why are we in are cession

8/14/2019 Why Are We in Are Cession

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The Financial Crisis is the Symptom, not the Disease!

Ravi JagannathanKellogg School of ManagementNorthwestern University

Based on:Joint work with Mudit Kapoor and Ernst Schaumburg

2009 Ravi Jagannathan


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The Great Recession

US Corporate Equities. .

2008: $15.2 Trillion (1.1 GDP)

1999: $42.1 Trillion (4.4 GDP)

Peak Unemployment

. 2008: 7.2%

June 2009: 9.5%


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Folk Wisdom

What caused the Global Recession? A. Financial Crisis

What caused the Financial Crisis? B. Easy Credit & Lax Regulation

C. Savings Glut, Too much money chasing too few opportunities

What caused the Savings Glut? . oo muc sav ng n s a, an oo e n e

Why Too Much Saving in Asia? E. Asians like to save

So what can we do to get out of the recession? F. Asians should save less; Americans should save more

Is that all that is needed will it work?


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A Deeper Driving Force?

What is wron with this lo ic?

It is misleading to think that the causality is from Too much savings in Asia, E D C B Financial

Crisis A Global Recession

All these phenomena are closely interlinked and

causality flows both ways ere are eeper un er y ng r v ng orces

Changes in Geo-Political-Organization of Countries

Major Technological Innovations


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Global Perspective:

Major Shocks to World Economy

Geo-Political-Or anization

The opening of China The opening of India

Technolo ical Innovations Communication & Transportation in the 90s


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Impact on Developed Worlds Economy

Chinese factories can compete directly with USfactories

Workers from India can directly compete with workersin the US

Workers in Developing World can participate in the

Developed Worlds labor market without moving uge ncrease n e or s a or supp y n a very

short time period


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Impact on Developed Worlds Economy

Financial and Legal Institutions to cope with thischange is the reason for the recession

exports Inability to absorb savings through increased domestic investment and

consumption

Currency controls motivated by national objectives

Inability of US economy to adjust to perverse incentives caused byhuge money inflows

Institutional incentives, checks and balances in place turned out to beinadequate

Set the stage for the recession

The financial crisis was the first symptom


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Rest of the Talk

Global trade and the savings glut

Where did the savings go? US Household Behavior

Financial engineering and the housing bubble

What makes a housing bubble different The way forward

Final thoughts


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Global Trade in Goods and Capital Flows

Global Trade and Savings Glut


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Global Trade Benefits

Cheaper goods and services in the developed world Low inflation in developed world throughout 1982 2007

1982 2008: Emer in economies in Asia rowin at+7% pa



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Global Trade Savings Glut

1997 Asian financial crisis

BRIC + NIAC (+ Middle East Oil exporters) Obsessed with building dollar reserves (through exports)

Dollar being the reserve currency

Huge Current Account Surplus (Savings)



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Global Trade Savings Glut

Combined Current Account Balance of+ + on :

1996: + $ 42000: + $ 1492004: + $ 3182007: + $ 798

US Current Account Balance1996 - $ 1252000: - $ 4172004: - $ 640

2007: - 739 Huge US Current Account Deficit

US should have de reciated say, relative to Yuan



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Yuan per US$ did not Rise!



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Capital Flows

Hu e Ca ital Flows into the US durin the 21st centur

To balance the huge current account deficit Especially from China



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Where did the money go?

Chinese holdings of US assets

$72 billion in Treasuries

$20 billion in Agencies ower ng n eres ra es on reasur es n par ue o ec n ng

deficits)

Subsequent Flow (2007 holdings)

$466 billion in Treasuries $376 billion in Agencies and some in corporate debt and

equities

(Treasuries + Agencies): 0.25GDP_China



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Change in China Holdings of US Assets

*

* Corporate = non-agency non-government debt


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Subsequent Flow into US

To accommodate the mone inflow investment banks

set up their own pools of private label non-conformingmortgages providing investors the desired higher yields

US Policy to promote increased home ownershipp aye a ma or ro e

That funneled the mone flow into US housin market Home mortgages (indebtedness) went up as Current Account

Deficit became large



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Current Account Deficit & Household Debt/HH

Current Account Balance and US Household Debt



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US Households

Wh did US households consume more leadin to the

huge increase in Current Account Deficit?

y ey ncrease e r orrow ng y so muc

I am oin to ar ue that US households behavedrationally!!

US Household


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Household Consumption & Wages

Private Consum tion to GDP Ratio 2000: 68.7%

2007: 70.3%

Wages, salaries, benefits, social security, andproprietors income to GDP Ratio .

2007: 64.2%

remained flat? Households felt wealthier!

US Household


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Stock and Housing Markets

Stock Market S&P500 Index remained flat 2000 Q

1: 1,499

2007 Q1: 1,421

Housing prices increased by 86%

S&P/Case Shiller Home Price Index 1 . 2007 Q1: 186.07

US Household


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Stocks: S&P 500 Index Values

US Household


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Housing: S&P/Case Shiller Index Q1 to Q1

200.00

140.00

160.00

180.00

100.00

120.00

40.00

60.00

.

0.00

20.00

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

US Household


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Home Values/Equity per Household

Household Real Estate Value (per household) 1980: $36,437

2000: $108,633

2007: $172,197

1980 to 2000: +$72,916

2000 to 2007: +$63,558

Household Home Equity (per household)

1980: $24,967 2000: $62,590

2007: $81,315

1980 to 2000: +$37,623 (52% of Household Real Estate Increase)

o : + , o ouse o ea s a e ncrease

So, they took out some of that wealth out to consume,

US Household


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Mortgage/Home Value (Leverage)

US Household


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After 2000: Sharp Rise in Household Debt

Financial Engineering


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A Model of Household Consumption Choice

(Journal of Monetary Economics, 2007)

ear to year c ange n ouse o consumpt on

= 683

+ 0.71(change in wages and salaries + proprietors income)+ 0.084(change in household home equity)

- 0.000($ change in other household assets) (almost no effect)

+ error

US households consume 71% of their salaries & in addition consume 8.4%of any increase in real estate wealth.

US Household


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Predicted vs Actual Change in Household Consumption

US Household


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Household Consumption: Recap

income during this 21st

century

ey so ecause t ey e t wea t er as ome pr ceswent up

That helped them borrow using home mortgage loans

o o ow: Why did home prices go up?

What is the relation to the current account deficit?

US Household


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CA Deficit and Capital Flows

$22 spent on imports

Underlying forces that trigger the $100 increase in,

$8 current account deficit

$8 flows back into the US as capital account flows (forconvenience sa from China

US Household


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CA Deficit Capital Flows Home Prices

In early years (late nineties and early this century,)

Made Treasury yields drop and less attractive Made Mortgage related debts more attractive

Subsequent capital account flows went to mortgagebacked debt

,easier availability of loans

Led to increased demand and higher housing

Feeds back through wealth effect leading to increasedconsumption, imports, and CA deficits

US Household


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Home Prices CA Deficit Feedback Effect

US Household


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Testing for Feedback Effect

When CA Deficit Increases

Pool of outstanding home mortgages shouldincrease (due to reduction in mortgage rates)

$ Change in pool of home mortgages

= +281. e c

- 0.26(Change in level of US Treasury Debt)

+ error

US Household


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Testing for Feedback Effect

Home values increase when Pool of outstandin home mort a es increase

Mortgage interest rate decreases

CA Deficit increases Other channels, viz. ease with which mortgage loans can be taken

$ Change in Household Real Estate Value

= -1,063- 181(Mortgage interest rate)

+ 1.21(Change in size of outstanding mortgage pool)

+ 2.91(CA Deficit)

+ error

US Household


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Back to Labor Supply Shock

What does labor supply shock have to do with all this?

Labor Supply Shock


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attained that growth through exports Japan, Taiwan, S. Korea, Hong Kong, Singapore

More recently, Chinas, and to a lesser extent, India

However, population of China (and India) is huge

, , , Japan + Taiwan + S. Korea + Hong Kong +

Singapore: 212 million

Labor Supply Shock


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most impressive, and export driven (Offshoring) Chinas share of World GDP : 0.5 for labor

employed using Ps technology by local firms)

Total output in R and P remains same at 1.41

20% unemployment in R and full employment in P Those in P working for R strictly better off

The 0.2 unem lo ed in P were em lo ed and received 0.18 those withcapital in R received 0.02 more.

Those unemployed (0.2 or 20%) lost 0.2


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A Stylized Model of Offshoring ..

This model does not seem to capture what happenedto the develo ed countries of the West when Ja anTaiwan, Korea developed through exports

Western economies also gained

What is wrong with the model?

We assumed that the 0.2 of labor in R replaced by 0.2 of laborin P will remain idle. But they can be redeployed in otherproductive activities That will increase output in R. A Win-Win situation.

be better off in real terms

Labor Supply Shock


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A Stylized Model of Offshoring

Redeployment of labor in R takes time

Can become an issue if the ma nitude of laborredeployment involved are large within a very shorttime

(offshoring) driven growth drive

,1) big increase in labor supply in the offshoring sector,

leading to surplus for P

(2) P has no financial market to save it in

,securities.

Labor Supply Shock


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Globalization and the US Recession

Wh did the recession not occur earlier? Financial Engineering plus easy money policy response channeled

the savings in developing countries into housing in the US That led to the Housing price bubble

Myopic US households felt wealthy and kept up their consumption

Hid the problems for a while

s n e s y ze mo e we exam ne

The labor employed by R in P saved 0.08 of their 0.18 wages andthose savings were invested in R to create a wealth effect to keepconsumption in R up

Some support for this view to follow

Labor Supply Shock


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China and India Exports (offshoring?)

China & India: Key Economic IndicatorsChina 1982 1992 2001 2002GDP US billions 221.5 454.6 1 167.1 1 232.7Gross domestic investment/GDP (%) 33.2 36.2 38.5 41.0Exports of goods & services/GDP (%) 8.9 19.5 25.5 29.5Gross domestic savings/GDP (%) 34.8 37.7 40.9 44.0

IndiaGDP (US$ billions) 194.8 244.2 478.5 510.2Gross domestic investment/GDP (%) 21.7 23.8 22.3 22.8Exports of goods & services/GDP (%) 6.1 9.0 13.5 15.2Gross domestic savin s/GDP % 18.3 21.8 23.5 24.2

Labor Supply Shock


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Some evidence for this view

Urban population in China increased by nearly 300 millionfrom 1990 to 2007

A large part of that migration of labor, presumably, was

facilitated by offshoring?

Labor Supply Shock


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Some evidence: Pressure on US Wages

Wages & Salaries 2000: 56.7% of GDP

2007: 53.7% of GDP

Change, 2000 to 2007: -3.0% of GDP

, ,increased Because of housing bubble and perceived increase in wealth

facilitated borrowing against that wealth

Next: More on Financial Engineering (FE)

Labor Supply Shock


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FE facilitated money flow to housing

Origination of non-prime mortgages rose from$500 bn in 2000 to $1500 bn in 2005

Mortgages Prior to 1990,

Conforming ( 80%LTV,..)

First lien mortgages

, Non conforming mortgages

Private label securitization

Asset Backed Securities market boom

50% market share by 2006


S f S ($/ )


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Share of Private Label ABS Increased ($/HH)


O i i ti f N P i M t T i l d ($B )


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Origination of Non Prime Mortgages Tripled ($Bn)


FE l d t th H i B bbl


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FE led to the Housing Bubble

Housing prices increased by 86%

S&P/Case Shiller Home Price Index

.2007 Q1: 186.07

Like all bubbles, housin bubble alsocollapsed

Wealth effect that kept up consumptionvanished

Recession followed


H i B bbl i Diff t f St k B bbl


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Housing Bubble is Different from Stock Bubble

Stock Bubble colla se Jul 2000/ Se 2001 NASDAQ: Over 60% drop

S&P500: Over 30% drop

Little wealth effect; Stock holdings of households not leveraged

Easy monetary policy temporarily helped:

Fed funds: 5.31% in 2001/3 to 2.09% in 2001/11 Housing Bubble collapse

A 25% drop in home values can wipe out entire home equity

Huge wealth effect => severe drop in consumer spending

Housing market transactions drop Job mobility severely affected

Inability to relocate affects speed of recovery

Housing Bubble

Home Ownership More Wide Spread & Levered


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Home Ownership More Wide Spread & Levered

Middle three wealth class quintiles, 2004 Principal residence: 66% of all assets

Corporate equities: 8% of all assets

Stock holdings 49% of families

Median value: $24,300

Primary residence 68% of families Median value: $131,000

Leverage Mort a e debt: 47% of real estate value

Other debt: 7% of other assets value Averages understate the severity of leverage

51% of loans ori inated in 2006 had CLTV > 80%

Source: E.N. Wolff, WP, New York University, 2007

Source: E.N. Wolff (2007) and A. Arora (2007)

Money Channeled into Housing: Bigger Price Effect


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Consider a h othetical econom with 10 householdswith $100 in housing per household $100 in stocks per household

Sudden helicopter drop of $10 per household, that theyhave to bid up prices of stocks or housing

Total value of stocks before: $1,000

Total increase in money: $100

=,

Whether everyone invests their $10 or they lend their $10 to otherswho use it to bid up stock prices does not matter

Housing Bubble



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Housin Suppose 9 households give their money to a bank

Bank lends the $90 to one household That household uses that $90 plus own $10 to bid up the price of one

house

% price rise = $100/$100 = 100%

Other households will also think that the value of their homes have

in the US.)

Leverage more in housing, not as much in stocks

Even when individual households can take levered positions in stocks Financial Intermediaries that channel money to

, ,accentuates the leverage effects

Housing Bubble



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Financial sector that intermediates mone flow intohousing is also very highly levered

Housing Bubble

Why did the bubble collapse?


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Why did the bubble collapse?

households triggered defaults Feed back effect

Tightening of credit

Larger Financial Crisis

Collapse of housing price bubble

Bubble Collapse

PPI and CPI Changes


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PPI and CPI Changes

Bubble Collapse

PPI and CPI Changes


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PPI and CPI Changes

Pressure on dis osable income of some householdstriggered defaults PPI increased sharply from 2004 relative to CPI Even though PPI rose, did not get passed on to consumers

More reliance on outsourcing

Energy prices rise sharply

Pressure on manufacturing wages and disposable income Some households default on loans

Bank losses, Flight to safety and Tightening of credit

Real Activities Impaired

Great Recession

Bubble Collapse

Tightening of Credit TED Spread


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Tightening of Credit TED Spread

Jul 2006: 32 b

August 2007: 175 bp

October 2008: 457 bp

July 2009: 38 bp

Bubble Collapse

Tightening of Credit: Repo Haircuts


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Tightening of Credit: Repo Haircuts

Bubble Collapse

From Arvind Krishnamurthy, Debt Markets in the Crisis, 2009, Forthcoming JEPS

Tightening of Credit


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Tightening of Credit

Bubble Collapse

How much is the Lost Wealth Effect on Spending?


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p g

Residential RE/GDP in 2007: 1.45

Consumption is 8.4% of change in RE wealth

If RE value drops (permanent) by 25% mpac on consump on ~ . . . = .

We should expect a permanent drop of about 3% GPD

in consumption from 2007 level We should be able to move on and grow from there

Bubble Collapse

The US is not alone


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These arguments should hold for all countries That experience a significant CA deficit

CA surplus countries should behave differently

International Evidence

Countries: CA Balance as % of GDP


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Countries: Home price inflation relative to CPI


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Handling a large labor supply shock & Wealth Destruction:A Lesson From History


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End of World War II Defense production stopped overnight

60 million workers with 16 million returning soldiers

25% rise in workforce in a very short time A major part of physical capital of the world destroyed

US Department of Labor Forecast 12 to 15 million unemployed with severe recession

Those predictions did not materialize

Policy and Institutional Response Channeled labor and savings to productive activities

Led to Prosperity instead of Doom

Similar response now, Globally

Going Forward

Handling a large labor supply shock & Wealth Destruction:A Lesson From History


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We have to realize that a large part of the wealth we imaginedwere there are not really there, and move forward

Fiscal policy response is needed now as after WWII

eve opmen o ns u ons o c anne sav ngs w n na,India, into productive activities

ncourage sav ngs n e . . , an no su s ze ous ng

Going Forward

why are we in are cession

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