5th Anniversary of Global Financial Crisis

August 2008 signified the start of the GFC when the French Bank BNP Paribas froze three money market funds which had taken heavy losses on US subprime mortgages. Immediately the ECB and the US Fed entered the fray and injected cash of 90bn to ensure that bank lending didn’t grind to a halt. The subprme debacle was merely the first in a series of major failures.

Keynes said in 1931

“We are today in the middle of the greatest catastrophe – due almost entirely to economic causes – of the modern world”

When Lehman brothers collapsed in 2008, even cautious forecasters expected recovery in three or four years. However, governments are grappling with an appropriate policy that will achieve growth when you are trying to implement austerity measures at the same time.

Even in 2007 the US the Fed was concerned about the looming threat of a credit crunch and proceeded to drop its key borrowing rate by 50 bps to 5.75%. Although soon after Ben Bernanke stated that the housing market collapse would have a limited impact on the economic growth in the economy. Bernanke obviously was too optimistic about the state of the US economy and soon after the Lehman Brothers collapse the credit crisis had officially begun.

Total debt levels in the US, UK and the eurzone are now higher than in 2007.
We are currently seeing soft data in all three time zones. The Week magazine came up with some thoughts about this:
* Too much saving – the results of exorbitant imbalances in trade and capital flows
* Asia’s saving growth flooded the global bond market, which enabled the West to continue running huge current account deficits until the economy was slowed.

Kevin Slavin: How algorithms shape our world

Although I have mentioned this TED talk on a previous post – The Fear Index – I thought it deserves a separate post for people to view the presentation.

Kevin Slavin argues that we’re living in a world designed for — and increasingly controlled by — algorithms. In this riveting talk from TEDGlobal, he shows how these complex computer programs determine: espionage tactics, stock prices, movie scripts, and architecture. And he warns that we are writing code we can’t understand, with implications we can’t control.

The mathematical equation that caused the financial crisis?

The Black-Scholes equation (see below), named after economists Fisher Black and Myron Scholes, brought a new dimension to derivative trading on financial markets. It enable traders to price derivative contracts before they matured – The Guardian likened it to “buying or selling a bet on a horse, halfway through the race.” The equation itself wasn’t the problem as its limitations were clearly defined, however it was how it was used in the market that brought about the complications. The equation became the industry-standard way of assessing the value of derivatives before they matured but this also led to derivatives themselves becoming commodities that could be traded in their own right.

According to The Guardian, by 2007 the international financial system was trading derivatives valued at one quadtrillion dollars a year – 10 times the total value of all products made by the world’s manufacturing industries over the last century. The drawback of the equation was that it made things even more complicated and companies employed financial engineers (mathemeticians basically) to analyse the markets. However the system came unstuck when markets became irrational and reliability on the equation was lost.

Over the last century the later part of financial crises tend to have been caused by herd mentality. This makes markets extremely volatile to sudden booms and slumps in prices.

“By studying ecological systems, it can be shown that instability is common in economic models, mainly because of the poor design of the financial system. The facility to transfer billions at the click of a mouse may allow ever-quicker profits, but it also makes shocks propagate faster.”

However, the equation wasn’t the major cause of the financial crisis. There are other variables that were influential namely:

- regulatory framework did not keep pace with financial innovation
- predatory lending – enticing borrowers to enter into “unsafe” or “unsound” secured loans
- easy credit conditions – very low interest rates
- housing bubble – the average US house price increased by 124% between 1997-2006
- financial Institutions became highly leveraged, increasing their appetite for risky investments and reducing their resilience in case of losses

According to Ian Stewart in The Guardian:

“the system is too complex to be run on error-strewn hunches and gut feelings, but current mathematical models don’t represent reality adequately. Teh world economy needs an overhaul and requires more mathematics not less.”

US Economy: Great Depression, Great Recession, Great Contraction – Which one?

Kenneth Rogoff – Professor of Economics at Harvard and former Chief Economist at the IMF – wrote an interesting piece suggesting that policy makers have got it wrong in describing the recent financial crisis as the ‘The Great Recession’. At the bottom of the post there is a very good interview with Rogoff criticising the present policy decisions in the US. Some good references to behavioural economics.

Great recession suggests that the economy is following the contours of typical recession but that it is more severe. Subsequently forecasters who have tried to make resemblance to post-war US recessions are “barking up the wrong tree” and are of the belief that conventional tools like expansionary fiscal policy, quantitative easing and bailouts are way to go. The real problem is that the global economy is badly leveraged and there is no quick fix without a transfer of wealth from creditors to debtors. Rogoff suggests that the “Second Great Contraction’ is a more realistic description of the current crisis in the global economy. The “First Great Contraction” was the Great Depression of 1929 but the contraction applies not only to output and employment, as in a normal recession, but to debt and credit, and the deleveraging that typically takes many years to complete.

In a typical recession the economy returns to pre-recession growth within a year and in most cases catches up to its rising long-run trend. The repercussions of the financial crisis typically can take 4 years just to reach the same per capita income level that it had attained at its pre-crisis peak.

Rogoff argues that the only practical way to shorten this coming period of painful deleverging and slow growth would be a sustained burst of moderate inflation, say, 4-6% for several years. Although inflation is unfair as it is the transfer of income from savers to debtors, such a transfer is the most direct approach to faster recovery. Eventually, it will take place one way or another, anyway, as Europe is painfully learning.

History suggests that recessions are often renamed when the smoke clears. Perhaps today the smoke will clear a bit faster if we dump the “Great Recession” label immediately and replace it with something more apt, like “Great Contraction.” It is too late to undo the bad forecasts and mistaken policies that have marked the aftermath of the financial crisis, but it is not too late to do better.

Inside Job – The Official Teacher’s Guide

Just purchased the Inside Job DVD and it is excellent viewing for economics students. It covers both the historical roots of the crisis and the central flaws of global financial regulation. The film draws heavily on intereviews with academics, politicians, journalists, financial insiders. A study guide has been put together and it includes 4 lesson plans with teacher notes and student handouts. The 4 lessons are:

1. “It’s utterly mad” – Allan Sloan, senior editor of Fortune magazine, describing the Goldman Sachs deal in which home buyers borrowed 99.3% of the price of their houses, and yet two-thirds of the deal backed by those loans was rated AAA, as safe as government securities.

2. “It was clear he was stuck with his ideology” – Alan Greenspan appears throughout Inside Job. The film describes how Greenspan, as Federal Reserve chairman, led the deregulation and consolidation of the financial sector, beginning in the 1980s.

3. “Sure, I’d make that bet” – Nothing motivates students to talk like money. Ask them what they would be willing to do for $10 million a year. Would they make secret bets that might lead their firms to collapse?

4. “It’s a Wall Street government” – In Inside Job, Robert Gnaizda calls President Barack Obama’s administration “a Wall Street government.” This activity asks students to describe the key players in the administration and to list the positions they held before and after the 2008 election.

Click the link below to download the study guide.

The Offical Teacher’s Guide – Inside Job

Below is an interview with the Director of the film Charles Ferguson. It seems that the mainstream media are either not resourced well enough to provide this level of in-depth analysis or don’t want to report it.

Do we still have a “Too Big to Fail” mentality?

The Institute for New Economic Thinking – INET – held its annual conference this week at Bretton Woods, New Hampshire at the historic Mount Washington Hotel – the site of the 1944 conference that launched the World Bank and established a new post-war global economic architecture. The theme of the conference was:

“Crisis and Renewal: International Political Economy at the Crossroads.”

Some notably speakers including Paul Volcker (former Fed Chariman), Larry Summers (Harvard Prof and former Treasury Secretary under Clinton), George Soros (Investment Banker and Philanthropist). However one speaker who has been getting particularly good raptures is Simon Johnson Professor of Entrepreneurship at MIT Sloan School of Management. He basically said we are no further down the track with regard to diminishing the “Too Big To Fail” state of the banking sector – in fact the banks are getting bigger. Worth a look.

Buy Now, Pay Later: A History of Personal Credit

A hat tip to John Fowler for this link to the Harvard Business School: Historical Collections. Buy Now, Pay Later: A History of Personal Credit. There has been great hand wringing over the nature of personal debt in recent years, and some commentators have made it seem as if this recent trouble was without historical precedent. This engaging exhibit draws on their historical materials “to show how previous generations devised creative ways of lending and borrowing long before credit cards.” The exhibit is divided into four sections, including “Credit in a Consumer Society” and “Credit in Pre-Industrial Society”. Each section has short topical essays, accompanied byimages of germane woodcuts, prints, engravings, legal documents, and otheritems that illustrate the relationship between credit and charity, credit reporting, and other matters. The exhibit is rounded out by the “Research Links” area, which brings together full-text manuscript and collection guides to items like the Briggs Motor Sales Company Records.

Economics in 2010 – DRINKBONDS, ALKIBONDS and PUKEBONDS

Here is something I got which was doing the rounds on email – very amusing.
________________________________________________________________________________________________________

I was asked to explain the Economic crisis in Ireland here is an example
as I understand it….( passed on of course !!)

Mary is the proprietor of a bar in Dublin . She realises that virtually all of her customers are unemployed alcoholics and, as such, can no longer afford to patronise her bar. To solve this problem, she comes up with new marketing plan that allows her customers to drink now, but pay later. She keeps track of the drinks consumed on a ledger (thereby granting the customers loans). Word gets around about Mary’s “drink now, pay later” marketing strategy and, as a result, increasing numbers of customers flood into Mary’s bar. Soon she has the largest sales volume for any bar in Dublin. By providing her customers’ freedom from immediate payment demands, Mary gets no resistance when, at regular intervals, she substantially increases her prices for wine and beer, the most consumed beverages. Consequently, Mary’s gross sales volume increases massively. A young and dynamic vice-president at the local bank recognises that these customer debts constitute valuable future assets and increases Mary’s borrowing limit. He sees no reason for any undue concern, since he has the debts of unemployed alcoholics as collateral.

At the bank’s corporate headquarters, expert traders figure a way to make huge commissions, and transform these customer loans into DRINKBONDS, ALKIBONDS and PUKEBONDS. These securities are then bundled and traded on international security markets. Naive investors don’t really understand that the securities being sold to them as AAA secured bonds are really the debts of unemployed alcoholics. Nevertheless, the bond prices continuously climb, and the securities soon become the hottest-selling items for some of the nation’s leading brokerage houses.

One day, even though the bond prices are still climbing, a risk manager at the original local bank decides that the time has come to demand payment on the debts incurred by the drinkers at Mary’s bar. He so informs Mary. Mary then demands payment from her alcoholic patrons, but being unemployed alcoholics they cannot pay back their drinking debts. Since, Mary cannot fulfil her loan obligations she is forced into bankruptcy. The bar closes and the eleven employees lose their jobs.

Overnight, DRINKBONDS, ALKIBONDS and PUKEBONDS drop in price by 90%. The collapsed bond asset value destroys the banks liquidity and prevents it from issuing new loans, thus freezing credit and economic activity in the community. The suppliers of Mary’s bar had granted her generous payment extensions and had invested their firms’ pension funds in the various BOND securities. They find they are now faced with having to write off her bad debt and with losing over 90% of the presumed value of the bonds. Her wine supplier also claims bankruptcy, closing the doors on a family business that had endured for three generations, her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 150 workers.

Fortunately though, the bank, the brokerage houses and their respective executives are saved and bailed out by a multi-billion euro no-strings attached cash infusion from their cronies in Government. The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-drinkers who have never been in Mary’s bar.

Now, do you understand economics in 2010?

NZ$ falls with S&P rating and Korean clash

The NZ$ dropped to its lowest level for 4 weeks against the US$ – now at US$0.76 from a high of US$0.79. Two main reasons for this:

1. New Zealand has the second-highest possible rating, AA+, but Standard & Poors (credit rating agency) has revised its outlook from stable to negative – one-in-three chance that NZ will be downgraded. It is New Zealand’s external position that is the main issue – kiwis borrow more than other kiwis are willing to lend. Net international liabilities of the country (as distinct from the Government) at the end of June were $164 billion. S&P said it seemed likely that as the economy strengthened, the problem of big deficits and ever-rising overseas debt would return, “and possibly with a vengeance”. This information for foreign currency dealers means that there is more risk attached to holding NZ$’s therefore you tend to see a sell-off on the market – supply curve to the right = price drops.

2. The clash between North and South Korea has brought about instability in the area and also made investors risk averse to regional currencies including the Aus$. Most of them have returned to the relative safety of American and Japanese bonds or even the US$. With the turmoil in Ireland and the concern that the rescue package from the IMF and the EU won’t be enough investors are tucking for cover. Additionally other countries with high levels of debt, in particular Portugal and Spain, may also have to seek financial help.

Credit Crunch – BBC Interactive Timeline

How did the credit crunch at the end of 2007 become a full financial meltdown by the middle of 2008, and finally turn into a global recession?

This interactive timeline highlights key dates in the financial collapse and helps you find the original reports of the events as they happened. You can see the BBC’s full coverage of the anniversary of the global financial meltdown – click here

RSA Animation – Crises of Capitalism

From the Royal Society for the Arts (RSA). They have put together some great animations of lectures on a variety of topics. Below is one on the Crises of Capitalism.

NZ debt – the good news and the bad news

Despite a glowing report from the IMF which stated that New Zealand has the second smallest government debt among 23 developed countries, credit rating agency Standard and Poor’s (S&P) has indicated that the overall level of debt has the country vulnerable. Treasury estimate govenment debt to be 27% of GDP by 2015 but this compares to total net debt at 90% of GDP with much of this in the private sector.
Their concern is that if there is a major budget crisis in other countries this could make markets nervous about investing in high debt economies – both government and private debt. New Zealand is borrowing up to $240 millilon dollars a week and if the former were to happen interest charges on that borowing would go up (maybe a downgrade by credit rating agencies) which ultimately would effect growth in the economy and the NZ$. S&P suggest that there is a need to rely less on foreign funds and generate more export revenue especially from the Asian markets. The balancing act is making sure that debt as a % of GDP doesn’t get too high but at the same time generating growth in the economy. Click here for Brian Fallow’s column in the NZ Hearld.

Federal Reserve vs European Central Bank

Each year central bankers from around the world meet in the US resort of Jackson Hole, Wyoming to discuss the state of the global economy. One of the main points of discussion is whether they should start to print more money to encourage growth.

The figures coming out of the US suggest that growth has been slower than expected and Ben Bernanke (Fed Chairman) is set to continue buying US Treasuries to increase liquidity in the market. By contrast his European counterpart, Jean-Claude Trichet, faces a situation where he may gradually remove the stimulus from the European economy as the euro-area economy was surpassing growth forecasts. Therefore there is likely to be discussion of different strategies for their economies. Furthermore, Trichet’s optimisim and Bernanke’s caution might see the euro strengthen against the dollar

The UK and Japan are likely to talk about how they might have to push more money into their economies to stimulate growth, a last resort when benchmark interest rates approach zero. Click here for an interesting article from ‘The Times’.

From the left: Jean-Claude Trichet (ECB President), Ben Bernanke (Federal Reserve Governor), Mervyn King (Governor of the Bank of England)

Financial Crisis: A Black Swan

The financial crisis that has hit the world economy is a direct result of the huge amount of credit that has been evident over the last 30 years. The current US debt is reminiscent of the 1920’s when there was incredible prosperity and confidence amongst the population. However, as with the 1920’s, far too much money has been lent to individuals who cannot service their debts. A similar trend to today is that of US debt as a % of GDP. From 1920 through to the Wall Street Crash in 1929, US credit expanded dramatically from 175% of GDP to 300% of which a large proportion of the borrowings were used to buy shares in firms like Cable and Wireless – the Internet of today. It took nearly 20 years before deleveraging was completed and the total US debt to GDP stabilized below 150%. Not surprisingly, there was a strong aversion to debt from 1950-80 and the 1987 stock market crash nipped in the bud any resurgence ofdebt. However, in recent years personal debt levels have soared and US debt to GDP has risen from 150% in 1980 to approximately 372% by the end of last year – 2009 (see chart below).

Total US Credit Market Debt as a % of GDP

Source: Bureau of Economic Analysis

The book entitled “The Black Swan” (2007) by Nassim Nicholas Taleb describes a black swan as a highly improbable event with three principal characteristics:

1. its unpredictability;
2. its massive impact; and
3. after it has happened, our desire to make appear less random and more predictable than it was.

The current banking crisis now being played out unquestionably meet the criteria as a Black Swan. No one saw it coming and no one knows how it is going to end. Nassim Nicholas Taleb could see the banking crisis being realized, and this quote from “The Black Swan” explains partly the rationale for the current environment. Remember it was written when the world was awash with cheap credit and leaders were content with what was happening.

“So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks – when one fails,
they all fall. The increased concentration among banks seems to have the effect of making financial crises less likely, but when they happen they are more global in scale and hit us very hard. We have moved from a diversified ecology of small banks, with varied lending policies, to a more homogeneous framework of firms that all resemble one another. True, we now have fewer failures, but when they occur I shiver at the thought.” Pages 225-226