The Global Recession
The Global Recession.
World GDP Growth,
2007-2010.
Emerging market countries hoped that they could avoid a similar fate, that
there would be in effect decoupling between advanced countries and
emerging market countries. As Figure 1 shows, these hopes were dashed.
The Trigger. U.S. House Price declines
U.S. housing prices,
2000-2009.
Housing prices increased
sharply from 2000 to 2006,
only to decline, equally
sharply, from 2006 on.
The Subprime Triggered Crisis: A Perfect Storm
Confluence of causes
– Past bailouts  Greenspan Put  Bulletproof system!?!??
– Financial innovations: Finance as end in itself
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Income lagging spending: Household debt…National debt
Easy credit...Fed Funds Rate kept low...fear of deflation
Market fundamentalism
Weak global aggregate demand
The Players
– Mortgage brokers/Banks—Securitizers/GSEs/Rating Agencies
Trigger and collapse
Bailouts: Wall Street, not Main Street
Stimulus
On-going slump
The Subprime Triggered Crisis: A Perfect Storm
Finding Fault
• Past bailouts  Too big/Too interconnected to Fail
– Black Monday (October 19, 1987)
– Asian CrisisContagionLongTermCapitalManagement
(1997-8)
– dot.com bubble … it takes a bubble
• Financial innovations
– Overnight funding
– Off-balance sheet vehicles – no capital requirements
– Default insurance
– Collateralized Debt Obligation (CDOs)
– Chemistry: JunkAAA
Financial Engineering
The Subprime Triggered Crisis: A Perfect Storm
Finding fault
• Easy Credit
– Global saving glut
– Fed policy: fear of deflationcheap raw material for
banks
• Market fundamentalism
– Greenspan “put”—we’ll clean up the mess
– Lax regulation
• Weak global aggregate demand—saving glut
– Accumulation of reserves—memories of ‘97
A “Global Saving Glut”
The best
of times
Capital Inflows
Easy Money
Policy
Escalating
House Prices
Ambitious
Mortgage Brokers
Eager Home
Buyers
Developer Clout
Innovative
Banks
Bank Regulators
Gov’t Sponsored
Enterprises
Securitization
MBSs
Rating
Agencies
The best
of times
Capital Inflows
Escalating
House Prices
Easy Money
Policy
Ambitious
Mortgage Brokers
Eager Home
Buyers
Developer Clout
Innovative
Banks
Bank Regulators
Gov’t Sponsored
Enterprises
Securitization
MBSs
Rating
Agencies
Amplification Mechanisms. Leverage, Complexity, and Liquidity
 When housing prices declined, and some mortgages went bad
 High leverage  sharp decline in the capital of banks.
 Forced sale of some assets that were often hard to value
 Fire sale prices
 Complexity of the securities (MBSs, CDOs) and bank true balance sheets
(banks, and their SIVs)
 Were banks solvent? Did they risk bankruptcy??
 Interbank lending froze.
 September 15, 2008:
 Lehman Brothers bankruptcy: a bank with $600 + billion in assets
 Leading financial outfits concluded that many, if not most, other banks
and financial institutions were at risk
 These guys vaguely knew the shape they themselves were in
...if they couldn’t trust themselves, how could they trust counterparties?
INTERBANK LENDING FROZE
Amplification mechanisms: Nervousness—Lack of Trust
The Ted Spread,
2007-2009.
The rate spread,
which reflects the risk
banks perceived in
lending to each other,
went sharply up in
September 2008.
Banks became very reluctant to lend to each other.
The TED Spread: The difference between the riskless rate (measured by the rate of 3month government bonds) and the rate at which banks are willing to lend to each
other (known as the Libor rate...which we now know was misstated!)
Responses Lender of Last Resort / Spender of Last Resort
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Tax Rebate $124 bil.
Fed Fund Rate Cuts
Fannie/Freddie $200 bil.
Bear-Stearns $29 bil.
AIG $174 bil.
Fed “Facilities”
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•
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Primary Dealer Credit Facility (PDCF) $58 bil.
Treasury Security Loan Facility (TSLF) $133 bil.
Term Auction Facility (TAF) $416 bil.
Asset- Backed Commercial Paper Funding Facility (CPFF) $1,777 bil.
Money Market Investor Funding Facility (MMIFF) $540 bil.
More Fed Fund Rate Cuts … Hold At ~0%
Fed Purchases of Long-Term Securities: GSEs & MBSs $600 bil.
Term Asset-Backed Securities Loan Facility (TALF) $200 bil.
Emergency Economic Stabilization Act/TARP $700 bil.
Government Loans
Government Equity
Stimulus Package $787 bil.
aka The American Recovery and Reinvestment Act (ARRA)
TARP II
• Stress Tests
•
Quantitative Easing: QEI, QE2, QE3
Feeding a Crisis: Alphabet Soup
• Finance and its discontents
SIV, Repo, MBS, CDO, CDO2, CDS, S&P, AAA, ARM, TED–LIBOR
FOMC, FF, FDIC, GSE, AIG, G-7
• Bailout “facilities”
PDCF, TSLF, TAF, CPFF, MMIFF, TALF
• Legislation
TARP, ARRA
• Ben Bernanke: The Fed and the Crisis
http://www.federalreserve.gov/newsevents/lectures/federal-reserve-response-to-the-financial-crisis.htm
The Subprime Triggered Crisis: The Players
Charles Kindleberger, Manias, Panics and Crashes
A Minsky Story in Five Acts: In general; in particular
1. Displacement—A breakthrough
–
Financial innovation: securitization—sell off risk
2. Credit Expansion & BOOM
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–
Low interest rates—defend against deflation
Shadow banking/SIVs/MBSs/CDOs/CDSs
3. Speculative Mania—self-fulfilling Euphoria
–
Teaser loans/ARMs/Home equity loans/Flipp’n’ to the bank
4. Distress—a Minsky/Wile E. Coyote moment
–
House prices plateau—Disappointed expectations
5. Panic & Crash—rush to liquidity…but there’s no liquidity
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–
Firesale
•
Foreclosures
– Contagion
» Debt Deflation
Bailout Helicopter Ben
A Long Slump:
Liquidity Trap and Deflation
The Liquidity Trap and
Deflation
In the presence of a liquidity trap, there is
a limit to how much monetary policy can
increase output. Monetary policy may not
be able to increase output back to its
natural level.
Suppose the economy is in a liquidity trap,
and there is deflation. Output below the
natural level of output leads to more
deflation over time, which leads to a further
increase in the real interest rate, and leads
to a further shift of the IS curve to the left.
This shift leads to a further decrease in
output, which leads to more deflation, and
so on.
In words: The economy caught in a vicious cycle: Low output leads to more
deflation. More deflation leads to a higher real interest rate and even lower output,
and there is nothing monetary policy can do about it.
Negatively sloped AD:
Inflation down
 Burden of debt on
debtors up 
 They spend less
 Wealth of creditors up
but they’re not
spenders
Prescriptions:
• Fiscal stimulus
• Increased gov’t debt  inflationary expectations
• Central bank commitment to irresponsible stance  inflationary expectations
• Debt forgiveness
• Raise wages and prices