Genesis Of Global Financial Crises

arifanees.com - Information-Inspiration-Perspiration 1

Genesis of Global Financial CRISES


1. Origins of the financial crisis.

2. The US current account deficits What about the economists who

argue that they are sustainable?

3. Global climate change negotiations. A proposed new architecture.


1. Origins of the crisis in the US

Well before 2007, there were danger signals: Real interest rates <0, 2003-

04; Early corporate scandals

(Enron 2001…); Risk was priced very low, – housing prices very high, – National Saving very low,– current account deficit big,– leverage high,– mortgages imprudent…


US real interest rate < 0, 2003-04

Real interest rates <0

Source: Benn Steil, CFR, March 2009


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/

http://juanpablofernandez.wordpress.com/2008/05/


Six root causes of financial crisis

1. US corporate governance falls short E.g., rating agencies; executive compensation …

▪ options; ▪ golden parachutes…

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

3. Politicians slant excessively toward homeownership

▪ Tax-deductible mortgage interest, cap.gains; ▪ Fannie Mae & Freddie Mac; ▪ Allowing teasers, NINJA loans, liar loans…

MSN Money & Forbes


Six root causes of financial crisis, cont.

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

▪ reminiscent of 1981-1990 5. Monetary policy was too loose,

during 2003-05,▪ accommodating fiscal expansion,

reminiscent of the Vietnam era.

6. Financial market participants during this period grossly underpriced risk.


Origins of the financial/economic crisis

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 institutionsStock

marketbubble

Housing

bubble

Stock marketcrash

Housing

crashFinancial

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

Excessive complexity

CDSsMBSsCDOs

Predatory lending

Homeownership bias


The US current account deficits

Some economists argue they are sustainable


And as the 1990s progressed,

the US experienced the longest economic expansion of its history;

America was declared to have a New Economy. Currency crises hit Korea,

and Southeast Asian countries in 1997-98.

And Asians were told to emulate the US model, especially its financial system: corporate governance, accounting standards, consumer finance, innovative products, securities markets, rating agencies, and Anglo-American style banking (market-oriented & arms-

length)


But as soon as the 2000s started,the 1990s assumptions were proven wrong

Bursting of the US dot-com bubble (2000).

Failure of US electoral institutions (Nov.2000). Failures of Sept.11(2001) &

US response (Iraq, Guantanamo) Failure of US corporate governance

in scandals of Enron, etc. (2001). Decade of flat median

income and rising debt.

http://images.google.com/imgres?imgurl=http://por-img.cimcontent.net/api/assets/bin-200912/6b5ff00c85493da01fc31cecdbc91cd5.jpg&imgrefurl=http://www.comcast.net/slideshow/finance-biggestcorporatescandals/16/&usg=__vINuEt-m_iD5uTuSevQxIQpgFxA=&h=400&w=346&sz=21&hl=en&start=41&um=1&tbnid=s8PJ3TZlcdE8qM:&tbnh=124&tbnw=107&prev=/images%3Fq%3Dcorporate%2Bscandal%26ndsp%3D20%26hl%3Den%26rlz%3D1T4GGLL_enUS309US342%26sa%3DN%26start%3D40%26um%3D1

http://images.google.com/imgres?imgurl=http://www.nndb.com/people/360/000022294/george-w-bush.jpg&imgrefurl=http://www.nndb.com/people/360/000022294/&h=307&w=243&sz=27&tbnid=8nbA6ZnFFbIJ:&tbnh=111&tbnw=88&start=1&prev=/images%3Fq%3DGeorge%2BW%2BBush%26hl%3Den%26lr%3D


Financial crisis (2007-2009) Bursting of US

housing bubble (2006) inevitably led to sub-prime

mortgage crisis (2007). Less predictably,

failures of US financial system led to disappearance of liquidity (2008)

and the 2nd recession of the decade, the worst since the 1930s. The rest of the world followed.


Who got pieces of it right, beforehand? Krugman: If a Depression can happen in

Japan, it can happen in any modern economy.

Rajan: Failures of corporate governance. BIS (Borio & White): Too-easy credit, via

asset prices, leads to crises -- with no inflation in between.

Shiller: US housing price bubble. Gramlich: Homeowners are taking

mortgages that they can’t repay. Rogoff: “This Time Is Not Different.” Roubini: The recession will be severe.


The US has lost its claim as an exclusive model for others to emulate

The desirable principles haven’t changed, only the claim that the US uniquely embodies them Open democracy, rule of law Competition in goods markets Corporate governance focused

on long-term shareholder value, ▪ not executives’ options prices▪ nor empire-building.

Government intervention to address market failure▪ E.g., tax pollution (don’t subsidize fossil fuels). ▪ Supervise banks, under rules (don’t take them over).


The US is in a hole Adroit monetary &

fiscal management has succeeded in limiting the length & severity of the recession. The turning point was

probably early summer, 2009 => we have avoided the mistakes

of ▪ the Depression, ▪ or Japan’s lost decades.

But the long-term fiscal outlook – already bad – has gotten worse.


The same with other major industrialized economies.

A remarkable role-reversal:• Debt/GDP of the top 20 rich countries (≈ 80%) is already twice that of the top 20 emerging markets;

• and rising rapidly. • By 2014 (at ≈ 120%), it could be triple.


The US financial positionhas deteriorated internationally

The twin deficits

China is now our largest creditor

The dollar appears in long-term decline.


Exorbitant Privilege of $

Among those who argue that the US current account deficit is sustainable

are some who believe that the US will continue to enjoy the unique privilege of being able to borrow virtually unlimited amounts in its own currency.


When does the “privilege” become “exorbitant?”

if it accrues solely because of size & history, without the US having done anything to earn the benefit by virtuous policies such as budget discipline, price stability & a stable exchange rate.

Since 1973, the US has racked up $10 trillion in debt and the $ has experienced a 30% loss in value compared to other major currencies.

It seems unlikely that macroeconomic policy discipline is what has earned the US its privilege !


The “Bretton Woods II” hypothesis

Dooley, Folkerts-Landau, & Garber (2003) : today’s system is a new Bretton Woods,

▪ with Asia playing the role that Europe played in the 1960s—buying up $ to prevent their own currencies from appreciating.

More provocatively: China is piling up dollars not because of myopic mercantilism, but as part of an export-led development strategy that is rational given China’s need to import workable systems of finance & corporate governance.


My own view on “Bretton Woods II”:• The 1960s analogy is indeed apt, • but we are closer to 1971 than to 1944 or

1958. • Why did the BW system collapse in 1971?

▪ The Triffin dilemma could have taken decades to work itself out.

▪ But the Johnson & Nixon administrations accelerated the process by fiscal & monetary expansion (driven by the Vietnam War & Arthur Burns, respectively).

▪ These policies produced: declining external balances, $ devaluation, & the end of Bretton Woods.

http://images.google.com/imgres?imgurl=http://www.presidentnixon.org/images/lbj.jpg&imgrefurl=http://www.presidentnixon.org/rankings.htm&usg=__MOJg4iLHGWaZfndBGIBvl9lOffw=&h=591&w=405&sz=45&hl=en&start=11&um=1&tbnid=GjFz9gkCjVbskM:&tbnh=135&tbnw=93&prev=/images%3Fq%3Dlyndon%2Bjohnson%26ndsp%3D18%26hl%3Den%26rlz%3D1T4RNWE_enUS312US312%26sa%3DN%26um%3D1


There is no reason to expect better today:

1) Capital mobilityis much higher now than in the 1960s.

2) The US can no longer necessarily rely on support of foreign central banks:

▪ neither on economic grounds

(they are not now, as they were then, organized into a cooperative framework where

each agrees explicitly to hold $ if the others do),

▪ nor on political grounds

(China & OPEC are not the staunch allies the US had in the 1960s).

3) A possible rival currency to the $ exists.


Central banks’ reserve holdings Frankel & Chinn (2007) estimated effects of country size, market depth, ability to hold value, and network effects

Simulation suggests € could overtake $ by 2022.

0.0

0.2

0.4

0.6

0.8

1.0

75 80 85 90 95 00 05 10 15 20 25 30 35 40

USD

DEM

EUR


When will the day of reckoning come?

• Not in 2008: In the short run, the financial crisis caused a flight to quality which evidently still meant a flight to US $.

• Chinese warnings in 2009 may have marked a turning point:– Premier Wen worried US T bills will lose value.

On Nov. 10 he urged the US to keep its deficit at an “appropriate size” to ensure the “basic stability” of the $.

– PBoC Gov. Zhou in March proposed replacing $ as international currency, with the SDR.


The global monetary systemmay move from dollar-based to multiple international reserve currencies

The € could challenge the $.

The SDR is again part of the system. Gold in2009 made a comeback

as an international reserve too. Someday the RMB will

join the roster with ¥ & ₤. = a multiple international reserve asset

system.


Lessons from the global financial crisis of 2008-09

For emerging markets Decoupling? What characteristics suited countries to

weather the storm of 2008-09 better than others?

For the field of macroeconomics: phylloxera analogy.

For global governance: the G20.


Decoupling?

Initial hopes of decoupling succumbed at the height of the crisis:

Financial contagion

Asian exports were especially hard-hit.


Asian exports plummeted

via RGE Monitor 2009 Global Outlook


But, in the end, there was a measure of decoupling after all. Asia has come roaring back. Asia now constitutes

an independent “growth pole” in the world.


Which bystanders got hit the worst by the global liquidity crisis of 2008?

Most emerging markets had followed the lessons of the 1990s crises: small or no current account deficits more flexible exchange rates more reserves less short-term & $-denominated loans

Those that didn’t are those that got into worse trouble: Central & Eastern Europe.


The Early Warning Indicators literature, updated

Reserves Economists wondered if emerging market reserves

had gotten too high by 2007 – ▪ Jeanne (2007), Summers (2006), Rodrik (2006)

But high reserves appear to have paid off in 2008.▪ Aizenman (2009) and Obstfeld, Shambaugh & Taylor (2009, 2010)

Low short-term foreign debt ▪ Sachs, Tornell & Velasco (1996), Frankel-Rose (1996), Guidotti Rule,▪ Bussiere, Frankel & Matthieu (2010)

Other leading signals▪ Equity prices: Kaminsky, Lizondo & Reinhart (1998); Rose & Spiegel

(2009)▪ See also Wei & Tong (2010)


“Where should mainstream macro go, in light of the 2007-09 global financial crisis?”

Some models that had been thriving in an emerging markets context may now help answer this question.

Some were applications of models originally designed for advanced-country financial markets, but never fully incorporated into the mainstream macro core.

A possible explanation why they had been transplanted to emerging markets: assumptions of imperfections in financial markets were considered more acceptable there, than in the context of advanced economies.


Financial crises: Not just for emerging markets anymore.

An analogy

In the latter part of the 19th century most of the vineyards of France were destroyed by Phylloxera.

Eventually a desperate last resort was tried: grafting susceptible European vines onto resistant American root stock.

Purist French vintners initially disdained what the considered compromising the refined tastes of their grape varieties.

But it saved the European vineyards, and did not impair the quality of the wine.

The New World had come to the rescue of the Old.


Implications of the 2008 financial crisis for macroeconomics? In 2007-08, the global financial system was

grievously infected by “toxic assets” originating in the United States.

Many ask what fundamental rethinking is necessary to save orthodox macroeconomic theory.

Some answers may lie with models that have been applied to the realities of emerging markets.

Purists may be reluctant to seek help from this direction.

But they should not fear that the hardy root stock of emerging market models is incompatible with fine taste.


What are some of these models? Asymmetric information

Credit rationing (Stiglitz…) Need for collateral (Kiyotaki & Moore,

Caballero…) The credit channel (Bernanke & Gertler… ) Balance sheet effects (Calvo…) Bank runs & multiple equilibria

(Diamond & Dybvyg; Velasco…) Speculative attacks

(Krugman; Obstfeld; Morris & Shin…) Moral hazard & incentive incompatibility

(Dooley; McKinnon & Pill…)

http://images.google.com/imgres?imgurl=http://www.iadb.org/idbamerica/images/feb07_G.Calvo-t3.jpg&imgrefurl=http://www.iadb.org/idbamerica/index.cfm%3Fthisid%3D4337&usg=__dPr8ZZd-B1jdQMAbrwCW0Yjkt98=&h=261&w=225&sz=61&hl=en&start=10&um=1&tbnid=dG9uIAr94LnxCM:&tbnh=112&tbnw=97&prev=/images%3Fq%3Dguillermo%2Bcalvo%26hl%3Den%26rlz%3D1T4GGLL_enUS309US342%26sa%3DN%26um%3D1

http://www.dallasfed.org/news/research/2003/sd/images/sd5.jpg


Also newly relevant are some almost-forgotten and less-formalized notions of cycles:

the credit cycle of von Hayek,

the bubbles & panics of Kindleberger,

the Minsky moment, and

Irving Fisher’s debt deflation.


The G-20

G-20 meetings in 2009:

London in April

Pittsburg in October


How successful were the measures supported by US & Korea at the G-20 meetings (2009)?

Coordinated fiscal stimulus to fight the recession as in the locomotive plan of G7’s Bonn Summit of 1978: no formal agreement, but it seemed to happen anyway.

Unexpected revival of the SDR and tripling IMF resources

The usual agreement for a standstill/rollback in trade barriers. Some backsliding followed, & little progress in Doha Round; on the US side:

▪ tariffs on Chinese tires, ▪ inability to ratify FTAs.

But, so far, not a bad trade record, for a severe recession.


Whatever the causes of the great recession, the policy response avoided 1930s mistakes:No Smoot-Hawley tariffsNo failed London

Economic SummitAggressive monetary expansion

rather than contraction.Fiscal expansion too.


The true significance of the G-20 in 2009 The G-20 accounts for 85% of world

GDP. A turning point: The more inclusive

group has suddenly become central to global governance, eclipsing the G-7, and thereby at last giving major developing/emerging countries some representation,

after decades of fruitless talk about raising emerging-market representation in IMF.


Four items on G-20 agenda for 2010

Possible financial regulatory reform Some steps underway in Basle, Financial Stability Forum The Europeans would like more, but are unlikely to get it. Personally, I might favor a small global tax on financial

transactions. Macroeconomic exit strategies Global imbalances between

developing countries and industrialized US and China should both admit responsibility

▪ US: the budget deficit is too big. Needs to be fixed.▪ China: RMB is too low. Needs to be unfixed.

Post-Copenhagen progress toward new agreement on climate change to take effect 2012.


Two principles of multilateral institutions1. It is inevitable that more power go

to large-GDP countries than small. This is why IMF works better than UN . The problem is that China, India, Korea, Brazil,

etc.,are larger than Canada, Netherlands… Hence the G-20.

The outcome must leave small countries better off, of course, or they will not go along.

2. Conversation is not possible with more than 20 in the room.


– Worked well for years, • with small steering groups

(US-EU, the Quad & G-7)• and few demands placed on developing countries.

– Failed when developing countries had become big enough to matter,• but were not given enough role: • Doha Round

Example: many rounds of tradenegotiations under the GATT.


Conversation is not possible with more than 20 people in the room. Delegates just read their talking points. The latest evidence:

The Climate Change CoP in Copenhagen The UNFCCC proved an ineffectual vehicle

▪ Incompetent management of logistics▪ Small countries repeatedly blocked progress

Obama was able to make more progress at the end with a small group of big emitters.▪ Korea is in a good position to build on this progress

▪ As the 1st non-Annex I country to take on binding emission targets.

To be honest, the G-20 is too big. My recommendation: an informal steering group within G-20.


Date post:	18-Oct-2014
Category:	Economy & Finance
View:	2,896 times
Download:	1 times

Genesis Of Global Financial Crises

Economy & Finance