Global Financial Crisis #1

Introduction

I’ve been approached on occasions to explain the movie Big Short to people who simply cannot digest the technical jargon involved. Before we do an course on the global financial crisis, it is useful to define what a financial crisis is, what a conceptual framework we’re thinking about having a financial crisis. The first thing to recognize, and it’s a starting point for any analysis, is that almost all of the wealth of the world is embodied in long lived assets that pay off slowly over time. Some fraction of that wealth however is needed to back short term safe assets that are used in transactions. Our ability to transact with each other rests on the confidence that we have that some fraction of our wealth is safe and can be embodied in these green pieces of paper, or in checking accounts, or in other safe assets that we use to transact. A panic happens when enough people get nervous about whether or not their money is safe and they try to convert it to something that they’re sure about. In the old days, that would be gold, these days it might be government bonds or it might be claims on real estate right away, any type of claim that they can be 100% sure about. A financial crisis happens when a panic or a fear of the panic effects the overall functioning of the financial system. I wanna start with this quote by Hyman Minsky, the economist who said in talking about what produces this risk of financial crisis, he said stability breeds instability. His basic point is it takes long period of relatively stable outcomes to produce the conditions that make you vulnerable to crisis. Kindleberger tells his history of financial crises, manias, panics, and crashes. And this is sort of stylist arc of that pattern. All crisis are different but they all follow this basic arc of mania over confidence. Exuberance creates the risk of panic. Panic produces crash in economic activity, Great Depression like outcomes.

Why study it?

Just like in an epidemic, people need to be quarantined, or in wartime, sometimes people who really don’t want to go and fight a war have to go fight a war. There are things that we have to do from a policy perspective during a financial crisis that would seem counter intuitive outside that crisis. The only way that we’re going to be able to do that successfully is for people, for citizens of the country to understand why these things need to be done. Ken Rogoff and Carmen Reinhart have written that in this history of financial crisis, this tragic history of financial crisis, unemployment typically rises seven percentage points over five years of job losses. Output typically falls more than 9% of GDP during two years of the decline. Government debt almost doubles. House prices fall by about a third. Equity prices fall by about half. And this is important, the direct fiscal costs of the financial rescues typically exceed 10% of GDP.

Themes

1. Reinhart and Rogoff in a book in 2008 called This Time Is Different, point out the important role of asset bubbles in financial crisis. Prior to all financial crisis, you will see a large increase in the price of at least one asset class. When this price later falls, we retroactively label that original increase to be a bubble.
2. A second theme is that in each successive generation we seem to have an uncanny ability based on need to invent new kinds of money. The rise of the modern state has allowed for sovereign backed fiat money, called fiat because it’s not actually backed by gold or silver or any other metal or commodity. Instead, it’s just a promise of the government. It is effectively backed by the human capital of the citizens of a country and the belief that the government in the future will be able to tax that human capital to pay off any debts that it has. So what we will see is that the traditional ways to produce money that the financial system had really insufficient to meet the demands for safe assets and for things that we could transact with in the economy going into the early part of the 21st century. At that point, the financial system did what it always does, and began to manufacture new forms of safe assets, using the collateral that was available and embodied in other long lived assets. In this case, housing.
3. The third theme is understanding the anatomy of a modern financial panic. For hundreds of years, panics were easy to spot. Depositors would literally run to their banks to exchange their bank notes, their currency at the time, for gold. The goal with financial crisis was different with the panics occurring out of public sight, in the non-bank part of the financial sector, often called Shadow Banking, or the Parallel Banking System.
4. Finally, the fourth theme of the course is fighting the panic and the things that need to be done in the midst of a meltdown in order to prevent it from getting even worse. To fight this particular crisis, the tools that were needed, forms of emergency lending by the central bank. Guarantees and capital injections by the fiscal authority were extended to creative new uses that were not anticipated when those rules were originally written down. The evidence shows that this panic fighting was a success, but the success came at the cost of some political backlash and in some cases reduced our firefighting capabilities for the next crisis.

What Causes Financial Crisis?

So let’s start with a little bit about the basic structure of Financial Systems. Financial Systems as you all know play this critical function in the economy. They take the savings of savers and loan or invest those recourses in activity that has some positive return. People lend them that money for a very short period, they expect it to be available on demand. And banks and other firms take those resources and lend them for longer periods of time to support people who want to borrow to finance the purchase of a home or a business, that wanna build a new factory. That’s the basic function of the financial system.

The structure of a typical bank, which is described here, has this thin base of common equity. A set of other forms of borrowing, long and short, deposits, secured, unsecured. And those finance the assets which are depicted on the left. This basic structure, by design, is fundamentally fragile because that equity cushion is thin and a large share of the remaining source of funds used to finance the loans of the assets of the institution can run, can be withdrawn in a crisis. And a bank doesn’t have the ability to sell assets quickly to meet a withdrawal of funds in extremis, thus, the inherent fragility of a financial system.

Imagine a simple illustration of the difference between a bank that has a more stable base of capital, or more conservative funding structure, and one that doesn’t. That narrower base signifies a greater vulnerability to shocks, greater fragility. Now this matters in part because the financial system is so closely linked with the rest of the economy. It’s like the power grid in the economy.

One way to illustrate this linkage is by showing the way this basic dynamic works.

So economic growth slows because of some adverse shock, the economy slows. That creates the fear of loses. Depositors start to withdraw their funds from what they perceive to be the weaker institutions. Those institutions try to sell assets or withdraw loans, call funding, to meet the demand for withdrawals of funds. That pushes down asset prices, the price of financial securities. In response to that, banks lend less. They pull back. That reinforces, intensifies the slowdown of the economy.That makes more institutions look weaker. The cycle continues. It’s a classic, vicious, self-reinforcing cycle in the context of financial distress.

But a fundamental thing is this set of beliefs. The set of beliefs that can contribute to a long boom in leverage and borrowing. I want to emphasize and explain the importance of the role beliefs play in making economies vulnerable to financial crises.

Crises that involve runs and panics are fundamentally different from the typical financial shock. They’re different, in part, because the response required to break a panic, the response required to protect people, protect the economy from the damage caused by financial crises is fundamentally different from the response that’s appropriate in the typical financial shock. In a panic, and this is kinda intuitive to many people, policy has to be much more aggressive in trying to reduce the risk of damage to the economy. And the type of strategies you adopt, as I’ll describe, are fundamentally different.

Here’s a way of thinking how the overlap is sort of limited between the strategies that work in a major financial crisis and the strategies that work in the more typical shock, and the fundamental tension and conflict between those two strategies. So in response to a typical financial shock, generally, you want to let failure happen. You want to haircut the creditors of failing banks, you want to allow the markets to adjust. You want to resist the pressure to intervene because it’s important and it’s healthy for the economy to go through that adjustment. For people that took too many risks to bear the full consequences of those risks. You might let the automatic stabilizers work in fiscal policy, those are things that automatically provide a little bit of assistance to the economy as growth slows. The central bank might want to do the normal standard liquidity provision to market certain institutions, and depending on the nature of, depth of the recession, the central bank might want to lower interest rates too.

But in a systemic financial crisis, you have to think about a fundamentally different set of tools. You have to think about a much more aggressive, much larger fiscal stimulus, much more aggressive, much less conventional monetary policy response. In terms of the financial system, you have to err on the side of providing guarantees and protections to limit the risk of runs, to limit the incentive to run. And you have to be very, very careful in allowing failure that could spread contagion, destabilize the rest of the system.

What caused the financial crisis of 2007, eight, and nine? If you think back to the eve of the crisis, the summer of 2007, the United States was extremely vulnerable to financial crisis. It wasn’t completely apparent the time, but I’m gonna show you the things that made us vulnerable to a severe crisis. This shows 100 years of losses in the banking system, and you can see the peak of losses in the Great Depression was terrible.

And following the Great Depression we had 70 years of relative calm. It wasn’t a period without crisis, there were lots of periods of financial trauma, financial distress. The S & L crisis is a good example. But those losses were very small, very mild, very moderate relative to the losses you saw in the Great Depression. This is important, because it led people to believe as memory of the severe crisis faded that we were living in a calmer, more benign, less risky financial environment.

Over part of this period, you saw what economists described as the great moderation. This was a period where the depth and frequency of recessions diminished, where the volatility of growth outcomes was more moderate. There seemed to be less risk, less risk of loss in income, less risk of acute periods of high unemployment, less risk of deep, broad, long-lasting recessions.

In part because of that, you saw this long rise in house prices.

People were more confident that the value of homes would rise, therefore they were more confident they could borrow a large amount relative to their income and lenders were more confident they could lend a large portion of someone’s income because that was backed by what they expected to be a rising value of that financial asset. And related to that, you saw this huge boom in borrowing relative to income which emphasizes the risks in this long rise in borrowing relative to income.

How is that borrowing financed?

If you look at the dark blue shaded area at the bottom, that’s the share of that rise in borrowing finance by what we think of as banks. And, if you look at that, it’s relatively flat, it drifts up gently in the later stage of the boom. But most of the increase in that borrowing, by individuals and by companies, was financed by other parts of the national system. By investment banks, by the government mortgage guarantors, Fannie and Freddie Mac, by non-bank financial institutions like GE Capital. And that’s important because those institutions existed outside the safety net, the safeguards established after the great depression. And they were financed in ways that made them much more vulnerable to runs and panics.

Alongside this rise in shadow banking, there was a substantial increase in short term deposit like liabilities that people thought they could withdraw on demand without any risk of loss. And that was critical to making the system vulnerable to the type of run and panic that ensued in the fall of 08.

So in the United States on the eve of the crisis, we were coming off a long period where belief in a more stable future produced a huge boom in lending and in financial assets. Huge increase in debt relative to income, financed in very dangerous, runnable forms, with most of the increment financed outside the core of the banking system, and that created the conditions for panic and collapse.

Now again, there were a lots of causes in these cases. We had a long trade where monetary policy was very accommodative, where real interest rates in the US and around the world were very, very low. There was a huge increase in savings in the most populous parts of the world, and over time a larger portion of those savings removing outside their home country to invest in places like United States.

There was a huge amount of fraud and predation in the US financial system. There were pockets of moral hazard most compellingly in the mortgage guarantors Fannie and Freddie. There were a mess of other incentive problems throughout the financial system, and we had a very Balkanized segmented regulatory structure.

What Do We Miss And Why Did We Miss It?

Part of the reason is because prior to the crisis, the U.S. financial system was designed with relatively limited tools to constrain the build up and risk.

The Federal Reserve and the bank supervisors had tools and authority to apply capital and liquidity requirements to banks, and to bank holding companies but those institutions represented only a relatively small share of the American financial system.

We didn’t have the ability to limit leverage in investment banks, in the government sponsored financial enterprises like Fannie and Freddie, in the investment banks and non-bank financial institutions in some of the big insurance companies. We couldn’t limit the funding risk in those institutions. We weren’t able to limit the risks that were building up in money market funds. We were not able to limit the amount individuals could borrow relative to the value of their home.

I want to illustrate a little bit about what happened to the evolution of the U.S. financial system over this period of time. If you look at this chart, it shows in a stylized form, the changing shape of our financial system. The center represents banks, where we’re able to limit leverage and some of the other risks in banks. The periphery where the firms are designated in blue, there were no effective constraints on risk and funding.

Look what happens in a system design like that way where you can have the unregulated, or the less regulated competing, with the regulated. Look what happens when you can only constrain risk taking in part of this system, in a context where there is this fundamental belief, this confidence, this exuberance about the stability about the economy and the prospect of rising asset prices.

If you can string part of the system, a lot of that growth gets financed in the periphery, where it’s less constrained and less regulated. You can see, over time, what happened in the American financial system is that the relative importance of the non-bank financial system, some people call it the shadow financial system. Investment banks, non-bank financial institutions, Fannie, Freddie, they all grew in relative importance, over time, because they were less constrained by the authorities.

There’s I think a Chinese saying about reminding people that water as it flows down a river, it finds its way around the stones in the river. Risk is like that too in periods of booms. Risk tends to find its way around the constraints. It tends to migrate where risk is not constrained. The important thing about this challenge is that the tighter you set the limits on part of the system, you’ll make that part of the system safer. You could make banks more stable but you’ll shrink the market share of banks. You’ll shrink the effective scope of those restrictions over time because over time, risk will migrate around them, and the relative size of those two different parts of the system will change in relative importance.

You can think that our biggest mistake, in some sense, was failure in imagination. We failed to contemplate the possibility that we could face a classic panic and run like what made the Great Depression so terrible. We thought that was inconceivable, unforeseeable, an, therefore, we didn’t build the system to be strong enough to reduce the risk of that type of classic panic.