1

Global Financial CrisisDon Kopka, PhD

Management DeptTowson University

2

Types of Financial Crises

• Currency – Sharp currency depreciation• Banking – Loss of confidence in banking

system• Foreign Debt – Country unable to service

foreign debt obligations

3

Previous Financial Crises

• Mexico 1995• Asia 1997

4

Shared Macroeconomic Causes of Financial Crises

• High inflation• Asset price inflation, especially housing and real

estate• Excessive expansion of domestic borrowing, often

against real property assets• Excessive real estate investment• Widening current account deficits• People unable to make mortgage and debt

payments• Culminates in burst of real estate bubble

5

International Monetary Fund World’s “Monetary Policeman”

Typical Policy Measures – “Washington Consensus”

- Tight macroeconomic policies in return for adjustment financing

•Cuts in public spending•Increased interest rates•Tight monetary policy•Deregulation•Privatization

6

United States and Global Financial Crisis 2008 to Present

“Global Economic Meltdown”

Simple Ideological Explanations• Insufficient government regulation• Government interference in the market• Greed

7

Multiple Factors – No Simple Explanations•Subprime loans to not necessarily low income home buyers

•Community Reinvestment Act for 1977 for minority housing – LIMITED IMPACT

•Fannie Mae and Freddie Mac mortgage programs – LATE TO SUBPRIME LENDING

•Federal Reserve‘s loose monetary policy – money too easy to borrow and invest/relend

•Congress and Executive Branch goals for home ownership inappropriate

United States and Global Financial Crisis 2008 to Present

8

Multiple Explanations (cont.)•Relaxed regulatory standards, especially capital requirements

•Collaterized Debt Obligations (CDOs) – packages of mortgages with various risks

•Credit Default Swaps (CDSs) – insufficient funds to cover issued CDSs

•“Mark to Market” accounting, reducing values of bank mortgages to less than real value

United States and Global Financial Crisis 2008 to Present

9

Multiple Explanations (cont.)•Statistical Models with unrealistic assumptions

•“Quants”•Mathematicians, engineers, physicists

•Bond rating services giving good ratings to high risk CDOs

•High Debt – real estate, government, international borrowing, consumer

•Organizational expectations for employees – “make the numbers”

United States and Global Financial Crisis 2008 to Present

10

Multiple Explanations (cont.)•“Shadow Financial System,” 40% of credit not from publicly traded financial institutions

•Greed•Balance Sheet Solvency Crisis NOT a Liquidity Crisis – financial institutions’ assets lost value and insufficient to cover debt obligations –”zombie banks”

United States and Global Financial Crisis 2008 to Present

11

United States and Global Financial Crisis 2008 to Present

Multiple Explanations (cont.)•Moral Hazard – behave badly but size and importance requires support, “too big to fail”

•Loss of integrity – banking mentality•Stagnant incomes leading to excessive borrowing to support consumption

12

Shared Macroeconomic Causes of American Financial Crisis with

Previous Crises

• Asset price inflation, especially housing• Excessive expansion of domestic borrowing, especially

against real property assets• Excessive consumer credit – between 2000 and 2007,

U.S. consumption grew by 9% but median income only grew by 3%

• Excessive real estate investment• Widening current account deficits• Culminates in burst of real estate bubble

13

Contagion – spread of the crisis•Interlinked global financial markets•Global financial institutions•Collapse of credit•Recession•Collapse of trade•Local government investments

•Reduced spending•Reduced employment•Aggravate economic decline

United States and Global Financial Crisis 2008 to Present

14

Dealing with the Present Global Financial Crisis

•Developed country governments and evolution to “Austerity-led Growth”

•Bank bailouts, government lending keep banks solvent and to support credit

•Central banks maintain low interest rates•High government expenditures to replace lost consumer spending

•Deleveraging, saving replacing debt – “paradox of thrift”

•Increased regulation of financial industry•Executive compensation

15

For more, seeCrisis Economics: A Crash Course in the Future of Fianance by Nouriel Roubini and Stephen Mihm, The Penguin Press, New York, 2010.

This Time Is Different by Carmen M. Reinhart and Kenneth S. Rogoff, Princeton University Press, Princeton, NJ, 2009.

All The Devils Are Here: The Hidden History of the Financial Crisis, by Bethany McLean and Joe Nocera, Portfolio/Penguin, London, 2010.

Freefall: America, Free Markets and the Sinking of the World Economy by Joseph Stiglitz, W. W. Norton & Company, New York, 2010.