Why Such a Big Financial Crisis Now? J. Bradford DeLong Professor of Economics, U.C. Berkeley dealing@econ.berkeley.edu http://delong.typepad.com
Readings •
Martin Baily, Robert Litan and Matthew Johnson (2008), "The Origins of the Financial Crisis" http://www.brookings.edu/~/media/Files/rc/papers/ 2008/11_origins_crisis_baily_litan/11_origins_crisis_baily_litan.pdf
•
Claudio Borio (2008), "The Financial Turmoil of 2007-?" http://www.bis.org/publ/ work251.pdf?noframes=1
•
Markus Brunnermeier (2009), "Deciphering the Liquidity and Credit Crunch 2007-2008," Journal of Economic Perspectives http://www.princeton.edu/~markus/research/papers/ liquidity_credit_crunch.pdf
•
David Greenlaw, Jan Hatzius, Anil Kashyap, and Hyun Song Shin (2008), "Leveraged Losses: Lessons from the Mortgage Meltdown" http://faculty.chicagogsb.edu/ anil.kashyap/research/MPFReport-final.pdf
•
Lars Jonung, Jaako Kiander and Pentti Vartia, "The Great Financial Crisis in Finland and Sweden: The Dynamics of Boom, Bust and Recovery" http://ec.europa.eu/ economy_finance/publications/publication13551_en.pdf
•
Gauti Eggertson and Michael Woodford (2003), "Optimal Monetary Policy in a Liquidity Trap" http://www.nber.org/papers/w9968
The Case for Financial "Sophistication" • Increasing financial sophistication lowers the cost of capital • Investors who want liquidity can have their cake • Investors who want to shed particular risks can have their cake too • And so can investors who think they know something and want to gamble
• Win-win-win for everybody--investors, intermediaries, and funded companies (except, possibly, the gamblers) • Or, rather, win-win-win for everybody as long a systemic risk can be contained, and finance preserved as a (macroeconomic) veil
Dealing with Financial Crises • A normal financial crisis can be fixed by the central bank • Lend freely at a penalty rate • Since the problem is, fundamentally, a collapse of confidence—and since the government is patient— the cost to the government should not be too high • Since you are lending at a penalty rate, little moral hazard created
The Debt-Deflation Theory of Great Depressions • But what if a good many “fundamental” investments are now under water? • And what if prices are flexible downward— while nominal contracts are not? • The debt-deflation theory of great depressions • And of international financial crises
Reasons to Think Finance Is a Veil •
•
Financial crises since the end of the 1960s •
Penn Central Railroad
•
Inflation/recycling bank crisis of the late 1970s
•
Latin American debt crisis of 1982
•
LOR stock market crash of 1987
•
Savings and Loan crisis of 1991
•
Mexican crisis of 1994
•
Thailand-Malaysia-Indonesia crisis of 1997
•
Korean crisis of 1998
•
Russian crisis of 1998
•
LTCM crisis of 1998
•
Dot-com crash of 2000
•
Argentinian crisis of 2001
Conclusion: the Federal Reserve is powerful and skilled enough to keep finance a veil, as far as macroeconomic issues are concerned
Consequences of the Belief that "Finance Is a Veil" • For repeal of Glass-Stegall • For regulation of derivatives • For worry about the housing bubble • For worry about "global imbalances" • Caveat about "global imbalances": the mechanism of foreign-currency crises and worry about the scale of the problem and the possible role of derivatives
The 2007 Wake-Up Call •
•
The housing bubble •
4M houses x $150K in excess mortgage debt per house = $600B
•
In an $80T world economy
•
And all the fancy derivatives and financial intermediation innovations of the 2000s were precisely to make it easier to distribute housing mortgage risk
•
Originate-and-distribute business model
It should not be a problem •
Shareholders have their incentives
•
CEOs have their incentives, or do they? Keynes: among bankers: "It is better to. Fail conventionally than to succeed unconventionally..."
•
"It's AAA": separation of origination departments and portfolio departments
•
The wake-up call
How Bad Can It Possibly Be? • 4M x $150K = $600B in an $80T world economy • But analytically-sophisticated hedge funds • And TED spreads • And the gradual recognition that there had been remarkably little in the way of distribution of these risks
The TreasuryEurodollar Spread
The S&P 500 Index
Three-Month U.S. Treasuries
Thirty-Year U.S. Treasuries
Bear Stearns and Its Aftermath • The Bear Stearns bankruptcy • The liquidity tsunami in response • Confidence that nobody else--save possibly Lehman Brothers--was anywhere close to the edge • Fear that inflation was now danger #1 • Fear that moral hazard had been powerfully enabled--teh "Bernanke put"
• Consensus as of June 2008: facing the smallest recession of the post-WWII era
Lehman Brothers and the Limits of Monetary Policy • The collapse of the financial system, and then of the economy • Conventional monetary policy • Quantitative easing and inflation expectations • Banking policy • Fiscal policy • Excess demand for asset X; but what is X? • Liquidity • Quality • Duration