The World Financial Crisis: Its Nature, Consequences, Causes and Resolutions

1
The World Financial Crisis Its Nature,
Consequences, Causes and Resolutions

• Robert Mundell
• University Professor, Columbia University,
• Nobel Laureate in Economics, 1999
• Astana, Kazakhstan
• March 11. 2009

2
Time of Great Crisis

• Today we are in the middle of a great crisis. The
  governments of the world are in a state of shock.
  All the major economies except China are in a
  state of contraction expected to last at least
  another full year.
• Many banks around the world are insolvent and
  unemployment is increasing rapidly.
• It is imperative that we act with bold measures
  quickly.

3
Currency Areas after the Euro

Canada
Russia

Korea
Sweden




RMB
India

Taiwan
Indonesia
Hong Kong
Mexico
Brazil
Australia
Gulf Countries
Latin American Caribbean
CFA
4
The Crisis
5
The Origins

• The early origins go back to the Federal Reserve
  policies used to cope with the global slowdown of
  2001-2.
• With very low interest rates and a low dollar in
  the recovery, a housing boom developed.
• As long as house prices were rising there was a
  cushion of safety between mortgages and house
  values.

6
End of the Boom

• When the house prices stopped rising and began to
  fall, the boom ended.
• When house prices fell below mortgage values,
  homeowners walked away from their mortgages.
• Sub-prime mortgage assets became toxic,
  creating a devastating hole in balance sheets.

7
Six innovations Good or Bad?

• Investment Banking (end of
• Glass-Steagal)
• Securitization of mortgages
• Derivatives
• Credit-Default-Swaps
• Mark-to-Market Accounting Rules
• Variable Rate Mortgages

8
Massive Liquidity Crisis

• Sudden awareness of the problem in the summer of
  2007 created a massive balance sheet problem for
  banks amounting to hundreds of billions of
  dollars.
• Mark-to-market accounting forced them to fill (or
  cover up!) the holes.
• The scramble for liquidity was completely
  unprecedented in the annals of finance.
• A financial panic was about to occur.

9
The Liquidity Crisis Aug 9-10, 2007

• Panic was averted by prompt action by the ECB. It
  offered unlimited credit at 4 on August 9.
• 95 billion in euros were lent at that rate
• More came from the Fed and other central banks
  when their markets opened later and the next day
  the lending continued.

10
Injections by ECB and FRB in Billions of Dollars
in August 2007
11
Solvency Problem

• The prompt actions of the ECB and FED and others
  in August 2007 solved the liquidity problem at
  the time.
• What remained was the solvency problem of those
  institutions with big holdings of these
  defaulting assets.

12
Slowdown and then Recovery

• After the resolution of the liquidity crisis
  there was relative quiet for 13 Months.
• The great expansion of 2002-2007 came to an end
  in the U.S. with the great slowdown in 2007 (4)
  and 2008 (1) and a near recession.
• But then expansion came in 2008 (2) with growth
  of 2.8.
• A recovery seemed to be coming.

13
The Spring Recovery

• In the spring of 2008 it looked as if the U.S.
  economy was recovering. There was 2.8 growth in
  the second quarter of 2008.
• Bear Stearns was a problem the biggest bailout
  since LTCM in Sept 1998 - but it seemed to be
  settled with its absorption into J.P. Morgan in
  May 2008.

14
Financial Blowout and Recession in 2008-II

• But instead of recovery in the last half of 2008
  we got the greatest financial disasters in
  American history and a an unambiguous recession
  with two consecutive quarters of negative growth
  in 2008 (3) and 2008(4).

15
Lehmans Collapse

• Lehmans demise was the biggest failure in world
  history.
• Previously, Enron in 2002 had been the biggest.
• But the Lehman failure was six times bigger than
  Enron.

16
Credit Dried Up

• The most serious cost of the failure of Lehman
  was a colossal increase in the demand for money
  on the part of both banks and the public.
• Money became even tighter. Credit became
  unavailable except for super-solvent firms.
  Credit for ordinary enterprises dried up.

17
Two Questions

• Two questions arise
• 1. What put Lehman Bros in danger?
• 2. Why did the Fed and Treasury let Lehman fail?

18
Lehmans Collapse

• Lehman was too big to fail BUT THE FED AND
  TREASURY LET IT FAIL.
• It was a mind-boggling mistake.
• It put other institutions at risk and made the
  take-over of AIG, at a cost of 78 billion
  inevitable.

19
The Big Question

• Why did the financial crisis occur and why did it
  happen to come about in August and September
  2008?
• What caused the debacle that September?

20
Currency Appreciation and Tight Money

• The dollar soared in July-September and the price
  of gold fell.
• These are two symbols of tight money.
• True, interest rates were low and monetary
  expansion was enormous, but not enough to offset
  the increase in the demand for money.

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The price of gold plummeted.
Tue Feb 10 162109 2009                      
                                                  
                                                  
                     
Tue Feb 10 162109 2009                      
                                                  
                                                  
                     
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Low Gold, Strong Dollar

• The soaring dollar and falling gold price were
  symptoms of a shortage of dollar liquidity.
• Had the FED recognized this shortage and bought
  foreign exchange to prevent the appreciation,
  there would probably have been no financial
  crisis in the fall.
• Instead, the dollar appreciation overvalued US
  dollar assets including all fixed income
  securities and mortgages, tipping Lehman Bros and
  other banks over the edge.

24
The Fed Screwed Up!

• The Federal Reserve cut off the economic recovery
  in 2008(2) and tipped the economy into recession
  and financial crisis.

25
Joint Fed-Treasury Mistake

• This does not exonerate the Secretary of the
  Treasury for the joint Fed-Treasury mistake in
  letting Lehman Brothers failed.
• The failure greatly increased the demand for
  money further, creating the casualties that
  followed.

26
Crises and Tight Money, Appreciation
27
Tight Money

• Crises are usually caused by unexpected tight
  money or (not unrelated) currency appreciation.
• Tight money always implies an excess demand for
  money.
• It can arise because demand increases or because
  the supply decreases or both.

28
Money Supply and Demand

• Central bankers dont always know when money is
  tight or easy.
• This is because while the money supply is easy to
  measure, the demand for money is not.
• So it turns out central bankers use many indirect
  indicators.

29
Variables Sometimes Used to Measure Tight Money

• 1. Interest rates (spot and forward)
• 2. Bank reserves (including free bank reserves)
  and rates of change
• 3. Rate of monetary expansion
• 4. Exchange rates (and rates of change)
• 5. Gold prices (and rates of change)

30
Interest Rates and Money Supply

• Interest rates can reflect inflation or deflation
  as well as the marginal productivity of capital
  and not therefore a good measure of tightness.
• Bank reserves mean nothing without consideration
  of the demand for reserves.
• Money supply expansion by itself can be
  misleading because demand might be greater than
  supply. Demand can increase because of economic
  growth or because of uncertainty.

31
Exchange Rates and Gold

• Currency appreciation under floating rates can
  indicate relative tight monetary conditions
  between two currencies.
• A falling gold price (denominated in the domestic
  currency) can reflect tight money because gold is
  the most liquid commodity and widely used as a
  hedge against inflation.

32
Debt Crises and Deflation

• Debt crises typically arise because of an
  exogenous event that suddenly changes
  expectations from inflation to deflation.
• In the late 1920s, it was the return to the gold
  standard which ended the roaring twenties and
  brought about high real interest rates and an
  unexpected 35 deflation in all the major
  countries (except the U.K. which the pound off
  gold in 1931) in 1929-32.

33
Debt Crises of the 1980s

• The debt crises of the early 1980s reflected
  deflation (more precisely disinflation) and
  dollar appreciation as the two-digit inflation
  rates of 1979-81 were brought down toward 4.
• The SL crisis came about when disinflationary
  policies brought short-term interest rates
  soaring above long term rates.

34
Asian Crisis

• The Asian crisis of the 1990s cam about as a
  result of the exchange rate instability of three
  major countries.
• Chinese Yuan, which devalued at the beginning of
  1994, raising the dollar from C5.5 to C8.7.
• The appreciation of the dollar against the yen,
  from 78 in April 1995 to 148 in June 1998.

35
Dollar Appreciation, Yen Depreciation

• The appreciation of the dollar against the yen
  weakened Southeast Asian countries in a triple
  way, by knocking them off their currency pegs, by
  eliminating their markets in Japan, and by ending
  Japans FDI to countries like Thailand, Malaysia,
  and Indonesia.

36
Consequences of the Crisis
37
Events Associated with the Crisis

• Demoralization of markets in the United States
  and all over the world.
• Banks afraid to lend because they fear insolvency
  of their clients.
• Increasing recession and growing unemployment in
  all the major countries.
• Lack of confidence in governments ability to cope
  with the crisis.
• Failure of international coordination.

38
EEMEA Currency Depreciation against USD yoy ,
as of 03/03/09
39
LATAM Currency Depreciation against USD yoy ,
as of 03/03/09
40

• Export yoy Latin American Countries

41

• Export yoy Asia

42
Asia Currency Depreciation against USD yoy ,
as of 03/03/09
43

• Export yoy EEMEA

44
International Reserves USD18.3bn
45
CPI yoy 8.7
46
PPI yoy -29.1
47
CDS USD 5Y 1368.9 bps
48
Stock Market Index 594.52
49
Currency against USD 150.44 Tenge/USD
50
KAZPRIME Interest rate 3M 15
51
Monetary Systems and Crises
52
Theories of the Crisis

• A crisis of capitalism.
• Global Imbalances
• Dollar as Reserve Currency
• Under-Regulation (IMF Theory)
• Unstable Exchange Rates
• Lack of a Global Currency

53
No Systemic Failures until Floating Began

• No systemic banking failures under the gold
  standard before World War I, nor under
  bimetallism from 1815 to 1973, nor under the
  Bretton Woods system from World War II until
  1971.
• Bretton Woods system broke down because of the
  misalignment of gold, not a problem of fixed
  exchange rates.

54
Recessions, Crises or Policy Failures Under
Fluctuating Rates

• 1974-5 Recession
• 1979-81three years of two-digit inflation
• 1981-3recessionunemployment over 11
• 1982--- International Debt Crisis
• 1982-3 SL Crisis
• 1995Mexico-ArgentinaLatin America crisis
• 1997-8Asian crisis
• 2001-2Global Slowdown Dot-com crisis
• 2007-9The Great Financial Crisis

55
Instability of Exchange Rates

• Instability of exchange rates has been culpable
  as instigator or aggravator in each one of these
  crises.
• Reflects unfavorably on system of fluctuating
  exchange rates.

56
Historical Error Nixon and Roosevelt

• My general thesis, underlying this lecture, is
  that the major problem lies with the failure to
  restore the international monetary system.
• President Roosevelt took the dollar off gold and
  broke up the system in 1933 but he put it back
  together again in 1934.
• Likewise, President Nixon took the dollar off
  gold and broke up the system, but failed to
  establish a new price.
• It was a mistake of leadership on his part, and a
  mistake of his subordinates.

57
Roosevelt Restored the System

• In March 1933 President Roosevelt in his first
  week as president closed the banks and took the
  dollar off gold at 20.57 an ounce.
• The next year in 1934 he put the dollar back onto
  gold at a higher price of 35 an ounce.
• He restored what would later be called the
  Bretton Woods System.
• It lasted four decades without major banking
  crises.

58
Nixon Failed to Restore the System.

• President Nixon, like Roosevelt four decades
  earlier, in August 1971, took the dollar off
  gold, bringing to an end the Bretton Woods
  international monetary system.
• But Nixon failed to follow up with a restoration
  of the system at a new price.
• Probably Watergate got in the way.
• This left the world without am international
  monetary system.

59
In Retrospect, What Should Nixon have Done?

• Nixon should have established a new Gold-SDR
  system.
• The SDR was created in 1968 as an incipient world
  currency with a gold-value guarantee.
• In 1971 the dollar price of gold could have been
  tripled to 100 an ounce and gold and SDRs (also
  tripled) made the core of a revised international
  monetary system alongside the dollar.

60
POLICIES FOR DEALING WITH THE CRISIS
61
Requirements

• A facility for increasing demand
• Restoring corporate competitiveness
• Restoring the banking system
• Stabilizing exchange rates Global Currencies
  National Currencies
• Cooperation and Policy Coordination

62
A Facility for Increasing Demand Dated Spending
Vouchers

• Dated Spending Vouchers (DSVs) of 3 of a years
  GDP that expire after three months. Retailers
  would use the executed vouchers as tax credits.
• This would amount to stimulus in one quarter that
  would represent a potential 12 increase in
  spending in the quarter's income.
• It is superior to a tax change because it is
  temporary and flexible it doesn't change the tax
  structure and it can be repeated as needed.

63
2. Restoring Corporate Competitiveness Slash
Corporate Profits Taxes

• Cut the corporate tax rate 15 to recapitalize
  banks and corporations and spur investment.
• This measure takes account of the fact that the
  government is already a non-voting shareholder in
  corporations taking a large fraction of earnings
  without adding any capital to the corporation or
  share in any losses.

64
3. Restoring the Banking System Restructure and
Privatize Insolvent Banks

• Government should act aggressively to take over
  and restructure insolvent banks and then
  subsequently re-privatize them.

65
4. Stabilizing Exchange Rates Global Currencies

• The U.S. should work with Europeans to reduce
  the instability of the dollar-euro rate.
• It should help the dollar-euro (fixed between
  margins) to be an anchor for non-global
  currencies.
• The Japanese yen and the Chinese yuan could also
  be tied to the dollar-euro rate after it has been
  stabilized.

66
4. Global Currencies, contd

• The stabilization can be done gradually by
  creating a band of fluctuation at the margins of
  which the banks intervene and then narrow the
  band as the FRB and ECB get more comfortable at
  coordinating monetary policies.
• The Treasury/FRB can start by putting a floor to
  the euro (and a ceiling for the dollar) at 1.20
  and the ECB put a floor to the dollar (and a
  ceiling for the euro) at 1.40.

67
4. Stabilizing Exchange Rates National Currencies

• Other countries should seek, wherever possible,
  to stabilize their currencies to either the
  dollar or the euro or a basket of the two
  currencies.
• Then support plans that would internationalize
  the global currencies into an international unit.

68
5. Cooperation and Policy Coordination An
International Macroeconomic Advisory Council

• Establish a global counterpart to the
  Volcker-Chaired Obama Advisory Council.
• Form a revolving committee to advise and evaluate
  macroeconomic policy and make recommendations. .
• Form on this basis an International Economic
  Advisory Council to report to the G-20 and/or the
  IMFC.

69
6. Project for a World Currency

• Propose to the G-20 the formation of an
  international study group to propose alternative
  routes to a global currency

70
Guidelines for a World Currency
71
Recent Phases of the International Monetary System
72
Alternative Approaches

• Regionalization Approach
• Dominant Currency Approach
• Precious Metals Approach
• IMU Approach

73
Regional Approach

• Basic model is to follow in Europes footsteps in
  its creation of the euro.
• Single currency requires security area (war-free
  zone) and considerable degree of political
  integration
• Not easy to achieve in Latin America, Africa or
  Asia.

74
An Asian Currency by 2015?

India

Russia
15

RINGITT
Baht

YEN
WON
P-Peso
EURO

Africa
RMB
Rupiah

HK
Latin Dollar
Australia-NZ
Arab Bloc
75
Dominant Currency Approach

• Likely to be the default position, if not plan
  for an international currency can be negotiated.
• Dominant Dollar Standard could be an efficient
  standard if the U.S. maintained price stability.
• But critics would maintain that it is not fair,
  it gives too much power to the U.S. and is
  unacceptable.

76
Anchored Dollar Standard 1934-1971.
Gold
Soviet Union
U.K.
U.S.
Japan
China
France
Italy
Germany
77
Gold Standard Approach

• Raise the price of gold to create enough gold
  liquidity to serve as international reserves.
• Would require a gold price of 7,000 the ounce to
  replace For. Ex. Reserves.
• Impossible to negotiate.

78
The Gold Standard and Economic Powers, c.1890
(Inner circles represent gold stocks)
France
Japan
K
Cuba
Spain
British Empire
Puerto Rico
Russian Empire
U.S.
Ottoman Empire
German Empire
German Empire
Italy
Austria-Hungarian Empire
79
INTOR APPROACH Alternative Names

• INTOR (Mundell, 1968) is one name for a world
  currency. Other names are
• BANCOR (Keynes, 1943)
• UNITAS (Harry Dexter White, 1943)
• MONDOR (Jacob Viner, 1944)
• SDR (IMF, 1967)
• IMU (International Money Units), Generic

80
INTOR APPROACH

• Develop a small core basket of the top 2-5
  currencies weighted by GDP.
• Decide whether or not to include or exclude
  commodities like gold or oil certificates in the
  basket.

81
APEC Europe?
Euro Area



D E Y

India

Russia
RMB

Africa
Latin Dollar
Dinar Area
Indonesia
82
Three Stages of Monetary Reform

• Stage I. Convergence of DEY (Dollar-Euro-Yen)
  Exchange Rates and G-3 Monetary Policy
• Use of DEY as platform, possibly with gold, for
  world currency, the INTOR
• Creation of INTOR and Ratification by the Board
  of Governors of IMF.

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The INTOR What could we expect?

• A single unit for quoting prices.
• A common unit for denominating debts.
• A common rate of inflation for participating
  countries.
• A common interest rate on risk-free assets.
• A global business cycle.

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Quotas in IMF
86
Intor Sandwich
87
World Map with the INTOR

India

RMB


Russia
Latin Dollar
Arab Bloc
Africa
88
Thank You