The subprime financial crisis: Reflections from a post-Keynesian viewpoint

The subprime financial crisis: Reflections from a

post-Keynesian viewpoint

Marc Lavoie

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Outline

• Some historical background

• A change of paradigm, in policy, in theory?

• Presuppositions in economic analysis

• Financialization

• Securitization

• A Minsky crisis? A new Great Depression?


Some recent historical background


A couple of years ago, hardly any economist knew about these terms

• ABS, MBS, RMBS, CMBS, ABCP, CDO, CDO2, CMO, CLO, CDS, EDS, SPE, SPV, SIV

• asset-backed securities, mortgage-backed securities, residential mortgage-backed securities, commercial mortgage-backed securities, asset-backed commercial paper, collaterized debt obligation, collaterized debt obligation squared,

• collaterized mortgage obligation, collaterized loan obligation, credit default swaps, equity default swaps, special purpose entity, special purpose vehicle, structured investment vehicle


Some warning signs

• 2005: High share of new mortgage loans that were subprime;

• 2006: Risky mortgage formula (interest only, 2/28, negative amortization)

• Mid 2006: US Real estate prices stop rising• Early 2007: the cost of insuring BBB

mortgage-backed securities against default losses rose briskly (MBX or ABX indices take a plunge)


Flow of US subprime mortgages


The real estate bubble bursts, first in the US (mid 2006) and then in the UK

U.S. AND U.K. HOME PRICES

-20

-15

-10

-5

0

5

10

15

20

25

30

2000 2001 2002 2003 2004 2005 2006 2007 2008

U.K. Nominal Average National Home Price

U.S. National Home Price Index S&P/Case Shiller

Y/Y percent change

Source: Moody's Economy, Nationwide Building Society


Falling values of MBX, the reverse of the cost of default insurance on MBS


The beginning of the end, all related to MBS

• August 2007: – confidence crisis: Near gridlock on the European interbank market;

• September 2007: – Bank run on Northern Rock; – AAA and BBB MBX indices plunge;

• March 2008: – Bear Stearns collapses and is bailed out;

• September 2008: – Freddie Mac, Fanny Mae; – Large Wall Street banks collapse and are bailed out, except for Lehman Brothers; – stock markets plunge;– Big commercial banks collapse in the US and Europe; – AIG is nationalized; – The entire Islandic banking system is nationalized.


Asset-backed short-term paper market in Canada shuts down in August 2007

-10

-8

-6

-4

-2

0

2

4

6

8

I II III IV I II III IV I II III IV I II III IV I II III IV

Other short-term paper liabilities, Issuers of asset-backed securities

billions of dollars

2004 2008 2007 2006 2005


Stock markets finally plunge for good in September 2008

U.S. AND CANADIAN STOCK MARKETS - 2008

800

900

1,000

1,100

1,200

1,300

1,400

1,500

1,600

Dec-26Oct-31Sep-5Jul-11May-16Mar-21Jan-25

8,000

9,000

10,000

11,000

12,000

13,000

14,000

15,000

16,000

S&P 500 (right)

S&P TSX (left)

Index, weekly closing price Index, weekly closing price

Source: Bloomberg

Bear Stearns TakeoverMar. 17

Lehman Bros. CollapseSep. 16


A change of policy paradigm ?


A second Keynesian pragmatic revolution

• In contrast to previous financial crises, the IMF advocates low interest rates and government stimulus packages with budget deficits;

• G20 leaders move away from unfettered markets and uncontrolled capitalism;

• Gordon Brown (UK): “The Washington consensus is out”;

• Financial Times: “The credit crunch has destroyed faith in the free market ideology”.

Click View then Header and Footer to change this textBrazilian Keynesian Association, Porto Alegre, September 2009

Is there also a second Keynesian academic revolution? A rather negative answer:

“These changes in ideology among world politicians create a different environment for economists. But as yet there are no strong shifts of opinion or practice among academic leaders of our profession. We search in vain for similar conversions or recantations. The signs are business as usual” (Hodgson, CJE 2009)


But there are indeed some academic leaders that reject current mainstream macro theory

• Willem H. Buiter 2009, LSE professor, former member of the Monetary Policy Committee of the Bank of England:

« The typical graduate macroeconomics and monetary economics training received at Anglo-American universities during the past 30 years or so [Lucas,Prescott, Sargent, Barro, Woodford], may have set back by decades serious investigations of aggregate economic behaviour and economic policy-relevant understanding. »

« Most of the profession continued to swallow the EMH [efficient market hypothesis] hook, line and sinker, although there were influential advocates of reason throughout, including James Tobin, Robert Shiller, George Akerlof, Hyman Minsky, Joseph Stiglitz and behaviourist approaches to finance. »


Two opposite views back in favour in the media

• Neo-Austrian theory (Hayek, von Mises), backed by new classical theory (Barro, John Taylor) at the forefront of the second counter-revolution;

• Post-Keynesian monetary theory (Galbraith, Minsky) at the forefront of the second Keynesian revolution;


The neo-Austrian view (not mine!) of the crisis in a nutshell• Government intervention and bad regulation are the causes of

the crisis. Free-market capitalism is essentially perfect and stable.– The US government would have forced banks to grant

subprime loans.– The Fed set short-term rates at too low a level (from 2002 to

2004).– The Chinese rigged the exchange rate and flooded long-

term bond markets, also leading to overly low long-term rates.

• There would be no crises if government was small and interest rates were always set at their natural levels.

• Expansionary fiscal policy and low interest rates will prolong the crisis, as it did in the 1930s.


The post-Keynesian view of the crisis in a nutshell• Western economies have moved towards a

financialization process over the last decades, with deregulation of the regulated financial system and growth of the unregulated financial system.

• The current regime of accumulation (based on low real wages and consumer debt) was unsustainable.

• Financial crises are an endogenous feature of unregulated capitalism.

• As a result, financial crises are ever more frequent and more severe.


Presuppositions in economics


Macro-economics

Heterodox authors

Neoclassical school

Marxists CambridgeKeynesians

OldKeynesians

Monetarists

New Keynesians

New Classicals

RadicalsFrench

RegulationSchool

Post-Keynesians

KEYNES


Mainstream economics

New Neoclassical Synthesis

New Consensus(DSGE)

New KeynesiansNew Classicals

Real business cyclesNeo-Austrians

(neo-Wicksellians)


Variety of Heterodox Keynesians

Heterodox Keynesians

Marxist Keynesians

French Regulation School

French Convention School

Cambridge Keynesians

Fundamentalist Keynesians

Institutionalist Keynesians


Presupposition Heterodox schools Mainstream or Neoclassical schools

Epistemology Realism Instrumentalism

Ontology/Method Holism, organicism, class analysis

Individualism

Rationality Reasonable rationality Hyper model-consistent rationality

Optimizing agent

Economic core Production, growth Exchange, scarcity

Political core Regulated markets Unfettered markets

Mathematical core Formalization is optional Formalization is a requirement

Presuppositions of the heterodox programme vs those of the mainstream (1989)


Example of instrumentalism

• The use of the parameters of the Cobb-Douglas function to estimate the production elasticities when we know that these parameters only estimate the shares of wages and profits.

• The use of the Gaussian copula function to estimate default correlation and thus the prices of CDO – the synthetic MBS. These were based on recent MBX prices, the prices of credit default swaps on MBS, on the assumption that markets price risk correctly, instead of being based on the default records of actual borrowers.

• For instrumentalists, “It is better to be precisely wrong than roughly right”.


Model-consistent vs reasonable rationality

• Model-consistent, rational, expectations– Agents know all contingencies– Agents all assume the same model– Agents can do the most complicated computations

• vs• Reasonable rationality

– Ecological rationality: simple rules– Reaction to a discrepancy wrt some norm– Traders, chartists, trends


Holism: Some crisis-related macro paradoxes

Paradox of thrift (Keynes) Higher saving rates lead to reduced output

Paradox of costs (Kalecki) Higher real wages lead to higher profit rates

Paradox of public deficits (Kalecki) Government deficits raise private profits

Paradox of debt (Steindl) Efforts to de-leverage might lead to higher leverage ratios

Paradox of tranquillity (Minsky) Stability is destabilizing

Paradox of liquidity (Nesvetailova) Efforts to become more liquid transform liquid assets into illiquid ones

Paradox of risk (Wojnilower) The possibility of individual risk cover leads to more risk overall


Tranquillity, liquidity, risk• As time goes on, the risk level as computed by

engineering models of finance (Value at Risk), appears to get smaller because the last recession is just one remote observation among a series of more recent successful years.

• A financial innovation that leads to both new ways to finance business and new substitutes for cash assets, decrease the volume of liquidity available to redeem the debts incurred …In the process of financial expansion the financial system contrary to appearances, becomes progressively illiquid” (Nesvetailova 2007)

• The “supposed immunity to financial risk always turns out to be illusory, and the risks and costs of shattering the illusion may be considerable” (Wojnilower 1980)


Scarcity vs abundance

• Credit is not a scarce resource:

“We may have as much, or as little, credit as we want: credit is created whenever we accept the liabilities of someone who desires more purchasing power” (Wray 1994)


Unfettered vs regulated markets

• “I have said that we fall into two main groups. What is it that makes the cleavage which thus divides us? On the one side are those who believe that the existing economic system is, in the long run, a self-adjusting system, through which creaks and groans and jerks, and interrupted by time lags, outside interferences and mistakes…. On the other side of the gulf are those who reject that idea that the existing economic system is, in any significant sense, self-adjusting. (Keynes speech 1934)


Financialization

Finance capitalism Stock-market capitalism Money manager capitalismRentier capitalism


Financialization: definition

• “Financialization means the increasing role of financial motives, financial markets, financial actors and financial institutions in the operation of the domestic and international economies” (Epstein 2006)


Financial institutions – stylized facts• The importance of the financial, insurance and real

estate sector has doubled– GDP share – Profits relative to those of non-financial

corporations – Profits of banks as a percentage of their total

assets– Compensation of employees in the financial sector

as a percentage of total compensation


Non-Financial corporations – stylized facts

• Non-financial corporations now hold as many financial assets as they hold tangible assets.

• Hence the interest and dividend income of non-financial corporations as a percentage of their gross value added had tripled.

• Non-financial corporations, that used to issue new equity to finance their investments, now often buy back their shares instead.

• Non-financial corporations now raise a larger proportion of their funds through bond issues.

• The interest payments of non-financial corporations as a percentage of their gross value added has quadrupled.

• The dividend payout ratio (as a percentage of their cash-flow) has doubled.


Distributional issues – stylized facts• The wage share of income has gone down.• The share of income going to rentiers has

risen.• Labour hourly productivity has grown much

faster than hourly earnings or even hourly total compensation of production and non-supervisory workers.

• There has been an incredible rise in the income share of the top centile.


Flow-of-funds – stylized facts

• The net accumulation of financial assets of corporations is positive, meaning that they lend their surpluses to households, with about half of these funds coming from financial corporations.

• The net accumulation of financial assets of households is negative, meaning that they borrow from corporations to pay for their consumption, financial and real estate investments.

• This has been made possible in particular by the use of margin debt – the borrowing of money, collaterized by equity in the stock market or equity in homes.


The net financial accumulation of Canadian households was negative 2000-7!

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Top Decile (10%) Income Share, USA, including capital gains (Saez 2009)


Top .01% Income Share, USA, including capital gains (Saez 2009)


Flow-of-funds – stylized facts

• The net accumulation of financial assets of corporations is positive, meaning that they lend their surpluses to households, with about half of these funds coming from financial corporations.

• The net accumulation of financial assets of households is negative, meaning that they borrow from corporations to pay for their consumption, financial and real estate investments.

• This has been made possible in particular by the use of margin debt – the borrowing of money, collaterized by equity in the stock market or equity in homes.


The net financial accumulation of Canadian households was negative 2000-2007 !

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Fordist regime of accumulation (1950-1975)• High real wages relative to labour productivity• Low real rates of interest• High investment expenditures• High public infrastructure expenditures


New regime – finance driven

• Low median real wages• High real interest rates and dividend

payments (for most of the period)• Rising debt to personal income ratios• High propensities to consume, based on

equity in the stock market and in real estate• The regime is not sustainable


Household debt to disposable income ratio, US and Canada

0

20

40

60

80

100

120

140

160

180

200

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Canada United States

debt / PDI

Source:

Canada

USA


Simulating current changes in financial flows


Effect of a one-time increase in the flow of gross household loans

to personal income


Effect of a one-time increase in the flow of gross household loans to personal income


Effect of a one-time decrease in the flow of gross household loans to personal income ratio, with a decrease in the propensity to consume out of personal income


2009: the worse of two worlds

• The real estate market crashed before these negative effects could really take effect.

• But now we have two negative effects operating at once on consumption:– The long-run negative effects of high household debt– The short-run negative effects of high saving rates, directly from

higher propensities to save, and indirectly from a lower propensity to take new debt


The boxed-in worker

Corporations

Finance

Globalization Environment

Central bank

Government


The boxing theories

• Environment: Global warming• Globalization: Comparative advantage (free trade),

financial deepening (free capital movements)• Government: Sound finance• Central bank: NAIRU, the neutrality of money• Corporations: Shareholder value, agency theory• Finance: Efficient market hypothesis


The corporate and finance lids of the box• Shareholder value and agency theory (stock

options) were supposed to take away the power of corporate managers and give it to small shareholders. Have they?

• Dividends out of profits are higher, but profits have been ransomed by CEOs

• Short-termism: take the money and run!


1/(1+)i1970s

G

R

Growth rate

Profit rate

Expansion frontier

Financefrontier

g1970s

i1990s

g1990s

r1990s

rmin

Shareholder governance with managerial surplus appropriation

Managerialsurplus

{


Securitization

The ‘originate and distribute’ model of banking


Securitized mortgages as a ratio of total mortgages, US and Canada

Mortgages securitzed as a % of total

0

0.1

0.2

0.3

0.4

0.5

0.6

Mortg Securitized US

Mortg Securitized Canada

1990-2008

USA

Canada

50%

25%


Two meanings to securitization

• First kind: bonds tied to the mortgage are issued on the liability side, but the bank keeps the loans on its books.– Often only conforming loans, insured by

some government agency• Second kind: the loans are removed from

the balance sheet of the bank– The bank may even decide to buy back the

securitized asset and take default insurance on it.


Securitization of the first kind

Asset Liability

Loan MBS

Bank


Securitization of the second kind

Assets Liabilities

Bank

Loans -100 Deposits -100

Special Purpose Entity

Loans + 100 MBS + 100

Investor

MBS +100

Deposits -100


The advantages of securitization and its derivatives, according to finance

• It reduces risk in the banking system• It makes the payment system immune to

insolvency• It spreads risk to those best able to handle it• It is a stabilizing factor• It diversifies the supply of assets• It reduces the cost of mortgages


The dangers of securitization

• Disconnects the risk of the defaulting borrower from the bank granting the loan.

• With deregulation, more fraud incentives (lender-induced liar loans)

• Creates a chain of self-serving agents getting bonuses (short-termism again):– Mortgage broker, property appraiser, loan

officer, securitizer, bond rater, lawyer, underwriter, CDS issuer, investment manager.


Credit default swaps according to Wojnilower 1984• “The recent entry of major insurance

companies into the business of insuring banks and bond investors against loan defaults represents another effort to stretch the safety net. Now it can be presumed, the authorities will have to intervene to interdict a cascading of defaults only if to save the insurance industry” (Wojnilower 1985, p. 356).


Securitization according to Minsky 1987• Securitization helps financial globalization• Securitization will lead to credit-enhancing

mathematical techniques (AAA yield rate at BBB yields)

• There will be “a thin market if price and quality of the securities deteriorate”

• “Securitization implies that there is no limit in creating credits for there is no recourse to bank capital”


Securitization suitable for a global financial structure

GROWTH IN FOREIGN HOLDINGS OF U.S. DOLLAR SECURITIES, 2003-2007*

0

50

100

150

200

250

300

350

400

Asset-backed securities Other Long-term Debt Equities

Average annual growth rate

*June-to-JuneSource: U.S. Treadury Department and TD Economics estimates


Securitization, globalization, and tax heavensSHARE OF U.S.-DOLLAR ORIGINATED MORTGAGE-

BACKED SECURITIES HELD ABROAD*

0 5 10 15 20 25

Remaining nations

Bermuda

China

Jersey

Belgium

Japan

Luxembourg

Germany

Netherlands

UK

Caymen Islands

Percent of total

*As of June 2008Source: Federal Reserve Bank of New York


Securitization of the second kind, and Basel II capital requirements

Assets Liabilities

Bank

Loans -100 Equity required -8.0

MBS +100 Equity required +1.6

Special Purpose Entity

Loans + 100 MBS + 100


Conclusions


Financial markets blew up on their own• This is not a true Minsky crisis.• In the Minsky crisis, the problem starts with

over-indebtedness of NF firms, and explodes because of rising interest rates.

• This was not really the case in 2007.• Both in 1929 and 2007, problems arose from

over-indebtedness of households, and, as in Japan, a meltdown of the real estate market and the equity market.


US non-financial corporation debt to equity ratio

Source: Wachovia Bank


Canadian non-financial corporation debt to equity ratio

Source: Statistics Canada, National Balance Sheet Accounts, 4th qtr 2008


Self-regulation does not work

• One needs tougher regulations on banks• Revamp Basel II, and backtrack towards Basel I• These regulations must be extended to all previously

unregulated financial sectors (off-balance sheets, investment banks, hedge funds, equity funds)

• Pay incentives have to be revamped, perhaps even eliminated

• Securitization of the second kind and CDS may need to be forbidden

• The role of central banks needs to be reconsidered (inflation vs financial stability)

• Fiscal policy must come back to the forefront

The subprime financial crisis: Reflections from a post-Keynesian viewpoint

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