ul>
  15. 15. <ul><li>Current state of the US economy </li></ul><ul><li>The US economy may well be in recession already. Economic collapse is likely to continue well into 2009 (and beyond?) </li></ul><ul><li>Retail sales dropped by 1.35% in 3 rd quarter 2008 </li></ul><ul><li>Almost a quarter of home owners with mortgages have zero or negative equity. </li></ul><ul><li>Because of the collapse of the commercial paper market, companies are facing straining balance-sheet capacity </li></ul>
  16. 16. Global Spread <ul><li>In the second half of 2007, banks and hedge funds around the world reported major losses from sub-prime mortgages </li></ul><ul><li>September 2007: Northern Rock, a major bank, was rescued by the UK government </li></ul><ul><li>Widespread bank failures in the second and third quarter of 2008 in a number of countries: UK, Belgium, Sweden, Iceland </li></ul><ul><li>In the 2 nd week of October, Britain ‘nationalized’ much of its banking industry </li></ul><ul><li>The impact on Asian countries? </li></ul><ul><li>No signs of significant ripple effects of the financial crisis, </li></ul><ul><li>but bound to be affected by the second-round (real-sector contrition in the US and other developed countries) effects)‏ </li></ul>
  17. 17. Reference <ul><li>Harris, Ethan S. (2008), Ben Bernanke’s FED: The Federal Reserve After Greemspan, Cambridge, AMS: Harvard Business Press. </li></ul><ul><li>Hartcher, Peter (2006), Bubble Man: Allan Greenspan & the Missing 7 Trilliona Dollars, Melbourne: Black Ink. </li></ul><ul><li>Kindleberger, Charls P. and Robert Aliber (2005), Manias, Panics, and Crashes: A History of the Financial Crises, Ney York: john Wiley and Sons. </li></ul><ul><li>Rubin, Robert E. and Jacob Weisberg (2003), In a Uncertain World,New York: Random House. </li></ul><ul><li>Shiller, Robert I. (2000), Irrational Exuberance, Priceton, NJ, Priceton University Press. </li></ul><ul><li>Soros, George (2008), The Credit Crisis of 2008 and what it Means, New York: Foreign Affairs </li></ul>