The global financial crisis: applying the models Pre-Crisis Financial System: Incentives: privatized gains, but socialized losses (more careless about spillover from their own difficulties) + financial deregulation ⇒ more or less uncontrolled (but also not known) increase in systematic risk Instruments: Mortgage-backed Security (MBS): a collection of mortgages and referred to as a securitized financial asset → the risk equals to the chance that the mortgage-bearer will default on their payments, and to minimize that risk there is diversification through collecting mortgages from different geographical regions + creating tranches where investors in lower tranches had higher return but also higher risk Collateralized debt obligations (CDOs): like an MBS but for loans; supposedly less risky because can combine many different products; use correlation measures to estimate risk (low correlation = low risk) Credit rating agencies (CRAs): assess the risk of financial products, where a Triple A rating means almost 0 risk of default CDOs based on MBSs: which were deemed as worthy of Triple A rating because of the diversification + the very large scope of mortgages ⇒ their high returns became very popular especially among institutions (like pension funds); N.B. super-senior trenches created which would only take losses if senior trenches took losses, so almost inconceivable risk Credit Default Swaps (CDS): as a form of insurance, using the super-senior trenches who had very low interest rate ⇒ brought temporarily a lot of income for banks → but at time of financial crash, the bail-out of those cost 118 billion for AIG alone Actors: deregulation + rise of short-term interest rate (but not of long-term ones) created a change in the behaviour of banks and other economic actors: Retail Banks (U.S.): high profitability from MBSs and CDOs gave them more incentive to give out more loans (paying less attention to creditworthiness) Global Banks: European (higher leverage) vs. American (higher risk): interesting example: Basel II regulatory regime (in Europe) requires a minimum capital cushion for every held asset, depending on its risk ⇒ given that a triple A rating asset has 0% risk, it requires no cushion ⇒ a lot of European banks invested in them Shadow Banking System: “credit intermediation involving entities and activities outside of the regular banking system”, like structured investment vehicles that served as separate institutions, subject to less regulations but were major players in trading with securities Bank Concentration and Interconnectedness: increasing, obviously (in years leading up to the crisis) → the creation of the “too-big-to-fail” institutions Upswing of the Financial Cycle: Subprime Lending in the U.S.: Subprime loans are all loans to people who would generally not receive one (like with no documentation, no source of income, no job, no assets…) Stagnating wages and the burst of the dot com bubble lead to a decrease in demand for owning homes among lower income households ⇒ the U.S. government pursued policies that encourage home-ownership → combining this with subprime loan, this lead to a house bubble with rising house prices (which in turn increased the banks’ collateral, making them even more willing to give out subprime loans) ⇒ rising leverages for individual households (which are only justifiable insofar as the prices keep rising) The Global Financial Upswing: The global banking system had several issues going on: (a) European regulatory regimes allowing for high leverage because of low risk weighting, (b) the incentives for risk taking provided by the implicit state guarantee for the banking system, and (c) the rise in importance of and trust in the ratings of ratings agencies for bank portfolio decisions. To the left, there is a description of the financial acceleration mechanism. European banks invested substantial amount of credits in the US banking system, and very often through the shadow banking institutions. The Crisis: Scale and Nature of Post-Crisis Recession: There is a much more severe drop among developed nations than among underdeveloped/ developing. The most severely hit were the G7, with UK unable to reach their pre-crisis peak in 2013. The graph here shows certain trends, like how consumption responded to the crisis much smoother than investment. While the U.S. is on a separate line, the effects are similar among all G7 nations. This was also supplemented by a rise of volatility in the S&P index. The Credit Crunch: 1. Collapse of subprime housing market (in US): the slowing rise of housing prices meant that new loans could no longer be used to cover old loans → as a result, a lot of the supreme loan users defaulted on their debt → eventually, this was also felt in France by BNP Paribas who started doubting the value of their CDO investments. 2. Seizing of money markets: essentially, a liquidity crisis: the financing of day-to-day operations became more difficult after subprime loans became so clearly unreliable and no lenders were willing to accept them as collateral ⇒ rising interbank interest rates ⇒ European banks, who were heavily leveraged to begin with, started experiencing this shock the most, leading even to the nationalization of some banks 3. Lehman Brothers fall: file for bankruptcy but were not bailed out by U.S. government → often seen as catalyst for crisis that followed The Crisis and Macroeconomic Policy (+3-equation model): Two main shortcoming revealed: The first is that the policy interest rate may only weakly affect the lending rate faced by firms and households; and the second is that in a crisis, conventional monetary policy loses its effectiveness if the central bank needs to achieve a real interest rate that is unattainable because the nominal rate cannot be lowered below zero. Policy Rate and Lending Rate: a disconnect created by the risk premium requirement; the collapse of a giant like Lehman Brothers created a higher expectation for a risk premium in lending, causing said disconnect Zero Lower Bound: 1) Negative demand shock (falling house prices) + fall in investment and consumption, caused by uncertainty, causing the IS shift 2) low real interest rate means that the Central Bank cannot really respond by lowering it enough to cushion this effect 3) Desired by the Central Bank was point C, but the reality was point D (and worse as crisis deepened) ⇒ deflation trap caused by limits of monetary policy + continuous decline in housing (and eventually also other product) prices = increase of the burden of debt ⇒ deepening the recession Policy intervention in the crisis Lessons from the Great Depression: Two main issues then were contractionary policies (like increasing taxation) and protectionism (raising import tariffs), which lead to a very prolonged crisis, so the lesson here is to support domestic demand by introducing fiscal stimulus packages (which was done for the 2008 crisis and really helped in coping with it). Monetary and fiscal policy in the crisis phase: in addressing the three main problems: (a) the liquidity problem: making liquidity more available; example: The Bank of England (BoE) made $10bn of reserves available for three-month loans to banks and widened the list of acceptable collateral. (b) the bank solvency problem: three main steps (further fiscal stimulus): the government taking ownership stakes, government (partially) nationalizing certain banks, and the government purchasing some toxic assets (primarily in the U.S.) (c) the stabilization of aggregate demand and expectations: preventing a deflationary trap: c.1. Quantitative easing (Central Bank buying government bonds to increase spending and consumption) about c.1.: monetary policy and the yield curve: explanation of quantitative easing: YC is the yield curve, and the goal is to incentivize long-term investments; if short-term interest rates are low, then YC starts at S (not at 0), and quantitative easing shifts curve down (by increasing price of gov bonds and reducing their interest rates), allowing for even further incentivization of long-term investment c.2. Discretionary fiscal policy: automatic stabilizers and fiscal stimulus: essentially, the goal is for these measures to address the recession directly and slow down/ prevent the leftward shift of the IS curve, most often this would be in form of tax cuts or spending increases; examples are: the UK cut its headline rate of VAT (i.e. sales tax) temporarily from 17.5% to 15%; the Australian government sent out ’tax bonuses’ to middle and low income individuals and families (i.e. the government gave cash handouts to the population) + very careful to not become more mercantilistic → the multiplier effect increases when international → main goal is to ensure temporarily of the crisis, since tax cuts today mean larger deficit/ higher taxation in future → The highly accommodative policy employed during the global financial crisis prevented a collapse of the global financial system and helped to support demand during a time of particularly low activity and high uncertainty. Austerity policies in the post-crisis recession: a.k.a. the adoption of tighter fiscal policy with the express aim of reducing the debt to GDP ratio (rather, for example, than to stabilize aggregate demand) risis) economy. The pressure on policy makers to shift from fiscal stimulus to austerity comes from the deterioration in government finances. But the evidence that has accrued suggests that the appropriate response to this is not to attempt to deal with the accumulation of public sector debt by an early tightening of fiscal policy. Unlike an individual household where debt is reduced by saving more, the paradox of thrift shows that in an economy with some spare resources (i.e. with a negative output gap), the attempt by the government as well as the private sector to save more can reduce aggregate demand and output, leaving aggregate saving unchanged but output lower. Fixing banks first may mean less government debt later: Experience from previous financial crises suggests that there is a case for governments to be pro-active as owner of a bank it has bailed out and focus on cleaning up the bank’s balance sheet; example: removing zombie banks (burdened by bad loans) Conclusion: The crisis highlighted the inadequacies of the pre-crisis policy framework that combined inflation-targeting central banks with light touch financial regulation. A major theme in the post-crisis policy debate is that measures should be put in place to prevent the upswing ofa financial cycle with its pro—cyclical build up of debt and leverage, which creates the basis for the upswing of a financial cycle, and the vulnerability of the economy to financial crisis. In other words, policy should be designed to prevent a financial cycle from taking hold. Aswe have seen, the root of the problem is that banks take excessive risks when measured from society’s point of view. This arises because banks do not internalize the impact of their actions on systemic risk and because they are implicitly subsidized by the prospect of a bailout.
