Causes of the Great Recession

International EconomicsLecture 12Causes of the Great Recession, 2007-2009 : 

1 1 International EconomicsLecture 12Causes of the Great Recession, 2007-2009 Paul Deng October 2010 1

Preview : 

2 Preview US interest rate too low for too long Misconceptions on housing and housing bubble Global savings glut and global imbalances The Great Moderation and its unintended consequences Financial deregulation and “innovative” financial products Rating agencies

Greenspan’s Legacy in Question : 

3 Greenspan’s Legacy in Question Economist Mag., January 2006 Interest rates stayed too low for too long...

Housing: The sole growth engine after dot.com bubble and 9.11 : 

4 Housing: The sole growth engine after dot.com bubble and 9.11 The low interest rate helped push down mortgage rate to historically low level

Housing: The sole growth engine after dot.com bubble and 9.11 : 

5 Housing: The sole growth engine after dot.com bubble and 9.11 Boom in mortgage refinancing and house owners’ heavy borrowing against their mortgage equity. GDP growth after 2000 was largely fueled by borrowing against home equity

Misconceptions toward Housing : 

6 Misconceptions toward Housing Housing prices never fell on national basis House ownership and the American Dream Time Magazine, 2005

Housing Bubble in Full Swing : 

7 Housing Bubble in Full Swing The hyperbolic rise of home price relative to rent.

Black Swan Events - : 

8 Black Swan Events - After black swan was discovered in western Australia in 1697, nobody thought it’s possible. When the rare events in our financial and economic system occurred, such as a nationwide decline of home prices, it threw all risk models into trash can that incorporated zero probability of ’black swan’ events.

Historical Low Personal Savings Rate : 

9 Historical Low Personal Savings Rate US personal savings rate became negative in 2005

Export-led Asia Fueled American Consumption : 

10 Export-led Asia Fueled American Consumption

Global Imbalances in Full Swing… : 

11 Global Imbalances in Full Swing…

What to Do With The Huge Trade Surplus? : 

12 What to Do With The Huge Trade Surplus? Dollar recycling China’s forex reserves reached $2 trillion in 2009 70% of those reserves is estimated to be in assets denominated in the US dollar China holds nearly $900 billion US treasury securities.

How Dollar Recycling Works : 

13 How Dollar Recycling Works Exporting firms & producers in China Importing firms & consumers in the US Export goods Import payment in $ China’s Central Bank $$$ Yuan US bond market (mainly government bonds) $$$ Purcahse of US government treasuries and bonds China’s purchase pushed down the yield (or interest rate) of US long term bonds Pushed down US mortgage rates Fueling housing bubble $$$ recyled back into the US

The Greenspan “Conundrum” : 

14 The Greenspan “Conundrum” Countries with huge trade surplus, China and Japan, recycled their dollars into the US by buying US treasuries and long-term debt, such as mortgage securities The increasing demand of mortgage debt increased prices for those securities and pushed down interest rate on those securities US mortgage rates were pushed down to the historical low level, adding extra fuel to the housing bubble Central bankers in the US were really puzzled by the historically low long-term interest rates, and Greenspan termed it as “the Conundrum”

Great Moderation and Its Unintended Consequences : 

15 Great Moderation and Its Unintended Consequences Low inflation expectations since mid 1980s…

Great Moderation and Its Unintended Consequences : 

16 Great Moderation and Its Unintended Consequences Stable GDP growth and two minor recessions (1991 and 2001) Economists seemed to have cured recessions and business cycles  so-called the Great Moderation

Great Moderation and Its Unintended Consequences : 

17 Great Moderation and Its Unintended Consequences Stock market volatility (as measured by VIX) was also at historical low right before the crisis hit And compare to what happened soon afterward In other words, people were too complacent with risks

Great Moderation and Its Unintended Consequences : 

18 Great Moderation and Its Unintended Consequences In a low-risk-and-low-return environment, banks were pressured to leverage themselves up to raise returns, and to beat their peers Banks leveraged themselves up to an unbelievable level, more than 50:1 in some cases!!!

Big Banks’ Big Gamble : 

19 Big Banks’ Big Gamble  Since mid 1980s, financial sector’s profits share had risen from around 20% to 50% at the peak.

Increasing Risk Appetite Can Be Seen Everywhere : 

20 Increasing Risk Appetite Can Be Seen Everywhere Household, corporate, big banks…

The Role of Rating Agencies : 

21 The Role of Rating Agencies