Macroeconomic Perspectives on the

Current Financial Crisis: Update

Ilian Mihov

June 2009

A perspective: US income over 130 years

US Real GDP per Capita

11
59900

22000
10

81009

30008
1870 1878 1886 1894 1902 1910 1918 1926 1934 1942 1950 1958 1966 1974 1982 1990 1998 2006

Year

Log scale. Source: Jones (1995) and WDI (2008)

1
 Summary

1. Proximate causes for the crisis

9 Bursting of the bubble on the housing market. Subprime.
9 High degree of leverage. Opacity.

2. Fundamental causes of the crisis:

9 Low interest rates (high savings in emerging markets)
9 Low (declining) inflation led the Fed to keep short-term rates low.
9 Regulatory mistakes: Lack of regulation for CDS, oversight for
credit rating agencies.
9 Regulation avoidance: Moving mortgages into mortgage-backed
securities off the balance sheet of banks (to meet capital adequacy
ratios); market for insurance
9 Financial complexity; poor benchmark models; misunderstanding
of systemic/correlated risk; teaser rates and refinancing frenzy.

Summary
3. Impulse
9 Loan resetting.

4. Amplification mechanisms (and vicious circles)

9 Mark-to-market standards (in general fine, but do not work well
when you have fire-sale prices and/or illiquid market).
9 Wholesale bank runs (i.e. unwillingness to lend to banks), which
combined with short-term financing (leverage) is an explosive
combination.
9 Uncertainty – decline in lending by banks leads to lower prices for
houses, which creates more defaults, decline in the value of MBS.
This feeds back into a deterioration of the banks’ balance sheet.
9 Difficulty to find financing hurts also the real economy. This again
creates a vicious circle through unemployment and low demand.

2
 Frozen markets
5. Lehman Brothers 15. 09.2008 Lehman fails
9 Policy mistake?
9 Forecasts.
TED Spread (% points)
Difference between 3-months T-bill rate and 3-months LIBOR

5.0
4.0
3.0
20
2.0
1.0
0.0
01-Mar-07

01-Nov-07

01-Mar-08

01-Nov-08
01-Jan-07

01-May-07

01-Jul-07

01-Sep-07

01-Jan-08

01-May-08

01-Jul-08

01-Sep-08

Anatomy of a crisis: The vicious circle of de-leveraging

1. Financial institutions are highly leveraged and they “transform” maturities:
They borrow from individuals, other financial institutions, funds, etc to invest in
securities with long maturity. It is typical to have a significant maturity mismatch
between long-term assets and short-term liabilities. Hence they cannot satisfy a
sudden increase in withdrawals if they are not prepared. Lehman Brothers
2. Wholesale bank run. With the increased defaults on mortgages, prices of
mortgage-based securities started to decline. The asset side shrinks (requiring
write-offs) and there is increased uncertainty whether financial institutions will be
able to pay their depositors. Massive withdrawals of funding lead to failure because
banks have to sell assets at fire-sale prices to meet their obligations.
3. The possibility of a failure makes banks and financial institutions more cautious
and they reduce their lending (since they may need the liquidity)
liquidity).
4. But if borrowers cannot get loans, then house prices fall and we go to point 2.
Firms also cannot borrow – unemployment increases, more people default on their
mortgages. As demand goes down, some firms do not repay their loans. Back to
point 2.

3
 Balance Sheet of Lehman Brothers

February 29, 2008 (Billions of USD)

Assets Liabilities
Cash
C h 24 13
24.13 Accounts
A t payable
bl 96 15
96.15
Receivables 52.40 ST debt/Current LT debt 428.56
Long Term Investments 695.34 Other current liabilities 28.83
Other LT assets 10.05 Long term debt 207.67
Equity 20.72
Total 781.92 Total 781.92

…the amount of funding that investment banks were doing through overnight repo
agreements surged between 2004 and 2007; they were rolling over one quarter of
their balance sheet every day prior to the crisis, making them vulnerable to a
sudden loss of confidence.
The Economist, May 16, 2009

Back

What is next?

4
 Have house prices fallen enough?
Index relative to income per capita (1990s=100)

200

March 2009: 110

180

160

140

120

100

80
Jan-87

Jan-89

Jan-91

Jan-93

Jan-95

Jan-97

Jan-99

Jan-01

Jan-03

Jan-05

Jan-07

Jan-09

What lies ahead? Plans and actions

House prices. The housing market needs still an adjustment of about 9%
(from the March 2009 level) to return to the average ratio of prices to
income. But it may certainly overshoot.
Real economy. Recession since December 2007. Expected contraction in
2009 varies from -6.2%
6 2% in Japan to -2.8%
2 8% in the US and growth of 1.6%
1 6%
in emerging markets. World output is now expected to contract by -1.3%
(lowest rate since WWII)

Policy actions:
1. Deal with the financial sector:
(a) Liquidity; (b) Recapitalization; (c) Deposit guarantees; (d) toxic assets
2. Monetary stimulus:
(a) interest rates at 0%; (b) quantitative easing; (c) credit easing;
3. Fiscal stimulus:
(a) Tax cuts; (b) government spending; (c) expectations
4. Regulatory reforms

5
 Unorthodox Monetary Policy

Assets of the Federal Reserve

Commercial
(Billions of USD)
paper

2500

2000
other
loans

1500
Other
(swaps)

1000
TAF

Repos
500
Treasury securities

0
Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09

Fed’s Balance Sheet (June 4, 2009)

Balance sheet of all Federal Reserve Banks (Billions of USD)

Assets Liabilities
Gold 11.0 Banknotes 868.8
US Treasury Securities 606.2 Deposits of depository institutions 844.7
Mortgage-backed Securities 427.3 US Treasury 237.5
Commercial paper 142.6 Other 82.5
Other portfolio holdings 62.4
Liquidity swaps 175.7 Capital 45.7
Other assets (TAC, Repos,..) 677.0

Total 2079.2 Total 2079.2

6
 Concern 1: Will there be hyperinflation?
Excess reserves
(Billions USD)

900
B k keep
Banks k reserves:
Required: ≈ $50 bln
Excess: ≈ $2 bln
600

Since Lehman’s collapse:

300 Excess: close to $800bln

June 3, 2009: $838bln

0
23-Jul 20-Aug 17-Sep 15-Oct 12-Nov 10-Dec 7-Jan 4-Feb 4-Mar 1-Apr 29-Apr 27-May

Monetary Base in Japan (Yen, trillions)

120

100

80

60

40
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

P.S. The balance sheet of the Fed has declined already by 200bln since the peak in 12/2008.
P.P.S: Who will be the next chairman of the Fed?

7
 Concern 2: Fiscal policy will generate excessive
burdens for future generations.

Yes. But what is the alternative?

Japan 1991-2005: Lack of decisive policy actions led to an increase of
d b
debt-to-GDP
GDP ratio
i from
f 64% to 175%
It is important to insist on fiscal conservatism, but it is in good times when
government spending is unjustifiably high. Bernanke’s speech.

Government debt (as % of GDP)

200

160

120

80

40

0
1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006

Euro Japan UK US

Smoke signals

1. Employment situation
2. Slope of the yield curve
3. Lending conditions
4. House prices
5. Consumption-to-income ratio
6. Households’ balance sheets
7. Other indicators (manufacturing, consumer confidence,…)

8
 Employment situation
1200 25

800

400

0
Jan-60 Jan-68 Jan-76 Jan-84 Jan-92 Jan-00 Jan-08

-400

-800 -25

Slope of the Yield curve

Slope of the yield curve (10-year minus 2-year)
3

1
Percentage points

-1

-2

-3

9
 Households’ balance sheet

Assets, Net Worth and Liabilities (% of GDP)

600.0%

500.0%

400.0%

300.0%

200.0%

100.0%

0.0%
1952-I 1958-I 1964-I 1970-I 1976-I 1982-I 1988-I 1994-I 2000-I 2006-I

Assets Liabilities net worth

Scenarios as of June 2009

(followed since October 2008)

A: The Great Depression: Dow Jones at 1,667. Very unlikely. Even politicians
will realize that this hurts everyone. Probability <1% (used to be 0%).
B: Japan 1990s. Political bickering and misunderstanding delays radical financial
restructuring. The US and EU economies grow at a paltry 1 to 1.5% in the next five-
ten years. Dow Jones may reach 4,000. Less likely. Probability: 20%
C: Japan “light”. Requires implementation of a bailout plan, fiscal policy stimulus
with some additional liquidity provision. This will allow the economy to start the
recovery in the second half of 2009. Dow Jones will fluctuate below 10,000 with
some serious volatility for the next year or so. Probability: 80%
D: Garden-variety recession. Rapid implementation of the bailout plan plus
aggressive monetary policy and quick recapitalization. Massive fiscal stimulus in
‘08Q4 and ‘09Q1. The economy may start recovering in 2009Q1. Probability: 0%.
E: “Roses and puppies” scenario. Vigorous recovery of the economy and the
stock market as a result of the restructuring of the financial sector and aggressive
policy actions right after the collapse of Lehman brothers. House price decline stops
by December 2008. Probability 0%.

10
 The Current Economic Crisis
The current crisis is a resolution of global
imbalances. It is more severe because of
72%

the toxic interaction between the financial 70%

Consumption-to-GDP
sector and the real economy. 68%

66%

The depth and the length of the recession 64%

are determined by policy actions:
62%
1. Monetary policy
2. Fiscal policy
60%
1960-I 1964-I 1968-I 1972-I 1976-I 1980-I 1984-I 1988-I 1992-I 1996-I 2000-I 2004-I 2008-I

3. Financial sector restructuring

mployment
1200 25
4. Regulation changes
800

Change in non-farm em
Key variables to watch (in addition to policies) 400

1. Consumption to income ratio 0

2. Employment (first Friday of the month) 0

Jan-60 Jan-68 Jan-76 Jan-84 Jan-92 Jan-00 Jan-08

3. House prices to income ratio -400

4. Resumption of lending (credit conditions)

5. Yield curve -800 -25

11