Economic Policy Implications in View of the Current Crisis Philip Arestis Cambridge Centre for Economic and Public Policy Department of Land Economy University

Economic Policy Implications in View of the Current Crisis

Philip Arestis

Cambridge Centre for Economic and Public Policy

Department of Land Economy

University of Cambridge

University of the Basque Country

Department of Applied Economics V

Presentation

1. Introduction: We discuss in this session the implications of the ‘great recession’ since August 2007, essentially from the point of view of economic policy reaction around the world;

2. Economic Policy Reactions

3. Regulatory and Policy Implications

4. Summary and Conclusions

Economic Policy Reactions

Early August 2007, when the subprime crisis began to spread outside mortgage and real-estate finance central banks around the world turned their attention to enhancing the liquidity of their banking sectors;

A unique element of the ‘great recession’ is the activist role played by central banks and Treasuries around the world;

Monetary and fiscal policies have been employed extensively and in an unparalleled way in the history of similar crises;


The Fed and the ECB were probably the first to commence it. The ECB began to lend to the EMU banks through the discount window or fine-tuning operations and the Fed through its repo operations;

At the same time the Bank of England, Bank of Canada, and the Bank of Japan announced similar measures to address elevated pressures in the short-term funding markets;


In December 2007, the Fed along with the Bank of England, Bank of Canada, the Bank of Japan, the ECB and the Swiss National Bank introduced the ‘Term Auction Facility’ (TAF);

This is a scheme whereby the Fed, and the other central banks, auction term funds to depository institutions under collateralised agreements;

Also under this scheme the Fed allows temporary dollar swaps to other central banks, so that the latter can pass on to counterparties in local operations;


The crisis worsened especially in March 2008 and subsequently;

The rescue in the US of the Investment Bank, Bear Stearns, by JP Morgan with funds from the Fed was only the beginning;

The rescue was justified on the argument that the Bear Stearns exposure was so extensive to third parties that a worse crisis would have developed without the bail out;

It was followed by the Fed/Treasury bailout and partial nationalization of Fannie Mae and Freddie Mac in July 2008 on the grounds that they were crucial to the functioning of the mortgage market;


In the UK the collapse of the Northern Rock in September 2007, which had been relatively more reliant on interbank markets rather than on deposits for funds and subsequently nationalized (early 2008), was another blow to the banking system;

Even worse was in September 2008 when the Fed and US Treasury allowed the investment bank Lehman Brothers to collapse in an attempt to prevent moral hazard by discouraging the belief that all insolvent institutions would be saved;

The argument put forward to justify the collapse was that Lehman Brothers was in a very bad shape and less exposed than Bear Stearns;


The inquest of the Lehman Brothers collapse (published on the 11th of March, 2010 and undertaken by Anton Valukas and handed to him by a US bankruptcy court) is actually devastating;

Lehman Brothers was an organisation prepared to take short cuts and huge risks to boost earnings;

Control and accounting procedures were found totally lacking;

In the process the device ‘Repo 105’ was invented, which allowed Lehman Brothers to reduce apparent leverage;


The device allowed Lehman Brothers to pledge assets as collateral worth 105% of the cash received from the counterparty – to be returned after a specified period;

The transaction is treated as a ‘sale’ in which case the assets pledged, more than was necessary, can be removed from the balance sheet;

Lehman Brothers would report its obligation to repurchase the securities at a fraction of the full cost;

It would then use the cash received to pay off liabilities thereby reducing apparent leverage at critical moments;


This was deemed legal and used widely by Lehman Brothers, although some lawyers question its validity under US law;

Anton Valukas concluded that including collateral cash and assets pledged to other financial institutions as part of its liquidity calculations was incorrect;

There is now an urgent need for global financial leaders to close this loophole;


An interesting lesson from this saga is that institutions with bank-like characteristics should be treated like banks and subjected to proper regulation. Or else, they should not be allowed to be a bank-like institution;

The focus of a recent relevant proposal by President Obama, the so-called ‘Volcker Plan’, is very much along these lines;


Shortly afterwards the insurance US giant American International Group (AIG) was bailed out and nationalized in an attempt to avoid the impact on insurance contracts on securities if it were allowed to fail;

The Lehman Brothers incident turned the liquidity crisis into a confidence crisis;

Causing panic in capital markets and a virtual freeze in global trade;


There was a widespread collapse of confidence in the banking systems in the industrialized world;

Especially so in the interbank market, and with the money markets becoming dysfunctional;

The transmission mechanism of monetary policy itself was thereby disrupted;


That led to an unprecedented and synchronized downturn in business and consumer confidence around the world; a significant drop in aggregate demand thereby ensued;

A fully-fledged global credit crunch and stock market crash emerged, as interbank lending was effectively frozen on the fear that no bank was safe anymore;


By early October 2008 the crisis spread to Europe and to the emerging countries as the global interbank market stopped functioning;

Interestingly enough, a number of Asian and Latin America countries managed to avoid the most serious aspects of the crisis: their precautionary measures after the 1997 Asian crisis helped (build up of large foreign reserves; reduced exposure to foreign borrowing); and tighter controls over their banking systems, especially so in some of the Latin American countries;


The crisis prompted significant government and central bank interventions, both to restore confidence in the financial system and to contain the impact of the crisis on the real economy;

Monetary and fiscal policy responses became very accommodative in many countries around the globe;

At the same time, though, it became clear that macroeconomists and central bankers knew less than what they had thought they did;

Central banks responded by flooding the financial markets with liquidity, while fiscal authorities attempted to deal with the decline in the solvency of the banking sector;


The UK authorities pumped equity into the banks, guaranteeing all interbank deposits and injecting massive liquidity into the system; the Bank of England reduced the Bank rate six times since October 2008 to an all time low of 0.5%;

In the UK a separate body had already been set up in the Autumn of 2008, UK Financial Investments, to oversee the system and to recoup the money spent on propping up the banking system;

It also has a role in vetting the banks’ business plans, finalizing bonus payments and has the final say on the appointment of non-executive directors.


A new Banking Act came into force in late February 2009, giving greater powers of intervention to the Bank of England. The purpose is for the Bank of England to be able to give hidden support to stricken banks for financial stability purposes;

Most importantly under the New Banking Act there is a new and permanent provision, the Special Resolution Regime, which gives the Bank for the first time the statutory objective to promote financial stability (working with the Treasury and the FSA);

Also the introduction of the Asset Purchase Facility (19 January 2009), a framework that enables the MPC of the Bank of England to initiate ‘quantitative easing’ – implemented on the 5th of March 2009;


The European authorities also flooded the financial markets with liquidity;

The ECB in the EMU pursued a slightly different approach under the banner of ‘enhanced credit support’ or ‘liquidity enhancing’ policy;

The latter “comprises non-standard measures that support financing conditions and credit flows above and beyond what could be achieved through reductions in key ECB interest rates alone” (ECB Monthly Bulletin, January, 2010, p. 68);

The ECB also reluctantly reduced the repo interest rate to 1% (May 2009);


Banks could be certain to obtain all desired liquidity at the ECB’s weekly tenders, provided that they had sufficient assets eligible as collateral in Eurosystem liquidity-providing operations;

The focus has been on banks since they are the primary source of financing for the real economy in the euro area;


The ECB decided that, as from 23 June 2009, to carry out refinancing operations with a maturity of 12 months, applying a fixed rate tender with full allotment;

Also, to purchase euro-denominated covered bonds issued in the euro area;

And to grant the European Investment Bank the status of eligible counterparty in the ECB’s refinancing operations;


The ECB Governing Council decided at its meeting of early December to gradually phase out those non-standard measures, beginning in the first quarter of 2010;

The reason in the view of the Governing Council is the improvement observed in the financial conditions;

Money markets are performing better, so that: “there would have been an increased risk of adverse

side effects had all measures been extended in the current circumstances” (ECB Monthly Bulletin, January, 2010, p. 70);


As a result of these decisions: The 12-month operations were terminated in

December 2009; The six-month operations were terminated in the first

quarter of 2010; The number of three-month operations is reduced

also in the first quarter of 2010; and they are going back progressively to a variable tender;

In its March 2010 monthly meeting the ECB decided to restrict its unlimited liquidity facility only for short-term maturities.


An EU-wide bank regulation body, the European Systemic Risk Council (ESRC), was proposed;

Comprising all ECB governing council and other central bankers, and managed by the ECB, while providing a critical role for the Bank of England;

It was designed to issue early warning signals on risk to EU’s system of financial supervision (to be operated from 2011);


Also in June 2009 and in the EU, a Pan-European Regime has been proposed to regulate the financial markets and institutions, which is to be enshrined in European law;

It comprises of the European Systemic Risk Council, which will monitor financial stability, and of European Agencies, which will police the banking, securities and insurance sectors;

Neither the Council nor the Agencies would have powers to dictate fiscal action in case of financial emergency;

Nor can they order governments to bail out or recapitalise banks.


We may note in passing the enormous exposure of a number of EMU banks to Central and Eastern European (CEE) countries. BIS data show that 90 percent of loans to CEE come from EMU banks (Austria, for example, is exposed to CEE by about 80 percent of its GDP; the Netherlands by 66 percent of GDP);

Clearly, this exposure provides risks to the current state of the EMU!


The US Treasury introduced the Troubled Asset Relief Programme (TARP) in October 2008, whereby $700 billion could be used to buy ‘toxic’ securities and thereby restore bank lending;

The US Treasury, following the UK Treasury, planned in this way to inject capital into the banking sector; but it was not clear whether solvent or insolvent banks were to be helped (supporting just insolvent banks could not be a solution of course);

From late 2008 to early 2009, the US Treasury through its TARP added $250 billion cash injection;

Also the US authorities provided insurance of senior interbank debt and unlimited deposit insurance for non-interest bearing deposits; the US Fed reduced the federal bank rate to a very low 0-0.25%;


The Fed was slow to recognise the solvency problem, which is a very serious problem in view of the market’s uncertainty about the solvency of individual or sectoral financial firms;

Financial markets cannot function when basic information about solvency of market participants is lacking;

Mid-February 2009, the US Senate voted for the Obama administration’s proposal of an injection of $787 billion, which was signed by the President on 18 February 2009;


Mid-March 2009, the US Treasury Secretary announced their plan to neutralise £1tn of toxic debts in the US banking system;

This is in the form of a partnership of public and private investment to rescue US struggling banks;

The Treasury would match private funds on a dollar-for-dollar basis to buy unsellable toxic assets that clogged up the banking system;


Private partners are able to borrow on a state-backed guarantee usually reserved for bank accounts;

Under the name ‘Public-Private Investment Programme’, the plan is for the US Treasury to purchase the troubled mortgages and securities;

500bn will come from the Treasury’s $700 ‘Troubled Asset Relief Programme’ (TARP), already approved by Congress;

Private investors are encouraged to participate with low-interest loans and guarantees via the Fed and the Federal Deposit Insurance Corporation – a government agency that backs bank deposits;


In May 2009 the ‘stress test’ was introduced, an exercise to identify undercapitalized banks, so that the government can make sure they have enough capital to recover;

The metric ‘stress test’ proposed is the ratio of two components;

The Tangible Common Equity (TCE) is one of them, which is the shareholder equities;

And the bank’s Risk-Weighted Assets (RWA), that is total assets, where different assets are given weights according to their perceived risk; for example, corporate loans are 100% risky assets, whereas government bonds are given no risk weighting at all;


The TCE/RWA ratio is then utilized, where an arbitrary 4% value is assigned to be achieved by 2010;

The biggest 19 banks were examined subsequently;

The outcome of the ‘stress test’ was that none of them were insolvent, but 9 out of the 19 examined needed more capital;


Early June 2009, the President of the US proposed a package to give new powers to the Fed as well as responsibility to secure overall financial stability;

The Fed will monitor systemic risks, thereby becoming a systemic super-regulator;

And should do so not merely for the banks but also for all companies big enough to threaten the financial system;

The Fed is to have powers to control and close down businesses in danger of collapse;

These are similar to the Governor’s of the Bank of England proposals.


The Fed has used the term ‘credit easing’, more akin to the Bank of England’s ‘quantitative easing’, but different from the ECB’s ‘enhanced credit support’, or ‘liquidity enhancing’ policy, in its approach to non-standard policymaking in the context of the recent financial crisis;

In the US and the UK it is financial markets, and not merely banks, that are the primary source of external financing for firms;

In the EMU the focus is on the banking sector; The decision to purchase covered bonds outright by the

ECB is with the specific aim to support the covered bond market, which is the major source of support of finance for the EMU banks;


Asian nations from China to Singapore and India also pledged more than $685 billion for similar purposes, as part of their spending programmes;

The measures taken after the South East Asian crisis of 1997 have helped greatly in containing the degree of impact upon these countries;

Similar attempts have been made in Latin America, where again the impact has been restrained in view of tight controls especially on the banking sectors of these countries.


The ‘unorthodox’ monetary measures discussed so far and which have been implemented, need more commentary;

These measures include a number of features as follows:

(i) Quantitative easing, comprising of: Conventional unconventional measures:

whereby central banks purchase financial assets, such as government securities or gilts, that boost the money supply;


Unconventional unconventional measures: in this way central banks buy high-quality, but illiquid corporate bonds and commercial paper, thereby paving the way for ‘quantitative easing’

The purpose under both measures is not merely to increase the money supply but also, and more importantly, to increase liquidity and enhance trading activity in these markets;


The Fed, under the acronym ‘credit easing’, the Central Bank of Japan under the acronym ‘quantitative easing’ and the ECB using the terms ‘enhanced credit support’ and ‘liquidity enhancing’ policy, pursued this type of policy;

In the UK the Bank of England announced on the 5th of March 2009 a £150bn ‘quantitative easing’, by buying government securities and commercial paper (£50bn on commercial paper);

£75bn pounds of the £150bn should be spent on government gilts and commercial paper for this purpose, over the April-June 2009 period;


Subsequently (May 2009) the latter was increased to 125bn pounds (9 percent of annual GDP);

Increased further to £175bn in August 2009; And to 200bn in November 2009; QE was paused beginning of 2010, but could return

depending on developments; There are doubts in terms of its effectiveness but one

advantage is clear: QE made it easier for the Government in its fiscal

policy because it provided a ready buyer for government debt. Without this there would have been difficulties and may have forced the Government to contain the degree of its fiscal initiative.


(ii) Dealing promptly and aggressively with distressed assets;

A related idea is the creation of so-called ‘bad banks’: siphoning off toxic assets from financial institutions into separate state-owned entities, thereby leaving the privately-listed institutions free from toxic-assets exposure;

Sweden used a similar plan in the 1990s to bolster its failing financial institutions; and more recently Ireland;

(iii) Recapitalising viable institutions with public funds; in this sense the UK Asset Protection Scheme (APS), designed to help banks with bad debts by insuring banks against further losses, is in the right direction.


The IMF view is that there are constraints on the effectiveness of orthodox monetary policy, and fiscal policy must play a central role in supporting demand;

This should be for a prolonged period of time and be applied across countries;

However, it should all be consistent with medium-term sustainability;

IMF also suggests: G-20 countries have adopted fiscal stimulus

measures amounting on average to around 0.5 percent of 2008 GDP, 1.5 percent of 2009 GDP, and 1.25 percent of 2010 GDP;


The fiscal stimulus so far consists of one third revenue measures and two thirds expenditure measures;

The combined fiscal stimulus is expected to have a considerable impact on G-20 growth in 2009 of the order of 0.5-1.25 percentage points;

In 2010, further measures are needed to achieve similar growth rates;


Fiscal deficits will no doubt increase. The IMF estimates that for the G-20 as a whole, the general government deficit is expected to grow by 3.5 percent of GDP, on average, in 2009;

IMF recognizes that the alternative of providing no fiscal stimulus or financial sector support would be extremely costly in terms of the lost output.


G20 Agreement (London, 02 April, 2009): IMF Resources: the centrepiece of the agreement,

whereby a dramatic increase in the funding for the IMF is recommended – from the current $250bn to $750bn increase to enable IMF to lend to countries facing financial difficulties;

IMF to sell off gold reserves to establish a new $50bn fund to help developing countries;

Emerging countries, China for example, to be given greater ‘say’ in the running of the IMF;

Bankers pay: a crackdown on pay and bonuses for bankers;


Global ‘quantitative easing’: IMF will increase the amount each country has in Special Drawing Rights (SDRs) by $250bn;

Fiscal stimulus: no explicit commitment, other than to reiterate that $5tr had already been pledged; and to quote from the G20 communiqué, “deliver the scale of sustained fiscal effort necessary to restore growth”;

Clamp down tax heavens: countries that refuse to provide full information to foreign tax authorities to help catch potential tax evaders will face sanctions and a list of such offshore tax heavens is to be published;


Toxic assets: each country will dispose these assets, either by setting up a ‘bad’ bank, or by insuring the assets against default. No provision for healthy ‘good’ banks mentioned;

Hedge funds and credit derivatives is where G20 will also impose tighter controls;

Protectionism: a 12-month freeze on introducing new trade barriers – no increase in tariffs or quotas on goods imported from overseas;


Tighten financial regulations: the current Financial Stability Forum, an international group of regulators, to be turned into a more pro-active global banking watchdog;

It will be renamed the Financial Stability Board (FSB), and its membership will be broadened to include developing countries, such as China, Brazil and India;

The FSB will monitor banks and financial houses, including credit rating agencies, on excessive risks, and inform national regulators

FSB is to bring large hedge funds and financial institutions into the global regulatory net;

However, FSB lacks explicit powers to damp down excessively risk-taking institutions;


Trade finance: provide $250bn in new trade quarantines – to be offered by the World Bank to allow exporters to obtain credit.

G20 Agreement (Pittsburgh, 25 September, 2009):

Decided to designate the G-20 as the “premier forum for our international cooperation”;

Thereby establishing the new ‘framework for strong, sustainable and balanced growth’;


The latter objective is to be achieved: National leaders agree priorities for the world

economy in annual G20 summits; Countries submit reports to show how their

domestic policies match the G20 priorities; IMF assesses whether national plans come

together to support global objectives; The enforcement mechanism will be based

on peer review with the thread of ‘naming and shaming’.

Regulatory and Policy Implications1. Introduction: We discuss in this session

the implications of the ‘great recession’ since August 2007, essentially from the point of view of economic policy reaction around the world;




Regulatory and Policy Implications Economic policies seriously and aggressively

targeting aggregate demand is what is needed; In doing so, though, we need a functioning, but

properly regulated, banking system; Interestingly enough and in the US, net lending to the

private sector reduced by 13 percent of GDP; the steepest fall over such a short time in the history of the series;

This sharp fall continued into 2009, 10 percent over the year, and is expected to continue its fall in 2010, not just in the US but elsewhere also;

Regulatory and Policy Implications Why is the banking sector so reluctant to lend? Worries about borrower credit risk: but this means

that worries are extreme to justify the complete cessation of lending;

Worries about having enough liquidity of their own; but central banks have provided ample liquidity;

Worries of being short of funds when investment opportunities improve;

Could be because they posses large quantities of mortgage backed securities (which explains why the banking sector is distressed);

Regulatory and Policy Implications The interesting question is what should policymakers

do to enable resumption of lending; Policymakers buy illiquid assets through auctions and

house them in a state entity, as was envisaged by the original ‘Troubled Asset Relief Programme’ (TARP);

Policymakers help to recapitalise entities that have a realistic possibility of survival, and merge or close the rest (moving the illiquid assets of those entities that are closed down into a holding entity to be disposed slowly over time);

The latter means intervention in the unregulated ‘shadow’ financial system, essentially a US phenomenon, which may be politically undesirable;

Regulatory and Policy Implications Policymakers pursue a mix of the two approaches

just discussed: clean up the regulated financial sector and buy at the same time illiquid assets;

Focusing on helping entities that are likely to become distressed;

Regulators be given new powers to control lending practices, as recently suggested by the UK’s Chairman of the Financial Services Authority;

Nationalise the banking sector along the Swedish experience of the early 1990s, which apparently was successful.

Regulatory and Policy Implications The dangers with the NCM type of conduct of

monetary policy are clear: frequent changes in interest rates can have serious effects;

Low interest rates cause bubbles; high interest rates work through applying economic pressures on vulnerable social groups;

There are, thus, severe distributional effects; Regulatory and prudential controls become,

then, necessary.

Regulatory and Policy Implications The obvious initial policy implication is that current

monetary policy should be abandoned; Monolithic concentration on price stability can lead to

economic instability; Coordination of monetary and fiscal policies is vital; In this coordination, financial stability and supervision

is also important; It contains two aspects: macroprudential, monitoring

the financial system as a whole; and microprudential regulation, monitoring individual firms;

Regulatory and Policy Implications In such a policy coordination targeting asset

prices might be appropriate; The standard argument against asset price

targeting is that it interferes with the free functioning of financial markets;

Proactive monetary policy would require the authorities to outperform market participants.

Regulatory and Policy Implications Central bankers prefer to deal with the consequences

of the burst of a bubble by minimizing the damages to the real economy, an approach that has been adopted by all major central banks around the world;

Especially so after Greenspan's attempt to fend the economy from the 'new technology bubble‘;

But the housing bubble, which precipitated the current financial crisis, is viewed as the result of the policies that Greenspan pursued in the first half of 2000s;

Asset price targeting may be necessary after all;

Regulatory and Policy Implications In fact, targeting net wealth of the personal

sector as a percent of disposable income, may be more important;

Net wealth is defined as the assets (financial and tangible) less the liabilities of the personal sector, which include mortgage debt and consumer credit;

A wealth target deals with the consequences of the rise and fall of asset prices on the economy and is not a target of asset prices per se - equities or houses;

Regulatory and Policy Implications Net wealth is an ideal variable to monitor (and

control) bubbles simply because it is at the heart of the transmission mechanism of asset prices and debt to consumption.

Economic policy should be tightened/loosened as the ratio of net wealth to disposable income, over a period of time, is above/below a predetermined threshold;

This would allow asset price booms, but it would prevent them from becoming bubbles that will ultimately burst with huge adverse consequences for the economy as a whole.

Regulatory and Policy Implications Such an approach will also help regulate financial

engineering, since the central bank will monitor the implications of financial innovations as they impact net wealth, even if it is ignorant of them [as in the case of Structured Investment Vehicles (SIVs)];

Financial engineering is so complex that central banks have a tough time in measuring, monitoring and controlling the total liquidity in the economy.

A net wealth target will check the consequences of this liquidity, while not impeding the financial engineering of the banks.

Regulatory and Policy Implications1. Introduction: We discuss in this session

the implications of the ‘great recession’

since August 2007, essentially from the

point of view of economic policy reaction

around the world;




Summary and Conclusions

We have highlighted the policy reactions to the current financial crisis;

Most importantly, though, is that more intervention on the policy front is desperately needed;

Regulatory and Policy Implications have been suggested.

Documents

Economic Policy Implications in View of the Current Crisis Philip Arestis Cambridge Centre for Economic and Public Policy Department of Land Economy University