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Interim Thoughts on the Financial Crisis

posted Aug 14, 2009, 8:03 AM by Anton Korinek   [ updated Aug 14, 2009, 8:10 AM ]
Article for the November 2009 issue of our college magazine WorldView:

During the winter of 2008/09 the world financial system was at the brink of collapse.  Some of the world's largest financial institutions were close to bankruptcy and living on governmental life support.  Cut off from the flow of credit that forms the basis of much of modern business activity, the real economy was in free fall.  Massive defaults on reckless mortgage loans had caused a shock to the financial system that overwhelmed the self-stabilizing forces of the market economy and had destroyed thousands of enterprises and millions of jobs and livelihoods.  Back then, many economists worried about the world economy entering a crisis of the proportions of the early 1930s.

Fortunately, the lessons of the Great Depression were not lost on our current economic policymakers: Fed chairman Ben Bernanke - probably the most eminent living scholar on the Great Depression - provided massive monetary stimulus to the economy by cutting interest rates to zero and starting a number of unprecedented programs to extend loans directly to the private sector.  His actions were supported by large injections of capital into financial institutions that had been weakened by the credit losses (though this had the unfortunate side effect of providing large windfall gains to the bankers). In addition, the fiscal stimulus package that we described in detail in the May issue of this magazine has created hundred billions of dollars of public spending that made up for part of the decline in private spending so as to soften the recession.  While some of the details of these policy measures can rightly be criticized, they have achieved their primary goal: over the past 6 months our financial system has stabilized and the rapid decline in the economy of winter 2008/09 has come to a halt.

Over the past months, the housing market has shown some tentative signs of recovery, the rapid destruction of jobs has slowed somewhat, and the stock market has rebounded from the lows reached in March.  However, a number of risk factors remain that carry the potential of upending economic recovery: as a result of the continuing high unemployment, more households fall behind on their mortgages and loose their homes every month; delinquencies on credit cards and other consumer loans continue to cause losses for banks; retail sales still have not fully recovered, hurting the financial position of retailers; this in turn saddles the holders of commercial mortgage backed securities with large losses; the balance sheets of some large banks are still weak and make them vulnerable to unexpected shocks; and adverse financial developments overseas, for example in the fragile emerging markets of Eastern Europe, may put the new-found confidence in the financial system to a severe test.

Furthermore, a full recovery is still far off: the economy has lost more than 7 million jobs since the beginning of the recession in 2007 which have yet to be recreated; the stock market is still far off its pre-crisis peak; and housing prices in many areas will  take more than a decade to return to the levels seen during the preceding bubble.

While public policy has been highly effective in avoiding another Great Depression this time, it has also created large moral hazard concerns that could lead to more financial fragility in future decades if not adequately addressed by proper regulation. After the Great Depression, policymakers realized this danger and imposed regulations on the banking system that led to more than half a century of relative financial stability.  Starting in the 1980s, these regulations were progressively weakened.  A new set of financial actors - the so-called "shadow financial system" - emerged that were exempt from banking regulation because they were not covered by governmental deposit insurance.  This allowed them to take on heavy risks and create the financial vulnerabilities that were one of the main drivers of the current crisis.

Like the traditional banking system, bankers in this shadow financial system know that their risks are now covered by the government.  They won't be allowed to fail because they are too important for the real economy.  In effect, they can gamble at the expense of the taxpayer, and as we now know, this gamble has paid off handsomely for many of the actors involved.  Efforts for a regulatory overhaul are currently underway, but there are serious concerns that heavy lobbying from Wall Street is making the proposed new legislative measures tooth-less.  If these concerns prove true, we can be assured of two things: outsized Wall Street profits coupled with fat paychecks in booms, as well as outsized bank bailouts using taxpayers' money in recessions, will be with us for some more time.


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