Christina Romer, ChairCouncil of Economic Advisors

Speech of September 24, 2009•Economic History

•Our Great Crisis vs. The Great Depression

•Cheerleading•Back from the brink•Recovery underway

•Policy Promotion•Continued stimulus•Regulatory initiatives

House Price – Foreclo

sureSpiral

Demand –Jobs –

Wages – Income –

SpiralDeleveraging – Debt DeflationSpiral

GovernmentRevenue – CutbackSpiral

Global Repercussion Spiral Macroecono

mic Linkages

and Feedbacks

Vicious Spirals Unleashed

House Price – Foreclo

sureSpiral

Demand –Jobs –

Wages – Income –

SpiralDeleveraging – Debt Deflation

Spiral

GovernmentRevenue – CutbackSpiral

Global Repercussion Spiral Macroecono

mic Linkages

and Feedbacks

Vicious Spirals Reversed? Tackle them all together!

StimulusProgram•Infrastructure Spending•Tax Cuts

Federal AidTo States

RefinanceMortgages

Revive dual banking systemCash for Trash•Recapitalize banks•Revive securitization

G – 20•Coordinated Stimulus

Macroeconomic Linkages and

Feedbacks

Vicious Spirals Unleashed

Great Depression vs. Great Crisis1929 – 1939

{Lead Up: BOOM Monetary Tightening}•Stock market crash, September 1929

•Fed injects liquidity

•Bank panic (9/30) / Bank of US (12/30)

2008 – 2009 {Lead Up: BOOM Monetary Tightening}•Housing Bubble Burst ~ Fall 2007

•Subprime meltdown MBS decline•Bear Stearns Bailout•Fannie/Freddie Bailout

•Lehman collapse, September 2008

Do Shocks Compare?1929 decline in household wealth: 3 %

– Stock market down 14 % for year

2008 decline in household wealth: 17%– House prices down 9 % for year– Stock market down 24 %, September – October 2008– TED Spread Peak: ~ 400 basis points [really 500+ basis points!]

• Is 1929 vs 2008 a fair comparison of wealth shocks?– Great Depression bank panics started in 1930– Great Crisis financial panic started in September 2008

Treasury Bill–to–Eurodollar Rate (TED) Spread

Source: www.federalreserve.gov/releases/h15/data.htm

Great Depression vs. Great Crisis1929 – 1939

{Lead Up: BOOM Monetary Tightening}•Stock market crash, September 1929

•Fed injects liquidity

•Bank panic (9/30) / Bank of US (12/30)•Passive Fed response•Defend gold! (October 1931)

•Discount rate up 2%•Great Contraction of money supply•Tax increase, 1932•Treasury Secretary Mellon: “… liquidate labor, liquidate stocks, liquidate the farmer, liquidate real estate…”

•1933 Bank holiday Confidence in banks restored

2008 – 2009 {Lead Up: BOOM Monetary Tightening}•Housing Bubble Burst ~ Fall 2007

•Subprime meltdown MBS decline•Bear Stearns Bailout•Fannie/Freddie Bailout

•Lehman collapse, September 2008•“Swift and bold” policy responses

•AIG nationalization•Innovative “facilities” maintain credit flow•TARP•Fiscal Stimulus

•2% of GDP in 2009•2 ½ % of GDP in 2010

•2009 Stress Tests Confidence in banks restored

2008/2009 ResponsesLender of Last Resort / Spender of Last Resort

• Tax Rebate $124 bil.• Fed Fund Rate Cuts• Fannie/Freddie $200 bil.• Bear-Stearns $29 bil.• AIG $174 bil.Fed “Facilities”• Primary Dealer Credit Facility (PDCF) $58 bil.• Treasury Security Loan Facility (TSLF) $133 bil.• Term Auction Facility (TAF) $416 bil.• Asset- Backed Commercial Paper Funding Facility (CPFF) $1,777 bil.• Money Market Investor Funding Facility (MMIFF) $540 bil.• More Fed Fund Rate Cuts … Hold At ~0%• Fed Purchases of Long-Term Securities: GSEs & MBSs $600 bil.• Term Asset-Backed Securities Loan Facility (TALF) $200 bil.Emergency Economic Stabilization Act/TARP $700 bil.

Government LoansGovernment Equity

Stimulus Package $787 bil. aka The American Recovery and Reinvestment Act

TARP II• Stress Tests

Other Stabilizing Forces• Automatic Stabilizers

• Big G• Progressive Tax System• Social Safety Net{Weaker in US than in Europe Europe downturn cushioned}

• Anchored inflation expectations1929 – 1930: Sharp deflation/Deflationary expectations• Real interest rates and debt burdens up• Collateral values down2008 – 2009• Modest and steady core inflation• Steady rates on TIPs

• Deposit insurance

Recoveries: 1930s vs 20091933 - 1937

• Real GPD growth ~ 10 % per year• Unemployment rate down 11 points from 25 % peakRecovery stifled by monetary and fiscal contractions

2009• Real GDP 7% below potential

– Stimulus raised growth to 2% range– Stimulus created ~ 1 million jobs above baseline

Okun’s Law: need 2 ½ % growth [or more] for unemployment rate to fall

“ … to talk seriously about stopping policy support at a time when the unemployment rate is nearing 10% and still rising is to risk nipping the nascent recovery in the bud.” Christina D. Romer

Financial Regulatory Reform: Then and NowLegacies of Great Depression

• Banking Act of 1933 FDIC• Securities and Exchange Act of 1934 SEC• Banking Act of 1935 FOMC• Investment Company Act of 1940 Regulate mutual funds• Employment Act of 1946 Activist commitment

Existing flaws• No regulator evaluates risk to entire system

» Too big to fail / Too interconnected to fail• Overlapping regulatory agencies regulatory arbitrage• No way to resolve major non-bank financial institutions• Weak consumer protection

Administration Wish – List • Fed as czar?• Council of regulators

– Evaluate systemic risks– Identify emerging financial innovations

• Resolution authority– FDIC model … insurance premiums based on systemic risk?

• Consumer financial protection agencyCan the Fed do it?Has the Fed done it????

Other ideas in the air• Central clearinghouse for ALL derivatives• “Consumer protection” for sophisticated financial products• Deferred compensation / “clawbacks”

Dynamics of Financial Crises in Emerging Market Economies

• Stage one: Initiation of Financial Crisis.• Path one: mismanagement of financial liberalization

• Weak supervision and lack of expertise lending boom.• Domestic banks borrow from foreign banks. • Fixed exchange rates give a sense of lower risk.• Securities markets not well-developed Banks important

• Path two: severe fiscal imbalances:• Governments force banks to buy government debt. • When government debt loses value, bank net worth down .

– Additional factors:• Increase in interest rates (from abroad)• Asset price decrease

• Uncertainty linked to unstable political systems

Dynamics of Financial Crises in Emerging Market Economies

• Stage two: currency crisis– Bank losses currency crises:

• Government cannot raise interest rates (doing so forces banks into insolvency)…

• … and speculators expect a devaluation. • Foreign and domestic investors sell the domestic currency.

• Stage three: Full-Fledged Financial Crisis:– The debt burden in terms of domestic currency increases– Banks are more likely to fail:

• Individuals are less able to pay off their debts (value of assets fall).

• Debt denominated in foreign currency increases (value of liabilities increase).

Financial Crises: Mexico 1994-1995

• Financial liberalization in the early 1990s: – Lending boom, coupled with weak supervision and

lack of expertise.– Banks accumulated losses and their net worth

declined.• Rise in interest rates abroad.• Uncertainty increased (political instability).• Domestic currency devaluated on December

20, 1994. • Rise in actual and expected inflation.

Financial Crises: East Asia 1997-1998

• Financial liberalization in the early 1990s: – Lending boom, coupled with weak supervision and

lack of expertise.– Banks accumulated losses and their net worth

declined.

• Uncertainty increased (stock market declines and failure of prominent firms).

• Domestic currencies devaluated by 1997. • Rise in actual and expected inflation.

Balance Sheet of All Commercial Banks (items as a percentage of the total, December 2008)

Bank ManagementLiquidity Management

Ample excess reservesBorrow reserves

Discount loansFederal funds market

Secondary reservesReduce loans

Asset ManagementReturn/Risk/LiquidityTradeoff/Balance

Liability ManagementDeposits/CDs/Fed funds…

Capital Adequacy ManagementPrevent failureRegulatory requirement

Basel Accord: Risk-based reqmtLeverage ratio

Performance MeasuresReturn on assets: ROAReturn on equity: ROEEquity multiplier: EM

EM = Assets/Equity CapitalCredit Risk

Screening / MonitoringSpecialized lendingRestrictive covenantsCompensating balancesCredit rationingCOLLATERAL

Interest-rate RiskGap and Duration analysis

Off-balance-sheet ActivitiesLoan sales—SecuritizationFee income: SIVs/UnderwritingTrading income•Value at risk/Stress test/Hedges