D£\NEVll
MIT LIBRARIES
3 9080 03317 5941
Massachusetts Institute of Technology
Department of Economics
Working Paper Series
THE CRISIS: BASIC MECHANISMS,
APPROPRIATE POLICIES
Olivier
AND
Blanchard
Working Paper 09-01
December 29, 2008
Room
E52-251
50 Memorial Drive
Cambridge,
MA 021 42
paper can be downloaded without charge from the
Social Science Research Network Paper Collection at
This
http://ssrn.con-)/abstract= 324280
1
w
The
Basic Mechanisms,
Crisis:
and Appropriate PoHcies*
Olivier J. Blanchard^
December 2008
Abstract
The purpose
of this lecture
is
to look
beyond the complex events
that characterize the global financial and economic
crisis, identify
the basic mechanisms, and infer the policies needed to resolve the
current
crisis,
as well as the policies needed to reduce the probability
of similar events in the future.
*
"Munich lecture'", delivered on November 18, 2008. I thank Stijn Clae.ssens,
Giovanni DeH'Ariccia, Giaiuii de Nicolo, Haiiiid Faruqee, Luc Laeven, Krishna
Srinivasan, and many others in the IMF Research Department for discussions and
help. I thank Ricardo Caballero. Cliarle.? Calomiris, Steve Cecchetti, Pi-ancesco
Giavazzi. Anil Kashyap, Arviud Kri.shuanunthy. Andrei Shleifer, and Nancy Zim-
merman,
for discussions
along
assistance,
t
MIT. NBKR. and IMF.
tlie
way.
I
thank loannis Tokatlidis
for research
Digitized by the Internet Archive
in
2011 with funding from
Boston Library Consortium IVIember Libraries
http://www.archive.org/details/crisisbasicmechaOOblan
It is
much
least
because
too early to give a definitive assessment of the
it is
far
from over.
It is
think about the policies we need to implement,
what
pass
ill
1
shall try to
do
not
not too early however to look for
the basic mechanisms that have taken us where
is
crisis,
in this lecture.
Take
it
we
are today,
now and
for
what
and
later.
it is,
a
to
This
first
the midst of the action.'
Figure
1
Iniliat Subprime Losses and Subsequent Declines In World GDP
and World Stock Market Capitalization (in Trillions US Dollars)
Estimate of Subprime Losses on Loans
Estimate of Cumulative World
and Securities by 10/Z0O7
Source IMF Global Financial
Exchanges.
The
best
Figure
losses
1.
GDP
Stability Report,
Decline
in
World Stock Market
Capitalization 9/07 to 10/08
loss
Wotid Economic Outlook November update and estimates, World Federation
way
of motivatiiij; tlic lecture
The
first l^ar
(which
is
on U.S. subprime loans and
2007. at about $250 billion dollars.
is
ol
to start with the chart in
barely visible) shows the estimated
securities,
estimated as of October
The second bar shows
the expected
full disclosure: This is a first pass by an economist who,
thought of financial intermecHation as an i.ssue of relatively little
importance for economic fluctuations...
1.
Ill
the interest of
until rccentl.y,
cumulative loss in world output associated with the
current forecasts. This loss
tries, of
constructed as the sum, over
November 2008.
IMF
all
coun-
20 times the
estimates and forecasts of output as of
for the years
the cumulative loss
is
initial
2008 to 2015. Based on these forecasts,
forecast to run at $4,700 billion dollars, so about
subprime
loss.
The
third bar siiows the decrease
the value of stock markets, measured as the sum, over
kets, of the decrease in stock
November
2008. This loss
100 times the
How
based on
the expected cumulative deviation of output from trend in
each coimtry, based on
in
is
crisis,
is
market capitalization from July 2007 to
equal to about $26,400 billion, so about
subprime
initial
mar-
all
loss!
The
question
is
an obvious one:
could such a relatively limited and localized event (the subprime
loan crisis in the United States) have effects of such magnitude on the
world economy?'
To answer
in
I
shall
proceed
by identifying the essential
First,
the
this question,
crisis. I
see
them
newly issued
initial
in four steps.
conditions which have shaped
as fourfold: the underestimation of risk contained
assets; the opacity of the derived securities
on the
balance sheets of financial institutions; the connectedness between
financial institutions,
both within and across countries; and,
finally,
the high leverage of the financial system as a whole.
Second, by identifying the two amplification mechanisms behind the
2.
Ironically, the other
shock which dominated the ncw.s until the financial
led to the opposite cjuestion:
How
could the very large increa,se in
oil
crisis
prices from the
early 2000s to mid-2008 have such a small apparent impact on economic activity?
After
all,
similar increases are typically
the 1970s and early 1980s.
lecture,
but
is
less fragile in
very
The
much worth
blamed
for
the very deep recessions of
plausible answer, which
exploring,
some dimensions, more
I
shall
not explore
in this
must be that the economy has become
fragile in others.
'
'i
'
;
I.
I
,
1
;
,
,
;
;
M
1
crisis,
bad
once the trigger had been pulled and some of the assets appeared
or doubtful.
I
see two related, but distinct, mechanisms:
sale of assets to satisfy liquidity runs
by
mechanisms
ca.n lead,
the
investors; and, second, the
sale of assets to reestablish capital ratios.
conditions, these
first,
Together with the
and indeed have
initial
led, to
very
large effects of a small trigger on world economic activity.
Third, by showing h(}w the amplification mechanisms have played out
in real time,
moving from subprime
to institutions,
to other assets, from institutions
and from the United States,
first
to Europe,
and then
to emerging countries.
Fourth, by turning to policies.
conditions for this
crisis...
It
is
too late to change the
So, current policies should
limiting the two amplification
mechanisms
at
work
initial
be aimed at
at this juncture.
Future regulation and policies should also aim however at avoiding a
repeat of some of those
fight current fires
Initial
1
The
initial conditions. In short,
and reduce the
we need
to both
risk of fires in the future.
Conditions
trigger for the crisis
United States. But,
in
was the decline
in
housing prices for the
the years preceding, four evolutions had com-
bined to potentially turn such a price decline into a major world
1.
A.s,set.s
crisis.
were created, sold, and bought, which iippenicd much
risky tlinn tlicy truly were.
less
Conditional on no housing price decline, most subprime mortgages
appeared relatively
riskless:
The value
relative to the price of the house, but
of the
it
mortgage might be high
would slowly decline over time
was
as prices increased. In retrospect, the fallacy of the proposition
in its premise: If
and when housing
prices actually declined,
many
mortgages would exceed the value of the house, leading to defaults
and
foreclosures.^
Why
who took
did the people
these mortgages, and the institutions
which held them, so underestimate the true
have been given, and
some
of
many
risk?
Many
potential culprits have been
explanations
named. To
list
them: Large saving by Chinese households, leading to a low
world mterest rate, and thus a "search
for yield"
by investors disap-
pointed with the return on truly safe assets; large private and pul)lic
capital inflows into the United States in search of safety, leading suppliers to offer
what looked
like safe assets to satisfy
expansionary a monetary policy
distribute"
itoring
model
of
the United States, with the im-
in
promise of low interest rates
plicit
for a long time; the "originate
mortgage financing, leading to
by the loan originators. Each
grain of truth, but only a grain.
Why
equilil:)iium
US
interest rate,
if
insufficient
and
mon-
of these explanations contains a
would a low world
necessarily lead to "search for yield"?
have set a higher
the demand; too
Why
interest rate
should Alan Greenspan
low interest rates reflected low
world rates, and there was no pressure on inflation?
should investors have bought mortgages from originators
if
Why
they knew
that monitoring was deficient?
3.
On
Foote
the relation between property values, mortgage.s, and foreclosui'es, read
et al [2008J
I
suspect that the fundamental explanation
is
more
general. History
teaches us that benign economic environments often lead to credit
booms, and to the creation of marginal assets and the issuance of
marginal loans. Borrowers and lenders look at recent historical
tributions of returns, and
become more
mistic about future returns.''
dis-
optimistic, indeed too opti-
The environment was indeed benign
in
the 2000s in most of the world, with sustained growth and low interest
And, looking
rates.
in
particular at
and lenders could point
US
housing prices, both borrowers
to the fact that housing prices
had increased
every year since 1991. and had done so even during the recession of
2001.^
Nor was
this
understatement of risk confined to subprime loans. Credit
default swaps (CDS), which sound complex but are in effect insurance
policies,
were issued against many
For low premia, firms and
risks.
institutions could insure themselves against specific risks, be
risk of default
And CDS
the
by a firm, by a financial institution, or by a country.
happy
issuers were
assumed the probability
2.
it
Securitization led to
to accept these low premia, as they
of having to
pay out was nearly
complex and hard
negligible.
to value assets on the bal-
ance sheets of financial institutions.
Securitization had started nuich
decade. In mid-2008, more than
curitized. In the
60%
of
but changed scale
all
in the last
U.S. mortgages were se-
mortgage market, mortgages were pooled
4.
For an analysis of
.see
Claessens et
5.
A
prices
eaxliei',
credit. Ijoonis
to
form
and hnsts over a large number of countries,
al [2008].
point that Charles Calorniris
would ever go down).
[2(J08]
has called "plausihie deniahilit\-" (that
mortgage-basod securities (MBS), and the income streams from these
more
or less
GlolDal Financial Stability
Report
securities were separated ("tranched") further to offer
risky flows to investors.
Figure
2,
(GFSR)
cial
taken from the 2007
IMF
gives a sense of the complexity of that part of the finan-
system.
tranches,
It
shows how
mortgages were securitized, cut in
initial
and then held by various
with different degrees of
rows would take the
investors
risk aversion.
and
financial institutions,
Going through the various
rest of the lecture.''
My
intent
is
ar-
simply to give
a visual impression of the complexity of the financing arra.ngements.
Figure
Mortage Finance
2.
Bough! hy
more
r
—
"
i
1"
*
/SIVshuyABS
and issue
BuiJu
l*ndcr
;
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icr
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seeking ioMMiirs
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rtttil
shori-
lurm dehi
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livi.ssuiiigdt^lii
r sk^s^H-'kioL
nviisiiirs
Source.
Adapted from Figure
Exposures'' Chapter
6.
On
this, see
I,
p. 11,
Gary Gortcni
1.10:
risk -SI kiiiu
nK)s
Mortgage Market Flows and Risk
October 2007 GFSR.
[2007]
illVLS
Why
did securitization take
such a way? Because
off in
it
was, and
a major improvement in risk allocation and a fundamentally
still is,
healthy development. Indeed, looking across countries before the
sis,
many
(including
me) concluded that the U.S. economy would
a decrease in housing prices better tlian most economies:
would be absorbed by a large
few
fina,ncial institutions,
set of investors, rather
and thus be much
resist
The shock
than just by a
easier to absorb... This
arginnent. ignored two aspects which turned out to be important.
first waij
that, with complexity,
to assess the value of simple
came
cri-
opacity.
While
was possible
it
mortgage pools (the MBS),
The
it
to assess the value of the derived tranched securities (the
was harder
CDOs), and
even harder to assess the value of the derived securities resulting from
tranches of derived securities (the CDO^s). Thus, worries about the
original
mortgages translated into large uncertainty about the values
of the derived securities.
securities
And,
were held by a large
in that
environment, the fact that the
set of financial institutions implied that
this large uncertainty affected a large
number
of balance sheets in the
economy.
3.
Securitization
and globalization
led to increasing connectedness be-
tween financial institutions, both within and across countries.
In the
same way
securitization increased connectedness across finan-
cial institutions, globalization
stitutions across countries.
increased connectedness of financial in-
One
of the early stcnies uf the crisis
the surprisingly large exposure of some regional
German banks
was
to U.S.
suliprime loans. But the reality goes far l)eyoiul tins anecdote. Figure
.3
shows the steady increase
m
foreign claims by banks from the
major
advanced countries, an increase from $6.3
five
2000
trillion in
to $22 trillion by June 2008. In mid-2008, claims by these banks just
on emerging market countries exceeded $4
implies
if,
for
trillion.
Think
any reason, those banks decided to cut on
exposure; unfortunately, this
figure stops in
of the decrease has
what
this
their foreign
indeed what we are seeing
is
June 2008. Much
then.)
of
now
(the
happened since
•
Figure 3
ConsoMcfatad Foreign Claims ol Reporting Banks on the Rest ol the World
ey Naiionalllv ot Reporting Banks. Trillions oT US doQars
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Germany
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United Slates
(Source: Table 9a, BIS Banking statistics)
4.
Leverage increased.
The
fourth important
Put another way,
less
and
initial
condition was the increase in leverage.
financial institutions financed their portfolios with
less capital,
thus incretising the rate of return on that capital.
What were
timation of
a
number
the reasons behind
risk,
optimism, and the underes-
it? Surely,
was again part
of
Another important factor was
it.
of holes in regulation. For example,
reduce required capital by moving assets
banks were allowed to
off their
balance sheets in so
called "structured investment vehicles" (SIVs). In 2006, for example,
the value of the off-balance sheet assets of Citigroup, $2.1
trillion,
exceeded the value of the assets on the balance sheet, $1.8
trillion.
(By mid 2008, writedowns and returns
of
some
of the assets back to
the balance sheet had decreased this ratio back to less than one half.)
The problem went
far
beyond banks. Fur example,
"monoline insurers" (that
is
at the
end
of 2006,
insurers insuring a particular risk, for ex-
ample default on municipal bonds), operating outside the perimeter
of regulation,
against
had capital equal to $34
more than $3
billion to
trillion of assets...
Whatever the reason, the implications
were straightforward.
back insurance claims
If,
of high leverage for the crisis
any reason, the value of the assets became
for
lower and/or more uncertain, then the higher the leverage, the higher
the probability that capital would be wiped out, the higher the probability that institutions
exactly
2
what we have
would become
insolvent.
And
this
is,
again,
seen.
Amplification mechanisms
Aromid the end
of 2006,
US
housing price indexes stopped rising and
then started declining more steadily. This implied that
many marginal
mortgages, especially the subprimes extended during the previous expansion, would default. As
we saw
in Figure
1,
the expected loss from
10
these defaults, as of October 2007, was $250 billion.
hoped that
this loss
would be
easily
One might have
absorbed by financial institutions,
with limited financial or economic implications. But, as we know, this
has not been the case.
The
larger crisis
is
the result of two amplifica-
tion mechanisms, interacting with the initial conditions
I
focused on
earlier.
1.
The
mechanism
modern
first
amplification
first
go quickly back to basics. Think of financial institutions
is
the
version of banli
runs.
Let
me
in the simplest terms,
sheet, liabilities
i.e.
with assets on the
on the right
side,
positive, the institution
insolvent. So,
when
both the expected
is
solvent;
The
first
if it is
So long as capital
negative, the institution
some
assets increases,
The
value of capital becomes both
more uncertain, increasing the probability
amplification
is
and the uncertainty associated with the asset
side of the balance sheet increases.
lower and
liabilities.
the prol^ability of default on
loss
side of their balance
and capital as the difference between
the value of the assets and the value of the
is
left
mechanism then has two
of insolvency.
parts:
Depositors and investors are likely to want to take their funds out
of the institutions
which might become insolvent. In traditional bank
runs, say during the Great Depression,
their
money out
then. First, in
of the banks.
Two
it
was the depositors that took
changes have taken place since
most countries, depositors are now largely insured, so
they have few incentives to run.
And banks and
tutions largely fina.nce themselves in
other financial
insti-
money markets, through
short
term "wholesale funding". Modern runs are no longer
literally runs:
11
What happens
is
that institutions that are perceived as being at risk
can nu longer finance themselves on these markets. The result
ever the
same
as in the old
bank
ability to borrow, institutions
To the extent that
many
extent that
time), there
If,
this
is
may be few deep
have to
sell assets.
is
same
sell
at "fire sale prices",
below the expected present value of the payments on the
prices
This
in
turn implies that the sale of the assets by one institution
all
onh" on the l^alance sheet of the institution which
the balance sheets of
all
amplification
mechanism
of the amplification
is
is
at work,
determined by
To the extent that the
similar assets, not
is
selling,
but on
the institutions which hold these assets. This
turn reduces their capital, forcing them to
The
at the
especially difficult for outside
further contributes to a decrease in the value of
in
to the
(i.e.
pocket investors willing to buy assets.
investors to assess, the assets are likely to
asset.
phenomenon
and investors are affected
in addition, the value of the assets
i.e.
how-
runs; Faced with a decrease in their
a macroeconomic
institutions
is
assets are
and so
on.
and you can see how the
size
sell assets,
initial conditions:
more opaque and thus
value, the increase in uncertainty will
f)e
difficult to
larger, leading to a higher
perceived risk of solvency, and thus to a higher probability of runs. For
the
same
more
buy these
reasons, finding outside investors to
difficult,
and the
fire sale
discount will be larger.
assets will be
To the extent
that securitization leads to exposure of a larger set of institutions,
more
institutions will be at risk of a run.
that institutions are more leveraged, that
And
is,
finally,
have
to the extent
less capital relative
to assets to start with, the probability of insolvency will mcrease more,
again increasing the probability of runs. As we have seen,
all
these
12
'^.
factors were very
much
this ampHfication
mechanism has been
2.
The second
present at the start of the
This
crisis.
is
why
particularly strong.
nnipUfication inechnnism conies from the need by
fi-
nancial institutions to maintain an adequate capital ratio.
Faced with a decrease
in the value of their assets,
capital, financial institutions
and thus a lower
need to improve their capital
ratio, either
to satisfy regulatory requirements, or to satisfy investors that they
are taking measures to decrease the risk of insolvency. In principle,
they then have a choice. They can either get additional funds from
outside investors, additional capital.
is,
Or they can
"deleverage"
that
,
decrease the size of their balance sheets, by selling some of their
assets or reducing their lending.
macroeconomic
In a
to be difficult. This
finding additional private capital
crisis,
is
for
is
may be
the same reasons as earlier: There
few deep pocket investors willing to put funds.
And
likely
to the extent
that the assets held by the financial institutions are difficult to value,
investors will be reluctant to put theii' funds in the institutions that
hold them. In that case, the only option for these institutions
some
The
of their assets.
The same mechanism
as before
is
is
sell
then at work:
sale of assets leads to fire sale prices, affecting the balance sheets
of all the institutions that hold them, leading to further sales
on.
to
And,
leverage
for the
all
same reasons
as before, opacity, connectedness,
and
imply more amplification.
The two mechanisms
in the
and so
are distinct. Conceptually, runs can
absence of any
initial
happen even
decrease in the value of assets. This
is
13
the well-known multiplicity of equilibria:
be liquidated at
first place.
If
funding stops, assets must
justifying the stop in funding in the
fire sale prices,
But, clearly, runs are more
the higher the doubts
likely,
about the value of the
assets. Conceptually, firms
measures to reestablish
their capital ratio
even
if
may want
to take
they have no short-
term funding problem and do not face runs. The two mechanisms
interact however in
many
ways.
A
financial institution subject to a
run may, instead of selling assets, cut credit to another financial
stitution,
which
may
turn be forced to
in
the channels through which the
tries to
lines
crisis
has
sell assets.
Indeed, one of
moved from advanced coun-
emerging market countries has been through cuts
from financial institutions
eign subsidiaries, forcing
them
in
in-
advanced economies to
in credit
their for-
in turn to sell assets or cut credit to
domestic borrowers.
Dynamics
3
The
in
Real Time
amplification mechanisms are
retrospect. In real time,
now
when housing
clear,
but this
is
true only in
prices started dechning,
most
economists and policy makers expected the impact to be much more
limited.
The scope
over time. Here
1.
is
of the amplification
nistitutions,
clear
the story in real time.
Contagion across
The widening
mechanisms only became
assets, institutions,
and
countries.
of the crisis to a steadily growing munlier of assets,
and countries
is
shown
in
Figure
4.
The
figure
is
a "heat
14
:;')ir'i
map", constructed
l>v
the IMF, which shows the evohition of heat
indexes for a number of asset classes.
is
complex, but the principle
is
simple:
The construction
The
of the index
larger the decrease in the
price of the asset, or the higher the volatility of the price, each relative
to
its
average value in the past, the higher the value of the index.
As the heat index
increases, the color goes
orange and to red (corresponding to
respectively, so orange
The
see
1, 2,
3
from green to yellow to
and 4 standard deviations
and red should be seen as very rare events).
from the bottom,
figure tells the history of the crisis. Starting
how
the crisis started with subprime mortgages in early 2007.
extended to financial institutions and money markets (the markets
where
financial institutions
summer
of 2007, to regular
borrow and lend to each other)
mortgage pools (Prime
RMBS)
in
and
the
cor-
porate credit at the end of 2007, and to emerging market countries
in the fall of 2008.
At the time
of this writing,
showing an exceptional decrease
2.
Increase in counterparty
Figure 5 shows
how
between banks,
i.e.
the
in prices
3-month
rate),
and increase
in volatility.
crisis led to
an increase
in
counterparty risk
to an increase in the perceived probability that
"Ted spread"
rate charged by
classes are in red,
risk.
a bank borrowing from another bank
plots the
all
,
which
is
may
not be able to repay.
It
the difference between the average
banks to each other
and the three-month
for ,3-month loans (the "Libor"
T-bill rate, the rate at
the government can borrow, for four different countries. Note
which
how
the
spreads increased from the middle of 2007 on, especially in the United
States and the United Kingdom, and
how they jumped when
the U.S.
15
,';;;,(
Figure
Heat Map: Developments
4.
Systemic Asset Classes
in
Emerging markets
Corporate credit
'
Prime
"^%
RMBS
Commercial
IVIBS
Money markets
Financial institutions
Subprime
RMBS
Jan-07
!
Jan-08
Jul-07
Oct-08
IMF, Global Financial Stabilily Reporl. Oclobei 200B
government
let
Lehman
Brothers to
file
for
bankruptcy
in
September
2008.
Until then, financial markets
not
let large,
and the
had assumed that the government would
systemic, banks
fact that claims
fail.
The
failure of
Lehman
on Lehman became frozen
convinced them otherwise, lea.ding to a very large
(Note the partial decline at the very end.
Associated with this large increase
in
I
Brothers,
for a long time,
jump
in the spread.
shall return to
it
perceived counterparty
later.)
risk,
was
a sharp decrease in the maturity of the loans that banks were willing
to
make
to each other.
The
result
keep enough cash on hand and
was the attempt, by each bank,
linrit
its
reliance^
to
on borrowing from
other banks.
16
Figure
5.
Counterparty Risk.
5.0
Ted Spreads: 3-month Libor Rate minus
(in
T-bill
Rate
percent)
4.0
Sep 15. 2008
Lehman Files
3.0
lor
Bankruptcy
j
P
''
1;
2.0
1.0
-
0.0
us
3.
Euro
UK
Japan
Tightening banking standards
One
of the wa,ys
rationing,
i.e.
a,
financial crisis affects the
is
through credit
the tightening of lending standards by banks
deleveraging. This
is
in the
who
are
indeed what has happened.
Figure 6 shows the evolution of an index
standards
economy
for
changes in bank lending
United States and the Euro Area,
loans and for commercial and inthistrial loans.
based on a cjuarterly survey of bank loan
for
The
both mortgage
index, wliich
officers, reflects
is
the differ-
ence between the balance of respondents between those wlio
sa.y
they
have "tightened considerably-tightened somewhat" and those who say
they have "eased somewhat-eased considerably"
.
The
how, since mid 2008, credit has become steadily tighter
figure
shows
for firms
and
households.
17
Figure
6.
Bank Lending Standards
^^
V
4.
,t>
^;^
-o^
r^^
V^
,^-
J-'
\^i
V
"o^
,<^'
Vt>
fV
fl
.-^
-^^
'l*
-
U.S.:
C&l loans
ECB
Large company loans
U.S.:
^J
\^
ivl
^,'
'o'
V
.-.^
It^-
^
f"-
*^
Mortgages
ECB Mongages
Emerging market spreads and sudden stops
Deleveraging has not been limited to domestic credit. For a long time
after the start of the financial crisis,
might be shielded from the
crisis.
it
looked as
if
emerging markets
The premium most emerging market
country governments had to pay relative to the
US government
As Figure
"sovereign spread") was small, and did not increase much.
7 shows however, things changed dramatically in the
fall
(the
of 2008. In
the process of deleveraging, advanced country banks started drastically reducing their exposiu'e to
emerging markets, closing credit
and repatriating funds. Other investors did the same. The
across the board, but not totally indiscriminate:
the
premium jumped up
substantially
more
The
figure
for countries
lines
selling
was
shows
tha.t
with large
current account deficits.
Deleveraging in the form of capital outflows presents additional macro-
economic problems. Not only do countries have to deal with a domestic
18
Figure
Sovereign
7.
CDS Spreads
(index 7/2/07 = 100)
9.'2'07
1l'2'07
Curreni account
deticil larger
than
5%
of
2007
GDP
Current account surplus, or small delicil
credit
saw
problem
(as
banks experience a run, and the mechanisms we
but they have to deal
earlier are at work),
exchange
rate.
eign credit, for
If
they have reserves, or
example
credit from central
IMF, they can use them
may have
if
witli pressure
on the
they have access to
for-
banks or loans from the
to limit the depreciation. Otherwise, they
to accept a large depreciation which,
if
domestic
liabilities
are denominated in foreign currency (which they often are) leads to
further burdens on debtors, be they households, firms, or financial institutions.
Asian
The mechanism
crisis,
is
familiar from past crises, especially the
and can lead to major economic disruptions.
It is
playing
out in a number of countries today.
5.
From
the financial crisis to a full-Hedged economic crisis
For some time after the start of the financial
crisis,
the effects of
the financial crisis on real activity appeared limittd. This however did
19
not
last.
Lower housing
prices, lower stock prices, triggered initially
by
the decreased stock market value of financial institutions, higher risk
premia, and credit rationing, started taking their
of 2007. In the
fall
toll in
of 2008 however, the effect suddenly
pronounced. The worry that the financial
uicnt'
the second half
became much
was becoming
crisis
worse, and might lead to another Great Depression, led to a dramatic
decrease in stock markets, and to a dramatic
fall in
consmrier and firm
confidence around the world.
Figure 8a. Stock Prices
EqurnltartnisrAdvincHjEccnwifc!
"^fe
*
:'i
.^
/ v'*^*
." i' .^ yt
ti^^-i^Q*-
_»
> <,«*«,«?
v*"
_*'
.
'
j"
v" -^^
6*=
/
p,"
B^ ^.1^
-J .>
-"
i* v"
-;**
v'"
**
^
-
Witt— ATHocnff A
-
I
iiiuice BloumtiBig
and IMH
"'^
^5TFn^ElBo'= :'
slall o^Iiioal^s.
Figure 8a shows the evolution of stock price indexes from markets
both
in
a long
m
advanced economies and
and
steatiy increase
in
emerging market
from 2002 on. stock prices started declining
the second half of 2007, and then
Figiu"e
8b shows the evolution
confidence.
It
countri(\s: After
of
shows the dramatic
fell
abruptly
in
the
fall
of 2008.
business confidence and consumer
fall in
both
intlexes, for the
States, the euro area,
and emerging economies,
These evolutions have
led in turn to a large decrease in
United
in the fall of 2008.
demand and
in
20
Figure 8b. Business and Consumer Confidence
;A
I
-
-
./^^^^^-
Unlwa St»rt»
EmBrglna^conomloi
EU
(right scale)
U.S. (Inn acaln)
output. Figure 9 shows the
IMF growth
forecasts as of
mid-November.
Most advanced countries now have negative growth, and the
are for negative growth in 2009 (year on year) as well.
Emerging mar-
ket countries are forecast to have positive growtli, but
than they have had
major economic
in
the past.
The world
is
forecasts
clearly
much
now
lower
facing a
crisis.
Figure
Real and Potential
for 2009; in
GDP
9.
Forecasted Growth Rates
percent
52
-0.4
Euro Area
-0.2
Japan
hi
Emerging & Developing
Economies
S Real GDP @ Potential GDP
21
'':
,
'
I-
''•!
Policies for the short run
4
crisis...
Thus,
must be
1.
change the
clearly too late to
It is
to
in
forward:
If
to limit runs
conceptually straight-
is
they have access to such funds, financial
do not need to
amplification
is
The way
the central bank to provide liquidity against good
(enough) collateral.
This
the two amplification mechanisms.
the runs.
It is for
stitutions
conditions which led to the
thinking about policies for the short run, the purpose
dampen
Dampening
initial
sell
assets at
fire sale prices,
and the
in-
first
mechanism does not operate.
exactly what central banks have done, acting as "lenders of last
resort" since the beginning of the crisis. Traditionally, such liquidity
provision was limited to banks, and the
list
of assets
which could be
used as collateral was relatively narrow. VVliat central banks have done
during this
the
list
crisis is to steadily increase
both the
set of institutions
and
of assets that qualify as collateral. Since mid-2008, the U.S.
Federal Reserve, in particular, has pursued a particularly aggressive
liquidity policy.
$841 billion
in
As a
result, the
monetary base has increased from
August 2008 to $1,433
trillion in
November, an increase
of $592 billion in four months...
Has
this provision of Ht|ui(lity
been successful? The answer appears
largely yes, at least with respect to domestic institutions. However,
for countries suffering
from capital outflows
—
largely,
but not only
emerging market countries
— things have been tougher. A few countries
have had access to credit
in foreign
banks, in the form of swap
Iceland, which
lines.
currency from the major central
But the others have been exposed.
had a very large banking system
relative to its
economy,
22
with assets
aiifl
of \hv
major
cfise,
liiil)ilili(\s
casualtic's
ol'
the inabihty to borrow
in
of the
first
Evuo and thus
(IcMioiiiiiiat-cd
la,rf);(>ly
he
I
tliree
and may need
Asset j)nrchiisrs and
2.
eliminates the
first
dress the scH'ond,
is
crisis ior
(|Mick
a.c;c:ess
ix'c:ij)ilnli'/.ii1i(iii.
namely the icestablishment
a large number
oi'
fairly well established,
not
(in
tliis
Ix'inf; |)a.rt
Icela.nihc l)a,nks weul,
the country as a whole.
Mut many are
likely to
to ibreign iitiuidity.
'The provision of
amplification m(>clianisni.
Based on the evidence iiom the
crises in
major
as exposed as Iceland was.
ar(>
runs
witli
one
access to the iiquidil y provided hy
not, lia.viufi,
bankrupt, creating a deep economic
face similar inns,
I<"a.('(!cl
money markets) and
the European Central Bank, the
Few counlries
crisis.
in ciiios, i;)eca,iiic
it
li(|iiidity
does not however ad-
of capital
resolul ion of a large
rat.icjs.
nnmbei- of banking
done
count, lies in the past, what, needs to be
and has two components:
bad or potentially bad
First, tlie state must, isolate
various ajjproaches to doing this.
One
is
ass(>ts. 'i'heic
lo leave tlie a,ssets
are
on the
balcUiee sheet, of the institutions, but have the state provide a floor
m
to theii' value,
Another, whit;h
1
exchange
for (^xa)nple
nujre attra.ctive,
lintl
is
h)i'
the balance sheet altogether, by buying
or
for'
prices: the (pre-intcivention)
|)ric(>
exiXHicd
a.nd thus
|)resenl
right solution
on
I
them
safe assets such as goveiiirnent. bonds.
that of the price at which to i)uy
is
he one hand,
embody
lo
set,
I
he
licm.
market
exchange
pi ice
for cash,
ccutra.l {|uest.ion
think
which may well be
:
or
I
is
two extreme
of
h(> I'st
a,
hre
imated
as the "iiold to maturity" price.
The
belwceii these two exi lemcs. giving,
inst tut ions incent ivcs
i
The
One can
piice.
in
a large hcinidily discount
known
value
t
take the assets
for tiie state to
off
sale
slifUcs in the institution.
to
sell
and. on the
ot hci'
hand.
23
taxpayers a reasonable expectation that,
the assets are indeed held
if
to maturity by the state, they will actually benefit from the purchase
in the long run.
The
effect of
such asset purchases
is
twofold. First,
it
sets the value of
the assets on the balance sheets, and by reducing uncertainty, allows
investors to better assess the risk of insolvency. Second,
the price of these assets from their
their mulerlying expected value,
of
all
fire sale
price to
increases
it
something closer to
and thus improves the balance sheets
the institutions which hold these assets, directly or indirectly.
These purchases are however
value of the assets
insolvent,
is
half of
what needs
some
institutions
clearer,
and thus should be
closed.
Most
Once the
to be done.
may
turn out to be
are likely to
show
positive,
but too low, capitalization and thus must be recapitalized. This can
be done through public funds only or through matching of public
and private funds,
in
exchange
for shares.
The purpose
is
to return
these institutions to a level of capital so they do not need to further
deleverage, to further
Where
are
saw the
sell
assets or cut credit.
some
time, governments
liquidity, thus a prol)lem to
be handled by the
we today on these two
crisis as
one of
fronts? For
central banks through liquidity provision. In the
clear that undercapitalization
was a major
fall
issue. In
United States introduced the "troubled asset
relief
of 2008.
it
became
October 2008, the
program" (TARP),
allowing the Treasury to buy assets or inject capital up to $700 billion.
A
few weeks
later,
meetings both
put
in
during an important week end in October, with
Washington and
in place financial
then, France has
in Paris,
programs along the
committed
to
major countries agreed to
lines
spend up to 40
sketched above. Since
billion euros,
Germany
24
Figure
10.
Ted Spreads: 3-month Libor Rate
minus T-bill Rate
5.0
4.5
/
4.0
3.5
\
-
3.0
2.5
2.0
1.5
1.0
0.5
^-.J^'-
^
—
-._.-''
--
-
O.O
,
.
8/16
8/1
hilliuii
'
.__
—
""
^
-^
—
^
,
9/15
8/31
US
up to 80
'^
eiuDS, the United
9/30
1
0/1
5
UK
Japan
Euro
Kingdom, 50
0/30
1
|
billicjii
pcjunds. In
addition, to alleviate worries about solveney before the programs are
fully implenrented,
most govenmients have extended the guarantees
accorded to depositors to interbank claims, that
is
claims of banks on
other banks.
The
size
and the complexity
and many governments are
States in particular, the
of the required
programs
is
enormous,
still
exploring their way. In the United
TARP
appears to have changed direction
twice, with an initial focus on the purchase of troubled assets through
auctions, then a shift in focus to recapitalization, and in the
more
recent past, (for example in the case of Citigroup) a reliance on both
providing a floor on the value of some of the assets on the balance
sheet,
and recapitalization. Other programs appear more consistent,
but the funds are being disbursed slowly.
25
Are these programs working? The
vtndict
mixed. As Figure 10
is
shows, the spread between the interbaul'C lending rate and the T-bill
rate has decreased, but remains surprisingly high, despite interbank
guarantees, and despite recapitalization of some banks. Little has been
done to dispose of bad
limited. Uncertainty
made
assets,
and public capital injections have been
about the course and the details of policy has
private investors hesitant to invest funds without knowing the
nature of future public interventions. The result
is
that deleveraging
continues, with banks continuing to reduce credit, both domestic and
abroad.
Issues of coordination are also at work.
for
some
assets can lead investors to
The
move
for
into those assets,
We
ing things worse for non-guaranteed assets.
United States
provision of guarantees
making things worse
when
in the
non-guaranteed mortgages. The provision of guar-
antees by one country can lead investors to
ple
have seen this
mak-
for
move
to that country,
other countries; this was the case for exam-
Ireland unilaterally offered guarantees to investors in the
of 2008. Putting capital controls in one country to
slowdown
fall
capital
outflows can lead to the perception that other countries will do the
same, therefore triggering capital outflows
tecting domestic depositors
and investors
in
those countries. Pro-
at the
expense of foreign
depositors and investors can create the risk of major outflows from
depositors and investors in similar situations elsewhere, and the risk
of similar measures by other countries.
just that led the United
get Iceland to change
its
Kingdom
The attempt by
Iceland to do
to invoke an anti-terrorist law to
mind. Finally, guarantees and other measures
taken in advanced countries make
it
more
attractive for investors to
put their funds in those countries, and thus can lead to further capi-
26
Figure
Sovereign
3000
11.
CDS Spreads
i
(Index 7'2;07=100)
2500
\
i
2000
r
1500
A
1000
i
\
\
\
/
500
y
11/2/07
9(2/07
-
-
3/2/08
1,'2/OS
Current account
deficit larger
5%
than
Current account surplus, or small
tal
7/2/08
5/2/08
of
2007
9/2/08
GDP
deficit
outflows from emerging market countries. As Figure 11 shows, the
sovereign spreads on emerging countries have decreased from their
October height, but they remain very high.
I
have focused on the measures needed on the financial
fall in
demand and
in
side.
The sharp
output in the past couple of months also requires
measures to increase demand. Interest rates on government bonds are
already very low, so the scope for using traditional monetary policy
is
limited.
The
focus must be
now on
tary side, "quantitative easing", that
other policies.
is
On
the mone-
the purchase of other assets
than government Ijonds by the central bank, can reduce spreads
dysfunctional credit markets.
to play a central role here.
It is
clear
however that
At the time of
fiscal
this writing,
in
policy has
most countries
27
are developing fiscal packages, intended at increasing
and decreasing the perceived
IMF
to do
2%
has argued for a
more
if
risk of
.
commitment
the macroeconomic situation becomes worse than cur-
in the next few
demand
is
likely to
be a central issue
months.
Policies to avoid a repeat
Looking forward beyond the
days), the question arises of
scenario,
how we can
Much work
is
crisis
(something
how we can
difficult to
do these
avoid a repeat of the same
decrease the fragility of the financial system,
without impeding too much
in
directly
another "Great Depression" The
global fiscal expansion, with a
rent forecasts. Sustaining world
5
demand
its efficiency.
already going on, both in international institutions and
academic departments, ranging from the examination of
rules gov-
erning ratings agencies, to constraints on executive compensation, to
rules for valuing assets
on balance sheets, to the construction of
ulatory capital ratios, and so on.
time here, to go into
details.
But
reg-
have neither the expertise, nor the
I
I
can try to give you a sense of the
broad directions.
Recall the basic argument of this lecture, that the scope of the crisis
is
due to the interaction between
mechanisms.
We
initial
conditions and amplification
have already discussed how liquidity provision and
state intervention can
dampen
maining question,
our context, becomes: Should we try to avoid
recreating
some
in
the amplification mechanisms.
of the initial conditions
which led to the
The
re-
crisis?
28
'';>
Some
of these initial conditions are clearly here to stay. Securitization,
and, by implication, relatively complex derivative securities, allow for
a
much
ity
better allocation of
from turning into
we have
in
activities
tition
risk.
opa.city;
The
challenge
to prevent complex-
we can probably do much better than
the past. Or, to take another
and
is
large cross border positions are also essential to
and the allocation
of funds
and
border
initial condition, cross
risk in the world.
compe-
They should
not and will not go away.
Where something can and probably should be done
leverage. Leverage of the financial system as a whole
too high before the
crisis.
is
in
decreasing
was almost surely
Regulation can force lower leverage. This
requires however increasing the perimeter of regulation beyond banks
to
many
other financial institutions.
The
where to draw the perimeter, whether,
funds in or out, and,
One must
also go
if
they are
challenge here
for
what
in,
is
how and
example, to put hedge
rules to put
beyond leverage within the
them under.
financial system,
and
look at leverage for the economy as a whole; Highly levered firms or
households are also highly exposed to small fluctuations in the value
of their assets.
leverage,
The
irony
is
that
many
existing tax rules favor such
from the tax deductability of mortgage interest payments
by households, to the tax deductability of interest payments
We
have to
Even
if
l)y
revisit these rules.
and when new
regulati(;n
introduced and tax laws are
is
changed, we should be under no illusion that systemic risk
fully
under control. Regulation
lag behind financial innovation.
will lead to
firms.
will
will
be
be imperfect at best, and always
There
will still
underestimation of risk (the
first of
benign times, and they
the initial conditions
I
29
beginning of the lecture). Thus, a major task of regulators
listed at the
be to monitor, and,
will
risk. In
doing
so,
if
needed, to react to increases in systemic
they will face two sets of challenges:
The
first is
about monitoring
how
to use
it
tional
itself,
what information
and international
We
level.
Some
positions
sons
why many advocate moving
among
of the information needed
do not know,
CDS
investors
for
tion of information.
And, even
and countries. This
if
The second
is
challenge
is
how
an attractive automatic
better collec-
is
a difficult conceptual
to react
when measures
which capital ratios increase
some index
stabilizer.
of systemic risk
of systemic risk,
They can dampen
sound
the build up
on the way up, and the amplification mechanisms on the way
down. The challenge
is
clearly in the details of the design, the choice
of an index, the degree of procyclicality.
monetary policy more
actively.
The
idea. Before the crisis,
was a very pool
Another avenue
is
to use
idea that monetary policy should
be used to fight asset price or credit booms
policy
foi'
are surely not there yet.
either in response to activity or to
of risk
one of the rea-
the information becomes available,
increase. Pro-cyclical capital ratios, in
like
just
trading from over the counter to a
to construct measures of systemic risk
We
is
example, the distribution of
centralized exchange; this would allow, in particular,
exercise.
and
to construct measures of systemic risk, both at the na-
not available today.
how
to collect,
is
an old and controversial
some consensus had developed that monetary
tool to fight asset price
booms, and
it
should
care only about asset prices to the extent that such prices had effects
on current or prospective
inflation.
The
crisis
has certainly reopened
the debate.
30
6
Let
the
Conclusions
me end where
And, as
crisis.
I
I
started. This lecture
write
it.
the
crisis
phase, in which a drop in confidence
and a major
written in the middle of
is
appears to be entering yet a new
is
leading to a drop in demand,
recession. This in turn raises a set of
new
issues,
from the
dangers arising from the interaction between a deep recession and a
weakened
financial system, to the risk of deflation
and
liquidity traps,
to further capital outflows from emerging comitries and sudden stops,
to an increased risk of trade wars, to the effects of the collapse of
commodity
to invite
prices on low-income countries.
me
I
am
afraid
you
will ha.ve
again next year for an update...
31
References
(I
have
made no attempt
to give a complete literature review, either
Some
in the lecture or in this bibliography.
below trace the ideas to the
Bank
of the recent articles listed
earlier literature.)
of International Settlements, 78th
Annual Report, June 2008.
Brunnermeier, M., 2009, "Deciphering the 2007-08 Lirjuidity and Credit
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