Transcript The Global Financial Crisis of 2008 .(English)

The Global Financial Crisis of 2008
Chandra Athukorala
Arndt-Corden Division of Economics
Research School of Pacific and Asian Studies
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Preview
• Financial Crisis: A ‘hardy perennial’
- ‘[A] subject that does not appear to be going
out of fashion’
(Robert M Solow, in the Foreword to
Kindleberger and Aliber 2005)
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Financial crisis results from the implosion of asset price
bubbles (or from the sharp depreciation of national
currencies)
(A bubble; a non-sustainable pattern of price changes or
cash flows)
Bubbles are generally associated with a robust, prolong
economic expansion :
manias associated with growth euphoria
rational behaviour morphs into irrational exuberance
A certain event, perhaps a change in government policy, an
unexplained failure of a firm/bank previously thought to
have been successful leads to bursting of the bubble.
Bubbles always implore, but this does not always lead to a
crisis (a soft landing is possible) – depends very much
on the money and capital market institutions of the time.
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• Financial crises have been more extensive and pervasive in the
last four decades than in any previous period. (An outcome of
‘financial globalization’?)
• We are now witnessing the third global crisis in a decade (199798 Asian crisis; dot-com crisis in 2001; the US housing market
crisis 2007 - )
• The ‘mother of all crises’ (so far!) in recorded history
has been the Great Depression following the crash of
the stock market bubble in the US in the late 1920s.
• The current unfolding crisis is similar in the source of
origin (US, the largest economy) and global spread.
The number of bank failures are going to be larger.
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Could it usher in the Second Great Depression?
Unlikely
• The global economy is much more ‘diversified’ than in
the thirties.
• All major countries have central banks which are ready
to act as ‘lenders of last resort’
• Floating exchange rate regimes (attempt to stick to the
‘gold standard’ was a major factor in deepening crisis in
the 1930s)
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The US Housing Boom and Bubble
Three key factors provided the setting:
• Surge in capital flows to the US
(A reflection of the on-going process of financial globalization.
implosion of the real state and stock bubble in Japan in the
early 1990s, the Asian crisis 1997-98, China’s meteoric
economic rise played a role)
• Robust growth propelled by productivity growth since the mid1990.
(productivity growth: 1974-95: 1.4%, 1996-2007 2.5% Rapid
productivity growth means the economy could grow faster without
exacerbating inflation)
• Historically low interest rates
in the aftermaths of the dot.com collapse and the terrorist attack of
September 11, 2001, FED lowered federal fund rates to 1 percent
and kept until June 2004. The subsequent hikes were marginal)
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The house price inflation began to exceed consumption
price inflation as early as 1998.
(Shiller 2000)
The rate of expansion of house prices began to exceed
household income growth staring in 2004 (a clear
sign of a bubble) (Harris 2008)
Housing stock value increased from about 4% of GDP in
the 1990s to 6% in 2006.
Almost two thirds of house owners had a mortgage by
2007 (compared to 50% in the 1990s)
Home-loans as percentage of consumption: 1990s: 26%;
2006: 36%
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Signs of aggressive speculative behaviour
• Surge in the use of hybrid (sub-prime) mortgages,
which required no down payment, demanded little
documentation of income or assts, or offered low
initial ‘teaser’ rates of payments.
(by 2006 sub prime mortgages accented for 15% of
the mortgage market)
• A surge in the number of buyers who were self
identified speculators (‘flippers’)
• Markets in ‘hot areas’ were getting hotter
(home price increases: Metro areas: 5% in 2004 to 7% in
2006 Cities: 20% to 28%)
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Linkages to the rest of the economy
• Housing sector boom was accompanied by a stock
market boon
• New financial derivatives based on to mortgages
contributed to massive expansion in overall financial
systems
• Thus, there was a high risk of a synchronized price
declines across many speculative markets.
• ‘regulatory failure’ amplified the potential risk.
- There was no regulatory reforms to match new
financial innovations
- New innovations made it hard for regulators to keep
track of firms’/banks’ exposure to credit risk.
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Was Greenspan part of the problem?
(Shiller 2000, Soros 2008, Harriss 2008, Rubin 2003)
• Greenspan was an ‘easy-money dove’
(A an easy money dove tends to be soft on inflation and
less inclined to hike interest rate.
A hawk is tough on inflation and inclined to hike
interest rates (and inflict pain on capital markets))
• He inadvertently encouraged the bubbles through
talks of higher trend growth propelled by productivity
growth and persistent low inflation 9in this he
exaggerated the China factor.
• He ignored the signs of housing bubble and kept
short-term interest rates too low for too long.
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Bursting of the Bubble and Onset
of the Crisis
Rumbling of the housing bubble from third quarter of 2007
Trigger: sub-prime credit defaults.
Feedback loop in the housing sector)
• The sharp pull back in lending to supreme borrows cased a sharp drop
in demand for homes (over 1 million homes on sale by mid 2008)
• Falling house prices
• Negative household equity (i.e the value of the home is less than the
value of the mortgage) creating an incentive for defaulting loans.
• More houses are being sold at bargain prices, pushing home process
lower.
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• Falling home construction and weaker demand, results in
further contraction in demand for houses
In addition
• Economy wide concretionary effects arising from
collapsing credit and share markets.
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Unfolding crisis
Nov/Dec 2007: The market for inter-bank lending
tightened up dramatically
January/February 2008: The auction rate market (where
state and local governments borrowing is rolled over)
ran into serious problems
March 2008; Bear sterns, a major investment bank, was
absorbed by JP Morgan
September 2008: Lehman Brothers collapsed - a
bellwether event which lead to virtual drying-up of the
commercial papers market seized.
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Policy Response
Greenspan-style gradualism in 2006 and 2007: the FED
continued to focus on inflation
Gradualism ended in January 2008: Bernanke announced
that recession, not inflation, was the main concern.
Late January 2008: 125 basic point cuts in fund rate
accompanied by array of new programs to directly add
liquidity to credit market
September 2008: 700 billion rescue package
Recapitalization of back has become part of the policy
package (following the British move in October)
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Current state of the US economy
The US economy may well be in recession already.
Economic collapse is likely to continue well into 2009
(and beyond?)
Retail sales dropped by 1.35% in 3rd quarter 2008
Almost a quarter of home owners with mortgages have
zero or negative equity.
Because of the collapse of the commercial paper market,
companies are facing straining balance-sheet capacity
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Global Spread
• In the second half of 2007, banks and hedge funds around the
world reported major losses from sub-prime mortgages
• September 2007: Northern Rock, a major bank, was rescued by
the UK government
• Widespread bank failures in the second and third quarter of
2008 in a number of countries: UK, Belgium, Sweden, Iceland
• In the 2nd week of October, Britain ‘nationalized’ much of its
banking industry
• The impact on Asian countries?
No signs of significant ripple effects of the financial crisis,
but bound to be affected by the second-round (real-sector
contrition in the US and other developed countries) effects)
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Reference
Harris, Ethan S. (2008), Ben Bernanke’s FED: The Federal Reserve After
Greemspan, Cambridge, AMS: Harvard Business Press.
Hartcher, Peter (2006), Bubble Man: Allan Greenspan & the Missing 7 Trilliona
Dollars, Melbourne: Black Ink.
Kindleberger, Charls P. and Robert Aliber (2005), Manias, Panics, and Crashes: A
History of the Financial Crises, Ney York: john Wiley and Sons.
Rubin, Robert E. and Jacob Weisberg (2003), In a Uncertain World,New York:
Random House.
Shiller, Robert I. (2000), Irrational Exuberance, Priceton, NJ, Priceton University
Press.
Soros, George (2008), The Credit Crisis of 2008 and what it Means, New York:
Foreign Affairs
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