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Narrative: From the East Asian Financial Crisis of 1997-1998 to the Credit Crisis of 2007-2009 J. Bradford DeLong University of California at Berkeley and NBER brad.delong@gmail.com http://delong.typepad.com/ +1 925 708 0467 April 28, 2009-May 5, 2009 April 28:

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n   n  (1 + g)  p t = limE t ∑ d t+i  + limE t ηt+n  n n−>∞  n−>∞ (1 + r)    i=0

If g is greater than or equal to r bubbles are not just “rational” and possible—they are required. € • If r > g than prices must be equal to fundamentals—if we identify “expectation” with orthogonal projection. • So we must find some way to drive r less than g—dynamicallyinefficient economy. • Or deprive “rational” investors of capital. • For we do see things we pretty much have to call “bubbles”—both the most recent one in the real estate market, but also and more frequently in the bond and stock markets as well. •

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 p − p t−1 + d t  p t+1 = p t + λp t (1− p t ) t − r p t −1  

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Short look-backs. Adopting recently-successful portfolio strategies. An initial displacement. And it is easy to generate bubbles and manias and overshooting. Panics and crashes are harder to generate.

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Let us change gears now and look back at the last big financial crisis—the East Asian crisis of 1997-1998: From Morris Goldstein:

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- In the first period investors bid for land, setting its price. - In the second period they receive rents, which are uncertain at the time of bidding. - Suppose that the rent on a unit of land could be either 25, with a probability of 2/3, or 100, with a probability of 1/3. - Risk-neutral investors would then be willing to spend (2/3)25 + (1/3)100 = 50 for the rights to that land. - But now suppose that there are financial intermediaries… able to borrow at the world interest rate… the Pangloss value: 100. What if this regime may not last? - Liabilities carried over from period 2 to period 3 might not be guaranteed. - The price of land will reflect only its expected return of 50. - On the other hand, if intermediaries are guaranteed, the price will still be 100… What about the price of land in the first period? - Investors now face two sources of uncertainty: o they do not know whether the rent in the second period will be high or low, o they do not know whether the price of land in the second period will reflected expected values or Pangloss values. Propose that creditors of financial intermediaries will be bailed out precisely once… - Suppose that in period 2 rents are disappointing - 25, not 100.

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- A less-than-Panglossian rent in period 2 means that creditors of intermediaries need to be bailed out in that period, - Future creditors can no longer expect a bailout. - So the intermediaries collapse, and the price of land drops from 100 to the expected rent 50. - Magnification effect. The "real" news about the economy is that rents in period 2 were 25, not the hoped-for 100. But land bought for 200 will now yield only 25 in rents plus 50 in resale value, a loss of 125 rather than merely 75. - The magnification effect is caused, of course, by the circular logic of disintermediation: the prospective end to intermediation, driven by the losses of the existing institutions, reduces asset prices and therefore magnifies those losses. - Multiple equilibria. - Second period rent of 100. - Land price at the end of the second period will also be 100 if guarantee is credible. - In that case no bailout will be needed; and so the government guarantee for intermediation will in fact continue. - But suppose that despite the high rents in the second period potential creditors become convinced that there will be no guarantee: Then price of land in the second period will be only 50. - That means that intermediaries that borrowed money in the first period based on Pangloss require a bailout--and since the government's willingness to provide for bailouts is now exhausted, investors' pessimism is justified. - Plunging asset prices undermine banks, and the collapse of the banks in turn ratifies the drop in asset prices.

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The East Asian crises seemed baffling because of:   • The absence of the usual sources of currency stress, whether in the form of fiscal deficits or macroeconomic difficulties; • The pronounced boom-bust cycle in asset prices prior to the currency crisis; • The severity of the crisis given a lack of strong adverse shocks, and the spread of the initial crisis to countries that seemed to have few economic links with the initial victims. We now have an admittedly primitive but still illuminating way to make sense of these paradoxes. The reason that traditional measures of vulnerability did not signal a crisis is that the problem was off the government's balance sheet: the underlying policy mistake was, like the guarantees that created the S&L fiasco, not part of the government's visible liabilities until after the fact. The boom-bust cycle created by financial excess preceded the currency crises because the financial crisis was the real driver of the whole process, with the currency fluctuations more a symptom than a cause. And the ability of the crisis to spread without big exogenous shocks or strong economic linkages can be explained by the fact that the afflicted Asian economies were in a sort of "metastable" state in any case - highly vulnerable to self-fulfilling pessimism, which could and did generate a downward spiral of asset deflation and disintermediation.

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Lessons not drawn from the East Asian financial crisis‌

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April 30: Now let’s go on to the present, a decade later… Martin Baily, Robert Litan and Matthew Johnson (2008), "The Origins of the Financial Crisis" Claudio Borio (2008), "The Financial Turmoil of 2007-?" Markus Brunnermeier (2009), "Deciphering the Liquidity and Credit Crunch 2007-2008," Journal of Economic Perspectives Brunnermeier: • • • • • • • • • • • • •

The shift to “originate and distribute” banking… Regulatory and ratings arbitrage… Housing boom February 2007 increase in subprime mortgage defaults On May 4, 2007, UBS shut down its internal hedge fund, Dillon Read, after suffering about $125 million of subprime-related losses Late May: Moody’s put 62 tranches across 21 U.S. subprime deals on “downgrade review Rating downgrades of other tranches by Moody’s, Standard & Poor’s, and Fitch unnerved the credit markets in June and July 2007. Mid-June: two hedge funds run by Bear Stearns had trouble meeting margin calls, leading Bear Stearns to inject $3.2 billion in order to protect its reputation. Countrywide Financial Corp. earnings drop on July 24. July 2007: market for short-term asset-backed commercial paper began to dry up. July 2007: IKB, a small German bank, unable to roll over assetbacked commercial paper. A €3.5 billion rescue package involving public and private banks was announced. July 31: American Home Mortgage Investment Corp. announced its inability to fund lending obligations: declared bankruptcy on August 6.

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August 9, 2007, BNP Paribas froze redemptions for three investment funds.

Each ABX index is based on a basket of 20 credit default swaps referencing asset-backed securities containing subprime mortgages of different ratings. An investor seeking to insure against the default of the underlying securities pays a periodic fee (spread) which—at initiation of the series—is set to guarantee an index price of 100. This is the reason why the ABX 7-1 series, initiated in January 2007, starts at a price of 100. In addition, when purchasing the default insurance after initiation, the protection buyer has to pay an upfront fee of (100 – ABX price). As the price of the ABX drops, the upfront fee rises and previous sellers of credit default swaps suffer losses.

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An interest rate spread measures the difference in interest rates between two bonds of different risk. These credit spreads had shrunk to historically low levels during the “liquidity bubble� but they began to surge upward in the summer of 2007. Historically, many market observers focused on the TED spread, the difference between the risky LIBOR rate and the risk-free U.S. Treasury bill rate. In times of uncertainty, banks charge higher interest for unsecured loans, which increases the LIBOR rate. Further, banks want to get first-rate collateral, which makes holding Treasury bonds more attractive and pushes down the Treasury bond rate. For both reasons, the TED spread widens in times of crises. The TED spread provides a useful basis for gauging the severity of the current liquidity crisis.

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• • • •

August 1–9, 2007, many quantitative hedge funds, which use trading strategies based on statistical models, suffered large losses, triggering margin calls and fire sales. Crowded trades caused high correlation across quant trading strategies (for details, see Brunnermeier, 2008a; Khandani and Lo, 2007). The first “illiquidity wave” on the interbank market started on August 9. At that time, the perceived default and liquidity risks of banks rose significantly, driving up the LIBOR. In response to the freezing up of the interbank market on August 9, the European Central Bank injected €95 billion in overnight credit into the interbank market. The U.S. Federal Reserve followed suit, injecting $24 billion. To alleviate the liquidity crunch, the Federal Reserve reduced the discount rate by half a percentage point to 5.75 percent on August

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17, 2007, broadened the type of collateral that banks could post, and lengthened the lending horizon to 30 days. September 18, the Fed lowered the federal funds rate by half a percentage point (50 basis points) to 4.75 percent. The U.K. bank Northern Rock was subsequently unable to finance its operations through the interbank market and received a temporary liquidity support facility from the Bank of England. October 2007 was characterized by a series of write-downs. For a time, major international banks seemed to have cleaned their books. The Fed’s liquidity injections appeared effective. Also, various sovereign wealth funds invested a total of more than $38 billion in equity from November 2007 until mid-January 2008 in major U.S. banks (IMF, 2008). Matters worsened again starting in November 2007 when it became clear that an earlier estimate of the total loss in the mortgage markets, around $200 billion, had to be revised upward. The TED spread widened again as the LIBOR peaked in midDecember of 2007. This change convinced the Fed to cut the federal funds rate by 0.25 percentage point on December 11, 2007. On December 12, 2007, the Fed announced the creation of the Term Auction Facility (TAF), through which commercial banks could bid anonymously for 28-day loans against a broad set of collateral, including various mortgage-backed securities. Monoline insurers focused completely on one product, insuring municipal bonds against default (in order to guarantee a AAArating). More recently, however, the thinly capitalized monoline insurers had also extended guarantees to mortgage backed securities and other structured finance products. This change would have led to a loss of AAA-insurance for hundreds of municipal bonds, corporate bonds, and structured products, resulting in a sweeping rating downgrade across financial instruments with a face value of $2.4 trillion and a subsequent severe sell-off of these securities. On January 19, 2008, the rating agency Fitch downgraded one of the monoline insurers, Ambac, unnerving worldwide financial markets. Emerging markets in Asia lost about 15 percent, and

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Japanese and European markets were down around 5 percent. Dow Jones and Nasdaq futures were down 5 to 6 percent Given this environment, the Fed decided to cut the federal funds rate by 0.75 percentage point to 3.5 percent—the Fed’s first “emergency cut” since 1982. At its regular meeting on January 30, the Federal Open Market Committee cut the federal funds rate another 0.5 percentage point. Collapse of Bear Stearns:150 million trades spread across various counterparties. It was therefore considered “too interconnected.” Officials from the Federal Reserve Bank of New York helped broker a deal, through which JPMorgan Chase would acquire Bear Stearns for $236 million, or $2 per share (ultimately increased to $10 per share). By comparison, Bear Stearns’s shares had traded at around $150 less than a year before. The New York Fed also agreed to grant a $30 billion loan to JPMorgan Chase. On Sunday night, the Fed cut the discount rate from 3.5 percent to 3.25 percent and for the first time opened the discount window to investment banks, via the new Primary Dealer Credit Facility (PDCF), an overnight funding facility for investment banks.

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May 5: • •

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Fannie Mae and Freddie Mac: July 2008-September 2008 The Witching Hour: • AIG • Merrill Lynch • Lehman Brothers • The collapse of Lehman: why?

In the aftermath of Lehman… The end of financial-real “decoupling” More Fed vehicles The TARP The Stimulus The new administration The “stress tests

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• • • • •

The bonuses The Republicans The Europeans Fear of deflation/inflation Thinking about the tails…

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Chicago: Robert Lucas:

[T]hr additional reserves the Fed has put into the system have induced double-digit growth in M1 and M2 domain monetary aggregates… rates which… if they were sustained would soon yield inflation at 1970s levels or higher…. [A]s confidence returns, which it will, velocity is going to return to pre-crisis levels and people are going to start spending more out of their cash balances.  So… that too is going to add to the inflationary pressures…. [I]t's absolutely necessary for the Fed to be able and willing to reverse course and sell off the assets its acquired over these years…. [I]t’ssomething you might as well think about it, because we're going to get there.  

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There's nothing technically hard about unwinding these Fed positions fast…. But, it's going to take political courage, or some kind of consensus….  I don't think it's an argument against the policy that's being followed, and I hope when the crunch comes we'll do the right thing, but it's a concern…. [W]ould a fiscal stimulus somehow… add another weapon that would help…. I just don't see [how]...  If the government builds a bridge, and then the Fed prints up some money to pay the bridge builders, that's just a monetary policy….  We can print up the same amount of money and buy anything with it…. [T]here are… different ways of getting the cash out there.  Maybe some of the things Bernanke's doing right now to get the cash out there are properly called fiscal policy….But if we do build the bridge by taking tax money away from somebody else, and using that to pay the bridge builder… then it's just a wash… there's nothing to apply a multiplier to.  (Laughs.)  You apply a multiplier to the bridge builders, then you've got to apply the same multiplier with a minus sign to the people you taxed to build the bridge.  And taxing them later isn't going to help, we know that…. [T]his monetary response that we're in the middle of… is a response to the lessons of the 1930s…. I think the current policy we're doing is the right one, and I just hope that we have the nerve to terminate it when it's done its job…. The Moody's model that Christina Romer -- here's what I think happened.  It's her first day on the job and somebody says, you've got to come up with a solution to this -- in defense of this fiscal stimulus, which no one told her what it was going to be, and have it by Monday morning.  

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So she scrambled and came up with these multipliers and now they're kind of -- I don't know.  So I don't think anyone really believes.  These models have never been discussed or debated in a way that that say -- Ellen McGrattan was talking about the way economists use models this morning.  These are kind of schlock economics.   Maybe there is some multiplier out there that we could measure well but that's not what that paper does.  I think it's a very naked rationalization for policies that were already, you know, decided on for other reasons.  I don't -- I'd like to talk about the Lucas critique but I don't -- I don't think we can -- (chuckles) -- deal with that issue…. The zero interest rate thing is -- there no -- look what Bernanke's done already.  After interest rates hit zero he's putt $1 trillion-plus into the economy.  So no one's ever going to -- whatever happens in this -- whatever Ben's does -- done for us he's completely removed this zero interest bound as something we have to think of as a limit on what monetary policy can do.   I think if you had to do something -- I mean, you're saying a slump is probably a pretty good time to build stuff with government programs.  I mean, the construction industry is slumping, wages aren't going to be going up fast, so we could take advantage of that and build some roads.  That's true in the private sector too.  It's a great time to buy a new car.  I mean, it's a great time to do a lot of things.  But people aren't -- so I think these incentives are not -- they're a force that's going to bring a private response.  You're describing if the interest structure thing is analogous to a -I agree with that.   I certainly don't think, you know, it would be a bad idea to build some new bridges.  But that's got to be justified not

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on stimulus or multipliers, just on the fact that we'd like better bridges and we're willing to pay for it if we are.  Now, right now maybe is not -- I don't think the government's exactly flush but, you know, I think those are the issues to talk about and I certainly don't think -obviously, the role for government in providing infrastructure is really central to the whole process…. I avoided this bank bailout issue in my 15 minutes and there's a reason for it.  I don't really get it.  Some of the problems you're talking about about deciding who gets paid and who doesn't, that's the whole function of bankruptcy law is to deal with that in an effective way.  Now, it may be that the kind of neighborhood effects of the bankrupt banks are sufficiently different from the neighborhood effects of a bankrupt auto company -- that they need some kind of special treatment.   But then it seems like the right public policy is something that -- maybe some kind of accelerated bankruptcy proceedings.  Just to say make them well on all the money they've lost over this thing, I just -- I do not get it and I know of -- I don't know whether we're headed that way or not.  I hope not.  Now, what was the first part of that?  (Off mike exchange.)  Oh, the differences with -- I did want to say something.   I think Friedman and Schwartz have got a lot to tell us about the current situation.  There's certainly plenty of differences between the '29 to '33 period and the present period besides magnitude, the whole role of who provides liquidity which was then more or less completely confined to cash and commercial bank deposits as, you know, partly because of the '70s inflation spilled out into the shadow banking system, which is, you know, unregulated and

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which the Fed has no special responsibility for.  And so there's been a lot of improvising in that dimension. I said I was going to not deal with moral hazard.  This is not the right time to worry about too big to fail, you know?  What I'd say now is the failure of the bank is going to cause spill over effects that deepen this recession and so on, it's now -- keep them alive.  We're going to come out of this with a new regulatory structure, a new set of incentives and we're going to have to kind of start from scratch anyway.  So in terms of you bailing out a bank and setting up incentives for the next 30 years for bank behavior, that's not what's going on right now I don't think…

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Narrative of the Financial Crisis