The influence of uncertainty in a changing financial envoronment

Halperin, The Influence of Uncertainty in a Changing Financial Environment, DOI 10.1007/978-3-319-48778-6_1 A Failure of Imagination Why I Wrote thIs Book After the financial crisis of

in a Changing Financial Environment

An Inquiry into the Root Causes

of the Great Recession

of 2007-2008

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Financial Environment

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The Influence of Uncertainty in a Changing Financial

Environment

An Inquiry into the Root Causes of the Great

Recession of 2007–2008

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ISBN 978-3-319-48777-9 ISBN 978-3-319-48778-6 (eBook)

DOI 10.1007/978-3-319-48778-6

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Retired from the World Bank

Maryland, USA

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At the end of 2001, I retired from the World Bank, where I had worked for 25 years, and soon after I recognized the splendid opportunity ahead:

I had free time and no longer had to worry about earning a salary for

a living! Even before graduate school, I had developed a love for nomics inspired by an excellent teacher at the University of Buenos Aires: Julio H.G. Olivera, and after retirement I decided to rekindle the rela-tion While consulting assignments came my way from time to time, I was finally able to catch up on my readings, which I had neglected due to the demands of my work; it helped that I had unlimited access to the Joint Library of the IMF and the World Bank

eco-Then came the Great Recession of 2007–2008, and a few years ago

I concluded that, while many excellent works discussing it were already available, some important aspects had not received the attention that they deserved, so I decided to write this book

During this time, I received suggestions from many former colleagues,

as well as encouragement and support from close friends and family I particularly want to thank Miguel E. Martinez, who read through several early versions of this book, providing me with very helpful comments.After Palgrave Macmillan accepted to publish the book, they followed their standard practice of sending it out to a peer reviewer, who provided very constructive comments and suggestions, which I was happy to take into account as best I could He, or she, deserves my thanks!

As authors usually declare, I alone bear responsibility for the ideas sented here To all those that helped this book come to print, my heartfelt thanks!

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7 Theories of Business Fluctuations 151

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Ricardo A. Halperin was born in 1940 in Buenos Aires, Argentina He

graduated from the University of Buenos Aires in 1963 with a CPA and later attended Columbia University, where he obtained an MBA (with concentration in Finance) in 1965 and a Ph.D (with concentration in Banking) in 1968

After graduating from Columbia, he returned to Argentina, where he taught Monetary Theory and Macroeconomics at the University of Buenos Aires until 1974, and from time to time also advised the Government

on financial policy issues While in Argentina, Mr Halperin published a number of articles on economic topics, all in Spanish, as well as a book:

Los Impuestos y la Inflación, which was published by Editorial Cangallo in

1975

In 1976, he joined the World Bank at its Washington DC headquarters, eventually rising through various management positions At the time of his retirement in 2002, he was Director of Infrastructure Operations for Europe and Central Asia

After retiring he collaborated with the World Bank’s Pension Finance Committee, which oversees the investments of the Bank’s pension fund, and carried out many consulting assignments He also wrote several short stories and essays in Spanish, which were published by the online literary

magazine Letralia.

Mr Halperin is married and has two daughters and three dren, to which this book is dedicated He lives in the Washington DC suburbs

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R.A Halperin, The Influence of Uncertainty in a Changing

Financial Environment, DOI 10.1007/978-3-319-48778-6_1

A Failure of Imagination

Why I Wrote thIs Book

After the financial crisis of 2007–2008 came close to ushering a depression comparable in severity to the one that the world experienced in the 1930s, Queen Elizabeth II rebuked the economics profession for failing to warn

in time about the dangers that the economy had faced and asked the tion in everyone’s mind:

ques-Why did nobody notice it?

The London School of Economics felt compelled to respond:

…In summary, your majesty, the failure to foresee the timing, extent and

sever-ity of the crisis and to head it off, while it had many causes, was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole….

While this assessment is not totally fair, as several prominent economists (which include Robert Shiller, Nouriel Roubini, and Raghuram Rajan) did warn in time that the US economy was facing significant risks, by and large it is true that most in public office as well as the media did not take those warnings seriously into account Years later, the then chairman of

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the Federal Reserve (Fed), the “Maestro” Alan Greenspan, would write

an article titled “Why I Didn’t See the Crisis Coming”.1

This book tries to shed some light on this question It starts with a cussion of how the Great Recession unfolded and of the actions taken to overcome it, and in the second part, it proceeds to examine the role played

dis-by developments in the financial sector

The third part of the book explores how economic theory has changed over time, and why macroeconomic models were not designed to provide warnings about the impending crisis It argues that the explanatory power

of these models had been eroded by developments in the financial sector and notes that this sector is especially vulnerable to public perceptions of risk, driven by uncertainty about the macroeconomic environment and its prospects

The last section of the book explores some policy options to reduce the likelihood of another major downturn originating in the financial sector and also to address some of the major challenges that the economy pres-ently faces

The Industrial Revolution that started in UK toward the end of the teenth century and eventually spread around the globe changed people’s worldviews and expectations For centuries household incomes had hardly witnessed any growth, but the technological changes that gave its name to the revolution enabled a quantum rise in production, as well as important changes in its composition

eigh-Despite initial high human and social costs, the Industrial Revolution eventually increased the well-being of the vast majority of the population

in those countries that, starting in the twentieth century, would be called the “developed world” This revolution provides the backdrop for the economic theories that prevail today

Presently we are living through a new wave of innovations in ogy which, though not as momentous as those of the past, continue to improve the quality of our lives Furthermore, today there is a widespread expectation that technological progress will go on, providing an impor-tant enabling condition for economic growth, despite the recent concerns

technol-of some economists that this progress may not be powerful enough to help us to achieve the rates of growth that we had in the past

Technological changes are unquestionably important and they may account for our failure to notice that in recent times change has also been taking place elsewhere, and it could also have significant consequences for the future of our economies: I am referring to the expansion of the financial sector, the appearance of new financial intermediaries and instru-ments, and the reduced role (in relative terms) of commercial banking; I argue that these developments constitute a financial revolution, and this book examines its implications.

The economic growth that the USA experienced, particularly since the end

of the Civil War, has enabled households to save some of their incomes, and over time this has resulted in a significant increase in national wealth, which includes housing, durable goods (such as automobiles), buildings and equipment used for the production of goods and services, and invest-ments in education and technical training (human wealth) Excluding the latter, wealth estimates for the USA amount to more than $80 trillion, and this figure may be compared to annual gross domestic product (GDP), which is about $18 trillion

Most households do not manage directly the physical assets used for production; this is mostly done by corporations Households provide them with the resources to do this and, in return, corporations issue legal instru-ments that entitle those households to a “share” of the net assets of the corporations, and consequently of their profits Households also provide corporations with loans, sometimes directly—by purchasing debt instru-ments that the corporations issue—and more often indirectly, through the financial intermediaries in which they place their savings Governments also have tapped into household wealth by selling them debt instruments Thus, other than for education, housing and consumer durables, the wealth of households is largely held in the form of financial instruments;

in the USA; vehicles, valuables and other physical assets for over 22%;

and financial wealth for 30% Other developed countries exhibit a similar pattern, the proportion of financial wealth depending on institutional arrangements and rising with the countries’ average income per capita.2

In the two or three decades immediately preceding the Great Recession

of 2007–2008, the world economy experienced a number of significant changes of which the most important was thought to be the spread of globalization On the other hand, until the Great Recession happened, the rapid growth that financial intermediation had been experiencing, accompanied by the proliferation of new financial instruments, did not receive much scrutiny and—by and large—was not discussed critically by the media It would appear that at the time awareness of its broader impli-cations was limited

This omission has become an important shortcoming When we ine macroeconomic developments, we should pay special attention to the financial markets, and the macroeconomic models upon which we ulti-mately rely should consider the linkages between the real and the financial sectors, and identify the variables that impact the latter The challenge, of course, will be to do so without engaging in excessive complexity

exam-the FInancIal revolutIon and economIc theory

While neoclassical economics was able to make a strong case for a market economy free from government involvement, because under reasonable assumptions it was shown to allocate resources efficiently through the unconstrained working of the price system, the importance acquired by the financial sector in recent times suggests that today a questioning of the market deserves to be considered

Financial decisions are not only based on interest rates but are also driven by the desire to contain risks (mainly that of losing all or part of the principal invested), and for this reason, they are strongly influenced by uncertainty Uncertainty is fed by a changing range of factors which are unpredictable in their timing and impact; in today’s environment, it causes macroeconomic expectations to change often, and as a result, financial markets are volatile In turn, this volatility affects economic activity, ulti-mately impacting employment and welfare

At present, the models that we use to examine economic policy options

do not take the impacts of uncertainty into account, and as a result, for many purposes they have lost explanatory power If Keynes had been concerned about the influence of expectations on investment decisions,

arguing that the latter’s sensitivity to them could result in economic fluctuations and unemployment, the financial revolution that we have experienced makes such concerns even more relevant today.

An important school of thought within the economics profession has argued that, by and large, expectations tend to be rational, which means that the lessons of the past as well as the information available in the pres-ent are appropriately weighed and fed into the decision-making processes

of firms and households and, of course, also of financial intermediaries.Uncertainty, however, limits the usefulness of this perspective, as—by definition—it implies that there is not enough relevant information avail-able on which to base some decisions The logic underpinning various plausible normative criteria for decision making under uncertainty (which are discussed later in the book) shows that in an uncertain environment there is no unequivocally “best” criterion for rational decision making This provides a powerful rationale for exploring what can be done to limit the effects of uncertainty on the real sector of the economy In addition, once uncertainty and its balance sheet impacts are taken into account, a better understanding of the Great Recession becomes possible

I am not suggesting that policymakers are naive and rely on simple textbook models rooted in neoclassical works or in Keynes’ general theory for their decisions It is evident that they do not, but the abundant infor-mation that comes to their attention often is not adequately integrated to the models at their disposal The chief merit of models is that they focus our attention on a few important variables, but that—of course—is also their Achilles heel, as it may downplay in the minds of some the relevance

of factors that they fail to take into account

Ben Bernanke—who chaired the Fed through most of the Great Recession—has been a pioneer in the theoretical development of mon-etary policy models Looking at other countries too, my sense is that, in most cases, policymakers have been well aware of the complexities of the environment in which they operated, even if they did not have all the tools

to formally integrate all these to ensure the optimality of their decisions

On the other hand, it appears that many commentators sought to

“explain” the financial crisis by focusing on the complexities of the cial system while abstracting from economic fundamentals, while others chose the opposite course Meanwhile, the Keynesian framework/model largely provided the lens through which most economists who lacked ade-quate information on the issues faced by the financial sector assessed the macroeconomic issues and policy options of the time

finan-In part, the failure to appropriately take into account developments in the financial sector or to explore balance sheet issues has to do with exces-sive compartmentalization in the training of economists and of financial professionals (though there has been progress, particularly in the last few decades3) Still in many instances, both regard the other cohort as work-ing in a related but still distinct field, and underestimate the need to thor-oughly understand its linkage to their own interests.

Anecdotally, at his Nobel Prize award ceremony, Harry Markowitz mentioned that when he defended his dissertation at the University of Chicago, Milton Friedman remarked that he could not be awarded a doctorate in economics, since the dissertation did not deal with econom-ics….4 The joke (?) presumably echoed a sentiment shared by others at the time There has been much progress since, and in recent years, there has been a renewed interest in financial economics, resulting in a growing and valuable amount of research in the field, which is yet to fully percolate to the realm of conventional macroeconomics

Despite important advances in method, the buildup of ever more prehensive databases and the explosive growth in econometric studies, no major paradigm changes have taken place in the past few decades While during that time there have been many valuable contributions to macro-economic theory, I have an uneasy sense that increasingly efforts have been directed at topics of marginal value; the law of diminishing returns seems to

com-be applying itself with a vengeance to the development of economic theory.Many economists appear to share this view, as evidenced in an article

published in the American Economic Review a few years ago, which was

commissioned by the journal to celebrate its 100th anniversary Six nent economists5 were assigned the task of identifying the “Top 20” arti-cles published in that journal, and the list that they put together includes only one published within the most recent 30 years,6 while four had been published 50 or more years ago!

promi-A quick review of some of the textbooks now being used shows that present thinking emphasizes “pure theory” and is heavily biased toward mathematical economics, which is a useful tool but of limited value to respond to the questions that are central to our time Or, to use Mrs Robinson’s words:

the orthodox economists have been much preoccupied with elegant elaborations

of minor problems, which distract the attention of their pupils from the genial realities of the modern world….7

uncon-This led Hyman Minsky, a monetary economist concerned with economic fluctuations, to the conclusion that8

the economic theory that is taught… – the intellectual basis of economic policy

in capitalist democracies – is seriously flawed… The model does not deal with time, money, uncertainty, financing of ownership of capital assets, and invest- ment… The Wall Streets of this world are important; they generate destabiliz- ing forces, and from time to time the financial processes of our economy lead to serious threats of financial and economic instability…

Minsky sought to reformulate the theory that he was questioning Though

he deserves credit for posing the difficult questions and made some ress toward addressing them, much of the challenge remains ahead This book is a modest attempt in that direction

Today, financial transfers across borders are easy to carry out and respond

in real time to developments everywhere Hence, economists and cians not only need to abandon the facile assumption that it is possible to develop economic policies for a country largely in isolation from what is taking place outside its borders; they must also work harder to coordinate policies between countries

politi-At present, the accumulated amounts of liquid savings that can move across borders have grown to such a level that, in many cases, currency runs cannot be readily offset by monetary authorities, adding volatility to exchange rates, potentially weakening their relationship to “real” variables

in the short run

Economists need to shed their aversion to policies designed to constrain short-term financial flows, and new instruments need to be enhanced or developed to implement such policies, while preserving as much as pos-sible the benefits of a substantially open economy

lookIng at the Past, But FocusIng on the Future

Economics needs to regularly address emerging issues and respond to the challenges posed by a changing environment Mercantilism, classical eco-nomics, neoclassical economics and Keynesian economics responded to the questions that appeared critical at their time Mercantilism helped to

develop policies to strengthen the nation-state Classical economics pated the growth potential to be unleashed by the Industrial Revolution and enabled the expansion of free enterprise and international trade that would usher the modern era Neoclassical economics provided a strong case for a market economy by showing that it enabled efficient resource allocation Keynes provided us the tools to understand the problem of unemployment and the actions necessary to address it while preserving the institutions of a market economy, and Friedman reminded us of the linkage between money and inflation The economic progress of the past two centuries can be partly ascribed to this capacity of economic thinking

antici-to adapt antici-to changing external conditions

Yet there is also a sense that over the past few decades, much of nomic thinking has isolated itself from its environment Economics has largely displaced political economy, generally regarded by today’s econo-mists as the eccentric aunt who is no longer mentioned in polite society and who ought to be prudently confined to the attic As a result, the con-nection between theory and reality has been weakened Theoretical rigor

eco-is important, but relevance eco-is even more

By 2016, the curtain had closed on the Great Recession of 2007–2008 (or, as pessimists may argue, on Act I) However, at the time there were reasons to be concerned with the slow recovery of corporate investments

in the USA, as well as with the high degree of unemployment that still prevailed in much of the EU and the high level of debt faced by several of its member countries, which constrains their ability to rely on expansion-ary policies to stimulate economic growth Meanwhile, the slowdown that was being experienced by China and Brazil, low oil and other commodity prices, and the high levels of internal debt in China, and of external debt

in many developing countries (which sought to take advantage of the vailing low interest environment), feed further concerns about the not too distant future

pre-Further fueling uncertainty, in June 2016, a referendum in UK called for exiting the EU (Brexit), a complex divorce that may take two years to

be finalized and which will have economic, and financial sector tions that will depend on the course of negotiations that have not yet formally started

implica-As if this range of problems were not enough, the future awaits us with others, some of which may be subject to a similar type of analysis as the one presented here, even though we may not have yet fully fathomed their magnitude or implications

The limited success of ongoing attempts to use monetary policy as an instrument to promote economic growth shows that governments need

to make use of a broader range of policy instruments, particularly fiscal policy; central bankers deserve credit for effort but monetary policy on its own cannot be expected to address all the problems that are being faced

A price will be paid if political factors stand in the way of policy flexibility

to address prevailing concerns, and that price will ultimately reflect itself

in lower welfare for the population as a whole

There is a concern that the monetary policies implemented to cope with the consequences of the recession may have unduly inflated share and bond prices and steered too many funds toward questionable invest-ments, including junk bonds and risky consumer loans Pension funds are facing the consequences of very low interest rates, and in some cases have decided to engage in riskier financial investments to earn an acceptable rate

of return Meanwhile, many financial institutions impress as still vulnerable and dependent on short-term borrowing, and tighter regulation of com-mercial banks risks driving more financial business to the shadow- banking sector, somewhat less in the shadows than before Dodd-Frank but still not

as thoroughly regulated and supervised as the commercial banking sector

It appears likely that present unhappiness with the failure of ments to stem the deterioration in income distribution that we witnessed

govern-in recent years will contgovern-inue to build up, leadgovern-ing to govern-increased political polarization and uncertainty about the course of economic policy The rhetoric during the 2016 presidential campaign suggests that the discon-tent underlying these trends, which also reflects the relative decline of the manufacturing sector of the USA (in part due to globalization), could lead the USA toward protectionism, reminding us of the Smoot-Hawley Tariff Act of 1930 and its impact on trade.9

The deterioration in income distribution is linked to other troubling trends, such as the practice of many corporate boards, dominated by insid-ers, to set executive compensations at levels which in many cases have reached values that are impossible to justify, as well as the custom in the financial sector to provide a substantial proportion of the remuneration of key operatives and executives in the form of bonuses, often linked to the results achieved during the year (thus encouraging a focus on short-term results) These groups (senior executives and financial sector managers) have seen their share of income and wealth rise substantially in the past few decades, at a time when the vast majority of workers have witnessed very limited gains, if any

In addition to the issues that are discussed in the pages of the daily media, there are others of a long-term nature that are building up pres-sures that will require the development of suitable policy responses.Demographic trends and progress in medicine are expected to con-tinue, resulting in an aging population structure in the developed and most of the developing world, and this will require savings to continue to steadily grow to enable a growing elderly population to support itself after retirement Consequently, an important policy challenge will be to protect savings and their earning capacity from wide swings in value, as this would have an important impact on the elderly.

At the same time, two related concerns arise: (a) as the labor force becomes a smaller proportion of the total population (because the spike caused by the incorporation of women to the labor market is largely behind us, and also because younger people spend more time studying before entering the market at the same time as life expectancies con-tinue to increase), will productivity continue to increase fast enough to offset these impacts and enable per capita incomes to continue to rise

as they did in the past?, and (b) will investment opportunities become available at the same pace as savings increase, or will excessive savings become a recessionary force that will need to be offset by government spending?

Climate change looms as a major concern that will only increase in importance as time passes; it will inevitably require governments to invest

in infrastructure to ameliorate its impact much more than they are doing

at present, and additional policy actions will need to be taken to conserve energy and reduce carbon emissions; in both cases, fiscal policy will need

to play an important role

We would be nạve to think that with this short list we have exhausted the issues that economic theory will need to address and there are oth-ers, such as the vulnerability of the financial sector to cyberattacks, which lie outside the traditional domain of economic analysis, but which pose

a concern about their potentially devastating impact Furthermore, with time, new challenges that we cannot identify today will develop and economic theory will need to periodically revisit its assumptions and mod-els to ensure that they remain relevant

This book does not explore these other important issues and is focused

on how we can develop a better understanding of our economic ment to help us to avoid repeats of financial crises, such as the one expe-rienced in 2007–2008

environ-What the Book Is aBout

The book advances four related arguments:

(a) The past century has witnessed an impressive growth in privately owned wealth, a large share of which is represented by financial assets As a result, the financial sector has become much more important within the economy Despite this, macroeconomic mod-els typically leave out an important part of all financial activity and limit themselves to the money market (which is but a segment of the financial sector, and does not capture what is happening else-where), and as a result, their explanatory power has been eroded (b) The growth of the financial sector has been accompanied as well by changes within it, in particular, the development of “shadow bank-ing” (intermediaries that compete with commercial banks in some

of their markets but are not subject to the same level of regulation and supervision), which puts into question the focus of Central Bank policy on the stock of money and on commercial banks (c) Despite a better understanding of issues of risk and uncertainty than a few decades ago, our grasp of the factors driving microeco-nomic decisions has not been well integrated to our thinking about macroeconomic policy, and conventional macroeconomic models still fail to adequately come to grips with these factors

(d) The short-term approach implicit in most macroeconomic models, which focus on how some key aggregate flow variables, such as income, consumption and investment, come into equilibrium, is inadequate This is because long-run equilibrium also requires that the composition of the balance sheets of households, firms and financial intermediaries be optimal If these balance sheets are over (or under) leveraged, or if they include too many (or too few) risky assets, then these actors will take actions to bring them to their desired levels, and in some cases, these adjustments can be suffi-ciently large to have important impacts on the real sector

Is thIs Book For you?

Many of the findings and conclusions presented in this book are rooted in

a growing body of literature examining the causes of the Great Recession and the policies that were implemented to deal with it Some of these

studies explore what should be done to strengthen the resiliency of the financial sector and the economy in general, to try to avoid major reces-sions in the future The book starts with a review of the factors at play prior to and during the collapse of the housing markets during 2007 and beyond, and then discusses the policy responses that followed the financial crisis and its aftermaths It argues that changes in the financial sector con-tributed to the onset of the Great Recession and helped to account for its severity, so it proceeds to describe these changes.

The book also argues that economic models failed to take into account the changes that had taken place in the financial sector in recent years, which helps to explain why policymakers were caught off guard when the Great Recession happened Against this context, the book argues that in today’s environment perceptions of risk, driven by uncertainty, have a much more significant on the financial sector, and consequently on the economy, than they did in the past For this reason, the book also exam-ines how risk and uncertainty affect economic decision making

While the book probably falls short of coming up with all the answers,

I hope that I was able to focus its readers on the important questions that policymakers will be facing in our time, and will spur the interests of some who will continue to investigate these topics and to test the hypotheses that it poses This is still a challenge, as the financial sector has been chang-ing so quickly that we do not have enough reliable data to enable much econometric work

Trained economists may feel withdrawal symptoms at the lack of tions and graphs, which largely responds to my wish to reach a broad audi-ence Having dabbled in econometrics and subjected my students to torture

equa-by mathematics earlier in my career, I now consider that, equa-by and large, mathematical models should be limited to serve two principal purposes: first, as a pedagogical tool to help students to understand basic principles

or, second, to develop stylized models that enable their users to examine with rigor the ultimate implications of some of the assumptions that econo-mists may adopt Beyond these objectives, however, such models may steer

us toward simplistic representations of reality, which can provide a ing sense of precision when we are trying to understand the workings of

mislead-an economic system On the other hmislead-and, seeking to integrate context mislead-and historical background to the analysis of economic reality can enable us to bring to life characteristics that mathematical models often miss

I hope that most will find that plain English goes a long way toward providing a coherent argument and to the extent that it falls short, I am afraid, that the fault lies with me and not with language

1 Greenspan, Alan “Why I Didn’t See the Crisis Coming”, Foreign

Affairs, November/December 2013, pp. 88–96.

2 Cf.: Campbell, J “Restoring Rational Choice: The Challenge of

Consumer Financial Regulation”, The American Economic Review,

May 2016, p. 5

3 In this regard, Jean Tirole’s “textbook” on corporate finance deserves a special mention, as the approach he pursues is largely indistinguishable from that of conventional microeconomics, and the many references that he provides come more from books and articles by economists than from the more conventional literature

on finance Cf.: Tirole, Jean, The Theory of Corporate Finance

Princeton: Princeton University Press, 2005

4 Markowitz wrote on portfolio selection and the article through which he introduced his approach was originally published in the

Journal of Finance.

5 American Economic Review, February 2011 The panel was

inte-grated by Kenneth Arrow, Douglas Bernheim, Martin Feldstein, Daniel McFadden, James Poterba and Robert Solow

6 An article written in 1981 by R. Schiller, “Do Stock Prices Move Too

Much to Be Justified by Subsequent Changes in Dividends?”

7 Robinson, Joan An Essay on Marxian Economics London:

Macmillan and Co., 1964, p. 2

8 Minsky, Hyman Stabilizing an Unstable Economy New York: Mc

Graw Hill, 2008, p. 4

9 This legislation was approved in 1930 It is named after the two Republican legislators who promoted it By levying taxes on US imports, it resulted in retaliatory actions from most trading part-ners, resulting in a reduction not just in imports but alsoin exports When it was being considered by Congress, over 1000 US econo-mists, including Irving Fisher, asked President Hoover to veto the bill However, this did not happen and Bernanke, who studied the Depression in depth, has argued that it increased its severity Looking back, it appears that the tariff increases under the law were not that significant and that the most negative consequence was its impact on international economic relations, shifting the position of the USA

on trade issues from promoting free trade toward protectionism

Crisis!

© The Author(s) 2017

R.A Halperin, The Influence of Uncertainty in a Changing

Financial Environment, DOI 10.1007/978-3-319-48778-6_2

The Great Recession of 2007–2008

By 2007 most people believed that the Great Depression belonged in the history books, and in prior years some economists had argued that we had the knowledge and the tools to ensure that a repeat incident could not happen.1 Yet, to some degree, in 2007 some of those weaknesses that John Galbraith found present in 19292 were still there, and the fear of a major Depression soon awoke

Until 1998 real estate prices had been increasing a little more than inflation, but not by much, but by 1998 the rises started to accelerate, averaging about 7% nationwide; the next year they went up again to over 8%, then almost 10% in the year 2000, continuing at roughly that pace until 2004 when they further accelerated to almost 15%, repeating that gain the following year Of course, these national averages hide the fact that some regions experienced much larger increases

Then, in late 2006, housing markets started a free fall that lasted for several years, causing many financial intermediaries with a significant stake

in those markets to run into serious trouble These developments cascaded throughout the financial sector and eventually the economy, causing a drop

in output and an important increase in unemployment They triggered a massive policy response from the government and the Fed, which eventu-ally stemmed the downturn and caused the economy to slowly improve

The seeds of the recession had been planted well before 2007, when economic prospects looked bright Interest rates then were relatively low, providing an incentive to borrow At a time when the growth of incomes tended to concentrate in the most affluent sectors,3 the incentive to bor-row appears to have been strong among those with lower incomes, who may have regarded it as a low-risk strategy to enable them to eventually increase their wealth.

Abundant liquidity caused financial intermediaries seeking returns higher than those from more conventional investments to invest in mortgage- backed instruments that were heavily weighted with sub-prime mortgages This appetite was fed by mortgage originators who proceeded

to securitize mortgage loans and sell those securities at a pace not nessed before While securitization was not a new phenomenon, Tirole notes that between 1995 and 2006 the rate of securitization of housing loans increased from 30% to 81%.4

wit-All these factors were known and could be regarded as ingredients for the perfect storm Despite this, how did the crisis of 2007–2008 creep upon us, seemingly without warning? Or is it that policy makers failed to understand them—or chose to ignore them?

Akerlof and Shiller answered these questions by arguing that:

… so many members of the macroeconomics and finance profession have gone so

far in the direction of rational expectations and efficient markets that they fail

to consider the most important dynamics underlying economic crises Failing

to incorporate animal spirits into the model can blind us to the real sources of trouble.5

As I went through the literature, I realized that initially many tors, including some economists who had not been paying close atten-tion to developments in the financial sector, were not clear as to what had driven the preceding real estate boom, how significant its impact had been, and why it had come to an end bringing the financial sector so close to collapse Eventually, however, a good understanding developed

commenta-on what had happened

What originated the rise in housing prices that preceded the Great Recession? Several factors appear to have played a role, starting in sev-eral foreign countries (led by China) where savings well in excess of their domestic investment needs caused them to look elsewhere for investment opportunities With interest rates low worldwide, financing real estate

purchases in the USA through mortgage lending impressed as a seemingly safe choice providing good returns, and this perspective gained traction when financial wizards developed the instruments to handle the default concerns associated to individual mortgage loans by slicing them and packaging the slices in “mortgage portfolios” against which they issued securities, arguing that they were substantially mitigating risks through diversification.

A second contributing factor was the widely held view among the population at large that investing in housing is always a sound long-run choice In addition, mortgage interest is tax deductible while rent pay-ments are not, which makes the option of purchasing more attractive than renting In addition, there was a sense that an aging population would cause increased demand for land and housing in states with warmer cli-mates, which would result in rising land prices, in turn providing an incen-tive to purchase homes in those parts of the country

Finally, the behavior of mortgage originators contributed: they oped new mortgage instruments that required less cash from home pur-chasers for the down payment than conventional mortgages and helped to relax lending standards and the qualifying criteria to obtain a loan Many housing purchasers could not qualify for a conventional mortgage and did not fully understand the potential risks of real estate investments Were it not for the relaxation in lending standards that took place to accommo-date the supply of funds available, they would not have been able to carry out those housing purchases

devel-The combination of relaxed lending standards and securitization proved lethal: mortgage originators sold off mortgage-backed securities to inves-tors, thus divesting themselves of risk The more they lent, the more they profited Meanwhile, most of the purchasers of mortgage-backed securi-ties typically were not commercial banks but other financial intermediaries

as well as foreign investors, seduced by the higher yields and apparent lower risks of these securities To add fuel to the forthcoming fire, some financial intermediaries (such as AIG) were willing to engage in credit default swaps (CDS), which insured mortgage-backed securities from the risk of default That is the heart of the story, for when problems started to develop in the housing market and borrowers started to default, the hous-ing sector crisis became a financial sector crisis

Initially, I was influenced by Stiglitz, who argued that the potential for

a crisis went largely unnoticed partly due to failings in economic models

He wrote6:

But economists (and their models) also bear responsibility for the crisis Flawed monetary and regulatory policies were guided by economists’ models, and the dominant models failed to predict the crisis … One of the reasons for the failures

of those models was their inadequate modeling of the credit markets (banks and shadow banks) …

When the bubble burst, many financial intermediaries, particularly in the shadow banking sector, faced the double punch of portfolio losses and loss of access to funding, and their struggle to stay afloat resulted in wide-spread concerns about the health of the financial system in general and loss

of public trust in its executives and their integrity

An interesting perspective was recently advanced by Mian and Sufi.7They do not challenge the view that many financial intermediaries exposed themselves to excessive levels of risk, which eventually led to a loss of con-fidence and curtailed access to funding, leading to fire-sale losses and even-tually the now infamous bailouts or, in some cases, bankruptcy However, Mian and Sufi also show that excessively leveraged households (they point out that the household debt to income ratio rose from 1.4 to 2.1 in the period going from 2000 to 20078), which may have purchased a house enticed by the very low monthly payments that many of the mortgage instruments available initially required them to pay (possibly in the expec-tation that they could sell at a profit in a short time), could not stand the reversals in real estate price increases that started late in 2006

Under this interpretation, the financial sector debacle was the second act of a tragedy that started in the real sector of the economy They point that the National Bureau of Economic Research (NBER) has dated the beginning of the recession to the fourth quarter of 2007, by which time real estate prices had been dropping for about a year

This reading ought to be complemented with the following tion by Eichner, Kohn and Palumbo9:

observa-… the years leading up to the financial crisis and recession were characterized

by an increase in net investment by the US household sector that was funded by borrowing rather than saving The household sector’s shift from its role from the 1960s through the 1990s as a net funding source for other sectors’ investment to

a net borrowing position is something that appears to have been unprecedented

in the US postwar period

In his memoirs, Bernanke tells us that the Fed was well aware of ments in the housing markets, which it monitored However, the potential

develop-for a major financial meltdown was underestimated until it was too late, and this may be in part because the shadow banking system did not get from the Fed the attention it deserved.

Geithner also confirms that by the summer of 2007, the Fed had become concerned about the course of the economy and points to the failure of Countrywide (a large mortgage originator) that took place in August 2007 as the starting event of the financial debacle.10 In a more recent speech, Stanley Fischer points to even earlier indications of trouble

in the financial sector, going to late 2006 and culminating in the failure

of Ownit Mortgage Solutions, a large sub-prime mortgage originator, in December of that year.11

Reading Bernanke and Geithner’s memoirs, one gets the sense that the Fed did have timely information on many important developments in the real as well as in the financial sector but failed to adequately interpret it until it was too late It may be that they were too close to the trees to be able to see the forest, and it does appear that still in 2007 concerns about inflation (which had been a perennial problem ever since the 1950s) were

in the minds of some decision makers “Group-thinking”, perhaps just as much as models, may account for this

On the other hand, the data then available on operations in the shadow banking system12 was sketchy, and even the Fed was dealing with frag-mentary information, a shortcoming that appears to have not been fully resolved to this day

While, in hindsight, what took place in 2008 was qualitatively similar to the financial bubbles that the world saw in the past,13 there were also some differences arising from the increased importance achieved in recent times

by the financial sector, reflected in the larger share of financial holdings in households’ wealth, and from the role played by the shadow banking sys-tem At the time, the increased importance of the shadow banking system, highly leveraged and dependent on short-term funding was not recog-nized by macroeconomic practitioners, who failed to capture its activities

in their models

the evolvIng nature of rIsks

Before the Industrial Revolution, households faced risks that largely inated outside the economic system, such as wars, theft, poor weather, fire, and epidemics Money consisted of gold and silver coins, which families held in their homes facing the risk of robbery, and the notion of

orig-“hiding it under the mattress” dates back to these times Counterfeiting and coin- shaving occurred often, sometimes leading people to weigh the coins that they received in payment to verify that they had not been tampered.

The wealth of most households was very small and at best consisted of their home and furnishings, tools and cattle The wealth of the rich was largely invested in their lands and buildings, as well as in precious metals, art and jewels Industry, as we now know it, did not exist; but there were artisans and tradesmen, who mostly resided in towns and villages In some cases, states did issue bonds, typically to help finance their wars, and these were force-fed to the rich and the few banks around, which were privately owned and had a limited customer base

As the economic system became more diversified and complex, new risks developed and many originated within the system itself Expectations

of large gains drove speculative ventures, such as the South Sea bubble in

1720, which happened from time to time as improvements in navigation gave rise to business opportunities, opening new markets and allowing access to valuable foreign products

The development of banking was an important supporting factor for the growth of the business sector subsequent to the Industrial Revolution but it also gave rise to other risks, those associated to the potential losses that depositors would face when a bank went under, and during the nine-teenth and early twentieth centuries, bank runs occurred from time to time throughout the developed world Stock markets and the develop-ment of new forms of financial intermediation, as well as new financial instruments further expanded the range of investment opportunities, and also of risks, that households and firms faced, at the same time that the expansion of the insurance industry helped to provide protection against other risks

In 1952, American economist Harry Markowitz wrote a seminal article

on what would become the theory of portfolio selection Whereas until then the conventional wisdom had focused on profit maximization as the driving force behind financial investment decisions, Markowitz (who focused on the stock market) argued that this perspective was too narrow and that those decisions were driven by dual goals: the search for returns but also the wish to contain risks But, how do you measure those risks? Markowitz argued that the history of fluctuations in the price of a security provided a measure of how likely it was that it could fall in value in the future Moreover, he went on, the behavior over time of all securities was

not perfectly correlated, so it was possible to design a portfolio of ties that was less risky than its individual components.

securi-Fast forward a few decades, add computers, some important fications (in particular those associated to the contributions of William Sharpe), and you find an industry of experts that help institutions of all sorts to manage their portfolios largely taking Markowitz’ approach into account

simpli-And then, something happened: in 1987 a very large hedge fund, which was established by two economists who earned the Nobel Prize for their work on option pricing, Robert Merton and Myron Scholes, went under The impact on the markets was so severe that the Federal Reserve felt the need to intervene by organizing a bailout, but despite this the shock of this event caused a recession How could these accomplished economists have misjudged so badly the risks to which their institution was exposed? Benoit Mandelbrot was a mathematician who was prone to follow the path less trod-den and he felt that he had found the answer: economists were modeling risk incorrectly by underestimating the likelihood of major falls in prices.14

In the past few decades a new concern has arisen, that of major short- term swings in financial markets arising from the ways in which markets now operate: many institutional investors have programmed to respond automatically to changes in market indicators in a similar way, poten-tially causing over-reactions when one of the markets many veils happens

to drop, and these reactions can snowball into panics Many years ago, Keynes had written about the animal spirits that tend to govern market sentiments, and later Paul Krugman referred to the “bandwagon effect”;

by 2007, this effect had largely become automatized!

The issue has acquired even more importance because financial balization has enabled very large financial flows across most national bor-ders Many of these flows are of a short-term nature and highly sensitive

glo-to changes in the political environment and glo-to macroeconomic ments worldwide coupled with widespread access to information in real time, this causes markets to respond faster and with greater intensity to changes in expectations and to uncertainty in specific countries

develop-the great recessIon

At the time of the housing and mortgage boom in the USA, in the early years of the millennium, many European financial intermediaries were also investing in securities backed by sub-prime mortgages issued in the USA

www.allitebooks.com

as well as in Ireland, Spain and other EU countries (with the notable exception of Germany15); this development did not receive much atten-tion within the USA until the bubble burst Many financial institutions outside the USA also faced problems when the sub-prime crisis happened,

as their mortgage holdings lost value, and this caused concerns about a worldwide financial crisis An international crisis is much more difficult for national authorities to contain, much less reverse, and it led to a wide-spread scramble to protect financial assets from meltdown

Financial intermediaries holding mortgage-backed securities, or ing positions on mortgage-related derivatives, were relying on short-term funding, particularly “repos” (repurchase agreements, under which the

tak-“loan” is structured as a security sale combined with the obligation to repurchase the same security the next day, presumably posing no risk to the “lender”) Despite the apparent safety of the instrument, the drop in real estate prices raised creditworthiness concerns and caused their funding sources to dry up The fact that this was also happening in other countries bolsters the argument that an abundant supply of funds and low interest rates had been an important driver of the boom, while local considerations (such as the role played by Fannie Mae and Freddy Mac in the US mort-gage market) were not so significant as some have argued

Financial wizards sold the idea that they had developed the perfect solution to address the perceived risks of sub-prime mortgages (which, by definition, are loans to poorer households that are less likely to be able to stand a reversal in their financial fortunes): they sliced the sub-prime mort-gages and then bundled the slices of many different operations as backing for securities that they placed with financial intermediaries It was argued that this approach diluted risk, and furthermore, that it was possible to group the slices that would be expected to collect first in case of default

in “senior” tranches in such a way that those securities would, in theory, bear a much smaller likelihood of default than those in the junior tranches This approach might have been reasonable for a steady market However,

it failed miserably when the housing market collapsed Seemingly, the notion that the real estate market could be driven by speculative forces, eventually causing housing prices to drop significantly, triggering mort-gage defaults nationwide, was not considered plausible by the public or by the rating agencies

The rating agencies, unregulated and unsupervised, were paid by gage originators to rate the quality of the mortgage-backed instruments that they issued Not surprisingly, they obliged by rating them as bearing

mort-very little risk, thus encouraging their purchase by financial institutions that were assumed to be looking after the quality of their portfolios.

As we now know, real estate prices did fall significantly, causing gage defaults which would affect the solvency of several of the intermedi-aries holding the instruments backed by them and raising concerns about the health of the financial system as a whole

mort-Initially, however, liquidity was the primary concerns of the affected intermediaries, as funding ceased to be available to them The explanation may lie in the problem of “asymmetric information” that we associate with the work of Stiglitz The usual sources of funding could not be sure to what extent the mortgage-backed securities portfolios of the intermediar-ies to which they lent may have lost value, or were at risk of doing so, so their prudent reaction was to avoid taking chances and to withdraw from the market This was one of the triggers of the crisis The institutions hit the hardest were not commercial banks but those intermediaries in the shadow banking system, including the insurance behemoth AIG, that were heavily invested in derivatives We will discuss this again later

a house of cards?

At the same time, outside the Fed a few seasoned economists that paid attention to market developments were able to figure out that something was amiss; however, when they spoke out they were largely ignored and in some cases almost treated as quacks

One of those to wave a warning flag that was noticed was Robert Shiller, who went on to win the Nobel Prize in 2013 Shiller is a financial economist, at the time already known to the general public for the widely used Case-Shiller index of housing prices,16 as well as for a bestselling

book Irrational Exuberance In the second edition of this work, published

in 2005 (as well as in some earlier statements) Shiller, who had already warned about the stock market bubble, discussed the bubble in hous-ing prices that had started in the late nineties and had heavily impacted selected regions of the country He mentioned then the now infamous

“Greenspan put”17 as one of the factors that drove the house pricing ble.18 Had his concerns been taken into account then, the Fed might have taken action to curb the excesses that eventually led to the financial crisis (in 2005 Shiller had argued for a “gently tighter” monetary policy).Another one was Raghuram Rajan, a respected University of Chicago professor and a former chief economist at the International Monetary

bub-Fund (IMF) Rajan, who years later was appointed to head India’s Central Bank, raised a number of troubling questions at a 2005 meeting hosted by the Federal Reserve Bank of Kansas City, attended by then Fed Chairman Alan Greenspan as well as by Larry Summers, who had been Treasury sec-retary for President Clinton At that time, Rajan noted that the structure

of the financial system had changed as a result of the appearance of new players, which were not closely regulated and had partially displaced tra-ditional commercial banks He argued that this development posed risks that needed to be addressed, as the managers of these institutions were faced with incentives that encouraged excessive risk taking, in particular

“tail risks” (risks hidden from customers which entail a potential for large losses), and tended to incur in “herd behavior” (going with prevailing trends) He also questioned whether banks would be in a position to pro-vide liquidity support if and when needed, given the increasingly large amounts that could be needed in a downturn

Rajan’s warnings19 impress today as remarkably prescient and reflected

a very clear understanding of some of the key issues that had to be faced after the crisis; however, in 2005 they were dismissed as excessive pessi-mism that missed the big picture

Nouriel Roubini’s warnings, delivered in 2006 and 2007 to an IMF audience,20 suffered the same fate as Rajan’s, though by 2007 some of the damage had already surfaced, and he was addressing an audience more receptive to his analysis (which provided a much better understand-ing of how the financial markets were operating at the time than what was available in the financial media) Roubini taught at the University of New York, which hosts some of the best economists working on financial markets

The question facing everyone then was the extent to which the turmoil

in the financial sector would affect the real sector and the degree to which

a recession in the USA would affect other economies Yet, at the time Roubini (aka Dr Doom) failed to note the extent to which the financial markets in Europe had followed the pattern of the USA, resulting in sub- prime bubbles that also burst at the same time; in other words, he was not pessimistic enough

Greenspan’s failure to see the crisis coming may have been influenced by the fact that the main forecasting instrument used by the Federal Reserve

is a model21 that pays limited attention to the financial sector, ignores the growing importance of the “shadow banking” system and does not relate increases in private sector debt to other developments in the economy

Regardless of whether it is possible to formulate models that are cantly better than the ones available now, in his reference to the obsolete models in use Stiglitz did—and does—have an important point, which is that economics has not yet been able to develop a theoretical framework,

signifi-if not a model, that enables us to keep in our sights the linkage between financial markets, uncertainty, and the real sector and to distinguish speculative booms from developments that are justified by a fundamental change in prevailing conditions Keynes had very much in mind these link-ages when he wrote about “animal spirits” but, other than through the introduction of a “speculative motive” for the demand for money, and for

a penetrating analysis of the factors driving investment decisions in the real sector, he did not formally incorporate them to his model of how the economy operates

After the 2007–2008 recession happened, with the benefits of hindsight many pundits would say that it was an inevitable consequence of a sub- prime mortgage boom, encouraged by loose regulation and poor enforce-ment, and/or by greed Others sought to blame the Clinton and Bush administrations for leaning on Fannie Mae and Freddie Mac, two privately owned firms which securitize mortgages and issue mortgage-backed secu-rities, to help to expand access to housing by the lower-income segments

of the population These two firms operated with a very high leverage but enjoyed excellent credit ratings because of their special status as government- sponsored enterprises (GSEs), which the market interpreted as an indication that if they ran into trouble the government would stand behind them; an interpretation that was eventually proved correct during the crisis

Though it is clear that the GSEs helped to attract funding to the gage sector, hence contributing to the boom, the argument that they held

mort-a primmort-ary responsibility for it is not consistent with the fmort-act thmort-at similmort-ar real estate booms were experienced in several European countries that lack such institutions

Others have argued that the financial debacle in the United States mately was a consequence of much deeper problems: weak fiscal discipline that resulted in major macroeconomic imbalances, masked by easy money policies that discouraged private savings and encouraged excessive reliance

ulti-on debt

Some economists22 have argued that ad hoc explanations are off the mark; what we witnessed was an old-fashioned price bubble for real estate, not that different in its essence from the tulip bubble that took place in Amsterdam in the late 1600s In both cases, elements of irrational behavior

were present; while this view is not inconsistent with the lax easy monetary policy perspective, which may be regarded as the fuel that stoked the bub-ble, it places greater emphasis on the irrational behavior of the investing public, the “animal spirits” to which Keynes had referred.

A characteristic of the 2007–2008 recession was that it took place at a time when the public sector’s ability to finance large budget deficits by issu-ing debt was constrained by the high amounts of debt already outstanding

We will return to this issue later Meanwhile, the private sector was already heavily indebted and, in too many cases, as jobs were lost households found that they could not meet their financial obligations These “initial condi-tions” are sometimes omitted from reviews of the events of the period; in

my view this is an important omission, had they not been present the sion would have been milder and it would have been much easier for the government to rely on an expansionary fiscal policy to deal with it

It appeared that, in the case of both financial intermediaries and holds, reliance on credit to leverage23 own resources, so as to maximize profits from expected returns in real estate played an important part Uncertainty and risk aggravate the impact of leverage, as it results in increased volatility of income after debt service

house-Debt causes income after debt service to fluctuate more than gross income, thus exacerbating the potential magnitude of business fluctua-tions: in boom times, the burden of debt is more than proportionately lower, while the opposite occurs during recessions For these reasons, uncertainty about future economic developments implies that when debt

is high the severity of business fluctuations will be higher than would erwise be the case This is a relationship that is not often explored, despite its importance

oth-In the case of financial intermediaries, the risks posed by leverage are particularly high because not only do they operate with very little equity (that is what the controversy on capital requirements is all about) but also because they rely on short-term funding, which is particularly attractive as

it normally carries a lower rate of interest However, access to this ing can very quickly vanish if there is a concern (valid or not) about the solvency of the institution and its ability to meet its obligations

fund-As mentioned before, during the crisis of 2007–2008, those financial intermediaries that went under had been relying on overnight funding,

through “repos” When their short-term funding ceased to be available, those financial intermediaries, which hitherto had operated profitably, had

to fire-sale securities, and the ensuing losses turned their liquidity shortage

to a solvency problem With a small equity base, it did not take too many losses to wipe most of it out, threatening bankruptcy

Regulatory shortcomings enabled many financial intermediaries to carry investments in securities that bundled sub-prime mortgages off their books, so the potential downside risks of these investments were partially concealed This “clever” strategy would be an important reason why the ensuing panic would become so widespread and severe, it relates

to the issue of “asymmetric information” discussed by Stiglitz.24 Once it became known that a financial intermediary had established a “structured investment vehicle” (SIV: a wholly owned separate entity that relied on short- term funding to hold what in some cases turned out to be toxic assets), depositors and investors became concerned about the impact of its potential for losses on the holding company’s finances and eventually trust in financial intermediaries in general was undermined and there was

a panic run to safety

The practice of bundling sub-prime mortgages (issuing a security that was backed by a large number of small slices of many such loans, on the theory that—while a small number might indeed default—this helped to reduce the risk of significant losses overall) served another purpose: it was regarded by regulatory bodies as a sound practice; as we will see later this enabled the institutions carrying these securities to benefit from lower capital requirements, providing an incentive for their misbehavior

The growth in sub-prime mortgages was an important reason (but not the only one) for the rise in the private sector’s debt, which became a major problem when the downturn took place, as the sector’s capacity to ser-vice the newly acquired debts became impaired and housing prices (which started to fall in 2006) tumbled, leading many borrowers to default.Leverage works admirably when things go well but becomes a loaded weapon pointed at its users when markets go sour Participants in the financial orgy dismissed the overall risks of this investment strategy on the grounds that packaging many operations and securitizing enabled the spread of the risks on individual operations to a manageable level This view, correct as long as housing prices were rising, proved to be a colossal failure of judgment when speculators decided that it was time to abandon ship and those prices quickly collapsed If the risks on individual sub-prime mortgages were underestimated, and there is evidence in that regard, the

correlation of the risks, which should have been a concern for the event of

an economic contraction, received no attention

What happens durIng fInancIal crIses

As we will see next, it is hard to avoid concluding that many of the mentators at the time that these events were taking place were not fully familiar with the literature on financial crises and with the abundant mate-rial, both theoretical and empirical, on which my generation had been brought up If we review the literature on prior episodes of financial crises, including the Great Depression, you will find that there is still not a full consensus about the weight to be attached to the many contributing fac-tors that led to those downturns, to their duration and to their intensity However, what is clear is that these factors acted upon each other and upon collective expectations, reinforcing their individual impacts That was also the case in 2007–2008

com-Reinhart and Rogoff25 (R&R) had similar misgivings, as their scholarly

work titled This Time Is Different, which was published in 2009, is the

most serious attempt to address the knowledge gap by presenting a sive collection of statistical information, spanning a period of over nearly 8 centuries and covering 66 countries, on the incidence (and recurrence) of financial crises and the behavior of key indicators of major disequilibria, as well as a typology of crises

mas-Very aptly, their book is subtitled Eight Centuries of Financial Folly I

believe it identifies the fundamental factors that led to the Great Recession

of 2007 However, due to the time span it covers, it understandably deals with this one episode in a very summary form, it looks at the forest but does not spend much time on each of the trees If you are focused on the bottom line this is a merit, as it increases the sharpness of the main conclu-sion: “It was debt what did it”

In particular, while R&R discuss very thoroughly the role of the ing system in financial crises, they do not explore how the deregulation of banking that took place in the nineties, the growth of financial wealth, the development of derivatives and the appearance of an important shadow banking system contributed to the onset and to the severity of the Great Recession

bank-Many of the crises that R&R discuss in their whirlwind review of eight centuries of financial crises were sovereign crises, often originated in developing countries, arising from poor fiscal and monetary policies or

unrealistic exchange rate management At the same time, it should be noted that banks in the developed world often contributed to those sov-ereign crises, by making short-term loans when they thought that the economic environment was sound and scrambling to withdraw their funds when concerns arose Developing countries were regarded as any other market, and lending from the developed world was driven by an assess-ment of returns and risks and the banks’ confidence in their ability to play the game of musical chairs better than others It is the concentration of risks and the magnitude of the impact that led such lending practices to result in major financial crises The Latin American debt crisis of the 1980s, which culminated in Mexico’s default in 1983 (causing the US Treasury

to invent the “Brady bonds”), was essentially similar to the Baring crisis of

1890, which came about because of that British bank’s excessive exposure

to Argentine bonds

If risk-taking was the common denominator of sovereign crises, it was also behind other events that were domestic in nature One impor-tant example, which would later sway minds in Congress and cause it to approve legislation to establish a Federal Reserve System, was the financial panic of 1907 While the US economy had been exhibiting signs of weak-ness and a recession might have happened regardless of developments in the financial sector, the panic in late 1907 was triggered by an attempt

to corner the market for United Copper’s shares, which was thought to have been financially supported by a New York financial institution: the Knickerbocker Trust Company, a bank in all but name.26 The attempt went sour and lack of information caused the public to become concerned about the Knickerbocker’s financial health As the institution was very large, the concerns soon spread to the potential impact of its failure on other financial institutions that had business with it, and it eventually resulted in a bank run Paul Krugman would later remark that the parallel between the Great Recession of 2007–2008 and the panic of 1907 should

be obvious

Turning again to the Great Recession of 2007–2008, I believe that lack

of familiarity with the data, both of the past (which R&R provide) or of the present (because it was hidden from view), is not enough to explain why the crisis found so many economists off guard While we have to be grateful to Mian and Sufi for pointing out the extent to which households indebted themselves prior to the crisis and for their discussion of the role played by their high level of debt as a trigger and aggravating factor of the recession, that should not cause us to leave aside the role played by

financial intermediaries in the crisis In this regard, what appears to be missing from some comments and analyses of the times is a full grasp of a number of important recent developments in the financial sector world-wide and an up-to-date framework to objectively interpret the central messages arising from the data.27

Think of the world economy as a complex system in which individual countries are linked in a variety of ways, then the argument would be that presently there are more links, and that these are stronger, than a few decades ago (Bookstader has argued that innovation has led the financial markets to become more “tightly coupled”28) As a result of this, an initial shock has the potential to be propagated and amplified with a broader and stronger impact The economic models on which we tend to rely fail to reflect this important characteristic of today’s environment

Starting in the seventies and strengthening in the eighties, a wave of opments took place in the world of finance: new institutions cropped up and new ways of doing business came into being The old banker stereo-type who made his credit decisions by looking at a prospective borrower

devel-in the eye to assess his character faded away to be gradually replaced by financial alchemists that relied on mathematical steroids to generate high returns, all the while arguing that they did so without incurring risks

In a world in which hedge funds bragged about annual returns well in excess of 20%, what was to distrust in Charlie Madoff’s business model that generously enabled a select few from the public at large to share in the spoils?

Seemingly forgotten were the lessons of the Great Depression that John Kenneth Galbraith illustrated vividly in his entertaining account of the period,29 as well as the work of Charles Kindleberger, whose history

of financial crises (primarily in Europe and the USA)30 to this day remains

a must-read for anyone interested in gaining a broader perspective on how these were shaped, and how governments responded to them in the past

Financial globalization was initially expected to help steer investment funds toward those countries that offered the best prospects for growth

as well as a safe investment environment, an expectation which proved,

at best, to be nạve In fact, it appears to have enhanced the volatility of financial flows, jeopardizing the capacity of domestic authorities to exer-

cise adequate control over their respective economies Most of the funds have gone not to the developing world but to the developed economies, and the savings drought in the USA was more than fully offset by the sav-ings surplus in the developing world, particularly China These fund flows helped to fuel the financial boom that preceded the crisis of 2007–2008.

While the ability of investors to respond to market developments in almost real time continued to increase since Corrigan’s assessment, a new set of instruments (derivatives) developed, the markets for which exploded in volume.32 However, derivatives largely evaded public scrutiny and super-visory presence in that sector was irrelevant (a prescient concern raised by Corrigan in the aforementioned article) In fact, the Commodity Futures Modernization Act of 2000 specifically exempted derivatives from regula-tion As the recession showed, this could cause, and did cause, unpleasant surprises that had widespread spillover impacts.33

Some economists have questioned the low interest rate policies sued by the Fed during the years preceding the Great Recession, arguing that they were an important contributing factor to its onset.34 Yet, when reviewing those policies one should remember that starting in 2001 the rate of unemployment, which had then reached a low of about 4%, had started to rise and by 2003 it stood at about 6% In those years, infla-tion (as measured by the cost of living index) was low and barely rose only above 3% in 2005 and 2006 This evolution makes the interest rate policies of the time consistent with the Fed’s key policy objectives (of low unemployment and inflation), which have been set by law It was not until the end of 2006/early 2007 that the unemployment rate dropped close

pur-to 4% only pur-to rise again soon, as should be expected, under the impact of the Great Recession