i f h C i iEmerging from the Crisis

Franklin AllenUniversity of Pennsylvania

Elena CarlettiEuropean University InstituteEuropean University Institute

Louvain-La-NeuveMay 6, 2010

What caused the crisis?• The conventional wisdom used to be that the basic

cause of the crisis was bad incentives in the mortgage g gindustry

But now we know much more was going on…g g• The large global impact of the crisis suggests that the

problems with subprime mortgages were a symptomth th thrather than the cause

• The main problem is that there was a bubble in property prices in the U S Spain Ireland andproperty prices in the U.S., Spain, Ireland and elsewhere, and we are now suffering the fallout from the collapse of that

22

Current Crisis:Case-Shiller 10 Cities Composite

3Source=S&P

Percentage Change inCase-Shiller 10 Cities Composite

4Source=S&P

What caused the bubble?What caused the bubble?

• The monetary policies of central banks particularlyThe monetary policies of central banks particularly the U.S. Federal Reserve and ECB in some countries were too loose – they focused too much on consumer price inflation and ignored asset price inflation

• Global imbalances – the Asian crisis of 1997 and the policies of the IMF led to a desire among Asian governments to save funds

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Reserves: A ComparisonReserves: A Comparison

6

To summarize:To summarize:

• The first aspect of the problem was the developmentThe first aspect of the problem was the development and bursting of the property bubble

• The second aspect was that this problem was considerably exacerbated by the poor functioning of h fi i l i h i ithe financial system in the crisis

• How much of the disruption to the real economy is• How much of the disruption to the real economy is due to the bursting of the bubble and how much is due to the financial crisis?

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due to the financial crisis?

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Spainp• One of the largest property bubbles occurred in Spain

• The bursting of this bubble has devastated the real economy – unemployment has doubled to a level of l 20%almost 20%

• BUT the financial system, and in particular the banks such as Santander and BBVA have come through the crisis very well until the problems in Greece

• This suggests that the bursting of the bubble can cause tremendous damage to the real economy even if the financial s stem remains strong

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the financial system remains strong

Spain’s property bubbleSpain s property bubble

Real House Price Indices (1996=100)Real House Price Indices (1996=100)

250.00

150.00

200.00

ce Inde

x

France

Germany

Greece

Italy

50.00

100.00

Hou

se Pri Italy

Portugal

Spain

UK

0.00

199619

9719

9819

9920

0020

0120

0220

0320

0420

0520

0620

0720

0820

09

USA

9

% in quarterly GDPquarter on quarter

2

0Q1-2007

Q2-2007

Q3-2007

Q4-2007

Q1-2008

Q2-2008

Q3-2008

Q4-2008

Q1-2009

Q2-2009

Q3-2009

Q4-2009%

-2

-4

US Japan France Germany Spain10

US Japan France Germany Spain

UnemploymentUnemployment

15

20

5

10%

0

Jan-

2007

Mar

-200

7

May

-200

7

Jul-2

007

Sep-

2007

Nov

-200

7

Jan-

2008

Mar

-200

8

May

-200

8

Jul-2

008

Sep-

2008

Nov

-200

8

Jan-

2009

Mar

-200

9

May

-200

9

Jul-2

009

Sep-

2009

Nov

-200

9

Jan-

2010

M N M N M N

US Japan France Germany Spain

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Why has the financial system performed so poorly?

• Why didn’t regulation help?

• Banking regulation is different from other kinds of regulation in that there is no wide agreement on the market failures it is designed to correct

• It is backward looking in the sense that it was put in place to prevent the recurrence of past types of crises

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RegulationRegulation

• What are the benefits and costs of regulation?What are the benefits and costs of regulation?

• The Basel agreements illustrate the lack of a widely• The Basel agreements illustrate the lack of a widely agreed theoretical framework

• What exactly are the market failures?• Panics• Panics• Contagion• Mispricing due to limits to arbitrage

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• Mispricing due to limits to arbitrage

Policy responsesPolicy responses

• Central banks and governments need to be muchCentral banks and governments need to be much more focused on preventing bubbles and global imbalances than in the past – this is the real cause of the crisis

• Banking regulation needs to focus on correcting market failures rather than being imposed ad hoc as has been done historically

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Preventing bubblesPreventing bubbles

• One of the main focuses of policy should be toOne of the main focuses of policy should be to prevent asset price bubbles because as Reinhart and Rogoff (2009) document this is the main cause of financial crises

• Frequent causes of asset price bubbles are – Loose monetary policy– Excessive availability of credit

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Reform of central banksReform of central banks• Central bank independence works well for combating

inflation but not for financial stabilityinflation but not for financial stability

• The private sector is being criticized for taking soThe private sector is being criticized for taking so much risk but it is really the Federal Reserve, ECB and other central banks that took the risks, e.g. low interest rates in 2003 and currently quantitative easing

Th d t b h k d b l• There needs to be some check and balance mechanism such as a Financial Stability Board that helps to control public sector risk taking

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helps to control public sector risk taking16

Global imbalances• Self-insurance by Asian countries through large

i i l f h S h Kreserves is optimal for them, e.g. South Korea

• However, it is a very inefficient mechanism from a global perspective

• Reform of the IMF? Global currency?Reform of the IMF? Global currency?

• Regional risk sharing

• Bilateral swaps to give foreign exchange safety net

• Rmb as a reserve currency17

Rmb as a reserve currency17

Banking regulationBanking regulation

• Capital regulation main tool for regulation in recentCapital regulation main tool for regulation in recent years

Wh t th k t f il thi l ti i• What are the market failures this regulation is solving?

• Basel agreements are silent on this issue

• Contagion is one of the most important market• Contagion is one of the most important market failures capital regulation can help prevent

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Banking regulation (cont )Banking regulation (cont.)• What is the cost of capital buffers – i.e. why is equity p y q y

more costly than other forms of finance?

• Most plausible explanation of the high cost of equityMost plausible explanation of the high cost of equity finance is that there is a tax subsidy to debt in the form of interest deductibility

• If this is the case then the best policy is to remove the interest deductibility of debt so that large capital y g pbuffers are both privately and socially optimal – it is not clear there is any good justification for the tax deductibility of interest

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deductibility of interest

Systemically important financial institutions

• “Too big to fail” is not “Too big to liquidate”g g q

• The government needs to guarantee the short term commitments of failing banks to prevent contagioncommitments of failing banks to prevent contagion

• When a bank fails or is close to failure the government should step in take it over and resolve itgovernment should step in, take it over and resolve it – the top 5 executives should be removed immediately– all employee pension claims should be eliminatedp y p– over the next few years the bank should be liquidated

• International issues20

International issues

Resolving large cross-border financial institutions

• Eliminate cross-border branches and requireEliminate cross border branches and require subsidiaries

R l t h ld it th d f i t h• Regulators should monitor the degree of mismatch between assets and liabilities within the country with significant mismatches leading to posting of collateralsignificant mismatches leading to posting of collateral

• Large equity buffers of 20 percent in terms of accounting and market capital

• Banks resolved when equity falls below 5 percent21

Banks resolved when equity falls below 5 percent

Limits to arbitrage and the mispricing of assets

• Many people believe that prices of securitized y p p pproducts broke free from fundamentals and this is why prices fell so low

• TARP and many other plans were designed to restore prices to their proper level more effective policiesprices to their proper level – more effective policies need to be developed to ensure asset prices reflect fundamentals

• Mark-to-market versus historic cost accounting

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Competition in financial servicesp• There is much discussion about bankers’ compensation

but the real issue is how banks are able to make sobut the real issue is how banks are able to make so much money that they can pay such high compensation

• What is really needed is a full competition review that establishes how they make so much money– Market structures that are anticompetitive?Market structures that are anticompetitive?– Front running in the bond market?– Conflicts of interest – e.g. Goldman Sachs

Swapping privileged information about takeovers and so– Swapping privileged information about takeovers and so forth with other institutions to make high profits on their proprietary trading?

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Performance of M&A targets relative to the k d d lmarket around deal announcement

0.25

0.3

0.15

0.2

0.05

0.1

-0.05

0

-125

-116

-107 -9

8-8

9-8

0-7

1-6

2-5

3-4

4-3

5-2

6-1

7 -8 1 10 19 28

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Problems in the Eurozone• Will Greece default or muddle through?

How much will the Germans pay?– How much will the Germans pay?– IMF conditionality is very severe and the population may

not accept the cuts they impose– Why didn’t the Eurozone/IMF team include restructuring?– Why can’t they do what Ireland did?

• What would a default look like?– Great uncertainty about how the default will proceed means y p

financial effects may be large– Significant contagion to Portugal/Spain/Italy

Bankruptcy mechanism for Eurozone countries is needed25

– Bankruptcy mechanism for Eurozone countries is needed

A bankruptcy mechanism for the Eurozone

• Mechanism should be designed to allow default gwithout a bailout

Wh th t d f lt it i ll d t i d bt• When the country defaults it is allowed to issue debt that is senior to defaulted claims so that it can support its banking system similarly to debtor-in-possession g y y pfinancing

• Team from ECB/Commission decides how much the• Team from ECB/Commission decides how much the debt will be written down so that the recovery path is sustainable with exit if the country disagrees

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Preventing booms in Eurozone countries

• Spain and Ireland’s economies have been wrecked by p ya monetary policy that was too loose for them and this led to property bubbles

• To prevent this in the future have limits on loan to value ratios that fall if property prices are rapidlyvalue ratios that fall if property prices are rapidly rising

• Tax property transfers with a tax that steadily increases as property price inflation rises

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What about other PIIGS and countries?What about other PIIGS and countries?

• Ireland – No defaultIreland No default

• Portugal – Severe problems

• Spain – Need to cut expenditure now

• Italy – Unstable

• The UK and US?

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Will the Eurozone survive?Will the Eurozone survive?

• Yes, but with modificationsYes, but with modifications

• But Keynesian Economics will not…

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