How did the Naughties economic crisis/es come about?

By:

Nik Azmi

With kind support:

Imran Mustafa

Brought to you by:

Azad Azman

Disclaimer There is no consensus on the ultimate cause

There are agreements on underlying causes that led to the crisis

Socio-political elements due to the nature of economics

Content has been simplified

What is economics?

Greek “οἰκονομία” - “management of the household

A branch of social science

“...the branch of social science that deals with the production and distribution and consumption of goods

and services and their management ...” [Princeton]

Slide 1

Financial Crisis Financial assets lose value

Cause a disruption is financial system

Often involve banks and financial institutions

Can precipitate into an economic crisis

Slide 2

Economic cycle

$ coming in. e.g. spending, investment, export

$ coming out e.g. taxation, savings, import

Basic Theory

Slide 3

Economic Crisis A period where the economic cycle is

disrupted/go down

Unemployment, low prices, low levels of trade and investment

Technical definition: 2 or more consecutive quarters of negative GDP growth

Slide 4

Adam Smith Moral philosopher

Laid the foundation for modern economics

Emphasis on morality: propriety, justice, prudence, benevolence, and self-command

Emphasis on the liberty of man

Slide 5

Adam Smith Theory of Moral Sentiments:

What produces moral behaviour in man

Moral judgements arise only in the interaction of sympathetic actors in society

CONTEXT is paramount in making an assessment/judgement

Man is incapable of forming moral judgements beyond a limited sphere of activity

Despite self-interest, man can still bring benefit to others

Slide 6

Adam Smith The Wealth of Nations:

Written in the context of the rise and dominance of 18th century chartered corporations (eg: Muscovy Company, English East India Company) in cohort with the state (Crown) in perpetuating monopoly, manipulation, exploitation

Staunch critic of state/Crown meddling with the economy, killing free enterprise

Attack on political abuse of economic system

Criticised “rent-seeking”

Created the notion of “invisible hand”

Slide 7

John Maynard Keynes Philosopher,

economist, government critic

“Founded” modern macroeconomics, supported liberalism

“Destroyed” classical and neo-classical economics

Slide 8

John Maynard Keynes The General Theory of Employment, Interest and

Money: Creating new terminology that defines modern

economics Written during Great Depression and in conjunction

with Franklin D. Roosevelt's “New Deal”

Reformed economic thoughts

Keynes shifted positions and ideas to suit “empirical reality” - bring justice and equity in line with the changing world

Quote: “...In the long run we are all dead...”

Slide 9

Idea vs Ideology

Idea: the content of cognition, thought, mind can be “neutral”

Ideology: imaginary or visionary theorization an orientation that characterizes the thinking of a

group or nation [Princeton] often “political”

Slide 10

Ideology

Pros: Provides a guidance, reachable by the mass (user-

friendly), easy to propagate An effective way to spread ideas

Cons: Consumes people (emotionally, spiritually) Brought destruction to (early) 20th century Europe

& (late) 20th century US

Slide 11

Ideology

Examples of abuse: Hijacking of Adam Smith's notion of a just economic

system by capitalist to justify greed in making profits (moral capitalism vs unbridled capitalism)

Hijacking of Keynes's notion of an active government by politicians to justify an expansionary policy (limited vs big brother govt)

Hijacking of Islam by Islamists to consolidate influence and power (Islam vs Islamism)

Communism – Mao's Cultural Revolution, Cambodia's Year Zero, US neo-conservative capitalism

Slide 12

What is a bank?

(Deposit-taking)Bank

Business

“Return”

“Profit”

Pays Interest

Takes itsshare

Gives to depositor

GetsInterest

Depositor “Investment”

Slide 13

What is an investment bank?

Business

“Return”

Pays “Return”

Takes fees and commissions

Gets“Return”

“Investor” Investment

Investment Bank

Slide 14

Criticism against banking practices

Keynes: that making and losing money in the financial markets makes “casino capitalism” of the stock market

Banks that speculate in the financial markets are “casinos” - thus not a (proper) bank

Great Depression: started with stock market crash (Black Tuesday) caused by false believe in the magic of the financial markets

Slide 15

Glass-Steagall Act Separate “banks” from “casinos” (deposit-taking

banks as compared to investment banks)

Introduced wide-ranging regulation

Introduced government-sanction deposit protection schemes

Repealed in stages in 1980's and 1990's

Gave rise to “monster/chimeric” banks

Slide 16

Bank

BankBank

Bank Bank

Bank

Interbank LendingSlide 17

Securitisation

Mortgage

SPV

Securities

UnsuspectingPublic

‘Package’

‘Slice”

Sell

Net effect: Public ended up lending directly to homeowners, with “banks” as their “agents”.

Slide 18

Derivative A broad class of financial instruments that derive

their value from other financial instruments (known as the underlying), events or conditions

Provide leverage or gearing - small underlying value change can cause a swing in derivative value

Speculate and to make a profit

Hedge or mitigate risk in the underlying

Allows more borrowing at lower risk

Slide 19

Loose Monetary Policy dotCom bust – stock market on the verge of

collapsing

Greenspan subjected the Federal Reserve to lead a period of low interest rate and expansionary money supply

Cheap credit, low risk – excessive borrowing - Created asset prices bubble

Slide 20

Alan Greenspan Federal Reserve

Chairman (1987-2006)

Proponent of laissez-faire capitalism & financial system

Influenced by Ayn Rand's Objectivism

Claimed that derivatives has stabilised the financial system

Slide 21

Loose Fiscal Policy George Bush's Iraq & Afghanistan war

China selling cheap goods

US factories shifted to China, creating massive US unemployment

US govt up spending, US consumers buy on credit

US govt borrow money from China to help this

US lived on large fiscal and current account deficits

Slide 22

Slide 23

Subprime Mortgage “Banks” lending to NINJA (no income, no job,

[only] allowance) who (in the end) cannot payback

Charge high interest to make profit before bankrupting NINJA later

Securitise subprime mortgages and sell to public

Effectively “robbing” money from public, “robbing” interest from NINJA and run away rich

Slide 24

Mervyn King Governor of the Bank

of England

Economist

Critical of government fiscal irresponsibility

Arguing against “moral hazard” of bank bailouts

Slide 25

Hank Paulson US Treasury

Secretary (2006-2009)

Former Goldman Sachs executive

Brought in to “save” Bush's near-bankrupt presidency

Slide 26

Jean-Claude Trichet President of European

Central Bank

Decisive in many decisions

Called for a paradigm change in the global economy

Slide 27

Ben Bernanke Federal Reserve

Chairman

Scholar of Great Depression

Pragmatist

Worked to prevent another Great Depression

Slide 28

Adair Turner Chairman of UK’s

Financial Services Authority

Banker, economist

Respectable regulator

Wrote a scathing criticism in a report on the banking crisis (Turner review)

Slide 29

Preamble to the fire 1999 – Banks evolved and began taking more risks.

Bankers were encouraged to “gamble” to make more profits.

2006 – Economists warned of asset bubbles (artificially inflated prices) due to loose monetary policy. Bankers and brokers pushed through deals for handsome commission and run away soon after.

2006 – Bankers compensation were excessively high – rewarded despite deals failing. Warren Buffet warned against rewarding failure & derivatives are “time bombs”

Slide 30

The first spark Dec 2006: Alan Greenspan (then replaced by Ben

Bernanke) warned that US economy is heading for a recession

Jan 2007: HSBC wrote down billions in its US mortgage book linked to subprime – anticipating US economic downturn. Bankers still partying hard

Aug 2007 – Barclays was forced to borrow overnight from the Bank of England, signalling uneasiness in the market

Slide 31

Economic cycle

$ coming in. e.g. spending, investment

$ coming out e.g. taxation, savings

Credit Crunch

Economy contracts

No $ coming in from debt

Banks hoard cash to themselves

Slide 32

Fire became inferno Jun-Sep 2007: Central banks coordinated efforts to

stave off illiquidity by injecting hundreds of billions of dollars into the financial system over 2 weeks. Northern Rock alone had to borrow ￡ 50b.

Sep 2007: Bear Stearns near-collapsed effectively pushed “pure” investment banks into extinction

2008 – Mervyn King warned that failed banks will not be bailed out due to “moral hazards”.

Feb 2008: UK Treasury nationalised Northern Rock (Mervyn King eats humble pie)

Slide 33

The 4 Gods of Wall Street

Slide 34

Inferno became (banking) Holocaust

Jun-Sep 2008: Credit crunch affected many banks. Many had to be taken over by rivals

Sep 2008: Lehman Brothers collapsed. Other banks on the verge of collapse.

2008-2009: Various coordinated effort to stabilise the financial system and prevent economic collapse

Bank bail outs & stimulus packages

Central banks guaranteed unlimited liquidity

Quantitative Easing i.e. printing money ex nihilo

Slide 35

Economic cycle

Fiscal Monetary

GovernmentTreasury

Central Bank

Lower interestrates

Increase moneysupply

Slide 36

Slide 37

What caused the crisis?

Hank Paulson (On the Brink):

Structural Deficit: countries living beyond means

Excessive Leverage: too many people borrow too much money

Outdated regulation & regulatory framework

Too Big To Fail: overly big and intertwined financial institutions

Slide 38

What caused the crisis?

Alan Greenspan (in Congressional hearing & public statements):

The belief that “banks, operating in their own self-interest, would do what was necessary to protect their shareholders and institutions” is wrong (greed is not good)

Indirectly: Capitalism (as an ideology) is debunked forever

Slide 39

What caused the crisis?

Lord Turner (Turner Review):

Theoretical failure eg: Efficient Market Hypothesis

Market can be irrational and usually is

Misplaced reliance on maths (to estimate risk, etc)

Failure of market discipline

Slide 40

All myths bustedSlide 41

End of main part

Thank you

Slide 42

Recommended Reading

Financial and Economic Crisis

http://news.bbc.co.uk/1/hi/7521250.stm

Quantitive Easing

http://news.bbc.co.uk/1/hi/business/7924506.stm

Slide A1

Recommended Reading

On the Brink The Idea of Justice

Slide A2

Recommended Reading

Lords of Finance The Turner Review

Slide A3

Recommended Reading

Capitalism: A Love Story (Movie)

Warning: Heavy propaganda. Take with a pinch of salt. Focus on facts, not propaganda.

Slide A4

In Fed We TrustSlide A5

And also in the TriumvirateSlide A6

Other Quotes

“…We [Goldman] are just doing god’s work…”

Lloyd Blankfein, Co-Chairman, Goldman Sachs

“...there is nothing so dangerous as the pursuit of a rational investment policy in an irrational world”...”

“...Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist...”

John Maynard Keynes

Slide A7

Other Quotes

“…[Economist] mistaken beauty for truth…”

Paul Krugman, Nobel Laureate, on the fallacy of economic thoughts when depending too much on mathematics

“…The "Keynesians" seem not to have studied Keynes and the neoclassicals misread or do not read Hayek. No wonder fallacies abound.…”

Edmund Phelps, Nobel Laureate, on theory wars and its impact

“... [Liberty] is… the source and condition of most moral values. What a free society offers to the individual is much more than what he would be able to do if only he were free. We can therefore not fully appreciate the value of freedom until we know how a society of free men as a whole differs from one in which unfreedom prevails.”...”

Friedrich von Hayek, Nobel Laurate, on liberty of man

Slide A8