Learning the lessons of the financial crisis Martin Wolf, Associate Editor & Chief Economics Commentator, Financial Times

King’s College, Cambridge

May 23rd 2009

2

Learning the lessons of the financial crisis

“Simply stated, the bright new financial system – for all its talented participants, for all its rich rewards – failed the test of the market place.” Paul Volcker, April 8th 2008

3

1. What has just happened?

• A global financial and economic crisis, triggered by a re-rating of risk in the core economies

• This re-rating revealed the under-capitalisation of the financial system and that in turn generated a panic

• This panic triggered a collapse in credit and consumer demand, which spread the crisis worldwide

• Those worst affected were exporters of manufactures and emerging economies dependent on foreign capital inflow

4

2. What is the underlying story?

• The story:

– Long build-up of imbalances and leverage;

– Excessive risk-tolerance;

– Then financial and economic crisis;

– Unprecedented monetary and fiscal stimulus; and now

– “Green shoots” or a decline in the rate of decline

• So are we on the way to sustainable recovery or to a relapse?

5

3. Path to a disaster

• The late Hyman Minsky produced a canonical model of financial instability, based on a simple idea:

– Confidence, then euphoria, then the “Ponzi game” and, finally, revulsion;

– We are now in the revulsion stage – flight to quality and dramatic increases in spreads

– Asset values, credit and, at worst, financial institutions collapse

• Success breeds excess and excess breeds collapse

6

3. Path to a disaster

TOTAL US PUBLIC AND PRIVATE DEBT(as per cent of GDP)

0.0

50.0

100.0

150.0

200.0

250.0

300.0

350.0

400.0

1870

1876

1882

1888

1894

1900

1906

1912

1918

1924

1930

1936

1942

1948

1954

1960

1966

1972

1978

1984

1990

1996

2002

2008

Source: Hoisington

GREAT US DEBT BOOM

7

3. Path to a disaster

US PRIVATE DEBT BOOM

US PRIVATE SECTOR DEBT(relative to GDP)

0.0%

20.0%

40.0%

60.0%

80.0%

100.0%

120.0%

140.0%

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

Households Non-financial Business Financial Sectors

8

3. Path to a disaster

HOUSE PRICE BUBBLE AND COLLAPSE

REAL HOUSE PRICES

50.0

100.0

150.0

200.0

250.0

300.0

350.0

400.0

450.0

Jan-

91

Jan-

92

Jan-

93

Jan-

94

Jan-

95

Jan-

96

Jan-

97

Jan-

98

Jan-

99

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Real Nationwide (UK) Real Case Shiller 10-city (US)

9

3. Path to a disaster

• So why did huge credit and housing bubbles occur?

1. The “Great Moderation” and resulting complacency among policymakers and investors

2. Emergence of huge global imbalances and extraordinary reserve accumulations in the late 1990s and early 2000s;

3. Low real and nominal interest rates and the “reach for yield”;

4. Accommodative monetary policy aimed at targeting inflation;

5. Innovation in the financial sector, to provide apparently safe, high-yielding assets; and

6. De-regulation and mal-regulation of financial system

10

4. Crisis

• Action of G7 governments has probably saved core banking institutions.

• But the recessionary forces are overwhelming:

– Dysfunctional credit markets and implosion of the shadow banking system;

– Ongoing asset price collapses in housing and equities across the globe;

– Need for higher savings in US, UK and other low-saving countries; and

– Cut off of funding to all risky borrowers everywhere

11

4. Crisis

RISK AVERSION SPREAD, AS BANKS DREW BACK

Emerging markets

Corporate credit

Prime RMBS

Commercial MBS

Money markets

Financial institutions

Subprime RMBS

Figure 1.2. Heat Map: Developments in Systemic Asset Classes

Source: IMF staff estimates.Note: The heat map measures both the level and 1-month volatility of the spreads, prices, and total returns of each asset class relative to the average during 2004-06 (i.e., wider spreads, lower prices and total returns, and higher volatility). The deviation is expressed in terms of standard deviations. Green signifies a standard deviation under 1, yellow 1-4 standard deviations, orange 4-7, and red greater than 7.MBS = mortgage-backed security; RMBS = residential mortgage-backed security.

Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09

12

4. Crisis

• Actions of G7 governments in October saved core banking institutions

• Confidence is returning

• But recessionary forces are powerful:

– IMF estimates financial sector write-downs at $4.1 trillion

– Asset price falls in housing are continuing; and

– Consumers have cut back spending, with a chance of further rises in savings in big indebted countries

13

4. Crisis

VALUE OF US RESIDENTIAL MORTGAGE-BACKED SECURITIES

0

20

40

60

80

100

120

12/3

0/20

05

2/28

/200

6

4/30

/200

6

6/30

/200

6

8/30

/200

6

10/3

0/20

06

12/3

0/20

06

2/28

/200

7

4/30

/200

7

6/30

/200

7

8/30

/200

7

10/3

0/20

07

12/3

0/20

07

2/29

/200

8

4/30

/200

8

6/30

/200

8

8/30

/200

8

10/3

0/20

08

12/3

0/20

08

AAA AA BBB BB

Source: Barclays

DEATH OF SAFE MORTGAGE-BACKED SECURITIES

14

4. Crisis

FINANCIAL SECTOR LOSSES EXPLODE

ESTIMATES OF POTENTIAL FINANCIAL SECTOR WRITE-DOWNS(by country of asset origin, $bn)

$1,068 $888

$131

$2,087

$1,644

$305

$1,966

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

$4,000

$4,500

US Europe Japan All

Loans Securities

Source: IMF GSFR April 2009

15

4. Crisis

THE GREAT BEAR MARKET

GLOBAL STOCK MARKET VALUATIONS(over GDP, per cent)

0.0

20.0

40.0

60.0

80.0

100.0

120.0

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

16

4. Crisis

EXPORT-ORIENTED ECONOMIES ARE HARD-HIT

MANUFACTURED OUTPUT

60.0

65.0

70.0

75.0

80.0

85.0

90.0

95.0

100.0

105.0

Jan-08

Feb-08

Mar-08

Apr-08

May-08

Jun-08

Jul-08 Aug-08

Sep-08

Oct-08

Nov-08

Dec-08

Jan-09

Feb-09

Mar-09

US Japan Germany France UK South Korea

17

4. Crisis

• Why is it so bad?

– The scale of the bubbles;

– Dispersion of risk, which means that nobody knows who holds the bad assets – and so radical uncertainty;

– Failed distribution of bad paper generated much bigger write-downs than expected Inadequate capitalisation of the banking system;

– Totally inadequate capitalisation of the shadow banking system;

– Mistakes by US treasury (over Lehman) and other authorities

18

5. Green shoots

• Stimulus applied has been massive, both fiscal and monetary;

• The biggest fiscal stimulus is in the countries with external deficits;

• Rate of economic decline has slowed; and

• Forward-looking signs of recovery have emerged

19

5. Green shoots

GENERAL GOVERNMENT FISCAL DEFICIT(per cent of GDP)

-16

-14

-12

-10

-8

-6

-4

-2

0

2

4

Canada France Germany Italy Japan United Kingdom United States

2006 2007 2008 2009 2010

Source: IMF

FISCAL STIMULUS IS MASSIVE

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5. Green shoots

CONFIDENCE BEGINS TO RETURN

SPREADS ON US SHORT-TERM SECURITIES(90 days commercial paper vis a vis Treasuries)

-0.5

0

0.5

1

1.5

2

2.5

3

3.5

4

01

/01

/20

04

01

/03

/20

04

01

/05

/20

04

01

/07

/20

04

01

/09

/20

04

01

/11

/20

04

01

/01

/20

05

01

/03

/20

05

01

/05

/20

05

01

/07

/20

05

01

/09

/20

05

01

/11

/20

05

01

/01

/20

06

01

/03

/20

06

01

/05

/20

06

01

/07

/20

06

01

/09

/20

06

01

/11

/20

06

01

/01

/20

07

01

/03

/20

07

01

/05

/20

07

01

/07

/20

07

01

/09

/20

07

01

/11

/20

07

01

/01

/20

08

01

/03

/20

08

01

/05

/20

08

01

/07

/20

08

01

/09

/20

08

01

/11

/20

08

01

/01

/20

09

01

/03

/20

09

01

/05

/20

09

21

5. Green shoots

BUT CONFIDENCE BEGINS TO RETURN

INTEREST RATES ON US CORPORATE BONDS

0

5

10

15

20

25

30

35

01

/01

/20

04

01

/03

/20

04

01

/05

/20

04

01

/07

/20

04

01

/09

/20

04

01

/11

/20

04

01

/01

/20

05

01

/03

/20

05

01

/05

/20

05

01

/07

/20

05

01

/09

/20

05

01

/11

/20

05

01

/01

/20

06

01

/03

/20

06

01

/05

/20

06

01

/07

/20

06

01

/09

/20

06

01

/11

/20

06

01

/01

/20

07

01

/03

/20

07

01

/05

/20

07

01

/07

/20

07

01

/09

/20

07

01

/11

/20

07

01

/01

/20

08

01

/03

/20

08

01

/05

/20

08

01

/07

/20

08

01

/09

/20

08

01

/11

/20

08

01

/01

/20

09

01

/03

/20

09

01

/05

/20

09

AA BAA B CCC

22

5. Green shoots

SPREADS OF EMERGING MARKET BONDS OVER US TREASURIES

(percentage points)

0100200300400500600700800900

1000

01

/01

/20

04

01

/03

/20

04

01

/05

/20

04

01

/07

/20

04

01

/09

/20

04

01

/11

/20

04

01

/01

/20

05

01

/03

/20

05

01

/05

/20

05

01

/07

/20

05

01

/09

/20

05

01

/11

/20

05

01

/01

/20

06

01

/03

/20

06

01

/05

/20

06

01

/07

/20

06

01

/09

/20

06

01

/11

/20

06

01

/01

/20

07

01

/03

/20

07

01

/05

/20

07

01

/07

/20

07

01

/09

/20

07

01

/11

/20

07

01

/01

/20

08

01

/03

/20

08

01

/05

/20

08

01

/07

/20

08

01

/09

/20

08

01

/11

/20

08

01

/01

/20

09

01

/03

/20

09

01

/05

/20

09

Europe Latin America

BUT CONFIDENCE BEGINS TO RETURN

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5. Green shoots

STOCK MARKET BOUNCE

STOCK MARKETS

40.0

50.0

60.0

70.0

80.0

90.0

100.0

110.0

120.0

01/0

1/20

07

01/0

2/20

07

01/0

3/20

07

01/0

4/20

07

01/0

5/20

07

01/0

6/20

07

01/0

7/20

07

01/0

8/20

07

01/0

9/20

07

01/1

0/20

07

01/1

1/20

07

01/1

2/20

07

01/0

1/20

08

01/0

2/20

08

01/0

3/20

08

01/0

4/20

08

01/0

5/20

08

01/0

6/20

08

01/0

7/20

08

01/0

8/20

08

01/0

9/20

08

01/1

0/20

08

01/1

1/20

08

01/1

2/20

08

01/0

1/20

09

01/0

2/20

09

01/0

3/20

09

01/0

4/20

09

01/0

5/20

09

FTSE All World Eurostock 300 UK FTSE 100 US S&P Composite Japan Dow

24

5. Green shoots

BUT CONFIDENCE BEGINS TO RETURN

PURCHASING MANAGERS' INDICES

20

25

30

35

40

45

50

55

60

65

Oct-0

1

Jan-

02

Apr-0

2

Jul-0

2

Oct-0

2

Jan-

03

Apr-0

3

Jul-0

3

Oct-0

3

Jan-

04

Apr-0

4

Jul-0

4

Oct-0

4

Jan-

05

Apr-0

5

Jul-0

5

Oct-0

5

Jan-

06

Apr-0

6

Jul-0

6

Oct-0

6

Jan-

07

Apr-0

7

Jul-0

7

Oct-0

7

Jan-

08

Apr-0

8

Jul-0

8

Oct-0

8

Jan-

09

Apr-0

9

UK Germany France Japan US

25

5. Green shoots

BUT CONFIDENCE BEGINS TO RETURN

CONSUMER CONFIDENCE INDICES

80

85

90

95

100

105

110

Jan-

99

May

-99

Sep-9

9

Jan-

00

May

-00

Sep-0

0

Jan-

01

May

-01

Sep-0

1

Jan-

02

May

-02

Sep-0

2

Jan-

03

May

-03

Sep-0

3

Jan-

04

May

-04

Sep-0

4

Jan-

05

May

-05

Sep-0

5

Jan-

06

May

-06

Sep-0

6

Jan-

07

May

-07

Sep-0

7

Jan-

08

May

-08

Sep-0

8

Jan-

09

US France Germany UK EU

26

6. Scenarios

• Deep recessions are certain this year;

• But what sort of recovery can we expect?

• The big questions are three:

– First, how long can governments maintain such massive stimulus, before risk-aversion spreads to sovereign debt and panic about inflation grows?

– Second, does de-leveraging in countries with high levels of private indebtedness need to occur before final demand recovers?

– Third, might private demand grow strongly elsewhere?

27

6. Scenarios

THE GRIM FUTURE – BUT IS IT GRIM ENOUGH?

WORLD ECONOMIC GROWTH(at purchasing power parity)

-6

-4

-2

0

2

4

6

8

10

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

World Advanced economies Emerging and developing economies

Source: IMF WEO April 2009

28

6. Scenarios

THE GRIM FUTURE – BUT IS IT GRIM ENOUGH?

GROWTH OF EMERGING ECONOMIES

-6

-4

-2

0

2

4

6

8

10

12

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Africa Central and eastern Europe Developing Asia Middle East Western Hemisphere

29

6. Scenarios

• Scenario 1: Swift recovery:

– Massive stimulus delivers quick restoration of demand in the big deficit countries and return to business as usual;

– But big further increases in private debt

– Little rebalancing of the world economy

– and so increased vulnerability for the future

– Also risk of oil price spike

• This would be a V-shaped recession, but with real danger of a relapse some years in the future

• What worries me is that this would be unsustainable

30

6. Scenarios

• Scenario 2: Muddling through:

– Modest pick-up of private spending; and

– Weak recovery in US followed by other deficit high-income countries in 2011, which would pull export-oriented economies

• This would be an extended “U-shaped” recession

• This seems a likely outcome.

• But it would also leave huge challenges of de-leveraging and re-balancing ahead

31

6. Scenarios

• Scenario 3: Full adjustment

– Strong pick up of demand in surplus countries

– Export- and investment-led growth in deficit countries

– De-leveraging in deficit countries, as well

• This also would be an extended “U-shaped” recession

• This seems a highly unlikely outcome.

• But it would leave more stable growth in the years ahead

32

7. Lessons

• Far too soon to tell.

• The first lesson - fragility of the financial system:

– Term transformation; and

– Pervasive asymmetric information

• Such systems are prone to serious errors

• They are also “run-prone”

• Securitisation did not make this better, but worse

• This has been an age of financial crises

33

7. Lessons

• Second Lesson - Global Macroeconomics:

– We need a different global monetary system;

– The present one is too vulnerable to the “Triffin problem”

– Countries that do not issue internationally acceptable currencies find it very dangerous to borrow substantially abroad

– So deficits end up in countries with internationally acceptable currencies

– This is inefficient and undesirable

– The solution is either a global currency or development of local currency finance or an international insurance arrangement on a much bigger scale

34

7. Lessons

• Third Lesson - Macroeconomic Policy

– Inflation Targeting is not enough;

– Need to “lean against the wind”;

– Run large fiscal surpluses in normal times;

– Adopt “macro-prudential” countercyclical capital requirements

35

7. Lessons

• Fourth Lesson - Microeconomic Policy

– Case for separating utility banking from the “casino”;

– Need to charge properly for guarantees, explicit and implicitly;

– Need to tax term transformation through liquidity requirements;

– Need to rethink the “shadow banking system”, which is a banking system, after all;

– Need to raise capital requirements against all activities;

– Need to reconsider risk weighting and abandon trust in risk models

36

7. Lessons

• Big issues outstanding:

– What are the regulatory and economic implications of the new “mega-banks”?

– Is there a future for the shadow financial system?

• If so, how do we manage and control it?

• If so, how do we regulate the utility and the casino?

• Should banks be prohibited from engaging in markets?

• Should casinos be prohibited from term-transformation?

– How do we limit risks to the state?

• What do we do about “too big to fail”?

• What do we do about foreign assets and liabilities of domestic institutions and domestic assets and liabilities of foreign institutions?

– Should we regulate household access to credit directly?

• If so, how do we do so fairly?

• Do we control total borrowing or the leverage of households?