Baseline Scenario, 11/10/08

Baseline Scenario, November 10, 2008
By Peter Boone, Simon Johnson, and James Kwak, copyright of the authors

The Baseline Scenario is our periodic overview of the current state of the global economy and our policy proposals. It includes two sections:

  1. Analysis of the current situation and how we got here
  2. Policy proposals

Please note that we do not currently publish our upside and downside risk scenarios in detail.


The roots of the crisis

For at least the last year and a half, as banks took successive writedowns related to deteriorating mortgage-backed securities, the conventional wisdom was that we were facing a crisis of bank solvency triggered by falling housing prices and magnified by leverage. However, falling housing prices and high leverage alone would not necessarily have created the situation we are now in.

The problems in the U.S. housing market were not themselves big enough to generate the current financial crisis. America’s housing stock, at its peak, was estimated to be worth $23 trillion.  A 25% decline in the value of housing would generate a paper loss of $5.75 trillion. With an estimated 1-3% of housing wealth gains going into consumption, this could generate a $60-180 billion reduction in total consumption – a modest amount compared to US GDP of $15 trillion. We should have seen a serious impact on consumption, but, there was no a priori reason to believe we were embarking on a crisis of the current scale.

Leverage did increase the riskiness of the system, but did not by itself turn a housing downturn into a global financial crisis. There is no basis on which to say banks were too leveraged in one year but were safe the year before; how leveraged a bank can be depends on many factors, most notably the nature and duration of its assets and liabilities. In the economy at large, credit relative to incomes has been growing over the last 50 years, and even assuming that credit was overextended, today’s crisis was not a foregone conclusion.

There are two possible paths to resolution for an excess of credit. The first is an orderly reduction in credit through decisions by institutions and individuals to reduce borrowing, cut lending, and raise underlying capital. This can occur without much harm to the economy over many years. The second path is more dangerous.  If creditors make abrupt decisions to withdraw funds, borrowers will be forced to scramble to raise funds, leading to major, abrupt changes in liquidity and asset prices.  These credit panics can be self-fulfilling; fears that assets will fall in value can lead directly to falls in their value.

A crisis of confidence

We have seen a similar crisis at least once in recent times: the crisis that hit emerging markets in 1997 and 1998.  For countries then, read banks (or markets) today.  In both cases, a crisis of confidence among short-term creditors caused them to pull out their money, leaving institutions with illiquid long-term assets in the lurch.

The crisis started in June 1997 in Thailand, where a speculative attack on the currency caused a devaluation, creating fears that large foreign currency debt in the private sector would lead to bankruptcies and recession.  Investors almost instantly withdrew funds and cut off credit to Malaysia, Indonesia and the Philippines under the assumption that they were guilty by proximity. All these countries lost access to foreign credit and saw runs on their reserves.  Their currencies fell sharply and their creditors suffered major losses.

From there, the contagion spread for no apparent reason to South Korea – which had little exposure to Southeast Asian currencies – and then to Russia. Russia also had little exposure to Asia. However, Russia was funding deficits through short-term ruble bonds, many of which were held by foreign investors. When short-term creditors panicked, the government and the IMF could not prevent a devaluation (and a default on those ruble bonds). GDP fell 10% the following year. After Russia, the story repeated itself in Brazil. In January 1999 Brazil let the currency float, leading to a sharp depreciation within one month.

In each case, creditors lost confidence that they could get their principal back and rushed to get out at the same time. In such an environment, any institution that borrows short and lends long is vulnerable to such an attack. The victims had one common trait: if credit were cut off they would be unable to find funding. The decision of credit markets became self-fulfilling, and policy makers around the world seemed incapable of stopping these waves.

The current crisis

The evolution of the current financial crisis seems remarkably similar to the emerging markets crisis of a decade ago.

America’s crisis started with creditors fleeing from sub-prime debt in summer 2007.  As default rates rose, investment-grade debt – often collateralized debt obligations (CDOs) built out of sub-prime debt – faced large losses. The exodus of creditors caused mortgage finance and home building to collapse.

The second stage began with the Bear Stearns crisis in March 2008 and extended through the bailout of Fannie Mae and Freddie Mac. As investment banks evolved into proprietary trading houses with large blocks of illiquid securities on their books, they became dependent on the ability to roll over their short-term loans, regardless of the quality of their assets. Given sufficient panic, it can become impossible to roll over those loans. And in a matter of days, despite no major news, Bear Stearns was dead. However, while the Federal Reserve and Treasury made sure that Bear Stearns equity holders were penalized, they also made sure that creditors were made whole – a pattern they would follow with Fannie and Freddie. As a result, creditors learned that they could safely continue lending large financial institutions.

This changed on September 15 and 16 with the failure of Lehman and the “rescue” of AIG, which saw a dramatic and damaging reversal of policy. Once Bear Stearns had fallen, investors focused on Lehman; again, as confidence faded away, Lehman’s ability to borrow money evaporated. This time, however, the Fed let Lehman go bankrupt, largely wiping out creditors. AIG was a less obvious candidate target. Despite large exposure to mortgage-backed securities through credit default swaps, no analysts seemed to think its solvency was truly in question. Overnight, however, without any fundamental changes, the markets decided that AIG might be at risk, and the fear became self-fulfilling. As with Lehman, the Fed chose not to protect creditors; because the $85 billion loan was senior to existing creditors, senior debt was left trading at a 40% loss.

This decisive change in policy reflected a growing political movement in Washington to protect taxpayer funds after the Fannie Mae and Freddie Mac actions. In any case, though, the implications for creditors and bond investors were clear:  RUN from all entities that might fail, even if they appear solvent. As in the emerging markets crisis of a decade ago, anyone who needed access to the credit markets to survive might lose access at any time.

As a result, creditors and uninsured depositors at all risky institutions pulled their funds – shifting deposits to Treasuries, moving prime brokerage accounts to the safest institutions (read JPMorgan), and cashing out of securities arranged with any risky institutions. The previously invincible Morgan Stanley and Goldman Sachs saw large jumps in their credit default swap rates. Washington Mutual and Wachovia vanished. LIBOR shot up and short-term US Treasury yields fell as banks stopped lending to each other and lent to the US government instead. The collapse of one money market fund (largely because of exposure to Lehman debt), and the pending collapse of more, sent the US Treasury into crisis mode.

At the same time, the credit market shock waves spread quickly throughout the world. In Europe, interbank loan rates and EURIBOR rates shot up, and banks from Bradford & Bingley to Fortis were nationalized. Further afield, Russia and Brazil each saw major disruptions in their interbank markets and Hong Kong experienced a (small) bank run. From late September, credit markets around the world were paralyzed by the fear that any leveraged financial institution might fail due to a lack of short-term credit. Self-fulfilling collapses can dominate credit markets during these periods of extreme lack of confidence.

The response

There are two ways to end a crisis in confidence in credit markets. The first is to let events unfold until so much deleveraging and so many defaults have occurred that entities no longer rely on external finance. The economy then effectively operates in a “financially autonomous” manner in which non-financial firms do not need credit.  This is the path most emerging markets took in 1997-1998. Shunned by the world investment community, it took many years for credit markets to regenerate confidence in their worthiness as counterparties.

The second is to put a large balance sheet behind each entity that appears to be at risk, making it clear to creditors that they can once again safely lend to those counterparties without risk.  This should restore confidence and soften the coming economic recession.

Governmental responses to the crisis were fitful, poorly planned, and abysmally presented to the public. The US government, to its credit, was the first to act, while European countries boasted they would be little affected. Still, though, Paulson and Bernanke had made the mistake of insisting right through the Lehman bankruptcy that the system was fundamentally sound. As a result, their rapid reversal and insistence that they needed $700 billion for Paulson to spend however he wished was greeted coldly on Capitol Hill and in the media.

The initial Paulson Plan was designed to increase confidence in financial institutions by transferring their problematic mortgage-backed securities to the federal government’s balance sheet. The plan had many problems, ranging from uncertainty over what price the government would pay for the assets to questions about whether it would be sufficient to stop the crisis of confidence. Our initial Baseline Scenario, on September 29, recommended passing the plan and supplementing it with four additional measures: the first two were unlimited deposit insurance and an equity injection program for financial institutions.

After the Paulson Plan was passed on October 3, it was quickly overtaken by events. First the UK announced a bank recapitalization program; then, on October 13, it was joined by every major European country, most of which also announced loan guarantees for their banks. On October 14, the US followed suit with a bank recapitalization program, unlimited deposit insurance (for non-interest-bearing accounts), and guarantees of new senior debt. Only then was enough financial force applied for the crisis in the credit markets to begin to ease, with LIBOR finally falling and Treasury yields rising. Continued interest rate cuts and liquidity measures by the Federal Reserve and its counterparts have been just enough to ensure a slight easing in interbank credit markets. However, the supply of credit to the real economy remains constrained.

Dangers for emerging markets

Although the US and Europe have grabbed most of the headlines, the most vulnerable countries in the current crisis are in emerging markets. Just like highly leveraged banks, highly leveraged countries – such as Iceland – are vulnerable to the flight of capital. Countries that got rich during the commodities boom are also highly vulnerable to a global recession.

The flight to safety is already destabilizing banks around the world. For companies that can get credit, the cost has skyrocketed. These financial sector tremors are sending shockwaves through emerging market economies. While wealthy nations can use their balance sheets to shore up banks, many other countries will find this impossible. Like Latin America in the 1980s, or emerging markets after 1997-98, the withdrawal of credit after a boom can lead to steep recessions and major internal disruptions.

Four sets of countries stand to lose.

  1. The over-leveraged. With bank assets more than ten times its GDP, Iceland cannot protect its banks from a run. Other countries that borrowed heavily during the boom face a similar situation.
  2. The commodity-dependent. Oil has already fallen below $80 per barrel, and demand continues to fall. All other major commodities will fall for the same reasons. Commodity exporters facing sharply reduced revenues will need to cut spending and let their currencies depreciate.
  3. The extremely poor. Sub-Saharan Africa, which was a beneficiary of the commodity boom, will be hit hard by the fall in commodity prices. At the same time, wealthy nations are likely to slash their foreign aid budgets. The net effect will be prolonged isolation from the global economy and increased inequality.
  4. China. The global slowdown has already had a major impact on several sectors of China’s manufacturing economy. The collapse in the Baltic Dry Index shows that demand for commodities and manufactured goods is plummeting. While China’s economic influence will only grow in the long term, a global recession could cause a severe crimp in its growth.

The world’s attention is currently focused on the G7. But crises in the rest of the world will inflict damage on G7 economies, increase global inequality, and create geo-political instability.

The current situation

Today, although it is by no means assured, it seems relatively likely that the financial panic will gradually ease and the successive collapse of many large banks in the US and Europe will not occur. However, the resumption of interbank lending alone will not be enough to reverse the downward trajectory of the real economy. Banks still need to deleverage in a major way and there are doubts about how much lending to the real economy will pick up. For example, mortgage rates in the US actually increased since the recapitalization plan was announced. In a worst case scenario, even some wealthy countries may not be able to absorb the losses sustained by their banks. The US will have to worry not just about its banks, but also about some insurance companies and quasi-financial companies such as GMAC, Ford, and GE.

Before the severe phase of the crisis began on September 15, the world was already facing an economic slowdown. The credit crisis of the past month and the lingering uncertainty have ensured that we are now in a global recession. In the face of uncertainty and higher credit costs, many spending and investment decisions will be put on hold. US and European consumption are declining along with housing prices, with a major fall in US personal consumption in Q3. With interest rates rising around the world, companies will pay down debt and reduce spending and investment plans. State and municipal governments will see lower tax revenues and cut spending. No country can rely on exports to provide much cushion, as growth and spending around the world have been affected by the flight from credit.

Recent economic indicators in the US show significant deterioration in the real economy. Because many of these indicators are from the entire month of September, they probably understate the effect of the acute credit crunch of the second half of the month, which we will not fully appreciate until October data appear in the middle of November. Consumer confidence is already at record lows. The recent unemployment report showing a net loss of 240,000 jobs in October will probably only get worse in the next few months.

The damage will be particularly acute in emerging market economies. As the wealthiest nations protect their banking sectors, investors and lenders will be less likely to put their money in countries perceived as risky. So far, Iceland, Hungary, and Ukraine have required bailouts from the IMF, sometimes joined by other entities such as the European Central Bank, and Pakistan is in negotiations with the IMF. Argentina has taken the extreme step of nationalizing its private pension system, most likely in an attempt to avert a national default. The psychology of fear is likely to take over as creditors try to guess which country will be next, just as in 1997-98. Unless a country has a sufficient balance sheet and a very large amount of reserves, there will be selective defaults and large devaluations. It is hard to see how the IMF or anyone else can provide resources on a sufficient scale to make a difference. Credit default swaps show that several countries in Eastern Europe and Latin America are at risk of default.

Falling commodity prices due to the coming recession will also hurt many exporting countries. Even Russia, with its large foreign currency reserves (and vast oil and gas reserves) may have a significant mismatch problem between short term liabilities and longer term assets. This is complicated further by large private sector debt in foreign currency. The government may be moving toward deciding which companies they will save. Hopefully, for the companies they do not support, it will be possible to have an orderly workout.

Even China is showing the negative effects of the global recession. With a risk that growth could fall below 6% this quarter (from 11-12% over the past few years), the Chinese government recently announced a $600 billion stimulus plan, spread over two years, in an effort to keep the economy growing fast enough to absorb a growing labor force.


The G7

So far, the US response has included major increases in liquidity, the $700 billion TARP program, the dedication of $250 billion of that money to bank recapitalization, unlimited deposit insurance, guarantees of new senior bank debt, a program for the Fed to buy commercial paper directly, an interest rate cut, and the usage of Fannie and Freddie to buy $40 billion per month of mortgage-related securities. Put together, this seems to have stopped the panic from worsening, although it certainly has not yet dissipated.

The US and other leading economic powers will have to continue to fight on several fronts for months if not years to come. We recommend the following program of steps:

  1. Ensure sufficient capital. While the credit markets have reacted with cautious optimism to recent initiatives, they must still be implemented successfully to have their desired impact. In the US, we recommend dedicating all $700 billion of the TARP money for bank recapitalization, because $250 billion may not be enough as a percentage of the assets involved. Purchasing mortgage-backed securities, if necessary, can be done by Fannie and Freddie. Treasury and the Fed will also need to find a meaningful way to encourage recipients of government capital to use the money to increase lending to the real economy while maintaining healthy capital levels.
  2. Lower interest rates. The monetary authorities of these countries need to lower interest rates dramatically. While the United States has little room to lower rates, the UK and the Eurozone still have room for additional reductions. The recent 0.5 percentage point reduction by the ECB, in particular, is particularly worring, as it indicates that the ECB is having a hard time shedding its inflation-fighting instincts to fight the global recession. With a global recession, falling commodity prices, and weak demand, inflation will be low and deflation is a risk.
  3. Maintain liquidity. Monetary authorities need to remain committed to pumping liquidity into the financial system as long as credit markets and interbank lending remain weak. This should be promised for at least one year.
  4. Fiscal stimulus. A major fiscal stimulus package is needed to help restore confidence back to the economy, and to encourage businesses not to postpone investment plans. All industrialized countries and most leading emerging markets should commit to a sizable fiscal expansion (at least 1 percent of GDP), structured so as to work within the local political environment, to offset the coming large decline in global demand. In the US, we recommend a stimulus of $450 billion (3% of GDP), including extended unemployment benefits, expanded food stamp aid, direct aid to state and local governments, and short- and long-term infrastructure spending, at least.
  5. Contain the damage in housing. In a credit cycle-driven recession, housing prices can fall below their fundamental value just as they rose above it during the boom. Direct measures need to be taken to break the cycle of foreclosures and fire sales that is driving down prices and causing collateral damage to communities. The goal should not be to prop up housing prices at artificially high levels, but to find outcomes that are better for both homeowners and lenders than foreclosures, large write-offs, and blighted neighborhoods that harm all homeowners.

In addition, these nations also need to determine how their financial sectors should be regulated in the future. Most economists and policy makers agree that the crisis was aggravated by some failure of the regulatory system. While there are disagreements over what that failure was, it is certain that a new regulatory system will be built.

The international arena

The risk for the global financial system is the prospect of financial war. With his appeals for assistance turned down by European countries, Iceland’s prime minister, Geir Haarde, said it is now “every country for itself.” This smacks of the financial autarchy that characterized defaulters in the 1998 financial crisis in Asia, when countries changed the rule of law to benefit domestic constituents over foreigners.

Most of the time, financial war of this kind is painful and costly. It will lead to decades of lower international capital flows and could have other far-reaching effects on politics and even global peace. Unless the leading industrial countries take concerted action, there’s a very real danger that we will all suffer more.

Highly leveraged countries are at risk of substantial private or public defaults. They need to assess their ability to cover their debts and decide which entities to protect and which to let fail. If necessary, they should commit to early Paris Club and London Club negotiations to restructure external national debts, and encourage private sector entities to begin negotiations with creditors.

Commodity exporters should let their currencies depreciate instead of spending reserves to slow down the adjustment process. Devaluation will be necessary to bring imports and exports back into balance.

The IMF can work with countries needing fiscal and balance of payments support.  It is already signaling that it will reduce the detailed conditions for which it is so well known, and increase its flexibility.  The G7 should support this, and make additional resources available.  We recommend a significant expansion in the IMF’s lending capacity, perhaps up to $1 trillion.

Finally, despite their domestic challenges, wealthy nations also need to do their part. We are going to recapitalize our banks and exercise greater control over them.  We need to make sure they continue to deal with emerging market banks.  We should also avoid cutting our aid to the world’s extremely poor. The upcoming G20 meeting is an opportunity for concerted action by both developed and emerging market countries to combat the global recession.

Conclusion: The need for coordination

We believe the US economy, along with many other parts of the world, is in a major recession precipitated by housing markets but deepened by an extreme loss of confidence in global credit markets. The withdrawal of credit undermines previously solvent institutions, causes unnecessary economic damage and constricts consumption and investment plans. Once confidence is gone, it is extremely difficult to restore. Even after the credit panic subsides, it will leave in its wake the worst global recession in decades.

The outlook for the global economy continues to worsen. While the US and several European countries are already in recession, we are also likely to see substantially more defaults and credit panics in smaller countries and emerging markets. These developments point out the urgent need for international coordination to limit the depth of the recession and avoid international financial warfare.

The last two months have shown that partial and piecemeal actions will no longer work. Small steps announced frequently, especially by a single country acting alone, are neither credible nor powerful enough to make much of a difference. It’s worth bringing a sufficient mass of economic power to bear, in a comprehensive program, to make an impact on the markets.

There is also a need to let prices move to a level supported by the market, which unfortunately means that wealth is likely to decline further. As we saw after the Asian crises, this can mean that stocks, bonds and other assets become very cheap, and it may take a long time for values to recover. Fiscal expansion and help to homeowners will reduce the pain from these losses, but it’s important to be clear that the success of the program should not be measured by rising asset prices.

Finally, we are well past the days where even dramatic steps could have prevented a major recession. Under any scenario, we will see many personal, corporate and perhaps even national bankruptcies. Once the genie of panic and uncertainty is unleashed, it takes years to put it back in the bottle. What we need to do is prevent a chaotic collapse arising from incomplete policies, lack of credibility and international financial warfare.

66 thoughts on “Baseline Scenario, 11/10/08

  1. A great article overall, summing up the enormity of the crisis across the globe. How come an important nation like India, one of the world’s largest democracies and the youngest nation in the world, has not been mentioned at all?

    The future of the emerging IT and BPO sector in India, which has led to the fears of job losses in the western economies in the last few years, needs some mention in the global financial arena.

  2. You missed the on “Root of the Crisis”. Where did it all begin? Wasn’t it President Clinton and Alan Greenspan who set the path to this mess in the first place. Greenspans easy money policies allowing very low interest rates and Clinton’s wanting to get all the possible, less fortunate people into a home of there own, that was the real seeds to this mess due to his signing in 1999 (I think) of a bill to allow these people to get these low or no downpayment loans? If I recall, Jimmy Carter also initiated the original bill when he was in office and Clinton changed it or made it easier to get the loans. Lets adress the REAL Reasons why we are in this mess and get the “The Real Roots of the Crisis.

  3. Alan, do you drink often?

    It’s Clinton’s AND Carter’s fault, huh?

    I’m sure it has nothing to do with fractional lending and rampant greed in the banking sector.

    To the best of my knowledge, there is no law that says a bank must not verify income and that it must offer ‘teaser’ rates to get a person to buy a home.

    I also don’t remember seeing any law that said a bank had to lever up 30-50 times.

  4. “Community Reinvestment Act had nothing to do with subprime crisis”
    — Business Week, September 29

    The CRA was first passed in 1977, and last amended in 1999 as part of the Gramm-Leach-Bliley Act; which, incidentally, also was the law which finally repealed the Glass-Steagal act which would have prevented BofA from buying Merrill (among other recent events).

  5. “Community Reinvestment Act had nothing to do with subprime crisis”
    — Business Week, September 29

    The CRA was first passed in 1977, and last amended in 1999 as part of the Gramm-Leach-Bliley Act; which, incidentally, also was the law which finally repealed the Glass-Steagal act which would have prevented BofA from buying Merrill (among other recent events).

  6. This dude who wrote this is a MORON. He just doesn’t know or understand the facts! There is plenty of blame to go around but everyone knows where it started. I am not saying Bush was a good little boy, but I am saying that the lax rules and regulations caused the problem, and Carter was the man, LOL, who set this mess in motion and all after him didn’t try to stop the mess, but only encourged it. There should have been strict rules applied to investment bussinesses to not allow extream leverage but there should never have been any loans made without at least 20% down and jobs buy the applicants to prove they could pay. This is where our leaders failed. They encouraged lending with less than 20% down, and sometimes nothing down.There should never be SUB-PRIME loans. You either have the 20% down to buy, or you wait until you do before you can buy. NO Gifts. Enough Said.

  7. “You either have the 20% down to buy, or you wait until you do ….”

    Perhaps we ought to apply the same strict standards to businesses that want to borrow. Or hedge funds….

  8. I started reading your web site after hearing Simon Johnson on NPR this morning. The timeline facts presented above drew me to two observations.

    First, one I concluded a while back: As you point out, a lack of confidence is keystone to start and continuance of this financial debacle. The lack of confidence is apparently rooted in lack of trust. I perceive there is a lack of trust between businesses because no one knows who is or is not accurately reporting their financial condition. Likely this is due to a combination of unregulated sectors of financial business and a lack of regulations and lack of regulation enforcement.

    The second, also pointed out in this article, is financial institutions and businesses alike have a mismatch of duration between assets and liabilities. This is violation a basic financial management principles. Having a mismatch always sets one up for possibility of a financial squeeze. Squeeze may occur due to short-term sources drying up (as in current liquidity crisis) and no longer being able to borrow to pay for assets you possess (leading to either sale of assets or bankruptcy). Or the plan one made regarding cost of capital is no longer possible due to short-term borrowing costs increasing beyond ability of asset to generate income to pay borrowing costs.

    The first observation is closely tied to lack of regulatory oversight combined with greed (lots of psychology and human behavior components related to greed).

    The second observation is closely tied to supposedly smart people being stupid. Stupid because they gambled by arbitraging long-term assets against short-term liabilities and assuming price relationships would stay the same.

    All in all, a lack of national and international regulatory oversight has left many people facing problems with food, clothing and shelter while a relative few are enjoying vast riches. In the United States, the executive leadership of my country, in eight years, did nothing to ameliorate the situation. Whether due to poor regulatory policy or ignorance, the current President has demonstrated he is not a leader. Other national top executives also bear responsibility and, thus, also are not leaders. Unfortunately, the ordinary citizen will feel the most pain.

  9. There certainly is a conflict of interest to have the regulators of an industry own stakes in it (i.e. TARP in it’s current incarnation.) Of course the alternative is having some of our financial institutions under-capitalized and on the brink of collapse.
    I think then the question of which is the better of 2 evils is based not on the argument of nationalization but how to best deal with the crisis of confidence.
    If I understand what I read above correctly, the fundamentals of our financial system have not changed and we are not merely ” reverting to the mean” of a natural cycle. There may be some underlying weakness caused by previous deregulation or other factors, but they were already there. This was a perfect storm of multiple factors starting with a normal boom/bust cycle in housing, the creation of mortgage backed securities, and the leverage of the financial houses that wrote these securities. Once the house of cards fell, the real scary beast, the fear, took hold. Anyone wonder why we didn’t have a ” crash” in the stock markets until October? We were in normal bear market territory until fear caused the contraction of credit.
    Long story short, we must deal with that fear, and restore the markets to a natural progression, which ironically means creating an artificial floor, but I think the most interesting point made was that we must be careful about what incentive we are giving to who and for what. This i think will define how the intiatives we create moving forward and how they react in the market.

  10. Like Mr.Bush (or whoever wrote his speech) said today, a small period of crisis should not undermine the power of free markets. The debate over free market economies vs centrally planned economies, if not between capitalism vs socialism, was over with the collapse of the Soviet Union.

  11. Dear Dr. Johnson!
    I’m ecstatic to see how somebody at least would be so courageous to tackle such a large and complex issue and work hard on explaining it in simpler terms and concepts. However, I would argue that your perspective in defining the problem, and especially in offering some prescription of how to tackle this global problem would be greatly enhance if you invite to other scholars (especially to others from a field different than economics) to critically assess your evaluation and especially your suggested solution (proposal). I think this might be especially relevant nowadays when another prestigious economist like the former FED Chairman recognized recently, that he has found “flaws in his thinking and in the workings of the free-market system”.

  12. I have to agree with Alan’s comment that Simon Johnson does not spell out the root cause of the crisis. Perhaps Johnson wants the taxpayer to pick up another monumental bill – and experience further unemployment! – sometime in the future?

    Let me quote from the book “The Economics of Money, Banking, and Financial Markets” by Frederic S. Mishkin, professor of Banking and Financial Institutions at the Graduate School of Business, Columbia University (“He has been a consultant to the Board of Governors of the Federal Reserve System, the World Bank, and the International Monetary Fund, as well as to many central banks throughout the world…”)

    Extract: “What we see in banking crises in these different countries is that history has kept on repeating itself…financial liberalization…can lead to an increase in moral hazard, with more risk taking on the part of banks if there is lax regulation and supervision; the result can then be a banking crisis…”

    Mishkin devotes an entire chapter to the 1997 Asian Financial Crisis. His summary: “Due to inadequate supervision of the banking system, the lending booms that arose in the aftermath of financial liberalization led to substantial loan losses, which became huge after the currency collapses that occurred in the summer of 1997…”

    On regulation, Mishkin has this to say: “Regulators and politicians are ultimately agents for voter-taxpayers (principals) because in the final analysis, taxpayers bear the cost of any losses…The principal-agent problem occurs because the agent (a politician or regulator) does not have the same incentives to minimize costs to the economy as the principal (the taxpayers)…As these examples indicate, the structure of our political system has created a serious principal-agent problem; politicians have strong incentives to act in their own interests rather than in the interests of taxpayers…

    “Because of the high cost of running campaigns, American politicians must raise substantial contributions. This situation may provide lobbyists and other campaign contributors with the opportunity to influence politicians to act against the public interest…”

  13. This crisis will eventually resolve but unless we want to go through this again we must change how we view and regulate the financial sector. When Lehman failed the theory “too big to fail” became reality and the dangers of moral hazard were dwarfed by the confidence crisis. Going forward we must accept that when financial institutions reach a certain size they become “too big to fail” triggering a confidence crisis. This includes banks, insurance companies, investment banks, hedge funds and perhaps other entities. The capital requirements for investment banks were created solely to protect customers and not to ensure the survival of the entity. That must change for the “too big” firms. Capital requirements must increase and leverage must be limited. Hedge funds will also need capital requirements and disclosure requiements once they become “too big.” The death of Lehman was the death of pure capitalism.

    Finally, sub-prime lending must be regulated so that this does not happen a third time, the first being the S&L crisis. It should be apparent by now that banks do not know how to make sub-prime loans without going belly-up.

  14. Perhaps some basic lending reform is in order. How about if the company writing the mortgage is required to hold the mortgage for at least one year after the teaser rate adjusts. That might make ’em think twice.

  15. @”New Era”: the book I mentioned in my above post covers the “too-big-to-fail” policy. You are right:

    “One problem with the too-big-to-fail policy is that it increases the moral hazard incentives for big banks. If the FDIC were willing to close a bank using the alternative payoff method, paying depositors only up to the $100,000 limit, large depositors with more than $100,000 would suffer losses if the bank failed. Thus they would have an incentive to monitor the bank by examining the bank’s activities closely and pulling their money out if the bank was taking on too much risk. To prevent such a loss of deposits, the bank would be more likely to engage in less risky activities. (Evidence reveals, as our analysis predicts, that large banks took on riskier loans than smaller banks and that this has led to higher loan losses for big banks…)”

    However, if you read the last couple of paragraphs of my last post, you will realize there is little hope for change – even with the election of Obama.

  16. Though I find it admirable to try to spell out the roots of this global crisis for everyone to understand, I do not find that you hit the target here.
    Your text is more like a journalists description of the path the crisis took rather than to explain the reasons why.
    Admitted – it’s complicated, and I do not claim to understand it all the way.
    However, much os this is due to a globalisation scheme, which has evolved without the participating nations being on level regarding currency policies and monetary policies. The US got its dollars back from China and Greenspan recycled them into the american society as debt through the banking system, where it created an inflationaty pricebubble in housing – and president Bush pointed out ‘spending’ to be the patriotic thing to do after 9/11.
    The dollars from China was brought into the housing market through instruments like the credit default obligations, which was sold with AAA-ratings on the assumption, that the entire american house market would never go down at the same time. And to further push the CDO’s to banks throughout the world they were sold with an extra guarantee, created as credit default swaps, which is basically a bet on whether the mortgages contained in the CDO’s would default or not. These credit default swaps is what brought down AIG.
    The CDO’s are everywhere in the banking system all over the world, and banks cannot determine the value of these instruments because they cannot find the exact mortgages backing the individual CDO. Banks do not lend to each other because CDO’s are the collateral that they will be offered in return for cash. Therefore the Treasury originally introduced the TARPprogram as a measure to lift CDO’s out of the banking system, but Mr. Paulson has given it up, because he is nowhere near having enough money to do so.
    Instead the FED is pouring money into banks against no collateral at all or against shares to keep the banking system afloat – and this has increased the amount of dollars immensely since the middle of september as can be seen here:
    This article offers a thorough investing into the crisis.

    Problem for the US and the world: it is not likely that the US should start spending again anytime soon. This breaks the globalisations dollarcycle and the import-export-relationship between emerging markets and advanced economies.
    Adding to the problem: Mr. Bernanke and Mr. Paulson and the rest of the the western world try to reinflate the bubble by making incredible amounts of meoney available to an insolvent banking system etc. But the problem of no one spending enaything will remain as long as the correction is housing prices are not through. The many attemps to try to keep up the inflated prices will only make this recession go further.
    Further adding to the problem: in order to inject cash in the system, the FED basically prints money. But the above mentioned article clearly shows, that in the near future it is going to be increasingly hard for the FED to find enough buyers of Treasuries. Who will buy american debt, when each and every advanced economy will be on the market trying to fill their own national borrowing needs? What happens when the proces of deleveraging in the banking system comes to the point where dollars are no longer in demand, cause the dollardenominated assets have been written off? This is the real big question for the US in the upcoming first half of 2009.

    In one word the origin of this crisis is debt.

  17. When money is dispersed from the $700 billion TARP program or if money has to be dispensed to make good on the AIG, Fannie Mae or any of the other myriad guarantees, does anybody know where it comes from? Is it borrowed? Does the Fed use open market operations to sell bills in exchange for the money? Is it just printed and dispersed to the recipient in exchange for something?

  18. “Political will” and that other thing called “political capital” are unmentioned constraints on the armchair ideas/ideals posed in the article.
    Again and again I ran into “shoulds” that don’t even come close to a 40/60 (i.e., negative) probability of realization.
    I was hoping to see some realistic thoughts about what to do to pick up the pieces after the failure(s) of the round-after-round-after-round revisions of the bailout(s).
    I found none.
    Here’s one thought. If gold were to shoot up to $2,000 or $3,000 per ounce based on the fact that countries are wontoning using the very viability of their national currencies to back up insolvencies that are tied into a bottomless pit.
    Those are currencies doomed to fail.
    The U.S. is squarely in that club, along with Western Europe.
    The plan for that is more elusive. After it fails, what, Herr Professor.
    Give my regards to Penti Kouri and Mike Porter if they are in your loop, and Andrew Crockett as well.
    For all the best,

    Roger Hefferan

    P.S.: If you want ideas about how to rise from the ashes after all currencies get burned and gold soars, just send a smkoe signal or something.

    My thoughts seem unable to stray from scenarios following that outcome

  19. Wow, great article and stimulating discussion. You’ve all touched on excellent points and theories concerning the Financial Crisis.
    The basis of the website and the required depth of the overview article in matching the defined goals of the blog seem to hinder many of the inter-related problems associated with the Crisis. Problems which might stimulate some additional discussions and thought would be:

    1. Quasi or “Shadow” banking entities as described by the folks at Pimco. These lenders have the same short/long borrowing to lending problems associated with banks, however, currently have no capital requirements. This area includes Hedge Funds, Lenders like GMAC, Private Equity Funds, etc. These Shadow banking entities contribute considerable instability to the system due to their opacity and highly leveraged positions.

    2. The problems associated with the unbalanced US GDP contributers. With 72% of US GDP in 2007 comming from Consumer Spending, and probably another 12% related to the Financial Industry, where do we go from here. The boomers will be retiring over the next 10 years or so and their retirement savings have been descimated. They are now forced to save in order to meet any chance of retirement. This savings will detract from future consumption, hence GDP. With home equity sources for spending drying up and credit tightening, the main engine of the US economy would appear to be flaming out. What can the government do to help rebalance the economy to minimize future disruption.

    3. Japan’s real estate based recession seems to closely mimic the problems the world faces today. Not just the US is facing a housing crisis (Britian, Spain, France to name a few). The “L” shaped recession the Japanese sustained following the implosion of their economy in the 1980s seems to be a real possibility today for the US and the rest of the world. Although the US and now other governments are actively attempting to head off the dreaded “L” are their any guarantees that these actions will have the desired effects.

    4. Economics seems to be viewed today as a science. Given A, adding actions B and C gives solution D. The chances of the great depression of ’29, the US problems of the 1970’s, the S&L problems of the 1980’s, Curency problems of the 1990s (Latin America, Asia, Russia), the Dot Com bubble of the 2001-2003 era and now, what I would guess would be the “Mother” of all recessions within our life times- is this really a science, or are we perhaps mixing the science with the arts and even perhaps a touch of “VooDoo”. When less than 120 days ago the powers that be can declare that the system is solid, only to have the rug slid out from under them, and Alan Greenspan talking of how his mental model of the world has been shaken- perhaps the “Fat” tails of probability are more of a contributer than anyone of us wants to admit.

    I look forward to your comments and thoughts, and thank the Baseline crew for their forum for such stimulating conversation-


  20. Well stated, BajaMike, but what’s stopping you from going one step further?

    It’ll be an “L” and a droopy “L” at that.

    It’s so obvious.


    It’ll be an “L” and a droopy “L” at that.

    You know the Humpty Dumpty story.

    Well, the global economy sat on a wall.
    The global economy had a great fall.
    All the king’s horses and all the king’s men
    Couldn’t put the global economy together again.

    And that’s the scoop on that.


  21. Well done. A minor point you might want to correct–Brazil devalued (let it currency float) on January 13, 1999 not in December 1998. I remember the first days of 1999 well.

    (No need to post this reply. Really meant for the authors if they wish to correct the original text.)

  22. “The bundling of consumer loans and home mortgages into packages of securities — a process known as securitization — was the biggest U.S. export business of the 21st century. More than $27 trillion of these securities have been sold since 2001, according to the Securities Industry Financial Markets Association, an industry trade group. That’s almost twice last year’s U.S. gross domestic product of $13.8 trillion.” – Mark Pittman, Oct. 27 (Bloomberg)

    Clearly, allowing the crisis of confidence to continue with such a large stock of CDO’s outstanding worldwide ($4 trillion more than the entire housing stock of the US), suggests potential levels of pain unanticipated even now….

  23. From another perspective, this situation is a result of agreeing to be victimized by OPEC. The housing bubble was formed deliberately to pay for oil, to generate credit instruments representing nonexistent pseudo extraction costs. When playing musical chairs, you should anticipate that the music will stop sometime. Now there is a huge overhang of basically valueless assets out there. Credit default swaps, insuring collateralized debt obligations, are reported to exist at a level of 63 trillion USD worldwide. (collateralized by what?, one wonders) To put this in perspective, world GDP is reportedly around 54 T, US: 13.7 T, Eurozone: 16.3 T. This stuff still has to be unwound, and nobody knows who will be left holding the bag on the underlying writedowns. The system can’t recover with the shadow of these obligations in the background. Is Dubai in trouble? How about Kuwait and the Saudis. AIG, which was exposed to this stuff, just had to be resaved, and I anticipate a re-re-save will be necessary, and so forth. So far, they haven’t told us who else holds this stuff, and they aren’t serious about dealing with the OPEC problem.

  24. I may be oversimplifying the problem but I think that it could be reduced to the following thought:
    If it is true that the amount of outstanding CDSs is in the 50/60 trillion dollars range and that at the end there could be 10% (?) of actual losses over a period of may be 10 years it seems obvious that the way things are going (at least in the US) the tax payers will be paying the bill in quarterly installments (see the 20/30 billion dollars that each quarter are pumped into each one of various financing institutions).
    The problem with this scenario is that nobody seems to really know the extent of the problem.
    So, in order to at least have an idea of the magnitude of the problem we will be facing, one possibility could be, for all nations involved, to create an international Clearing house where all outstanding CDSs and similar “fuzzy” financial instruments should be registered by any financial institution that receives bail-out funds?.
    Once the magnitude of the problem is known, then it could be possible to work out a multinational plan to solve it.

  25. Good article. However this is dangerous:
    “housing prices can fall below their fundamental value just as they rose above it during the boom…”
    It implies that people can recognize disparities between market prices and what they perceive as actual value. People cannot; and when politicians especially think they can, the very worst policies are enacted. Who is to say what the fundamental value is or should be, other than by dynamic market pricing -? Much of our current debacle has root with banks and Congress seeing prices as below their particular opinions of value.
    Slippery slope here.

  26. In response to “Alan”–in a “free market”, banks are free to lend to whomever they choose at whatever terms they choose. They screwed up–they should be allowed to take the hit or go under. How do you bail these banks out and not do anything for GM, when it affects 100’s of thousands of jobs across the country?

    Maybe you should explain how Carter “set this mess in motion”, because it’s not at all obvious from your comment. Oh I see, now you’re blaming Clinton–never mind.

    To me it seems pretty obvious that this unregulated, wild-west gambling atmosphere of CDO’s & CDS’s is to blame for most of the mess we are in. Probably most of the bankers didn’t even understand the hazards of what they had gotten into.

  27. I tend to agree with John Henriksen. I think the article does a great job describing the mechanics of the immediate crisis, but it does not address the underlying macro trends and it does not offer recommendations for those.

    Of course the crisis will eventually correct the macro imbalances that caused the crisis, but policy should address it too, in order to lessen the impact.

    The underlying factor was that the US over-consumed of everything. The government, the corporate sector and individuals have all been loading on debt, absorbed the production of the World while offering little in return. Trade deficits, budget deficits, household deficits made the US extremely vulnerable. This is why the US recession will be much sharper than the Asian recessions in 98 – those countries did not have this many balance problems.

    Part of the balance problem was that GDP gains went to the richest segment of the population in the whole World. Income differences skyrocketed everywhere.

    As a result there was a glut of money available for investment, but since the middle and lower classes did not see significnat gains in their real income the only way to absorb the products and services from the new investment was to borrow. When they tapped out their creditworthiness growth ended, and so now we face a real crisis because people have to start living within their means. Actually, below their means because they have to repay their borrowings.

    This is another imbalance that needs correction: this is why Obama’s idea of redistributing wealth makes perfect sense. This should be part of the recommendations if we want to fix the economy beyond treating the immediate financial crisis.

    My recommendations would be centered around restoring balances: trade deficit, budget deficit, hosehold deficit. Make sure GDP growth is distributed proportionally so a 3% increase in GDP corresponds with a 3% growth in real income of the lower and middle classes. That will fix the problems long term.

    This will mean tax increases, cutting unaffordable expenses such as wars, tackling tough problems like why do we spend so much on education and health care and get terrible results.

  28. I agree with engineer27 on 12Nov. If you don’t have the down payment, then you don’t get the mortgage or investment funds. We have become an economy that wants to invest with zero down. Get your debt financed and also your equity. Then it becomes a game, a gamble, with bets and puts, short and long buys. We should not allow gaming in our stock markets.
    Margin calls worsened Black Monday in 1997 and exacerbated the problem this year.

  29. My thanks to Messrs. Boone, Johnson and Kwak for an excellent article communicating the fruits of their collective research. I appreciate the ability to convey a complicated issue in more accessible terms.

    I also appreciate the blog-setting to facilitate discussion in an open forum. Many ideas and comments reflected by those folks are interesting, insightful, and enriching.

    The historical perspective, at least in part, will likely be a topic chewed over by professors, students, grad-students, pundits, and just about everybody else under the sun for years. Specifically, how did we get here will provide great fodder for politcal axe-grinding, academic debate, economic agendas and of course somewhere through the diatribes will emerge a learned discussion of the root causes without (hopefully) an overt political or social commentary.

    However, I respectfully request that as you continue to add to your research, you include an analysis of the historical tax aspects of successive administrations insofar as whether any of your recommendations can indeed be implemented under the current Obama administration’s planned economic efforts. Further, an analysis of the current effort to “bail out” the Big 3 automakers (as an example) would also be helpful.

    Indeed, as an accountant, I would be most interested in an assessment of the projected outcomes of dispensing with a bailout of (for example only) the Big 3 and putting the proposed sum of $50 billion into a targeted Investment Tax Credit vehicle (please pardon the pun) with a goal of a new energy/propulsion source to replace the internal combusion engine. The basis for the interest is that, historically, the taxpayers have bailed out Detroit and yet we’ve seen no meaningful change in their business model. Yet Toyota, Honda, Volkswagen, et al are able to be profitable and produce their vehicles in the US; so this does not appear to be easily disposed of as a “price tag” from globalization.

    I would be further interested in a historical analysis (perhaps since Eisenhower or Kennedy) of marginal and capital gains tax rates on economic growth and wealth creation. Obviously the topic of tax generates a great deal of politicking, depending upon which side of the aisle someone is on, but we have seen that the lower tax environments have indeed fostered far greater overall tax receipts for this country than times when taxes have been raised.

    Further, some more simple ideas that would be interesting to have such learned folks as yourself consider include: 1) across the board write-down of mortgages for EVERYONE to 3% for an 18-36 month period; 2) Further reduction in both capital gains tax rates and marginal (both personal and corporate) tax rates; 3) Imposition of a minimum level of tax payment for all taxpayers (not AMT, but rather based on AGI – for example, the lowest AGI paying $50, and progressing up to current levels where applicable rates commence) to create “buy-in” to the government; and 4) sun-setting all provisions funded by US government dollars so that earmarks, agencies, departments, etc. must also compete for resources and legitimately justify their existence.

    Finally, there are enough historical lessons available that exploration of the current President-elect, and subsequent candidates (as well as previous candidates) could provide precedent for how respective provisions will affect the country. For example, will an effort to redistribute wealth to bring more balance to US households be effective or counter-productive?

    I offer some “wild-eyed” ideas that most participants in the discussion forum can jump all over and discard out of hand. Yet there are definitive elements, regardless of how wild-eyed, that justify exploration as ways to both generate or grow both confidence and trust as well as elements that were demonstrably huge generators of wealth, income, jobs, and GDP growth.


  30. I think you need to go a step further Pocsi. Income redistribution is not going to help much if the people receiving the re-distributed income do not pay off their debts. Most likely, in this scenario, they will not.

    We are now being forced into a post capitalism phase. People, including Bush, can hem and haw all they want about the virtues of capitalism. Maybe capitalism was good for a significant part of modern human history. But it has exploded for reasons that will not be fully understood for decades, perhaps longer.

    We should see what the US and European governments are doing for what it is. By any other name, it is called “nationalization.” The economies of the world seem puny compared to the financial tsunami of CDOs and CDSs engulfing them. Any objective observer, an observer without an ideology, but simply looking at things from a systemic point of view, has to conclude that this is a fatal system crash. Not dissimilar from the fatal system crash of a computer when it is overloaded with data.

    What do you do with a crashed computer? You reboot it. Depending on the nature of the problem, rebooting may be all you need to do. Or, you may need to completely change the computer or change the applications it is running. This is not the best analogy, because someone will point out that you might only need a SW patch. Clearly, a “patch” will not work in the system we call our global economy.

    What we need is a re-boot of the computer with an entirely new system. In fact, the seeds of this are being laid by way of the TARP, the auto bail out, AIG, and more and more that keeps getting added to the list. Then there will be re-TARP, and so on. Ultimately, this will reach an end point where no more can be done. The tsunami will have washed over everything leaving almost no evidence of the capitalism that came before.

    So, what is the new system? Like it or not, if you simply look objectively at what is happening, the new system will be some form of communism. Maybe you’d prefer I call it socialism. In either case, we will be left with large state owned monopolies. Or, perhaps privately owned monopolies under considerable state control. Sounds horrible, I know, but I do not how anyone could look at the current trajectory and not conclude that this is where we are heading.

  31. I have very mixed feelings about the discussion on this site. Specifically, the generalities may be fine but the lack of data specifically about debt is a big problem. In September the the Federal Reserve issues its quarterly Flow of Funds Account. I just finished analyzing in detail the levels of debt in the economy. I scale both the growth rate to the Growth rate of GDP and the levels and amounts of debt to GDP. The conclusions are the following

    1. While debt has been increasing relative to GDP for a long time, government debt is relatively tame having actually declined recently in its level as growth of GDP was faster than government borrowing.

    2. The consumer on average must be over mortgaged and the data has to be worse than the average. Specifically, mortgage debt has roughly doubled under Bush. Its the bulk of the new Household debt relative to GDP. If the interest rates have halved relative to GDP for the consumers for all the loans taken out then the debt burden would be the same but it has not.
    With falling property values people who have negative equity may find it advantageous to move to housing with in effect cheaper rentals than their mortgages leaving the banks to foreclose

    3. Under Bush the level of financial Debt has doubled for financial institutions. The level of debt is now twice GDP. With falling profits we are over leveraged and the many may go bankrupt as well as the US auto industry further accelerating the decline.

    3. The good news if any is that the Government indebetness has declined and the US in a deflationary environment can afford to print money i.e. if necessary hire all the unemployed workers to do makework. A massive investment in the economy and rebate checks to the lowest income brackets are in order.

    4. The question to ask about the US economy is why did debt levels accelerate NOW, Robert Frank in a key book has argued that the trickle down effect of wealth at the top causes people both for rational and irrational reasons. The acceleration of American indebtedness started with the Reagan Tax cut which turned a society whose income distribution was on the par with Europe to one which was on the par with an undeveloped nature i.e. the Ivory coast. The consulation prize to the less fortunate was easy credit. The good and bad news about easy credit is that debt for consumption needs not be repaid, there is no more debtors prison. The people with an abundance of wealth will have to find more productive things to invest in like say alternative energy and education rather than housing. The lack of regulation of capital markets was a likely outcome of too much wealth concentrated in too few people who wanted the freedom to lend at rates that the traffic would bear

    5. Marriner Eccles, Roosevelt’s chairman of the Fed in a very persuasive memoire has argued that unequal income distribution leads to a situation like now very parallel to the 1920s. Without the capacity to purchase the good and services necessary to the economy massive assumption of Debt at the bottom was more or less an inevitability.

    6. I suspect at this point Redistribution of wealth simply will have to take place one way or another either by Depression, or at least by Federal Taxation. The creditor class needs to have less to lend, borrowing has to become tighter but wealth more spread. Given a more equitable distribution of wealth so that people can purchase their perceived needs the need for excessive leverage and borrowing should decrease

    7. With the poor wealth distribution, the third world countries a.k.a. the United States and the underdeveloped World are especially vulnerable.

    8. I find this discussion coherent, and not discussed in detail anywhere save by me and perhaps Doug Henwood. I would like to see this refuted in detail. Like Simon J., I do not feel that the collapse was inevitable and I do believe there was much bubbling in a generally acknoweldged incompetent administration. To think that this was just a viscissitude of the Bush administration is at best a half truth. As Simon implicitly noticed and Greenspan remarked the preconditions for this crisis
    in the US have been going on for a long time.

  32. If people want to believe this crisis wasn’t inevitable given the utter incompetence and self-interest of politicians, then the U.S. is on a path of self-destruction.

    Simon Johnson was cited in the WALL STREET JOURNAL. Is Wall Street stupid enough to endorse someone who tells the truth about what these financial institutions have been up to? The public have been taken for a ride, and are now being taken for fools.

    The “bailout” money is being frittered away on dividends for investors, bonuses and luxury retreats for executives, and for buying up rival firms – everything but restoring the financial system to good health. This is what happens when you give money to private financial institutions with no conditions attached – let alone any oversight!

    In short, this collapse is the result of lax regulation. Bush, the other day said, don’t listen to those saying regulation is needed – it’s not regulation! – many nations with strict financial regulations are going through what we are going through – keep the market “free”! This after massive state intervention to the tune of over $700 billion.

    Bush, as usual, lied, claiming other nations have been exposed to as big a collapse as the U.S. However, Australia, for example, with fairly tough banking regulations – and little exposure to America’s sub-prime mess – has experienced few problems. Britain, on the hand, with very few regulations (like the U.S.), and a large exposure to the sub-prime meltdown, has had to bail out its banks to the tune of 500 billion GBP.

    It’s not the public’s job to analyze this to death. The fact that no proper analysis has been offered to the public should tell you all you need to know; namely, that you are being lied to AGAIN – just as Bush lied to you over WMD in Iraq.

    Finally, Simon Johnson talks about the Asian Financial Crisis, but makes no mention of the state of the Asian banking system before the currency crisis – again, another clue that we are being lied to. In my previous post I quoted Frederic S. Mishkin, Professor of Banking and Financial Institutions at the Graduate School of Business, Columbia University, and author of “The Economics of Money, Banking, and Financial Markets”:

    Mishkin devotes an entire chapter to the 1997 Asian Financial Crisis. His summary: “Due to INADEQUATE SUPERVISION of the banking system, the lending booms that arose in the aftermath of FINANCIAL LIBERALIZATION led to substantial LOAN LOSSES, which became huge after the currency collapses that occurred in the summer of 1997…” [emphasis is mine]

  33. I am in general agreement with “The Baseline Scenario’s” authors. It is my opinion that the overriding economic condition that has precipitaed the crisis is still being overlooked. We all (individuals, households, institutions, governments) got too big and too big in an unsustainable economic fashion. The over-extension and over-use of credit went parabolic in the last five years (credit of all stripes and colors, not simply mortgage credit,) although credit growth has been growing at too rapid a rate for decades. Collectively, we became unable to service the outstanding debt as is clear in many metrics, e.g., total debt load/total assets which (for households) is now over 130%, and interest costs/gross income at a level that now exceeds the basic expenses of life: food. The avaiable revenues generated from asset bases and gross income can no longer sustain and service the immense levels of indebtedness outstanding.

    This condition can only be corrected by getting “small.” Again, collectively, debt levels must be reduced substantially and throughout the global economic system to an “economically” sensible, servicable level. This unservicable debt crisis is being magnified and mutiplied by the shrinkage of the market value of the asset side of all balance sheets which, in turn, produces more asset sales and debt liquidation… and so on.

    The situatuion can not be “corrected” by making lending easier… that is just pouring fuel on the fire and there is no demand for credit systemically, in the aggregate, because debtors can’t pay down their existing obligations.

    Credit worthy (deleveraged) borrowers should be extended credit, but the credit-unworthy borrowers must not receive more credit but must get small (de-lever.) The current situation, unfortunately, is that credit-worthy entities are in the vast minority.

    This period of adjustment will be very painful for the entire world and will take years and years to resolve. The U.S. is the most leveraged entity in the world and our deleveraging will take down all other worldwide economies/countries. This is only logical due to the U.S.’s absolute and relative size (and imbalances) in the world’s economy.

    It’s all about getting small and frugal and, therefore, we all face the dire spectre of global deflation. This is not a pretty picture.

    I welcome all comments and criticisms of my opinion.

  34. Why is there no mention of the mark-to-market rule? The FASB issued rule 157 taking effect in November 2007. With lower home prices, some large institutions had to take losses when their mortgage-backed securities were
    valued at a current sale price rather than a cash-flow value.

  35. When I buy a share of stock on margin, I must put up 50% in cash or equivalents (unless I’m a hedgie). If the value of my account drops too low, 20% above water I believe, the margin clerk sells out my account, cramming me down, to protect the lender. Historically, you could buy homes on 20% margin, and there was no margin clerk. We got into this mess because recently, you could buy a home on 0% margin, and with no margin clerk. Now who, please explain, thought this was a good idea? And why should I bail out the lender? Remember, somebody voluntarily contracted for these deals. In the land of Oz here, the margin clerk doesn’t get involved until the thing is substantially underwater and the foreclosure guarantees the lender a big loss. Maybe we should consider tapping our heels together and returning to Kansas.

  36. To wGraves

    Fingers can be ponted everywhere; there are many culpable parties. The damage is done and irreversible over the near-term.

    What you are discribing was based on the principle (incorrectly) that real estate prices would continue upwards indefinately. In the real world, when the music stopped, there were no chairs for anyone to have a seat.

    But, if you care to look at my earlier post, mortgage debt insanity is only the tip of the debt iceberg.

  37. Increase Minimum wage and unemployment will rise.

    Debt = Growth

    with a huge increase in GDP, we should also have a huge increase in our debt, We Did Not.

    Congress makes the law and the voter votes for the Congress.

  38. It’s significant that the authors use the term housing “boom” (althought the term “bubble” shows up everywhere in the commentary). The authors seem bent on ascribing irrational behavior exclusively to the current period of falling asset values and not to the previous period of rising asset values. Or if they do not deny there was some irrationality in the upward movement, they seem to want to downplay it rhetorically. I’m not sure why. But I’d recommend reading Robert Schiller on the importance of trying to understand the irrational psychology that contributed to the crisis on the way up, not just the way down.

  39. Oh, I don’t think it’s that significant, except maybe in a Freudian sort of way. I totally agree that the boom was a bubble and it included plenty of irrational behavior. And I think a lot of the behavior during the crisis has been quite rational, at least on an individual basis. Fear can be quite rational: if you think everyone else is trying to get their money out of a bank that is solvent on paper, then the rational thing to do is get your money out first.

  40. Are we to assume that the reason there is a crisis of confidence is because Treasury and the Fed allowed Lehman Brothers to go bankrupt, in addition to lowering the standing of creditors of AIG?

    Would this incredible mess have been largely avoided if the Fed and Treasury had continued to save the creditors of large financial institutions as they had done with Bear Stearns?

    It seems to me that a big part of the problem was a fundamental lack of transparency. Lenders simply could not know with any certainty what financial shape potential borrowers were in. Isn’t it the unregulated derivatives market which is mainly responsible for this lack of transparency, in particular lack of transparency of the credit default swap contracts?

    If what I suggest is true, then it would seem that a top priority should be to shed a bright light on the health of all financial organizations by instituting some very strong regulations of the derivatives market.

  41. on derivitives:

    Agree transparancy is necessary. This can be achieved by a central clearing facility (regulated exchange) to assure counterparty certainty on contractual obligations. Let’s not leave this regulation up to the legislative branch of the federal government. They have a full plate already and their decisions will also take years to ammend and correct and be friendly to capitalism.

  42. Big article, lots of info. people explains with tons of reason…does anyone goes back to economics 101, it’s goverenment intervention, way too much.
    please allow Mr. Adam Smith comes in and let his invisile hand to resolve this mess. Well, the poor will suffer, but that’s the fact. It’s always unfair.

  43. Professor Kwak, do I correctly discern the implications of your analysis:
    a. Most of the freezing up of credit markets can be attributed policy decisions by Treasury and the Fed regarding Lehman and AIG
    b. Policy decisions that would have protected Lehman’s and AIG creditors would have prevented credit markets from freezing.

    And some questions:
    1. Should policy makers foreseen the impact of their decisions regarding Lehman and AIG? If so, why? (historical experience, economic theory, information available about Lehman’s and AIG debts, etc.)
    2. What should Treasurya and the Fed done regarding that would have prevented the crisis in confidence? Add, did they have legal authority to undertake those actions (and, if they didn’t, should that have stopped them from taking those actions)?
    3. Would economic forces already at work before Sept. 15-16 caused a US/global recession — which has been hastened or worsened by the credit freeze?

    Thank you for a very illuminating post.

  44. I am trying to put together the vicious circle of demand that fueled the financial crisis. Does this sum it up?
    1. Willing to tolerate inflation, US monetary and fiscal policy move very aggressively to avoided recession since the George H W Bush recession. This stimulates consumption and boosts demand for finished goods and raw materials.
    2. A centralized but capitalist China joins the WTO and floods the market with cheap industrial labor. Prevent their currency from rising, China artificially discounts the price of labor and finished goods which further boosts demand for finished goods and raw materials both of which are priced in US Dollars.
    3. Demand out-paces supply of raw materials driving rapidly rising inflation of commodities and building the wealth of nations such as Middle Eastern oil exporters.
    4. Exporting nations are largely not democratic and do not follow free trade policies. An international cartel inflates the price of a raw material. In many nations, centralized wealth limits consumption of finished products from Europe and the US.
    5. As the trade imbalance widens, money pools in exporting nations.
    6. Returns on US Treasury investments are suppressed by high demand from these nations and an aggressive domestic policy to stimulate economic expansion.
    7. Demand skyrockets for US Dollar denominated (and Euro) high cost, complex financial products with high returns. The exporting nations that purchase these products, supply consumers with discounted debt with which to further drive demand for finished products and raw materials.

  45. One problem with attempting to intervene in the housing sector and eliminate foreclosures by renegotiating mortgages is that many subprime mortgages have been securitized as collateralized mortgage obligations. If a mortgage is part of a security, it cannot be renegotiated without breaking a contract to owners of the security.

    One possibility would be to have the government buyout the mortgage and then issue a new mortgage at better terms for the borrower. In this case the government takes over the role of lender. This could be very costly for the government, particularly if the borrower runs into trouble making payments again. If the terms of the new mortgage allow the borrower to continue paying it off, then eventually the government could make money off of it.

    The difficulty in restructuring mortgages which have been securitized makes me wonder if it is such a good idea to securitize mortgages. I understand it is necessary to do this to provide a robust housing market. I wonder if it wouldn’t be possible to structure CMOs in such a way that failing mortgages that are part of the CMO might be adjusted after the fact. Surely this would be to the benefit of the security holder since a renegotiated mortgage which pays a smaller interest rate is certainly preferable to a failing mortgage which pays nothing back.

  46. Noel: I feel the need to point out that I am not actually a professor, though Simon is.

    To respond to your questions: first, it is much easier to be in my chair than in Henry Paulson’s. I freely admit that. You are right that we attribute a lot of significance to the decision to let Lehman and AIG’s creditors lose their money. However, while that was the precipitating cause of the panic, protecting those creditors in particular would not necessarily have prevented the panic. One could argue that the crisis would have just spread to the next investment bank (Morgan Stanley in this case), and it’s not certain that a string of serial bailouts would have prevented some type of credit crisis. And I think it is highly likely that the US at least would have ended up in a recession in any case. However, it’s almost certain that the intense panic of September 15 to October 15 deepened the recession.

  47. But thou, O Daniel, shut up the words, and seal the book, even to the time of the end: many shall run to and fro, and knowledge shall be increased. Is. 8:16, Rev. 22:10

    Many shall be purified, and made white, and tried; but the wicked shall do wickedly: and none of the wicked shall understand; but the wise shall understand. Zech. 13:19, Rev. 14:13; Ps. 1:5

    And he saith unto me, Seal not the sayings of the prophecy of this book: for the time is at hand. 10:4;
    Dan. 8:26

    just a few thoughts to consider in our neo post-modern world ;-)

  48. well my friends… the universe is expanding exponentially faster than it ever has before… we are not now even sure of the origin of our universe or/if what its ultimate conclusion/eventual end will be…

    maybe perhaps this has something to do with the current turmoil on our planet… perhaps it is time to seek a donor planet with new resources since earth’s capacity has almost reached it’s summit or carrying capacity for humans…

    master of arts
    educational technology
    universe city of northern iowa alumnae

    (much of my knowledge of critical thinking outside of the box i attribute to frje echeverria, my painting professor) who taught me that the visual learning world of seeing/looking/perceiving is just as or more important than the verbal/talking world of thinking/learning…sometimes our best ideas or solutions come when we quiet our minds and turn off our thinking…. i.e. carlos castaneda “the art of dreaming”

  49. While most of you have great ideas and economic sense that I admire, The question I would pose is this.

    Why did the banks offer mortgages to people who could not pay them back? Someone with an income of 30k, should qualify for no more than 90k, depending on debt load. 50k income, 150k mortgage ALSO figuring in the taxes, insurance AND Mortgage insurance if the down payment was less than 20%. A no down loan should never have existed, I’m not sure if 5% was a good policy…The blame goes on lax restrictions, greed and ……..well …….more greed.
    Now we all have to pay the piper and it will take some time to pay off the mortgage that was put on OUR futures.

  50. A comparison with Canada’s financial system is in order. Remember, they’re just north next door, and integrally linked with the US economy. Canada has some declining demand problems, to no ones surprise, but they do not have bank solvency and liquidity problems. Some one in the US should figure out why.

    Also, your situation statement does not adequately describe the level of sleaze, fraud, and conflict of interest in the mortgage markets (origination, rating, securitizing, sales to buy-side) that existed in late 2005, 2006, 2007, and early 2008. When “liar’s loan” entered the common vocabulary in 2007, anyone who was paying attention then knew that a major solvency problem would hit US financial institutions.

  51. I think we all need to take a look at some of our basic assumptions about economic growth, wealth, and GDP.

    If economic growth is measured in dollars that are created by fancy financial derivatives, then we are not measuring anything real. We are finding that much of this so-called growth can disappear in the blink of an eye.

    It is very hard to come up with a definition of something with intrinsic value. Neither money, nor real estate, nor oil, nor gold has any intrinsic value. Yet our modern world depends on having some measure of value. When whatever it is at the moment that we think of as the best holder of intrinsic value starts to lose value (meaning whatever the market says it is), then the world goes into turmoil.

    Someone could win a Nobel prize for untangling this conundrum.

  52. The baseline scenario was well articulated and argued.

    A couple of naive points…

    1. Bailout, for the most part, did not expand credit market(s). Bailout was, effectively, a transfer of liability from private sector firms to public sector [transfer of balance sheets.] Foreign purchase of treasury bonds, without waste by government, is a method of expanding domestic credit market(s). Foreigners would have likely, but not necessarily, invested in U.S. credit markets if interest rates were high(er).
    2. Inflation will occur, from printing of monies, lowering of discount rate, and lowering of federal funds rate, when housing prices re-appreciate. Crudely stated, a cost of current strategies will be realized at a future date.
    3. Capital Purchase Program creates opportunities for influence peddling.
    4. Changing yield of treasury bonds create profit opportunities in secondary market.

  53. can i ask a question? what is your audience for this stuff? if it is people who are already literate in the gloomy science then fine, they will understand it. but if it is intended to inform and explain to the economically illiterate, then i suggest you are wasting your time. consider the opening sentence which reads: ‘For at least the last year and a half, as banks took successive writedowns related to deteriorating mortgage-backed securities, the conventional wisdom was that we were facing a crisis of bank solvency triggered by falling housing prices and magnified by leverage. However, falling housing prices and high leverage alone would not necessarily have created the situation we are now in.’
    you may understand what a writedown is but most ordinary people don’t have a clue. why can’t you use simpler language or explain terms as you go along?
    what does leverage mean to most people? i would suggest that most people equate leverage with influence but in economics/finance it clearly has another meaning – so why don’t you use a simpler term, such as debt, or explain what leverage means.
    now that’s just the first paragraph. god knows what the rest of the piece contains in the way of specialised language and terminology that leaves most people scratching their heads. if you are trying to explain a complex issue to ‘simple’ people then you must use ‘simple’ language. end of lecture, honest!

  54. This is a tricky problem. Our audience includes everyone from beginners to specialists. As a result, we have two kinds of posts. Most of our posts, like this one, presume some familiarity with the concepts and vocabulary. If we had to explain what a credit default swap is every time we wanted to use one in a sentence, we would never get through anything.

    For that reason, we also have “beginners” posts, most of which are collected on the Financial Crisis for Beginners page. The idea is that if you read all of those, you should be able to understand all the other posts. If you don’t – that is, if you find a piece of jargon in a regular post that is not explained in a beginners post – let me know and I will put it on the list of stuff to cover in beginners posts. (Right now there is nothing on that list.)

  55. james
    can i make a suggestion? i have written several books dealing with subjects that are somewhat similar in nature to what you are doing – they were about subjects everyone was aware of, but which were also sufficiently complex and esoteric to confound and frustrate many readers. i decided that the best way to deal with this was to have a ‘glossary of terms’ section at the end of the book which readers could consult. why don’t you do the same, giving a link some prominence on your opening page. it worked, i think, with me;

  56. How depressing to read both the article and feedback. Not one participant in this debate even touched on the fact that confidence plummeted when people lost trust because they realised that what was being done was W-R-O-N-G – wrong – in most cases, because they too were behaving unethically. No one was able to recognise the ethics of the issue. Americans seem to be so obsessed with protecting your ‘rights’ – by codifying every move into rules and law, to ensure you can enforce compliance. It appears you have completely lost any capacity for personal discretion about deciding what is right or wrong, and thus taking personal responsibility.
    One can only pray that the election of Obama may allow some audacity to hope that Americans will actually start to reflect on the fact that actions have consequences and the life lived well is not just about self-interest maximisation at the expense of everyone else.

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