Global crisis

1. The Financial
Crisis and the
Great Recession
Chapter 15
© Dünhaupt, Dullien, Goodwin, Harris, Nelson, Roach, Torras

2. Chapter Outline
1. Prelude to a Crisis
2. Economic Impacts of the Crisis
3. Underlying Causes of the Financial Crisis
4. Remedies and Ideas for Averting Future Crises
Chapter 15 2

3. Learning goals
 After today’s lecture, you will be able to:
– Describe the development of the housing bubble and the reasons for its collapse.
– Understand how a crisis in one sector spread to the whole economy.
– Understand the similarities and differences between the Great Recession and the
Great Depression.
– Be aware of how factors such as inequality, bank size, regulatory policy, corporate
incentive structures, and global financial imbalances can contribute to
macroeconomic instability.
– Describe the major fiscal and monetary responses to the crisis.
– Be aware of financial regulatory reforms implemented in response to the crisis,
criticisms of these reforms, and proposals for further reform.
Chapter 15 3

4. Prelude to a Crisis

5. The housing bubble in the U.S.
 increase in demand for real estate
 increase in real estate prices
 increase in home prices fed a speculative frenzy
– millions rushed to buy, believing that prices could only go up
 speculative flurry was fed by:
– the “dot-com bubble”
– the unprecedented access to credit in the form of mortgages
– very low mortgage rates among other factors
Chapter 15 5

6. Figure 15.1 Historical housing prices in the U.S.
0
50
100
150
200
250
1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Shiller
Housing
Price
Index
Source: Shiller dataset. www.econ.yale.edu/~shiller/data.htm.
Chapter 15 6

7. Figure 15.2 Housing bubble and credit access
0
1
2
3
4
5
6
7
100
110
120
130
140
150
160
170
180
190
200
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Effective
Federal
Funds
Rate
Shiller
Housing
Price
Index
Housing Price Fed Interest Rate
Sources: Federal Reserve (www.newyorkfed.org/markets/statistics/dlyrates/fedrate.html/ and
www.federalreserve.gov/releases/h15/data.html);
Shiller dataset, www.econ.yale.edu/~shiller/data/ie_data.xls.
Chapter 15 7

8. Mortgage-backed security (MBS)
people take out
mortgages
investment banks
group mortgages into
Mortgage-Backed
Securities (MBS)
CDO
Chapter 15 8
MBS MBS
MBS
MBS
MBS
Pools
Mortgage default
AAA
AA
BBB
BB unrated
A
lower yield first paid
higher yield last paid
AAA
AA
BBB
unrated
A
CDO tranches
each MBS is divided
into tranches; the first
is to be paid in the
event of mortgage
default and hence
the safest
financial institutions developed collateralized debt
obligations (CDOs): making a “bundle of bundles” of
mortgages.
A hierarchy of tranches is available, each carrying a
calculated risk-return balance

9. Credit default swap
Chapter 15 9
Investment
Bank
or Insurance
Company
Investment
Bank
credit default swap seller credit default swap buyer
a buyer of the CDS pays a fee to the seller
the seller agrees to cover losses in case of default
credit default swap: a security that is effectively an insurance
policy against defaults related to MBS and CDOS

10. The subprime crisis
 rising demand for bundled securities
 banks relaxed lending criteria
 subprime mortgage: a mortgage that does not meet
the quality standards of traditional mortgages
 2006: wave of subprime foreclosures hastened
downward spiral of prices (glut in house supply)
Chapter 15 10

11. From housing crash to banking crisis
 falling house prices
 limited equity of home owners
 many mortgages became worthless
 losses in the value of MBSs and CDOs
 banks put part of their funds in CDOs
 presumption: every bank is a high-risk borrower
 banks stopped lending to each other and to
customers
 output contracted sharply
Chapter 15 11

12. Housing bubbles in Europe
 house prices increased tremendously in Ireland, Spain
and Britain
 MBSs and CDOs played no role in European countries
 with the end of the U.S. housing bubble, real estate
bubbles in Europe also burst
 banks in Europe became more careful in lending
 with falling house prices, households started to
default on their mortgages and property developers
on their loans
 national banking crises in European countries
Chapter 15 12

13. Economic Impacts of the Crisis

14. Unemployment and the vicious recessionary spiral
 in the industrialized world, 14 million jobs were lost
 households saw their wealth diminished
 vicious circle:
Chapter 15 14
Income falls
Banks
increase
lending
standards
Less credit
Less
aggregate
demand
Employment
falls

15. The Great Depression and the Great Recession
compared
 both downturns were preceded by a period of
economic strength
 but: consequences are different due to
– social safety net
– government regulations to protect ordinary citizens
– activist macroeconomic policy
 government programs kept current downturn from
becoming far worse
Chapter 15 15

16. Table 15.1: Selected economic indicators for ten
industrialized economies* in the Great Depression and the
Great Recession
Indicator Great Depression
1932 vs. 1929
Great Recession
2009 vs. peak 2007/8
GDP, real, change in percent -10.0 -4.0
Manufacturing production, change in percent -23.2 -20.2
Exports, change in percent -58.5 -20.9
Stock market index, change in percent -55.4 -53.4
Employment, change in percent -17.3 -2.5
Unemployment rate (1932 and 2010) 19.6 9.2
Unemployment rate, change in percentage
points
13.2 3.1
Inflation, in percent -12.8 1.0
Source: Karl Aiginger (2010). The Great Recession versus the Great Depression: Stylized Facts on Siblings That
Were Given Different Foster Parents. Economics: The Open-Access, Open-Assessment E-Journal, 4 (2010-18): 1—41.
* Austria, Germany, Belgium, Spain, France, Finland, Sweden, United Kingdom, the United States and Japan.
Numbers are unweighted averages for these ten countries.
Chapter 15 16

17. Underlying Causes of the
Financial Crisis

18. Inequality
 U.S.:
– since 1999, low and middle incomes started to decline
– majority of families faced difficulties to maintain level of consumption
– debt-financed consumption
 Germany:
– wages of the poorer half of the population declined
– consumption stagnated
– rich households and corporations earned more money than they could
(or would) spend
– net savings increased
Chapter 15 18

19. Bank size and deregulation
 since the 1980s, bank mergers led to a growing
number of large banks
 financial sector became deregulated
 “too big to fail”: when a company grows so large that
its failure would cause widespread economic harm in
terms of lost jobs and diminished asset values
 “too big to fail” mentality of banks encouraged more
risk taking
 governments had to bail out banks
Chapter 15 19

20. Figure 15.3 Increasing bank size in the U.S.
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
84:1 87:1 90:1 93:1 96:1 99:1 02:1 05:1 08:1 11:1
Year: Quarter
Assets > $10 Billion Assets $1 Billion - $10 Billion
Assets $100 Million - $1 Billion Assets < $100 Million
Percent
of
Total
Bank
Sector
Assets
Source: Federal Deposit Insurance Corporation (www2.fdic.gov/qbp/);
www.fdic.gov/bank/statistical/stats/2012dec/industry.html.
Chapter 15 20

21. Misguided corporate incentive structure
 CEO pay in the form of stock options
 performance related pay scheme encouraged short-
term orientation
– focus on short-term gains
– ignoring long-term risks
Chapter 15 21

22. Globalization and long-term economic trends
 distribution of gains and losses from globalization
reinforce growing patterns of inequality
– in the U.S.: debt financed consumption
– in Germany: increase in savings
 savings from other parts of the world contributed to
U.S. housing boom and asset price inflation
 investment banks and hedge funds possessed large
amounts of capital, took on more risk and debt to
multiply returns
Chapter 15 22

23. Remedies and Ideas for
Averting Future Crises

24. Fiscal and monetary responses
 governments passed stimulus packages
 innovative policy measures
– “cash for clunkers” programs (Car Allowance Rabat System
in the U.S.; “Umweltprämie” in Germany
 higher multiplier effect than government transfers
 monetary policy: central banks implemented stimulus
plans
 but: monetary policy has limitations:
– if consumers and businesses are pessimistic, they save
Chapter 15 24

25. Reregulating the financial sector
 in the U.S.: Dodd-Frank Wall Street Reform and
Consumer Protection Act
– minimum criteria to lend to prospective homeowners
– commercial banks exposed to a minimum amount of the
mortgage default risk
– restrictions on CDSs
– …
Chapter 15 25

26. Reregulating the financial sector
 at the European level:
– pan-European institutions were created to coordinate the
regulation of the financial sector
– a systemic risk board was created to spot macroeconomic
risks through the financial system
– limits on manager compensation
– markets for derivatives more strictly regulated
– new rules for rating agencies
Chapter 15 26

27. Beyond current regulations
 criticism of financial regulation:
– bills create significant costs for financial firms, slowing down
business and job creation
– legislation is too complex
– legislation has been “watered down” by lobbying efforts
Chapter 15 27

28. But how to redirect finance to the goal of increasing
overall benefits to society?
 limit speculative activities of banks
 ban overly complex products or risky products
 ask investors to pay a modest tax on financial
transactions (Tobin tax)
Chapter 15 28

29. What to take home
 the financial crisis of 2007-2008 and its aftermath are
widely referred to as the “Great Recession”
 the crisis began in 2007 with a crisis in the subprime
mortgage market in the U.S. and developed into an
international banking crisis
 many causes for the financial crisis have been
suggested
 in the aftermath of the financial crisis, the financial
sector was reregulated
Chapter 15 29