1

The Global Financial The Global Financial Crisis of 2008Crisis of 2008

22

““The global pool of money”The global pool of money”

Subprime crisis Subprime crisis housing bust housing bust credit credit crunch crunch global financial crisis global financial crisis Great Great Recession Recession • ¼ of residential mortgages “underwater” ¼ of residential mortgages “underwater”

(w/negative equity)(w/negative equity)• ““real” unemployment is about 17% (counting real” unemployment is about 17% (counting

discouraged and underemployed workers) discouraged and underemployed workers) • cuts to public spending (social services) at all cuts to public spending (social services) at all

levelslevels• And now: “And now: “foreclosure crisis”foreclosure crisis”

33

Role reversal?Role reversal?

In the lead-up to the 2008 global In the lead-up to the 2008 global financial crisis, the “hot money” is financial crisis, the “hot money” is pouring into the US, fueling a pouring into the US, fueling a “speculative real estate boom” like “speculative real estate boom” like the ones seen in East Asia in the late the ones seen in East Asia in the late 90s90s

44

History of US financial regulationHistory of US financial regulation

1940s-1970s: Regulatory Expansion1940s-1970s: Regulatory Expansion

1980s-present: Deregulation1980s-present: Deregulation

circa 2011? circa 2011? • uncertaintyuncertainty• crisiscrisis

55

Key events in US financial regulationKey events in US financial regulation 1940s-1970s - Regulatory Expansion1940s-1970s - Regulatory Expansion: highly regulated financial : highly regulated financial

institutions, high capital requirements, capital controls, etc., took us out of institutions, high capital requirements, capital controls, etc., took us out of historical boom-bust cycleshistorical boom-bust cycles• Glass-Steagall ActGlass-Steagall Act (1933) (1933) mandated a separation between commercial mandated a separation between commercial

banking (handling deposits and lending) and investment banking (buying/selling banking (handling deposits and lending) and investment banking (buying/selling securities, underwriting, etc.) securities, underwriting, etc.)

1980s-present - Deregulation: 1980s-present - Deregulation: placing faith in free markets, regulation placing faith in free markets, regulation was loosened, regulatory agencies downsized, increasingly leveraged was loosened, regulatory agencies downsized, increasingly leveraged banks, growth of derivatives, high-frequency trading – highly volatilebanks, growth of derivatives, high-frequency trading – highly volatile• Sparked by the Reagan revolution, deregulation continued under Democratic and Sparked by the Reagan revolution, deregulation continued under Democratic and

Republican administrations alikeRepublican administrations alike• Gramm-Leach-Bilely Financial Services Modernization Act

(1999)::tore down Glass-Steagall's wall separating commercial and investment tore down Glass-Steagall's wall separating commercial and investment bankingbanking

• Commodity Futures Modernization Act (2000): Commodity Futures Modernization Act (2000): banned the banned the regulation ofregulation of derivatives derivatives

2010:2010: Dodd-Frank Wall Street Reform & Consumer Protection ActDodd-Frank Wall Street Reform & Consumer Protection Act• Critics charge the bill is weak, and many provisions won’t take effect for yearsCritics charge the bill is weak, and many provisions won’t take effect for years• Bill does not fundamentally address incentive structures that promote risk taking Bill does not fundamentally address incentive structures that promote risk taking

or Too Big To Fail (TBTF) -- systemic riskor Too Big To Fail (TBTF) -- systemic risk TARP (aka the bank bail-out) made big banks biggerTARP (aka the bank bail-out) made big banks bigger

66

Arguments for separating Arguments for separating commercial & investment bankingcommercial & investment banking

Conflicts of interest characterize the granting of credit Conflicts of interest characterize the granting of credit (lending) and the use of credit (investing) by the same (lending) and the use of credit (investing) by the same entityentity

Depository institutions possess enormous financial power, Depository institutions possess enormous financial power, by virtue of their control of other people’s money (O-P-M), by virtue of their control of other people’s money (O-P-M), must be limited to ensure soundness and competition in the must be limited to ensure soundness and competition in the market for funds (loans or investments)market for funds (loans or investments)

Securities activities can be risky, leading to enormous Securities activities can be risky, leading to enormous losses, which could threaten the integrity of depositslosses, which could threaten the integrity of deposits• In turn, the Government insures deposits and could be In turn, the Government insures deposits and could be

required to pay large sums if depository institutions were to required to pay large sums if depository institutions were to collapse as the result of securities lossescollapse as the result of securities losses

Depository institutions are supposed to be managed to limit Depository institutions are supposed to be managed to limit risk, so managers may not be conditioned to operate risk, so managers may not be conditioned to operate prudently in more speculative securities businessesprudently in more speculative securities businesses

(http://digital.library.unt.edu/govdocs/crs/permalink/meta-crs-9065:1)(http://digital.library.unt.edu/govdocs/crs/permalink/meta-crs-9065:1)

7

““Why We Have to Change Why We Have to Change Capitalism”Capitalism”

Joseph Stiglitz, Excerpted from Joseph Stiglitz, Excerpted from Freefall: Free Markets and the Freefall: Free Markets and the Sinking of the Global EconomySinking of the Global Economy, ,

20102010

88

The Great Recession that began in The Great Recession that began in America in 2008 soon turned globalAmerica in 2008 soon turned global Millions of Americans lost their Millions of Americans lost their

homes & jobshomes & jobs Many more saw their retirement and Many more saw their retirement and

education investments dwindle in education investments dwindle in valuevalue

Soon tens of millions lost their jobs Soon tens of millions lost their jobs worldwideworldwide• 20m in China alone20m in China alone

99

Economic bubblesEconomic bubbles

economic bubbleeconomic bubble: buying and selling in : buying and selling in high volumes in assets with inflated values high volumes in assets with inflated values (i.e., at prices far in excess of intrinsic (i.e., at prices far in excess of intrinsic values). Sometimes called speculative values). Sometimes called speculative bubbles, they are typically the result of a bubbles, they are typically the result of a "bandwagon effect," where investors, "bandwagon effect," where investors, seeing an upward trend in prices, quickly seeing an upward trend in prices, quickly enter the market; typically, bubbles are enter the market; typically, bubbles are followed by even faster sell-offs once followed by even faster sell-offs once prices decline.prices decline.

1010

Boom-bust cycleBoom-bust cycle Boom-bust cycleBoom-bust cycle: a pattern of performance over : a pattern of performance over

time in an economy or an industry that alternates time in an economy or an industry that alternates between extremes of rapid growth (booms) and between extremes of rapid growth (booms) and extremes of slow growth or decline (busts), as extremes of slow growth or decline (busts), as opposed to sustained steady growth, extreme opposed to sustained steady growth, extreme form of business cycleform of business cycle

Examples of "Booms & Busts":Examples of "Booms & Busts":• Holland's Tulip mania in the 1630sHolland's Tulip mania in the 1630s• California Gold Rush of the late 1840sCalifornia Gold Rush of the late 1840s• Roaring Twenties that led to Wall Street Crash of 1929Roaring Twenties that led to Wall Street Crash of 1929• Dot-com bubble in the late 1990sDot-com bubble in the late 1990s• Subprime lending boom in the 1990s and early 2000s, Subprime lending boom in the 1990s and early 2000s,

followed by the Subprime Mortgage Crisis of 2006 and followed by the Subprime Mortgage Crisis of 2006 and beyondbeyond

1111

Housing bubblesHousing bubbles In late stages, characterized by:In late stages, characterized by:

• rapid increases in valuations of real property until rapid increases in valuations of real property until unsustainable levels are reached (relative to incomes, unsustainable levels are reached (relative to incomes, price-to-rent ratios, and other indicators of affordability)price-to-rent ratios, and other indicators of affordability)

• reduction in price levels reduction in price levels • falling home prices put many owners "underwater," in a falling home prices put many owners "underwater," in a

position of negative equity (a mortgage debt higher than position of negative equity (a mortgage debt higher than the value of the property)the value of the property)

US Housing Bubble:US Housing Bubble:• At national level in the US, housing prices peaked in At national level in the US, housing prices peaked in

early 2005, and started to decline in 2006early 2005, and started to decline in 2006• Underlying causes are complex; factors include Underlying causes are complex; factors include

historically low interest rates, lax lending standards historically low interest rates, lax lending standards (including predatory lending), and a speculative fever(including predatory lending), and a speculative fever

1212

Current crisis has uncovered deep flaws in Current crisis has uncovered deep flaws in capitalist system, esp. American-style capitalismcapitalist system, esp. American-style capitalism

Even incomes in the middle have Even incomes in the middle have stagnated for at least a decade stagnated for at least a decade

Increasing income/wealth inequalityIncreasing income/wealth inequality Declining social mobilityDeclining social mobility

statistical chances of a poor American making statistical chances of a poor American making it to the top are lower than in “Old Europe”it to the top are lower than in “Old Europe”

1313

Rugged individualism & market fundamentalism Rugged individualism & market fundamentalism have undermined community and trusthave undermined community and trust

Even in a market economy, Even in a market economy, trusttrust is is the grease that makes society the grease that makes society functionfunction

Big lesson of the crisis is that our Big lesson of the crisis is that our complex financial system still complex financial system still depends on trust – when trust broke depends on trust – when trust broke down, financial system frozedown, financial system froze

1414

Excessive risk-taking in the financial Excessive risk-taking in the financial sector caused the crisis. Solution?sector caused the crisis. Solution?

Reinstitute regulations & change Reinstitute regulations & change incentive structures that reward incentive structures that reward excessive risk-takingexcessive risk-taking• reinstitute Glass-Steagall reinstitute Glass-Steagall (some version of it)(some version of it)

Increase transparencyIncrease transparency Increase capital requirements for Increase capital requirements for

banksbanks Overall: reduce leverage & place Overall: reduce leverage & place

restrictions on risky productsrestrictions on risky products

1515

But US response–NSA bail-outs–But US response–NSA bail-outs–was shaped by same political was shaped by same political

forces that caused crisis forces that caused crisis revolving doorrevolving door: movement of personnel : movement of personnel

between roles as legislators and regulators between roles as legislators and regulators (of industries personnel had previously (of industries personnel had previously legislated on)legislated on)• can lead to “can lead to “regulatory capture”regulatory capture”

moral hazard,moral hazard, or or the adverse incentives the adverse incentives provided by bail-outs & expectations of provided by bail-outs & expectations of bail-outs, has only increasedbail-outs, has only increased

1616

Too Big To Jail?Too Big To Jail?America’sTheft Inflection Point?America’sTheft Inflection Point?

(www.Firedoglake.com)