The Causes of the Financial Crisis

INTRODUCTION: In a recent editorial (September 8th), the Economist suggested that  the financial crisis of September 2008 will be regarded as one of the defining  events of the early 21st century, alongside 9/11.Hence the importance of knowing  what caused it ten years ago and preventing another similar crisis

For most people, the story  started in August, 2007, when BNP Paribas, a major French bank, stopped customers withdrawing money from three sub-prime, largely US-based mortgage investment funds. (Sub-prime mortgages are those to less financially secure borrowers). By doing this, BNP Paribus was implying that money invested in these funds might not be repaid. Banks rely on borrowing from other banks via the inter-bank market. The BNP action cast doubt on the stability of the banking system and made banks less willing to lend in this market, causing increased interest rates and a lack of liquidity, despite central banks trying to offset this. As the inter-bank market froze, more financial institutions such as TSB, Bradford and Bingley, Lloyds, Alliance & Leicester and HBOS, found themselves in difficulties and confidence among banks fell further. A month later the reality of the crisis reached British high streets when Northern Rock suffered a “bank run” –  the first in the UK for 141 years – after doubts were cast on the BBC over its solvency. It had invested heavily in the sub-prime market and the value of its assets fell as house prices fell in the USA. Then, ten years ago on 15th September, 2008, Lehman Brothers, the fourth largest investment bank in the US collapsed and the world entered the worst financial crisis for decades.

THE CAUSES:

FUNDS SEEKING A HIGH RETURN – An early cause  can be traced back to  the late 1990s when vast quantities of money from Asian countries with large balance of payments surpluses were invested in the USA and Europe, seeking high returns. This increased the supply of money, reduced interest rates and  discouraged saving. It also encouraged banks and other financial institutions to look for areas with a high rate of return, particularly in the booming housing market and to lend to mortgage borrowers. This caused large increases in house and share prices and helped create the asset price bubble which preceded the crisis.

THE RISE OF NEW FINANCIAL PRODUCTS – As the quantity of loans increased, there was a huge expansion of new financial products particularly CDOs (collaterised debt obligations), which were intended to spread risk but ultimately made it worse. They work as follows: imagine a bank makes five loans of $200,000 each to housebuyers at 5%, guaranteed by the value of the houses. It finances this by bundling them together into a bond (called a CDO) and selling it for $1m (5 x $200,000), paying 3%, thus making a profit, and uses the money to lend again. This process is securitisation – transforming a stream of cash payments into an asset.  To understand the concept, think of a butcher taking different types of meat (mortgages), mincing them all together and making sausages (CDOs) from the mixture. In theory, the CDO was safer than individual loans since, if a bank made one loan and it failed, it lost all the money but, with a CDO, where it had a slice of many loans bundled together, one individual loan failing was relatively insignificant. The CDOs were involved in long chains – banks might buy CDOs, then re-bundle them into new CDOs and sell them to other financial institutions who sold them again with borrowed money (sometimes from the original institution) financing many of these transactions, like the butcher then taking the sausages and mixing them together to make different sausages from the mixture.

SUB-PRIME MORTGAGES – A significant component  of the CDOs were sub-prime mortgages  which had increased during the early 2000s since they provided a higher return. Although offered to low-income households, they were regarded as a safe investment since housing markets were booming and if the borrower defaulted, the lender would re-possess the property and sell it at a profit. There was a failure of ratings agencies to properly assess the risk of these new financial products in the USA, which were highly-rated, because they focussed on the credit risk (the risks arising from non-payment) rather than the liquidity risk (the risk of not being able to sell the CDO).  This was combined with a lack of awareness by government regulators of the possibility of a financial crisis since they focussed on CDOs spreading risks and did not anticipate the possible risk of a housing collapse.

When the US sub-prime market collapsed, due to rising interest rates, deemed necessary to reduce inflation, and falling house prices, the CDOs, despite their high rating, were seen to be risky and quickly depreciated in value. They  became illiquid since no one wanted to buy them, so their holders were unable to sell them to realise even part of their value. Simultaneously banks became reluctant to lend to other banks holding CDOs in their assets and first Northern Rock and then other banks failed. However because the original mortgages had been converted into CDOs and often re-bundled into other CDOs, it was not easy to tell which assets were safe and which were not, and therefore all such products were assumed to be risky, the institutions which held them were avoided by lenders and liquidity in the financial system evaporated. Because these products were bought and sold  by financial institutions in USA, Europe and Asia, the crisis spread quickly between the continents.

LOW BANK RATIOS – Banks need a balance between the loans which they make and their share capital and liquid reserves which can be used in case any of their loans fail. In the approach to the crisis, their leverage ratios (loans:capital) increased greatly, meaning that they were supporting their loans on a much smaller base. Lehmann Brothers, for example, had a ratio of 35:1. When the housing market fell, the banks wished to build up their capital by selling the properties on which the loans were based. However the increased supply of housing onto the market further reduced house prices and the value of the sub-prime mortgages, making the crisis worse. It should be noted that it was much easier for a US mortgage borrower to abandon their property without a financial penalty than in the UK. What many sub-prime borrowers did when they could not afford the higher interest rates and house prices fell below the value of their mortgage  was to drop the keys back to their lender and move into rented accommodation. It was then up to the bank to try to sell the house and get their capital back.

POOR REGULATION – Another contributory factor was the level of regulation of the financial sector. Authorities such as the IMF focussed on how securitisation reduced risk and global bank  reforms aimed to make it easier for banks to lend. in the UK there was also a change in the financial regulatory framework. Previously the Bank of England had been responsible  for the regulation of the banking system and the operation of monetary policy. Following the election of the Labour Government in 1997, Gordon Brown, created a three-way structure involving the Bank of England, the Treasury and Financial Services Authority. The FSA was responsible for maintaining confidence in the financial system, preserving financial stability, protecting consumers and reducing financial crime. The move from a single body regulating the financial system to a tripartite arrangement possibly hindered a speedy response to the crisis.Subsequently, in 2013, the FSA was replaced by the Financial Conduct Authority which is responsible for regulating 56,000 financial services firms to protect consumers, protect financial markets and promote competition).

THE SOCIAL CLIMATE – There has been much media attention in the last ten years blaming the crisis on the greed of bankers, earning enormous salaries and bonuses from their activities. . The FT, in a series of articles on the crisis talks of “Massively leveraged investment banks engaged in socially useless trading of huge volumes of complex credit securities.” However it is not only bankers who were keen to make money. Housebuyers borrowed more than, in retrospect, was sensible and even everyday savers  used their savings to dabble in financial products they did not understand in a bid to obtain a higher return.

Then, on 15th Sept 2008 Lehman Brothers filed for bankruptcy protection. It was not the first chapter in the financial crisis but its size and the probability that it would be allowed to fail, can be regarded as the moment when the crisis became apparent. Within two weeks of Lehman’s collapse the global interbank money market had frozen, creating fear of economic collapse in the USA, Europe and Asia and the Dow Jones Index experienced its largest drop since the September 11 attack in 2001.

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A confusing week for economists

This week has seen a considerable amount of contradictory economic information. On the positive side, employment in Britain reached a record high in the three months to April, 2018, with an employment rate of 75.6%. Unemployment has remained at its current low of 4.2% and the inactivity rate, those people, such as students, of working age, but not in the labour force, is also at a record low. Retail sales grew by a record 4.1% in May

However the rate of increase in earnings, which we would expect to be high given the low unemployment figures (as suggested by the Phillips Curve), has dropped from 2.6% to 2.5%. In real terms, the rate of growth in real earnings was only 0.1%, implying that future consumption growth will be low.

Other disappointing news was an announcement from Land Rover that they are moving production of the Discovery from the UK to Slovakia and news that Poundland and House of Fraser have collapsed, putting thousands of jobs at risk. However even these news items are not clearcut. One of the reasons behind Land Rover’s actions is that, once production has moved out of the UK, the site will be used to produce new, more high-tech, more expensive hybrid and electric models and the decline in traditional retailing is happening as on-line purchases increase, creating delivery and warehouse jobs.

However possibly the most disappointing pieces of news were firstly the latest data on manufacturing output for April, showing the fastest fall for 6 years and secondly, the deterioration in the UK’s trade deficit which grew by £1.6bn to a deficit of £9.7bn, the worst monthly figure since October 2016.

Possibly the best way to evaluate the data is to look at what the markets thought and they were pessimistic, thinking that the weakness of the economy will make an interest rate rise less likely and therefore sterling fell in the foreign exchange markets.

Olen niin iloinen

For those of you who do not speak Finnish, a clue to the meaning of the words above might be found in the following questions.

What happens on 20th March 2018?

Answer – UN has declared it to be World Happiness Day

What do Norway and Burundi have in common?

Answer – they both dropped in the UN World Happiness Report. Burundi dropped to bottom place while Norway dropped out of the top slot to be replaced by Finland – hence the Finnish comment “I am so happy”.

The Report ranks 156 countries by their happiness levels, and, this year, it also looked at 117 countries by the happiness of their immigrants, with Finland coming top in both rankings.

The top and bottom 10 are recorded below. A sample in each country are asked to score their happiness on a scale of 10 (most happy) to 1 (least happy) with Finland scoring 7.6 and Burundi 2.9. In order to identify the reasoning behind the score, the report also looks at economic strength (measured in GDP per capita), social support, life expectancy, freedom of choice, generosity, and perceived corruption. The biggest loser was Venezuela, dropping 2.2 on the scale, which is little surprise considering the state of their economy. This year the study also looked at the happiness of migrants,

It is worth a warning note about the numbers – the difference between the top 6 countries is only 0.191 on the 1 – 10 scale.

The world’s happiest – and least happy – countries 2018 World Happiness Report
Happiest Least happy
1. Finland 147. Malawi
2. Norway 148. Haiti
3. Denmark 149. Liberia
4. Iceland 150. Syria
5. Switzerland 151. Rwanda
6. Netherlands 152. Yemen
7. Canada 153. Tanzania
8. New Zealand 154. South Sudan
9. Sweden 155. Central African Republic
10. Australia 156. Burundi

TRADE WAR 2

It is rare to see two successive blog posts on the same topic but it is also rare for an economic issue to receive the attention which President Trump’s proposed tariffs on steel and aluminium have attracted. Since the last post, Gary Cohn, his chief economic adviser, has resigned in protest at the decision, swaying the political balance in the White House from supporters of free trade towards protectionists, the EU has added to its list of potential targets for retaliation to include peanut butter, Bourbon, Florida orange juice and Harley Davidson motorcycles, and President Trump has continued to threaten retaliation against the retaliation, talking of tariffs against EU car exports. There have also been comments in the newspapers looking back to the 1930s and the protectionist measures imposed by the USA as a way of helping them escape the Great Depression, which served only to make the world situation worse.

The language of the debate (if that is what it can be called) continues to be confused. On the one hand President Trump argues that the tariffs are justified by WTO rules on the grounds of national security, a legitimate reason for imposing tariffs; the argument being that steel is an important product for the defence industries. However the main exporters of steel to the USA are the EU (the largest), Canada, Mexico and South Korea – hardly countries which are likely to go to war with the USA. China does not feature among the list of the major steel exporters to the USA. Furthermore some of the steel exported is highly specialised and not even manufactured in the USA.

While talking of national security as a justification, President Trump simultaneously continues to refer to the need to reduce the US balance of payments deficit, arguing that the deficit is “BAD” and the fault of foreign countries. Not only has the deficit occurred in part because foreign producers can produce more cheaply than US ones, it has also allowed the US to consume more than it produces and, subsequently, living standards have risen. Foreign trade is not a zero-sum game – both deficit and surplus countries benefit from greater trade.

So how has a country like the USA (and the UK) been able to run such a large and persistent deficit? This is because foreign governments, banks and individuals have been willing to hold dollars and US assets rather than change them back into their own currency. In the same way that a generous parent’s continual lending allows their children to spend more than they earn, the UK current account deficit might be partially financed by a financial account surplus caused by rich foreigners and businesses placing money earned from selling to the UK in UK banks or buying property in London, UK shares or government bonds. The same applies to the US, but is reinforced by the additional benefit the USA has which is that the dollar is so widely used for international trade and as a reserve currency.

New insights into GDP

A new book “The Growth Delusion” by David Pilling, a Financial Times journalist, provides interesting insights into our obsession with economic growth and how we measure it. This blog highlights only some of his key points which are relevant to A’level and IB economics. The book is definitely worth a read. Modern GDP statistics (“the value of goods and services produced in a given period”)  have their origin in the USA around the 1930s with the work of Kuznets, who produced the first national income data to see the impact of the Great Depression on the US economy. They became more important during the Second World War when the UK government, prompted by Keynes, and the US government needed to be able to manage the war effort to maximum effect while still providing enough resources for consumption.

Pilling points out the many failings of GDP as an economic indicator such as the way it takes no account of what is produced, merely its value. Thus he points out that  wars can be good for GDP if they involve countries producing more tanks, weapons and aircraft. Similarly, two forks are, in GDP terms, as useful as a knife and fork, but less useful in reality when trying to spread jam on toast or cut one’s steak.  He is also scathing about the use of averages and points out that while a rich country might have a high average GDP, and therefore, according to economists, a high standard of living, if this is held by a very small number of people, the standard of living of the majority might be below that of a country with a lower average of GDP.

Measurement of GDP is difficult since it is impossible to measure every transaction and therefore relies on surveys e.g. the Living Costs and Food Survey for about 5,000 households and monthly surveys of approximately 45,000 businesses. The development of technology has made the measurement of GDP more difficult. The UK Government set up an inquiry under Charlie Bean – OB and former Deputy Governor of the Bank of England – who made comments similar to those expressed by David Pilling in terms of activities which are now much harder to measure and value such as using Google Maps rather than buying a paper OS map or streaming films rather than buying or renting DVDs. Another problem is that many things have become cheaper and better – my new recorder is easier to use and records more than a previous DVD recorder  but, in GDP terms, it is less valuable because it is cheaper.

There have been many debates over what should be included in GDP and although these might seem largely irrelevant, they matter when trying to compare countries’ GDP. In the past certain things, such as the sale of cannabis in cafes in Holland were legal and therefore recorded while a similar purchase in Romford would not be counted. However Eurostat wanted consistency among its members and decided that all transactions for goods or services involving money were to be recorded, whether they legal, illegal, good or bad. Therefore, in a purely numerical way, those who argue in favour of increasing GDP as being a key government objective, could argue that encouraging the sale of drugs or prostitution is as valid as increased spending on education or health – something even an economist would find hard to justify! More relevantly sales of guns in the UK  are part of the shadow economy but in the US they are legal, widespread and contribute to their GDP.

Pilling also considers the problems of measuring GDP in developing countries where a significant percentage of production takes place in the shadow economy; for example in Zimbabwe only 6% of the is formally employed. Similarly, my purchase of bottled water from Waitrose  is counted in the UK’s GDP, but the effort of a African villager who spends hours walking to and from a stream or well to collect “free” water has no value according to GDP statistics. He describes the way lights at night are used to indicate economic activity in different areas with increases in intensity over time indicating growth. Such methods indicate that the proportion of economic activity occurring in villages, and not always measured, is more significant than thought and therefore the GDP of many developing countries is, similarly, larger than previously calculated.

Falling Share Prices – Causes and Effects

This week has seen major falls in share prices across the world with $6 trillion being wiped off world share values.  America’s Dow Jones index dropped 5.2%, Japan’s Nikkei index fell 8.1% and the UK’s FTSE index fell 4.7%, the lowest it has been for 15 months, while in Japan and America the falls broke records for the size of their drop since October 2008.

The initial reason for the fall was, paradoxically, good US economic data as their service sector boomed and wage levels grew at the fastest rate since the start of the decade. This good news meant that it is now more likely that US interest rates will rise sooner and by more than had previously been anticipated. Mark Carney reinforced this view when he expressed similar sentiments about the future of UK interest rates.

Although a rise in interest rates has been expected for some time as the world economy’s growth accelerated, the reminder that it might occur soon has come as an unpleasant shock. The scaling back of QE by central banks is expected to reduce the ability to borrow cheaply, some of which has financed recent purchases in shares. Financial investors expect that the forthcoming rise in interest rates will reduce company profits, therefore reducing the demand for shares. Simultaneously existing shareholders might be encouraged to sell quickly before prices fall further, thereby increasing the excess demand. In addition, the economic uncertainty was increased by the fall in the value of bitcoin by approximately 50% since the state of the year.

Economists are trying to decide whether we are currently experiencing a “correction” or  are entering a bear market, where prices fall by more than 20%. The “correction” proponents believe that shares are over-priced in terms of their price compared to their earnings – the price:earnings ratio – and therefore the fall was due. However there is concern that the behaviour of investors, whether in shares, currencies or commodities, sometimes leads to markets over-shooting since falls (increases) in price encourage selling (buying) which further reduces (increases) the price.

According to economic theory, the fall in share prices might lead to a negative wealth effect (the idea that consumption is determined by one’s wealth as well as one’s income). However, given that many shareholders are in the upper income brackets, their marginal propensity to consume will be low and therefore the effect will small. More significant might be the general impact on consumer and business confidence from the media reports about the falling share prices. As Keynes wrote in his General Theory,  “animal spirits” outweigh the  “weighted average of quantitative benefits multiplied by quantitative probabilities.”.