The Crisis

Lecture GWU, August 5, 2009 Olivier Blanchard

Basic Facts

1. A deep, worldwide, recession. Probably bottoming out.

2. A sharp drop in stock markets. Partially recovering.

GDP growth, past, current, and forecast

(percent; quarter-over-quarter, annualized)
12

Emerging economies

10 8

World

6 4 2 0 -2 -4

Advanced economies
10Q4

-6 -8 -10

07Q1

07Q3

08Q1

08Q3

09Q1

09Q3

10Q1

10Q3

Stock prices
(index, 1/1/2007=100)
140

120

Emerging

100

80

Advanced

60

8/4

40 Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Where Did the Crisis Come From? The Trigger:

Decline in housing prices Subprime mortgages But: Losses on subprimes less than $300 billion How could it lead to such a large decline in wealth, in output? Output losses: more than 5 trillion Stock market wealth loss: more than 20 trillion

U.S. Housing Market

U.S. House Price
(monthly; NSA, Jan 2000=100)
240

220

200 Case Shiller (Composite 10)

180

160

140

120
May 09

100 00 01 02 03 04 05 06 07 08 09

The Amplification Mechanism. 1. Banking Basics

Assets Liabilities Capital ratio Leverage Ratio

Bank 1

100

80 20 95 5

20 %

Bank 2

100

5%

20

Capital ratio: Capital/assets. Leverage ratio: Assets/capital. Now suppose Assets decreases from 100 to 90. insolvent. Second bank is

This is what happened. Leverage was high for US financial system.

The Amplification Mechanism. 2. Uncertainty, Fire Sales

Bad loans (subprime mortgages) Risk of insolvency/uncertainty Reluctance of banks to lend to each other Investors taking their funds out (wholesale funding) Need to raise funds by selling some of the assets Asset prices fall (fire sales), decreasing A, K further ``Freezing of financial intermediation

TED Spread
Money Market Spreads
(3-Month LIBOR minus 3-Month government bond yield)
5
United States

4
Euro area/Germany

0 Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

The Amplification Mechanism. 3. How could it happen?

Excess optimism. Housing prices cannot decrease. Complex securities. MBS, CDOs. Why issue such securities? Incentives and competence of rating agencies.

10

The Macroeconomic Effects

Large increase in borrowing rates. Drop in confidence.

Borrowing rates
U.S. Corporate Bond Yields
(in percent)
11 10 9
A AAA AA

11

8 7 6 5 4 3 Jan-07

BBB

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

U.S. Business and consumer confidence

United States
(Jan 2007 =100)
120

12

100

80

60

40
Consumer Confidence (Conference Board) Business Confidence (AIM)

20

0 Jan-07

May-07

Sep-07

Jan-08

May-08

Sep-08

Jan-09

May-09

13

Back to IS-LM
Y = C (Y-T, confidence) + I ( i+ risk premium, Y) + G M/P = L( i, Y)

Decrease in confidence. Increase in risk premium.

The Direct Effects of the Financial Crisis

Decrease in confidence Increase in risk premium
LM

14

A i
Interest rate, i

i IS IS

Y Output, Y

15

Why did the rest of the world decline so much?

Higher risk premia / Lower capital flows Lower exports

Open economy IS:

Y = C(Y-T, confidence) + I(i+ risk premium, Y) + G + NX(e,Y,Y*)

16

Drop in GDP Growth and Openness

Manufacturing Share and GDP Growth
0

GDP Growth (2008Q4, saar)

-5

-10

-15

-20

R2 = 0.7243
-25

10

12

14

16

18

20

High and Medium High-tech manufacturing value added

(% of GDP)

Emerging Economies Faced Significant Outflows

Capital Inflows into Emerging Economies
(in billions of U.S. dollars)
600

17

400

200

Net derivatives FDI liabilities

-200

Other investment liabilities Portfolio liabilities Total inflows 08Q4

07Q1 08Q1

-400 05Q1 06Q1

18

Monetary Policy
Provide guarantees to depositors/lenders. Provide funds to banks. Liquidity provision Accept more assets as collateral. Decrease the interest rate. In terms of ISLM, decrease risk premium, decrease i. Why not enough? Liquidity trap: Central bank cannot decrease i below zero.

19

The Liquidity Trap

Nominal interest rate, i

LM

LM

Increase in M/P No effect on the nominal rate 0

Output, Y

20

Monetary policy and the Liquidity Trap

IS

IS'
Nominal interest rate, i

LM

LM

0 Y

A Y

Output, Y

21

The Liquidity Trap and the need for a fiscal stimulus

Fiscal stimulus IS

IS'
Nominal interest rate, i

IS

LM

A Y Output, Y Y

Fiscal Stimulus in 2009 and 2010

Overall Deficit: Contributions from Automatic Stabilizers and Discretionary Measures
(fiscal deficit in percent of GDP; change from 2007)

22

10 8 6 4 2 0 -2

2009

2010

10 8 6 4 2 0 -2

U . .S

an Fr

1/ PPP GDP-weighted average.

0 -2 G

U . .K

a in Ch n pa Ja y an m er G ce

a in Ch n pa Ja y an m er G ce an Fr

. .S U

0 -2 G

. .K U

1/

Where are we now?

Worse outcomes (tail risks) probably avoided. Dynamic effects of initial shocks fading away. Bank credit still weak. Some markets missing. Where will the recovery come from?

1/

23

Tightening lending standards

Lending Officer Surveys
(net percentage)
100
U.S. Euro Area

24

80

60
Net tightening

U.K.

40

20

0
Net easing

-20 Jan-06

Jul-06

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

25

Sustaining the Recovery

Back to IS: Y = C(Y-T, confidence) + I(i+ risk premium, Y) + G + NX(e,Y,Y*) Continue with G and T? Consumption? Investment? Large deficits and high debt.

Likely to remain low. Bank credit. Retirement saving Low capacity utilization. Housing

Increase in net exports? Need for a dollar depreciation. Vis a vis who? Asia, China

Evolution of debt to GDP for Advanced Countries

(Percent of GDP)

26

Government Debt
120

100

80

60

40
G-20 G-20 (Adv)

20
G20 (Emerging)

0 00 02 04 06 08 10 12 14
Source: IMF, World Economic Outlook.

27

Current account balances G20

28

Current Account Balances. G20

29

Conclusions

A failure of macroeconomic policy?

Pre crisis. Did not see the shock coming. During the crisis. Strong actions, monetary, financial, fiscal Role of the IMF. Provision of foreign liquidity, coordination of fiscal policies.

A failure of macroeconomics?
Mechanisms all familiar. (all in finance/macro textbooks) Leverage, fire sales Liquidity trap Role of fiscal policy. Dangers of high debt. Did not realize that it could happen on such a scale.