Financial Globalization Culprit, Survivor or Casualty of the Great Crisis? A publication of the Yale Center for the Study of Globalization Financial Globalization Culprit, Survivor or Casualty of the Great Crisis? A publication of the Yale Center for the Study of Globalization From the proceedings of a conference by the same name, held on November 12 and 13, 2009 Yale University New Haven, Connecticut Financial Globalization: Culprit, Survivor or Casualty of the Great Crisis? A Yale Center for the Study of Globalization eBook Yale Center for the Study of Globalization Betts House 393 Prospect Street New Haven, CT 06511 USA Tel: (203) 432-1900 Email: [email protected] Web: www.ycsg.yale.edu ©Yale Center for the Study of Globalization, 2010 The papers contained in this book are based on presentations from the conference Financial Globalization: Culprit, Survivor or Casualty of the Great Crisis?, organized by the Yale Center for the Study of Globalization at Yale University in New Haven, Connecticut on November 12 and 13, 2009. The conference was made possible by generous support from the Ford Foundation. Yale Center for the Study of Globalization The Yale Center for the Study of Globalization (YCSG) was established in 2001 to enhance understanding of this fundamental process and to promote exchanges of information and ideas about globalization between Yale and the policy world. The Center is devoted to examining the impact of our increasingly integrated world on individuals, communities, and nations. Globalization presents challenges and opportunities. The Center’s purpose is to support the creation and dissemination of ideas for seizing the opportunities and overcoming the challenges. It is particularly focused on practical policies to enable the world’s poorest and weakest citizens to share in the benefits brought by globalization. It also explores solutions to problems that, even if they do not result directly from integration, are global in nature, and can therefore be effectively addressed only through international cooperation. In addition to drawing on the intellectual resources within the Yale community, the Center actively collaborates with institutions and individuals across the globe. Financial Globalization Culprit, Survivor, or Casualty of the Great Crisis Part One Taking Stock of the Causes and the Damage So Far Moderator: William Nordhaus Sterling Professor of Economics, Yale University Raghuram Rajan Eric J. Gleacher Distinguished Service Professor of Finance, University of Chicago Booth School of Business Jan Kregel Senior Scholar, The Levy Economics Institute of Bard College Willem Buiter Professor of European Political Economy, European Institute, LSE Jeffry Frieden Department of Government, Harvard University James Galbraith Lloyd M. Bentsen Jr. Chair in Government/Business Relations, Professor of Government, University of Texas at Austin Viral Acharya Professor of Finance, Stern School of Business, NYU Carmen Reinhart Department of Economics, University of Maryland Part Two International Financial Architecture, Financial Regulation, and the Future of Financial Innovation Moderator: William Brainard Arthur M. Okun Professor Emeritus of Economics, Yale University Avinash Persaud Chairman, Intelligence Capital Charles Goodhart Programme Director, Regulation & Financial Stability, LSE Professor Emeritus of Banking and Finance Rakesh Mohan Stanford Center for International Development Richard Portes Professor of Economics, London Business School Ronald McKinnon William D. Eberle Professor of International Economics, Department of Economics, Stanford University Dimitri Papadimitriou Executive Vice President of the College, The Levy Economics Institute of Bard College Anne Krueger Professor of International Economics, School of Advanced International Studies Keynote Address Containing Too Big To Fail E. Gerald Corrigan Managing Director, Goldman Sachs Former President and CEO, Federal Reserve Bank of New York Part Three National and Regional Perspectives Moderator: T.N. Srinivasan Samuel C. Park, Jr. Professor of Economics, Yale University C.P. Chandrasekhar Centre for Economic Studies and Planning, Jawaharlal Nehru University Padma Desai Gladys and Roland Harriman Professor of Comparative Economic Systems and Director, Center for Transition Economies, Columbia University Wing Thye Woo Department of Economics, University of California, Davis Guillermo Ortiz Governor, Central Bank of Mexico Tommaso Padoa-Schioppa President, Notre Europe; Former Minister of Economy and Finance, Italy Roundtable Discussion Globalization After the Crisis Ernesto Zedillo Frederick Iseman ’74 Director, Yale Center for the Study of Globalization Jagdish Bhagwati University Professor, Columbia University Niall Ferguson Laurence A. Tisch Professor of History at Harvard University and William Ziegler Professor of Business Administration at Harvard Business School Harold James Professor of History and International Affairs, Princeton University Part One Taking Stock of the Causes and the Damage So Far Economists are still debating what are the key causes of the crisis, or at least the weight that each should be given. It will still be a matter of question how long it will take before the crisis is over and a recovery is achieved. Also it is a subject of contention whether, if and when the recovery takes place, growth with price stability can be resumed as before the crisis. This section of the conference is intended to address these and related questions. William Nordhaus Sterling Professor of Economics, Yale University Moderator Since the name of the session is “Taking Stock Of The Causes and Damage So Far,” I was reminded of Keynes’s phrase in one of his marvelous passages, which I’ll paraphrase, that we overstate the power of vested interests but understate the power of vested ideas. There is a passage from the transcript of a House hearing just after the Lehman bankruptcy, where Representative Henry Waxman (D-CA) asked Alan Greenspan about his views. He said, “Dr. Greenspan, do you think you made a mistake?” And Greenspan said, “Yes, I found a flaw in the model that I perceived as a critical functioning structure that defines how the world works. I was shocked because I’d been going for 40 years or more” (so that takes it back to 1968 or more), “with the very considerable evidence that it was working well. I made a mistake in presuming that the self-interest of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders. So, the problem here is something that looked to be a very solid edifice, and indeed a critical pillar to market competition, and free markets did break down. And that shocked me, and I still do not fully understand why it happened.” This is, as much as anything, a testament to the power of vested ideas and a good introduction to this session. Raghuram Rajan University of Chicago, Booth School of Business We do understand the global roots of this crisis. Ken Rogoff, my predecessor as chief economist at the IMF, and I, were going on and on while we were at the Fund about global current account imbalances. I think Ken, perhaps more than I did, recognized that the way they might come down might just be through a financial crisis. But I think none of us saw the magnitude of what might happen. What I want to do here is talk a little bit about why it was the banks that got hit, and I’m going to offer some hypotheses. I don't think we really know the answer, but to my mind this suggests that we have to be very careful when we’re thinking about regulation. Since we don’t really know what the answer is, we have to be careful that whatever regulation we put in place can actually mitigate the kinds of problems we saw this time, even while helping to ward off future problems -- the unknown unknowns so to speak. If you drill down to what was happening in the financial sector in industrial countries, especially in the United States and the U.K., you will conclude that the financial firms were taking a variety of tail risks – low probability risks with very costly consequences if they occurred. For the macro-international economist, this is often known as peso risk. For the micro-finance types, this is tail risk, the classic example being earthquake insurance. The point about writing earthquake insurance is if you can collect the premium up front and nobody knows that you’re writing earthquake insurance, you look like a genius. You’re making money with absolutely no risk. And that allows you to pay the premiums out to yourself or to the firm’s shareholders as big dividends. The problem, of course, is when the earthquake actually hits. People ask you to pony up the insurance. And if there’s none left, you go to the government and say, “Surprise. It’s your baby now – you own the problem.” That, in reduced form, is essentially what happened -- two broad kinds of tail risk were being taken. One was default risk. Now, default risk -- idiosyncratic default risk -- is not really a tail risk. Firms go bust all the time. But there was risk being taken on the collective default -- for example, on mortgage-backed securities -- which pooled mortgages across the country. The tail risk there was the low probability event that house prices across the country could fall and create severe distress in the housing sector. This kind of default risk was being taken, for example, by AIG, writing insurance against the super senior pieces of mortgage-backed securities; and by UBS, doubling and tripling the size of its balance sheet, investing in AAA mortgage-backed securities, borrowing at UBS’s cost of capital, making the little spread, and multiplying that many times. Default risk was one form of tail risk. The other form of tail risk that was being taken was liquidity risk; a lot of banks were funding illiquid positions with very short-term debt. A classic example of this was the off-balance sheet Structured Investment Vehicles (SIVs) and conduits that banks had created to hold mortgage-backed securities.