The global fi nancial crisis is often defi ned by the collapse of the investment bank The FirstGlobalFinancialCrisisofthe21stCentury Lehman Brothers in September 2008. This book, fi rst published as an eBook three months prior to the collapse, recognises that a global crisis was already well underway. The First Global It highlights how losses in the US subprime market had spread beyond the confi nes of the US mortgage sector and the borders of the United States, how risk spreads had ballooned and liquidity in some markets had dried up forcing large fi nancial Financial Crisis institutions to report signifi cant losses. Bank runs were no longer the stuff of history. The fi nancial crisis that emerged and the policy responses have been unprecedented in scale. They have also challenged economists to explain where the global of the 21st crisis came from, where it was heading, and what could be done. This book Part I:August2007–May2008 brings together the views and predictions of leading economists published on VoxEU.org months before the developments of late 2008 in a volume that holds its Century own against the events that followed. Part I: August 2007– May 2008 Edited by Andrew Felton and Carmen Reinhart Centre for Economic Policy Research 77 Bastwick Street, London EC1V 3PZ Tel: +44 (0)20 7183 8801 Fax: +44 (0)20 7183 8820 A VoxEU.org Report Email: [email protected] www.cepr.org The First Global Financial Crisis of the 21st Century A VoxEU.org Publication Centre for Economic Policy Research (CEPR) Centre for Economic Policy Research 53-56 Great Sutton Street London EC1V 0DG UK Tel: +44 (0)20 7183 8801 Fax: +44 (0)20 7183 8820 Email: [email protected] Website: www.cepr.org © June 2008 Centre for Economic Policy Research British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN: 978-0-9557009-3-4 The First Global Financial Crisis of the 21st Century A VoxEU.org Publication Edited by Andrew Felton and Carmen Reinhart Centre for Economic Policy Research (CEPR) The Centre for Economic Policy Research is a network of over 700 Research Fellows and Affiliates, based primarily in European universities. The Centre coordinates the research activities of its Fellows and Affiliates and communicates the results to the public and private sectors. CEPR is an entrepreneur, developing research initiatives with the producers, consumers and sponsors of research. Established in 1983, CEPR is a European economics research organization with uniquely wide-ranging scope and activities. The Centre is pluralist and non-partisan, bringing economic research to bear on the analysis of medium- and long-run policy questions. CEPR research may include views on policy, but the Executive Committee of the Centre does not give prior review to its publications, and the Centre takes no institutional policy positions. The opinions expressed in this report are those of the authors and not those of the Centre for Economic Policy Research. CEPR is a registered charity (No. 287287) and a company limited by guarantee and registered in England (No. 1727026). Chair of the Board Guillermo de la Dehesa President Richard Portes Chief Executive Officer Stephen Yeo Research Director Mathias Dewatripont Policy Director Richard Baldwin Contents Preface ix Introduction 1 Section 1 Why Did the Crisis Happen? 5 The relationship between the recent boom and the current 7 delinquencies in subprime mortgages Giovanni Dell’Ariccia, Deniz Igan and Luc Laeven Why bank risk models failed 11 Avinash Persaud Blame the models 13 Jon Danielsson The subprime crisis: observations on the emerging debate 17 Charles Wyplosz The subprime series, part 1: Financial crises are not 21 going away Stephen G. Cecchetti The subprime series, part 2: Deposit insurance and the 25 lender of last resort Stephen G. Cecchetti The subprime series, part 3: Why central banks should be 29 financial supervisors Stephen G. Cecchetti The subprime series, part 4: Does well-designed monetary 33 policy encourage risk- taking? Stephen G. Cecchetti The subprime crisis: Greenspan’s Legacy 37 Tito Boeri and Luigi Guiso The impact of short-term interest rates on risk-taking: 41 hard evidence Vasso P. Ioannidou, Steven Ongena and Jose Luis Peydró Why did bank supervision fail? 45 Guido Tabellini vi The First Global Financial Crisis of the 21st Century The subprime crisis and credit risk transfer: 49 something amiss Luigi Spaventa The crisis of 2007: some lessons from history 51 Michael D. Bordo Reflections on the international dimensions and policy 55 lessons of the US subprime crisis Carmen Reinhart Section 2 How Is the Crisis Unfolding? 61 Federal Reserve policy actions in August 2007: 63 frequently asked questions (updated) Stephen G. Cecchetti An extensive but benign crisis? 73 Tommaso Monacelli Not (yet) a ‘Minsky moment’ 77 Charles W. Calomiris A B & B future for subprime borrowers? 85 Willem Buiter Double counting 101: the useful distinction between inside 91 and outside assets Willem Buiter Bagehot, central banking and the financial crisis 99 X. Vives The financial crisis: why it may last 103 Angel Ubide Fallout from the credit crunch 107 Dennis J. Snower Four mega-dangers international financial markets face 109 Dennis J. Snower Federal Reserve policy responses to the crisis of 2007–8: 113 a summary Stephen G. Cecchetti While the ECB ponders, the Fed moves – and cleverly at that 117 Charles Wyplosz Contents vii Section 3 What Can Be Done? 119 The subprime crisis: Who pays and what needs fixing 121 Marco Onado Filling the information gap 125 Alberto Giovannini and Luigi Spaventa Lessons from the North Atlantic financial crisis 129 Willem Buiter Lessons from Northern Rock: banking and shadow 133 banking Willem Buiter Lessons from Northern Rock: how to handle failure 137 Willem Buiter Ratings agency reform 145 Richard Portes How to avoid further credit and liquidity confidence crises 151 Guillermo de la Dehesa The inappropriateness of financial regulation 155 Avinash Persaud There is more to central banking than inflation targeting 159 Paul De Grauwe Can monetary policy really be used to stabilize asset prices? 163 Katrin Assenmacher-Wesche and Stefan Gerlach A missed opportunity for the Fed 167 Willem Buiter and Anne Sibert The central bank as the market-maker of last resort: 171 from lender of last resort to market-maker of last resort Willem Buiter and Anne Sibert Avoiding disorderly deleveraging 179 Luigi Spaventa Chronology 183 Glossary 191 Preface This book is a selection of VoxEU.org columns that deal with the subprime crisis. VoxEU.org is a portal for research-based policy analysis and commentary written by leading economists. It was launched in June 2007 with the aim of enriching the economic policy debate by making it easier for serious researchers to contribute and to make their contributions more accessible to the public. The subprime crisis, which boiled over in August 2007, was the perfect showcase for Vox’s unique approach. Mainstream media’s explanations of it as a liquidity crisis did not seem to fit the facts. How could a few deadbeat homeowners in the United States bring down a German Landesbank, force a restructuring on a major French bank, and compel the Fed and the European Central Bank (ECB) to under- take emergency injections of cash? The story was surely deeper than a standard-issue credit problem. Starting on 13 August 2007, Vox posted a slew of columns by economists who really knew what they were talking about and were willing to explain the crisis in terms that any trained economist could understand. Mainstream media’s limits (800 words written for the average newspaper reader) just did not work for an event of this complexity. Vox provided commentators with the space to explain the situation using standard economic terminology. It raised the level of the public debate and this attracted researchers who had also been at the cutting edge of policy-making, such as: Willem Buiter (professor at LSE and former member of the Bank of England’s rate-setting Monetary Policy Committee), Steve Cecchetti (professor at Brandeis University and former Executive Vice President and Director of Research at the New York Fed), Charles Wyplosz (professor at the Graduate Institute, Geneva and adviser to central banks), Marco Onado (professor at Bocconi and former Commissioner of the Italian public authority responsible for regulating the Italian securities market, CONSOB), Tito Boeri (professor at Bocconi and editor of LaVoce) and Luigi Spaventa (professor in Rome and former Chairman of CONSOB). On behalf of CEPR and the Vox editorial board, I would like to thank Carmen Reinhart for agreeing to edit this compilation of columns. Together with her col- league at the University of Maryland’s School of Public Policy, Andrew Felton, the result is what follows, a primer on what is probably the worst financial crisis of our generation. Richard Baldwin, VoxEU.org, Editor-in-Chief and CEPR Policy Director June 2008 ix Introduction Global financial markets are showing strains on a scale and scope not witnessed in the past three-quarters of a century. What started with elevated losses on US subprime mortgages has spread beyond the borders of the United States and the confines of the mortgage market. Risk spreads have ballooned, liquidity in some market segments has dried up and large complex financial institutions have admit- ted significant losses. Bank runs are no longer the subject exclusively of history. These events have challenged policy-makers, and the responses have varied across regions. The ECB has injected reserves in unprecedented volumes. The Bank of England participated in the bailout and, ultimately, the nationalization of a depository, Northern Rock. The US Federal Reserve has introduced a variety of new facilities and extended its support beyond the depository sector.