Finanancial Meltdown and Bail-outs : Where are we Heading ? Where do I invest ?

Global Economic Connec.vity and Economic Crisis Global Business Forum 15TH January ,2009 University of Miami Ricardo Lago Economist and Consultant Former Senior of the EBRD, The World Bank , IADB Former Director of Economic Policy of the Treasury of Mexico 1

Global Connec1vity and Economic Crisis

Descrip(on: The global economic crisis has precipitated rapidly and has spread across the world due to increased connec.vity of global markets. This session will explore the background and the current state of affairs of the global economic crisis. The session will also explore possible solu.ons and direc.ons of global markets. Senior execu.ves from major financial ins.tu.ons across the globe will provide their wisdom and predic.ons – Manuel Santos, Professor and James L. Knight Chair, Department of Economics, School of Business Administra.on, University of Miami – Roberto Higuera, Vice Chairman & Chief Execu.ve Officer, Member of the Board of Directors, Banco Popular Español – Ricardo V Lago , Economist . Adviser to business and governments – Richard Dorfman, President and CEO, Federal Home Loan Bank of Atlanta Loca1on: Frost School of Music, Gusman Hall

Santos , Higuera , Dorfman, Lago

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BAIL OUTS

MONETARY STIMULUS

FISCAL STIMULUS

THREE GENERAL REFLECTIONS • THE TALE THAT SUB‐PRIME MORTGAGES WERE THE CAUSE OF THE CRISIS IS SIMPLISTIC AND FLAWED . SUB‐PRIME WAS THE FIRST MANIFESTATION OF A DEEPER PROBLEM • IN THE 1990s and 2000s LIKE IN THE 1920s : WE HAD ENTERED AN ERA OF – innova.on and fast produc.vity growth – Great expecta.ons : prosperity was here to stay!

– Easy money and excessive consumer spending in US and Europe – High leverage ra.os – Regulators : too many , too uncoordinated , looking at the wrong thing in the wrong places, and red‐taping everyone with costs • FREE MARKETS WORK .THE PROBLEM IS THAT USA AND EUROPE ARE DEPARTING FROM THE RULES AND ETHICS OF FREE MARKETS

Look at Peru with free markets : departing from chaos in 1990 (Average anual GDP growth 2002- 2008)

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STRONG INNOVATIONS ,PROSPERITY BOOMS, AND EVENTUAL BUSTS

TWO ERAS OF UNPRECEDENTED PROSPERITY • IN THE 1920s – Innova.ons : radio , electrifica.on , and telephone – Market expansion : the resump.on of mul.lateral trade ader World War I

• IN THE 1990s and 2000s – Innova.ons : PCs , Cellphones , and Internet – Market expansion : incorpora.on of China , India and Eastern Europe to world trade

NOW I TURN TO THE FOUR CENTRAL QUESTIONS ASKED BY PROFESSOR SANTOS :

• QUESTION 1 : Monetary and fiscal policies in US and EU, Will they work ?

• QUESTION 2: When will the banking system be opera.ng smoothly • QUESTION 3 :How long will the recession last?

• QUESTON 4 How do you foresee the evolu.on of the stock market, the dollar, and stock markets overseas?

When will the banking system be opera.ng smoothly?

QUESTION 1 Monetary and fiscal policies in US and EU, Will they work ?

MONETARY POLICY

TRIVIA QUESTION What is the cost of producing a US$100 dollar note ?

ANSWER

• During Fiscal Year 2008 the Bureau of Engraving and Prin(ng delivered 7.7 billion notes at an average cost of 6.4 cents per note.

Vernon Smith , Nobel Laureate to WSJ “Why is this crash a classic?

In every market, there is ul(mately only one source of liquidity: buyers. And this is what central bankers hope to see return when they speak euphemis(cally of restoring confidence.All other sources of liquidity are stop gaps,bridges, band aids, and now a duct‐tape bailout. Every seller in dire need of a buyer is in a liquidity crisis”

MACROECONOMICS 101 – MONEY SUPPLY

• MONETARY BASE (MB)

– The Fed lends to banks , to the government ( buys TBs or Bonds) , others , or buys foreign currencies – How ? : by prin.ng money

• MONEY SUPPLY MULTIPLIER (k) – That money ends in people pockets , part they keep it in the pocket and part they deposit in the banks – Banks invest the deposits either in loans to business or people or else leave it in Reserves (in TBs or at the Fed)

• MONEY SUPPLY (M)

M =MB x K

WHAT IS HAPPENING NOW WITH MONEY SUPPLY GROWTH ?

• Monetary Base (MB) is growing at a huge 144% p.a.

• Monetary Supply (M2) is growing at 7.6% p.a • Hence , the Mul.plier (k) has declined by 56% p.a • CONCLUSION : – Fed is prin.ng to much money – Individuals are keeping much of it in cash – Banks are accumula.ng reserves rather than lending

MACROECONOMICS 101 - AGGREGATE DEMAND MONEY SUPPLY x VELOCITY = PRICE LEVEL x gdp

M x V= P x gdp

 As we saw M is growing at 7.6 % ,  but V is dropping at 10% to 15%  Inflation may be zero or even negative  If inflation were at zero , then gdp is falling by 3% to 8%

FISCAL ESTIMULUS

MACROECONOMICS 101‐FISCAL POLICY • PEOPLE DO NOT CONSUME MUCH , AND BUSINESS DO NOT INVEST ENOUGH • WHY NOT HAVE THE GOVERNMENT SPEND MORE TO MAKE UP FOR IT !

• PRESIDENT OBAMA’S 800 ‐Billion DOLLAR STIMULUS PLAN AND OTHERS • WILL IT WORK ?

DOES IT MEAN THAT THERE HAS BEEN NO STIMULUS SO FAR ?

• BUT SO FAR THERE HAVE BEEN ALREADY A MYRIAD OF VERY EXPENSIVE PUBLIC INTERVENTIONS .

RESCUE AND /OR STIMULUS HOWEVER WE WANT TO CALL THEM • BAIL OUTS : TARP , BEAR STERNS , AIG , FANNIE , FREDDY , AUTO INDUSTRY , SEVERAL FED SCHEMES ETC ETC • FORBES MAGAZINE HAS MADE AN ESTIMATE AT US$ 6 Trillion IN BAIL OUTS • IN 2008 THERE WAS A TAX REDUCTION STIMULUS PACKAGE FO US$150 billion .

THE DOWNSIDE OF MORE BUDGET DEFICITS IS THE LONG RUN SOLVENCY PROBLEM • THE PEOPLE WANT TO SAVE TO IMPROVE THEIR BALANCE SHEETS , THE GOVERNMENT IS DIS‐SAVING AND FRUSTRATING IT • WHAT IS GOOD FOR THE SHORT RUN IS BAD FOR THE LONG RUN • HIGH DEBT AND LOW SAVINGS ARE A PROBLEM

THE PROBLEM IS THE DEBT

THE WAY OUT OF THE RECESSION : THE RAZOR BLADE PATH PROBLEM • DEFLATION MOOD SCENARIO : JAPAN ( 1991 to PRESENT ) – LOW GROWTH – PERPETUATION OF INSOLVENT BANKS – TOO MUCH FISCAL ACTIVISME AND EXPLODING PUBLIC DEBT

• HIGH INFLATION SCENARIO – ORDERLY REWINDING OF THE BALANCE SHEET OF THE FED–ONCE

MULTIPLIER AND VELOCITY PICK UP – AND BALANCING THE BUDGET MAY BE DIFFICULT TO STAGE – RISK OF FALLING INTO HIGH INFLATION OR EVEN HYPERINFLATION

FISCAL STIMULUS INTERNATIONAL COORDINATION • IDEAL SCENARIO ( US$ 3 TRILLION OR 6% of World GDP) – THE CREDITOR COUNTRIES ( CHINA ,GULF COUNTRIES , ETC ) SHOULD TAKE MORE OF THE BURDEN – THAT THE DEBTOR NATIONS , UK , US AND OTHERS PILE UP MORE DEBT IS A PROBLEM

Ques.on 2 When will the banking system be opera.ng smoothly?

WILL IT WORK ?

• WHEN INSOLVENT BANKS ARE WOUND UP OR PROPERLY CAPITALIZED • WHEN BANKING INTERMEDIATION SHRINKS TO THE REAL VALUE OF THE ASSETS : MALINVESTMENTS ARE WRITTEN OFF • WHEN LEVERAGE RATIOS ARE BROUGHT DOWN TO REASONABLE LEVELS • AS STOCK MARKETS SEE THE LIGHT AT THE END OF THE TUNNEL

QUESTION 3 How long will the recession last?

DURATION OF LONGEST RECESSIONS SINCE 1900 • GREAT DEPRESSION (1929‐33) : 43 months • OIL –GOLD RECESSION (1973‐75) : 16 months • VOLKER RECESSION (1981‐83 ) : 16 months

Willis Hawley, a congressman from Oregon,

and Reed Smoot, a senator from Utah

1929 ‐1933 Collapse of Word Trade

HOW LONG WILLTHE CURRENT RECESSION LAST? ASSUMING IMPROVED GLOBAL CO‐ORDINATION AND COOPERATION ON : • No protec.onism (Buy America , Buy Brazil ?? – Remember Smou – Howley !! ) • Beuer coordina.on on fiscal –monetary policy

• THEN CURRENT RECESSION WOULD LAST ABOUT 30 MONTHS • THAT IS THE AVERAGE BETWEEN THE 43 OF THE GREAT DEPRESSION AND THE 16 OF THE TWO OTHER LONGEST • In March (2009 ) we will be in the 16th month ‐How much longer ? : 12 to 16 months longer ‐We are half the way down ‐ We will be out by the 1st or 2nd quarter of 2010

QUESTION 4 How do you foresee the evolu.on of the stock market, the dollar, and stock markets overseas?

Ranking of currencies with beuer to lower perspec.ves • Gold • Some emerging countries currencies : Yuan, Real , Chilean Peso , Peruvian Sol • Euro • Dollar • Yen • Sterling Pound

Best Stock markets • BRICs and some other emerging markets – They will be leading the recovery

• US : Technology Stocks (Nasdaq 100) – They are global companies with lots of cash and no debt – They are growth‐stocks now discounted to price mul.ples of value‐stocks

Treasury Bills

• If you have any bonds ( maturi.es 2 years of longer ) of the US , UK , and many European countries , dump them as quickly as you can

• US and other stock markets are massively undervalued by any standard • The problem is not figuring out the prospects of the stocks themselves , • the problem is the value of the dollar and the Euro , and the other currencies

WHY ARE STOCKS MASSIVELY UNDERVALUED ?

• Because in the last 200 years their value ( inc. Reinvestment of dividends ) has scauered year to year around an exponen.al line • This exponen.al line shows a real return of 6.6% per year • The devia.on from that line can be as much as :  +100% in an extreme Bull market  ‐50% in a extreme Bear market

• But has not exceeded those levels on a year average basis • Note , though, that the range of devia.on is a huge : if being right on the line the value is 100 , the upper bound can be as high as 200 and the lower bound as low as 50 !

• That is the upper bound is 4 .mes the lower bound

EXAMPLE

• IF WE PLOT THE CHART IN LOGARITHMIC PAPER : IT FLATTENS THE VERTICAL AXIS HENCE , CONVERTING : – 10 into 1 – 100 into 2 – 1000 into 3 – 10000 into 4 – And so on

THEN WE GET ….

WHY ARE US STOCKS MASSIVELY UNDERVALUED ?

• Because in the last 200 years their value ( inc. Reinvestment of dividends ) has scauered year ader year around an exponen.al line • This exponen.al line shows a real return of 6.6% per year • The devia.on from that line can be as much as :  +100% in an extreme Bull market  ‐50% in an extreme Bear market

• But the average value of any year has not surpassed those levels • Note , though, that the range of devia.on is a huge : – if being right on the line the value is 100 – the upper bound can be as high as 200 – and the lower bound as low as 50 • That is the upper bound is 4 .mes the lower bound !

SO WHY ARE US AND OTHER STOCKS MASSIVELY UNDERVALUED ?

• Because at the lowest point on November 21st ,2008 , stocks prices were precisely below the line by exactly ‐ 50% • Today , January 15th , stocks prices are below the line ‐42%

THE TWO REAL THREATS IN THE MONTHS AHEAD • ON THE INFLATION FRONT THE MONETARY AND FISCAL STIMULUS MAY GET US OUT OF DEFLATION /DEPRESSION BUT WITH HYPERINFLATION AND RACHITIC GDP RECOVERY

• ON THE REAL GDP FRONT A RETURN TO PROTECTIONISM : STRAIGHT OR IN DISGUISE (Buy Spain , Buy America , Buy Brazil, etc )

• HENCE , NEED FOR GLOBAL CO‐ORDINATION ON FREE TRADE AND ON FISCAL /MONETARY STIMULUS

What is Benjamin Franklin telling me?

Franklin’s most famous quote !

“We must, indeed, all hang together or, most assuredly, we shall all hang separately”