International Think-Tank on Innovation and Competition
The Crisis
February 28, 2009
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This is a key year for the evolution of international markets. The global economy is experiencing the most severe downturn since the thirties, is temporarily leaving a path of sustained growth that characterized the last decades, and is facing a collapse of international trade between countries. Banks are going bankrupt, firms are exiting from markets or reducing their production, workers are being fired and investment in business creation is shrinking. Meanwhile, the stock market has crashed, consumers' confidence has dropped at its minimum and expansionary policies and international coordination have failed to counteract the crisis until now. It is quite likely that all this will change soon, but at the end of this crisis our understanding of the macroeconomy may change as well in a many ways.
The origin of the crisis derive from the impressive boom that the U.S. and global economy experienced during the 90s. However, it was in the middle of that boom that the problems started. Right at the core of the growing economy, the U.S. The American consumption boom went as far as to reach a rate of savings out of disposable income below 2% in 2000 and a rate of indebtedness out of disposable income at 140 %. While a similar extreme behavior could be rationalized on the basis of high growth expectations, it persisted when these expectations changed at the turn of the century (with the stock market crash first, and then with the terroristic attacks of September 11, 2001), and turned into a pathological incapacity to save, leading to serious imbalances. These can be summarized in three main critical consequences of the consumption boom: 1) the excessive imports of foreign goods maintained a large deficit in the foreign accounts, 2) the excessive borrowing in terms of easy mortgages put upward pressure on real estate prices, and 3) the excessive leverage of equity capital in the financial sector drugged stock market prices. Some commentators, led by Shiller (2005), have argued that the dot-com boom (peaking in 2000) and the real estate boom (peaking in 2006) could be explained only in part by structural factors, but also by cultural and psychological factors associated with a sort of "irrational exuberance". Whether a large part of these booms were "bubbles" or not, the American imbalances could only be corrected with a drastic depreciation of the Dollar, with the house price crash and with the financial crisis.
During 2008, the global economy has entered in its deepest economic recession since the Great Depression of 1929. Multiple factors have caused this crisis, including the rapid but temporary increase in the oil price during the first half of the year (a negative supply shock similar to those of the 70s, though shorter). However, there is a large consensus that the main source of the global recession was in the losses emerged from the subprime crisis associated with the bursting of the U.S. housing boom in 2006, and with the consequent stock market crash and the depression of consumer confidence (a negative demand shock similar to that of the Great Depression). What the debate is mainly about, however, is the mechanism that has propagated and deepened the crisis: is it revised expectations on future prosperity? or irrational depression? a collapse of consumer demand due to the wealth losses? a pure credit crunch? or bad or insufficient policy reactions? Before advancing our hypothesis, let us establish the facts.
For a decade before the real estate downturn in the U.S., loan incentives and a long-run trend of rising housing prices encouraged Americans to assume mortgages with the hope that they could refinance at more favorable terms later. However, once housing prices started to drop, refinancing became more difficult, and in front of a fall in prices by 25 % or more (especially in towns like Boston, Los Angeles or Miami), many borrowers ended up with negative equity, that is with a mortgage worth more than the house, and became insolvent. The number of borrowers in default kept increasing with the housing bust (and now with the crisis of the real economy), but the worst consequences were going to happen in the financial sector.
The so-called "subprime crisis" was exactly due to the high default rates on subprime and other adjustable rate mortgages made to higher-risk borrowers with lower income or worse credit history than prime borrowers. The market for subprime lending reached a fifth of total U.S. mortgage market. The potential losses in the event of a real estate downturn would have not been such a big problem if risks were properly taken into account by the mortgage brokers: this was not the case since they were able to repackage the returns on these mortgages, bundle them together and sell them in different slices to financial institutions, even under high ratings that had no relation with the underlying reality of the actual subprime mortgages. In a recent book on the role of animal spirits in driving the economy Akerlof and Shiller (2009) notice that, as long as housing prices kept increasing this was "an economic equilibrium that econmpassed the whole chain, from the buyers of the properties, to the originators of the mortgages, to the securitizers of the mortgages, to the rating agencies, and finally to the purchasers of the mortgage-backed securities. They each had their own motives. But those at the beginning of the chain - those who took on the mortgages and the houses they could not afford, and those who were the ultimate holders of the debt - were buying a modern form of snake oil."
The wide (and unregulated) diffusion of derivatives based on these risky assets spread the related losses throughout the American and international financial markets, with effects that were largely ignored by rating agencies and that emerged in their magnitude only later, gradually and everywhere. In February 2008 a highly leveraged British bank, Northern Rock, had to be nationalized because of its heavy liquidity problems which triggered a bank run. Since then, a number of American and European financial institutions that were widely engaged in the securitization of mortgages started facing similar problems. In March 2008, Bear Stearns had to be acquired by JP Morgan Chase with the assistance of the Fed. In July, one of the largest mortgage lenders in the U.S., IndyMac Bank, collapsed. In September 2008, the U.S. Government placed the huge mortgage lenders Fannie Mae and Freddie Mac into federal conservatorship and bought 80% of the major insurance company AIG. On September 15, 2008, the investment bank Lehman Brothers filed for Chapter 11 (the largest bankruptcy in U.S. history) after the Bush Administration refused to bail it out (probably to avoid further moral hazard problems). In the meantime, Merrill Lynch was acquired by Bank of America (and Wachovia by Wells Fargo) and the two remaining large investment banks, Goldman Sachs and Morgan Stanley, were converted to traditional banks, concluding the era of investment banking, and maybe also the Anglo-Saxon dominance of the global banking sector.
In the Fall 2008 the crisis entered an acute phase characterized by a stock market crash, the failure of prominent banks, efforts by American and European authorities to bailout distressed financial institutions, lack of confidence and further defaults. As Krugman (2008) has noticed, "the result of this self-reinforcing process was, in effect, a massive bank run that caused the shadow banking system to shrivel up, much as the conventional banking system did in the early 1930s. Auction-rate securities, in effect a banking sector providing $ 330 billion worth of credit, disappeared. Asset-backed commercial paper, another de facto banking sector, dropped from providing $ 1.2 trillion in credit to providing only $ 700 billion." The lack of confidence froze interbank lending worldwide and induced a substantial reduction of lending to firms. Subsequent announced and implemented nationalizations spread additional fear and lack of confidence in the markets and led to further stock market crashes at the beginning of 2009. Larry Summers, Director of the White House's National Economic Council, has calculated that worlwide wealth lost about $ 50 trillion in the last year and half, more or less two thirds of global GDP.
The Obama Administration is reacting to the crisis with an unprecedented expansionary fiscal policy and with a plan by the Treasury Secretary Tim Geithner to deal with the "toxic assets" that are clogging up bank balance sheets, while the Fed, led by the main academic expert of the Great Depression, Ben Bernanke, has implemented an equally unprecedented expansionary monetary policy. The rest of the Western world has followed a similar road adopting deficit spending and reducing drastically the interest rates. Meanwhile, the financial crisis has extended its disruptive impact from financial institutions to countries (in particular small European countries outside the E.U. or inside it but not in the Euroarea) whose financial accounts and currencies were (and will keep being) under heavy pressure, in particular Iceland, the Baltic Republics, Hungary, Bulgaria and Ukraine.
The melt down of stock market capitalizations reduced even more the incentives to invest and create new business activities. In the U.S., venture capital investment, a key source (and indicator) of innovation and business creation (amounting to 0.22% of American GDP in 2007), went down by a third in the last quarter of 2008 (compared to the previous year). Other traditional forms of investments in business creation collapsed as well, possibly limited by a credit crunch. This weakness of the investment process transmitted the financial crisis to the real economy. First, firms reduced their production levels, exhausted their inventories and stopped hiring new workers, then they started to close factories and fire workers. At the end of 2008, consumer demand in the Western world started decreasing as well, quickly for durable goods (as it always happens during recessions), and slowly for the other goods. In the last quarter of the year most Western countries were officially in recession. At the time of writing, estimates for 2009 GDP growth feature - 3/4 % for the U.S. and the Euro area and -5/6 % for Japan.
Markets have experienced two main phenomena. On one side investment has decreased, business creation and investments in innovation have been limited or postponed, many multi-brand firms have reduced the number of brands supplied on the market, other firms simply stopped exporting to selected countries, some others have merged or are trying to merge with direct competitors, and other firms have gone bankrupt. The consequent drop in net firms entry has led to a reduction in the number of firms or products within many sectors. On the other side, surviving firms have undergone a process of rationalization and job cuts. This process has been quite spectacular in certain global and highly concentrated sectors, starting with the automotive and electronic markets, where most of the leading manufacturers announced job cuts almost at the same time. But of course, it is in smaller and local markets that business destruction leads to substantial reductions in the number of active firms. Likewise, many suppliers of large companies (for instance in the automotive and electronic markets) and downstream firms go bankrupt as a consequence of the problems of the leading companies. This is going to increase the levels of concentration in many markets, allowing the remaining firms to exploit the only ways to cover the fixed costs of production in the presence of a smaller aggregate demand: first, by reducing the remuneration of labor and real wages when it is feasible, or by reducing employment otherwise, and, second, by gradually increasing their mark ups.
The recession is generating a reduction of labor income (in absolute and as a share of total income) and profits, but a relative increase of mark ups. In other words, the smaller surplus of the production activity is being shifted away from labor income, and this has a crucial consequence: a further reduction in aggregate consumption (and total employment), generating an additional depression of the aggregate demand and a collapse of trade across countries. Surviving firms are reducing production and cutting jobs, contributing to the raise of unemployment. This is exactly the competition effect of the Endogenous Market Structures approach in action, though of course it is working in reverse: in a recessionary context net business destruction deteriorates the division of surplus between wages and mark ups and contributes to depress demand. In turn, this reduction in demand is going to exert a negative feedback effect on profits and stock market evaluations with an additional negative impact on business creation, competition and trade, so as to propagate the recession over time and space.
