An Historical Perspective on the Current Crisis

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An Historical Perspective on the Current Crisis

• Michael D. Bordo
• Rutgers University and NBER

Prepared for The conference The Global
Financial Crisis Historical Perspective and
Implications for New Zealand Reserve Bank of
New Zealand Wellington Wednesday June 17, 2009
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An Historical Perspective on the Current
CrisisIntroduction

• The current global financial crisis displays many
  similarities to crises observed across the world
  in the past two centuries.
• There are also some novel features.
• This talk considers how the present crisis fits
  into the historical pattern. I discuss what is
  familiar and what is novel about recent events
  with emphasis on financial innovation, policy
  errors and private sector behavior.
• As background I also briefly survey the
  historical evidence for many countries on crisis
  incidence, duration and depth.
• Finally I assess how economic policy has
  addressed the current crisis and conclude with
  some lessons for policy from an historical
  perspective.

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2. Historical Evidence on Crisis Incidence2.1
Bordo, Eichengreen, Kliengebiel and
Martinez-Peria(2001)

• Bordo, Eichengreen, Kliengebiel, and
  Martinez-Peria(2001), provide evidence for a
  panel of 21 countries for 120 years and 56
  countries for the 4 recent decades on the
  frequency, duration and severity of currency,
  banking and twin crises across 4 policy regimes.

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• 2.2 - Counting Crises
• We define financial crises as episodes of
  financial turbulence leading to distress
  significant problems of illiquidity and
  insolvencyamong major financial market
  participants and/or to official intervention to
  contain those consequences.
• We identified currency crisis dates using
  exchange market pressure measure and,
  alternatively, survey of expert opinion. We use
  the union of these indicators and an EMP cutoff
  of 1.5 standard deviations from the mean.
• For banking crises, we adopted World Bank dates
  for post-1971 period, and used similar criteria
  (bank runs, bank failures, and suspensions of
  convertibility, fiscal resolution) for earlier
  periods.
• Twin crises banking and currency crises in same
  or consecutive years. Crises in consecutive years
  counted as one event.

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• We distinguish four periods
• 1880-1914 prior period of financial
  liberalization and globalization
• 1919-1939 period of exceptional currency,
  banking and macro instability
• 1945-1971 Bretton Woods period of tight
  regulation of domestic financial systems and of
  capital controls
• 1973-1998 second period of financial
  liberalization and globalization

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• 2.3 Frequency of Crises
• We divide the number of crises by the number of
  country year observations in each sub-period.
  (See figure l)
• Alarmingly, all crises appear to be growing more
  frequent
• Crisis frequency of 12.2 since 1973 exceeds even
  the unstable interwar period and is three times
  as great as the pre 1914 earlier era of
  globalization
• Results driven by currency crises, which have
  become much more frequent in recent period
• This challenges the notion that financial
  globalization creates instability in foreign
  exchange markets since pre 1914 was the earlier
  era of globalization
• May be due to a combination of capital mobility
  and democratization

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• In contrast, incidence of banking crises only
  slightly larger than prior to 1914, while twin
  crises more frequent in the late twentieth
  century
• Note that interwar period had highest incidence
  of banking crises
• Bretton Woods period was notable for the absence
  of banking crises due to financial repression
• A comparison of crisis frequency between emerging
  and industrial countries (See figure 2), suggests
  that with the exception of the interwar period,
  the majority of crises occurred in the emerging
  countries

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• 2.4 Duration of Crises
• We define the duration of crises as the average
  recovery time. The number of years before the
  rate of GDP growth returns to its 5-year trend
  preceding the crisis. (See Figure 3 and Table 1)
• Recovery time today for currency crises is longer
  than preceding 2 regimes but shorter than pre
  1914
• Banking crises last not much longer now than in
  earlier periods
• Recent period twin crises produce the longest
  slump for emerging markets
• The dominant impression from comparison of pre
  1914 and today for all crises is how little has
  changed
• To the extent that crises have been growing
  longer, we have simply been going back to the
  future

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• 2.5 Depth of Crises
• We calculate the depth of crises by calculating,
  over the years prior to full recovery, the
  difference between pre-crisis trend growth and
  actual growth. (See Figure 4 and Table 1 which
  shows cumulative output loss as a percentage of
  GDP)
• We find that output losses from currency crises
  were even greater before 1914 than today. The
  difference is most pronounced for emerging
  countries.
• Output losses from banking crises also greater in
  pre 1914 regime than today
• Twin crises show comparable output losses for
  today and pre-1914 for emerging markets
• Key unsurprising fact is the large output losses
  in the interwar from both currency and twin crises

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• 2.6 Reinhart and Rogoff
• Carmen Reinhart and Kenneth Rogoff (2008) have
  extended the data base of financial crises in
  Bordo et al (2001) to include many more
  countries, to include episodes back to 1800 and
  forward to 2008
• The incidence of banking crises they show in
  Figure 5 (the proportion of countries with crises
  weighted by their shares of income) presents a
  pattern for banking crises which echoes that in
  Bordo et al(2001), with the highest incidence in
  the interwar and a recurrence of crises since the
  early 1970s.
• The recent episode promises to be as severe as
  the crises of the 90s

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3. Credit Crunches, Asset Busts, Banking Crises
and Recessions

• The current recession was preceded by a massive
  housing boom in the U.S., U.K., and a number of
  other countries. The boom turned into a bust in
  2007 and this led to serious financial stress,
  then a credit crunch and now a serious recession
  which has become global
• There is considerable evidence both recent and
  historical linking the severity of recessions to
  asset price busts and credit crunches
• Claessens, Kose, and Terrones (2008) study the
  behavior of financial variables around
  recessions, credit crunches, and asset price
  busts for a panel of 21 OECD countries, 1960-2007
• They find that house price busts (declines in
  real prices from cyclical peaks to troughs of at
  least 30) significantly deepen and prolong
  recessions
• They also find that credit crunches (declines of
  at least 20 from cyclical peaks to troughs) also
  worsen and prolong recessions
• Real equity price busts (declines of at least 50
  from cyclical peak to trough) do not have as
  serious effects on recessions.

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• See Table 3 which summarizes their results.

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• Reinhart and Rogoff (2009) present historical
  evidence on systemic financial crises.
• They include the recent big five advanced
  economy crises (Spain 1977, Norway 1987, Finland
  1991, Sweden 1991, and Japan 1992), the Asian
  crisis of 1992, Colombia 1998, Argentina 2001 and
  two historical episodes Norway 1899 and the U.S.
  1929.
• They calculate peak to trough changes in real
  housing prices, real equity prices and real per
  capita GDP for each banking crisis episode.
• Figure 6 shows that real housing price busts
  associated with banking crises last an average 6
  years. Housing prices fell on average by 35.5
• Figure 7 shows that real equity price busts,
  associated with banking crises, although deeper
  than housing price busts, last much shorter, for
  3.4 years. Stock prices fell on average by 55.9
• Finally, they show in Figure 8 that real per
  capita GDP in these events declines on average by
  9.3 percent and lasts 2 years.
• The current U.S. recession which began in
  December 2007 may very well fit this pattern.

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Figure 6
Figure 6
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Figure 6
Figure 7
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Figure 6
Figure 8
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An Historical Perspective on the Crisis of
2007-2008Introduction

• Todays events have echoes in earlier big
  international financial crises which were
  triggered by events in the US financial system.
  e.g. 1857,1893,1907 and 1929-33.
• This crisis has many similarities to those of the
  recent past but also some important modern
  twists.
• Crisis started with collapse of US subprime
  mortgage market spring 2007.
• Causes include government initiatives to extend
  home ownership, changes in regulation , lax
  oversight, relaxing of lending standards, a
  prolonged period of abnormally low interest
  rates, and a savings glut in Asia.

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Introduction

• Default on mortgages following housing bust
  spread via elaborate network of derivatives.
• The crisis has spread over the real economy
  through a virulent credit crunch.
• The crisis and recession has spread from the U.S.
  to the rest of the world.
• Fed and other CBs responded in a classical way by
  flooding the financial markets with liquidity.
• Fiscal authorities still to deal fully with the
  decline in solvency in banking system following
  template of earlier bailouts like RFC in the
  1930s, Sweden 1992 and Japan late 1990s.

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Introduction

• I provide an historical perspective on the
  current crisis, contrasting the old with the
  modern and offer some lessons for policy.

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Some Descriptive Historical Evidence

• Figure 1 upper panel shows monthly Baa-Ten year
  Treasury constant maturity bond spread and NBER
  recessions 1953 to January 2009.
• The quality spread can reflect asymmetric
  information and signal a credit crunch.
• Figure 1 also shows important events like banking
  crises, stock market crashes and political
  events. Lower panel shows the Federal Funds rate
• Figure 2 shows Baa, ten year Treasury composite
  bond spread from 1921 to January 2009. The
  discount rate is substituted for the FFR.

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FIGURE 1 FEDERAL FUNDS RATE AND Baa AND 10-YEAR
TCM SPREAD
Percentage points
Bear Stearns Rescue
S and L crisis and Continental Illinois
Stock market crashes
Tech bust
Y2K
Sub-prime crisis
Penn Central
Kennedy assassination
Lehman fails
LTCM
Spread
September 11
Federal Funds Rate
Sources Federal Reserve Board and NBER
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FIGURE 2 DISCOUNT RATE AND Baa AND COMPOSITE
TREASURY OVER 10 YEARS SPREAD
Percentage points
Bear Stearns Rescue
Banking Crises
Tech bust
S and L crisis and Continental Illinois
Stock market crashes
Subprime Crisis
Y2K
Penn Central
Pearl Harbor
Lehman fails
September 11th
Kennedy assassination
Spread
LTCM
Discount rate
Sources Federal Reserve Board and NBER
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Some Descriptive Historical Evidence

• The peaks in the credit cycle proxied by the
  spread line up with upper turning points of the
  business cycle.
• Many events like banking crises and stock market
  crashes occur close to the peaks.
• Policy rates peak very close to or before the
  peaks of the credit cycle.
• In the recent crisis the spreads are higher than
  the recession of 2001 and the recession of the
  early 1980s. They are close to those of the
  early 1930s.

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Historical Parallels and Modern Twists

• Many of the financial institutions and
  instruments caught up in the crisis are part of
  the centuries old phenomenon of financial
  innovation.
• The rise and fall of financial institutions and
  instruments occurs as part of the lending booms
  and busts cycle financed by credit. Credit cycle
  connected to the business cycle.
• Irving Fisher ( 1933) and others tell the story
  of a business cycle upswing driven by a
  displacement leading to an investment boom
  financed by bank credit and new credit
  instruments.
• The boom leads to a state of euphoria and
  possibly bubble.

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Historical Parallels and Modern Twists

• A state of overindebtedness leads to a crisis.
• A key dynamic in the crisis stressed is
  information asymmetry manifest in the spread
  between risky and safe securities. (Mishkin,
  1997)
• The bust would lead to bank failures and possibly
  panics. This led to the case for a LLR following
  Bagehots rule.
• Countercyclical monetary policy is also an
  integral part of the boom-bust credit cycle.
• Stock market booms occur in environments of low
  inflation, rising real GDP growth and low policy
  interest rates. As the boom progresses and
  inflationary pressure builds up, central banks
  inevitably tighten policy helping to trigger the
  ensuing crash. (Bordo and Wheelock, 2005)

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Historical Parallels and Modern Twists

• Similar story in housing (Leamer 2007)
• Stock market crashes can have serious real
  consequences via wealth effects and liquidity
  crises.
• Housing busts can destabilize the banking system
  and depress the real economy.
• The recent housing boom was likely triggered by a
  long period of abnormally low interest rates
  reflecting loose monetary policy from 2001 to
  2004 and a global savings glut.
• The bust was likely induced by a rise in rates in
  reaction to inflationary pressure.

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The Non Bank Financial Sector, Financial
Innovation and Financial Crises

• The traditional view sees a financial crisis as
  coming from the liability side as depositors rush
  to convert deposits into currency. In recent
  decades, since advent of deposit insurance,
  pressure has come from the asset side.
• Examples include the commercial paper market Penn
  Central 1970 Emerging market debt in 1982
  hedge funds LTCM in 1998.
• Historical example of 1763 crisis in market for
  bills of exchange.(Schnabel and Shinn 2001)
• Financial innovation which increased leverage is
  part of the story with Penn Central (commercial
  paper) savings and loan crisis (junk bonds)
  LTCM (derivatives and hedge funds) today
  securitization of subprime mortgages

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Modern Twists

• Recently risk has been shifted from the
  originating bank into mortgage backed securities
  which bundles shaky risk with the more
  creditworthy
• Asset backed securities absorbed by hedge funds,
  offshore banks and commercial paper.
• Shifting of risk didnt reduce systematic risk
  and may have increased risk of a more widespread
  meltdown.
• Another key modern twist is growth of the
  unregulated shadow banking system
• Repeal of Glass Steagall in 1999 encouraged
  investment banks to increase leverage. So did the
  investment banks going public.

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Modern Twists

• When the crisis hit they were forced to delever,
  leading to a fire sale of assets in a declining
  market which lowered the value of their assets
  and those of other financial firms.
• A similar feedback loop in Great Depression
  (Friedman and Schwartz, 1963)

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Prospects for the Emerging Markets

• Financial crises have always had an international
  dimension.
• Contagion spreads through asset markets
  ,international banking and international
  standard.
• Baring crisis of 1890 classic historical example
  of contagion, central bank tightening led to
  sudden stops, currency crises and debt defaults
  in the emergers similar to 1997-98.
• Current crisis has spread from the US to the
  advanced countries via holding of opaque subprime
  mortgage derivatives in diverse banks in Europe
  and elsewhere.

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Prospects for the Emerging Markets

• Current crisis initially was contained to the
  advanced countries, which were exposed to
  subprime mortgages.
• Pressure has subsequently spread to emerging
  markets, especially those indebted in hard
  currency to advanced countries, e.g. Iceland,
  Hungary, Latvia and Ukraine.
• Many Asian and Latin countries initially avoided
  the crisis because of defensive measures taken in
  reaction to the 1990s meltdown.
• As the credit crunch continued and recession
  spread in US and Europe, emergers also were
  affected.
• They are facing sudden stops and some may end up
  defaulting on sovereign debt.

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Policy Lessons

• Crisis has implications for monetary policy on
  key issues of liquidity, solvency, stability of
  real economy.

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Liquidity

• Central banks reacted quickly in the Bagehot
  manner to unfreeze interbank market in August
  2007.
• Run on Northern Rock September 14, 2007 reflected
  inadequacies in UK deposit insurance and
  separation of financial supervison and regulation
  from the central bank.
• Bear Stearns crisis in March 2008 led Fed to
  develop new programs for access to discount
  window lending.
• The Fed changed its tactics away from general
  liquidity provision via OMO and leaving
  distribution of liquidity to individual firms to
  the market.
• It has developed a large number of credit
  allocation facilities. Much of the credit
  extended was sterilized. However since September
  2008, the monetary base has expanded.

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Liquidity

• Targeted lending exposes the Fed to politicize
  its selection of recipients of credit. This is a
  throwback to policies followed earlier in the
  twentieth century.
• Also the Fed has greatly reduced its holdings of
  Treasury securities. How will it be able to
  eventually tighten with its large holdings of
  unmarketable mortgage backed securities?

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Solvency

• The Fed and US monetary authorities bailed out
  firms too systematically connected to fail Bear
  Stearns March 2008, GSEs July 2008, AIG September
  2008 and three times since, Citigroup (three
  times) and Bank of America.
• Lehman Brothers was allowed to fail in September
  on the grounds it was basically insolvent and not
  as systematically important as the others.
• Had Bear Stearns been allowed to fail, could the
  more severe crisis in September/October 2008 have
  been avoided?
• Had Bear Stearns been closed and liquidated it is
  likely that more demand for Fed credit would have
  come forward than actually occurred.

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Solvency

• When Drexel Burnham Lambert was shut down in
  1990, there were no spillover effects.
• Assume a crisis in March 2008 like the one that
  followed Lehman failure in September had
  occurred as the Fed feared at the time.
• It would have not been as bad as what actually
  occurred in September because the Bear Stearns
  rescue led investment banks and other market
  players to follow riskier strategies than
  otherwise on the assumption that they also would
  be bailed out.

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Solvency

• This surely made the financial system more
  fragile than otherwise so that when the MA let
  Lehman fail the shock that occurred and the
  damage to confidence was much worse.
• The deepest problem facing the banking system is
  solvency. The problem stems from the difficulty
  of pricing securities backed by a pool of assets
  because the quality of individual components of
  the pool varies
• The credit market is plagued by the inability to
  determine which firms are solvent and which firms
  are not.
• Lenders are unwilling to extend loans when they
  cannot be sure that a borrower is credit worthy

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Solvency

• This is a serious shortcoming of the
  securitization process that is responsible for
  the paralysis of the credit markets
• The Fed was slow to recognize the solvency
  problem.
• The US Treasury's TARP plan of October 13 2008
  based on the UK plan to inject capital into the
  banking system only went part way to help solve
  this problem. However the credit crunch continues
  and bad assets keep piling up as house prices
  have continued to decline.
• There is precedence to the Treasury's plan with
  the RFC in the 1930s, Sweden in 1992 and Japan in
  the late 1990s.

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Solvency

• The recent Financial Stability Plan to set up a
  Public Private Investment Fund whereby private
  institutions will be subsidized to acquire
  troubled assets may work but the banks may be
  reluctant to sell them. They fear that this would
  further erode their capital base.
• The Treasurys plan to provide capital to the
  leading U.S. banks as warranted by a stress test
  combined with the (PPIP) may only help to
  overcome the banking crisis when insolvent banks
  have been taken over, their management replaced
  and they are recapitalized.
• Adopting the Good Bank Bad Bank solution of the
  Swedes may still be required.

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Real Economy

• Given the Feds dual mandate, attenuating the
  recession consequent upon the credit crunch is
  now the primary goal of monetary policy.
• The recent shift to Quantitative Easing will most
  likely attenuate the recession.
• The fiscal stimulus will not likely be as potent
  as monetary ease. The record of the 1930s in the
  U.S. and Japan in the 1990s makes the case.
• Once recovery is in sight and inflationary
  expectations pick up it will behoove the Fed to
  return to its (implicit) inflation target.

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Conclusion

• The monetary authorities in the US and Europe
  acted quickly to resolve the liquidity aspects of
  the crisis.
• This is in stark contrast to the Great Depression
  when the Fed did virtually nothing.
• Expansionary monetary policy and less likely
  fiscal stimulus packages may attenuate the
  downturn.
• The solvency aspect still remains.
• Without a resolution to the banking crisis as
  occurred in the U.S. in the 1930s, 1990s,
  Sweden in 1992 and elsewhere, and until the
  solvency problem is solved, recovery will be
  limited.