A Crisis Primer

It started out as a mere subprime crisis.      It is bound to get much bigger

The speed and depth of the economic crisis that afflicts the world baffled even the experts. Why, until recently it was nothing but a financial crisis, wasn’t it, nothing to do with the real economy. And it was constrained to the US alone, their subprime mess and all. No risk of contagion to us sensible, hard-saving Europeans, let alone to the blistering-growth emerging economies.

And yet here we are. Growth has stopped dead in its tracks, investments and confidence have plummeted, credit dried up. Talk about a bad case of global cooling. What triggered all this? How did it get this bad?

No less than the International Monetary Fund’s chief economist, Olivier Blanchard, came to Munich to explain it all, and offer a glimpse of what’s to come. Awarded this year’s Distinguished CES Fellow prize, he gave a lecture called (no prize for guessing) “The World Financial and Economic Crisis” to a packed audience. An audience that was afterward much enlightened, if also quite a bit shaken.

Excusing the fact that this was just “a first pass in the midst of the action”, he set out to identify the basic mechanisms behind this crisis and then to delineate the measures that would have to be put in place in order to avoid such a crisis in future.

The roots of the crisis can be traced back in part to an understatement of risk, he said. Understandable, in the circumstances: there is a certain inability in human nature to think about risk when you haven’t seen it for a while. In the US, for instance, house prices had been increasing every year since world war two. There was no reason to think it wouldn’t continue to be so.

So, offering and taking mortgages seemed quite a safe thing to do. Banks even happily gave them to folks populating the euphemistically labelled “subprime” bracket, i.e. those with less than perfect creditworthiness. But the banks, instead of holding mortgages in their books, proceeded to securitise them, that is, they repackaged them into investment instruments that, like a good recipe for a dish, combined various debt instruments to achieve a desired level of risk. Then they were sold to other investors. These re-securitised such instruments, sold them on, and the buyers then re-securitised them and, well, you get the picture. This made the assets opaque in terms of understanding their real value, even for the people in the business.

This did not prevent institutions around the world from gobbling them up. After all, they were “collateralised”, that is, real assets (say, a house) guaranteed their value, and on top of that they paid good interest. But as uncertainty regarding the true value of the original asset, i.e. the subprime mortgage or the associated house, increased, it made it virtually impossible to ascertain the degree of exposure each institution had. Their balance sheets became extremely difficult to understand.

Was opacity intentional? “I think not”, said Mr Blanchard. “I think to a large extent this securitisation was a good thing, in terms of better risk allocation. But clearly there was more than that. There were incentives, given the regulations, to create these assets and make them more opaque than they needed to be, and that’s a lesson for the future.”

The other thing was increased leverage. Banks have assets on the one side and liabilities on the other. The difference is capital. When we say high leverage it means the capital was very small. Why did this happen? There was an incentive for financial institutions to have the minimum amount of capital needed for operations: the lower the amount of money you put in, the larger the profit you make per unit of money parked as equity.

The cause of this was bad regulations that created strong incentives for financial institutions to create off-balance-sheet entities to carry out these operations with very low levels of capital.

When the subprime mortgage-takers started defaulting on their debts, the highly leveraged edifice came crashing down, and with it the stock market itself. So, there you have the trigger.

Two central mechanisms then amplified the mess: runs and capital. Runs, because as doubts spread regarding the solvency of financial institutions people, and other banks, rushed to withdraw their money from them. And capital, because the assets underpinning that capital lost value and no one was willing —or able— to come forth and replenish the banks' equity coffers. So the banks have been forced to sell assets as quickly as possible at firesale prices to raise equity. But these firesale prices further reduce the institutions' capital ratio, which in turn provides an incentive for them to sell even more assets, depressing prices even further. And, in a globalised world, this goes well beyond national boundaries.

By now, the financial crisis has become a full-fledged economic crisis. Confidence has collapsed. Demand has collapsed. Companies are tottering. The financial crisis is not a side show anymore.

Still, in terms of the financial crisis, said Mr Blanchard, we can hope that we have turned the corner. “But on the economic crisis, we are just at the beginning.” There’s much worse to come in the next year. There is also a danger of the economic crisis feeding back into the financial crisis.

So, What to Do?
There are two main tools to tackle the malaise: monetary policy and fiscal policy. We have nearly used up the former: central banks cannot lower interest rates much further. But as regards fiscal policy we still have some elbow room.

In normal times, the advice of the IMF to Europe would have been “please decrease your fiscal deficits, please slow down the debt-to-GDP ratio”. But, warns Mr Blanchard, “these are not normal times”. In fact, these are very special times. “One has to take risks. And I have no doubt that the only instrument we have at this point is a large fiscal expansion, far beyond what we would have thought about in normal times.” 

His institution, the International Monetary Fund, has argued for a global 2% fiscal expansion, on top of what has been done so far. “Of course there are dangers," he admits. "But they are less than the danger of doing nothing.”

That was not all. He suggested as well the regulatory measures that would have to be enacted to prevent such crises from recurring. The lecture, by all means, was outstanding. We warmly recommend you to follow it in its entirety by clicking on the link below:

http://www.ifo.de/link/_videolect/lect-blanchard2008.htm

Who is Olivier Blanchard?
Professor of Economics at the MIT Department of Economics and Chief Economist and Director of the Research Department of the International Monetary Fund (IMF). He is also this year’s recipient of the Distinguished CES Fellow prize, which was awarded to him at the University of Munich in November.

With this prize, the Center for Economic Studies (CES) honours Mr Blanchard’s pioneering achievements in macroeconomics. His research on the dynamic effects of supply and demand shocks on output and unemployment as well as the role of the financing of state expenditures and deficits as determining factors of interest rates are well known.

Many also know him as the author of Macroeconomics, a worldwide bestselling textbook.

Mr Blanchard was born in Amiens, France, in 1948. He obtained his Ph.D. from the Massachusetts Institute of Technology (MIT) in 1977. He taught several years at Harvard University, returning to MIT in 1982. He served as Chairman of the MIT Department of Economics for five years. Currently he is on leave from MIT and Chief Economist and Director of the Research Department at the International Monetary Fund (IMF). From 2000 to 2006 he was on the Scientific Advisory Council of the Ifo Institute for Economic Research.

As macroeconomist he is active in many fields of research, including the role of monetary policy, the nature of speculative bubbles, the labour market and the determinants of unemployment and the transformation process in former East Bloc countries. He has given policy advice to numerous governments and has collaborated with international organisations.

More from the CESifo Group on the financial and economic crisis:

• Banking crisis – too many financial innovations, too little regulation?
• What Can be Learned from the Banking Crisis
• Plugging the Leaks: What Caused the Banking Crisis
• Lessons for Germany from the Banking Crisis
• Central Banks Must Reconsider Their Role as Lenders
• CESifo Working Papers published in the past three months