E. Applications and current issues
2. Responding to external shocks (cont'd.)

    Example2: loss of investor confidence: the US versus Mexico

    The US (1987):
    Black Monday, Oct.19, 1987: stock market crash: Dow Jones Industrial Average fell by 508 points (23%)

     Mexico (1994): The tequila crisis

    handout

    Lesson: When savers initiate capital outflows, the resulting depreciation itself has expansionary macro effects, but trying to prevent the depreciation causes contractionary effects instead.

3. The financial crisis: a global perspective (powerpoint)

Part 1: Domestic origins to the financial crisis.

    Factor 1: Beginning in the late 1990s, the government adopted policies specifically designed to promote homeownership.

    Factor 2: The government scaled back regulation of the financial services industry.

    An investment bank underwrites and/or acts as the client's agent in the issuance of securities. Unlike commercial banks and retail banks, investment banks do not take deposits. From 1933 (Glass–Steagall Act) until 1999 (Gramm–Leach–Bliley Act), the United States maintained a separation between investment banking and commercial banks. Other industrialized countries, including G8 countries, have historically not maintained such a separation.

    Note: Derivatives were not regulated but also did not qualify for government support, such as federal deposit insurance.

    Factor 3: Complicated and risky financial innovations proliferated within a “shadow banking system” run by unregulated investment banks.

• Collateralized debt obligations (CDOs): Bonds (securities) consisting of pools of mortgages with varying degrees of risk that are bought by investment banks and bundled together for resale.
      The returns come from incoming mortgage payments, and the associated houses provide the collateral.
• Credit default swaps (CDSs): Contracts in which insurance companies (such as AIG) collect premiums from investment banks in exchange for a promise to pay the bank the face value of a loan and take it over if the original borrower defaults.

    Professional investment managers generally are compensated based on the volume of client assets under management. There is, therefore, an incentive for asset managers to expand their assets under management

    CDO issuance grew from an estimated $20 billion in Q1 2004 to its peak of over $180 billion by Q1 2007, then declined back under $20 billion by Q1 2008.
    The credit quality of CDO's declined from 2000–2007, as the level of subprime and other non-prime mortgage debt increased from 5% to 36% of CDO assets.

    AIG did not have the financial strength to support its many CDS commitments as the crisis progressed and was taken over by the government in September 2008. U.S. taxpayers provided over $180 billion in government support to AIG during 2008 and early 2009.

Part 2: A global perspective on the financial crisis

    Back in 1996, the world’s current account balances corresponded pretty well to basic capital migration theory. The US was the standout exception.

Several significant events altered global finances from 1996 to 2006:

1. Several high-income countries with aging populations increased their savings rates to prepare for future retirement spending.
2. China, a country with fixed exchange rates and restricted capital markets, generated huge national savings through its Export-Led Industrialization backed by an undervalued exchange rate.
3. The inflation-adjusted price of oil more than doubled, resulting in substantial CAB surpluses in OPEC countries with fixed exchange rates and restricted capital mobility.
4. A series of financial crises from 1997-2001 in several emerging-market economies prompted savers to look for investment opportunities in “safe-haven” countries.

Net capital flows increased from less than $200 billion in 1996 to over $1.2 trillion in 2006, with virtually all of it flowing to high-income countries with booming mortgage markets