History of Global Financial Crisis 2007

I have written a summary of the main arguments of Mian and Sufi in “House of Debt”. This book provides the answer to the question “How does macro-economics need to change, in light of the Global Financial Crisis?” This has been asked of many but none have given a satisfactory answer. Mian and Sufi analysis is to the GFC what Keynes was to the Great Depression — in fact Mian and Sufi provide the first satisfactory explanaton for both events.  My full length review is available from SSRN at: http://ssrn.com/abstract=2517476..  Below I provide an excerpt from my review which gives the history of the Global Financial Crisis, linking it causally to the East Asian Crisis.

2.1      The East Asian Crisis

Financial de-regulation in the Reagan-Thatcher era led to a vast expansion of capital available for investment in the USA and UK. Rates of return to investments in the western world were low, and capitalists sought to open up foreign markets, where higher rates were available. In particular, a combination of carrot and stick were used by USA and IMF to force the highest growing East Asian economies to open up to foreign investments in the 1990’s. As a result, millions of dollars flowed into these economies, creating asset price bubbles in lands, buildings, and stock markets. Eventually the bubble burst, leading to massive capital flight out of the East Asian countries. This sudden withdrawal of foreign capital created an economic crisis. In a strange twist of fate, this crisis eventually led to the GFC via a causal chain described by Mian and Sufi that is discussed in the next section.

Islam stresses that earnings must relate to provision of products or services. Ownership of capital is not considered a service to society; thus, earnings on capital are permissible only if  the lender shares in the risk of business.  Had the principle of equity based loans been followed by investors in East Asia, the resulting crisis could have been averted. However, investment was done on the basis of standard debt contracts, which guarantee returns to the investor, regardless of whether the investment succeeds or fails. This is inherently unjust since the wealthy parties providing the loans get returns without risk, while the debtors suffer extremely adverse consequences in case of failure. This leads to dramatic increases in poverty and inequality following financial crises, as has been repeatedly observed empirically in the past few decades.

2.2      Consequences of the East Asian Crisis

Sudden withdrawal of money leads to a collapse in asset prices which depresses aggregate demand in an economy. It also threatens viability of financial institutions, like banks, which operate on trust. Central Banks respond to these crises by providing liquidity – they create high powered money and provide it to financial institutions by various means, so as to avert financial crisis. In the East Asian crisis, financial institutions had liabilities in dollars, and Central Banks did not have sufficient foreign reserves to rescue them. They were forced to appeal to the IMF, which did provide the required liquidity, but at the cost of extremely stringent conditions. All over the world, governments respond to crises by providing relief, and liquidity. To protect interests of the foreign creditors, East Asian governments were forced to do the opposite – IMF required them to raise the interest rates and taxes, and balance budgets by cutting social welfare programs precisely when they were most needed.

The misery inflicted by painful austerity measures forced on East Asia by IMF was noted all over the world. To avoid being caught in a similar trap, Central Banks all over the world sought to increase their holdings of dollars. From 1990 to 2001, central banks bought around $100 billion annually. From 2002 to 2006, the rate of reserve accumulation just about septupled. Central Banks prefer to hold dollars in highly liquid, but also extremely safe interest bearing assets, rather than cash which has zero interest. Thus, there was a massive increase in demand for super-safe assets denominated in dollars.

It is worth noting that in retrospect, this was the wrong response to the East Asian crisis. Many of the proposals made in the aftermath of the crisis suggest that various types of capital controls were necessary to prevent the crisis, and also to resolve the post-crisis economic problems.  At the moment, Central Banks all over the world are over-loaded with dollars, which has allowed the USA virtually unlimited leverage in using seigniorage and the inflation tax to finance wars and bailouts for the wealthy. However theories of liberalization, the Washington Consensus, and the might of the multinational institutions prevented even the contemplation of solution based on restrictions on capital flows, which were the root of the problem.

2.3      Reverse Say’s Law combined with Gresham

A new asset – a near money – was created to satisfy this massive increase demand. A new type of security which was backed by mortgages (MBS) was created. The theory was that this was a super-safe security. The MBS utilized diverse pools of mortgages, thereby lowering risks. They also utilized complex prioritized payoff structures, which supposedly provided further safeguards against failure. All mortgages required insurance, which was another guarantee against failure. The ratings agencies also gave these “private label” securities the highest AAA ratings, certifying them as super safe.  These financial gimmicks deceived investors, and created a huge demand for these mortgage backed securities, which paid much higher returns compared to the safer government issued treasury bills. As money poured into these MBS, over the five years from 2002 to 2007, mortgage debt doubled from $7 trillion to $14 trillion.

Say’s law also operates in the reverse: demand generates supply. The multi-trillion dollar demand for MBS led to the creation of the supply of mortgages. Prior to 2002, default rates in the mortgage industry in USA never went over 6.5% historically. However, in the five year period preceding the crisis, the rules were re-written. Mortgage initiators found that mortgages could be resold to these security agencies with no questions asked. The mortgage packaging agencies in turn sold these mortgages bundled into securities, to investors seeking dollar backed securities. In this supply chain of mortgages, no one had primary responsibility to ensure that the underlying mortgage was sound. The presence of mortgage insurance added to the apparent safety of these investments. In fact, in presence of insurance, it was rational for investors to ignore the probability of default – the insurance would pay in event of default.

Over the period of 2002 to 2007, these enormous inflows of money to purchase “private label” MBS created a huge amount of “toxic” debt. These were mortgages that all informed parties knew would never be repaid. The easy availability of loans for mortgages led to a dramatic rise in values of property – an asset price bubble which may be termed the “revenge of East Asia”.  Eventually, defaults started piling up. In 2007, a new phenomenon was observed: defaults on mortgages occurred within months of origination of the mortgage. Default rates reached historic highs of over 10%. As jittery investors moved out of these mortgage-backed securities, the entire market for them collapsed. The sudden withdrawal of credit led to a collapse in values of housing to the tune of $4 trillion. With this collapse in housing values, about a quarter of the mortgagers went “under-water” ! That is, the amount of debt they owed on their houses was greater than the value of the house which had been pledged as collateral for the debt. On a narrow cost-benefit basis, it would be rational from them to stop payments on their mortgage loans and allow the bank to foreclose on their property.

The collapse of market for MBS led to the global financial crisis. It also had huge negative impacts on the US Economy, leading to a massive increase in unemployment. Today, seven years after the crisis, unemployment, homelessness, hunger and poverty are at the highest levels seen in the USA since the great depression. In addition to piecing together the story outlined above, the key contribution of Mian and Sufi is to explain exactly how the collapse of asset price bubble in housing led to an economy wide crisis.

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5 comments
  1. sharingrisk said:

    Interesting thesis but was there empiridlcal evidence provided by Mian and Sufi for the proposition that the build up of forex reserves caused the emergence of the huge growth in the MBS market vs. An alternative hypothesis that low interest rates led to a domestic housing bubble in the US that only attracted foreign investors leaving treasuries for MBS during the period where housing price increase began rising at an accelerating rate. Do they present any emirical studies that could differentiate between these two or vs another explanation?

    • Yes, Amir & Sufi provide empirical evidence for most of their claims. For the issue you raised, they distinguish between two types of counties — high elasticity of price for new constructions and low elasticity. They argue that the geography of certain counties is such that additional housing can be easily be built at marginal cost — the counties lie on flat plains. Others are locked in by lakes/rivers/mountains and additional housing stock is hard to construct so prices increase more rapidly in response to demand. If money was attracted in by increasing prices then more would flow into counties with high price elasticities where the price increase would be more rapid. However, data shows that same amount of money went into increased mortgages in counties where prices increased rapidly and others where it did not. This suggests that the causality ran from excess supply of money to demand for mortgages and increase housing prices rather than the other way around.

  2. That is a very similar analysis to what Paul Krugman was saying in 2005 (http://www.nytimes.com/2005/08/08/opinion/08krugman.html) making the distinction between “Flatland” and “Zoned Zone” and suggesting that a housing price bubble was starting to make a hissing sound in the “Zoned Zone” (http://blog.redfin.com/local/wp-content/uploads/sites/2/2009/02/case-shiller-redfin-markets_2008-122.png) even as early as 2005 whereas Phoenix (to use one example of Flatlandia) didn’t start dropping until very early 2007 (and later on a year-on-year basis): http://us.spindices.com/indices/real-estate/sp-case-shiller-az-phoenix-home-price-index.

    There are a few things not right with his analysis, but the rise in prices in Phoenix, hadn’t really started going hyperbolic (on a year-over-year basis) until late in 2005 around the time Krugman was writing. However, the pattern of Zoned Zones peaking first followed by Flatlandia does make sense as you describe as being driven by an excess supply of money because the money went first to where it was familiar (and where there was a case of constricted supply which would make more appealing to fundamental investors) but later overflowed into areas where the fundamental case is less strong.

  3. Bruce E. Woych said:

    When prices go up in “aggregate demand” terms of reference we place it in a category of inflation. When speculative demand drives unrealistic profits and rewards based upon not only phantom derivatives but parasitic reliance upon public support (government backed anything), we call it a bubble. Inflation is quantitative and equative with a measurable set of parameters. A “bubble” is simply boundaries that fail. The normal economy was scavenged for finance to continue “inflating’ their profit potentials and it became manic and blind. They stripped every asset they could find to pull “investment” into their speculative rodeo show. It truly was a frenzy behind closed doors and insider players were using every power brokering string they had to maintain a financial growth industry that undercut its own investments into hard commercial assets as expendable and “for profit” exploit, and this was a direct result of merging finance and commercial banks under one penthouse roof.

    Call it what you will but the economics of transactions have not been categorically classified in any effort to assess when real things begin to happen including “LOOTING THE TREASURY” to save the day for more of the same. Today we are told the system is one solid entity and money is under deflationary forces. But if this is true, the so-called monetary easing and the continued (unmentioned) exponential expanse of derivatives continue to “inflate” (for lack of a better term…thank you very much economic Masters!)…yes inflate the cost of that dollar in the street while finance creates a separate and very much unequal balloon and bubble in the global skies.

    Debt excess was not the primary cause, the primary cause is one step further. Why did such unstable debt ever get so far out of hand. And the answer is unregulated derivatives, excessive and unrealistic profits on speculations, and overpaid corporate CEOs that are the best thieves that money can buy. And of course, a culture of corrupted and perverted incentives certainly was in the grandstands doing the play by play analysis of what they were paid to see!

    • Bruce E. Woych said:

      i would like to suggest that while gold or some solid form of value standard is not supporting the true value of the dollar, that monetary easing is creating a specialized tier of inflationary expansion in the financial sector. Essentially that implies that two separate monetary values exist under the unmeasurable fiat system of paper exchange. The upper tier simply proportionately adjusts numbers to balance their books, while they frantically seek to cover real value by gutting the economy under privatize everything schemes by hedge funds and tycoon private equity types that operate from global stations as much as off shore and in our own back yard. Asset backed mortgages and the derivatives that ate them to the point of economic disease…well that is just ONE example that is “trickling down’ because it can be measured without total disclosure of how the systemic is based upon wealth creation over austerity and real asset building investment into infrastructure to support an “aggregate economy.” No one wants to admit financial tyranny in slow insidious motion, but the moral hazards of private wealth creation and its ‘creative destructive’ rationale is a rent economy that can not survive without eventual and complete fascist enforcement. It will happen here: it is happening right under our intellectual noses!

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