The Global Financial Crisis: Causes and Consequences

Franklin Allen University of Pennsylvania

and

Elena Carletti European University Institute

June 30, 2009

1. Introduction Financial crises have been pervasive for many years. Bordo et al. (2001) find that their frequency in recent decades has been double that of the Bretton Woods Period (1945-1971) and the Gold Standard Era (1880-1993), comparable only to the period during the Great Depression. Nevertheless, the financial crisis that started in the summer of 2007 came as a great surprise to most people. What initially was seen as difficulties in the U.S. subprime mortgage market, rapidly escalated and spilled over first to financial markets and then to the real economy. The crisis has changed the financial landscape worldwide and its full costs are yet to be evaluated. The purpose of this paper is to consider the causes and consequences of the crisis and how the financial system should be reformed in terms of institutions and regulations. Despite its severity and its ample effects, the current crisis is similar to past crises in many dimensions. In a recent series of papers, Reinhart and Rogoff (2008a, 2008b, 2009) document the effects of banking crises using an extensive data set of high and middle-to-low income countries. They find that systemic banking crises are typically preceded by credit booms and asset price bubbles. This is consistent with Herring and Wachter (2003) who show that many financial crises are the result of bubbles in real estate markets. In addition, Reinhart and Rogoff find that crises result, on average, in a 35% real drop in housing prices spread over a period of 6 years. Equity prices fall 55% over 3 years. Output falls by 9% over two years, while unemployment rises 7% over a period of 4 years. Central government debt rises 86% compared to its pre-crisis level. While Reinhart and Rogoff stress that the major episodes are sufficiently far apart that policymakers and investors typically believe that this time is different, they warn that 1

the global nature of this crisis will make it far more difficult for many countries to grow their way out. A thorough overview of the events preceding and during the current financial crisis is provided in Adrian and Shin (2009), Brunnermeier (2009), Greenlaw et al. (2008), and Taylor (2008). Its seeds can be traced to the low interest rate policies adopted by the Federal Reserve and other central banks after the collapse of the technology stock bubble. In addition, the appetite of Asian central banks for (debt) securities contributed to lax credit. These factors helped fuel a dramatic increase in house prices in the U.S. and several other countries such as Spain, Ireland and the U.K. In 2006 this bubble reached its peak in the U.S. and house prices there and elsewhere started to fall. Mayer, Pence and Sherlund (2009) and Nadauld and Sherlund (2008) provide excellent accounts of the developments in the housing market preceding the crisis. The fall in house prices led to a fall in the prices of securitized subprime mortgages, affecting financial markets worldwide. In August 2007 the interbank markets, particularly for terms longer than a few days, experienced considerable pressures and central banks were forced to inject massive liquidity. Conditions in collateralized markets also changed significantly. Haircuts increased and low quality collateral became more difficult to borrow against. The Federal Reserve and other central banks introduced a wide range of measures to try to improve the functioning of the money markets. During the fall of 2007, the prices of subprime securitizations continued to fall and many financial institutions started to come under strain. In March of 2008 the Federal Reserve bailed out Bear Sterns through an arranged merger with J. P.

Morgan. Public funds and guarantees were required to induce J. P. Morgan to engage in the transaction. Although the financial system and in particular banks came under tremendous pressure during this time, the real economy was not much affected. All that changed in September 2008 when Lehmans demise forced markets to re-assess risk. While Lehman's bankruptcy induced substantial losses to several counterparties, its more disruptive consequence was the signal it sent to the international markets. Reassessing risks previously overlooked, investors withdrew from the markets and liquidity dried up. In the months that followed and the first quarter of 2009 economic activity in the U.S. and many other countries declined significantly. Unemployment rose dramatically as a result. The general consensus is that the crisis is the worst since the Great Depression.

2. What caused the crisis? From August 2007 until September 2008, there was fairly wide agreement that poor incentives in the U.S. mortgage industry had caused the problem. According to this explanation what had happened was that the way the mortgage industry worked had changed significantly over the years. Traditionally, banks would raise funds, screen borrowers, and then lend out the money to those approved. If the borrowers defaulted, the banks would bear the losses. This system provided good incentives for banks to carefully assess the creditworthiness of borrowers. Over time, that process changed and incentives were altered. Instead of banks originating mortgages and holding on to them, what happened was that brokers and also 3

some banks started originating them and selling them to be securitized. This process is termed the originate and distribute model. The originators, the brokers and the banks, were paid based on the number of mortgages that they approved so their incentives were to sell as many mortgages as possible. Since they were selling them off, it wasn't their problem if the borrowers defaulted. The second stage in the process of this new originate and distribute mortgage system was securitization. The entities that undertook securitizations such as investment banks would pool a whole set of mortgages together. These would be taken from across the country so they would have good risk properties in terms of diversification. The securitizing investment bank would then tranche them so that the risk was spread differentially, depending on the particular tranche owned. The buyers of the most junior trench would be allocated any default losses first. Then as more losses were accumulated they would exhaust the lowest tranche and start to be allocated to the next most senior one and so on up the seniority chain. There would have to be a large amount of losses before the most senior ones would bear any losses so they were regarded as fairly risk-free and were rated triple-A. More junior tranches would have lower ratings. Initially with this new system, the most junior tranches would be held on to by the investment bank or other entity doing the securitization. If there was a problem, they would be hit first. The reason for this was to provide good incentives to those doing the securitization to ensure that the originations and everything else was done properly. Increasingly what happened, though, was that all tranches were sold off, including the junior ones. This took away the incentives of those doing the securitization to check that everything was done properly. In a careful empirical study, Purnanandam (2009) found that 4

mortgages that were originated under the new originate and distribute model were of significantly lower quality than those originated under the traditional system where they were held on the originating banks balance sheet. Another important incentive issue concerned the ratings agencies. Since buyers of the tranches looked at ratings, the question was: Are the ratings agencies doing a good job? Many argue that the answer was no because the agencies began to receive a large proportion of their income from undertaking ratings of the securitized products. The idea was that they started to lose their objectivity and to give ratings that weren't justified. According to the mortgage incentives view of the crisis, the whole procedure for checking the quality of the borrowers, and the mortgages underlying the securitizations broke down. This view of the world suggests that it is fairly simple to solve the crisis and stop it from reoccurring. The government needs to regulate the mortgage industry to ensure everybody has the correct incentives, and this will stop the problem. The whole crisis would then go away and things would quickly return to normal. It seems from the statements of the Federal Reserve and the Treasury at the time that initially this was the view that they took. However, as the crisis continued and then after the default of Lehman the dramatic collapse in the global real economy made this view that subprime mortgages were to blame less and less plausible. The economies in many countries in Asia and in Europe were drastically affected even though their banks had very little exposure to U.S. securitizations and remained strong. In Japan, for example, GDP fell by 4 percent in the first quarter of 2009. Less extreme drops in industrial production and GDP than those experienced in Japan were occurring all over the world and the world economy began to gradually seize up. As this happened it became much 5

more difficult to believe that what caused all of this was an incentive problem in the U.S. mortgage industry. What was going on then?

3. The real estate bubble We shall argue that the basic problem that caused the crisis was that there was a bubble in real estate in the U.S. and also in a number of other countries such as Spain, Ireland and the U.K. What happened is that the bubble burst, and this has caused the huge problems in the securitized mortgage market and in the real economy. This bubble was a huge bubble. It was global in many ways. That is why the effects on the real economy were so large. Figure 1 shows the Case-Shiller 10-city index since 1990. The figure illustrates the dramatic acceleration in house price increases in the early 2000s and their fall since July 2006. The next question given this view is: What caused the bubble? We argue that there were two main causes. The most important reason that the bubble was so big in the U.S. was the policies of the Federal Reserve back in 2003. What they did to avoid a recession after the collapse of the tech bubble in 2000 and the 9/11 terrorist attacks in 2001 was to cut interest rates to the very low level of one percent. This was at a time when housing prices were still growing quite strongly at a rate above one percent. Even if they had only been growing at the rate of inflation, which was around three percent, the Fed suddenly created an incentive to go out and borrow at one percent and buy houses going up at three percent. In addition there were various other aspects that made it advantageous to buy. These included the tax advantages of being able to deduct interest on mortgages compared to no deductibility of rent payments, plus some other policies to encourage poor people to buy houses. All these 6

factors created a huge demand for buying houses. That led to an increase in house prices and the process then fed on itself. When house prices started to go up five or ten percent a year, then it became worth borrowing even after the Fed raised interest rates. Thus the Feds low interest rate policy was the first factor that really caused prices to take off in a huge way. However, this was not the only factor. In some European countries such as Spain and Ireland there were also large property bubbles. Of course, there the ECB was controlling interest rates and they did not go nearly as low so it is not possible to just blame the Fed. The second important element in addition to low interest rates in the U.S. was global imbalances. This problem started with the Asian Crisis of 1997. Many Asian economies, which had done very well, like South Korea, fell into serious difficulties. In the case of South Korea it was because its firms and banks had borrowed too much in foreign currency. They turned to the International Monetary Fund (IMF) for help to see them through these difficult times. In exchange for providing financial assistance, the IMF required South Korea to do two main things. The first was to raise interest rates and the second was to cut government spending. That is the exact opposite of what the U.S. and Europe have done when faced with a very difficult crisis. To understand why this happened, its important to remember that the IMF is a European and U.S. dominated institution. The head of the IMF up to now has always been a European and the head of the World Bank has always been an American. That was part of the carve-up of responsibilities when the Allies negotiated the Bretton Woods agreement at the end of the Second World War (even though it is not explicitly stated anywhere in the treaty). What about Asian countries? Well, they don't get represented at the highest levels. So, when you had this problem of the IMF going in and imposing very harsh 7

policies that were going to be extremely painful, there was no effective mechanism for the Asian countries to protest and say, Look, this is the wrong thing to do. We have fundamentally sound economies. This is unfortunate that this has happened, but don't be harsh on us. The Asian countries didn't have much weight in the governance process. Their quotas (i.e. effectively their shareholdings) were small, and also there were relatively few Asian senior staff. What the Asian countries deduced from the 1997 crisis was that if they don't have the right representation, what they must do is to make sure that never again would they have to go to the IMF to obtain relief from a crisis. Instead they accumulated literally trillions of dollars of assets. Figure 2 shows this accumulation of reserves by China, Hong Kong, Japan, Singapore, South Korea and Taiwan. This is the line marked Asia. In contrast, Latin American and Central and Eastern European countries did not increase their reserves during this period. How were the Asian countries to invest these reserves? You might think they should invest in firms equity. What happened, though, was that it became difficult for the Chinese in particular to buy companies. For example, when their state oil company CNOOC wanted to buy Unocal the transaction was blocked by the U.S. authorities on the grounds that Unocal was a strategic firm. That happened on a number of other occasions. What the Chinese ended up having to do was to invest mainly in debt instruments. They bought a large amount of Treasuries, Fannie and Freddie mortgage-backed securities, and many other debt securities. particularly for mortgage borrowers. This wave of debt happened not just in the U.S. but also in Europe, particularly in countries like Spain and Ireland. This huge supply of debt helped

to drive down lending standards to ensure that it was all taken up. The large amount of debt resulting from global imbalances was the second major factor contributing to the bubble. These were not the only factors. For example, another factor was the yen carry trade. Essentially, investors could go to Japan and borrow at zero interest rates and invest somewhere else such as Australia and New Zealand at much higher rates. There was an exchange rate risk, but most of the time it was possible to make a large amount of money. There was a large outflow of funds from Japan. The problem is that we dont have too much idea exactly how big the yen carry trade was but it probably helped contribute to the property bubble in Australia, for example.

4. The effects on the real economy Why did the collapse of the bubble create so many problems? The whole global economy went into a downward trend. It can be argued that what went wrong is that people made the wrong decisions for about a decade, based on the assumption that asset prices would keep on going up. In the U.S., the aggregate saving rate fell to zero. What was the point of saving? If you owned a house, its price was going to keep on going up. If you owned stocks, their value was going to keep on going up. So people stopped saving and many borrowed to finance consumption. The leverage ratios of households, of firms, and of institutions, all went up. When there was the big fall in asset values, people found they were overleveraged and they had saved too little. That means that they stopped doing what they were doing before and started saving to pay down debt and build up their assets. The problem is that because things had been out of whack for about a decade or more, it became very uncertain what things were worth. For example, stock prices have been 9

incredibly volatile in both directions. In January and February, they were falling. There was a dramatic drop with the S&P going to 686 by the beginning of March. Then the price went up about 30 percent in the next few weeks. It is very difficult for people to estimate how much their stock is worth in the long run. It wouldn't be surprising if the stock market went up 50 percent in the next few months. It also wouldn't be surprising if it went down 50 percent after these moves. Another example of price volatility is commodities. It was only last summer that oil was trading at $147 dollars a barrel, and then the price went down to around $40 in a short space of time. If you are going to buy a car, should you buy a Toyota Prius, which is going to be fuel efficient, but costs two or three thousand dollars more, or should you buy an SUV on the assumption that gas prices are going to be low in the long run? Again, it's a very difficult to make that decision. For firms making investments it's also a significant problem to know what to do. In addition to the uncertainty about commodity prices, exchange rates have also been volatile. If you look back to the summer of 2008, the pound sterling was over $2. Then it went down to $1.40. The Euro was at $1.60 then. It went down to about $1.25 before rising back to about $1.40. To summarize, it is very difficult for anybody trying to make decisions because they don't know where prices are going to be a month from now, let alone a year from now. In our view, this is what is chilling the global economy. People are unwilling to make decisions because they don't know what prices are likely to be going forward. That's the major issue. This is true for consumers and it is true for firms. That is why sales of consumer durables

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like cars and investment goods like machine tools have stalled. Since these represent a large proportion of exports and imports, world trade has collapsed.

5. The effects on the financial system Of course, price uncertainty is not the only problem. There are also problems in the financial system. This is a major cause of the economic difficulties. In fact, it's the interaction between the real economy and the financial system that we would argue is particularly damaging. Let us next focus on the financial system. The crisis started in the summer of 2007 with the meltdown in subprime mortgages as discussed above. This caused a problem because these mortgages were held by institutions that don't deal very well with asset price falls. When people hold stocks in a mutual fund for their retirement, it is not such a large problem if there is a significant fall because on average the money is not needed for many years. However, the mortgages were held in debt-based institutions. Many of them were in investment banks or structured investment vehicles (SIVs) and to a large extent they were financed by rolling over short-term debt. In this case, as soon as there is a fall in prices there is a significant problem, because lenders don't know whether they are going to be paid back. The problems started in securitized subprime mortgages but then they spread to many other parts of the financial system because of the interaction with the real economy. These credit risk problems have led to a flight to quality with many people wanting to buy government securities. What the central banks have been doing is to try and deal with this desire for high grade securities. Now a triple-A rating doesn't mean anything unless you know exactly what you're getting, like a government security. The central banks have facilitated this with all these programs that they have where they allow financial institutions 11

to swap a wide range of securities for Treasuries. As a result the Federal Reserves balance sheet has expanded form about $800-$900 billion before the start of the crisis to about $2,000-$2,500 billion afterwards. To summarize, there are two basic problems. The first is that people don't know the prices that should be guiding economic decisions. The second problem is the financial system has enormous problems and the two interact.

6. Why has the financial system performed so poorly? The financial services industry is the most regulated sector in practically all economies. In the U.S., the Federal Reserve, the Office of the Comptroller of the Currency (OCC), the Securities and Exchange Commission (SEC), The Federal Deposit Insurance Corporation, and a number of other regulatory bodies are responsible for regulating the financial sector. What happened? Why did things get so out of control? Why did this crisis come as such a surprise to regulators? The first important point is that banking regulation is very different from other kinds of regulation. For example, with environmental regulation there is wide agreement concerning the basic problem. There is a missing market. If a firm pollutes, then it does not have to compensate the people who are damaged. That missing market means that without any controls or regulations, there is a lot of damage done to the environment. We all accept that this is the basic problem. Given this agreement, we can come up with the best ways to control pollution such as quantitative controls or trading permits. Antitrust is another important area of regulation. There the problem is monopoly. It is necessary to make sure that firms aren't monopolistic and everybody agrees that this is the problem. 12

With banking regulation, the problem that is being solved is not at all clear. Is the problem one of panics, contagion or what? In fact, there is no wide agreement that there is even a problem. Many central banks work with dynamic stochastic general equilibrium models that don't even include a banking sector. The view underlying these models is that the real economy is going to work fine and the financial system is unimportant except for pricing assets (see, e.g., Muellbauer (2009)). Given this approach it is not surprising that so many central banks completely failed to predict the crisis. What is it that determined the current structure of banking regulation? In the Great Depression, the economic situation was so bad that people said, We have to make sure that this never happens again. What they did is to adopt a whole range of measures to stop any kind of problem. They put in place the Glass-Steagall Act separating investment and commercial banking, they founded the Securities and Exchange Commission (SEC), they put in place all the SEC Acts, and everything became extraordinarily regulated. This regulation was successful in terms of stopping crises. From 1945 until the early 1970s, there were no financial crises in terms of banking crises, except for one in Brazil in 1962 (see Bordo et al. (2001)). So we know how to stop crises. We just stop financial institutions taking risks. The problem is that the alternative to private institutions taking risks is that basically the government decides who gets credit. This is done in different ways. Some countries like France nationalized the banks and the government directly made decisions. In the U.S., the government introduced so many regulations that banks couldn't take many risks and so low risk industries were allocated credit. As a result the financial system stopped fulfilling its basic purpose of allocating resources where they are needed. In the 1970s it became clear how inefficient this is and financial liberalization started in many countries. However, this 13

led to a revival of crises. Since then, there have been crises all around the world (see, e.g., Boyd, De Nicolo, and Loukoianova (2009)). This historical evolution has led to a mishmash of regulations designed to stop particular problems rather than a well thought out way of reversing market failures in the financial system. If there was a problem, the regulators put in place a regulation. We would argue that the actual regulation we have is rather unfortunate as it requires much time and effort for banks to comply with it, but doesnt actually do much in terms of benefits.

7. Banking regulation In order to design effective banking regulation it is necessary to have a clear idea of what are the benefits and what are the costs. The benefit of regulations is that they can potentially stop very damaging crises. But the cost is that if you really want to guarantee you don't have them, you stop the financial system doing its job of allocating resources. That stops growth and innovation and many desirable things. A good example of what happens if you dont have in mind a clear idea of the benefits and costs of regulation is the Basel Agreements. There is no clear statement of what the problem the Agreements are solving is anywhere in the documents. Banks and governments have spent billions of dollars designing and implementing them. Yet if you ask why are the capital requirement ratios set at the numbers they are, there's no explanation. They simply chose ratios that banks had used in the past. Not surprisingly the agreements did not prevent the crisis and seem to have had very little effect in reducing its severity. What are the market failures in banking? There are three main ones in our view. 1. The inefficient provision of liquidity. 14

2. Persistent mispricing of assets due to limits to arbitrage. 3. Contagion. We will consider each in turn. The first problem is inefficient liquidity provision (see, e.g., Allen and Gale (2004) and Allen and Carletti (2006)). Throughout the current crisis we have seen that the financial markets are not doing a good job of providing liquidity. That is why central banks have been stepping in and designing many programs, trying to inject liquidity into the banking system and so on. What we need to have going forward is a better understanding of why is it that markets don't provide liquidity properly. The basic problem is that liquidity is costly to hold. The only way that you are going to get people to hold it in a financial system without government intervention is if there is significant price volatility. But it's price volatility that causes crises. When prices fall to low enough levels this can bankrupt financial institutions. The second market failure, which is a very important one, is persistent mispricing of assets due to limits to arbitrage. One of the big issues in the current crisis is how much are the mortgage-backed securities worth? Why doesn't the market tell us that? If markets are efficient then you can trust market prices. The basic idea behind market efficiency is that if something gets underpriced, there is a profit opportunity. Investors can buy the underpriced security and make a profit. That incentive provides the arbitrage mechanism to make sure that prices rise to the correct level. In the current crisis something seems to have gone wrong with this. In particular, there are limits to arbitrage. A good example is what happened in the fall of 2007. The prices of the mortgage-backed securities went down. So what did investors do? They doubled up. They thought, "Okay, these are cheap. We should go in and buy." But the problem is that the prices kept on going down and that caused a huge problem for 15

many investors. It became too risky to arbitrage the securities. The mispriced securities became the so-called toxic assets. If you think about the dotcom bubble, it's the same idea there. Prices were too high. Why didn't investors short the assets? The problem was that if you shorted them in 1997 or 1998, when their prices were high, you were wiped out because their prices kept on going up. That's the limit to arbitrage. We need to understand these limits to arbitrage. We need to have mechanisms for overcoming them so markets are efficient and market prices can be trusted. The third market failure is contagion (see, e.g., Allen, Babus, and Carletti (2009) for a survey). This is the really important one. This is the one that central banks often use to justify intervention. An example is their intervention to help arrange the takeover of Bear Stearns. If you read Chairman Bernanke's speech at Jackson Hole in August 2008 (Bernanke (2008)), the argument he used was that if the Federal Reserve didn't save Bear Stearns, then the firm would have defaulted. That would have led to a whole chain reaction where many other financial institutions would have gone bankrupt. There might have been a complete collapse of the financial system. Now, were they right to do that? Probably, given the circumstances they were in. They only had two days to figure out the degree of interconnectedness of Bear Stearns, and they couldn't really do it in that time. Immediately after the arranged takeover of Bear Sterns, the Federal Reserve opened up the discount window to the investment banks. The quid pro quo for that was that they would allow Fed teams to inspect their books find out their positions. Six months later in September, the Fed had a much better idea of the interconnectedness of these banks. When it became clear that Lehman Brothers would not survive on its own and the Fed had to decide 16

what they should do, it appears that they believed there would not be the classic kind of contagion if they allowed Lehman to go bankrupt. In fact there was contagion but it was quite complex. The first thing that happened was that Reserve Capital, the oldest money market mutual fund, held a significant amount of Lehman debt and when this debt became almost worthless the fund broke the buck. In other words, the value of Reserve Capitals shares fell significantly below the mandated level of one dollar a share. Investors in other money market funds suddenly started to realize that there could be a wave of similar problems. There was a large withdrawal of funds from money market mutual funds. Within a few days the government was forced to provide a guarantee of all money market mutual funds. Just after Lehman Brothers was allowed to fail it became clear that AIG was on the point of default. In this case the government decided they could not take another risk so, they saved AIG to prevent an even larger problem of contagion. In addition to these direct contagion effects, there appear to have been indirect effects that were very damaging. The realization the government might allow a financial institution to fail caused a loss of confidence in many financial services firms. The volumes in many important financial markets fell significantly and there was a large spillover into the real economy. Up to that point the crisis had been largely confined to the financial sector with relatively few effects on real economic activity. Figure 3 shows how GDP fell significantly in the fourth quarter of 2008, particularly in Japan and Germany. This underlines the importance of the process of contagion. At the moment, however, our understanding of the indirect contagion effects is rather limited. We need to develop a much better understanding of the many different aspects of contagion. 17

Going forward it is important that banking regulation is structured to solve these and other market failures. We need to understand the best way for central banks to intervene to restore liquidity in crucial markets like the interbank market. Market structures need to be designed to try to make them as efficient as possible so we do not have extended episodes of mispricing of assets. Finally, we need to design regulations that will minimize the pernicious effects of contagion. Capital regulation would appear to have an important role to play here.

8. How will the crisis develop? The next question is what is going to happen going forward? This is the big issue that we face. People talk an awful lot about the Great Depression. The problem is that the Great Depression was more than 75 years ago. Institutions, technologies, and many other aspects were very different in those days. Were there any other recent crises that were similar? As mentioned above, since the early 1970s there have been many crises all over the world. They haven't happened in the U.S., with the possible exception of the S&L crisis, but they have happened in many other places. The most similar crisis perhaps was Japan in the 1990s. The reason is that Japan is the second biggest economy and had an enormous bubble both in stock prices and in property prices. Was it really a bubble? In the mid-1980s, the Nikkei was around 10,000. By the end of the decade in December 1989, the Nikkei peaked at just under 40,000. That was almost 20 years ago and yet recently the Nikkei has been trading in the range of 7,000 to 10,000. It is around a quarter to a fifth of where it was 20 years ago. That indicates it was a bubble.

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What about property prices? At the peak of the boom, the value of the few hundred acres that the Imperial Palace stands on in Japan had the same value as all the land in Canada or California (see Ziemba and Schwartz (1992), p. 109). That was a bubble, too! Real estate prices fell 75 percent over 15 years. This fall caused enormous problems in the real economy and Japan went from having one of the most successful and the fastest growing economies in the world, to having one of the slowest growing. If you think the U.S. has had a bubble, the question is will the after effects of it bursting be equally bad as in Japan? Many people argue that it wasn't nearly as big a bubble in the U.S. in the sense that there wasnt such an increase in asset prices to the same kind of very high absolute levels. We did see the tech bubble in stock prices reverse in 2001, but of course now the issue is, was there also a stock bubble from 2003 to 2007? Stock prices have fallen to around a half of what they were at the peak at the end of 2007. Is this a long-lived phenomenon, like in Japan? Or is this just a liquidity problem such that prices are going to snap back to where they were in a year or two as they did after the crash of 1987? Many people believe they are going to go back because once the government has cleaned up the financial system, everything will be fine. Many experts argue that in the U.S. property prices were about 25 percent above trend. Using the Case-Shiller indices property prices now are about 30 percent down. Does this mean that price adjustment is finished and the economy will start to go back to normal as it did eventually in Japan? Not necessarily. The problem is that Japan has a very different kind of economy. The way that firms and banks reacted is very different from the U.S. In particular, in Japan, firms are much more stakeholder-oriented. In other words, they don't

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care so much about the shareholders. They care about the workers, the suppliers and other stakeholders. What is the evidence for this? There are surveys, for example, where the question asked is, What's the prevalent view in your country? If times get bad, should firms maintain dividends and lay off workers or should firms cut dividends and keep stable employment?" Figure 4 shows that the answer to this question differs significantly across countries. In Japan, pretty much everybody says, What firms should do is cut dividends and maintain employment. In Germany and France, it is not quite as extreme, but clear majorities believe that. In the U.S. and the U.K., it's the complete opposite. Firms should fire the workers and keep dividends up. In the last 20 years, this focus on shareholders has been a wonderful thing for the U.S. and the U.K. because it has allowed resources to be reallocated in the economy very quickly. If resources are being misused somewhere, then they can be transferred to other firms. If you look at Japan in the 1990s and 2000s, the firms weren't able to do that. It's usually argued that in the European economies, they have the same problem as in Japan that resources arent reallocated very easily. The problem is, though, that if firms lay off workers in the current crisis environment, there can be a very different outcome. What is happening in the U.S. is that firms are firing many workers, unemployment is going up, and that's having dramatic macroeconomic consequences. The unemployment rate in the U.S. just before the crisis started in July 2007 was 4.7 percent. By May 2009 this had risen to 9.4 percent. However, its not just the unemployment itself that is so damaging it is also the fear of unemployment that this triggers. This also has very serious macroeconomic effects. 20

What's happening in the U.S. compared to what's happening in other countries? What we've done in Figure 5 is to look at companies in the auto industry and in white goods or consumer durables. Both industries are being hit quite badly. What you see is dramatically different responses in these different countries in terms of layoffs. In the U.S. there are many layoffs. In the other countries they're also laying off workers but not nearly as much. If you take German firms at the other extreme, they are not cutting very much. In fact, Volkswagen is increasing employment. What that means is that in Germany, people are not worried by unemployment because they don't feel personally threatened. So the lack of layoffs has two effects. Firstly, it has the beneficial effect that there are relatively few unemployed people. But secondly, and perhaps more importantly, the fear of unemployment is much less. If you look at the aggregate statistics for unemployment in Figure 6, what you see is that U.S. unemployment is going up dramatically. Moreover, it looks to continue going up for some time. In contrast for Germany, the line is basically flat. The workers, therefore, don't feel threatened. They are still consuming. If you think back to the G20 meeting at the start of April, one of the big issues was that the U.S. and the U.K. were saying, Look, we need to have these stimulus packages. France and Germany were saying, No, we don't need that. One of the important reasons for this big difference is that the crisis doesn't affect people in France and Germany nearly as much as in the U.S. and U.K. because they have very different kinds of corporate governance. Japan is an interesting case because they've always had this great commitment to full employment. But a few years ago, they introduced a temporary worker category. What's actually happened is all those temporary workers have been fired and they have huge problems because of that. It doesn't show up in their unemployment statistics because since 21

they weren't employed fully and didnt have full-time jobs, when they get fired, they don't show up as unemployed. To sum up, focusing on value creation for shareholders works well for the efficiency of the economy in boom times as it facilitates the reallocation of resources to their most efficient uses. However, in crisis times laying off workers has the potential to create macroeconomic instability. A rapidly rising unemployment rate can cause significant feedback effects. A critical issue when comparing Japans experience in the 1990s with U.S. experience now is how big these feedback effects will be in the U.S. Japan had a lost decade with slow growth but did not have a large contraction in GDP and increase in unemployment. In the U.S. we have yet to see if the feedback effects will in the end be large.

9. An assessment of current policies An important issue is how most central banks and governments view the problem of the crisis at the current time. As mentioned above, initially the general reaction was that the crisis was due to a problem in the financial system, and in particular it was a result of poor incentives in the mortgage market in the U.S. As the crisis developed, there were other significant problems in the financial system. With the view that the problems are in the financial system, the solution is to solve those problems. As long as enough money is put into doing that, the financial system will start working again. Firms will start borrowing, consumers will start borrowing, everything will snap back quickly and the problem will be solved. The real economy will quickly go back to normal.

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There are problems with this view that by putting enough money into the financial system the crisis will be ended and the economy will recover.. Why is it that banks aren't lending? One possibility is that its not fear of lending, but rather that they want to hoard liquidity. They're worried about things getting worse and that's why they're hoarding liquidity. But equally important, there's a real problem that people don't want to borrow. They have already borrowed enormous amounts in recent years. Many of the people who want to borrow are people who have to borrow. Everybody else is trying to pay down debt. Arguably the big problem for the next couple of years is going to be deflation. That is what happened in Japan. With deflation, debt is the last thing that people want because real servicing costs are going to go up dramatically. People who have the choice don't want to borrow and this is compounded by fear of unemployment, and all those factors. The only people who want to borrow are people with no choice who are usually a terrible credit risk. That's why the banks are so reluctant to lend to them because they know they are bad credit risks. Does the Geithner plan solve the problem? It may help the financial system somewhat but it's going to cost a great deal of money and it's not clear that it is going to work. Instead it can be argued that what the government should have done is something very dramatic. What Roosevelt did when he became President in 1933 was introduce a banking holiday. He closed down all the banks. They did an audit to check which were safe and which were not. That was a very dramatic act and it helped the situation. The equivalent would have been to step in and nationalize the banks that are in big trouble like Citigroup and Bank of America. The government would then have control and they could stabilize things because customers would know that they are dealing with the government. 23

The government thinks they are going to solve the problem with their current policies. So far, that hasn't happened. Even if they solve the problem in the financial system, which is difficult, there is still this problem in the real economy of the burst bubble and the resulting price uncertainty. This is why in our view it is misplaced to focus entirely on the financial system. The real problem is real estate prices take a long time to adjust, particularly if you've had a big bubble. If you think about Japan, it took 15 years for property prices to hit bottom. When are property prices in the U.S. going to hit bottom? That's a very difficult question to answer. It could be next year or another two years or three years from now. As long as the process of price adjustment is happening, people don't know their wealth and how much to save. Since people are risk averse, they tend to save more and are reluctant to buy consumer durables and so forth. This is all compounded by the fear of unemployment. Arguably, the current government policies to try to stop house prices falling such as asking banks not to foreclose tend to exacerbate this problem of price adjustment. It would be better to let housing prices to fall as quickly as possible because then people will start buying again.

10. Excessive risk taking in the private or public sectors? Going forward, what should governments be doing to minimize the risk of a future financial crisis? What reforms in addition to changes in banking regulation should be undertaken? There has been a tremendous focus on the private sector and what the private sector did wrong: all those terrible people on Wall Street who took risks and ruined the economy because they were greedy! But if you believe that the basic cause of the crisis was 24

the real estate bubble and central banks played a big role in creating that, then the first thing that we need to worry about is how to prevent them from creating a similar problem going forward. We need to ensure that central banks don't go out and take huge risks. After the inflationary experiences of the 1970s, many countries made their central banks independent. The rationale was that if they are independent, they are not going to succumb to political pressure to cut interest rates and cause an inflationary boom every time there is an election coming up. This has worked very well for preventing inflation. However, this crisis has demonstrated that central bank independence is not good for financial stability. Essentially there are a few people making decisions that are very important with little in the way of checks and balances. If you think about the Fed, they cut interest rates to one percent in 2003. Who basically decided that? It was one person, Alan Greenspan. In those days there wasn't much dissension within the Board of Governors. He decided they should do that to make sure we didn't have a recession. It worked in the short run, but of course now we've got an enormous recession. Maybe there should have been more of a debate about it when the Fed did it. We didn't have that discussion. The current governance mechanism, which is that the Fed reports to congressional committees, doesn't work at all well. The committee members don't ask the right questions. They're not particularly economically sophisticated. In our view one of the significant risks today is quantitative easing. What that means is that the Fed is going to effectively print money and buy back long-term government bonds. Is it a good idea to go out and print another two trillion dollars in money, put all this liquidity out there - won't we have a lot of inflation? It hasn't really been tried very much. They tried it in Japan in the 1990s. It didn't cure the problem. It didnt lead to inflation in

25

Japan either but it did probably lead to a larger yen carry trade than would otherwise have occurred. To illustrate the riskiness of quantitative easing, suppose that after increasing the money supply there is a burst of inflation. What is the Fed likely to do? They are going to start soaking up liquidity by selling the bonds that they have bought with the program of quantitative easing. The problem is that it's much easier to buy than it is to sell. Suppose, for example, the Chinese and other foreign holders of U.S. Treasuries decide to take some of their money out of the U.S. and start diversifying their investment into euros, and yen. Everything starts going against the Fed and there is a run on the dollar. We may quickly get a very difficult situation of stagflation. There has been very little public discussion of these issues. The Fed can simply make a decision to do this irrespective of the risks involved. There is very little in our governance mechanisms that ensure there is even a debate about whether what they are doing is a good idea. We need to have a better system of checks and balances to constrain this risk taking in the public sector. A good illustration of the deficiencies of the current system is provided by Chancellor Merkels June 2, 2009 speech concerning quantitative easing. She heavily criticized the Bank of England and the Federal Reserve for their programs of quantitative easing arguing that this kind of unconventional monetary policy could sow the seeds of the next crisis. It is highly unusual for a German Chancellor to discuss monetary policy so this was a significant break with tradition. The next day Chairman Bernanke said that he respectfully disagreed with the Chancellors views. In subsequent weeks there were stories in the press that there were internal doubts in the Fed about quantitative easing because of

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the inflation risk. This unusual sequence of events shows that more formal checks and balances are needed to prevent the Federal Reserve taking large risks. The recent Obama Administration white paper on financial regulation reform has suggested that the Fed should take the role of systemic risk regulator. In our view this is not a good idea. As we have argued, they are one of the main causes of the crisis. We need to have a separate systemic risk regulator that will be above or on the same level as the Fed. The Fed can then interact with people that understand these issues much better than the people in Congress do. This is an extremely important reform.

11. Preventing global imbalances As mentioned above, the IMF arguably caused the second problem of global imbalances through their harsh policies in the 1997 Asian Crisis. They caused enormous pain there. There was no mechanism to stop this because the Asians are underrepresented in the IMF governance process. Today, the Asian countries are the ones that have the money. The Chinese have two trillion dollars, the Japanese have another trillion, the South Koreans have several hundred billion and so on. They are the countries with the economic power. In the current crisis Asian countries such as South Korea have done much better than they did in 1997. For example, rather than raising interest rates and cutting government expenditure as the IMF forced them to do then, South Korea cut interest rates and allowed a large fall in the value of their currency. In contrast to the 1997 crisis when unemployment rose to more than 9 percent, it has only increased slightly in the current crisis. The reason that they were able to pursue these policies is that their large reserves meant they could make

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their own decisions and did not have to approach the IMF. They ran their reserves down but without worries since they still had plenty left. While it is individually advantageous for countries to self-insure by accumulating reserves, this is a very inefficient mechanism from a global perspective. The countries that are accumulating reserves must lower their consumption to do so and there must be other countries that run deficits to offset these surpluses. In practice the U.S. was the main country that did this. The resulting buildup of debt and its role in triggering the crisis meant that this was very undesirable. This raises the question of what are the alternatives to self-insurance through the accumulation of reserves. The IMF can perform an important role by providing funds to countries that are hit by shocks. If countries could always rely on being treated fairly and equitably and not being forced to implement harsh measures, they would not need to accumulate large levels of reserves. In order for this to happen the IMF needs to abandon the principle of always having a European head it and it needs to reform its governance structure so that Asian countries play a much larger role. This should be accompanied by an increase in Asian staff at all levels. Unfortunately, current proposals do not go nearly far enough in this regard and it seems unlikely that the IMF will be sufficiently reformed to make large reserves unnecessary in the short to medium run. A number of Chinese officials have made proposals for a global currency to replace the dollar. This kind of approach has the great long run advantage that reserves can be created initially without large transfers of resources and the attendant risk of a crisis. All countries could be allocated enough reserves that they could survive shocks. The problem with this proposal is that there would be a need for an institution to implement the currency. 28

It would need to be like the IMF. There would again be the issue of whether Asian countries would be fairly represented. A more likely medium term scenario is that the Chinese Rmb becomes fully convertible and joins the U.S. dollar and the euro as a third major reserve currency. With three reserve currencies there would be more scope for diversification of risks and China itself would have very little need of reserves in just the same way that the U.S. and Eurozone countries do not need significant reserves.

12. Other key reforms So far we have suggested three important reforms. The first is that banking regulation should be based on a coherent intellectual framework of correcting market failures. The second is that the Federal Reserve and other central banks need to be subject to more checks and balances than is currently the case. The third is that the IMF needs to be reformed so that Asian countries can rely on being treated in the same way as European countries so they do not need to build up enormous reserves. In this section we consider several other key reforms.

Too big to fail is not Too big to liquidate One of the most important principles guiding policy during the current crisis has been that large institutions are Too big to fail. The notion is that if Citigroup is allowed to fail, this is going to cause many other institutions to fail all through the financial system. This is the contagion problem discussed earlier. The way that this policy has been implemented is that governments have bought preferred shares in many institutions that would otherwise 29

have failed. They have made clear that these institutions will be provided with the capital that they need in order to survive. We would argue that this is the wrong way to deal with the Too big to fail problem. As Lehman Brothers demise illustrated, contagion is a very real problem and large banks should not be allowed to simply go bankrupt. However, Too big to fail doesn't mean that we should allow these institutions to survive. It's a very bad precedent to provide failing banks with the funds they need to survive. In the future, what is going to happen is that banks and other financial institutions will grow and become large. They know they are then Too big to fail, and everything's going to be fine for most of their employees. Firms that form a business relationship with them know they are going to be able to continue. The banks will then be willing to take large risks since they receive the payoffs if the gambles are successful while the government bears any losses. However, Too big to fail does not mean Too big to liquidate. Financial institutions should be prevented from failing in a chaotic way. The government should step in and take them over in order to prevent contagion. But rather than allowing them to continue these institutions should be liquidated in an orderly manner. That would allow the other institutions that didn't fail and that are well-run to expand and take their business. Propping up the weak ones that did badly is not a good idea in the long-term. It rewards risk taking and perhaps more importantly it prevents prudence from being rewarded. Well-run banks that survive should be allowed to benefit. An important aspect of such a scheme for allowing the government to prevent contagion by nationalizing failing institutions is to have bankruptcy rules for financial institutions that allow the equivalent of prompt corrective action for banks. With a bank, the 30

government can step in before it goes bankrupt and take control. There doesnt have to be a vote of the shareholders. We need to have that for all the financial institutions. That's what the government should have been able to do with Bear Stearns and Lehman Brothers. This would have prevented the great uncertainty that occurred when they failed. Current proposals to allow these powers in the Obama Administration white paper are a step in the right direction.

Resolution of large complex cross-border financial institutions A major difficulty in designing a framework that allows financial institutions to be liquidated is how to deal with large complex cross border institutions. In particular, there is the problem of which countries should bear any losses from an international mismatch of assets and liabilities. This has proved a thorny problem for the European Union in designing a cross border regime to support its desire for a single market in financial services. For countries without political ties like the EU it is an even more difficult problem. Designing such a system is one of the most urgent tasks facing governments. One possible way to proceed would be to eliminate cross border branching. Then any subsidiaries would regulated by the host country. These regulators would be charged with ensuring that they were comfortable with any imbalances between and assets and liabilities in their country. They would be responsible for intervening should a foreign subsidiary or home institution come close to failing and would be responsible for covering any shortfalls of cross border assets and liabilities that failure would lead to. The issue of cross border resolution is one of the most important and urgently needs to be addressed. Current proposals have made very little progress on this issue. 31

Limited government debt guarantees for financial institutions In the current crisis bank bondholders have effectively had a government guarantee. There is an important issue of whether this is desirable. Such a guarantee prevents disorderly wholesale runs. However, this again provides undesirable long term precedents. Going forward holders of bank debt will know it is guaranteed and will not have any incentive to exert market discipline. If failing banks are nationalized and liquidated in an orderly manner as discussed above, it should be possible to impose losses on long term bondholders and other debt holders. This should provide incentives for market discipline by bondholders.

Removal of tax subsidies for debt The tax system in many countries subsidizes the use of debt in many ways. For example, in the U.S. mortgage interest is tax deductible. These kinds of incentives to use debt are not desirable in a financial stability context. They should be removed.

Capital adequacy regulation should be based on market capital as well as accounting capital Capital adequacy rules have an important role to play in preventing contagion and other problems. However, one aspect of their current implementation is that they are based on accounting capital. When Wachovia failed last year its accounting capital was well above regulatory limits even though the market was no longer willing to provide funds. This example underlines the importance of using market capital in regulation, in addition to accounting capital.

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Mark-to-market or historic cost accounting? Financial institutions have traditionally used historic cost accounting for many of their assets. This is problematic if assets fall in value as they are able to hide this fact for significant periods of time. A good example is the S&L crisis in the U.S. in the 1980s. This kind of episode encouraged a move to mark-to-market accounting in by the IASB and U.S. FASB (see, e.g., Plantin, Sapra, and Shin (2008) and Allen and Carletti (2008a)). During the current crisis where it is not at all clear that market prices reflect fundamental values, markto-market accounting has come under severe criticism by financial institutions and has been relaxed by the FASB under political pressure from Congress. How should the advantages and disadvantages of mark-to-market accounting be balanced? As long as markets are efficient, mark-to-market accounting dominates. However, if as during times of crisis they cease to be efficient, market prices do not provide a good guide for regulators and investors. The key issue then becomes how to identify whether financial markets are working properly or not. Allen and Carletti (2008b) suggest that when market prices and model based prices diverge significantly (more than 2% say), financial institutions should publish both. If regulators and investors see many financial institutions independently publishing different valuations they can deduce that financial markets may no longer be efficient and can act accordingly.

A role for public sector banks in a mixed system Some countries such as Chile with its Banco Estado have a publicly owned commercial bank that competes with private sector banks. In times of crisis, such a bank can expand and help stabilize the market as all market participants know that it is backed by the 33

state and will not fail. At the moment, that's what the Fed is effectively doing. They've become one of the biggest commercial banks in the world. But the people in the Fed don't have much expertise in running a commercial bank. They don't know much about credit risk. They're mostly macroeconomists who are interested in real business cycles. It would be better to have expertise in the public sector which allows the state to perform commercial banking functions during times of crisis.

13. Concluding remarks If the speculation above that the most similar recent crisis to the current one is Japan in the 1990s is correct, the implication is that the after effects of the current crisis will be long lived. The problem is that when bubbles burst it is not just the effects on the financial system that are damaging. Prices have been wrong and finding the correct new prices can take a long time particularly if the bubble was largely in real estate. During the adjustment period economic activity can be badly affected. In the current crisis not only are residential property prices still falling but commercial property is also falling. That may well cause the same kind of problems in commercial-backed securitizations as with subprime securitizations. The other major problem is corporate defaults. Projections for corporate default rates are quite steeply up (see, e.g., the June 20th, 2009 edition of the Economist). One of the things that is surprising about the current crisis is that corporate defaults were at low level initially but now they are spiking up. Thus the current crisis may have some way to go, especially as these two factors of commercial property and corporate defaults may lead to another round of problems in the banks.

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References Adrian, T. and H. Shin (2009). Liquidity and Leverage, Journal of Financial Intermediation, forthcoming. Allen, F., A. Babus, and E. Carletti (2009). Financial Crises: Theory and Evidence, Annual Review of Financial Economics 1, forthcoming. Allen, F and E. Carletti (2006). Credit Risk Transfer and Contagion, Journal of Monetary Economics 53, 89-111. Allen, F and E. Carletti (2008a). Mark-to-Market Accounting and Liquidity Pricing, Journal of Accounting and Economics 45, 358-378. Allen, F. and E. Carletti (2008b). Should Financial Institutions Mark to Market? Bank of France Financial Stability Review 12, October 2008, 1-6. Allen, F. and D. Gale (2004). Financial Fragility, Liquidity, and Asset Prices, Journal of the European Economic Association 2, 1015-1048. Bernanke, B. (2008). Opening Remarks, Maintaining Stability in a Changing Financial System, 2008 Federal Reserve Bank of Kansas City, Jackson Hole Symposium, 1-12. Bordo, M., B. Eichengreen, D. Klingebiel and M. Martinez-Peria (2001). Is the Crisis Problem Growing More Severe? Economic Policy, April 2001, 53-82 + Web Appendix. Boyd, J., G. De Nicolo, and E. Loukoianova (2009). Banking Crises and Crisis Dating: Theory and Evidence, working paper, University of Minnesota. Brunnermeier, M. (2009). Deciphering the Liquidity and Credit Crunch 200708, Journal of Economic Perspectives 23, 77-100. 35

Greenlaw, D., J. Hatzius, A. Kashyap and H. Shin (2008). US Monetary Policy Forum Report No. 2. Herring, R. and S. Wachter (2003). Bubbles in Real Estate Markets, Asset Price Bubbles: The Implications for Monetary, Regulatory, and International Policies edited by William C. Hunter, George G. Kaufman, and Michael Pomerleano, Cambridge: MIT Press. Mayer, C., K. Pence, and S. Sherlund (2009). ''The Rise in Mortgage Defaults'', Journal of Economic Perspectives forthcoming. Muellbauer, J. (2009). Household Decisions, Credit Markets and the Macroeconomy: Implications for the Design of Central Bank Models, working paper, Bank for International Settlements, Basel. Nadauld, T., and S. Sherlund (2008). The Role of the Securitization Process in the Expansion of Subprime Credit, working paper Federal Reserve Board. Plantin, G., H. Sapra, and H. Shin (2008). Marking-to-Market: Panacea or Pandora's Box? Journal of Accounting Research 46, 435-60. Purnanandam, A. (2009). Originate-to-Distribute Model and the Subprime Mortgage Crisis, working paper, University of Michigan. Reinhart, C., and K. Rogoff (2008a). This Time is Different: A Panomaric View of Eight Centuries of Financial Crises, NBER Working Paper 13882. Reinhart, C., and K. Rogoff (2008b). Banking Crises: An Equal Opportunity Menace, NBER Working Paper 14587. Reinhart, C., and K. Rogoff (2009). The Aftermath of Financial Crises, American Economic Review, forthcoming. 36

Taylor, J. (2008). The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong, working paper, Stanford University. Ziemba, William T., and Sandra L. Schwartz, 1992, Invest Japan, Chicago, Ill: Probus.

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Figure 1
The Case-Shiller 10 Cities Composite Index

Source: The S&P Case-Shiller website

38

Figure 2
A Comparison of Foreign Exchange Reserves in Different Regions

Source: IMF website. Asia is the six East Asian countries China, Hong Kong, Japan, Singapore, South Korea, Taiwan province of China.

39

Figure 3
Quarterly Changes in GDP (Annualized)

40

Figure 4
Job Security or Dividends?

Japan

97 3 59 41 60 40 11 89 11 89

Germany

France United States United Kingdom

Job Security more important Dividends more important

Number of firms surveyed: Japan, 68; United States, 83; United Kingdom, 75; Germany, 105; France, 68.

Source: Masaru Yoshimori, Whose Company Is It? The Concept of the Corporation in Japan and the West. Long Range Planning, Vol. 28, No. 4, pp. 33{44, 1995. 41

Figure 5

Source: Company reports.

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Figure 6 Unemployment Rates

43