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Wednesday, May 02, 2012 |
3. The financial crisis: a global perspective (powerpoint)
At first, inflows to the US helped fuel the dot-com boom, driving the stock market to an all-time high by the end of 1999.
Savers then shifted to safer bonds, driving bond prices up and interest rates down. The Fed also lowered interest rates to promote a “soft landing” for the economy. Real mortgage interest rates fell 50%.
increases in home values, together with a stock-market recovery that began in
2003, have recently returned the wealth-to-income ratio of U.S. households to
5.4, not far from its peak value of 6.2 in 1999 and above its long-run
(1960-2003) average of 4.8.
since 1996 wealth-to-income ratios have risen by 14 percent
in France, 12 percent in Italy, and 27 percent in the United Kingdom; each of
these countries has seen their current account move toward deficit, as already
noted.
We all know now that the hard landing is what we ended up with.
Free cash used by consumers from home equity extraction doubled from $627 billion in 2001 to $1,428 billion in 2005 as the housing bubble built, a total of nearly $5 trillion dollars over the period.
There is strong evidence that the riskiest, worst performing mortgages were funded through the "shadow banking system" and that competition from the shadow banking system may have pressured more traditional institutions to lower their own underwriting standards and originate riskier loans ($4 trillion in shadow banking vs. $10 trillion in banking system)
The International Monetary Fund estimated that large U.S. and European banks lost more than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009. These losses are expected to top $2.8 trillion from 2007-10. U.S. banks losses were forecast to hit $1 trillion and European bank losses will reach $1.6 trillion. The International Monetary Fund (IMF) estimated that U.S. banks were about 60% through their losses, but British and eurozone banks only 40%.
One of the first victims was Northern Rock, a medium-sized British bank. The highly leveraged nature of its business led the bank to request security from the Bank of England. This in turn led to investor panic and a bank run in mid-September 2007. Calls by Liberal Democrat Treasury Spokesman Vince Cable to nationalise the institution were initially ignored; in February 2008, however, the British government (having failed to find a private sector buyer) relented, and the bank was taken into public hands.
The response of the U.S. Federal Reserve, the European Central Bank, and other central banks was immediate and dramatic. During the last quarter of 2008, these central banks purchased US$2.5 trillion of government debt and troubled private assets from banks. This was the largest liquidity injection into the credit market, and the largest monetary policy action, in world history. The governments of European nations and the USA also raised the capital of their national banking systems by $1.5 trillion, by purchasing newly issued preferred stock in their major banks.
So, where does the giant pool of money appear to be headed now?
Net capital flows have returned to close to their pre-crisis level, with a shift back in the direction predicted by capital migration theory: industrial countries have accounted for 84% of CA increases and only 18% of CA decreases.
Recommendations based on the global approach to the financial crisis:
US:
1. Reduce the budget deficit (but note that current account deficits
persisted during the budget surpluses of the 1990s).
2. Increase domestics
savings (but the huge capital inflows themselves have depressed savings by
pushing down interest rates and pushing up asset prices).
Emerging markets:
1. Improve governance
2. (Re)open capital markets
Once poorer countries bring their savings home and richer countries send
theirs abroad,
the US standard of living may fall,
but US manufacturing jobs
will come back.
Fed Chair contender: Glenn Hubbard (2006)
Summary: Capital outflows occur for two reasons:
(1)
h earnings opportunities abroad (pure external shock)
Ex: the EMS in 1992
Expansionary with floating ERs
Contractionary with fixed ERs
(2)
i domestic earnings opportunities
loss of confidence
Ex: 2007 crash of the housing market
g
i wealth g
i spending g
i Y
Fixed ERs make it worse
4. The Eurozone crisis (handout)
The
PIIGS (Portugal, Ireland, Italy,
Greece, and Spain)
Factor
1: The giant pool of savings
= the PIIGS = the US of the Eurozone
Capital flight g hr*
Factor 2: austerity policies to reduce government debt and budget deficits => iG & hT
Factor 3: the PIIGS have fixed ERs => R fixed unless Pdom changes
| Y | = | C(Y-T,wealth) | + | I(r*) | + | G | + | NX(R) | |
| i f iwealth, hT | i fhr* | i | must h
or else Y falls |
||||||
For NX to rise, R must fall => Pdom must fall
Factor 4: EU labor markets have many restrictions that limit wage and price flexibility
Example: Greece: Termination: Terminating employment must be accompanied by written motivation and adequate warning. A legal basis must be provided for any termination and, until that basis is given, full wages must be paid. If the worker has worked between 10 and 28 years, he is entitled to 6 months' severance pay. If the worker has served 28 years, he is entitled to two years' severance pay. Employers can claim financial hardship or other financial issues as a reason to lay off workers.
Is the Eurozone an optimal currency area?
Works best with:
(1) easy factor mobility
can laid off
workers in Nevada easily migrate to California?
can laid off
workers in Greece easily migrate to Germany?
(2) synchronized business cycles
Neither fits the Eurozone
note the mismatch between the business
cycle situations in the PIIGS and the other Eurozone-12 members