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paraphrase.docxWhy there is a problem
As long as investors understand what is going on and such activities do not pose undue risk to the financial system, there is nothing inherently shadowy about obtaining funds from various investors who might want their money back within a short period and investing those funds in assets with longer-term maturities. Problems arose during the recent global financial crisis, however, when investors became skittish about what those longer-term assets were really worth and many decided to withdraw their funds at once. To repay these investors, shadow banks had to sell assets. These “fire sales” generally reduced the value of those assets, forcing other shadow banking entities (and some banks) with similar assets to reduce the value of those assets on their books to reflect the lower market price, creating further uncertainty about their health. At the peak of the crisis, so many investors withdrew or would not roll over (reinvest) their funds that many financial institutions—banks and nonbanks—ran into serious difficulty.
Had this taken place outside the banking system, it could possibly have been isolated and those entities could have been closed in an orderly manner. But real banks were caught in the shadows, too. Some shadow banks were controlled by commercial banks and for reputational reasons were salvaged by their stronger bank parent. In other cases, the connections were at arm’s length, but because shadow banks had to withdraw from other markets—including those in which banks sold commercial paper and other short-term debt—these sources of funding to banks were also impaired. And because there was so little transparency, it often was unclear who owed (or would owe later) what to whom.
In short, the shadow banking entities were characterized by a lack of disclosure and information about the value of their assets (or sometimes even what the assets were); opaque governance and ownership structures between banks and shadow banks; little regulatory or supervisory oversight of the type associated with traditional banks; virtually no loss-absorbing capital or cash for redemptions; and a lack of access to formal liquidity support to help prevent fire sales.
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Output Loss
The $6 trillion to $14 trillion base estimate of lost output following the crisis depends on assumptions about the economy’s trend rate of growth and whether an oil-price shock in 2008 might have caused a mild recession anyway.[3] This estimate of the aggregate cost of the crisis covers 2008 to 2023, when output is assumed to fully return to trend. Ultimately, there is no way to know for sure what path output would have followed or even if the financial crisis caused the output drop. The standard assumption is that trend growth would have continued at a pace similar to that in the preceding period. From 1984 to 2007—a period often referred to as the Great Moderation due to its relative economic and price stability—the average annual growth rate of gross domestic product (GDP) per capita was 2.1 percent.
Conceivably, historically high crude oil prices were partly responsible for the contraction that followed, and trend growth overstates what output would have been. The cause of the oil shock, however, may be inseparable from the roots of the financial crisis. A global-imbalances narrative posits that an influx of overseas demand for U.S. financial assets fueled an unsustainable creation of structured credit products (financial instruments such as mortgage-backed securities) that pushed real (inflation adjusted) interest rates lower. This connection between financial flows and various hard-asset commodity prices—including the crude oil price spike—sowed seeds of instability in 2007–2008.
EnlargeThe estimated gap between what GDP would have been absent the financial crisis and realized GDP is shown in Chart 2. The graphic also captures the possibility that an oil-shock recession would have occurred regardless of the crisis.
The forecast (represented by the red line in Chart 2) provides a reasonable middle ground between the extremely unlikely, immediate return to trend and the uncertain, perpetual output loss implied by a continued modest pace of economic growth (represented by the blue line in Chart 2). In addition to impacting the amount of U.S. goods and services produced, the 2007–09 bust triggered (or is at least associated with) a worldwide downturn. A similar output-loss exercise for world GDP excluding the U.S. results in an estimated $8.1 trillion loss just through year-end 2012.
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THE COST OF REDUCED WEALTH
The crisis wiped out an enormous amount of financial wealth. Household net worth in the U.S. fell $16 trillion, or 24 percent, from third quarter 2007 to first quarter 2009. This steep reduction in accumulated savings shook household confidence. However, a more appropriate measure of how much harm was done to households is the loss of total wealth, which includes human capital. The permanent income hypothesis proposed by Friedman (1957) states that the decision of how much to consume in a given period is not based on income in that period but on the average present value of
expected income over one’s remaining lifetime. Hall (1978) demonstrates that consumption should thus follow a “random walk with drift,” and any movements in consumption above or below its average growth rate reflect a revision to households expected permanent income. Durable goods, which continue to be consumed beyond the initial period in which they were purchased and therefore share characteristics with investment, are excluded from consumption to try to isolate the change in permanent income. Over 1974ñ2007, consumption of nondurables and services per working-age adult grew at an average annual rate of 1.7 percent. From year-end 2007 to year-end 2009, it fell 3.4 percent. Consumption has grown at an average annual rate of only 1.2 percent since- it is 8.4 percent below where it would have been if it had kept growing at its historical average (Figure 5 ). According to the permanent income hypothesis, this $5,000 reduction per working-age adult, scaled up to also account for consumption
Of durable goods, represents a large downward revision of households’ expectations of their lifetime income and can be used as a measure of the cost of the crisis that does not rely on forecasts or estimates of trend output growth.
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THE UNINTENDED CONSEQUENCES OF GOVERNMENT INTERVENTION
Policy Response
The Treasury Department, Federal Deposit Insurance Corp., and Federal Reserve took unprecedented actions to stem a panic that hit financial markets, creating spillover to the real economy. These actions helped break an adverse feedback loop of financial system dysfunction and sought to address the subsequent recession. Further, monetary easing in many economies around the world helped lower interest rate and liquidity constraints in an attempt to encourage economic activity and bolster asset prices. However, these actions also carry potentially negative unintended consequences that could offset many intended benefits. The degree to which the costs of the policies’ unintended consequences should be attributed to the crisis
isn’t obvious. We take the approach that aggressive countercyclical public policies would not have been implemented if not for the crisis and thus consider their unintended consequences to be largely attributable to the crisis.
COSTS OF THE CRISIS HAMPER AN ECONOMIC COMEBACK
The 2007-09 financial crisis cost the U.S. economy at least 40 to 90 percent of one year’s total goods and services. The estimate depends on what growth would otherwise have been and what it will be in the future. A more comprehensive evaluation of other factors suggests the costs and consequences of the crisis are even greater. Thus, the 40 to 90 percent of one year’s output is the bottom-line estimate of the total cost of the crisis. The output loss in other countries due to the financial crisis could easily match the U.S. output loss. We assume output will return to its prerecession path, but there is some evidence that financial crises lower the level of potential output, further extending the losses. A downshift in consumption due to the crisis could reflect a large downward revision to household expectations of lifetime income, implying a loss of one or two years of output. This may overstate the loss if consumption was pushed unsustainably high in the boom and the fall was partially driven by temporary damage to credit markets. However, even these hefty estimates ignore the intangible costs beyond lost income. A stark legacy of the recession is extended unemployment a lackluster labor market that is associated with deterioration in mental and physical health, including reduced subjective well-being among both the unemployed and employed. Subtly, but still significantly, the crisis also started the nation down a path of government intervention aimed at stemming and reversing damage from the crisis and preventing the occurrence of similar episodes. These actions may have been successful and worth the allocation of taxpayer funds, but they came with a related cost that would not have been incurred without the crisis. Perhaps most important though harder to quantify the government and affiliates such as the Federal Reserve have likely seen their ability to respond to future downturns impaired. The narrowest and most easily quantifiable cost of the crisis is large, and the consequences are vast. Given our range of estimates, the tepid economic recovery, and the litany of other adverse effects stemming from the Second Great Contraction, we suggest that the total domestic cost is likely greater than the equivalent of an entire year’s output. Thus, it is crucial to identify the primary causes and implement effective policy to avoid future episodes whose magnitude could exceed even the staggering costs and consequences of the most recent financial crisis.
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He Role of Short-Termism in the Financial Crisis
At this point, you may be asking what all of this has to do with the financial crisis. The answer is: plenty.
As has been the case with most previous crises, a central cause of this crisis was excessive debt and leverage across our financial system. In the decade leading up to 2006, when U.S. home prices reached their peak, total U.S. mortgage debt increased by 180 percent, and average U.S. home prices rose by almost 190 percent. Rising home prices prompted mortgage lenders to focus on temporarily inflated collateral values, while they relaxed underwriting standards that traditionally ensured that the borrower could repay the loan over time.
Most of the subprime loans made at the height of the boom imposed a large upward adjustment in the interest rate and monthly payment after two or three years, frequently making the loans unaffordable. As long as home prices kept rising, these borrowers could usually refinance. But after prices leveled off, and then began falling, subprime borrowers defaulted in record numbers.
Meanwhile, financial institutions frequently sought to maximize their balance-sheet leverage. They could sometimes move assets to shadowy off-balance-sheet structures where regulation and capital requirements were less stringent. That strategy worked brilliantly until the eventual collapse of investor confidence and market liquidity forced these assets back onto the balance sheet, where there was not enough capital on hand to support them.
Leading financial companies proved adept at creating innovative new loan structures and funding strategies in the years leading up to the crisis. But all too often these innovations left participants with badly misaligned economic incentives. The compensation of loan officers, portfolio managers and bank CEOs was typically based on current-year loan volume, earnings or stock price, with little regard for the risks that were building up in the system.
Most damaging of all, some of the largest and most complex financial companies were made exempt from the discipline of the marketplace because their size, complexity, and interconnectedness made them Too Big to Fail under the resolution processes in place at that time. The expectation that the largest financial companies enjoyed the implicit backing of the federal government allowed the managers of those companies to book short-term profits while ignoring the build-up of “tail risk” inherent in the complex mortgage instruments they held.
In the financial market chaos that followed the September 2008 bankruptcy of Lehman Brothers, the expectation of government support for systemically-important financial institutions, or SIFIs, became a reality. Government assistance to financial institutions took on a variety of forms, amounting to a total commitment of almost $14 trillion by the spring of 2009. [5] Direct assistance to the largest financial institutions eased the short-term crisis of confidence in the interbank market, and our financial system began to function again. But policymakers failed to effectively attack the root cause of the problem, which was the enormous backlog of unaffordable and underwater mortgage loans that continues to slow the recovery of our housing markets and our economy.
Bailouts result in a host of adverse consequences for our financial system over the long term. They undermine market discipline and promote risk-taking. They inhibit the restructuring of troubled financial companies and the recognition of losses. They keep substandard management in place and preserve a suboptimal allocation of capital. They are inherently unfair to well-run banks.
The bailouts of 2008 tainted the reputation of the entire banking industry and tilted the competitive balance in favor of some megabanks. In the first quarter of this year, the cost of funding earning assets was only about half as high for banks with more that $100 billion in assets as it was for community banks with assets under $1 billion. In the end, bailouts violate the principles of limited government on which our free-enterprise system is founded.
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The hemorrhaging of American jobs accelerated at a record pace at the end of 2008, bringing the year's total job losses to 2.6 million or the highest level in more than six decades.
A sobering U.S. Labor Department jobs report Friday showed the economy lost 524,000 jobs in December and 1.9 million in the year's final four months, after the credit crisis began in September.
The unemployment rate rose to 7.2% last month from 6.7% in November - its highest rate since January 1993. The steep annual drop in jobs marked the highest yearly job-loss total since 1945, the year in which World War II ended. "We're seeing a complete unraveling of the labor market and are on track for getting beyond 10% unemployment," said Lawrence Mishel, president of the Economic Policy Institute. The total number of unemployed Americans rose by 632,000 to 11.1 million. November, in which 584,000 jobs were lost, and December marked the first time in the 70-year history of the report in which the economy lost more than 500,000 jobs in consecutive months.
"We have a bigger economy now, but even on a proportional basis, the last months have been the worst since [1945]," said Kurt Karl, head of economic research at Swiss Re. "It's just an enormous acceleration of job losses."
By comparison, the 2.6 million jobs lost in 2008 nationwide were equal to the number of jobs found in states such as Wisconsin, Missouri or Maryland.
Under-employment at a record high
A growing number of workers seeking full-time jobs were able to find only part-time work. Those working part-time jobs - because they couldn't find full-time work, or their hours had been cut - jumped by 715,000 people to 8 million, the highest since such records were first kept in 1955.
The so-called under-employment rate, which counts those part-time workers as well as those without jobs who have become discouraged and stopped looking for work, rose to a record 13.5% from 12.6%. Calculations for that measure began in January 1994.
"The existing unemployment figures are greatly understated," said billionaire steel tycoon Wilbur Ross in a recent interview with CNNMoney.com. "They count as employed someone who used to have a high-paid manufacturing job, and now is working at a Wal-Mart or a Wendy's."
In another discouraging sign, the average hourly work week fell last month to 33.3 hours - the lowest level in history - from 33.5 hours. Even with a modest 5-cent gain in the average hourly salary, the average weekly paycheck fell by $2 to $611.39.
Job losses widespread
Job losses were spread across a wide variety of industries. Manufacturing lost 149,000 jobs, the leisure and hospitality industries cut 22,000 jobs, and the mining industry shed 1,000 positions.
Even in the midst of the holiday shopping season, retailers still slashed payrolls by 66,600 workers last month. Professional and business services jobs, a category seen by some economists as a proxy for overall economic activity, dropped by 113,000. And financial services jobs fell by 14,000.
Only two of ten industry categories were hiring last month. Government hiring, which has stayed relatively strong throughout the downturn, added another 7,000 jobs in December. Education and health services also grew payrolls by 45,000 employees.
Construction employment shrank further by 101,000 jobs, and the rate of construction unemployment soared to 15.3% - by far the highest of any group.
"Today's jobs report ... is conclusive evidence that it is time to put people back to work building America," said Terry O'Sullivan, general president of the Laborers' International Union of North America. "Now it's time for Congress to move to create jobs with the same urgency as they did on the $700 billion Wall Street bailout."
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