Jh Causes Of The Crisis

The Crisis: What Caused It? By Julio Huato [email protected] Associate Professor of Economics St. Francis College

The appearance of the crisis On the surface, the crisis appears to regular people as suddenly increased risk of losing their homes , their savings , and their jobs . On Wall Street, it manifests itself as a sudden, large drop in asset prices, a “flight to safety,” and the credit freeze. How did we get here?

The chain of causation In the last few days , stock prices fell, not because the economy is in a recession (job creation: negative, industrial production: falling), but because financial firms (“banks”) were going broke. In the last few weeks , financials were going broke because they held bad loans, directly and packaged in complex “derivatives,” as a result of credit freeze. (A global problem: banks everywhere bought them. Risk was underestimated or disregarded.) In the last few months , credit froze, mainly to other banks (but also to consumers and businesses, including short-term), because banks’ suspected other banks may go broke.

The toxic assets The bad assets held by banks were subprime mortgage loans (SML). A SML is a loan to people with weak or no credit histories [higher default risk]. Why did subprime borrowers borrow? Because they: needed a home (state of the economy, inequality, poverty) [CB: Owner-occupied homes < 70%, including partial rentals. JH: 45-65% not owners], were manipulated by predatory lenders (“asymmetric information”) [variable rates, low initial 6m-3y rates, that then jumped sharply], and thought home prices would keep going up (“housing bubble”) [see next slide].

Home prices

The credit boom

For households, it was mainly a boom in mortgage credit, but also in commercial credit.

The credit boom

Household debt led – to fund consumption. Maybe because gov’ ts slacked and people Made up for it?

The credit boom

The debt of the nonfinancial sector was the most dynamic of them all, especially households (previous graph)

The credit boom: Debtors

Notice the log scale: change reads as growth rate (percentage change). Who borrowed fastest? Insurers, ROW, B&Ds.

The credit boom: Creditors

Who lent? In speed, funding corps, S&Ds, ROW. In size, ROW, commercial banks, GSE’s (e.g. Fanny Mae, Freddy Mac).

The macroeconomics of the credit boom

By definition of savings: S = Y – T – C. Hence: Y = C + S + T (1) By the basic national accounting identity: Y = C + I + G + (X – M) (2) Subtract (2) from (1) and re-arrange to get: (X – M) = (S – I) + (T – G) That is, our trade and budget deficits are funded by the ROW!

Savings declined from mid 1980s, public finances temporarily improved (1992-2000), but then biggest deficits ever. Hence, current account deficits, foreign funding of those deficits.

Why did the financial sector grow so much? Financial firms are for-profits. Changes in the legal framework spawned the financial sector: 1971: Nixon unilaterally withdrew from the Bretton Woods agreement, which ensured some stability in exchange rates [boom of forex markets] 1980: Depository Institutions Deregulation and Monetary Control Act, began repealing the GlassSteagall Act 1933 1989: Gramm-Leach-Bliley Financial Services Modernization Act, completed the repeal of GlassSteagall [boom of non-bank financial firms, derivatives, hedge funds]

Summary Credit boom (fueled by profit motive, unleashed by de-reg) Target of funds: Domestic consumption, especially at the top, but also below (out of need) Source of funds: the ROW Poverty and inequality hurts us in many ways [much more $ blown now in bailing out banks than would have been required to help poor people buy homes safely to begin with]