Crisis Blanchard

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The Crisis

Lecture GWU, August 5, 2009

Olivier Blanchard

1

Basic Facts

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

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



2

GDP growth, past, current, and forecast(percent; quarter-over-quarter, annualized)

-10

-8

-6

-4

-2

0

2

4

6

8

10

12

07Q1 07Q3 08Q1 08Q3 09Q1 09Q3 10Q1 10Q3

Advanced economies

World

Emerging economies

10Q4

3

40

60

80

100

120

140

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09

Stock prices

(index, 1/1/2007=100)

Emerging

Advanced

8/4



4

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, inoutput?

Output losses: more than 5 trillion

Stock market wealth loss: more than 20 trillion

5

100

120

140

160

180

200

220

240

00 01 02 03 04 05 06 07 08 09

U.S. Housing Market

Case Shiller(Composite 10)

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

May 09



6

The Amplification Mechanism. 1. Banking Basics

Capital ratio: Capital/assets. Leverage ratio: Assets/capital.

Now suppose Assets decreases from 100 to 90. Second bank isinsolvent.

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

Assets Liabilities Capital ratio Leverage Ratio

Bank 1 100 80 20 % 520

Bank 2 100 95 5% 205

7

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’’



8

TED Spread

0

1

2

3

4

5


United States

Euro area/Germany

Money Market Spreads(3-Month LIBOR minus 3-Month government bond yield)

9

The Amplification Mechanism. 3. How could it happen?

Excess optimism. “Housing prices cannot decrease.’’

Complex securities. MBS, CDOs. Why issue suchsecurities?

Incentives and competence of rating agencies.



10

The Macroeconomic Effects

Large increase in borrowing rates.

Drop in confidence.

11

Borrowing rates

3

4

5

6

7

8

9

10

11


AAA

AA

A

BBB

U.S. Corporate Bond Yields(in percent)



12

U.S. Business and consumer confidence

0

20

40

60

80

100

120

Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09

Consumer Confidence (Conference Board)

Business Confidence (AIM)

United States(Jan 2007 =100)

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.



14

The Direct Effects of the Financial Crisis

I n t e

r e s t r a

t e , i

Output, Y

LM

IS

Y’

A’

Y

i’

A

i

IS’

Increase in risk premium

Decrease in confidence

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

R 2 = 0.7243

-25

-20

-15

-10

-5

0

0 2 4 6 8 10 12 14 16 18 20

High and Medium High-tech manufacturing value added(% of GDP)

G D P G r o w t h ( 2 0 0 8 Q 4 , s a a r )

Manufacturing Share and GDP Growth

Drop in GDP Growth and Openness

17Emerging Economies Faced Significant Outflows

-400

-200

0

200

400

600

05Q1 06Q1 07Q1 08Q1

Net derivatives

FDI liabilities

Other investment liabilities

Portfolio liabilities

Total inflows

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

08Q4



18

Monetary Policy

Provide guarantees to depositors/lenders.

Provide funds to banks. “Liquidity provision’’ Accept moreassets 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

N o m i n

a l i n t e

r e s t r a

t e , i

Output, Y

LM

0

LM’

Increase in M/P

No effect on thenominal rate



20

Monetary policy and the Liquidity Trap

N o m i n

a l i n t e

r e s t r a

t e , i

Output, Y

LM

IS

Y

A

0

Y’

A’

IS'

LM’

21

The Liquidity Trap and the need for a fiscal stimulus

N o m i n

a l i n t e

r e s t r a

t e , i

Output, Y

LM

IS

Y”

A

0

Y’

A’

IS'IS’’

Fiscal stimulus

A’’



22

-2

0

2

4

6

8

10

G - 2 0 1 /

U . S . U . K .

F r a n c e

G e r m a n y

J a p a n

C h i n a

Overall Deficit: Contributions from Automatic Stabilizersand Discretionary Measures

(fiscal deficit in percent of GDP; change from 2007)

2009 2010

Fiscal Stimulus in 2009 and 2010

-2

0

2

4

6

8

10

G - 2 0 1 /

U . S . U . K .

F r a n c e

G e r m a n y

J a p a n

C h i n a

1/ PPP GDP-weighted average.

23

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?



24

Tightening lending standards

-20

0

20

40

60

80

100

Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09

U.S.

Euro Area

U.K.

Lending Officer Surveys(net percentage)

Net tightening

Net easing

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? Large deficits and high debt.

Consumption? Likely to remain low. Bank credit. Retirement saving

Investment? Low capacity utilization. Housing

Increase in net exports?

Need for a dollar depreciation.

Vis a vis who? Asia, China



26

0

20

40

60

80

100

120

00 02 04 06 08 10 12 14

G-20

G-20 (Adv)

G20 (Emerging)

Government Debt

Evolution of debt to GDP for Advanced Countries(Percent of GDP)

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.

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Crisis Blanchard