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«Abstract What caused the crisis? Initially many thought that it was due to incentive problems in the U.S. mortgage industry. However, after the large ...»

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The U.S. was not the only country that experienced a bubble in property prices.

Spain and Ireland also had very large run ups in property prices. Taylor (2008) argues that these countries also had loose monetary policies relative to the Taylor rule. He points out that Spain, which had the largest deviation from the rule, also had the biggest housing boom as measured by the change in housing investment as a share of GDP. Other countries in the Eurozone such as France and Germany did not have a housing boom because their inflation rates and other economic indicators were such that for them the European Central Bank’s interest rates did not correspond to a loose monetary policy.

Loose monetary policy was not the only factor. As Allen and Gale (2000, 2007) have argued, growth in credit is important for asset price bubbles. The second important element in addition to low interest rates in the U.S. was global imbalances. These helped cause a growth in lending in the countries with loose monetary policy.

Why are there global imbalances? This is a complex issue. However, we will argue that an important factor was the Asian Crisis of 1997. Many Asian economies, which had done very well, like South Korea, Thailand, and Indonesia, fell into serious difficulties. In the case of South Korea it was because its firms and banks had borrowed too much in foreign

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through these difficult times.

In exchange for providing financial assistance, the IMF required South Korea to raise interest rates and to cut government spending. That is the exact opposite of what the U.S.

and Europe have done when faced with a very difficult crisis. One potential reason why this happened is that the IMF is a European and U.S. dominated institution. The head of the IMF up to now has always been a European while the head of the World Bank has always been an American. Asian countries are not represented at the highest levels. That was part of the arrangements that were made when the Bretton Woods agreement was negotiated at the end of the Second World War (even though it is not explicitly stated anywhere in the treaty), when Asian countries were not as important as today in the world economy. The Asian countries did not have much weight in the governance process and their quotas (i.e.

effectively their shareholdings) were small. All this implied that when the IMF imposed harsh policies on the Asian countries at end of the 1990s, there was no effective mechanism for these countries to protest and argue that they had fundamentally sound economies.

The consequence was that many Asian countries such as South Korea realized they had to become economically independent so that they woukd not need to go to the IMF to obtain relief from a crisis in the future. To achieve this independence, they accumulated trillions of dollars of assets. Figure 3 shows this accumulation of reserves by Asian countries (here China, Hong Kong, Japan, Singapore, South Korea and Taiwan). In contrast, Latin American and Central and Eastern European countries did not increase their reserves during this period.

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reserves, is probably more complex than this. First, although they were not so directly affected by the Asian crisis, similarly to other Asian countries, China realized that it would be risky to seek help from the IMF should they need it in the future. Second, and perhaps more importantly, it seems that China started accumulating reserves initially to avoid allowing its currency to strengthen and damage its exports. Over time China’s reserves have continued to increase. As of the end of the third quarter of 2009, they stood at the level of $2,273 billion. This was an increase of $141 billion or 6.6% over the previous quarter. One reason for this continuing growth is the potential political influence this gives them, particularly with the U.S. China has been increasing its military spending over the last few years. Acquiring such large reserves gives them an alternative means of security.

How were the Asian countries to invest these reserves? One possibility could have been firms’ equity. However, it became difficult in particular for the Chinese to buy companies. For example, when the Chinese state oil company CNOOC wanted to buy Unocal in 2005 the transaction was blocked by the U.S. authorities on the grounds that Unocal was a strategic firm. This happened on a number of other occasions. Thus, the Chinese ended up having to invest mainly in debt instruments. They bought a large amount of Treasuries, Fannie and Freddie mortgage-backed securities, and many other debt securities. Similarly, other countries acquiring reserves also invested large amounts in debt securities. It can be argued that the large supply of debt helped to drive down lending standards to ensure that there was enough demand for debt from housebuyers and other borrowers.

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global imbalances were in our view two important factors responsible for the real estate bubbles. However, other factors contributed to the bubble. One of these was the yen carry trade. This involves investors borrowing at zero interest rates in Japan and investing somewhere else such as in Australia and New Zealand at much higher rates. The carry trade involved an exchange rate risk, but most of the time it was possible to earn a significant return. There is not much information on how large the outflow of funds the yen carry trade involved but it may well have helped contribute to the rise in property prices in Australia, for example.

4. The effects on the real economy Why did the collapse of the bubble create so many problems? The whole global economy went into a downward trend. It can be argued that what went wrong is that people made the wrong decisions for a number of years, based on the assumption that asset prices would remain high and would continue to rise. In the U.S., the aggregate saving rate fell to zero and many people borrowed to finance consumption. The leverage ratios of households, firms, and institutions went up. When the large fall in asset values occurred, people realized they were overleveraged and they had saved too little. They started saving to pay down debt and build up their assets.

The problem was because there had been a bubble for some time, the real value of assets became very uncertain. For example, stock prices were very volatile. In these circumstances, it became difficult for people to estimate how much their stock was worth in the long run. At the start of 2009, it would not have been surprising if the stock market went

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50 percent.

Another example of price volatility was provided by commodities. In the summer of 2008 oil was trading at $147 dollars a barrel. Then the price went down to around $40 in a short space of time. This volatility made decision making very difficult. For example, should individuals buy a fuel efficient hybrid car that costs significantly more, or rather something less fuel efficient but cheaper on the assumption that oil prices were going to be low in the long run? Firms faced similar problems in making their investments.

In addition to the uncertainty about stock prices and commodity prices, exchange rates were also very volatile. In the summer of 2008, the pound sterling was over $2. Then it went down to $1.40. The Euro was at $1.60 then. It went down to about $1.25 before rising again. This movement in exchange rates contributed to the general uncertainty and to the slowdown of any economic activity.

To summarize, it was very difficult for anybody trying to make long run economic decisions because of the great uncertainty about future price levels, both in the short and the long run. In our view, this was one of the main factors that chilled the global economy. This was true for consumers as well as for firms. That is why sales of consumer durables like cars and investment goods like machine tools stalled in many countries. Since these represented a large proportion of exports and imports, world trade collapsed.

5. The effects on the financial system Of course, price uncertainty was not the only problem. Another major cause of the economic difficulties lay in the problems encountered in the financial system and the

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Let us next focus on the financial system. The crisis started in the summer of 2007 with the meltdown in subprime mortgages as discussed above. This caused a major problem because these mortgages were held by institutions that are badly hurt by asset price falls. When individuals hold stocks in a mutual fund for their retirement, it is not such a large problem if there is a significant fall because on average the money is not needed for many years.

However, the mortgages were held in institutions with mainly debt liabilities. Many of them were held in investment banks or structured investment vehicles (SIVs) that were financed to a large extent by rolling over short-term debt. As soon as prices fell, there was a significant problem because lenders didn't know whether they were going to be paid back. The problems started in securitized subprime mortgages but then spread to many other parts of the financial system.

These credit risk problems led to a flight to quality with many people wanting to buy government securities. In response to this great desire for high grade securities, central banks introduced many programs to essentially allow financial institutions to swap a wide range of securities for Treasuries. As a consequence, the Federal Reserve’s balance sheet expanded from about $800-$900 billion before the start of the crisis to about $2,000-$2,500 billion during the crisis.

To summarize, there were two basic problems. The first is that there was great uncertainty concerning the value of assets and people did not know the prices that should be guiding long term economic decisions. The second problem was that the financial system faced enormous difficulties because of the short term financing structure of many of the financial institutions where a large proportion of debt instruments were held.

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The financial services industry is the most regulated sector in practically all economies. In the U.S., the Federal Reserve, the Office of the Comptroller of the Currency (OCC), the Securities and Exchange Commission (SEC), The Federal Deposit Insurance Corporation, and a number of other regulatory bodies are responsible for regulating the financial sector. What happened? Why did things get so out of control? Why did this crisis come as such a surprise to regulators?

The first important point is that banking regulation is very different from other kinds of regulation. For example, with environmental regulation there is wide agreement that the basic problem is one of a missing market. If a firm pollutes, it does not have to compensate the people who are damaged. That missing market means that without any controls or regulations, there is a lot of damage done to the environment. Given this, it is possible to come up with the best ways to control pollution such as quantitative controls or trading permits. Antitrust is another important area of regulation. There the problem is monopoly. It is necessary to make sure that firms aren't monopolistic and everybody agrees that this is the problem.

With banking regulation, the problem that is being solved is not clear. Is the problem one of panics, future deterioration in the value of assets, contagion or what? In fact, there is no wide agreement that there is even a problem. Many central banks work with dynamic stochastic general equilibrium models that don't include a banking sector. The view underlying these models is that the real economy works efficiently and the financial system is unimportant except for pricing assets (see, e.g., Muellbauer (2009)). Given this initial

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predict the crisis.

The current structure of banking regulation is more a series of answers to accidents in the past rather than the implementation of a clear regulatory design. In the Great Depression, the economic situation was so bad that people said, “We have to make sure that this never happens again.” Thus, they adopted a whole range of measures to stop any kind of problem.

In the U.S., legislators put in place the Glass-Steagall Act separating investment and commercial banking, they founded the Securities and Exchange Commission (SEC), they put in place all the SEC Acts, and the financial system became heavily regulated. In other countries, regulation was also increased and in some such as France, financial institutions were nationalized. This regulation and government ownership was successful in terms of stopping crises. From 1945 until the early 1970’s, there were no financial crises in terms of banking crises, except for one in Brazil in 1962 that occurred together with a currency crisis (see Bordo et al. (2001)). So it is possible to stop crises by stopping financial institutions from taking risks.

However, the alternative to private institutions taking decisions about risks is basically that the government decides who gets credit. This was done in different ways.

Some countries like France nationalized the banks and the government directly made decisions. In the U.S., the government introduced so many regulations that banks couldn't take many risks and so low risk industries were allocated credit. As a result, the financial system stopped fulfilling its basic purpose of allocating resources where they are needed. In the 1970s it became clear how inefficient this was and financial liberalization started in many countries. However, this led to a revival of crises. Since then, there have been crises all

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evolution has led to a set of regulations designed to stop particular problems rather than a well thought out way of reversing market failures in the financial system. Whenever there was a problem, the regulators put in place a regulation.

7. Banking regulation In order to design effective banking regulation it is necessary to have a clear idea of what are the benefits and what are the costs. The benefit of regulation is that it can potentially stop very damaging crises; but the cost is that the regulation needed to prevent these crises effectively prevents the financial system from doing its task of allocating resources. In turn that slows down growth, innovation and ultimately damages efficiency.

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