The Worst Crisis in 75 The Worst Crisis in 75 Years: Years: Origins, Magnitude Origins, Magnitude

and Responseand Response

Jeffrey FrankelJeffrey FrankelHarpel Professor of Capital Formation & GrowthHarpel Professor of Capital Formation & Growth

Harvard UniversityHarvard University

The Boston Security Analysts The Boston Security Analysts SocietySociety

Thursday, June 25, 2009. Thursday, June 25, 2009.

2

Origins of the crisisOrigins of the crisis Well before 2007, Well before 2007,

there were danger signals there were danger signals in US:in US: Real interest rates <0 , Real interest rates <0 ,

2003-04 ; 2003-04 ; Early corporate scandals Early corporate scandals

(Enron (Enron 20012001…);…); 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

US real interest rate < 0, US real interest rate < 0, 2003-04 2003-04

Real interest Real interest rates <0 rates <0

Source: Benn Steil, CFR, March 2009

4

In 2003-07, market-perceived volatility, as measured by options (VIX), plummeted.So did spreads on US junk & emerging market bonds.In 2008, it all reversed.

Source: “The EMBI in the Global Village,” Javier Gomez, May 18, 2008

juanpablofernandez.wordpress.com/2008/05/

5

Six root causes of financial Six root causes of financial crisiscrisis

1. US1. US corporate governance falls corporate governance falls shortshort E.g., rating agencies; E.g., rating agencies; executive compensationexecutive compensation … …

options; options; golden parachutes…golden parachutes…

2. US households save too little,2. US households save too little, borrow too much.borrow too much.

3.3. Politicians slant excessively Politicians slant excessively toward toward homeownershiphomeownership

Tax-deductible mortgage interest, cap.gains; Tax-deductible mortgage interest, cap.gains; FFannieannieMMae & Freddie Macae & Freddie Mac; ; Allowing teasers, Allowing teasers, NINJANINJA loans, liar loans… loans, liar loans…

MSN Money & Forbes

6

Six root causes of financial crisis,Six root causes of financial crisis, cont.cont.

4. Starting 2001, the 4. Starting 2001, the federal budgetfederal budget was set on a reckless path,was set on a reckless path,

reminiscent of 1981-1990reminiscent of 1981-1990

5. Monetary policy was too loose during 5. Monetary policy was too loose during 2004-05,2004-05,

accommodating fiscal expansion,accommodating fiscal expansion, reminiscent of the Vietnam era.reminiscent of the Vietnam era.

6. Financial market participants during 6. Financial market participants during this period grossly this period grossly underpriced risk.underpriced risk. Possible risks were: Possible risks were:

housing crash, housing crash, $ crash, $ crash, oil prices, oil prices, geopolitics….geopolitics….

7

Monetary policy easy

2004-05

Federal budget deficits

Underestimated risk in

financial mkts

Failures of corporate

governance

Households saving too little, borrowing too

much

Excessive leverage in financial institutions

Stockmarketbubble

Housing

bubble

Stock marketcrash

HousingcrashFinancial

crisis2007-08

China’s growth

Low national saving

Lower long-term

econ.growth

Eventual loss of US hegemony

Recession2008-09

Oil price spike2007-08

Gulfinsta-bility

Foreign debt

Origins of the financial/economic Origins of the financial/economic crisescrises

Excessive complexity

CDSsMBSsCDOs

Predatory lending

Homeownership bias

8

Monetary policy easy

2004-05

Federal budget deficits

Underestimated risk in

financial mkts

Failures of corporate

governance

Households saving too little, borrowing too

much

Excessive leverage in financial institutions

Stockmarketbubble

Housing

bubble

Stock marketcrash

HousingcrashFinancial

crisis2007-08

China’s growth

Low national saving

Lower long-term

econ.growth

Eventual loss of US hegemony

Recession2008-09

Oil price spike2007-08

Gulfinsta-bility

Foreign debt

Origins of the financial/economic Origins of the financial/economic crisescrises

Excessive complexity

CDSsMBSsCDOs

Predatory lending

Homeownership bias

9

Onset of the crisisOnset of the crisis Initial reaction to troubles:Initial reaction to troubles:

Reassurance in mid-2007: “The subprime Reassurance in mid-2007: “The subprime mortgage crisis mortgage crisis is contained.” is contained.” It wasn’t.It wasn’t.

Then, “The crisis is on Wall Street, sparing Main Then, “The crisis is on Wall Street, sparing Main Street.” Street.” It didn’t.It didn’t.

Then Then de-couplingde-coupling : : “The US turmoil will have less effect on the rest “The US turmoil will have less effect on the rest of the world than in the past.” of the world than in the past.” It hasn’t.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.

10

Bank spreads rose sharplyBank spreads rose sharplywhen sub-prime mortgage crisis hit (Aug. when sub-prime mortgage crisis hit (Aug.

2007) 2007) and up again when Lehman crisis hit (Sept. and up again when Lehman crisis hit (Sept.

2008).2008).Source:

OECD Economic Outlook (Nov. 2008).

11

Corporate spreadsCorporate spreads between corporate & government between corporate & government

benchmark bondsbenchmark bonds zoomed after zoomed after Sept. 2008Sept. 2008

US

€

12

The return of KeynesThe return of Keynes

Keynesian truths abound todayKeynesian truths abound today:: Origins of the crisisOrigins of the crisis The Liquidity TrapThe Liquidity Trap Fiscal responseFiscal response Motivation for macroeconomic Motivation for macroeconomic

intervention:intervention:to save market microeconomicsto save market microeconomics

International transmissionInternational transmission Need for coordinated expansionNeed for coordinated expansion

13

The origin of the crisis was an asset bubble The origin of the crisis was an asset bubble collapse, loss of confidence, credit crunch….collapse, loss of confidence, credit crunch….

like Keynes’ animal spirits or beauty contestlike Keynes’ animal spirits or beauty contest . . Add in von Hayek’s credit cycle, Add in von Hayek’s credit cycle, KindlebergerKindleberger 78 78 ’s “manias & panics”’s “manias & panics” the “Minsky moment,” the “Minsky moment,” & Fisher’s “debt deflation.”& Fisher’s “debt deflation.”

The origin this time was The origin this time was notnot a monetary a monetary contraction contraction in response to inflationin response to inflation as were 1980-82 or 1991.as were 1980-82 or 1991.

But, rather, a credit cycle: 2003-04 monetary But, rather, a credit cycle: 2003-04 monetary expansion showed up only in asset prices. expansion showed up only in asset prices. (Borio of BIS.)(Borio of BIS.)

14

US RecessionUS Recession The US recession started in December 2007 The US recession started in December 2007

according to the NBER Business Cycle according to the NBER Business Cycle Dating Committee Dating Committee (announcement of Dec. 2008)(announcement of Dec. 2008) . .

As of May 2009, the recession’s length As of May 2009, the recession’s length broke broke thethe postwar records of 1973-75 & 1981-82 postwar records of 1973-75 & 1981-82 = 4 quarters; 16 months= 4 quarters; 16 months One has to go back to 1929-33 for a longer One has to go back to 1929-33 for a longer

downturn.downturn.

Probably also as severe Probably also as severe as recession of 1982as recession of 1982..

15

BUSINESS CYCLE REFERENCE DATESBUSINESS CYCLE REFERENCE DATES   Source: NBERSource: NBER

PeakPeak TroughTrough ContractioContractionn

Quarterly dates are in parenthesesQuarterly dates are in parentheses Peak to TroughPeak to Trough

August 1929 (III)August 1929 (III)May 1937 (II)May 1937 (II)February 1945 (I)February 1945 (I)November 1948 (IV)November 1948 (IV)July 1953 (II)July 1953 (II)August 1957 (III)August 1957 (III)April 1960 (II)April 1960 (II)December 1969 (IV)December 1969 (IV)November 1973 (IV)November 1973 (IV)January 1980 (I)January 1980 (I)July 1981 (III)July 1981 (III)July 1990 (III)July 1990 (III)March 2001March 2001 (I) (I)December 2007December 2007 (IV) (IV)

March 1933 (I)March 1933 (I)June 1938 (II)June 1938 (II)October 1945 (IV)October 1945 (IV)October 1949 (IV)October 1949 (IV)May 1954 (II)May 1954 (II)April 1958 (II)April 1958 (II)February 1961 (I)February 1961 (I)November 1970 (IV)November 1970 (IV)March 1975 (I)March 1975 (I)July 1980 (III)July 1980 (III)November 1982 (IV)November 1982 (IV)March 1991March 1991 (I) (I)November 2001November 2001 (IV) (IV)

434313138811111010881010111116166616168888

Average, all cycles:Average, all cycles: 1854-2001 (32 cycles) 1854-2001 (32 cycles) 1945-2001 (10 cycles)1945-2001 (10 cycles)

  

17171010

16

No, the fact that the recession is of No, the fact that the recession is of record length does not record length does not in itselfin itself imply imply

we are near the end.we are near the end.

kuya

17

US employment peaked in Dec. 2007,which is the most important single reason why

the NBER BCDC dated the peak from that month.

Since then, 6 million jobs have been lost (5/09).

Payroll employment series Source: Bureau of Labor Statistics

18

On June 5, commentators were encouraged when BLS reported a sharp moderation in

the rate of jobs decline in May.

Payroll employment series Source: Bureau of Labor Statistics

19

My favorite monthly My favorite monthly indicator is total hours indicator is total hours worked in the economyworked in the economy

It confirms: US recession turned severe in September; but hours worked has not yet shown any sign of moderating.

20

The The US recessionUS recession so far is so far is deep,deep,

Source: IMF, Source: IMF, WEOWEO, April 2009, April 2009

compared to compared to pastpast

and to and to others’others’

21

Job loss now cumulates to the Job loss now cumulates to the worst since the 1940s.worst since the 1940s.

Source: BLS, May 8

22

Prime-Age Male Prime-Age Male Unemployment RateUnemployment Rate

again suggests we have hit the record again suggests we have hit the record for post-war recessions.for post-war recessions.

23

Recession was soon Recession was soon transmittedtransmitted

to rest of world: to rest of world: Contagion: Falling securities Contagion: Falling securities

markets & contracting credit.markets & contracting credit. Especially in those countries with weak fundamentals: Especially in those countries with weak fundamentals:

Iceland, Hungary, Ukraine, Latvia…Iceland, Hungary, Ukraine, Latvia… Or oil-exporters that relied heavily on high oil prices: Or oil-exporters that relied heavily on high oil prices:

Russia…Russia… But even where fundamentals were relatively strong: Korea…But even where fundamentals were relatively strong: Korea…

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

Recession in big countries will be transmitted to Recession in big countries will be transmitted to all trading partners through loss of exports.all trading partners through loss of exports.

24

25

Source: OECD

26

““World Recession”World Recession” No generally accepted definition.No generally accepted definition.

A fall in China’s growth from 11% to 6%, A fall in China’s growth from 11% to 6%, should probably be considered a recession. should probably be considered a recession.

Usually global growth < 2 % is considered a Usually global growth < 2 % is considered a recession.recession.

The World Bank forecasts that The World Bank forecasts that global growth would be negative in 2009,global growth would be negative in 2009, for the first time since the 1930s.for the first time since the 1930s.

27

especially considering that especially considering that successive forecasts of the successive forecasts of the current episode have been current episode have been repeatedly over-optimistic?repeatedly over-optimistic?

How do we know this will

not be another Great Depression?

The usual answer: we The usual answer: we learned important lessons learned important lessons from the 1930s, and we won’t from the 1930s, and we won’t repeat the mistakes we made repeat the mistakes we made then.then.

28

One One hopeshopes we won’t repeat the 1930s we won’t repeat the 1930s mistakes.mistakes.

Monetary response: good this timeMonetary response: good this time

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

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

Trade policy:Trade policy: Let’s not repeat Smoot-Hawley ! Let’s not repeat Smoot-Hawley ! E.g., the Buy America provision. China emulating.E.g., the Buy America provision. China emulating. Mexican trucksMexican trucks

29

U.S. Policy U.S. Policy ResponsesResponses

MonetaryMonetary easingeasing is is unprecedented, unprecedented, appropriately avoiding the mistake of 1930s. appropriately avoiding the mistake of 1930s. (graph)(graph) But it has largely run its course: But it has largely run its course:

Policy interest rates ≈ 0.Policy interest rates ≈ 0. (graph)(graph)

The famous liquidity trip is not mythical after all.The famous liquidity trip is not mythical after all. & lending, even inter-bank, builds in big spreads. & lending, even inter-bank, builds in big spreads.

Now we have aggressive quantitative easing: Now we have aggressive quantitative easing: the Fed continues to purchase assets not the Fed continues to purchase assets not previously dreamt of.previously dreamt of.

30

The Fed certainly has The Fed certainly has not not repeated repeated the mistake of 1930s: letting the the mistake of 1930s: letting the

money supply fall.money supply fall.

SourcSource: e:

IMF, IMF, WEOWEO, , April April 20092009Box Box 3.13.1

1930s

2008-09

31

Federal Reserve AssetsFederal Reserve Assets ($ billions)($ billions)have more-than-doubledhave more-than-doubled, ,

through new facilities, rather than through new facilities, rather than conventional T bill purchasesconventional T bill purchases

Source: Federal Reserve H.4.1 report

32

Major central banks have cut interest Major central banks have cut interest rates sharply.rates sharply.

33

Policy Responses,Policy Responses, continuedcontinued

Obama policy of Obama policy of “financial repair”:“financial repair”:Infusion of funds is more conditional,Infusion of funds is more conditional,

Conditions imposed on banks that get help:Conditions imposed on banks that get help: (1) no dividends,(1) no dividends, (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.

Enough to make some banks balk at keeping the Enough to make some banks balk at keeping the funds.funds.

The “stress tests” achieved the drawing of a The “stress tests” achieved the drawing of a (dotted) line between “good banks” and “bad (dotted) line between “good banks” and “bad banks.”banks.”

So far we have avoided nationalization.So far we have avoided nationalization.

34

Desirable longer-term financial reformsDesirable longer-term financial reforms Executive compensationExecutive compensation

Compensation committee not under CEO. Maybe need Chairman of Compensation committee not under CEO. Maybe need Chairman of Board.Board.

Discourage golden parachutes & options, unless truly tied to Discourage golden parachutes & options, unless truly tied to performance.performance.

SecuritiesSecurities Regulatory agencies:Regulatory agencies: M Merge SEC & CFTC? erge SEC & CFTC? Create a central clearing house for Create a central clearing house for CDSsCDSs . . Credit ratings: Credit ratings:

Reduce reliance on ratings: AAA does not mean no risk.Reduce reliance on ratings: AAA does not mean no risk. Reduce ratings agencies’ conflicts of interest.Reduce ratings agencies’ conflicts of interest.

LendingLending MortgagesMortgages

Consumer protection, including standards for mortgage brokersConsumer protection, including standards for mortgage brokers Fix “originate Fix “originate to to distribute” model, so lenders stay on distribute” model, so lenders stay on the the hook.hook.

Banks: Banks: Regulators shouldn’t let banks use their own risk modelsRegulators shouldn’t let banks use their own risk models;; should make capital requirements less pro-cyclical .should make capital requirements less pro-cyclical .

Extend bank-like regulation to “Extend bank-like regulation to “near banksnear banks.”.”

35

Policy Responses,Policy Responses, continuedcontinued

Unprecedented $800 b Unprecedented $800 b fiscal fiscal stimulusstimulus.. Good old-fashioned Keynesian stimulusGood old-fashioned Keynesian stimulus

Even the principle that spending provides more Even the principle that spending provides more stimulus than tax cuts has returned;stimulus than tax cuts has returned;

not just from Larry Summers, e.g., not just from Larry Summers, e.g., but also from Martin Feldstein.but also from Martin Feldstein.

Was $800 too small? Too large?Was $800 too small? Too large? Yes: Too small to knock out recession ;Yes: Too small to knock out recession ; too small to reassure global investors re US debt.too small to reassure global investors re US debt. I.e., just about right.I.e., just about right.

36

Fiscal responseFiscal response“Timely, targeted and “Timely, targeted and

temporary.”temporary.”American Recovery & Reinvestment Plan American Recovery & Reinvestment Plan

includes:includes: Aid to states: Aid to states:

education, education, Medicaid…; Medicaid…;

Other spending.Other spending. Unemployment benefits, food stamps,Unemployment benefits, food stamps, especially infrastructureespecially infrastructure, and, and

Computerizing medical records, Computerizing medical records, smarter electricity distribution grids, andsmarter electricity distribution grids, and high-speed Internet access.high-speed Internet access.

37

Fiscal stimulus also included tax cuts: Fiscal stimulus also included tax cuts: for lower-income workers (“Making Work Pay”)for lower-income workers (“Making Work Pay”)

EITC, EITC, refundable child tax credit.refundable child tax credit.

Fix for the AMT Fix for the AMT (for the middle class).(for the middle class).

Soon we must return toward fiscal discipline.Soon we must return toward fiscal discipline. Let Bush’s pro-capital tax cuts expire in 2011.Let Bush’s pro-capital tax cuts expire in 2011.

But the budget passed by Congress omitted some But the budget passed by Congress omitted some of the newly-responsible features proposed by of the newly-responsible features proposed by Obama:Obama: Cuts in farm subsidies for agribusiness & farmers > $250 millionCuts in farm subsidies for agribusiness & farmers > $250 million Auctioning of GHG emission permits in future,Auctioning of GHG emission permits in future,

with revenue used, e.g., to cut taxes on low-income workers.with revenue used, e.g., to cut taxes on low-income workers. Will Secy. Gates’ attempt to cut unwanted weapons systems Will Secy. Gates’ attempt to cut unwanted weapons systems

(such as the F22 fighter) meet the same fate?(such as the F22 fighter) meet the same fate?

38

Motivation for macroeconomic Motivation for macroeconomic interventionintervention

The view that Keynes stood for The view that Keynes stood for big government is not really right.big government is not really right. He wanted to save market microeconomics from He wanted to save market microeconomics from

central planning, which had allure in the 30s & 40s.central planning, which had allure in the 30s & 40s.

Some on the Left today reacted to the crisis & Some on the Left today reacted to the crisis & election by hoping a new New Deal would election by hoping a new New Deal would overhaul the economy.overhaul the economy. My view: faith in the unfettered capitalist system My view: faith in the unfettered capitalist system

has been shaken has been shaken with respect to financial markets, true; with respect to financial markets, true; but not with respect to the rest of the economy; 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.

39

Bottom line of Bottom line of macroeconomic policy macroeconomic policy

response:response: A good guess is that the monetary and fiscal A good guess is that the monetary and fiscal

response response we have seen so far have been sufficient to halt we have seen so far have been sufficient to halt the economic free-fall, so that the steep rate of the economic free-fall, so that the steep rate of decline decline will level off in the 2will level off in the 2ndnd half of this year. half of this year.

It won’t be enough to return us rapidly It won’t be enough to return us rapidly to full employment and potential output.to full employment and potential output.

Given the path of debt that was inherited in 2009, it Given the path of debt that was inherited in 2009, it is unlikely that more could be done.is unlikely that more could be done. Chinese officials already questioning our creditworthinessChinese officials already questioning our creditworthiness US could lose AAA rating, US could lose AAA rating, according to David Walkeraccording to David Walker (GAO, Petersen).(GAO, Petersen).

US long-term interest rates have risen latelyUS long-term interest rates have risen lately Hard landing for the $ ?Hard landing for the $ ?

40

The The nextnext crisis crisis

The twin deficits:The twin deficits: US budget deficit => current account deficitUS budget deficit => current account deficit

Until now, global investors have happily financed Until now, global investors have happily financed US deficits.US deficits.

The flight to quality paradoxically benefited The flight to quality paradoxically benefited the $,the $, even though the financial crisis originated in the US.even though the financial crisis originated in the US. In 2008, US TBills were still viewed as the most liquid In 2008, US TBills were still viewed as the most liquid

& riskless.& riskless.

41

““Be careful what you wish for!”Be careful what you wish for!”US politicians have not yet learned US politicians have not yet learned

how dependent on Chinese financing how dependent on Chinese financing we have become.we have become.

42

Sustainable?Sustainable? Can the US rely on foreign central banks indefinitely ?Can the US rely on foreign central banks indefinitely ? Especially if we keep telling China to Especially if we keep telling China to stopstop buying $? buying $?

Although the day of reckoning did not arrive in 2008,Although the day of reckoning did not arrive in 2008,

Chinese warnings in the spring of 2009 Chinese warnings in the spring of 2009 may have been a turning point:may have been a turning point:

PM Wen worried US T bills will lose value.PM Wen worried US T bills will lose value.

PBoC Gov. Zhou proposed PBoC Gov. Zhou proposed replacing $ as international replacing $ as international currency with the SDR.currency with the SDR.

4343

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)

.0

.1

.2

.3

.4

.5

.6

.7

.8

1980 1990 2000 2010 2020 2030 2040

USD

DEM/EUR

USD forecast

EURforecast

Tipping point in updated simulation: 2015

Simulation predicts € may overtake $ as early as 2015

44

Appendix: Appendix:

As bad as the Great As bad as the Great Depression?Depression?

45

U.S. output loss & unemployment U.S. output loss & unemployment riserise

in the current downturn in the current downturn

Source: Federal Reserve Bank of St. Louis

would still have a very long way to gowould still have a very long way to gobefore reaching the depth of the before reaching the depth of the

1930s...1930s...

46

……but, by at least one measure, but, by at least one measure, the world is on track to match the the world is on track to match the

1930s !1930s !

Industrial production

Source: George Washington’s blog

Jeffrey FrankelJeffrey FrankelJames W. Harpel Professor of Capital James W. Harpel Professor of Capital

Formation & GrowthFormation & GrowthHarvard Kennedy SchoolHarvard Kennedy School

http://ksghome.harvard.edu/~jfrankel/ihttp://ksghome.harvard.edu/~jfrankel/index.htmndex.htm

Blog: Blog: http://content.ksg.harvard.edu/blog/jeff_frankels_whttp://content.ksg.harvard.edu/blog/jeff_frankels_weblog/eblog/