The global financial crisis
Jeffrey Frankel
Harpel Professor of Capital Formation & Growth
Boston Committee on Foreign Relations
Union Club, Boston, May 12, 2009
Outline

The international financial crisis of 2007-2009




Root causes in the US
Transmission to rest of world
Forecasts
Multilateral Cooperation:



The next crisis: Hard landing for the $ ?


China’s dollar purchases
Emerging Markets



The G-20 meeting
The locomotive theory of fiscal policy
The 3rd capital inflow boom 2003-2007 and its end in 2008
Are the 1994-2002 lessons on how to avoid crises holding up?
Appendices
2
Six root causes of US 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
3
Six root causes of financial crisis,
cont.


4. Starting 2001, the federal budget
was set on a reckless path,
5. Real interest rates were too low during
2004-05 -- mostly due to Fed policy,
tho some point to high Asian saving.
6. Financial market participants
during this period grossly
underpriced risk.
4
US real interest rate < 0, 2003-04
Source: Benn Steil, CFR, March 2009
Real interest rates <0
5
The 2003-06 underpricing of risk

showed up everywhere:
in options prices (e.g., VIX)
 in bond spreads (e.g., “high yield” corporate bonds)
 in emerging markets (low sovereign spreads)



as low in 2006 as it had been high in 1998
Explanations?

Estimated variances (e.g., in Black-Scholes formula)


backward-looking, rather than forward looking.
Option-implied volatility seems to follow US fed funds
interest rate (with a lag): e.g., low in 1993 & 2004
6
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
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…
& even where fundamentals were relatively strong: Brazil, Korea…
Some others are experiencing their own housing crashes:
Ireland, Spain…

Recession in big countries has been transmitted to all
trading partners through loss of exports.
9
The Financial Crisis
Hit Emerging Markets in Late 2008:
Stock markets plunged and sovereign spreads rose
Source: IMF WEO, Oct. 2008
10
International Trade has Plummeted
Source: OECD
11
Asian exports are especially hard-hit
via RGE Monitor 2009 Global Outlook
12
The recession has hit more
OECD countries than any in 60 years
13
Unemployment rates are rising everywhere
14
Forecasts
15
Interim forecast
OECD 3/13/09
Forecast
for 2009 =
-3½%
16
IMF, too, forecasts 2009 as sharpest downturn
Source: WEO,
April 2009
17
“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 (March) now forecasts
negative global growth in 2009,
for the first time in 60 years.
 So does the IMF (April) when GDPs compared at current exchange rates.

18
IMF forecasts, April 2009
19
BRIC growth has disappeared
20
2009 April
21
Multilateral initiatives
 E.g.,
G-20,
 which
met in London
 in April 2009.
22
International coordination
of fiscal expansion?
As in the classic Locomotive Theory
 Theory:
in the non-cooperative equilibrium, each country
holds back fiscal expansion for fear of trade deficits.
Classic prisoner’s dilemma of Nash
 Solution:
A bargain where all expand together.

23
The Locomotive Theory in Practice

The example of G-7 Bonn Summit, 1978

didn’t turn out so well:
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.
Coordinated expansion failed
at G-20 Summit in London, this April.

As had cooperation in 1933 (London Monetary & Economic Conference)
24
US
fiscal
stimulus
looks the
largest of
But others point out
the G-10.
that they have larger automatic stabilizers than the US
25
But G-20 Summit did accomplish some things

Expansion of the IMF
Tripling of size of IMF quotas.
 New issue of SDRs (a la Keynes)


More inclusion of developing countries

Eventually:




Locus shifted from G7 to G20 at London meeting.
Regulatory reform? Still to come.


Reallocation of voting shares in IMF and World Bank?
Break US-EU duopoly on MD & President?
Reduce procyclical Basel capital requirements; FSB; ….
Hold the line against protectionism? Not yet clear.
26
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.
27
The 2007-08 financial crisis
probably further undermined
US long run hegemony.



US financial institutions have lost credibility.
Expansionary fiscal and monetary policy
may show up as $ depreciation in the long run.
The slow descent of the $ as an international
currency may accelerate.
28
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
29
1980
1990
2000
2010
2020
2030
29
2040
“Be careful what you wish for!”
US politicians have not yet learned how dependent
on Chinese financing we have become.
30
If China gave US politicians
what they say they want...

we’d regret it.

especially if it included reserve shift
to match switch in basket weights.

As of early 2009, a floating yuan might not even appreciate !

Even if RMB did appreciate,
US TB & employment might not rise:


fall in US bilateral trade deficit with China
would be offset by rise in US bilateral deficit
with other cheap-labor countries,
What if all Asian currencies appreciated together?



Yes, that would help US TB;
but US interest rates probably would rise:
possible hard landing for the $.
31
What about China’s currency reform
announced in July 2005?
China did not fully do what it implied,
 i.e., basket peg (with cumulatable +/- .3% band).

Frankel & Wei (2007) & Frankel (2009) estimates:
 De facto weight on $ still very high in 2005-06.
 Little appreciation against the implicit basket,
 but appreciation against $ in 2007, as the basket gave substantial
weight to the € which appreciated against $.
 Beijing responded to pressure on exporters in 2008
by switching back to a dollar peg.
Just in time to ride the $ up in its year of reverse-trend appreciation !
32
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.
33
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
34
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. [i]

Precedent: The Suez crisis of 1956
 is often recalled as the occasion on which
Britain was forced under US pressure to
abandon its 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] 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
35
35
Emerging markets
36
Real interest rates in the US,
when low, have sent capital flowing into developing countries:

1st boom -- recycling petrodollars, 1974Ended with the international debt crisis of 1982-

2nd boom -- emerging market bonanza: 1990Ended, for Mexico, in 1994.
Perhaps precipitated -- as predicted by Calvo, Leiderman & Reinhart –
by increase in US interest rates.

3rd boom -- the search for yield: 2003

e.g., carry trade from ¥, CHF & $, into NZ, Iceland, S.Africa.…
Convergence play from € into Hungary, Baltics…
Ended in the fall of 2008.
37
Capital flow cycle
Capital Inflows to Developing Countries as % of Total GDP
(Low and Middle Income)
5.00
4.50
International
debt crisis of
1982
4.00
3.50
Net Total Private
Capital Flows
3.00
East Asia
crisis of
1997
2.50
2.00
1st boom:
1975-81
1.50
3rd
boom:
2004-
2nd boom:
1990-1996
1.00
ct
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
1972
-
1970
0.50
Source: World Development Indicators
38
3 peaks in net private capital flow cycles
to emerging markets, by region
peaking in 1982, 1997 and
2008
Source: Capital Flows to Emerging Market Economies, IIF, 1/27/09.
39
Cycle in capital flows to emerging markets

1st developing country lending boom
(“recycling petro dollars”): 1975-1981



2nd lending boom (“emerging markets”): 1990-96



Ended in international debt crisis 1982
Lean years (“Lost Decade”): 1982-1989
Ended in East Asia crisis 1997
Lean years: 1997-2003
3rd boom (incl. China & India this time): 2003-2008
40
The latest
emerging
market
boom
began in
2003, and
surpassed
the 1990s
boom.
Source: IMF WEO, 2007
41
This time, many countries used the inflows
to build up forex reserves, rather than
to finance Current Account deficits
7.00
6.00
in % of GDP
(Low- and
middle-income
countries)
5.00
4.00
3.00
Net Capital
Flow
Change in
Reserves
2.00
1.00
2003-07
boom
1991-97 boom
2.00
3.00
4.00
Current
Account
Balance
42
20
06
20
05
20
04
20
03
20
02
20
01
20
00
19
99
19
98
19
97
19
96
19
95
19
94
19
93
19
92
19
91
19
90
19
89
19
88
19
87
19
86
19
85
19
84
19
83
19
82
1.00
19
81
19
80
0.00
As a result, reserves reached extreme levels....
As a result, reserves in developing countries
soon reached high levels....
43
…, especially in Asia
Traditional denominator
for reserves: imports
44
New denominator: short-term debt.
After 2000, many brought their reserves above
the level of short-term debt (the Guidotti rule).
45
Source: IMF WEO, 2007
This time, China and India shared in major inflows.
But, again, capital inflows financed only reserve accumulation,
not current account deficits as in the past.
By 2007, reserves in some countries seemed grossly excessive. 46
Capital flows to emerging markets
peaked in 2007, fell in 2008
from: EM Fund Flows, Citi, December 200847
All decoupling ended in Septemb
Source: Benn Steil, Lessons of the Financial Crisis, CFR, Marc
48
What characteristics have helped
emerging markets resist financial
contagion in the past?






High FX reserves and/or floating currency
Low foreign-denominated debt (currency mismatch)
Low short-term debt (maturity mis-match)
High Foreign Direct Investment
Strong initial budget, allowing room to ease.
High export/GDP ratio,
Sachs (1985); Eaton & Gersovitz (1981), Rose (2002)
Calvo, Izquierdo & Talvi (2003); Cavallo & Frankel (2008);


but openness might not be helpful resisting a global recession
49
Are big current account deficits dangerous?
Neoclassical theory –
if a country has a low capital/labor ratio
or transitory negative shock, a large CAD can be optimal.
In practice – Developing countries with big CADs often get into trouble.
Traditional rule of thumb: “CAD > approx. 4% GDP” is a danger signal.
“Lawson Fallacy” – CAD not dangerous if government budget is
balanced, so borrowing goes to finance private sector, rather than BD.
Amendment after 1994 Mexico crisis – CAD not dangerous if BD=0 and
S is high, so the borrowing goes to finance private I, rather than BD or C.
Amendment after 1997 East Asia crisis –
CAD not dangerous if BD=0, S is high, and I is well-allocated,
so the borrowing goes to finance high-return I, rather than BD or C or
empty beach-front condos (Thailand) & unneeded steel companies (Korea).
Amendment after 2008 financial crisis – CAD dangerous (?).
50
Some references on statistical predictors of
crises among developing countries
• Jeffrey Sachs, Aaron Tornell & Andres Velasco,
“Financial Crises in Emerging Markets: The Lessons from 1995” (1996):
Combination of weak fundamentals (changes RER or credit/GDP) and low
reserves (relative to M2) made countries vulnerable to tequila contagion.
• J. Frankel & Andrew Rose, "Currency Crashes in Emerging Markets" (1996):
Composition of capital inflow matters (more than the total): short-term bank
debt raises the probability of crash; FDI & reserves lower the probability.
•Graciela Kaminsky, Saul Lizondo & Carmen Reinhart,
“Leading Indicators of Currency Crises” (1998).
Best predictors: Real ex. rate, M2/Res, GDP, equity prices.
•A.Berg, E. Borensztein, G.M.Milesi-Ferretti, & C.Pattillo,
“Anticipating Balance of Payments Crises: The Role of Early Warning Systems,” IMF (1999).
The early warning indicators don’t hold up as well out-of-sample.
51
Eichengreen & Mody (2000):
Spreads charged by banks
on emerging market loans
are significantly:
• increased if the country has:
-----
high total ratio of Debt/GDP,
rescheduled in previous year
high Debt Service / X, or
unstable exports; and
• reduced if it has:
-- a good credit rating,
-- high growth, or
-- high reserves/short-term debt
52
The lessons of the 1994-2002 crises

Many emerging markets after the 1990s learned to
(1) float or hold large reserves or both
 (2) use capital inflows to finance reserve accumulation
(“self-insurance”), rather than current account deficits
 (3) take capital inflows more in the form of FDI
or local-currency-denominated debt flows;


avoiding the currency mismatch of $ liabilities


and avoiding short-term bank loans.
The ratio of reserves to short-term liability seemed
the most robust predictor of the likelihood &
severity of crises.
53
Have those who obeyed the lessons of 1994-2002
done better in response to the current shock?

It is striking that some who had large current account
deficits and foreign-currency debts did have trouble,



particularly in Central & Eastern Europe: Hungary, Ukraine, Latvia…
Systematic studies are only beginning.
An early one by Obstfeld, Shambaugh & Taylor :

“Financial Instability, Reserves, and Central Bank Swap Lines
in the Panic of 2008,” March 2009, NBER WP 14826.

Finding: Countries’ reserve holdings just before the current crisis,
relative to requirements (M2), significantly predict 2008 depreciation.
Current account balances & short-term debt levels are not
statistically significant predictors, once reserve levels are taken into
account.

54
Precautionary insurance




Collective Action Clauses
New Flexible Credit Line from IMF
Mexico has both ($47 b credit line, April 18 2009)
Neither has been needed so far, of course
Have they helped ward off speculation?
 Too soon to say.


Reserves have turned out to be the ultimate
insurance.
55
56
Appendices

1. The financial crisis of 2007-09




2. Repeat of Great Depression? US policy response





US origins
The US recession
Transmission to rest of world
Monetary easing
Financial repair
Fiscal expansion
International cooperation
3. Emerging markets


Contagion
The car crash analogy
57
1. Origins of the US financial 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…

58
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 on Wall Street;
it may spare 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.
59
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
60

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.)
61
Bank spreads rose sharply
when sub-prime mortgage crisis hit (Aug. 2007)
and up again when Lehman crisis hit (Sept. 2008).
Source:
OECD Economic Outlook
(Nov. 2008).
62
Corporate spreads
between corporate & government benchmark bonds
zoomed after Sept. 2008
US
€
63
US Recession

The US recession started in December 2007
according to the NBER Business Cycle Dating
Committee (announcement of Dec. 2008) .

As of April 29, 2009, the recession’s length tied
the postwar records of 1973-75 & 1981-82
= 4 quarters; 16 months
 One has to go back to 1929-33 for a longer downturn.


Likely also to be also as severe as oil-shock recessions
of 1973-75 and 1980-82, though not yet.
64
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
65
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
66
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…)
67
The US recession so far is deep,
compared to past and to others’
Source: IMF, WEO, April 2009
68
U.S. output lost in the current downturn
would still have a very long way to go
before reaching the depth of the 1930s...
Source: Federal Reserve Bank of St. Louis
69
…but, by at least one measure, the world is
on track to match the Great Depression !
Industrial production
Source: George Washington’s blog
70
2. How do we know this will
not be another Great Depression?

especially considering that
successive forecasts of the
current episode have been
repeatedly over-optimistic?

The usual answer: we learned
important lessons from the 1930s,
and we won’t repeat the mistakes
we made then.
71
One hopes we won’t repeat the 1930s mistakes.

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
72
U.S. Policy Responses

Monetary easing is unprecedented,
appropriately avoiding the mistake of 1930s.
But it has largely run its course:
 Policy



interest rates ≈ 0.
(graph)
(graph)
The famous liquidity trip is not mythical after all.
& lending, even inter-bank, builds in big spreads.
Now we have aggressive quantitative easing: the Fed
continues to purchase assets not previously dreamt of.
73
The Fed certainly has not repeated the
mistake of 1930s: letting the money supply
fall.
2008-09
1930s
Source:
IMF,
WEO,
April
2009
Box 3.1
74
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 banks75
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.
76
The PPIP was attacked from both sides
in part due to anger over AIG bonuses, etc.
FT, Mar 25, 2009
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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;
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Policy Responses,
 Unprecedented

continued
$800 b fiscal stimulus.
Good old-fashioned Keynesian stimulus

Even the principle that spending provides more
stimulus than tax cuts has returned;
not just from Larry Summers, e.g.,
 but also from Martin Feldstein.

 Is
$800 billion too small? Too big?
 Yes:
Too small to knock out recession ;
 too big to keep global investors confident inUS debt.
 I.e., just about right.
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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.
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
Fiscal stimulus also included tax cuts:

for lower-income workers (“Making Work Pay”)




Fix for the AMT (for the middle class).
Soon we must return toward fiscal discipline.


EITC,
refundable child tax credit.
Let Bush’s pro-capital tax cuts expire in 2011.
The budget passed by Congress omitted
some of the best features proposed by Obama:


Cuts in farm subsidies for agribusiness & farmers > $250 million
Auctioning of GHG emission permits in future,

with revenue used, e.g., to cut taxes on low-income workers.
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Appendix 3: Emerging Markets
1. Currency crises of 1994-2001
2. Contagion
3. The car crash analogy
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Contagion
In August 1998, contagion
from the Russian devaluation/default jumped oceans.
Source: Mathew McBrady (2002)
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Categories/Causes of Contagion
• “Monsoonal effects” (Masson, 1999) Common external shocks
• E.g., US interest rates ↑,
• world recession, or
• $ commodity prices ↓ …
• “Spillover effects”
• Trade linkages
• Competitive devaluations
• Investment linkages
• Pure contagion
• Imperfect information (“cascades”)
• Investor perceptions regarding, e.g., Asian model or odds of bailouts
• Illiquidity in international financial markets or reduced risk tolerance
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THE CAR CRASH ANALOGY
Sudden stops:
“It’s not the speed that kills, it’s the sudden stops”
– Dornbusch
Superhighways:
Modern financial markets get you where you want to go fast,
but accidents are bigger, and so more care is required.
– Merton
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Is it the road or the driver? Even when many countries
have accidents in the same stretch of road (Stiglitz), their own
policies are also important determinants; it’s not determined
just by the system.
– Summers
Contagion is also a contributor to multi-car pile-ups.
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THE CAR CRASH ANALOGY
Moral hazard -- G7/IMF bailouts that reduce the impact of a given
crisis, in the LR undermine the incentive for investors and
borrowers to be careful. Like air bags and ambulances.
But to claim that moral hazard means we should abolish the IMF
would be like claiming that drivers would be safer with a spike in
the center of the steering wheel column.
– Mussa
Correlation does not imply causation: That the IMF (doctors)
are often found at the scene of fatal accidents (crises) does not
mean that they cause them.
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Reaction time: How the driver reacts in the short interval
between appearance of the hazard and the moment of
impact (speculative attack) influences the outcome.
Adjust, rather than procrastinating (by using up reserves
and switching to short-term $ debt) – J Frankel
Optimal sequence: A highway off-ramp should not dump
high-speed traffic into the center of a village before streets
are paved, intersections regulated, and pedestrians learn not
to walk in the streets. So a country with a primitive
domestic financial system should not necessarily be opened
to the full force of international capital flows before
domestic reforms & prudential regulation.
=> There may be a role for controls on capital inflow
(speed bumps and posted limits).
-- Masood Ahmed
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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/