The global financial crisisThe global financial crisisJeffrey FrankelJeffrey Frankel

Harpel Professor of Capital Formation & GrowthHarpel Professor of Capital Formation & Growth

Boston Committee on Foreign RelationsBoston Committee on Foreign RelationsUnion Club, Boston, May 12, 2009Union Club, Boston, May 12, 2009

2

OutlineOutline The international financial crisis of The international financial crisis of

2007-20092007-2009 Root causes in the USRoot causes in the US Transmission to rest of worldTransmission to rest of world ForecastsForecasts Multilateral Cooperation: Multilateral Cooperation:

The G-20 meeting The G-20 meeting The locomotive theory of fiscal policyThe locomotive theory of fiscal policy

The The next next crisis: Hard landing for the $ ?crisis: Hard landing for the $ ? China’s dollar purchasesChina’s dollar purchases

Emerging MarketsEmerging Markets The 3The 3rdrd capital inflow boom 2003-2007 and its end in capital inflow boom 2003-2007 and its end in

20082008 Are the 1994-2002 lessons on how to avoid crises Are the 1994-2002 lessons on how to avoid crises

holding up?holding up? AppendicesAppendices

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Six root causes of US Six root causes of US financial crisisfinancial crisis

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

options; options; golden parachutes…golden parachutes…

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

3.3. Politicians slant excessively Politicians slant excessively toward toward homeownershiphomeownership

MSN Money & Forbes

4

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,

5. Real interest rates were too low 5. Real interest rates were too low during 2004-05 during 2004-05 ---- mostly due to Fed mostly due to Fed policy,policy,tho some point to high Asian saving.tho some point to high Asian saving.

6. Financial market participants6. Financial market participantsduring this period grossly during this period grossly underpriced risk.underpriced risk.

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US real interest rate < 0, US real interest rate < 0, 2003-042003-04Source: Benn Steil, CFR, March 2009

Real interest Real interest rates <0 rates <0

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The 2003-06 The 2003-06 underpricing of riskunderpricing of risk

showed up everywhere:showed up everywhere: in options prices (e.g., VIX)in options prices (e.g., VIX) in bond spreads (e.g., “high yield” corporate in bond spreads (e.g., “high yield” corporate

bonds)bonds) in emerging markets (low sovereign spreads)in emerging markets (low sovereign spreads)

as low in 2006 as it had been high in 1998as low in 2006 as it had been high in 1998

Explanations?Explanations? Estimated variances (e.g., in Black-Scholes Estimated variances (e.g., in Black-Scholes

formula)formula) backward-looking, rather than forward looking.backward-looking, rather than forward looking.

Option-implied volatility seems to follow US fed Option-implied volatility seems to follow US fed funds interest rate (with a lag): e.g., low in 1993 funds interest rate (with a lag): e.g., low in 1993 & 2004& 2004

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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 Origins of the financial/economic crisesfinancial/economic crises

Excessive complexity

CDSsMBSsCDOs

Predatory lending

Homeownership bias

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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…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… & even where fundamentals were relatively strong: Brazil, & even where fundamentals were relatively strong: Brazil,

Korea…Korea…

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

Recession in big countries has been transmitted Recession in big countries has been transmitted to all trading partners through loss of exports.to all trading partners through loss of exports.

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The Financial Crisis The Financial Crisis Hit Emerging Markets in Late 2008:Hit Emerging Markets in Late 2008:

Stock markets plunged and sovereign Stock markets plunged and sovereign spreads rosespreads rose

Source: IMF Source: IMF WEOWEO, Oct. 2008, Oct. 2008

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Source: OECD

International Trade has Plummeted

12

Asian exports are especially Asian exports are especially hard-hithard-hit

via RGE Monitor 2009 Global Outlook

13

The recession has hit more The recession has hit more OECD countries than any in OECD countries than any in

60 years60 years

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Unemployment rates are rising Unemployment rates are rising everywhereeverywhere

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Forecasts

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Interim forecastInterim forecast OECD OECD 3/13/093/13/09

Forecastfor 2009 = - 3 ½ %

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IMF, too, forecasts 2009 as IMF, too, forecasts 2009 as sharpest downturnsharpest downturn

Source: Source: WEOWEO,,April 2009April 2009

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

A sharp fall in China’s growth from 11% is a A sharp fall in China’s growth from 11% is a recession. recession.

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

The World Bank The World Bank (March)(March) now forecasts now forecasts negative global growth in 2009,negative global growth in 2009, for the first time in 60 years.for the first time in 60 years. So does the IMF So does the IMF (April) when GDPs compared at current exchange rates.(April) when GDPs compared at current exchange rates.

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IMF forecasts, April IMF forecasts, April 20092009

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BRIC growth has disappeared

21

2009 April

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Multilateral initiativesMultilateral initiatives

E.g., G-20,E.g., G-20,which met in London which met in London in April 2009. in April 2009.

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International International coordination coordination of fiscal expansion?of fiscal expansion?

As in the classic Locomotive TheoryAs in the classic Locomotive Theory Theory:Theory:

in the non-cooperative equilibrium, each in the non-cooperative equilibrium, each country holds back fiscal expansion for country holds back fiscal expansion for fear of trade deficits.fear of trade deficits. Classic prisoner’s dilemma of NashClassic prisoner’s dilemma of Nash Solution: Solution:

A bargain where all expand together.A bargain where all expand together.

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The Locomotive Theory in The Locomotive Theory in PracticePractice

The example of G-7 Bonn Summit, 1978The example of G-7 Bonn Summit, 1978 didn’t turn out so well: didn’t turn out so well:

inflation turned out to be a bigger problem than inflation turned out to be a bigger problem than realized realized

& the German world was non-Keynesian.& the German world was non-Keynesian. Inflation is less a problem this time; Inflation is less a problem this time;

the Germans are the same.the Germans are the same.

Coordinated expansion failed Coordinated expansion failed at G-20 Summit in London, this April.at G-20 Summit in London, this April.

As had cooperation in 1933As had cooperation in 1933 (London Monetary & Economic (London Monetary & Economic Conference)Conference)

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USfiscal

stimulus

looks the

largest of

the G-10.

than the USBut others point out that they have larger automatic stabilizers

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Expansion of the IMFExpansion of the IMF Tripling of size of IMF quotas. Tripling of size of IMF quotas. New issue of SDRs New issue of SDRs (a la Keynes)(a la Keynes)

More inclusion of developing countriesMore inclusion of developing countries Eventually: Eventually:

Reallocation of voting shares in IMF and World Bank?Reallocation of voting shares in IMF and World Bank? Break US-EU duopoly on MD & President?Break US-EU duopoly on MD & President?

Locus shifted from G7 to G20 at London meetingLocus shifted from G7 to G20 at London meeting .. Regulatory reform? Still to come. Regulatory reform? Still to come.

Reduce procyclical Basel capital requirements; FSB; Reduce procyclical Basel capital requirements; FSB; ….….

Hold the line against protectionism? Not yet Hold the line against protectionism? Not yet clear.clear.

But G-20 Summit did accomplish But G-20 Summit did accomplish some thingssome things

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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 US Until now, global investors have happily financed US deficits.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 The US can no longer necessarily rely on support of foreign

central banks, either economically or politically.central banks, either economically or politically.

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The 2007-08 financial crisisThe 2007-08 financial crisisprobably further probably further

underminedunderminedUS long run hegemony.US long run hegemony.

US financial institutions have lost US financial institutions have lost credibility.credibility.

Expansionary fiscal and monetary policy Expansionary fiscal and monetary policy may show up as $ depreciation in the may show up as $ depreciation in the long run.long run.

The slow descent of the $ as an The slow descent of the $ as an international currency may accelerate.international currency may accelerate.

2929

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

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““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.

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If China gave US If China gave US politicians politicians what they say they what they say they want...want... we’d regret it.we’d regret it.

especially if it included reserve shift especially if it included reserve shift to match switch in basket weights.to match switch in basket weights.

As of early 2009, a floating yuan might not even As of early 2009, a floating yuan might not even appreciate !appreciate !

Even if RMB did appreciate, Even if RMB did appreciate, US TB & employment might not rise:US TB & employment might not rise: fall in US bilateral trade deficit with Chinafall in US bilateral trade deficit with China

would be offset by rise in US bilateral deficit would be offset by rise in US bilateral deficit with other cheap-labor countries, with other cheap-labor countries,

What if all Asian currencies appreciated together?What if all Asian currencies appreciated together? Yes, that would help US TB;Yes, that would help US TB; but US interest rates probably would rise:but US interest rates probably would rise: possible hard landing for the $.possible hard landing for the $.

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What about China’s currency What about China’s currency reform announced in July 2005?reform announced in July 2005?

China did not fully do what it implied, China did not fully do what it implied, i.e.,i.e., basket peg (with cumulatable +/- .3% band). basket peg (with cumulatable +/- .3% band). Frankel & WeiFrankel & Wei (2007)(2007) & Frankel & Frankel (2009)(2009) estimates: estimates:

De facto weight on $ still very high De facto weight on $ still very high in 2005-06in 2005-06.. Little appreciation against the implicit Little appreciation against the implicit basket,basket, but appreciation against $ in 2007, as the basket gave but appreciation against $ in 2007, as the basket gave

substantial weight to the € which appreciated against substantial weight to the € which appreciated against $.$.

Beijing responded to pressure on exporters in 2008Beijing responded to pressure on exporters in 2008 by switching back to a dollar peg. by switching back to a dollar peg.

Just in time to ride the $ up in its year of reverse-trend Just in time to ride the $ up in its year of reverse-trend appreciation !appreciation !

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In the short run, however, the In the short run, however, the financial crisis has caused a financial crisis has caused a

flight to quality which flight to quality which apparently still means a flight to apparently still means a flight to

US$.US$. US Treasury bills are more in demand than ever, US Treasury bills are more in demand than ever, as reflected in very low interest rates.as reflected in very low interest rates.

The $ The $ appreciatedappreciated in 2008, rather than depreciating as in 2008, rather than depreciating as the “hard landing” scenario had predicted.the “hard landing” scenario had predicted.

=> The day of reckoning had not yet arrived.=> The day of reckoning had not yet arrived.

Recent Chinese warnings may be a turning point:Recent Chinese warnings may be a turning point: Premier Wen worried US T bills will lose value.Premier Wen worried US T bills will lose value. PBoC Gov. Zhou proposed PBoC Gov. Zhou proposed

replacing $ as international currency.replacing $ as international currency.

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Historical precedent: £ Historical precedent: £ ((1914-1956)1914-1956)

With a lag after US-UK reversal of ec. size & With a lag after US-UK reversal of ec. size & net debt, $ passed £ as #1 international net debt, $ passed £ as #1 international currency.currency.

““Imperial over-reach:” the British Empire’s Imperial over-reach:” the British Empire’s widening budget deficits and overly ambitious widening budget deficits and overly ambitious military adventures in the Muslim world.military adventures in the Muslim world.

The 2001-2020 decline in The 2001-2020 decline in international currency status for the international currency status for the

$ would be only one small part of $ would be only one small part of a loss of power on the part of the US. a loss of power on the part of the US.

But: But:A loss of $’s role as #1 reserve A loss of $’s role as #1 reserve currency could in itself have currency could in itself have

geopolitical implicationsgeopolitical implications..

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The 2001-2020 decline in The 2001-2020 decline in international currency status for the international currency status for the

$ would be only one small part of $ would be only one small part of a loss of power on the part of the US. a loss of power on the part of the US.

But: But: A loss of $’s role as #1 reserve currency A loss of $’s role as #1 reserve currency could in itself have could in itself have geopolitical geopolitical implicationsimplications. . [i][i]

Precedent: The Precedent: The Suez crisis of 1956Suez crisis of 1956 is often recalled as the occasion on whichis often recalled as the occasion on which

Britain was forced under US pressure to Britain was forced under US pressure to abandon its imperial designs. abandon its imperial designs.

But recall also the important role But recall also the important role played by a simultaneous run on the played by a simultaneous run on the ££ and the American decision not to help and the American decision not to help the beleaguered currency. the beleaguered currency.

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

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EmEmerging marketserging markets

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Real interest rates in the USReal interest rates in the US,,

when low, have sent capital flowing into developing when low, have sent capital flowing into developing countries:countries:

11stst boom -- recycling petrodollars, 1974- boom -- recycling petrodollars, 1974- Ended with the international debt crisis of 1982-Ended with the international debt crisis of 1982-

22ndnd boom -- emerging market bonanza: 1990- boom -- emerging market bonanza: 1990-Ended, for Mexico, in 1994.Ended, for Mexico, in 1994.Perhaps precipitated -- as predicted by Calvo, Leiderman & Perhaps precipitated -- as predicted by Calvo, Leiderman & Reinhart – Reinhart – by increase in US interest rates.by increase in US interest rates.

33rdrd boom -- the search for yield: 2003- boom -- the search for yield: 2003- e.g., carry trade from ¥, CHF & $, into NZ, Iceland, e.g., carry trade from ¥, CHF & $, into NZ, Iceland,

S.Africa.…S.Africa.… Convergence play from € into Hungary, Baltics…Convergence play from € into Hungary, Baltics… Ended in the fall of 2008.Ended in the fall of 2008.

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Capital flow cycleCapital flow cycle Capital Inflows to Developing Countries as % of Total GDP (Low and Middle Income)

-

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

4.50

5.00

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

Net Total Private

Capital Flows

ct

Source: World Development Indicators

1st boom:1975-81 2nd boom:

1990-1996

3rd boom:2004-

Internationaldebt crisis of

1982

East Asiacrisis of

1997

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3 peaks in net private capital 3 peaks in net private capital flow cyclesflow cycles

to emerging markets, by regionto emerging markets, by regionpeaking in 1982, 1997 and 2008 peaking in 1982, 1997 and 2008

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

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Cycle in capital flows to Cycle in capital flows to emerging marketsemerging markets

11stst developing country lending boom developing country lending boom (“recycling petro dollars”): 1975-1981(“recycling petro dollars”): 1975-1981 Ended in international debt crisis 1982Ended in international debt crisis 1982 Lean years (“Lost Decade”): 1982-1989Lean years (“Lost Decade”): 1982-1989

22ndnd lending boom (“emerging markets”): 1990- lending boom (“emerging markets”): 1990-9696 Ended in East Asia crisis 1997Ended in East Asia crisis 1997 Lean years: 1997-2003Lean years: 1997-2003

33rdrd boom (incl. China & India this time): 2003-boom (incl. China & India this time): 2003-20082008

41

The latest emerging market boom

began in 2003, and surpassed the 1990s

boom.

Source: IMF WEO, 2007

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This time, many countries used the This time, many countries used the inflowsinflows

to build upto build up forex reservesforex reserves, , rather rather thanthan

to finance to finance Current AccountCurrent Account deficits deficitsNet Capital

Flow

Change in Reserves

Current Account Balance

-4.00

-3.00

-2.00

-1.00

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

% o

f GD

P

in % of GDP(Low- and

middle-income countries)

2003-07

boom1991-97

boom

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As a result, reserves reached extreme levels....

As a result, reserves in developing countriessoon reached high levels....

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Traditional denominator for reserves: imports

…, especially in Asia

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New denominator: short-term debt. After 2000, many brought their reserves above the level of short-term debt (the Guidotti rule).

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This time, China and India shared in major inflows. But, again, capital inflows financed only reserve accumulation,

not current account deficits as in the past. By 2007, reserves in some countries seemed grossly excessive.

Source: IMF WEO, 2007

47

Capital flows to emerging Capital flows to emerging marketsmarkets

peaked in 2007, fell in 2008peaked in 2007, fell in 2008

from: EM Fund Flows, Citi, December 2008

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Source: Benn Steil, Lessons of the Financial Crisis, CFR, March 2009

All decoupling ended in September 2008

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What characteristics have What characteristics have helped emerging markets helped emerging markets

resist financial contagion in resist financial contagion in the past?the past?

High FX reserves and/or floating currencyHigh FX reserves and/or floating currency Low foreign-denominated debt Low foreign-denominated debt (currency mismatch)(currency mismatch) Low short-term debt Low short-term debt (maturity mis-match)(maturity mis-match) High Foreign Direct InvestmentHigh Foreign Direct Investment Strong initial budget, allowing room to ease.Strong initial budget, allowing room to ease. High export/GDP ratio,High export/GDP ratio,

Sachs Sachs (1985);(1985); Eaton & Gersovitz Eaton & Gersovitz (1981),(1981), Rose Rose (2002)(2002) Calvo, Izquierdo & Talvi Calvo, Izquierdo & Talvi (2003);(2003); Cavallo & Frankel Cavallo & Frankel (2008);(2008); but openness might not be helpful resisting a but openness might not be helpful resisting a

global recessionglobal recession

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Are big current account deficits dangerous?Neoclassical theory – if a country has a low capital/labor ratio or transitory negative shock, a large CAD can be optimal.

In practice – Developing countries with big CADs often get into trouble.Traditional rule of thumb: “CAD > approx. 4% GDP” is a danger signal.

“Lawson Fallacy” – CAD not dangerous if government budget is balanced, so borrowing goes to finance private sector, rather than BD.

Amendment after 1994 Mexico crisis – CAD not dangerous if BD=0 and S is high, so the borrowing goes to finance private I, rather than BD or C.

Amendment after 1997 East Asia crisis –CAD not dangerous if BD=0, S is high, and I is well-allocated, so the borrowing goes to finance high-return I, rather than BD or C or empty beach-front condos (Thailand) & unneeded steel companies (Korea).

Amendment after 2008 financial crisis – CAD dangerous (?).

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Some references on statistical Some references on statistical predictors of crises among predictors of crises among

developing countriesdeveloping countries• Jeffrey Sachs, Aaron Tornell & Andres Velasco, “Financial Crises in Emerging Markets: The Lessons from 1995” (1996):Combination of weak fundamentals (changes RER or credit/GDP) and low reserves (relative to M2) made countries vulnerable to tequila contagion.

• J. Frankel & Andrew Rose, "Currency Crashes in Emerging Markets" (1996): Composition of capital inflow matters (more than the total): short-term bank debt raises the probability of crash; FDI & reserves lower the probability.

•Graciela Kaminsky, Saul Lizondo & Carmen Reinhart, “Leading Indicators of Currency Crises” (1998). Best predictors: Real ex. rate, M2/Res, GDP, equity prices.

•A.Berg, E. Borensztein, G.M.Milesi-Ferretti, & C.Pattillo, “Anticipating Balance of Payments Crises: The Role of Early Warning Systems,” IMF (1999). The early warning indicators don’t hold up as well out-of-sample.

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Eichengreen & Mody (2000):Spreads charged by banks on emerging market loans are significantly:

• increased if the country has:-- high total ratio of Debt/GDP,-- rescheduled in previous year-- high Debt Service / X, or-- unstable exports; and

• reduced if it has: --  a good credit rating, -- high growth, or--  high reserves/short-term debt

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The lessons of the 1994-The lessons of the 1994-2002 crises2002 crises

Many emerging markets after the 1990s Many emerging markets after the 1990s learned tolearned to (1) float or hold large reserves or both(1) float or hold large reserves or both (2) use capital inflows to finance reserve (2) use capital inflows to finance reserve

accumulation accumulation (“self-insurance”),(“self-insurance”), rather than current account rather than current account deficitsdeficits

(3) take capital inflows more in the form of FDI (3) take capital inflows more in the form of FDI or local-currency-denominated debt flows; or local-currency-denominated debt flows; avoiding the currency mismatch of $ liabilities avoiding the currency mismatch of $ liabilities

and avoiding short-term bank loans.and avoiding short-term bank loans. The ratio of reserves to short-term liability The ratio of reserves to short-term liability

seemed the most robust predictor of the seemed the most robust predictor of the likelihood & severity of crises.likelihood & severity of crises.

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Have those who obeyed the lessons Have those who obeyed the lessons of 1994-2002 done better in of 1994-2002 done better in

response to the current shock?response to the current shock? It is striking that some who had large current It is striking that some who had large current

account deficits and foreign-currency debts did account deficits and foreign-currency debts did have trouble,have trouble, particularly in Central & Eastern Europe: Hungary, Ukraine, particularly in Central & Eastern Europe: Hungary, Ukraine,

Latvia…Latvia…

Systematic studies are only beginning.Systematic studies are only beginning. An early one by Obstfeld, Shambaugh & Taylor :An early one by Obstfeld, Shambaugh & Taylor :

““Financial Instability, Reserves, and Central Bank Swap Lines Financial Instability, Reserves, and Central Bank Swap Lines in the Panic of 2008,”in the Panic of 2008,” March 2009, March 2009, NBER WP 14826NBER WP 14826..

Finding: Countries’ reserve holdings just before the Finding: Countries’ reserve holdings just before the current crisis, current crisis, relative to requirements (M2),relative to requirements (M2), significantly significantly predict 2008 depreciation. predict 2008 depreciation.

Current account balances & short-term debt levels are Current account balances & short-term debt levels are notnot statistically significant predictors, once reserve levels are statistically significant predictors, once reserve levels are taken into account. taken into account.

55

Precautionary insurancePrecautionary insurance Collective Action ClausesCollective Action Clauses New Flexible Credit Line from IMFNew Flexible Credit Line from IMF Mexico has both Mexico has both ($47 b credit line, April 18 ($47 b credit line, April 18

2009)2009) Neither has been needed so far, of courseNeither has been needed so far, of course

Have they helped ward off speculation?Have they helped ward off speculation? Too soon to say.Too soon to say.

Reserves have turned out to be the Reserves have turned out to be the ultimate insurance.ultimate insurance.

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AppendicesAppendices 1. The financial crisis of 2007-091. The financial crisis of 2007-09

US originsUS origins The US recessionThe US recession Transmission to rest of worldTransmission to rest of world

2. Repeat of Great Depression? US policy 2. Repeat of Great Depression? US policy responseresponse Monetary easingMonetary easing Financial repairFinancial repair Fiscal expansionFiscal expansion International cooperationInternational cooperation

3. Emerging markets 3. Emerging markets ContagionContagion The car crash analogyThe car crash analogy

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1. Origins of the US 1. Origins of the US financial crisisfinancial crisis

Well before 2007, Well before 2007, there were danger there were danger signals in US:signals in US: Real interest rates <0 , Real interest rates <0 ,

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

(Enron…);(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…

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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 is contained.” mortgage crisis is contained.” It wasn’t.It wasn’t.

Then, “The crisis is on Wall Street; Then, “The crisis is on Wall Street; it may spare Main Street.” it may spare Main Street.” It didn’t.It didn’t.

Then Then de-couplingde-coupling : : “The US turmoil will have less effect on the “The US turmoil will have less effect on the rest 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.

60

The return of KeynesThe return of Keynes

Keynesian truths abound today:Keynesian 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 macroeconomic coordinationNeed for macroeconomic coordination

61

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, KindlebergerKindleberger78 78 ’s “manias & panics”’s “manias & panics” the “Minsky moment,” &the “Minsky moment,” & Fisher’s “debt deflation.”Fisher’s “debt deflation.”

It was It was notnot a monetary contraction a monetary 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.)

62

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).

63

Corporate spreadsCorporate spreads between corporate & government between corporate & government

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

US

€

64

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 April 29, 2009, the recession’s length As of April 29, 2009, the recession’s length tied tied 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.

Likely also to be also as severe Likely also to be also as severe as oil-shock as oil-shock recessions of 1973-75 and 1980-82, though not yetrecessions of 1973-75 and 1980-82, though not yet..

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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

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

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

economyeconomy

It confirms: US recession turned severe in September, when the worst of the financial crisis hit (Lehman bankruptcy…)

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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’

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U.S. output lost in the current U.S. output lost in the current downturndownturn

Source: Federal Reserve Bank of St. Louis

would still have a very long way would still have a very long way to goto go

before reaching the depth of the before reaching the depth of the 1930s...1930s...

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……but, by at least one measure, the but, by at least one measure, the world is world is

on track to match the Great on track to match the Great Depression !Depression !

Source: George Washington’s blog

Industrial production

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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?

2. 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.

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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 provisionE.g., the Buy America provision Mexican trucksMexican trucks

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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.

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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

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Policy Responses,Policy Responses, continuedcontinued

Obama policy of Obama policy of “financial repair”:“financial repair”:Infusion of funds has been more conditional,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 But so far they have avoided “nationalization” of banksbanks

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Secretary Geithner announced PPIP 3/23/09: Secretary Geithner announced PPIP 3/23/09: Public-Private Partnership Investment ProgramPublic-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 Policy Responses -- Financial Repair,Repair, cont.cont.

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The PPIP was attacked from The PPIP was attacked from both sidesboth sides

in part due to anger over AIG bonuses, etc.in part due to anger over AIG bonuses, etc.

FT, Mar 25, 2009

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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. Remember, Bretton Woods blessed Remember, Bretton Woods blessed

capital controls capital controls and and free trade.free trade.

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 has My view: faith in the unfettered capitalist system has

been shaken 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;

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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.

Is $800 billion too small? Too big?Is $800 billion too small? Too big? Yes: Too small to knock out recession ;Yes: Too small to knock out recession ; too big to keep global investors confident inUS too big to keep global investors confident inUS

debt.debt. I.e., just about right.I.e., just about right.

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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.

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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.

The budget passed by Congress omitted The budget passed by Congress omitted some of the best features proposed by Obama:some of the best features proposed by Obama: Cuts in farm subsidies for agribusiness & farmers > $250 Cuts in farm subsidies for agribusiness & farmers > $250

millionmillion 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.

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Appendix 3: Emerging Appendix 3: Emerging MarketsMarkets

3. The car crash analogy

2.Contagion

1.Currency crises of 1994-2001

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Contagion In August 1998, contagion from the Russian devaluation/default jumped oceans.

Source: Mathew McBrady (2002)

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Categories/Causes of Contagion • “Monsoonal effects” (Masson, 1999) Common external shocks

• E.g., US interest rates ↑,

• world recession, or

• $ commodity prices ↓ …

• “Spillover effects” • Trade linkages

• Competitive devaluations

• Investment linkages

• Pure contagion• Imperfect information (“cascades”) 

• Investor perceptions regarding, e.g., Asian model or odds of bailouts 

• Illiquidity in international financial markets or reduced risk tolerance

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THE CAR CRASH ANALOGY

Sudden stops: “It’s not the speed that kills, it’s the sudden stops”

– Dornbusch

Superhighways: Modern financial markets get you where you want to go fast, but accidents are bigger, and so more care is required.

– Merton

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Is it the road or the driver? Even when many countries have accidents in the same stretch of road (Stiglitz), their own policies are also important determinants; it’s not determined just by the system. – Summers

Contagion is also a contributor to multi-car pile-ups.

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THE CAR CRASH ANALOGY

Moral hazard -- G7/IMF bailouts that reduce the impact of a given crisis, in the LR undermine the incentive for investors and borrowers to be careful. Like air bags and ambulances.

But to claim that moral hazard means we should abolish the IMF would be like claiming that drivers would be safer with a spike in the center of the steering wheel column. – Mussa

Correlation does not imply causation: That the IMF (doctors) are often found at the scene of fatal accidents (crises) does not mean that they cause them.

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Optimal sequence: A highway off-ramp should not dump high-speed traffic into the center of a village before streets are paved, intersections regulated, and pedestrians learn not to walk in the streets. So a country with a primitive domestic financial system should not necessarily be opened to the full force of international capital flows before domestic reforms & prudential regulation.

=> There may be a role for controls on capital inflow (speed bumps and posted limits). -- Masood Ahmed

Reaction time: How the driver reacts in the short interval between appearance of the hazard and the moment of impact (speculative attack) influences the outcome. Adjust, rather than procrastinating (by using up reserves and switching to short-term $ debt) – J Frankel

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/