Lecture 17 the Financial Crisis

8/12/2019 Lecture 17 the Financial Crisis

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International Political Economy #17

The Global Financial Crisis

William Kindred Winecoff

Indiana University Bloomington

October 29, 2013

W. K. Winecoff | IPE #17: The Global Crisis 1/25
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Why Is This Worth Talking About?

Alan Greenspan: Likely to be judged the most virulent global financial

crisis ever.

Huh? What about the Great Depression? How could this be more

virulent than that?

The U.S. lost $14 trillion in wealth, or 100% of GDP, via the

stock market collapse in 2008-2009.

The U.S. lost $8-13 trillion in production as well.

Fine, but it was just a U.S. crisis, right?

Nope. Global equity wealth destroyed was nearly $35 trillion,

or the combined GDP of US, EU, and Japan... worlds three

largest economies at the time.

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0.5

0.0

0

.5

1.0

Period

PercentChange

2004 2005 2006 2007 2008 2009

Global Equity Markets, 20042009

S&P 500FTSEHang SengNikkei

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What Is This Worth Talking About?

Okay, but thats just stock markets. Rich people can afford it.

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Ouch. That five percentage point drop represents about 17 million

Americans that lost their jobs, and theyve mostlystayedlost.

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5

0

5

10

15

Year

GDP

Growth

2001 2002 2003 2004 2005 2006 2007 2008 2009

GDP Growth, 20012009

United StatesUnited Kingdom

JapanChina

World

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Who Can We Blame For This?

Scape-goating is the national pastime. So who should we put in the

stocks? Some popular explanations:

Bankers are greedy bastards. Then again, bankers are always

greedy bastards; cant explain change with a static variable.

Government: policies that rewarded risky mortgage lending?Regulators: hobbled by free market economic ideology?

Issues:

Need to explain the global nature of the crisis.

Need to explain why the crisis occurred in many different

jurisdictions, with different banking sectors, regulatory

policies, and government types.

Crisis not limited to places where US government set

housing/monetary policy.

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Who Can We Blame For This?

So the popular explanations contain some truth, but they cant explaineverything. They dont explain why we got the financial crisis we got,

when we got it.

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Why We Got What We Got When We Got It

The financial collapse began with complicated financial instruments

linked to the subprime mortgage real estate sector.

Explaining those in detail is too wonky for this class, but for those

interested see two This American Lifepodcasts:

The Giant Pool of Money (episode 355, 5.9.2008)

Another Frightening Show About the Economy (episode

365, 10.3.2008)

These partially reinforce the greedy bankers and bad regulatorsexplanations. But there is a difference between proximate causes and

fundamental causes.

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The Story of Chimerica: the linkages between the U.S. and Chinese

economies during the Naughties. (Subset of the Global Savings Glut.)

The U.S. had low unemployment, and wanted to consume.

China had high unemployment, and wanted to produce.

U.S. policy: tax cuts + plus cheap loans for students and home-buyers =

Ownership society + Go shopping or the terrorists win.

China policy: Under-valued currency + savings rates from 40-50% of

GDP = boost employment via exporting goods and capital to U.S.The result:

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Remember your national accounting: S - I = X - M.

China: S > I implies X > M.

U.S.: S < I implies X < M.

A U.S. current account deficit implies an equal capital account surplus.

I.e., China (a poor country) was sending the U.S. (a rich country)

consumption goodsand investment finance. In exchange we gave them

IOUs and boosted their employment. Crazy?

No. Political. We want our houses and consumption goods. They want

jobs. Leaders in both countries enacted policy to meet the demands oftheir polities.

Hundreds of billions of dollars flowing into the U.S. economy every year

has to go somewhere.

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Okay. But why housing? Macroeconomic story:

1 Foreign purchases of $ >

2 $ appreciation >

3 Increase in imports (CA deficit) + increase in non-tradable

goods prices relative to tradable goods prices >

4 Shift in investment from manufacturing to housing.

At first, this just meant low mortgage rates for qualified borrowers. But

then there were no more qualified borrowers, and still all this foreignsavings coming into the U.S.

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Macropolitical story:

1 GSG increases supply in (non-US) S >

2 Fannie Mae/Freddie Mac guarantee + tax/regulatory code

increases demand for (US) I

>

3 Creation and global dissemination of mortgage-backed

securities make risky mortgages safer.

Not mutually exclusive of course. The result: a huge housing bubble,

backed up by mountains of opaque, illiquid financial instruments. These

later become known as toxic assets, or, the sort of thing you dont

want to be holding when the music stops. This is what TARP bought.

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In other words, theres plenty of blame to go around: the citizens, the

bankers, the regulators, the government, the Chinese. We in the U.S.

wanted the things big houses, cheap consumer goods that the

financial sector, incentivized by the government, provided.

But this only explains why the U.S. had a financial crisis. How did a

local housing crisis turn into a global meltdown?

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How They Got What They Got When They Got It

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What They Got

So there are dozens of banking crises around the world, almost all of

which happened in developed countries strongly connected to the U.S.

(according to IMF researchers).

So there is a debt crisis that threatens to destroy the Europeanmonetary union. (More on Thurs)

So there is a fixed investment bubble in China that threatens to pop and

drag down the worlds fastest-growing major economy.

So there is a drop in Japanese growth and increase in debt, even before

the earthquake and nuclear meltdown in Fukushima.

The collapse in global demand hurts poor workers in exporting countries.

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What They Got

Many governments respond with expansionary monetary policy (i.e. low

interest rates) to try to stabilize the banks and generate economic

activity by stimulating consumption and investment demand. The U.S.

Federal Reserve is the most important, globally.

But there is an unintended consequence: extreme commodity price

volatility, which (remember Malthusian conflict?) can lead to civil

unrest, particularly in places with youth bulges in large urban areas.

Which places are those? Refer to past lectures.

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What They Got

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What We All Did

Developed Countries:

Governments bailed out banks (U.S., E.U., Japan).

E.U. bailing out highly-indebted countries (kind of).Voted out our governments (U.S., U.K., Ireland, Iceland,

Greece, Japan, etc.).

Stimulus vs. austerity: Leads to protest movements, e.g. Tea

Party and Occupy Wall Street. Spanish Indignados. General

strikes in a number of European countries (e.g. Greece, Italy).

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What We All Did

Developing Countries:

Some governments e.g. Saudi Arabia increase transfers

to citizens and/or institute price controls to keep food and

fuel prices from spiraling too far out of control.

Some pass a number of reforms related to civil rights.

Others do not. Let them eat cake". Protests begin.

Citizens of Tunisia, Egypt, Libya, Yemen overthrow their

governments.

Citizens of Bahrain, Syria, Iran still trying.

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The Lesson

Maybe Greenspan was right: maybe this was most virulent financial

crisis ever.

Outcomes not as bad as Great Depression because governments

intervened earlier, plus institutions exist to foster cooperation (IMF, UN,

EU). Thankfully, we learned some lessons.End up with Arab Spring rather than another World War?

But interventions are political... should we be bailing out the banks?

How do we narrow deficits: raise taxes or cut spending? How do we

manage civil unrest in the Gap?

Central point: the causes of the crisis, and the reactions to it, were

largely political and largely global. Just blaming the bankers isnt good

enough.

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Documents

Lecture 17 the Financial Crisis