learning the lessons of the financial crisis martin wolf, associate editor & chief economics...
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Learning the lessons of the financial crisis Martin Wolf, Associate Editor & Chief Economics Commentator, Financial Times
King’s College, Cambridge
May 23rd 2009
2
Learning the lessons of the financial crisis
“Simply stated, the bright new financial system – for all its talented participants, for all its rich rewards – failed the test of the market place.” Paul Volcker, April 8th 2008
3
1. What has just happened?
• A global financial and economic crisis, triggered by a re-rating of risk in the core economies
• This re-rating revealed the under-capitalisation of the financial system and that in turn generated a panic
• This panic triggered a collapse in credit and consumer demand, which spread the crisis worldwide
• Those worst affected were exporters of manufactures and emerging economies dependent on foreign capital inflow
4
2. What is the underlying story?
• The story:
– Long build-up of imbalances and leverage;
– Excessive risk-tolerance;
– Then financial and economic crisis;
– Unprecedented monetary and fiscal stimulus; and now
– “Green shoots” or a decline in the rate of decline
• So are we on the way to sustainable recovery or to a relapse?
5
3. Path to a disaster
• The late Hyman Minsky produced a canonical model of financial instability, based on a simple idea:
– Confidence, then euphoria, then the “Ponzi game” and, finally, revulsion;
– We are now in the revulsion stage – flight to quality and dramatic increases in spreads
– Asset values, credit and, at worst, financial institutions collapse
• Success breeds excess and excess breeds collapse
6
3. Path to a disaster
TOTAL US PUBLIC AND PRIVATE DEBT(as per cent of GDP)
0.0
50.0
100.0
150.0
200.0
250.0
300.0
350.0
400.0
1870
1876
1882
1888
1894
1900
1906
1912
1918
1924
1930
1936
1942
1948
1954
1960
1966
1972
1978
1984
1990
1996
2002
2008
Source: Hoisington
GREAT US DEBT BOOM
7
3. Path to a disaster
US PRIVATE DEBT BOOM
US PRIVATE SECTOR DEBT(relative to GDP)
0.0%
20.0%
40.0%
60.0%
80.0%
100.0%
120.0%
140.0%
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
Households Non-financial Business Financial Sectors
8
3. Path to a disaster
HOUSE PRICE BUBBLE AND COLLAPSE
REAL HOUSE PRICES
50.0
100.0
150.0
200.0
250.0
300.0
350.0
400.0
450.0
Jan-
91
Jan-
92
Jan-
93
Jan-
94
Jan-
95
Jan-
96
Jan-
97
Jan-
98
Jan-
99
Jan-
00
Jan-
01
Jan-
02
Jan-
03
Jan-
04
Jan-
05
Jan-
06
Jan-
07
Jan-
08
Jan-
09
Real Nationwide (UK) Real Case Shiller 10-city (US)
9
3. Path to a disaster
• So why did huge credit and housing bubbles occur?
1. The “Great Moderation” and resulting complacency among policymakers and investors
2. Emergence of huge global imbalances and extraordinary reserve accumulations in the late 1990s and early 2000s;
3. Low real and nominal interest rates and the “reach for yield”;
4. Accommodative monetary policy aimed at targeting inflation;
5. Innovation in the financial sector, to provide apparently safe, high-yielding assets; and
6. De-regulation and mal-regulation of financial system
10
4. Crisis
• Action of G7 governments has probably saved core banking institutions.
• But the recessionary forces are overwhelming:
– Dysfunctional credit markets and implosion of the shadow banking system;
– Ongoing asset price collapses in housing and equities across the globe;
– Need for higher savings in US, UK and other low-saving countries; and
– Cut off of funding to all risky borrowers everywhere
11
4. Crisis
RISK AVERSION SPREAD, AS BANKS DREW BACK
Emerging markets
Corporate credit
Prime RMBS
Commercial MBS
Money markets
Financial institutions
Subprime RMBS
Figure 1.2. Heat Map: Developments in Systemic Asset Classes
Source: IMF staff estimates.Note: The heat map measures both the level and 1-month volatility of the spreads, prices, and total returns of each asset class relative to the average during 2004-06 (i.e., wider spreads, lower prices and total returns, and higher volatility). The deviation is expressed in terms of standard deviations. Green signifies a standard deviation under 1, yellow 1-4 standard deviations, orange 4-7, and red greater than 7.MBS = mortgage-backed security; RMBS = residential mortgage-backed security.
Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09
12
4. Crisis
• Actions of G7 governments in October saved core banking institutions
• Confidence is returning
• But recessionary forces are powerful:
– IMF estimates financial sector write-downs at $4.1 trillion
– Asset price falls in housing are continuing; and
– Consumers have cut back spending, with a chance of further rises in savings in big indebted countries
13
4. Crisis
VALUE OF US RESIDENTIAL MORTGAGE-BACKED SECURITIES
0
20
40
60
80
100
120
12/3
0/20
05
2/28
/200
6
4/30
/200
6
6/30
/200
6
8/30
/200
6
10/3
0/20
06
12/3
0/20
06
2/28
/200
7
4/30
/200
7
6/30
/200
7
8/30
/200
7
10/3
0/20
07
12/3
0/20
07
2/29
/200
8
4/30
/200
8
6/30
/200
8
8/30
/200
8
10/3
0/20
08
12/3
0/20
08
AAA AA BBB BB
Source: Barclays
DEATH OF SAFE MORTGAGE-BACKED SECURITIES
14
4. Crisis
FINANCIAL SECTOR LOSSES EXPLODE
ESTIMATES OF POTENTIAL FINANCIAL SECTOR WRITE-DOWNS(by country of asset origin, $bn)
$1,068 $888
$131
$2,087
$1,644
$305
$1,966
$0
$500
$1,000
$1,500
$2,000
$2,500
$3,000
$3,500
$4,000
$4,500
US Europe Japan All
Loans Securities
Source: IMF GSFR April 2009
15
4. Crisis
THE GREAT BEAR MARKET
GLOBAL STOCK MARKET VALUATIONS(over GDP, per cent)
0.0
20.0
40.0
60.0
80.0
100.0
120.0
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
16
4. Crisis
EXPORT-ORIENTED ECONOMIES ARE HARD-HIT
MANUFACTURED OUTPUT
60.0
65.0
70.0
75.0
80.0
85.0
90.0
95.0
100.0
105.0
Jan-08
Feb-08
Mar-08
Apr-08
May-08
Jun-08
Jul-08 Aug-08
Sep-08
Oct-08
Nov-08
Dec-08
Jan-09
Feb-09
Mar-09
US Japan Germany France UK South Korea
17
4. Crisis
• Why is it so bad?
– The scale of the bubbles;
– Dispersion of risk, which means that nobody knows who holds the bad assets – and so radical uncertainty;
– Failed distribution of bad paper generated much bigger write-downs than expected Inadequate capitalisation of the banking system;
– Totally inadequate capitalisation of the shadow banking system;
– Mistakes by US treasury (over Lehman) and other authorities
18
5. Green shoots
• Stimulus applied has been massive, both fiscal and monetary;
• The biggest fiscal stimulus is in the countries with external deficits;
• Rate of economic decline has slowed; and
• Forward-looking signs of recovery have emerged
19
5. Green shoots
GENERAL GOVERNMENT FISCAL DEFICIT(per cent of GDP)
-16
-14
-12
-10
-8
-6
-4
-2
0
2
4
Canada France Germany Italy Japan United Kingdom United States
2006 2007 2008 2009 2010
Source: IMF
FISCAL STIMULUS IS MASSIVE
20
5. Green shoots
CONFIDENCE BEGINS TO RETURN
SPREADS ON US SHORT-TERM SECURITIES(90 days commercial paper vis a vis Treasuries)
-0.5
0
0.5
1
1.5
2
2.5
3
3.5
4
01
/01
/20
04
01
/03
/20
04
01
/05
/20
04
01
/07
/20
04
01
/09
/20
04
01
/11
/20
04
01
/01
/20
05
01
/03
/20
05
01
/05
/20
05
01
/07
/20
05
01
/09
/20
05
01
/11
/20
05
01
/01
/20
06
01
/03
/20
06
01
/05
/20
06
01
/07
/20
06
01
/09
/20
06
01
/11
/20
06
01
/01
/20
07
01
/03
/20
07
01
/05
/20
07
01
/07
/20
07
01
/09
/20
07
01
/11
/20
07
01
/01
/20
08
01
/03
/20
08
01
/05
/20
08
01
/07
/20
08
01
/09
/20
08
01
/11
/20
08
01
/01
/20
09
01
/03
/20
09
01
/05
/20
09
21
5. Green shoots
BUT CONFIDENCE BEGINS TO RETURN
INTEREST RATES ON US CORPORATE BONDS
0
5
10
15
20
25
30
35
01
/01
/20
04
01
/03
/20
04
01
/05
/20
04
01
/07
/20
04
01
/09
/20
04
01
/11
/20
04
01
/01
/20
05
01
/03
/20
05
01
/05
/20
05
01
/07
/20
05
01
/09
/20
05
01
/11
/20
05
01
/01
/20
06
01
/03
/20
06
01
/05
/20
06
01
/07
/20
06
01
/09
/20
06
01
/11
/20
06
01
/01
/20
07
01
/03
/20
07
01
/05
/20
07
01
/07
/20
07
01
/09
/20
07
01
/11
/20
07
01
/01
/20
08
01
/03
/20
08
01
/05
/20
08
01
/07
/20
08
01
/09
/20
08
01
/11
/20
08
01
/01
/20
09
01
/03
/20
09
01
/05
/20
09
AA BAA B CCC
22
5. Green shoots
SPREADS OF EMERGING MARKET BONDS OVER US TREASURIES
(percentage points)
0100200300400500600700800900
1000
01
/01
/20
04
01
/03
/20
04
01
/05
/20
04
01
/07
/20
04
01
/09
/20
04
01
/11
/20
04
01
/01
/20
05
01
/03
/20
05
01
/05
/20
05
01
/07
/20
05
01
/09
/20
05
01
/11
/20
05
01
/01
/20
06
01
/03
/20
06
01
/05
/20
06
01
/07
/20
06
01
/09
/20
06
01
/11
/20
06
01
/01
/20
07
01
/03
/20
07
01
/05
/20
07
01
/07
/20
07
01
/09
/20
07
01
/11
/20
07
01
/01
/20
08
01
/03
/20
08
01
/05
/20
08
01
/07
/20
08
01
/09
/20
08
01
/11
/20
08
01
/01
/20
09
01
/03
/20
09
01
/05
/20
09
Europe Latin America
BUT CONFIDENCE BEGINS TO RETURN
23
5. Green shoots
STOCK MARKET BOUNCE
STOCK MARKETS
40.0
50.0
60.0
70.0
80.0
90.0
100.0
110.0
120.0
01/0
1/20
07
01/0
2/20
07
01/0
3/20
07
01/0
4/20
07
01/0
5/20
07
01/0
6/20
07
01/0
7/20
07
01/0
8/20
07
01/0
9/20
07
01/1
0/20
07
01/1
1/20
07
01/1
2/20
07
01/0
1/20
08
01/0
2/20
08
01/0
3/20
08
01/0
4/20
08
01/0
5/20
08
01/0
6/20
08
01/0
7/20
08
01/0
8/20
08
01/0
9/20
08
01/1
0/20
08
01/1
1/20
08
01/1
2/20
08
01/0
1/20
09
01/0
2/20
09
01/0
3/20
09
01/0
4/20
09
01/0
5/20
09
FTSE All World Eurostock 300 UK FTSE 100 US S&P Composite Japan Dow
24
5. Green shoots
BUT CONFIDENCE BEGINS TO RETURN
PURCHASING MANAGERS' INDICES
20
25
30
35
40
45
50
55
60
65
Oct-0
1
Jan-
02
Apr-0
2
Jul-0
2
Oct-0
2
Jan-
03
Apr-0
3
Jul-0
3
Oct-0
3
Jan-
04
Apr-0
4
Jul-0
4
Oct-0
4
Jan-
05
Apr-0
5
Jul-0
5
Oct-0
5
Jan-
06
Apr-0
6
Jul-0
6
Oct-0
6
Jan-
07
Apr-0
7
Jul-0
7
Oct-0
7
Jan-
08
Apr-0
8
Jul-0
8
Oct-0
8
Jan-
09
Apr-0
9
UK Germany France Japan US
25
5. Green shoots
BUT CONFIDENCE BEGINS TO RETURN
CONSUMER CONFIDENCE INDICES
80
85
90
95
100
105
110
Jan-
99
May
-99
Sep-9
9
Jan-
00
May
-00
Sep-0
0
Jan-
01
May
-01
Sep-0
1
Jan-
02
May
-02
Sep-0
2
Jan-
03
May
-03
Sep-0
3
Jan-
04
May
-04
Sep-0
4
Jan-
05
May
-05
Sep-0
5
Jan-
06
May
-06
Sep-0
6
Jan-
07
May
-07
Sep-0
7
Jan-
08
May
-08
Sep-0
8
Jan-
09
US France Germany UK EU
26
6. Scenarios
• Deep recessions are certain this year;
• But what sort of recovery can we expect?
• The big questions are three:
– First, how long can governments maintain such massive stimulus, before risk-aversion spreads to sovereign debt and panic about inflation grows?
– Second, does de-leveraging in countries with high levels of private indebtedness need to occur before final demand recovers?
– Third, might private demand grow strongly elsewhere?
27
6. Scenarios
THE GRIM FUTURE – BUT IS IT GRIM ENOUGH?
WORLD ECONOMIC GROWTH(at purchasing power parity)
-6
-4
-2
0
2
4
6
8
10
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
World Advanced economies Emerging and developing economies
Source: IMF WEO April 2009
28
6. Scenarios
THE GRIM FUTURE – BUT IS IT GRIM ENOUGH?
GROWTH OF EMERGING ECONOMIES
-6
-4
-2
0
2
4
6
8
10
12
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Africa Central and eastern Europe Developing Asia Middle East Western Hemisphere
29
6. Scenarios
• Scenario 1: Swift recovery:
– Massive stimulus delivers quick restoration of demand in the big deficit countries and return to business as usual;
– But big further increases in private debt
– Little rebalancing of the world economy
– and so increased vulnerability for the future
– Also risk of oil price spike
• This would be a V-shaped recession, but with real danger of a relapse some years in the future
• What worries me is that this would be unsustainable
30
6. Scenarios
• Scenario 2: Muddling through:
– Modest pick-up of private spending; and
– Weak recovery in US followed by other deficit high-income countries in 2011, which would pull export-oriented economies
• This would be an extended “U-shaped” recession
• This seems a likely outcome.
• But it would also leave huge challenges of de-leveraging and re-balancing ahead
31
6. Scenarios
• Scenario 3: Full adjustment
– Strong pick up of demand in surplus countries
– Export- and investment-led growth in deficit countries
– De-leveraging in deficit countries, as well
• This also would be an extended “U-shaped” recession
• This seems a highly unlikely outcome.
• But it would leave more stable growth in the years ahead
32
7. Lessons
• Far too soon to tell.
• The first lesson - fragility of the financial system:
– Term transformation; and
– Pervasive asymmetric information
• Such systems are prone to serious errors
• They are also “run-prone”
• Securitisation did not make this better, but worse
• This has been an age of financial crises
33
7. Lessons
• Second Lesson - Global Macroeconomics:
– We need a different global monetary system;
– The present one is too vulnerable to the “Triffin problem”
– Countries that do not issue internationally acceptable currencies find it very dangerous to borrow substantially abroad
– So deficits end up in countries with internationally acceptable currencies
– This is inefficient and undesirable
– The solution is either a global currency or development of local currency finance or an international insurance arrangement on a much bigger scale
34
7. Lessons
• Third Lesson - Macroeconomic Policy
– Inflation Targeting is not enough;
– Need to “lean against the wind”;
– Run large fiscal surpluses in normal times;
– Adopt “macro-prudential” countercyclical capital requirements
35
7. Lessons
• Fourth Lesson - Microeconomic Policy
– Case for separating utility banking from the “casino”;
– Need to charge properly for guarantees, explicit and implicitly;
– Need to tax term transformation through liquidity requirements;
– Need to rethink the “shadow banking system”, which is a banking system, after all;
– Need to raise capital requirements against all activities;
– Need to reconsider risk weighting and abandon trust in risk models
36
7. Lessons
• Big issues outstanding:
– What are the regulatory and economic implications of the new “mega-banks”?
– Is there a future for the shadow financial system?
• If so, how do we manage and control it?
• If so, how do we regulate the utility and the casino?
• Should banks be prohibited from engaging in markets?
• Should casinos be prohibited from term-transformation?
– How do we limit risks to the state?
• What do we do about “too big to fail”?
• What do we do about foreign assets and liabilities of domestic institutions and domestic assets and liabilities of foreign institutions?
– Should we regulate household access to credit directly?
• If so, how do we do so fairly?
• Do we control total borrowing or the leverage of households?