The Fall: A Chronicle of the Financial Crisis - PowerPoint Presentation

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The Fall: A Chronicle of the Financial Crisis

Joseph E. StiglitzSlide2

The Crisis in Brief

Excess credit fed a housing bubble

Problems exacerbated by poorly designed mortgages (low doc “liar loans,” zero or negative amortization loans, variable rate mortgages, teaser rates)Slide3

The Crisis in Brief

Excess credit fed a housing bubble

Securitization meant that originator did not bear costs of flawed mortgage products

Based on the principle that a “fool is born every moment”

Globalization had opened up a global marketplace for fools

Rating agencies’ flawed incentives and flawed models made it all possibleSlide4

The crisis was predictable, and predicted

The bubble was not sustainable

Savings rate had dropped to zero

House prices were soaring, while most people’s incomes were decliningSlide5

The crisis was predictable, and predicted

When the bubble broke, it was inevitable that there would be long term consequences

Excessive leverage on the part of households and banks

Deleveraging is a slow process

Bankruptcies destroy organizational capitalSlide6

This crisis is like many other crises around the world

Crises have marked capitalism since the beginning

The only period in which there were not crises is the short period after the Great Depression when there was good regulationSlide7

This crisis is like many other crises around the world

Since the deregulation movement began 30 years ago, there have been more than 100 crises, mostly in developing countries

Governments and the IMF came to the rescue

The wrong inference was made: markets worked, but only because they were rescued Slide8

Crisis is like a slow train wreck

First, the rate of increases in housing prices slowed down

Some mortgage products were designed to run into problems even then

Then housing prices crashed—with predictable consequencesSlide9

Crisis is like a slow train wreck

Banks had created complex, non-transparent products—which they and investors did not fully understand—and engaged in off balance sheet activities

While some of the products were justified as helping to manage risk, they actually increased risk

Meant that banks didn’t know their own balance sheet

Couldn’t know that of others

Credit markets frozeSlide10

Government to the rescue

Saved the banks, the bankers, their shareholders and bondholders

Ersatz Capitalism—new level of moral hazard (socializing losses, privatizing gains)

Repealing the ordinary rules of capitalism (entailing bankruptcy when debt obligations cannot be paid, putting banks into conservatorship)

Increased concentration in the banking system—increasing the problems of too-big-to-failSlide11

Mortgages

Finally did something—but too little

Almost nothing about the underwater mortgages

Pace of foreclosures continues almost unabatedSlide12

The Stimulus

Worked—but for the stimulus, the unemployment rate would probably have peaked at close to 12%

But it was too small, and not well designed

Based on the hypothesis that the economy had hit a small bump, repair the financial system, and everything would return to normalSlide13

Hypothesis was wrong

There were fundamental problems before the crisis—growth in America and around the world was largely supported by unsustainable American consumption

Even if America’s financial institutions were functioning perfectly, households unlikely to return profligate waysSlide14

What will fill the gap?

Government has been doing this temporarily

But ability and willingness to do this is limited

Growing fiscal pressures are leading to more contractionary policies around the world, especially in Europe after the Greek crisis

In US, states and localities are facing massive shortfalls of revenues—with balanced budget framework, negative stimulus to the economySlide15

What will fill the gap?

Monetary policy has little power to stimulate the economy

Though it may succeed in creating bubbles in emerging markets

It has not succeeded in encouraging lending by banks in the US and Europe

Understandable, given their weak balance sheetsSlide16

The Crisis Continues

As government came to the rescue, its fiscal positions worsened

In effect, debts were transferred to the government

Assumed that government could manage them better

Rescue policies did work—were it not for policies, there likely would have been a depressionSlide17

Again, following historical pattern

Sovereign debt crises often follow financial crises

Hope that this time things would be different

Most crises are in developing countries, with limited ability to raise taxes and high debt to GDP ratios Slide18

Again, following historical pattern

Hope that this time things would be different

But European crisis shows that that is not the case

Greece had high debt and deficit

But many of the countries in Europe face similar problems

Explanation for the Trillion Dollar Bailout ProgramSlide19

Not Just a Matter of Profligacy

Spain had a budget surplus before the crisis

Spain had only a 60% debt/GDP ratio

Spain had better bank regulation (at least in some dimensions) than the US and most other countriesSlide20

Not Just a Matter of Profligacy

Yet today, Spain stands at the precipice

Huge deficit

20% unemployment

More than 40% youth unemploymentSlide21

The world faces a dilemma

Response demanded of Spain and other countries with large deficits is to cut back spending (or raise taxes)

The effect could be massively contractionarySlide22

The world faces a dilemma

The improvement in the deficit will be minimal

Reminiscent of Argentinean death spiral

Disappointment with size of improvement in deficit/GDP will cause higher interest rates, worsening the problem, leading to further cutbacks

Even the rescue packages may not due the trickSlide23

Global Perspectives

One bright spot is growth in Asia

Partial decoupling—based on vast untapped domestic markets

But too small to lead to recovery of US and Europe

And there is limited spillover from their expansionSlide24

Global Perspectives

Problems of reserve accumulation (which weakens global aggregate demand) worsened

Those countries with large reserves fared better Slide25

But Europe’s problems will impact US

Irony: America exported its toxic mortgages and its recession to Europe

Now, Europe is likely to return favorSlide26

But Europe’s problems will impact US

One hope for American recovery was strong exports

Based on a weak dollar

US had been winning “negative beauty contest”

But it looks like Europe will take over, at least for a time

Prospects of strong exports with a weak euro (strong dollar) and a weak Europe are bleakSlide27

Prospects of a quick global recovery remain bleak

In U.S., problem is not that of a jobless recovery, but rather of an anemic recovery—too slow to create jobs for new entrants to the labor force, let alone to eliminate the job deficit

One out of six Americans who would like a full time job still can’t get one

Housing problems may impede recovery of labor market

Middle of decade (at earliest) before return to “normal”Slide28

Prospects of a quick global recovery remain bleak

In Europe, matters are even worse

Questions are raised: Will the euro survive? Will some European governments default?

Will countries be willing to take cutbacks required by “markets”?

Especially with prolonged high unemployment rates (including among the youth)

Uncertainties will play on investors, force higher interest rates, and exacerbate the problemsSlide29

“Can it Happen Again?”

If history is our guide, not only can it happen again, it will happen again

Though it may take slightly different form

With slightly different instrumentsSlide30

“Can it Happen Again?”

Question is: have we “learned the lessons,” so that the likelihood is reduced, the consequences mitigated?

The answer is almost surely no:

We know that markets are not self-regulating

We know that perverse incentives give rise to perverse behavior

We know that regulations are required Slide31

“Can it happen again?”

But

so far

the responses to the crisis have been mixed—little has been done about underlying problemsSlide32

“Can it happen again?”

And in some dimensions, matters are worse

A more concentrated banking system—giving rise to greater problems of “too big to fail”

The bailouts and the manner in which they were conducted exacerbated moral hazard problemSlide33

“Can it happen again?”

And in some dimensions, matters are worse

Prevalent incentive structures provide incentives for short sighted behavior and excessive risk taking.

Open question still about derivatives regulations

Some success in preventing worse mortgage abusesSlide34

Regulation and Creativity

In some quarters, there are worries about whether new regulations will stifle creativity

But much of the sectors’ creative energy was directed at regulatory, tax, and accounting arbitrageSlide35

Regulation and Creativity

This undermined the sector fulfilling its core functions of allocating capital (providing credit to small and medium sized enterprises) managing risk, running an efficient payments system, all at low transactions costSlide36

Regulation and Creativity

A good regulatory system holds out the promise of directing innovative energies of the sector in ways more consonant with its role in our society

Creating not only a more stable economy, but a more prosperous one.