GLOBAL FINANCIAL Crisis

1
GLOBAL FINANCIAL Crisis
Why, What Happened, Whats Next?

• 1978-2002, 117 Banking Crises in 93 economies.
• 3rd Global Crisis in 3 decades
• Latin America
• East Asia/Russia/Brazil/Argentina/Turkey
• Developed and Developing economies
• But the first where US, UK, Euro economies and
  Japan are simultaneously in recession. IMF
  2009, 1st time since WWII developed economies
  will have negative growth.
• Reinhart and Rogoff (2008) demonstrate, the
  antecedents and aftermath of banking crises in
  rich countries and emerging markets have a
  surprising amount in common. There are broadly
  similar patterns in housing and equity prices,
  unemployment, govt revenues and debt.

2
Unfolding Crisis JP Morgan Global Manufacturing
Index
Global Manufacturing PMI Summary Nov Dec
Change Summary Global PMI 36.5 33.2 Index at
series-record low Output 33.1 28.8 Index at
series-record low New Orders 29.8 25.3 Index at
series-record low Input Prices 36.2 31.3 Index
at series-record low Employment 39.6 36.7 Index
at series-record low Global manufacturing ended
2008 on an exceptionally weak footing with a 15
decline. Dec. PMI data pointed to series-record
contractions in output, new orders and employment
as companies continued to face weak market demand
resulting from the worldwide economic downturn
and ongoing crises in the financial and credit
markets. This was most striking in the US, where
production and new work received fell at the
fastest rates in the 61 year ISM survey. Almost
all of the national output and new orders indexes
for which Dec. figures were available were at
their lowest or second-lowest readings in their
respective series histories.
3
World-wide declines

• Manufacturing surveys reflect simultaneous
  contraction in manufacturing throughout the G7
  and in key emerging markets like China, Brazil
  and Russia verifying the global recession that is
  well on course.  PMI and Industrial production is
  at least decade lows in key emerging markets and
  US and EU PMI surveys reflect the weakest levels
  in several decades
• Merrill Industrial production, has absolutely
  collapsed everywhere, most notably in Asia. 
  Retail sales have been severely affected,
  particularly those of durable goods, such as
  autos, which have seen a plunge of 20-40 yoy
  globally,  creating severe downside risks for Q4
  GDP everywhere around the world. 
• JPMorgan  The weakest performance was registered
  by Japan, whose output and new orders indexes
  fell to levels unprecedented in the histories of
  any of the national manufacturing. Employment
  also fell at series-record rates including all of
  the Eurozone nations, China and the UK. With the
  orders and inventory ratio falling further, an
  intense contraction phase in industry should
  remain in place for some months to come.
• Chinese orders has been in contraction for five
  months and industrial production has been slowing
  sharply in many Asian countries as external and
  domestic demand weaken. Estimated 10,000 of
  60,000 Hong-Kong owned factories in southern
  China are in the process of closing, as exports
  have plunged 11 in December. Trade finance is
  collapsing. China in process of illegally
  encouraging trade thru tariffs subsidies, which
  will increase trade tensions.

4
Long recession since Great Depression
At the end of 2008, Consumer confidence new
orders lowest ever. Manufacturing and home
constructions lowest levels in decades. Home
prices decline nationwide largest on record.
Factory sales fall off cliff, plunging 5.3 in
November, the biggest drop on record. Loan
losses for U.S. banks are expected to rise to 3
by the end of 2010, from 1.5 in 3rd Q 2008, hurt
by an increased percentage of bad loans, greater
consumer leverage and faster problem recognition
by banks, Deutsche Bank said, and Loan losses
might even surpass the 3.4 loss levels reached
in 1934 during the Great Depression. 200,000
retailers and 3000 malls and outlets may declare
bankruptcy.
5
Background

• The global imbalances probably represent the
  single largest current threat to the continued
  growth and stability of the US and world
  economies (Bergsten, 07)
• U.S. CA deficit as a sword of Damocles hanging
  over the global economy (Rogoff 07).
• The first major financial crisis of the 21st
  century involves esoteric instruments, unaware
  regulators, and skittish investors. It also
  follows a well-trodden path laid down by
  centuries of financial folly. Is the special
  problem of sub-prime mortgages this time really
  different? standard indicators for the US, such
  as asset price inflation, rising leverage, large
  sustained CA deficits, and a slowing trajectory
  of economic growth, exhibited virtually all the
  signs of a country on the verge of a financial
  crisis indeed, a severe one
• Examination of 100s currency debt crises finds
  stunning qualitative and quantitative parallels
  across a number of standard financial crisis
  indicators. US buildup up debt is less, the
  pattern of US CA deficits is markedly worse. The
  aftermath of other episodes suggests that the
  strains can be quite severe, typically leading to
  fall of GDP by 2 and a prolonged 2-year
  slowdown.
• Starting in the summer of 2007, the US
  experienced a striking contraction in wealth,
  increase in risk spreads, and deterioration in
  credit market functioning. The US sub-prime
  crisis, of course, has it roots in falling
  housing prices, which have in turn led to higher
  default levels particularly among less
  credit-worthy borrowers. The impact of these
  defaults on the financial sector has been greatly
  magnified due to the complex bundling of
  obligations that was thought to spread risk
  efficiently. Unfortunately, that innovation also
  made the resulting instruments extremely
  nontransparent and illiquid in the face of
  falling house (Reinhart and Rogoff, 08)

6
A Crisis like no Other?

• Tolstoy famously begins his classic novel Anna
  Karenina with Every happy family is alike, but
  every unhappy family is unhappy in their own
  way. While each financial crisis no doubt is
  distinct, they also share striking similarities,
  in the run-up of asset prices, in debt
  accumulation, in growth patterns, and in current
  account deficits. The majority of historical
  crises are preceded by financial liberalization,
  as documented in Kaminsky and Reinhart (1999).
  While in the case of the US, there has been no
  striking de jure liberalization, there certainly
  has been a de facto liberalization. New
  unregulated, or lightly regulated, financial
  entities have come to play a much larger role in
  the financial system, undoubtedly enhancing
  stability against some kinds of shocks, but
  possibly increasing vulnerabilities against
  others. An examination of the aftermath of severe
  financial crises shows deep and lasting effects
  on asset prices, output and employment.
• 1) Real housing price declines average over 35
  over a six year period. Note in other crises,
  residential real estate was not necessarily a
  focus of the bubble. Even excluding Japan (which
  has suffered a 17 year housing price decline) the
  average is over 5 years. 2) Equity prices fall
  55 over three and a half years.3) GDP fall an
  average of 94) Unemployment increases 7 over
  previous norms.5) Government debt "explodes",
  increasing an average of 86, but the cause is
  typically not a banking industry
  recapitalization, but maintaining services in the
  face of collapsing tax revenues and
  countercyclical measure ex financial system
  measures.
• Perhaps the US will prove a different kind of
  happy family. Despite many superficial
  similarities to a typical crisis country, it may
  yet suffer a growth lapse comparable only to the
  mildest cases. Perhaps this time will be
  different as so many argue. Nevertheless, the
  quantitative and qualitative parallels in run-ups
  to earlier postwar industrialized-country
  financial crises are worthy of note.

7
A Crisis waiting to happen

• These global imbalances are unsustainable for
  both international financial and US domestic
  political reasons. On the intl side, the US must
  now attract 8 billion of capital from the rest
  of the world every working day to finance the US
  CA deficit and foreign investment outflows. Even
  a modest reduction of this inflow, let alone its
  cessation or a sell-off from the 14 trillion of
  dollar claims on the US now held around the
  world, could initiate a precipitous decline in
  the . This could, in turn, sharply increase US
  inflation and interest rates, severely affecting
  the equity and housing markets and potentially
  triggering a recession. Fred Bergsten May 07
• The world economy faces an acute policy dilemma
  that, if mishandled, could bring on the mother of
  all monetary crises. Many dollar holders,
  including central banks and sovereign wealth
  funds as well as private investors, clearly want
  to diversify into other currencies. Even a modest
  realization of these desires could produce a free
  fall of the US currency and huge disruptions to
  markets and the world economy. Fears of such an
  outcome have risen sharply in both official
  circles and the markets. Bergsten Dec 07.
• If only Asia would save less, spend more and so
  import more from America, it is argued, the
  deficit would simply vanish. The problem is that
  America's imports are 50 larger than its
  exports, so if both simply grow at the same pace,
  the CA automatically widens. If imports rise by
  10, then exports need to grow by 15 just to
  prevent the deficit from widening. This means
  that while stronger foreign demand would
  undoubtedly help, the US cant reduce the deficit
  by exporting its way out.
• China says US should put its own house in order
  save moreand stop blaming others for its
  problems.

8
Falling Savings

• US personal savings rate have fallen from 10 to
  0. Credit Card debt is approaching 10,000
  household, home foreclosures have soared. We
  borrow from other economies - 8 billion a day,
  70 of the worlds savings. US Current Account
  Deficits have reached 600-800 billion for years.
  14 years of 4 real consumer growth likely to
  slow 1-2 for 3-5 years. UNSUSTAINABLE.
• Current Account Deficits are appropriate for
  emerging countries that need investment whereas,
  US is borrowing for Wars, Consumption
  Housing.
• Wall Street responsible for facilitating the
  financing of Asian/Oil Exporters to
  over-leveraged consumers.
• The world economy faces an acute policy dilemma
  that, if mishandled, could bring on the mother of
  all monetary crises. Many dollar holders,
  including central banks and sovereign wealth
  funds as well as private investors, clearly want
  to diversify into other currencies. Even a modest
  realization of these desires could produce a free
  fall of the US currency and huge disruptions to
  markets and the world economy. Fears of such an
  outcome have risen sharply in both official
  circles and the markets. Bergsten Dec 07.

9
Impact on US Ownership

• Foreigners account for about 2.2 trillion, or a
  little over half, of the outstanding total of
  4.3 trillion of US Treasury securities held by
  the public. Official institutions, mainly central
  banks, account for about 60 percent of this
  total. In addition, foreigners as a whole
  probably hold close to 1 trillion, or about 15,
  of US government agency securities. These totals
  and ratios have risen rapidly over the past 20
  years. From 1985-06, foreigners acquired almost
  75 percent of the overall increase in outstanding
  treasuries. From 1995-06, domestic holdings
  actually fell while foreign holdings grew by
  twice the aggregate increase. Since 2001, foreign
  purchases of treasuries have accounted for nearly
  all of the rise in the total outstanding debt.
• Hence, the CA is now being financed by short-term
  money and by central banks, which is
  unprecedented. FX reserves (65 in ) have risen
  by 1 trillion in just 18 months. The previous
  addition of 1 trillion to official reserves took
  a decade. These purchases of have nothing to do
  with the prospective returns in the US, but are
  aimed at holding down the currencies of the
  purchasing countries.
• Worse still, in recent years capital inflows into
  America have been financing not productive
  investment (which would boost future income) but
  a consumer-spending binge and a growing budget
  deficit. A CA deficit that reflects a lack of
  saving is hardly a sign of strength.
• Debt is 11 times export earnings and comparable
  to crisis victims such as Argentina and Brazil

10
(No Transcript)
11
(No Transcript)
12
Record Financial Losses

• It has been a year of record misery the largest
  bankruptcy, bank failure and Ponzi scheme in U.S.
  history 720 billion in writedowns and losses by
  financial institutions 30.1 trillion in market
  valuation wiped out including 7 trillion in the
  US
• The biggest loss and the hardest thing to
  recover, though, may be something that cant be
  precisely measured -- confidence in the markets
  and the firms that rely on them. Lehman with
  assets of 639 billion, filed the largest
  bankruptcy in U.S. history on Sept. 15. Its
  creditors lost 75 billion. Financial companies
  tumbled the most among the 10 main industries in
  the SP 500 this year, falling 57 percent. The
  SP 500s 38 decline in 2008 was the first that
  exceeded 30 since the 39 percent plunge in 1937.
  In, 2002, 1974, the SP was down 23 29.7, the
  following year there were annual gains of 26 and
  32 respectively.
• In the largest U.S. bank failure, WAMU collapsed
  in September with 307 billion in assets (more
  than last six year combined). There were 25 bank
  failures in 2008, the most in 15 years. The wave
  of writedowns and losses that swamped financial
  institutions around the world reached 720
  billion this year. It also eroded employment
  250000 in financial services.
• Wall Street bonuses became so rich in recent
  years that 1 million was referred to as a buck.
  The U.S. government was forced to rescue the
  worlds largest insurance company, AIG with a
  152.5 billion package of investments, loans and
  capital infusions.
• Overall, the Govt has committed 8.5 trillion in
  trying to jumpstart a shrinking economy.
• The paralysis of credit markets sent ripples
  through many of the businesses that had flooded
  Wall Street with profits over the past decade.
  Corporate profits have declined for seven
  straight quarters. Should earnings fall through
  the first half of 2009, as analysts expect that
  would be the longest stretch of decreases since
  the government started tracking quarterly data in
  1947.

13
Causes Litany of Errors

• Financial Liberalization coupled with poor
  regulation, enforcement, lax underwriting bond
  ratings, skewed incentives in the financial
  sector. Greed ignorance by Wall Street and
  Main Street with Govt indifference. Capitalism
  went from a referred boxing match to a bar room
  brawl with no bouncer and rules. Reinhart Banana
  republic approach of supervision no one seems to
  know who is responsible for what. "Received
  wisdom was that such supervisory disarray could
  only happen in an emerging market - we now know
  better.
• Global Imbalances caused by falling US savings
  rates, and Mercantilism (structural or exchange
  rate manipulated) leading to a Savings Glut by
  other economies. US China in financial embrace
  addicted to cheap goods credit (US) export
  growth and financial stability (China)
• Borrowing good to finance investment. In 1800s,
  we borrowed from British to build railroads. But
  in past 8 years, government borrowed for Iraq
  consumer for SUVs, houses
• Monetary Glut Serial Bubble Economy, Interest
  Rates too low, too long record low 2002-2004,
  leading to housing boom bust. Tremendous
  increase in liquidity and growth in the
  nonbanking/shadow banking sector.
• Perception of Risk and disregard of history
  This time is different. However, 1.2 trillion in
  bad debt, and may reach 2 trillion. The most
  expensive financial crisis in history.

14
Causes Financial regulations

• Financial crises have accelerated across the
  world during Financial Globalization Deregulation
  (pushed by US) , increased Financial Flows,
  Loosening of Capital Capital Controls at the
  heart of over 100 crisis including the Asian and
  Latin American financial crises of the 1990s
  foreshadowed the current situation and argues
  that the rise of unregulated financial
  institutions--or "shadow banks"--since then has
  been the real problem
• Banks and other Financial institutions are
  inherently instable due to very high leverage
  ratios Gross capital flows into the United States
  totaled 7.8 trillion over the five years from
  2003 through 2007, increasing each year to reach
  2.1 trillion in 2007.1 bursting of the
  debt-fueled property bubble and the crippling
  losses suffered by banks,
• The principal instruments were MBSs (mortgage
  backed securities), CDOs (collateralized debt
  obligations) and CDSs (credit default swaps),
  which were a form of insurance against default.
  These depended on the liquidity and solvency of
  the insurer, for example the huge insurance
  company AIG which the government had to take
  over. Derivatives, securitization, deregulation,
  greedy bankers, overpaid traders, fraudulent
  behavior
• Another example is the hands-off attitude that
  was taken toward hedge funds, even as they became
  a larger and larger part of the financial system,
  and even after the crisis caused by the
  near-collapse of Long-Term Capital Management in
  1998. Grew 1.8 trillion
• All told, the non-bank financial system grew to
  be very large (10.5 trillion)

15
Govt Promoted Free Market

• Ed Gramlich, a Fed governor warned in 2000 that a
  fast-growing new breed of lenders was luring many
  people into risky mortgages they could not
  afford. But when Gramlich privately urged Fed
  examiners to investigate mortgage lenders
  affiliated with national banks, he was rebuffed
  by Greenspan. Mr. Gramlich asked. The question
  answers itself the least sophisticated
  borrowers are probably duped into taking these
  products.
• In 2001, Bair (Treasury), tried to persuade
  subprime lenders to adopt a code of best
  practices and to let outside monitors verify
  their compliance. None of the lenders would agree
  to the monitors, and many rejected the code
  itself. Housing advocacy group in CA meeting with
  Greenspan in 2004, warned that deception was
  increasing and unscrupulous practices were
  spreading. However, Greenspan encouraged the use
  of flexible rate mortgages and new innovations.
• Federal Govt stopped more than 30 states attempts
  to curb mortgage brokerage lenders bad behavior.
  Both the Fed and the Bush adm. placed a higher
  priority on promoting financial innovation and
  the ownership society. Further, the Fed
  counted on the housing boom to prop up the
  economy after the stock market collapsed in 2000.
  
• Homeowners with subprime mortgages end up in
  foreclosure almost 20 of the time, or more than
  6 times as often as experiences that begin with
  prime mortgages. House price depreciation plays
  an important role in generating foreclosures, as
  subprime lending borrowers are particularly
  sensitive to falling house prices. By comparison,
  the success rate for borrowers who finance their
  home purchase with a prime mortgage is 97.

16
Housing is partially to blame
17
Impact on US Ownership

• Foreigners account for about 2.2 trillion, or a
  little over half, of the outstanding total of
  4.3 trillion of US Treasury securities held by
  the public. Official institutions, mainly central
  banks, account for about 60 of this total. In
  addition, foreigners as a whole probably hold
  close to 1 trillion, or about 15, of US
  government agency securities.These totals and
  ratios have risen rapidly over the past 20 years.
  From 1985-06, foreigners acquired almost 75
  percent of the overall increase in outstanding
  treasuries. From 1995-06, domestic holdings
  actually fell while foreign holdings grew by
  twice the aggregate increase. Since 2001, foreign
  purchases of treasuries have accounted for most
  of the rise in the total outstanding debt.
• Hence, the CA is now being financed by short-term
  money and by central banks, which is
  unprecedented. FX reserves (65 in ) have risen
  by 1 trillion in just 18 months. The previous
  addition of 1 trillion to official reserves took
  a decade. These purchases of have nothing to do
  with the prospective returns in the US, but are
  aimed at holding down the currencies of the
  purchasing countries by China, Japan, Hong Kong,
  Taiwan
• Worse still, in recent years capital inflows into
  America have been financing not productive
  investment (which would boost future income) but
  a consumer-spending binge and a growing budget
  deficit. A CA deficit that reflects a lack of
  saving is hardly a sign of strength.
• Debt is 11 times export earnings and comparable
  to crisis victims such as Argentina and Brazil

18
Deleveraging

• The U.S. and Western Europe is in the grip of a
  downward spiral that financial experts call
  deleveraging. Having accumulated debts beyond
  what's sustainable, households and financial
  institutions are being forced to reduce them. The
  pressure to do so results from a decline in the
  price of the assets they bought with the money
  they borrowed. It's a vicious feedback loop. When
  families and banks tip into bankruptcy, more
  assets get dumped on the market, driving prices
  down further and necessitating more deleveraging.
  This process now has momentum that even 700
  billion in taxpayers' money may not suffice to
  stop it.
• In the case of households, debt rose from about
  50 of GDP in 1980 to a peak of 100 in 2006.
  Much of the increase in debt was used to invest
  in real estate. The result was a bubble at its
  peak, average U.S. house prices were rising at
  20 a year. Then as bubbles always do it
  burst.
• Banks and other financial institutions are in
  worse shape their debts are accumulating even
  faster. By 2007 the financial sector's debt was
  equivalent to 116 of GDP, compared with a mere
  21 in 80. The banks net losses imply that they
  will need to shrink their balance sheets by 10
  times that figure almost a trillion dollars
  to maintain a constant ratio between their assets
  and capital. That suggests a drastic reduction of
  credit, since a bank's assets are its loans.
  Fewer loans mean tighter business conditions
  credit leading to layoffs.
• The Wall Street crash lead to a U.S. stock market
  declined a staggering 89, reaching its nadir in
  July 1932. The index did not regain its 1929 peak
  until 1954. Yet the underlying cause of the Great
  Depression as Friedman and Schwartz argued was
  not the stock-market crash but a "great
  contraction" of credit due to an epidemic of bank
  failures. By 1932, 1,860 banks had failed.

19
Shadow Banks Securitization

• It's started with the collapse of these 300-plus
  non-bank mortgage lenders. shadow banking
  system.  The non-bank mortgage lenders -the
  broker-dealers, the hedge funds, the private
  equity, the money market funds look like banks
  by borrowing short.  They're highly leveraged,
  more than banks.  They lend long and illiquid
  ways. 
• The originators of the mortgages had little or no
  incentive to ensure that the mortgagees could
  afford to take out the mortgages without default.
  Only if they retained some of the loans or
  instruments would they have an incentive, This is
  very different from the old-fashioned way when
  local banks retained the risks and therefore made
  themselves adequately familiar with the
  mortgagees. It is not surprising that the new
  procedure is called the originate-to-distribute
  model. securitization
• It became impossible for mortgagees to
  renegotiate the loans with the ultimate lenders,
  since the latter were effectively dispersed.
  Contrast this with the negotiations that took
  place in the 80s between the govt of developing
  countries and the intl banks in resolving the
  LDC debt crisis.
• There was an effect that was fatal, and indeed
  set off the world credit crisis. Once the US
  housing market went into decline and a proportion
  of  sub-prime mortgagees defaulted there was a
  critical information problem. Holders of these
  instruments, which were composites of many
  different mortgages, did not know and could not
  know what risks they were running.  All they
  knew was that they could make big losses or
  they might not. As a result they wanted to get
  rid of them, and the market value of the
  instruments fell dramatically. A device which was
  meant to off-load and spread risk which indeed
  it did spread fear. And this led to the next
  step,  Panic

20
Lessons from Past events - IMF

• Financial systemsboth financial institutions and
  the channels of intermediationhave historically
  been prone to periods of rapid expansion followed
  by corrections.
• Episodes of financial turmoil characterized by
  banking distress are more often associated with
  severe and protracted downturns than episodes of
  stress centered mainly in securities or foreign
  exchange markets.
• The likelihood that financial stress will be
  followed by recession is greater when a housing
  and credit bubble period precedes it. Moreover,
  greater reliance on external financing by
  households and nonfinancial firms coupled with
  leverage is associated with sharper downturns in
  the aftermath of financial stress.
• The importance of core financial intermediaries
  in transmitting financial shocks to the real
  economy suggests that policies that help restore
  the capital base of these institutions within a
  strong framework of financial stability can help
  alleviate downturns.
• The patterns of asset prices and aggregate
  credit in the US during the current episode of
  financial stress appear similar to those of
  previous episodes that were followed by
  recessions. In particular, changes in the pattern
  of household net borrowing closely track the
  trajectory of past recessions.
• Nonfinancial firms entered the turmoil from a
  relatively strong position. Combined with the
  large losses sustained by core banking
  institutions, these factors suggest that the
  United States continues to face considerable
  recession risks.

21
(No Transcript)
22
(No Transcript)
23
(No Transcript)
24
Why have they lent US

• Gross capital flows into the United States
  totaled 7.8 trillion over the five years from
  2003 through 2007, increasing each year to reach
  2.1 trillion in 2007.1
• Why are foreigners willing to invest an average
  of over 5 billion every day in the USespecially
  given relatively low returns relative to
  comparable investments in other countries and a
  widespread expectation of continued dollar
  depreciation? Forbes Foreigners investing in
  U.S. equity and bond markets have earned lower
  returns over the past five years than if they had
  invested in the same asset classes in their own
  countries, and the advantages of the US are
  diminishing honest, highly developed liquid
  market that is uncorrelated with their own
  market. ever, as developing financial markets
  (especially in low-income countries) is a
  prolonged process. If countries with less
  developed financial markets begin to question the
  relative advantages of U.S. financial markets,
  this could lead to a more rapid adjustment in
  U.S. capital inflows, global imbalances and asset
  prices.
• NY Times (Jan 08) China Losing Taste for US
  Debt. China has bought more than 1 trillion of
  American debt, but as the global downturn has
  intensified, Beijing is starting to keep more of
  its money at home, a move that could have painful
  effects for American borrowers. I Past five
  years, China has spent as much as 1/7 of its
  entire economic output buying foreign debt,
  mostly American. In September, it surpassed Japan
  as the largest overseas holder of Treasuries.
  Last year, China spent 415 billion, while this
  year it is expected 177 billion as deficit
  soars. Chinas voracious demand for American
  bonds has helped keep interest rates low for
  borrowers ranging from the US Govt to home
  buyers. Reduced Chinese enthusiasm for buying
  American bonds will reduce this dampening effect.

25
Potential instability

• Economist America's policies are putting at
  risk the dollar's role as the world's dominant
  intl currency.
• IMF - With its rising budget deficit and
  ballooning trade imbalance, the US is running up
  a foreign debt of such record-breaking
  proportions that it threatens the financial
  stability of the global economy. IMF reported
  sounded a loud alarm about the shaky fiscal
  foundation of the US, questioning the wisdom of
  the Bush adm. tax cuts and warning that large
  budget deficits pose "significant risks" not just
  for the US but for the rest of the world. The
  report warns that the US' net financial
  obligations to the rest of the world could be
  equal to 40 percent of its total economy within
  a few years "an unprecedented level of external
  debt for a large industrial country, that could
  play havoc with the value of the dollar and intl
  exchange rates.
• The danger, according to the report, is that the
  United States' voracious appetite for borrowing
  could push up global interest rates and thus slow
  global investment and economic growth.
• "Higher borrowing costs abroad would mean that
  the adverse effects of U.S. fiscal deficits would
  spill over into global investment and output,"
• The I.M.F. is right," said C. Fred Bergsten,
  director of the Institute for International
  Economics in Wash. "If those twin deficits of
  the federal budget and the trade deficit
  continue to grow you are increasing the risk of a
  day of reckoning when things can get pretty
  nasty."

26
Myths Lessons

• Lower macroeconomic risk the Great Moderation.
• Lower financial risk due to financial innovations
  (increased systematic risk)
• Lower risk due to efficient, nonfailing markets
• Lead to increased leverage
• Decoupling lead to believe that emerging markets
  were no longer tied to US but we are
  interconnected via trade in goods, services,
  assets and institutions.
• US is a different type of borrower than emerging
  economies
• Global imbalances and the US consumers can
  continue to borrow forever
• International financial integration like
  international trade produces more winners than
  losers
• Government is bad No, government is critical
  for establishing honest, transparent markets and
  enforcing contracts, free flow of information and
  protecting private property. Capitalism can not
  work with markets, there are to many
  externalities, and free riders. Reliable
  information needs government enforcement, not
  voluntary private enforcement.
• Lessons Confidence, like reputation, is a
  fragile commodity hard to earn, easy to lose.
  Once it is shattered, mistrust and caution will
  prevail for awhile, putting back the pieces takes
  time and faith.

27
Surprise?

• In 2003, Case Shiller wrote, The popular press
  is full of speculation that we are in a housing
  bubble that is about to burst. Barrons, Money
  Magazine and The Economist have all run recent
  feature stories about the irrational runup in
  prices and the potential for a crash in home
  prices. The Economist has had a series of
  articles with titles like Castles in Hot Air
  House of Cards Bubble Trouble, Betting the
  House. These accounts have necessarily raised a
  lot of concerns among the general public. But,
  how do we know if the housing market is in a
  bubble? there are elements of a speculative
  bubble in single family home prices in some
  cities the strong investment motive, the high
  expectations for future price increases and the
  strong word of mouthThe consequences of such a
  fall in home prices would be severe for some
  individuals. Given the high level of personal
  debt relative to personal income, an increase in
  bankruptcies is likely. Such an increase could
  potentially worsen consumer confidence, creating
  a renewed interest in replenishing savings.
  Personal consumption expenditure, which has
  driven the economy so far, may drop, stalling the
  current economic recovery.
• Leamer in 2003 also warned of a housing bubble,
  but Greenspan argued that there really wasn't a
  single national market for housing, but rather a
  collection of many local markets. Even if a
  bubble emerged in one market, he said, there was
  no reason to think it would spill over into other
  markets. He dismissed the idea--or, for that
  matter, any comparison to the stock market, which
  had recently gone through a high-tech bubble--on
  the grounds that housing was different because of
  substantial transaction costs and more limited
  opportunities for speculation.
• Paul Kaiser noted that 60 of banks' earning
  assets were mortgage-related--twice as much as
  was the case in 1986. If the housing market were
  to go bust, the banking system would suffer
  significant damage. And since the banking system
  is the transmission mechanism between the Fed and
  the economy, any serious downturn in that sector
  could make monetary policy impotent, thus pulling
  down the entire economy.

28
IMF Summary Forecast

• 1) The world is heading into a severe slump, with
  declining output in the near term and no clear
  turnaround in sight.
• 2) Consumers in the US and the nonfinancial
  corporate sector everywhere are trying to
  rebuild their balance sheets, which means they
  want to save more.
• 3) Govts have only a limited ability to offset
  this increase in desired private sector savings
  through dissaving (i.e., increased budget
  deficits that result from fiscal stimulus). Even
  the most prudent govts in industrialized
  countries did not run sufficiently
  countercyclical fiscal policy in the boom time
  and now face balance sheet constraints.
• 4) Compounding these problems is a serious test
  of the eurozone financial market pressure on
  Greece, Ireland and Italy is mounting Portugal
  and Spain are also likely to be affected. This
  will lead to another round of bailouts in Europe,
  this time for weaker sovereigns in the eurozone.
  As a result, fiscal policy will be even less
  countercyclical, i.e., Govts will feel the need
  to attempt precautionary austerity, which amounts
  to a further increase in savings.
• 5) At the same time, the situation in emerging
  markets moves towards near-crisis, in which
  currency collapse and debt default is averted by
  fiscal austerity. The current IMF strategy is
  designed to limit the needed degree of
  contraction, but the IMF cannot raise enough
  resources to make a difference in global terms -
  largely because potential creditors do not
  believe that large borrowers from an augmented
  Fund will be responsible.

29
IMF Forecast

• 6) The global situation is analogous to the
  problem of Japan in the 1990s, in which
  corporations tried to repair their balance sheets
  while consumers continued to save as before. The
  difference, of course, is that the external
  sector was able to grow and Japan could run a
  current account surplus this does not work at a
  global level. Global growth prospects are
  therefore no better than for Japan in the 1990s.
• 7) A rapid return to growth requires more
  expansionary monetary policy, and to be led by
  the US.
• 8) The push to re-regulate, which is the focus of
  the G20 intergovernmental process could lead to a
  potentially dangerous procyclical set of policies
  that can exacerbate the downturn and prolong the
  recovery. There is currently nothing on the G20
  agenda that will help slow the global decline and
  start a recovery.
• 9) The most likely outcome is not a V-shaped
  recovery (which is the current official
  consensus) or a U-shaped recovery (which is
  closer to the private sector consensus), but
  rather an L, in which there is a steep fall and
  then a struggle to recover.

30
Links between Economies

• Markets have entered a vici
• Markets have entered a vicious cycle of asset
  deleveraging, price declines, and investor
  redemptions. Credit spreads spiked to distressed
  levels, and major equity indices dropped by about
  25 percent in Oct. Emerging markets came under
  even more severe pressure. Since Oct. spreads on
  sovereign debt doubled, returning to 2002 levels,
  with more than a third of the countries in the
  benchmark EMBIG index trading at spreads above
  1,000 basis points. Emerging equity markets lost
  about a third of their value in local currency
  terms and more than 40 percent of their value in
  U.S. dollar terms, owing to widespread currency
  depreciations.