The Financial Crisis: A global perspective

(cont’d.)

Net capital flows increased from less than $200 billion in 1996 to over $1.2 trillion in 2006, with virtually all of it flowing to high-income countries with booming mortgage markets

The $1 trillion shift in Current Account Balances from 1996-2006 (shares of global total)

Shares of CAB increases Shares of CAB decreases

China 21%

OPEC 20% US 67%

High-income, non-housing boom countries

37% Other high-income housing boom countries

29%

1997-2001 debt-crisis LDCs

22% LDCs, excluding OPEC and debt-crisis countries

4%

Total 100% Total 100%

At first, inflows to the US helped fuel the dot-com boom, driving the stock market to an all-time high by the end of 1999.

Inflation-adjusted total return index for the S&P 500, 1871-1999: Percentage deviation from its upward trend of 6.6% per year since 1871

-40.8%

65.7%

-58.3%

94.7%

-61.6%

29.4%

-51.1%

-4.2%

-46.3%

89.3%

-51.2%

104.2%

-80.0%

-60.0%

-40.0%

-20.0%

0.0%

20.0%

40.0%

60.0%

80.0%

100.0%

120.0%

1871

1876

1881

1886

1891

1896

1901

1906

1911

1916

1921

1926

1931

1936

1941

1946

1951

1956

1961

1966

1971

1976

1981

1986

1991

1996

Percentage deviation from trend

But the dot-com boom ended in 2000. The stock market fell by 50% over the next 3 years. Investors went looking for other options as the economy faced the threat of a recession.

Inflation-adjusted total return index for the S&P 500, 1960-2003: Percentage deviation from its upward trend of 6.6% per year since 1871

-60.0%

-40.0%

-20.0%

0.0%

20.0%

40.0%

60.0%

80.0%

100.0%

120.0%

1960

1961

1962

1963

1964

1965

1966

1967

1968

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

Savers then shifted to safer bonds, driving bond prices up and interest rates down. The Fed also lowered interest rates to promote a “soft landing” for the economy. Real mortgage interest rates fell 50%.

Real interest rate on conventional mortgages

0.0

1.0

2.0

3.0

4.0

5.0

6.0

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

With low interest rates and depressed stock prices, savers were motivated to look elsewhere in an attempt to earn higher but still safe returns.

• Mortgages, backed by real property as collateral, had historically been safe assets, with returns that exceeded government bonds, so savers turned to the housing market.

• And borrowers, attracted by the low interest rates, borrowed not just for new housing purchases, but also to refinance existing mortgages and cash in some of their new housing wealth to pay for increased consumption.

• The rest is our recent history.

The basic economic model of capital migration was completely reversed during the decade leading up to the global financial crisis.

Funds that ordinarily would have been used to finance productive investments in low-income, capital scarce countries were instead used to fund residential housing investments and higher consumption spending in high-income countries.

The same 1999 article that described the government’s pending homeownership drive expressed concerns about its long-run effects:

New York Times, Sept. 30, 1999: In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's.

In his 2005 address, Bernanke mixed of cautious optimism and concern:

“[A] return to approximate balance may take some time. Fundamentally, I see no reason why the whole process should not proceed smoothly. However, the risk of a disorderly adjustment in financial markets always exists.”

We all know now that the hard landing is what we ended up with.

So, where does the giant pool of money appear to be headed now?

Net capital flows have returned to close to their pre-crisis level, with a shift back in the direction predicted by capital migration theory: industrial countries have accounted for 84% of CA increases and only 18% of CA decreases.

Shifts in Current Account Balances from 2006-2010 (shares of global total)

Shares of CAB increases Shares of CAB decreases

High-income housing boom countries, excl. US

18%

China 16% OPEC 35%

US 72% LDCs, excluding OPEC and debt-crisis countries

24%

High-income, non-housing boom countries

12% Debt-crisis LDCs 24%

Total 100% Total 100%

Inflation-adjusted housing prices have continued to fall, but they remain above the stable level of the 1990s.

US real house price index (1991 = 100)

108.

3

150.

5

117.

9

80.0

90.0

100.0

110.0

120.0

130.0

140.0

150.0

160.0

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

Stock prices have rebounded since the depths of the crisis but are still nearly 15% below their past trend.

Inflation-adjusted total return index for the S&P 500, 1960-2003: Percentage deviation from its upward trend of 6.6% per year since 1871

-45.6%

-14.9%

-60.0%

-40.0%

-20.0%

0.0%

20.0%

40.0%

60.0%

80.0%

100.0%

120.0%

1960

1961

1962

1963

1964

1965

1966

1967

1968

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

US: 1. Reduce the budget deficit (but note that current account deficits persisted during the budget surpluses of the 1990s). 2. Increase domestics savings (but the huge capital inflows themselves have depressed savings by pushing down interest rates and pushing up asset prices).

Emerging markets: 1. Improve governance 2. (Re)open capital markets

Recommendations based on the global approach to the financial crisis:

Bernanke focused on the LDC part of the remedy in his 2005 remarks:

[H]elp and encourage developing countries to re-enter international capital markets in their more natural role as borrowers, rather than as lenders. For example, developing countries could improve their investment climates by continuing to increase macroeconomic stability, strengthen property rights, reduce corruption, and remove barriers to the free flow of financial capital. Providing assistance to developing countries in strengthening their financial institutions--for example, by improving bank regulation and supervision and by increasing financial transparency--could lessen the risk of financial crises and thus increase both the willingness of those countries to accept capital inflows and the willingness of foreigners to invest there. Financial liberalization is a particularly attractive option, as it would help both to permit capital inflows to find the highest-return uses and, by easing borrowing constraints, to spur domestic consumption.

Once poorer countries bring their savings home and richer countries send theirs abroad, the US standard of living may fall, but US manufacturing jobs will come back.

The PIIGS (Portugal, Ireland, Italy, Greece, and Spain)

= the US of the Eurozone

4. The Eurozone crisis

The giant pool of savings flowed in from 1996-2006.Current Account Balances, 1996 vs. 2006: The PIIGS and other high-income countries

-3.3

2.7 3.

2

-3.9

-0.2

-0.6

4.0

-0.8

-1.6

-11.

3

-3.5

-2.6

-10.

8

-9.4

6.2

4.6

-3.2

-6.0

-8.0

-6.2 -5

.7

-6.8

-9.2

6.7

0.7

-2.4

-4.4

-15.0

-12.0

-9.0

-6.0

-3.0

0.0

3.0

6.0

9.0

Greece Ireland Italy Portugal Spain Germany Others (avg.) UnitedKingdom

United States

CA

B,

Per

cen

t o

f G

DP

1996

2006

1996-2006

The PIIGS Other Eurozone-12 UK and US

And the giant pool of savings is now flowing out.Current Account Balances, 2006 vs. 2011: The PIIGS and other high-income countries

-11.

3

-3.5

-2.6

-10.

8

-9.4

6.2

4.6

-3.2

-6.0

-8.3

0.1

-3.1

-6.6

-4.0

5.7

2.5

-1.9

-3.1

3.0 3.

6

-0.6

4.1

5.5

-0.4

-2.1

1.3

2.8

-15.0

-12.0

-9.0

-6.0

-3.0

0.0

3.0

6.0

9.0

Greece Ireland Italy Portugal Spain Germany Others (avg.) UnitedKingdom

United States

CA

B,

Per

cen

t o

f G

DP

2006

2011

2006-2011

The PIIGS Other Eurozone-12 UK and US

But the US floats, while the PIIGS are trapped in the euro.