Anatomy of the Financial Crisis
with comments on
Acemoglu, Brunnermeier,
El-Erian, & Portes
Jeffrey Frankel
Harpel Professor of Capital Formation & Growth
Harvard Kennedy School
Meeting of Commission on Growth &
Development
at Center for International Development, April 20-21, 2009
Six root causes of financial crisis

1. US corporate governance falls short


E.g., rating agencies;
executive compensation


options;
golden parachutes…
MSN Money & Forbes
2. US households save too little,
borrow too much.
3. Politicians slant excessively
toward homeownership
 Tax-deductible
mortgage interest, cap.gains;
 FannieMae & Freddie Mac;
 Allowing teasers, NINJA loans, liar loans…
2
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 2004-05,
 accommodating fiscal expansion,
reminiscent of the Vietnam era.
6. Financial market participants during
this period grossly underpriced risk

risks:
housing crash,
 $ crash,
 oil prices,
 geopolitics….

3
Current account imbalances

Richard Portes: “Global Imbalances caused crisis.”



I disagree.
I view low US National Saving as main source of CA.

I agree with Richard this crisis is not the feared US sudden stop



=> low volatility and interest rates => leverage.
That’s the next crisis.
But then why interest rates low? Easy money.
Many disagree (My “9 Reasons…” for Growth Commission)

Global savings glut hypothesis (Bernanke…)


But measured world saving did not rise in this decade.
Bretton Woods II (Dooley, Garber…) .


(Like 1960s.)
But BW I operated for only 14 years. We’re near the end.
US offers the high-quality assets. (Forbes, Gourinchas, Caballero..)

Not really. Was clear in 2001 (Enron…)
4
But I would think herd mentality – the opposite of
heterogeneous views -- would be the bigger problem.
Yes.
Note: time-varying variance itself gives fat tails.
Yes.
We thought
securitization of
mortgages would
“spread the risk.” But it
5
spread risk like a virus
!
I would like to suggest a fourth “new” idea
in volatility:
When using Black-Scholes or other
formulas to price options (VIX) or bond
spreads (corporate bonds), analysts simply
plug in variance estimated
from the recent past.
During 2004-2006, lagged variance
was low, tho forward-looking risk was high.
6
As Adrian & Brunnermeier point out

(p.5),
“After a string of good news, risk seems tamed, but,
when a new tail event occurs, the estimated risk measure
may sharply increase. This problem is most pronounced
if the data samples are short. Hence, regulatory
requirements that are naively based on estimated risk
measures would be stringent during a crisis and lax
during a boom. This introduces procyclicality –
exactly the opposite of the goal of effective regulation.”
I couldn’t agree more. But: (i) Does this require
that tail events are asymmetrically negative?
(ii) If so, could the causality run from a variance
innovation, via the risk premium, to a fall in
asset prices, instead of the other way?
7
Origins of the financial/economic crises
Monetary
policy easy
2004-05
Stock
market
bubble
Underestimated
risk in
financial mkts
Failures of
corporate
governance
saving too little,
borrowing too
Homeownership bias much
Excessive leverage in
financial institutions
Predatory
lending
Excessive
complexity
MBS
s
CDSs
China’s
growth
Stock
market
crash
Gulf
instability
CDO
s
Financial
crisis
2007-08
Oil
price
spike
2007-08
Households
Recession
2008-09
Federal
budget
deficits
Low
national
saving
Housin
g
bubble
Foreig
n debt
Housin
g
crash
Lower longterm
econ.growth
Eventual loss
of US hegemony
8
The return of Keynes

Keynesian truths abound today:
 Origins
of the crisis
 The Liquidity Trap
 Fiscal response
 Motivation for macroeconomic intervention:
to save market microeconomics
 International transmission
 Need for macroeconomic coordination
9

The origin of the crisis was an asset bubble
collapse, loss of confidence, credit crunch….

like Keynes’ animal spirits or beauty contest .






Add in von Hayek’s credit cycle,
Kindleberger ’s “manias & panics”
the “Minsky moment,” &
Fisher’s “debt deflation.”
78
It was not a monetary contraction
in response to inflation as were 1980-82 or 1991.
But, rather, a credit cycle: 2003-04 monetary expansion
showed up only in asset prices. (Borio of BIS.)
10
Financial regulation
Good for Daron !
True.
But if we don’t draw
up an informed list,
politicians will come
up with a worse one.
11
Desirable longer-term financial reforms

Executive compensation



Securities



Regulatory agencies: In US, merge SEC & CFTC?
Create a central clearing house for CDSs .
Credit ratings:



Compensation committee not under CEO. Maybe need Chairman of Board.
Discourage golden parachutes & options, unless truly tied to performance.
Reduce reliance on ratings. AAA does not mean no risk.
Reduce ratings agencies’ conflicts of interest.
Lending

Mortgages



Banks:



Consumer protection, incl. standards for mortgage brokers
Fix “originate to distribute” model, so lenders stay on the hook.
Regulators shouldn’t let banks use their own risk models (VAR);
should make capital requirements less pro-cyclical .
Extend bank-like regulation to “near banks.”
Heavy
overlap
with
Richard
Portes’
list,
FT,
11/11/08
12
I always thought CoVar stood for Covariance.
But that is no more – nor less – confusing than VAR standing for
Value at Risk instead of either Variance or Vector AutoRegression.
In fact CoVaRiance rather captures the spirit of the idea.
Adrian & Brunnermeier make the sensible
point that regulators should worry about how
much a bank contributes to systemic risk
(CoVaR), more than just own risk (VaR).
Analogous to a CAPM for regulators.
13
Lehman Brothers, whose failure inflicted maximum adverse
effect on the financial system in Sept. 2008, shows up with
almost the highest risk rating by CoVaR, but also by VaR.
14
I would phrase it:
We have learned something we should
have already known -financial markets need a lot of
regulation, but market capitalism
still works best in the real economy.
15
Motivation for macroeconomic intervention

The view that Keynes stood for
big government is not really right.



He wanted to save market microeconomics from
central planning, which had allure in the 30s & 40s.
Remember, Bretton Woods blessed
capital controls and free trade.
Some on the Left today reacted to the crisis & election by
hoping a new New Deal would overhaul the economy.


My view: faith in the unfettered capitalist system has been shaken
with respect to financial markets, true;
but not with respect to the rest of the economy;
Obama’s economics are centrist, not far left.
16
 International
transmission remains as
powerful as ever (no “de-coupling”)

Consistent with old-fashioned Keynes-MeadeMundell-Fleming transmission via trade balances.
17
International coordination
of fiscal expansion?
As in the classic Locomotive Theory

Theory: in the Nash non-cooperative equilibrium
each country holds back from fiscal expansion
for fear of adverse trade deficits.


Solution: A bargain where all expand together.
In practice: example of Bonn Summit, 1978



didn’t turn out so well,
primarily because inflation turned out to be a bigger problem than
realized (& the German world was non-Keynesian).
Inflation is less a problem this time. The Germans are the same.
18
Multilateral initiatives


Hold the line against protectionism
Attempts at multilateral reform

More inclusion of developing countries
Locus shifted from G7 to G20 at London meeting (April).
 The IMF and World Bank





Regulatory reform.


Reallocation of shares
Break US-EU duopoly on MD & President
Tripling of size of IMF, incl. new SDR issue (a la Keynes)
Reduce procyclical Basel capital requirements; FSF; ….
Coordinated expansion? Failed at London G-20.

As had cooperation in 1933 (London Monetary & Economic Conference)
19
US
fiscal
stimulus
looks the
largest of
the G-10.
But most others have larger automatic stabilizers than the US
20
Mohamed El-Elrian & Mike Spence,
“Essential Task for G20 Leaders is a
Cinema Trip to See A Beautiful Mind”
The Daily Telegraph, March 30, 2009

Apparently Mohamed and Mike think
the producers of that movie took the
opportunity to teach the audience the
simple principle of the prisoner’s dilemma.
A reasonable inference.

But that’s not how I remember the movie.
Hollywood doubts the analytical aptitude/interests of the public.21
22
Appendices





Origins of the crisis
The US recession
Transmission to rest of world
Global forecast
The US policy response




Global current account imbalances



Monetary easing
Financial repair
Fiscal expansion
Implications of the crisis for the status of the dollar
Adjustment in surplus countries
End of the 3rd emerging markets capital boom
23
Origins of the crisis

Well before 2007,
there were danger signals in US:
Real interest rates <0 , 2003-04 ;
 Early corporate scandals (Enron…);
 Risk was priced very low,

housing prices very high,
 National Saving very low,
 current account deficit big,
 leverage high,
 mortgages imprudent…

24
US real interest rate < 0, 2003-04
Source: Benn Steil, CFR, March 2009
25
Onset of the crisis

Initial reaction to troubles:
Reassurance in mid-2007: “The subprime mortgage crisis
is contained.”
It wasn’t.
 Then, “The crisis is in Wall Street, sparing Main Street.”
It didn’t.
 Then de-coupling :
“The US turmoil will have less effect on the rest
of the world than in the past.”
It hasn’t.


By now it is clear that the crisis is
 the worst in 75 years,
 and is as bad abroad as in the US.
26
US Recession
In December 2008, NBER Business
Cycle Dating Committee proclaimed
US recession had started in December 2007.


As of March 2009, the recession’s length ties the
postwar record of 1981-82 (16 months).
Recovery unlikely before late 2009
 => recession is already longest since 1930s.


Likely also to be as severe as oil-shock recessions
of 1974 and 1980-82.
27
BUSINESS CYCLE REFERENCE DATES
Peak
Trough
Quarterly dates are in parentheses
August 1929 (III)
May 1937 (II)
February 1945 (I)
November 1948 (IV)
July 1953 (II)
August 1957 (III)
April 1960 (II)
December 1969 (IV)
November 1973 (IV)
January 1980 (I)
July 1981 (III)
July 1990 (III)
March 2001 (I)
December 2007 (IV)
Average, all cycles:
1854-2001
March 1933 (I)
June 1938 (II)
October 1945 (IV)
October 1949 (IV)
May 1954 (II)
April 1958 (II)
February 1961 (I)
November 1970 (IV)
March 1975 (I)
July 1980 (III)
November 1982 (IV)
March 1991 (I)
November 2001 (IV)
(32 cycles)
1945-2001 (10 cycles)
Source: NBER
Contraction
Peak to Trough
43
13
8
11
10
8
10
11
16
6
16
8
8
17
10
28
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).
employment
Source: Bureau of Labor Statistics
PayrollPayroll
employment
series series Source:
Bureau of Labor Statistics
29
My favorite monthly indicator:
total hours worked in the economy
It confirms: US recession turned severe in September,
when the worst of the financial crisis hit (Lehman bankruptcy…)
30
The US recession so far is deep
compared to past and to others’
Source: IMF, WEO, April 2009
31
Recession was soon transmitted
to rest of world:

Contagion: Falling securities
markets & contracting credit.




Especially in those countries with weak fundamentals:
Iceland, Hungary & Ukraine…
Or oil-exporters that relied heavily on high oil prices: Russia…
But even where fundamentals relatively strong: Korea, Brazil…
Some others experiencing their own housing crashes:
Ireland, Spain…

Recession in big countries was soon transmitted
to all trading partners through loss of exports.
32
International Trade has Plummeted
Source: OECD
33
The recession has hit more
countries than any in 60 years
34
Forecasts
35
Interim forecast
OECD 3/13/09
Forecast
for 2009 =
-3½%
36
“World Recession”

No generally accepted definition.
A sharp fall in China’s growth from 11% is a recession.
 Usually global growth < 2 % is considered a recession.


The World Bank now (March) forecasts
negative global growth in 2009,

for the first time in 60 years.
37
Unemployment rates are rising everywhere
38
Do we know this won’t be another Great Depression?
One hopes we won’t repeat the mistakes of the 1930s.

Monetary response: good this time

Financial regulation: we already have bank regulation
to prevent runs.
But it is clearly not enough.

Fiscal response: OK, but : constrained
by inherited debt. Also Europe was
unwilling to match our fiscal stimulus at G-20 summit.

Trade policy: Let’s not repeat Smoot-Hawley !


E.g., the Buy America provision
Mexican trucks
39
The Fed certainly hasn’t repeated the
mistake of 1930s: letting M1 fall.
2008-09
1930s
Source:
IMF,
WEO,
April
2009
Box 3.1
40
U.S. Policy Responses

Monetary easing is unprecedented,
appropriately. But it has largely run its course:
 Policy
 The


(graph)
famous liquidity trip is not mythical after all.
As Krugman & others warned us re Japan in 90s.
& lending, even inter-bank, builds in big spreads


interest rates ≈ 0.
since mid-2007, not just since September 2008.
(graph)
Now aggressive quantitative easing, as the Fed
continues to purchase assets not previously dreamt of.
41
Source: OECD
Major central banks have cut interest rates sharply.
42
Bank spreads rose sharply
when sub-prime mortgage crisis hit (Aug. 2007)
and up again when Lehman crisis hit (Sept. 2008).
Source:
OECD,
Datastream
43
Corporate spreads
between corporate & government benchmark bonds
zoomed after Sept. 2008
US
€
44
Policy Responses, continued

Obama policy of “financial repair”:
Infusion of funds has been more conditional,
vs. Bush Administration’s no-strings-attached.
 Some money goes to reduce foreclosures.
 Conditions imposed on banks that want help:

(1) no-dividends rule,
 (2) curbs on executive pay,
 (3) no takeovers, unless at request of authorities &
 (4) more reporting of how funds are used.


But so far they have avoided “nationalization” of banks45
Policy Responses -- Financial Repair,

cont.
Secretary Geithner announced PPIP 3/23/09:
Public-Private Partnership Investment Program
 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.
46
Policy Responses -- Financial Repair,
cont.
 How
much money is the government
putting into the PPIP?
 designed
to be enough to attract participants, but not more.
 From the Treasury (already set aside under TARP),
leveraged courtesy of FDIC & Fed.
 Taxpayers

share equally with new private investors in upside,
 but
admittedly bear all the downside risk.
 Nationalization could have been a lot more expensive.
47
The PPIP was attacked from both sides
in part due to anger over AIG bonuses, etc.
FT, Mar 25, 2009
But the stock market reacted very
positively, and some respected
commentators are supportive.
48
Policy Responses,
 Unprecedented
continued
US fiscal expansion.
Obama proposed an $825 expansion
 Version passed by Congress was just a bit worse.
 Good old-fashioned Keynesian stimulus


Even the belief that spending provides more
stimulus than tax cuts has returned;
not just from Larry Summers,
for example,
 but also from Martin Feldstein.

49
Fiscal response
“Timely, targeted and temporary.”
American Recovery & Reinvestment Plan includes:

Aid to states:
education,
 Medicaid…;


Other spending.


Unemployment benefits, food stamps,
especially infrastructure, and



Computerizing medical records,
smarter electricity distribution grids, and
high-speed Internet access.
50
Fiscal stimulus also included

Tax cuts
 for


lower-income workers (“Making Work Pay”)
EITC,
child tax credit.
 Fix

for the AMT (for the middle class).
But soon will need to return toward fiscal discipline
Let Bush’s pro-capital tax cuts expire in 2011.
 Economists want to substitute energy taxes for others.

51
The next crisis

The twin deficits:

US budget deficit => current account deficit

Until now, global investors have happily financed US deficits.

The recent flight to quality paradoxically benefited the $,



even though the international financial crisis originated in the US.
For now, US TBills are still viewed as the most liquid & riskless.
Sustainable?


How long will foreigners keep adding to their $ holdings?
The US can no longer necessarily rely on support of foreign central
banks, either economically or politically.
52
The 2007-08 financial crisis has
probably further undermined US
monetary hegemony in the long run



US financial institutions have lost credibility
Expansionary fiscal and monetary policy may show
up as $ depreciation in the long run.
The long slow decline of the $ as an international
reserve currency may accelerate.
53
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)
.8
Simulation predicts € may overtake $ as early as 2015
.7
USD
.6
EUR
forecast
.5
USD forecast
.4
.3
DEM/EUR
.2
Tipping point in updated
simulation: 2015
.1
.0
54
1980
1990
2000
2010
2020
2030
54
2040
The 2001-2020 decline in international currency
status for the $ would be only one small part of
a loss of power on the part of the US. But:
A loss of $’s role as #1 reserve currency could in
itself have geopolitical implications.
Historical precedent: £ (1914-1956)


With a lag after US-UK reversal of ec. size &
net debt, $ passed £ as #1 international
currency.
“Imperial over-reach:” the British Empire’s
widening budget deficits and overly ambitious
55

Precedent: The Suez crisis of 1956

is often recalled as the occasion
on which Britain was forced
under US pressure to abandon
its remaining imperial designs.

But recall also the important role
played by a simultaneous run on
the £ and the American decision
not to help the beleaguered currency.
[i]
[i] Frankel, “Could the Twin Deficits Jeopardize US Hegemony,”
Journal of Policy Modeling, 28, no. 6, Sept. 2006.
At http://ksghome.harvard.edu/~jfrankel/SalvatoreDeficitsHegemonJan26Jul+.pdf .
Also “The Flubbed Opportunity for the US to Exercise Global Economic Leadership”;
in The International Economy, XVIII, no. 2, Spring 2004 at http://ksghome.harvard.edu/~jfrankel/FlubJ23M2004-.pdf
56
56
“Be careful what you wish for!”
US politicians have not yet learned how dependent
on Chinese financing we have become.
57
In the short run, however, the financial
crisis has caused a flight to quality which
apparently still means a flight to US$.

US Treasury bills are more in demand than ever,
as reflected in very low interest rates.

The $ appreciated in 2008, rather than depreciating as the
“hard landing” scenario had predicted.

=> The day of reckoning had not yet arrived.

Recent Chinese warnings may be a turning point:


Premier Wen worried US T bills will lose value.
PBoC Gov. Zhou proposed
replacing $ as international currency.
58
Global Current Account Imbalances
may now be forced to adjust

US deficit will likely diminish,


though adjustment requires $ depreciation.
Who must take corresponding reduction in
current account surpluses?



Europe says: “Not us. Overall we are in balance.”
Others say: Europe can expect to take a share, roughly
proportionate to its share in world trade,
IMF seems to think oil exporters will take all adjustment
(see graph)
59
Current account adjustment:
US vis-á-vis oil exporters
(as % of GWP;
source: IMF)
60
The OECD sees the €-area
bearing much of the adjustment.
Source: OECD Economic Outlook, Nov. 2008.
3/ as % of GDP
61
But emerging markets
now have to spend some hard-earned reserves
62
3 cycles of net private capital flows
to emerging markets, by region
peaking in 1982, 1997 and
2008
Source: Capital Flows to Emerging Market Economies, IIF, 1/27/09.
63
Capital flows to emerging markets
peaked in 2007
from: EM Fund Flows, Citi, December 200864
Source: Benn Steil, Lessons of the Financial Crisis, CFR, Marc
65
BRIC growth has disappeared
66
Jeffrey Frankel
James W. Harpel Professor of Capital Formation & Growth
Harvard Kennedy School
http://ksghome.harvard.edu/~jfrankel/index.htm
Blog: http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/