|Date||May 26, 2009|
|Speaker||Franklin ALLEN(Nippon Life Professor of Finance and Economics, The Wharton School of the University of Pennsylvania)|
|Moderator||SUGA Chizuru(Deputy Director, Trade and Investment Facilitation Division, Trade and Economic Cooperation Bureau, METI)|
A question remains as to what caused the current crisis. Conventional wisdom says that the crisis was caused by bad incentives in the mortgage industry. The change to the "originate and distribute" model in the last decade led to the securitization of mortgages. The investment banks and other sponsoring entities for the securitizations would hold onto junior tranches so that they would bear the losses if there were any problems. This gave the sponsoring entities incentives to make sure that originators were properly screening mortgage candidates. As time progressed, all of the tranches were sold off and rating agencies began drawing large portions of their income from entities that were carrying out this securitization, thus taking away any incentives to oversee the mortgage practices of originators.
The original view holds that there were bad incentives in the mortgage industry leading to a large amount of bad debt being underwritten. This view lends itself to the problem being limited to subprime mortgages. However, with the collapse of Lehman Brothers came a collapse in the real economy that spread around the world. The severity of the real effects of the crisis can be seen even in countries with relatively healthy banking systems. Today, more people recognize that the subprime mortgage problem was more of a symptom than a cause.
The main problem was that there was a bubble, first with stock prices and then in property prices. The monetary policies of central banks, the U.S. Federal Reserve Bank (the Fed) in particular, were much too loose. In the United States, low interest rates coincided with continuously increasing house prices, creating a situation where one could borrow at 1% and invest in property at 3%. Additionally, tax incentives made mortgages more attractive than renting. This system caused home prices to increase more than inflation and even interest rate increases could not stymie the home-buying boom. This, however, does not provide a complete explanation because many other countries had price bubbles. The housing booms in Spain and Ireland are interesting examples because the European Central Bank (ECB) did not have a low interest rate policy like the Fed.
Global imbalances were another factor. In the Asian Financial Crisis of 1997, strong Asian economies like Thailand and South Korea got into trouble because they borrowed too much in foreign currency. In helping them with their balance of payments problems, the IMF imposed increased interest rates and lower government expenditures on these Asian economies, the exact opposite of what the U.S. and Europe have done when faced with a crisis. Because the IMF is dominated by Americans and Europeans, the Asian economies had no formal or informal way to explain to the IMF that their policies were not appropriate for economies that were as strong as they were. Learning from the IMF's austere treatment of their economies, Asian countries began amassing large reserves in their central banks. Asian economies found that it was difficult to invest these funds in anything but debt securities. This contributed to the surplus of funds worldwide, making it easier for people around the world to borrow money.
The huge GDP drops seen around the world can be explained by the fact that people, particularly in the U.S., made decisions based on the wrong asset prices for more than a decade. People in the U.S. concluded that since stock and housing prices would continue to increase, having a stock portfolio and a home would negate the need to save. The savings rate in the U.S. dropped to zero as a result. When the bubble burst, assets that people were depending upon to see them through old age were no longer sufficient.
Price volatility is the main problem in the real economy because nobody knows what the prices are to allow them to make decisions. Now that the bubble has burst, it is very unclear what the correct prices of stocks, property and commodities will be going forward. This is causing confusion determining how much people should save. The 1930s was the last period that was characterized by enormous volatility in prices. Oil prices are a prime example of price volatility affecting spending and saving patterns as consumers do not know what kind of car to buy in preparation for future gas prices. Exchange rate volatility is also making long-term decisions for firms difficult because there is no telling where prices will end up.
The crisis has created a credit risk problem with governments making guarantees, though governments have now become the risk. Two primary problems exist: the bursting of the bubble and problems in the financial system. These two problems feed back and forth on each other.
The question remains as to why the financial sector, a heavily regulated sector in all economies, has performed so badly. Banking regulation has, by and large, been accomplished on a historic basis by protecting against the specific issues that caused past problems. Banking regulation is different from other kinds of regulation in that there is no wide agreement on the market failures it is designed to correct. Regulations look as though they were designed to stop rogue banks, being designed on an individual bank basis. There is no notion of systemic risk that underlies the problem.
Bank regulation comes with certain costs and benefits. Benefits include stopping banking crises, as the lack of banking crises for the first 20 years of the post-war period attests to. Heavy regulations shielding banks from risk ended up being seen as hampering the banking system from performing its basic task of allocating resources across different industries and playing the invisible hand of the market. From the 1970s onward, financial liberalization took place and crises soon returned.
There is lack of agreement on what the market failures are in the banking system that regulations should strive to correct. The Basel agreements highlight this with their lack of clear and concrete reasoning behind the regulations. There are three primary failures of the banking system. The first is inefficient liquidity provision. Private markets do not do a good job of providing liquidity because holding liquidity is costly. Central banks thus scramble to provide liquidity with various ill-designed plans and thus exacerbate the problem. The second is mispricing of assets. The basic concept of people stepping in to drive prices up or down depending on whether they are under or overpriced has broken down. Prices of triple-A rated tranches fell and investment banks doubled-up on them, which caused drops in prices and bigger losses. Such tranches' prices are still not known for sure.
The third and most serious market failure is contagion. Contagion is represented by the Fed stepping in to help J.P. Morgan buy Bear Stearns. It was thought that Bear Stearns' bankruptcy would have created a domino effect of bankruptcies due to how connected Bear Stearns was with so many other firms. Even though the Fed did not have enough time to assess exactly how interconnected Bear Stearns actually was, it did not want to take the risk and decided to save it. Over the next six months, Fed teams were sent to other investment banks to assess what position they were in. When Lehman Brothers failed, the government believed that there was no contagion risk. However, the Lehman failure ended up causing huge ripples in the economy because contagion was more complex than was previously thought.
Central banks and governments hold too much to old views of what the crisis is about. There is a problem in believing that the crisis is primarily a problem of the banking system. In cases where lending is not happening, it is never clear which side of the market is causing the problem. In this case, both sides were probably important, which led to the problems in the inter-bank markets. Most consumers and firms who have the choice are averse to borrowing.
The government is not doing the right thing by initially purchasing preferred stock and thus providing a de facto debt guarantee. The government has no control and the banks know they have a blank check to do what they want. The government needs to temporarily nationalize large banks like Citigroup and Bank of America, and then break them up and sell them off.
The real problem of the bubble bursting is that price adjustment takes a long time. It could take between two and three years for prices to adjust completely in the U.S. Current government policies will have little effect on this problem and may, in fact, exacerbate it.
One factor that has not received much attention in the crisis but is very important for macroeconomic stability is corporate governance. Japan and Germany have had large GDP drops but their unemployment rates have been affected much less than other countries. Unemployment in the U.S. has increased steadily while Germany has increased nominally and Japan has remained relatively stable. The fear of unemployment in the U.S. causes people to reduce spending and save more, though fear of unemployment is not as much of a problem in France, Germany and Japan. One explanation of these differing employment trends is variations in corporate governance.
In a survey of managers, it was discovered that manager in Japan, Germany and France believed that the company exists more for the interests of all stakeholders while in the U.S. and Britain, the interests of shareholders take precedence. Likewise, managers in Japan, Germany and France believe that job security was more important than dividends, while in the U.S. and Britain the opposite is true.
Workforce reductions among sectors that have been particularly hard hit by the crisis in the U.S. have been significantly larger than in Japan, Germany or France. Even with the bad year that 2008 was, more firms in the U.S. increased dividends rather than cut them, whereas Germany saw a dramatic rise in the number of firms that cut dividends in 2006-2008.
Regarding employment reduction methods, Germany and France mix firing, buyouts and non-replacements; Japan has large numbers of temporary worker terminations; and U.S. firms engage in firings and buyouts to reduce headcounts. In regards to where firings have been taking place, none of the Japanese, German or French firms surveyed reduced employment in their home countries, but U.S. headcounts were cut back substantially among by companies from all four countries. In this way, the U.S. has become the dumping ground of unemployment. Additionally, it was found across the board that firms with employee directors generally did not fire as much as firms without employee directors.
The Anglo-Saxon system of firing people and pursuing shareholder interests is a great system when times are good. Throughout the 1990s in the U.S. it was a great system for reallocating resources. However, in bad times it is very good to have a stakeholder system. Globalization has led to the U.S. becoming a dumping ground for foreign firms' employment reduction efforts. A full evaluation of stakeholder governance is needed in order to further promote it.
Questions and Answers
Q: The price mechanism is relied upon for information and mark-to-market accounting is the best means of obtaining real time, fundamental data. The fundamentals underlying complicated securities or new innovations are very difficult to measure. Mark-to-market accounting tends to promote the general movements of the market, be they bullish or bearish. If the market is left to choose its path on its own, where it leads itself may not be the best place for it to end up. Downturns also need system management so the economy can emerge in a position with appropriate pricing. What would be a mechanism to foster this?
Most of the time markets are efficient and reflect fundamentals. In such situations, mark-to-market accounting works well. In times of crisis, there are limits put on arbitrage that prevent markets from being efficient and on mark?to-market pricing because it can be very damaging. This is the problem with toxic assets. Merrill Lynch was forced to sell originally triple-A rated securities for 22 cents on the dollar, which was not a fundamental price and thus it did not make sense for others to mark their triple-A rated assets at the same price. In such cases, mark-to-market accounting has to be suspended, which is what the U.S. government has done.
The Geithner plan is unlikely to work because banks are terrified that if they start participating and selling such assets, the market price may be lower than what they currently have them recorded for on their books. Banks should be required to provide market prices, model prices and historic cost accounting. Model prices deviating from market prices in a wide range of institutions could signal that mark-to-market accounting is not working properly. At the same time, historic costs come with the danger of getting locked in that system, as is what happened in the savings and loan crisis in the U.S.
Regarding the time it takes for prices to adjust, the time it takes real estate prices to adjust is problematic. This is one of the reasons why the government should temporarily nationalize the banks that have problems. It would allow the government to regain control of the financial system and provide people with much better information on the risks they face. At the same time, banks that fail need to be scaled-back and liquidated to avoid moral hazard problems. The Japanese government dealt with its banking problems better than the Americans are now.
Q: Regarding the relationship between corporate governance and the macroeconomy, do you see the corporate governance system of each country as an exogenous factor, or is there a possibility for firms or the system as a whole to change the governance system when facing an economic crisis? Given the 10-15 years you predict is needed to recover, do you see any chances for firms to change the system?
In Europe, this may happen because, for example, a German company that wants to incorporate a more Anglo-Saxon system can relocate to the United Kingdom, much like Air Berlin. Another thing that can be done is to become a European company, which allows a different way for a firm to choose its board system. Although this choice is available, not many companies are changing. At the moment, these factors are exogenous. As time goes on, however, it may become more of an endogenous point.
Q: In the 1980s, there were many arguments that the Japanese corporate governance system had to change. However, the statistics shown in the presentation prove that the system has not changed very much. What obstacle do you see in the way of this change?
Over time, the dividends-versus-employment survey shows very stable results in Japan. The existence of firms to supply stable employment is a deeply seated cultural norm in Japan.
Q: It is quite interesting to see the unemployment rate and the shock of the financial crisis. What do you think about the low unemployment rate and the large shock to the Japanese economy in the financial crisis?
There is definitely a relation given the size of the shock, but firms are concerned with retaining regular workers. Instead, temporary and overseas workers are being let go.
Q: My view is slightly different. The 4% drop in GDP was caused primarily by foreign markets due to the financial crisis in the U.S. and emerging markets. The shock affected Japan differently than Anglo-Saxon countries as employment adjustment is much slower. Right now, in spite of a declining GDP and GDE, unemployment is still low. The next stage is still not clear and whether retaining this unemployment rate will have a good or bad effect is also unclear.
Due to the stakeholder model of the Japanese economy, employment adjustment is slower than in the U.S. However, this adjustment process allowed Japanese firms to retain firm-specific skills and organization-specific assets, thus turning it into a competitive edge for the Japanese economy in the 1980s. Do you foresee a similar story playing out in the U.S.?
While the adjustment may be slower, the same kind of adjustment may not happen. The real unemployment level in the U.S. is much higher than the reported level, and even if Japan changes to a more Anglo-Saxon system, it is unlikely that Japan will see that kind of unemployment.
Q: My sense is that one side effect of keeping the unemployment rate low is that it props up the consumption level. Additionally, since the banking crisis of 1997, the Japanese economy's system diversified rapidly while the national characteristics of the Japanese economy still remain. What is unique right now in Japan is the combination of lifetime employment and temporary workers. There is currently a debate on the position of temporary workers and inequality in society. On the other hand, however, Japanese firms will be able to compete because of these temporary workers.
You listed the main causes of the financial crisis as the burst of the bubble. However, this is not the first bubble to burst in the U.S. There were bubbles bursting in the 1980s and 1990s. Why couldn't the U.S. learn from the mistakes it made in past bubbles?
What is different in the U.S. is that it has not had a truly nationwide fall in property prices since the Great Depression. One of the most interesting facts is that when looking at the data and analysis which is used to evaluate mortgage securities, the Asian experience was never looked at. Most Asian countries have had property price bubbles at some point in the last 20-30 years. The U.S. did not think it could happen and did not consider it a danger at all. Bubbles in the stock market are very different and do not do nearly as much damage as property bubbles because the way people hold equities is different from how people hold debt securities due to the fixed promises they represent in the financial system. Usually equity securities are not held against fixed promises, which is the big difference.
Q: The Japanese GDP decreased more than the U.S. GDP, though the U.S. is more likely to use redundancy as a method of cutting back its workforce. You mentioned that with unemployment fears comes a drop in consumption. How do you explain the drop in the Japanese GDP even though Japanese people are unlikely to have such unemployment fears?
It is related to the Japanese economy being very export oriented, with the most valuable exports dropping due to the economic fears abroad. Japanese consumption is actually doing better than U.S. consumption because of the U.S. fear of unemployment.
Q: The export component of the Japanese economy is only 10%. With such a small number, do you think a drop in exports could have such a severe effect on the economy?
The hit on world trade has been so big that its effect on the economy is huge.
Q: Regarding the financial situation, governments at the G20 summit in April presented many tools and policies. After this G20 package, what is the next step you would like to see the Japanese government take?
The G20 did not achieve much although much was announced. One of the things talked about was reform of the IMF, but that is not going to happen. While this does not happen, there will be huge balances in Asia causing a global imbalance problem.
As for the next step for the Japanese government, stimulus is not a good idea. It wastes money and creates debt for future generations. The Japanese government is spending too much money on stimulus.
Q: What do you feel about the activities of the ECB? The ECB is functionally limited as it can only manipulate interest rates; it has no direct control over liquidity or the credit system.
The Fed should have bought structured finance products much earlier than it did, because just after the bubble burst the asset-backed CP market dried up and the Fed did not buy any CP or asset-backed securities. The Fed probably made a mistake in the timing of the use of its market facility. What are your views on this matter?
The ECB has big problems in a crisis. It is interesting that it controls the interest rate but it has no fiscal responsibility. The ECB had a long policy of taking low-quality collateral, which has started to default. This is impacting its ability to take losses and forcing it to draw funds from its member states. As the crisis moves forward, the ECB will have to confront widely recognizable problems that will spur governance reform.
As for the Fed, it most certainly should have bought up those assets earlier. If it had done so last fall it would have been much better, but it is too late now.
Q: Corporate governance is very important, though national governance may be another important aspect. Comparing the Chinese and Japanese systems, China seems to be doing well in the short run. This is somewhat similar to Germany's performance during the Great Depression. What is your opinion on China's economic performance? What do you see in the long run?
Further, you mentioned that the U.S. is the dumping ground for the unemployment of multinationals. However, many Chinese small and medium-sized enterprises lost workers, but it looks like Chinese employment is coming back quicker than the U.S.
China has an advantage because the government already owns the banks, thus negating the need to nationalize. The top three banks in the world are all Chinese. There is enormous amount of control that the Chinese government holds over the economy, and this is precisely the time when that is a good thing.
In addition, the Chinese SME sector is very powerful and has driven a large part of that country's growth. Although the sector is not doing very well now, the Chinese government will most likely switch from being export-oriented to being much more internally driven. Like Japan, China's exports account for only a small percentage of GDP, making it relatively easy for the economy to become more inward-looking to maintain growth. China will do well in the long run. In the very long run, governance is an issue, though there does not seem to be much desire for democracy in China. India seems to have the best prospects in the very long run.
*This summary was compiled by RIETI Editorial staff.