The Great Recession, How Does it Differ

From Others?FCCC 7

This ‘great’ vs. “normal” recessionHow Different; How Similar ?

5 years after Lehman …

• http://video.ft.com/2661154716001/Lehmans-legacy-The-world-economy/Markets

Savings Glut ?

• Different? savings glut flowed into poorly regulated shadow banking system• In USA, housing prices rose 30% in five years preceding crisis.

Housing booms also in UK, Spain, Eastern Europe (earlier scandanavian, japan)

• Similar to previous in e.g. debt build up

Goods Market Eqbm (Closed)Sd = Id

• Sd = Id so:

• Y – Cd – G = Id => (Cd + Id + G) = Y

• If unsold goods: I > Id • diseqbm, but expenditure approach still true Y = C + I

+ G

 

• At r0, I0 > S0: amount firms wish to invest > amount savers want to lend so in closed economy, r↑

• (assume NFP = 0, so NX = CA)

Open Economy Goods Market Eqbm

NXIS dd

What can be done with national savings ?

I: lend to domestic firms buying new capital goods

CA surplus: lend to foreigners who want to purchase your goods (more than you want to buy their’s)

• Assume nation too small to have any influence on world interest rate

Small Open Economy Model

r I S

rROW

• Assume 2 nations in world

• rWORLD adjusts until int’l lending = int’l borrowing (eqbm r)

• Nation with relatively high ID has high rAUTARKY

• Nation with relatively low ID has low rAUTARKY

• Eqbm rWORLD rate lies between 2 autarky rates

Large Open Economy Model

r I S

rROW

Similar 1:Asset Price Boom

Agnello, Schuknecht (2011)

1971

Similar 2.Credit Boom

• Boom:• Y, C & I rise above trend

in build-up phase (then fall below in bust phase)

• Higher PHouse • Real exchange rate

appreciates • CA deficit

Similar 3:Marginal Loans & Systemic Risk

• Households bought marginal assets requiring excellent conditions to pay off

• Subprime => debt servicing sensitive to recessions & changes in credit/monetary conditions• Housing loans sensitive to PHouse declines (indeed, became non-

performing loans with falling PHouse)

• Many foreign currency denominated loans• In good times required lower interest payments• In crisis, more difficult for borrowers to repay with depreciated

currency

Similar 4:Regulation & Supervision

• Previous post-liberalization credit booms led into crises due to lack of reforms

• Underdeveloped financial systems unable to handle large capital inflows

• In recent crisis, shadow banking system (finance companies, investment banks, off-balance sheet entities) not subject to bank regulation

• Regulators underestimated conflicts of interest of “originate to distribute” model

Different 1:Increased Opaqueness

• Mortgage securitization: greater lender-borrower distance

• No monitoring of loan ‘originators’ who sought greater volumes (not quality)

• Assessing risk difficult so investors had to rely heavily on ratings

• Collateral but value fell limiting security

http://portal.hud.gov/hudportal/HUD?src=/federal_housing_administration

Different 2:Financial Integration

• Benefits of greater financial openness (and more foreign banks)• GDP growth• Develop financial sector • Discipline macro policies• Expose local firms to int’l competition for efficiency gains

• But intensifies cross-border spillovers:• Liquidity pressure• Asset prices• Depletion of bank capital

• (US financial assets represent 31% of world financial assets, USD represent ca 62% of all reserve assets)• Most believed US financial assets offered safety and liquidity

Different 3:Leverage

• Greater leverage • In commercial banks• Also in shadow banking

sector

• Cut ability to absorb even small losses (high LTV => P fall pushed household’s equity negative)

• Led to loss of confidence & greater counterparty risk

Different 4:Households

• 2008: households heavily in debt, especially in subprime• Yet aggregate credit growth more moderate than in previous

recessions• (previous crises due to gov’t or corporations’ debt)

• Low interest rates makes easier to service debt

• Household debt to income also rose in UK, Spain & Ireland

Different 5:Old & New Combined

• Vicious cycle: • Rising foreclosures• Falling home values• Securitization markets thinned (fewer mortgages so sped up P declines)

• Reinforced by tighter mortgage standards• Rising rates & falling home P limited households’ ability to refinance

mortgages

• Securitized assets’ value unknown (mix of subprime + prime)• MBS less valued as collateral• Higher counterparty risk (didn’t know if counterparty healthy so

stopped trading => freeze in interbank markets)