Lecture 11: Great Recession 2007-2009

Global Imbalances

• The lessons that Asia learned from their crisis leads to this huge imbalance

  • Buying up US currency to put into their reserves

  • Exports more to US than US exports to them

Global imbalances: international bargaining failure → US blames…

Savings Glut (saving too much)

• Bush administration tries to push China to expand consumption and allow RMB to appreciate against dollar

• Tries to shift IMF's attention to China Unsuccessful

• presses European governments (Germany) to reduce their Current Account surpluses

Global imbalances: international bargaining failure → Govs in surplus counties blames …

US, demand American policy changes instead

• EU says that its not saving too much, US is spending too much

• Europeans blame US federal gt's budget deficit following 2001 tax cut for US CA deficit

• EU argued not their issue, since overall Euro area in CA deficit

  • As a whole the EU is in balance

• China adopts more flexible peg in 2005, but otherwise also demands US balance its budget instead

Global imbalances: international bargaining failure Result

no action, flow of cheap and plentiful credit from the surplus countries to the US

Cheap Credit in the US fuels real estate bubble

• Real estate prices rose 60% btw 2000 and 2006

• Mortgage-backed securities: bundles of different risk in a single security

• Easier and easier to get loan for a house

  • Low interest rate

  • No credit check

  • Little check on you in general

  • Prices rose bc more buyers in system

• Financial institutions discounted risk of nationwide collapse of real estate prices, worst case scenario planned for: regional collapse

• 2007: real estate prices fall by almost 25 percent nationwide, mortgage default rates rise sharply

  • Banks taking a lot of risks and underestimating the risks in the real estate market

    • Planned for regional default

    • Did not plan for national default

      • Fewer and fewer people are able to afford their homes bc the mortgages can’t be paid

• Securities suffered large losses, many bought with debt - debt-service problems entire financial system

Crisis becomes international

• Great Britain, Ireland and Spain, had their own real estate bubbles that collapsed

  • Copied the US business model

• European financial institutions had purchased mortgage-backed securities in large quantities - suffer same losses

• Freezing of global credit markets after bankruptcy of Lehman Brothers in fall of 2008 made it difficult for all financial institutions to secure credit for their activities

  • Banks lend a lot to each other to keep each other/system going

    • Usually with low interests rats

• Credit dries up -> interest rates on inter-bank lending grow sharply

Policy reactions

• Bank bailouts

• Monetary policy

• International cooperation

Policy reactions: bank bailouts

• Initially US government regulators close some failing banks, arrange sales

  • E.g. Bear Stearns sold to JP Morgan

  • failed to find buyer for Lehman Brothers

• Banks deemed too big to fail got bailouts in both the US and the EU

• Ireland with the largest bailouts in the EU => creates debt problems in the Eurozone debt crisis

Policy reaction: monetary policy

• Central Banks inject liquidity → As much money as possible

• August 2007: ECB, Bank of England, and Fed inject $200 billion into markets, again in December 2007

  • Lower interest rates to 0

• Eventually: Unconventional monetary policy - asset purchasing to stimulate the economy = "Quantitative Easing"

Quantitative easing

• Creation of money to try and fix economy

• Creation of new/more money —> not printing but digital

  • Increase money supply

  • CB decreasing money supply

• Abandoned safe investment and go more for riskier ones (goal)

• Long run will lead to inflation (hindsight- not the case)

• Short run - stopped a deep recession

• At the time untested policy, no other choice —> no action will lead to catastrophe

Put more money into the system but commercial banks were keeping more in

Policy reaction: International cooperation

• Shift from importance of G-7 to G-20 (with emerging markets) to coordinate response

• Governments agreed to coordinate fiscal stimulus measures to boost economic activity

  • Try to grow out of the crisis

• Expanded IMF lending capacity

• Financial Stability Board charged with coordinating and monitoring efforts on reform of financial regulation

Current account balances today

• Global imbalances stubbornly large

• US continues to have CA deficits

• Trump (largely unsuccessfully) pressured China and Germany to change their policies (sound familiar?)

How to prevent banking/financial crisis for banks

Regulation!

• Increase Reserve requirements - share of deposits/liabilities a bank has to hold as reserves

  • Need to have more in reserve

  • Less that they can lend out

• Deposit insurance - the government insures bank deposits

  • Learned from Great Depression

  • Need people to believe that their money is safe otherwise bank run = bankruptcy

• Division between risky investment & retail banking

• Regulatory Oversight

  • Limit risk

How to prevent banking/financial crisis for governments

• Governments can try (but often fail) to prevent the global imbalances that drive financial crisis

  • Coordinate monetary and fiscal policy —> happens rarely (too self interested)

How to prevent banking/financial crisis for both

Lenders of Last Resort

• Institutions that lend money in a crisis to provide emergency liquidity (although beware of moral hazard!)

• Central Banks, IMF

• Good idea to have a lender of last resort —> prevent moral hazards

  • Saves you from things like bank-runs —> good for banks

  • Trust in system

Pair lender of last resort with good/strong regulatory oversight