IP6001 Seminar 1 The Causes of, and Responses to, the Global Financial Crisis

IP6001 Seminar 1 The Causes of, and Responses to, the Global Financial Crisis

PART ONE – CAUSES OF & RESPONSES TO THE FINANCIAL CRISIS

• Causes of the Credit Crisis

• Causes of the Great Recession beyond the Credit Crisis

• US Policy responses to the Economic Downturn

PART TWO – CAUSES OF & RESPONSES TO THE EUROZONE CRISIS

• Causes of the Eurozone Crisis

• Responses to the Eurozone Crisis

PART THREE – WHAT ELSE COULD HAVE BEEN DONE?

• Should any other Policy Instruments have been implemented?

PART ONE

Main Causes of Credit Risk in 2008

• Policy Mistakes

• Weak Regulatory and Supervisory Frameworks

• Growth of Imbalances situation in US

Policy Mistakes

• Glass-Steagall Act ‘33 - Separated commercial & investment banks

• Established as a response bank failure during the Great Depression

• Over the years, financial communities and lobbies lead to the eventual repeal of the Act in ’99

• US banks are allowed to take risky assets.

• Moral hazard

• The interconnected flow of the US mortgage market• Selling debt to large investment banks and GSEs (Fannie & Freddie).• Banks and GSEs pooled debt and sold to investors around the world

(securitization)• Fall of housing prices and rising defaults on subprime mortgage in

2007 many individuals mortgages-holders did not make payments• “Underwater” - the amount of mortgage debt was greater than value

of home. MBSs became “toxic assets”

Weak Regulatory & Supervisory Frameworks

• Potential collapse of large financial institutions

• Governments acted in some cases to prevent systematic collapse (AIG, etc.)

• Other institutions were allowed to fail (Lehman Brothers)

• Weak regulation of subprime mortgage

• Limited or no oversight of “shadow banking system”

Weak Regulatory & Supervisory Frameworks

The Growing Imbalances in US

• Asia, oil producing and other developing countries have large account surplus, while large deficit has occurred in US.

• Imbalances situation leads to increased in saving rates in countries

surpass domestic investment.

• Surplus in Asia is channeled to purchasing activities of US treasuries , further causing credit boom in US .

Was the credit crisis the sole causes to the recession in 2009?

BREAD PPT DESIGN

The high price of oil1

Expectation of society:too optimistic

economic forecast 2

Globalization3

CONTENTS

The Rising Price of Oil




The percentage of wages is much higher than the percentage of GDP. Most of the higher costs will eventually have to be paid for by individuals, through higher taxes or higher prices on goods or services.


Their salaries didn’t increase the same percentage as GDP, and in fact, the wage rose much slower than GDP.


Then what will consumers do facing this situation ?

They had to cut down their expenditure, in order to save money to pay for their

daily expenses, especially during the time of great recession when everyone feared

about the future. Frustrating expectation.

CONSUMPTION DECLINED



The Rising Price of OilA domino effect began


The Rising Price of OilThe domino effect still went on

Government spending


The Rising Price of OilTo sum up:The rising price of oil led the prices of goods and services to go up, salary constant----consumption decreased.Businesses had to lay off their workers or close their doors completely, which led to high unemployment rate and less investment. Further, facing with the higher unemployment rate, the government had to pay more unemployment benefits and collect few taxes, which led to the decrease of government spending. All these consequences helped cause the great recession.

Expectation of society: Too optimistic economic forecast

Too optimistic economic forecast

Early in February, 2007, New Century Financial Corporation issued a

profit warning for the fourth quarter of 2006 and in April, it finally

declared bankruptcy.

HSBC Holdings increased $1.8 billion of bad debts for the subprime

mortgage business in United States.

Too optimistic economic forecast

Lack of Government action

Too optimistic economic forecastThe government did not take action immediately until in August 2007.

Economists: In the middle of 2007, they estimated that financial institutions might

lose a total of $150 billion on subprime mortgages, but they thought it was not a lot

compared to the U.S. annual GDP of $14 trillion.

The optimistic economic forecast aggravated the financial crisis

caused the great recession in 2009.

Globalization

“if the US sneezes, the rest of the world catches a cold”.

In terms of global financial system, before the financial crisis, the

mortgage-backed financial instruments, like CDOS and MBS had

been marketed globally to other countries

GlobalizationAs for global trade system, America is the important importer in the world. As the financial crisis happened, the consumption in U.S. went down dramatically, which led the government to decrease its import from other countries.

GlobalizationIn terms of the stock market, as the Dow Jones Index of stock prices plunged substantially, loads of stock markets around the world also experienced a sharp plunge.

What economic policies have been adopted in the main industrial countries to deal with the downturn?

International Response

• “…the overarching risk is that further delays in implementing policies to stabilize financial conditions will inevitably lead to an intensification of the negative feedback loops between the real economy and the financial system.” (IMF, 2009, G20 Global Economic Policies and Prospects)

• Need for coherent national, regional, and int’l strategies.

International Response

•Types of response: fiscal stimulus, tax cuts, and adjustments to government spending.

• G20 Countries Response:

• Implemented stimulus packages of 1.5% of world GDP in ‘09 and 1.25% of GDP in ’10

• ½ cut personal income taxes• 1/3 cut indirect taxes; excise and value added• ¾ increased government expenditures on infrastructures

Asia Response

TJ Pempel Seminar – August 7, 2013

• Largely immune

• Avoided risky financial instruments & maintained regulatory control

• Regionalization focus of trade and finance

• China became #1 destination for regional exports

Asia Response

• Yet, Asia not completely immune, and many countries have implemented new policies.

• Japan - Abenomics 3 Arrows:

1 – Quantitative Easing 2 – Fiscal flexibility 3 – Structural reforms

US Response 4 Main Strategies:

• Bailouts

• Fiscal Stimulus

• Monetary Policy

• Regulatory/Legislative

US Response Bailouts:

• Emergency Economic Stabilization Act of 2008

• Troubled Asset Relief Program (TARP)

• “Too big to fail”

US Response Major TARP Recipients:

• $70B committed to AIG

• $12.5B for “Asset Guarantee Program”

• >$80B for the auto industry

•>$420B total

• CNN-Money Bailout Tracker

http://money.cnn.com/news/storysupplement/economy/bailouttracker/index.html

US Response Response to Bailouts:

• “If they’re too big to fail, they’re too big.” -- Alan Greenspan

• “By any objective standards, the Troubled Asset Relief Program worked: it helped stop widespread financial panic, it helped prevent what could have been a devastating collapse of our financial system.” -- Says Who?

US Response Response to Bailouts:

• “If they’re too big to fail, they’re too big.” -- Alan Greenspan

• “By any objective standards, the Troubled Asset Relief Program worked: it helped stop widespread financial panic, it helped prevent what could have been a devastating collapse of our financial system.” -- US Treasury Dept

Response to Bailouts:• As of July 2013: US taxpayers have recovered 95% of funds

US Response Fiscal Stimulus:

• American Recovery and Reinvestment Act of 2009 • Goal: preserve jobs, increasing governmental investments, stabilize state and local budgets, assist those most impacted by the recession.


• Transparency website:• www.recovery.gov

• Initial $787B in stimulus promised later increased to $840B

• Three broad categories for funds:• Tax benefits and cuts ($290.7B)• Entitlement programs ($253.5B)• Funding for grants and loans ($256.6B)

http://www.recovery.gov/


• Keynesian strategy

• “…the government should actively stimulate aggregate demand when aggregate demand appeared insufficient to maintain production at its full-employment level.”(Mankiw, p. 794)

US Response Fiscal Stimulus Response:

• Political split – right vs. left

• Some say not enough stimulus!•“…The centerpiece of Obama’s economic strategy, the American Recovery and Reinvestment Act, was the biggest job-creation program in U.S. history – but it was also woefully inadequate to the task.”(Krugman, “End This Depression Now!, 2012, p. 109)

US Response Monetary Policy:

“Whatever it takes” – Ben Bernanke

US Response Monetary Policy – The Fed

• Duel mandate – maximizing employment and ensuring price stability

• Goal of “conventional” monetary policy - achieve low and stable inflation using the instrument of short-term interest rates to achieve target inflation.

US Response Monetary Policy – The FedInterest Rate Policy

• Federal Fund Rate = the overnight rate banks can lend to other banks with deposits at the Federal Reserve.

• Discount Rate = the rate banks can borrow directly from the Fed

• Low Rates cheaper for banks to borrow from each other and from the Fed easier for banks to make more loans.

US Response

US Response Monetary Policy – The FedInterest Rate Policy

• BUT – short-term interest rates have been essentially zero for a long time!

• ‘Liquidity Trap’

• “…Conventional monetary policy appears powerless.” (Ricardo Reis, 2009)

US Response Monetary Policy – The FedQuantitative Policy

“Unconventional Policy”

• Fed also purchased troubled assets from commercial banks and other private institutions – Quantitative Easing – ‘QE’

• Forward Guidance – Attempt to reassure banks and investors about future policy and rates.

US Response Regulatory/Legislative:

• Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) • Goal: “… Improving accountability and transparency in the financial system, to end ‘too big to fail’, to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices…”(US Congress, 2010)

US Response Regulatory/LegislativeDodd-Frank

• Creation of Consumer Financial Protection Bureau to protect people against unfair practices in financial services

• Regulate shadow banking: The Volcker Rule – limits commercial banks ability to participate in prop-trading.

• SEC – Authority over security-based swaps. Licensing exams and registration for some derivatives traders.

US Response Regulatory/LegislativeDodd-Frank – Response

• Problems with regulations - some risk is necessary to foster competition. How to determine what is healthy versus what is a systemic risk?

• Agreement b/w regulators is difficult

• Has the “culture of risk” changed?

PART TWO

Was unstable public finance the sole cause of Eurozone crisis in 2011?

How did the Eurozone Crisis start?



Misallocation of resources, fiscal profligacy and uncompetitive policies added fuel to the crisis

Root Causes of the Eurozone Crisis

Weakness in the design of EMU

• Stipulated in the Maastricht Treaty that EU member countries have to satisfy a set of macroeconomic convergence criteria - 3% fiscal deficit and 60% gross public debt• These thresholds were not strictly adhered to and many countries

did not meet the entry criteria

Gross public debt

Government deficit

Weakness in the design of EMU

• Stability and Growth Pact was set up to enforce budgetary discipline • But countries within the economic union had very diverse

background and less integrated than required by the optimum currency theory• EMU was underinstitutionalised and lacked coordination of fiscal

policies.

Macroeconomic factors in peripheral countries

Mismanagement of public funds - Unsustainable public sector wages and pensions

Capital inflows fuelled an unsustainable real estate bubble – housing prices rise 200% from 1996 to 2007


Economy suffered from a lack of competitiveness and was the slowest growing economy among the peripheral countries

Faced with a banking crisis where governments had guaranteed bank debts that financed housing bubbles


History of high public debts and loss of competitiveness as wages increase


•No independent monetary policy to offset fiscal austerity. ECB unwilling to act as lender of last resort

•No ability to devalue and restore competitiveness

•No real fiscal transfers to stimulate spending

Global Financial Crisis

• Global financial crises worsened domestic economic conditions in several high debt European periphery countries• The crisis led to the economic recession in which the

growth rate and tax revenue fell resulting in greater financial imbalances• Overleveraged banks expose the banking and monetary

system in Europe to even weaker and fragile state in the face of recession

European Reponses to the Eurozone Crisis

• €4.6 trillion from European Governments towards European-wide recovery Programme• Equivalent to 39% of EU GDP

• Aid packages: • Urged austerity• Conditional upon adoption of deflationary economic policies

The European Stability Mechanism (ESM)• An apparatus to help guarantee prevention of future crises• Central stockpile of funds to secure the Euro• €440 billion given by Eurozone, €250 billion by IMF – goal to

expand to €1 trillion

Outright Money Transactions (OMTs)• The buying up of Eurozone member state government bonds• Again, strictly conditional upon macroeconomic policy adjustments• Was a contributor to the pacification of government bond

spreads – De Grauwe and Yuemi

The Effect of OMTs on Bond Spreads

2011 20122010 2013

Further ResponsesTwo-pack

Six-pack

Both complemented the pre-existing Stability and Growth Pact (SGP)

Further ResponsesSix-pack (2011)• Increased powers of monitoring granted to the European

Commission (EC)• Shifts focus from ‘correction’ to ‘prevention’

Two-Pack (2013)• 1. EC able to analyse budget plans before they are put in place• 2. EC able to carry out financial and economic surveillance of

states experiencing difficulties

A Complete Success Story?• ‘Structural Adjustment’ policy implementations can produce

undesirable results• Reductions in effective demand, slower growth across Eurozone

- Patomäki• AND – will €1 trillion be the true limit??• Asking for more funds could worsen the crisis

PART THREE

OTHER POLICY INSTRUMENTS

Delay retirement age, Negative Interest Rate and Immigration Policy

Delay Retirement AgeFacts

“The UK government has scrapped the default retirement age of 65 from October 2011.” (Kevin Peachey, Sep 2011) Also, “People who decide to keep on working after 65 will draw a slightly larger state pension when they eventually retire”.The French government also plans to extend the legal retirement age from 60 to 62 years old and increase payment of pension credits.Germany voted in 2007 to raise the retirement age from 65 to 67 over the next several years. In Germany, since 1 January 2012, such law related to retirement extension will take effect to determine that workers retirement age delay to 67 years old. Greece announced reforms to its pension system in early 2010 aimed at reducing early retirement and raising the average age of retirement to 63. Incentives to keep workers in the labor market beyond 65 have likewise been adopted.

Delay Retirement AgeWhy?

British workers should be forced to delay their retirements now or see £750billion added to the national debt, the International Monetary Fund warned (“Hugo Duncan, 12 April 2012)

Delay Retirement AgeWhy?

Average Per Capita Personal Income in a single year

Country 2000 2001 2002 2003 2005 2006 2009 2010

United States 29,469 30,413 30,906 31,632 34,586 36,714 39,138 40,584

NOTE: Per capita personal income was computed using midyear population estimates of the Bureau of the Census.

Source: U.S. Department of Commerce, Bureau of Economic Analysis, Survey of Current Business. Web: http://www.bea.gov/newsreleases/relsarchivespi.htm .

Factbook 2012 - ISSN - © OECD 2012 1 person

Expenditure on Pensions (% of GDP) 1 year 59,106.00

2000 2005 2006 2007 2008 2009 2010 5 year 295,530.00 Dollars

United States 5.9 6 5.9 6 6.2 6.8 ..

13,898.3 billion (GDP) 1 million persons

Source: OECD Statistics Web: http://www.oecd.org/statistics/ 5 year 2.9553E+11 Dollars

National Average Per Capita Compensation and Pension Dollars /per month

2000 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

United States 1,371 1,557 - 1,314 1,409 1,453 1,664 1,928 2,104 2,586

Data collected from usa government website Web: http://www.usa.gov/Topics/Seniors/Retirement.shtml

Delay Retirement AgeHow?

Respond to the financial crisis by retirement age extension,Does work in short run, Does not in long terms, even worse

Ponzi Scheme?

Negative Interest Rate

Swedish crisis in 1991, the Swedish central bank forced policy rates into negative territory temporarily by charging banks a premium for storage of funds within the central bank, as well as for access to LOLR services. This encouraged banks to actually lend funds which they were being issued.


“Zero Lower Bound” (ZLB)* Monetary policy- interest rate does not work* Response of householders- less consumption

Is the eurozone in a ‘zero lower bound’ situation?* Low interest rates are supposed to save the economy* Households in Price Sticky theory


Normally, borrower have to make regular interest payments to their lenders money.

What is a 'negative interest rate?Lender would pay the borrower for the privilege of lending? Yes

* Why would they lend in those circumstances?* Banks want to keep large amounts of “liquid” reserves at the central bank * ‘forward guidance’ statements of Draghi, president of the European Central Bank* Negative effect of healthy surge in lending on banks

How negative interest rates could recover economy from Recession?

Immigration vs Economy Growth

Immigration reformUS GDP will grow by as much 3.3 percent in 2023, and 5.4 percent in 2033, if the Senate version of immigration reform is put into law. Converted into today’s dollar values, those increases would roughly translate into $700 billion in 2023, and $1.4 trillion in 2033. the Congressional Budget Office (CBO)

* Demographic channels on economic growth* The budget outlook through its impacts on economic growth


Immigration cause InnovationImmigrants have displayed entrepreneurial rates above that of the native born population.

Solve the problem of a shortage of labour* an ageing population, Birth rate, Employment replacement rate

‘Increased immigration might lead to an increased number of relatively young workers and, in the near term, such immigrants could contribute positively to public finances by lowering dependency rates’ (OECD, 2008, p. 123)

* Diverse Labor market low-skilled vs High-skilled

* Job creation* Employment market* Worker incentive, productivity and protection


Unemployment and immigration in Netherlands, 1970–2009

Muysken & Ziesemer (2013)

Documents

IP6001 Seminar 1 The Causes of, and Responses to, the Global Financial Crisis