The global financial crisis

A bank run

Financial panic in “Mary Poppins”

http://www.youtube.com/watch?v=C6DGs3qjRwQ(via LoseTheNameOfAction)

A fatal combination• Financial globalization

– Great increase in (two-way) capital flows across national borders– Net flows from emerging market economies to advanced economies

(especially, U.S.)• Financial deregulation

– Blurring of lines between commercial and investment banking– Free international capital mobility across as a norm– Allowing big banks to use their own risk models in determining leverage– The rise of an unregulated “shadow banking system” – Lack of regulation of new financial products

• “Financial innovation,” esp. securitization • Colletarallized debt obligations (CDO), credit-default swaps (CDS)

Greater liquidity and lower returns on traditional investments spur risk-taking and high leverage.

Financial globalization: United States

Source: Maurice Obstfeld (2011)

flows

Financial globalization: Iceland and Ireland

Source: Maurice Obstfeld (2011)

stocks

Historical relationship between capital mobility and crises

Source: Reinhart and Rogoff (2008)

The U.S. as a borrower: twin deficits

Source: Econbrowser, http://www.econbrowser.com/archives/2011/09/lost_decades_th.html

The appeal of financial innovation in housing

Who wouldn’t want credit markets to serve the cause of home ownership? So:

• introduce some real competition into the mortgage lending business by allowing non-banks to make home loans

• let them offer creative, more affordable mortgages to prospective homeowners not well served by conventional lenders.

• enable these loans to be pooled and packaged into securities that can be sold to investors– reducing risk in the process.

• divvy up the stream of payments on these home loans further into tranches of varying risk– compensating holders of the riskier kind with higher interest rates

• call on credit rating agencies to certify that the less risky of these mortgage-backed securities are safe enough for pension funds and insurance companies to invest in

• just in case anyone is still nervous, create derivatives that allow investors to purchase insurance against default by issuers of those securities.

How did financial innovation work?

Source: http://www.thedeal.com/newsweekly/features/chain-of-fools.php

The result: a housing “bubble”

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Source: Robert Shiller, http://www.irrationalexuberance.com/.

How the crisis plays out: the collapse of confidence and contagion

The death spiral:

reduction in housing pricesÞ defaults on mortgagesÞ reduction in CDO values and loss of confidenceÞ reduction collateral valuesÞ reduction in ability to borrow short-term Þ need to sell off assets (deleveraging)Þ further reduction in asset values Þ …Þ freezing of financial markets: no-one want to lend to anyone else

(“flight to safety”)

Who or what is the culprit? (1)

• unscrupulous mortgage lenders who devised credit terms?– such as “teaser” interest rates and prepayment penalties– perhaps, but these strategies would not have made sense for lenders unless

they believed house prices would keep on rising • a housing bubble that developed in the late 1990s?

– and the reluctance of Alan Greenspan’s Fed to burst it?– even so, the explosion in collateralized debt obligations (CDOs) and other

securities went far beyond what was needed to sustain mortgage lending– especially true of credit default swaps, which became an instrument of

speculation instead of insurance • Irresponsible financial institutions of all types leveraging themselves to the

hilt in pursuit of higher returns?• credit rating agencies that fell asleep on the job?

• high-saving Asian households and dollar-hoarding foreign central banks that produced a global savings “glut”?– which pushed real interest rates into negative territory, in turn stoking the U.S.

housing bubble while sending financiers on ever-riskier ventures• macroeconomic policy makers who failed to get their act together and

move in time to unwind large and unsustainable current-account imbalances?

• the U.S. Treasury, which played its hand poorly as the crisis unfolded?– bad as things were, what caused credit markets to seize up was Paulson’s

decision to make an example of Lehman Brothers by refusing to bail it out. – might it have been better to do with Lehman what he had already done with

Bear Stearns and would have had to do in a few days with AIG: save them with taxpayer money.

• all (or none) of the above?

Who or what is the culprit? (2)

The “deeper” causes of the crisis: hypotheses

• Ideas– Economists’ ideas on market efficiency, the virtues

of deregulation, and ineffectiveness/inefficiency of government regulation

Was it economists and their ideas? (1)

The myth of a self-regulating, self-correcting market.• Example: securitization

– in principle, allows diversification and distribution of risk (tranched CDOs)

– But requires good models of risk, full information, absence of agency/incentive problems…

Alan Greenspan:"I made a mistake in presuming that the self-interests of

organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms.” (October 2008)

Was it economists and their ideas? (2)

But there was no shortage of research on departures from benign view of financial markets.

Literatures on: • emerging market financial crises• agency theory• asymmetric information• financial market bubbles• self-fulfilling runs (“bank runs”)• systemic risk• behavioral finance• …

Why did economists focus on single model at the expense of these alternatives and ignore the consequences of their own research?

The “deeper” causes of the crisis: hypotheses

• Ideas– Economists’ ideas on market efficiency, the virtues

of deregulation, and ineffectiveness/inefficiency of government regulation

• Interests – The capture thesis: the role of banks and special

interests (Simon Johnson)

The financial capture thesis

• Pursuit of policies that advance banks’ interests, due to– lobbying– financial contributions– the revolving door

• When things go wrong, banks’ influence ensure they get bailed out– “too big to fail”

• Key: “a belief system” that associates public interest with banks’ interests (S. Johnson)– Note role of ideas again

The “financialization” of the economy

Source: Johnson (2009)

The “deeper” causes of the crisis: hypotheses

• Ideas– Economists’ ideas on market efficiency, the virtues

of deregulation, and ineffectiveness/inefficiency of government regulation

• Interests – The capture thesis: the role of banks and special

interests (Simon Johnson)– The compensation thesis: the role of GSEs (Frannie

and Freddie) in providing cheap housing finance (Raghuram Rajan)

Growing inequality…

Source: Mother Jones online. http://motherjones.com/politics/2011/02/income-inequality-in-america-chart-graph

…pushes government to provide cheap housing finance?

Share of Frannie and Freddie in total outstanding mortgage backed securitiesSource: Econbrowser, http://www.econbrowser.com/archives/2008/07/did_fannie_and.html.

But much of the dramatic appreciation in house prices came in the two years after the GSEs began to contract.

S&P/Case-Shiller Composite 10 home price index

Source: http://www.econbrowser.com/archives/2008/07/did_fannie_and.html

Questions

• What are the fundamental causes of the proclivity of modern economies to financial crises?– contribution of ideas versus interests

• What does each theory say about avenues of reform?

• What is/should be the role of economic thought?