Tag Archives: Global Crisis

The Importance of Capital Requirements

Arnold Kling of EconLog has done the hard work of setting out his theory of the financial crisis and what we should learn from it in a fifty-page but highly readable paper available here. I have some quibbles but think it is  worth a read.

Here are the causes of the crisis in one table:

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Expert Panels and Bipartisan Consensus

Last week, Planet Money aired an interview by Adam Davidson with Barney Frank, the blunt and colorful chairman of the House Financial Services Committee. Davidson and Frank had a pitched disagreement over the question of whether it made sense to appoint a bipartisan, expert panel to take some time – figures between one and three years were thrown around – to study the causes of the financial crisis and, on that basis, recommend regulatory changes. Davidson thought it was a good idea; Frank thought it was nonsense.

I’m with Frank on this one, and the argument applies to the Financial Crisis Inquiry Commission, also known hopefully as the “New Pecora Commission,” appointed by Congress to study the causes of the crisis.

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Revisionist History

Probably most of you have already read David Cho’s Washington Post article on how the Big Four banks (a) have gotten bigger through the crisis, (b) have increased market share (“now issue one of every two mortgages and about two of every three credit cards”), (c) are using their market clout to increase fees (while small banks are lowering fees), and (d) enjoy lower funding costs because of the nearly-explicit government guarantee.

I just want to comment on this statement by Tim Geithner: “The dominant public policy imperative motivating reform is to address the moral hazard risk created by what we did, what we had to do in the crisis to save the economy.” (Emphasis added.)

Um, no.

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Causes: Too Much Debt

Menzie Chinn, one of my favorite bloggers, and Jeffry Frieden have a short and highly readable article up on the causes of the financial crisis. Chinn is not given to ideological ranting and is a great believer in actually looking at data, so I place significant weight in what he says.

Chinn and Frieden place the emphasis on excessive American borrowing, by both the public and private sectors.

This disaster is, in our view, merely the most recent example of a “capital flow cycle,” in which foreign capital floods a country, stimulates an economic boom, encourages financial leveraging and risk taking, and eventually culminates in a crash.

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Larry Summers on Preventing and Fighting Financial Crises

This fall I am taking a course on the “international financial crisis” taught by Jon Macey and Greg Fleming (yes, the former COO of Merrill Lynch). The first assigned reading is a speech that Larry Summers gave at the AEA in 2000 entitled “International Financial Crises: Causes, Prevention, and Cures,”* summarizing the state of the art in preventing and combating financial crises. It’s based on experiences from emerging market crises in the 1990s, and doesn’t even contain a hint that something similar might happen here; however, few people could fault Summers for making that oversight back in 2000, and I certainly won’t.

Many people, including Simon and me, have discussed the similarities between our recent financial crisis and the emerging market crises of the 1990s, so I’ll be brief. The main similarities are excessive optimism that creates an asset price bubble, a sudden collapse of confidence that causes the rapid withdrawal of money and credit, a liquidity crunch, and rapid de-leveraging that threatens solvency. (We have also argued that there are political similarities, but let’s leave that aside for now.) The biggest difference is that instead of being compounded by flight from the affected country’s currency and government debt, in our case the exact opposite happened; investors fled toward the U.S. dollar and Treasuries, making things easier for us than for, say, Thailand. Also, to a partial extent, the parallel requires an analogy between emerging market countries and United States banks; for example, the issue of bailouts and moral hazard arises in the context of the IMF bailing out Indonesia and in the context of the United States government bailing out Citigroup.

Summers’s speech makes a lot of sense, so I’ll just highlight a few points he makes that I think are particularly instructive given our recent experience. I think these are all excellent points. For each one, I’ll quote from Summers, and then comment on its relevance to our situation.

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Mixed Messages

David Wessel seems to be doing the impossible: his book, In Fed We Trust, is getting mentions from all over the Internet, even before its publication, despite competition from what seem like dozens of other crisis books. That’s what a good PR campaign (and a good review from Michiko Kakutani) will do for you.

I obviously haven’t read the book yet, but I was interested in this description in Bloomberg:

None of the senior government policy makers anticipated the credit-market collapse that followed Lehman’s bankruptcy filing in the early hours of Sept. 15, according to Wessel’s book. . . .

On a conference call the previous week, Paulson, Bernanke, Securities and Exchange Commission Chairman Christopher Cox, and senior staff members from those agencies had agreed that companies and investors who did business with Lehman had learned from Bear Stearns and would have acted to protect themselves from a Lehman failure, Wessel wrote.

What were they supposed to learn from Bear Stearns? That they should be very, very afraid of a major bank failure and take steps to protect themselves? Or that the government would step in, so that even if shareholders were largely wiped out, counterparties would be protected? It seems like more of them drew the latter conclusion, even though Paulson, Bernanke, et al. wanted them to draw the former conclusion.

This seems to me an illustration of the fact that you can never be sure what message you are sending. Perversely, even letting Lehman fail ultimately convinced market participants that the government would step in the next time – because the damage done by Lehman’s collapse was so great. One-off intervention are a crude and risky way of communicating policy and creating incentives.

By James Kwak

What Will Change?

Timothy Garton Ash is a prominent modern European historian, who became famous writing about the collapse of Communism and the transformation of Eastern Europe in the 1990s. It was something many people thought they would never live to see.

A friend asked me what I thought of Ash’s article a couple of months ago in The Guardian, where he asked what will come of modern capitalism in the wake of the financial and economic crisis.

An extreme “neoliberal” version of the free-market economy, characterised not just by far-reaching deregulation and privatisation but also by a Gordon Gekko greed-is-good ethos – and fully realised in practice only in some areas of Anglo-Saxon and post-communist economies – seems likely to find itself [left in ruins or at least very substantially transformed]. But how about a modernised, reformed version of what postwar German thinkers called the “social market economy”?

Ash goes even farther than what you might call the Continental European social-democratic model, and envisions a world with a better balance between production and consumption, between national and international governance, and between exploitation and protection of the environment.

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