NATIONAL BUREAU OF ECONOMIC RESEARCH
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The Global Financial Crisis


The National Press Club
September 22, 2011


An NBER symposium held at the National Press Club in Washington, DC discussed the causes of the global financial crisis, how it spread so rapidly, and what policies could reduce country vulnerability in the future. The symposium featured leading academics, investors, policymakers and the press. Participants debated policy responses for the past crisis as well for the current challenges facing Europe and the global economy. The meeting agenda may be found at http://www.nber.org/~confer/2011/GFCf11/GFCf11prg.html. The discussion drew from the analysis in fourteen new NBER research papers presented at a research conference in June, 2011. (See http://www.nber.org/confer/2011/GFC11/summary.html for more information on the research conference.)

The symposium began with an introduction by Kristin Forbes. Forbes used covers of the Economist to remind the audience of the dramatic shifts in economic sentiment over the past few years-from the euphoria of 2006 to the global panic in 2008 to the quick rebound in confidence in 2010. In 2011, the rapid deterioration in the global economic outlook-and especially Europe and the United States-was creating a sense of deja vu. Even the Economist was recycling covers from 2007/2008 to capture the panic in Europe and concerns about another recession in the United States. If the world was on the verge of another tumultuous period, what lessons could be learned from 2007-2009? What steps could be taken to reduce contagion and avoid another sharp global contraction? What structural changes could be taken today to prevent crises in the future? These questions were the focus of the symposium.

Financial Integration, Capital Flows and Global Imbalances
Charles Engel opened the first panel by summarizing the key results of new research papers on the causes of the crisis, including the role of globalization, international capital flows, and global imbalances. Bertaut, DeMarco, Kamin, and Tryon document how flows from European investors into U.S. asset-backed securities contributed to downward pressures on U.S. interest rates, which when combined with innovations and deficiencies in the U.S. credit market, contributed to the U.S. housing bubble and other vulnerabilities that led to the financial crisis. Lane and Milesi-Ferretti provide an in-depth analysis of how global imbalances evolved directly before, during and after the crisis. Forbes and Warnock disaggregate the historic "waves" in capital flows into movements driven by foreign and domestic investors to find that global factors, especially global risk, are the most important determinants of extreme capital flow movements. Gourinchas, Rey, and Truempler evaluate how these changes in international capital flows, when combined with changes in asset valuations, led to a massive transfer of wealth across countries during the crisis.

David Wessel chaired the remainder of this first session, in which Philip Lane discussed how global imbalances contracted during the crisis and showed that this was achieved primarily through demand compression-a method of adjustment that has a number of undesirable consequences. He also showed that official external assistance and ECB liquidity cushioned the exit of private capital flows for some countries. Pierre-Oliver Gourinchas emphasized the importance of studying gross asset positions and capital flows instead of simply net positions and flows when understanding crises. He also discussed the asymmetry between deficit countries that need to adjust imbalances compared to surplus countries which are under less pressure. Mohamed El Erian offered a market perspective and focused on the inter-linkages between healthy and non-healthy balance sheets around the world. Closer investigation of balance sheets before the crisis would have shown the vulnerabilities in the system. He pointed out that solving a number of current global challenges will involve engaging the "healthy balance sheets" (such as large multinationals, Germany, Brazil and China) to help support demand as those in a weaker position rebuild.

In the open discussion, the panelists discussed various aspects of global financial integration. El Erian recounted the different stages of financial globalization: enabling productive investments, creating a financial society (starting in 2005), and recently a contamination of the last healthy balance sheets (of public and central banks). Wessel and several members of the audience prodded panelists to discuss policy options and their effects. Lane suggested that better global regulation of banks could prevent global financial integration from amplifying mistakes and he predicted greater financial integration (especially in banks across Europe) in the future. Gourinchas argued that it is useless to think in terms of a world where crises do not happen. Instead, perhaps we should think about influencing where the crisis could be located, not only geographically, but also by asset class. It is very dangerous to let a crisis contaminate other systems and there is currently a pressing need to isolate the banking system. Lane noted that it is very difficult to know exactly what safe fiscal policy is. El Erian argued that the only way to achieve the needed engagement of those with strong balance sheets is to convince players that the big actors in the global economy (Europe and the US), will "get their act together." European and U.S. authorities need a convincing plan that will attract investment and spending from firms and individuals holding a lot of cash. Lane highlighted the need to better understand the links between financial and fiscal stability, and especially to work on better cooperation of the banking sector across countries. Gourinchas emphasized that we are in a "stable disequilibrium." He suggested that we may be moving toward a world with multiple reserve currencies, but the main players are not yet in a position to play this role and there is currently no other alternative. He also pointed out that it is a dangerous time to step back from fiscal expansion because of the rapid deleveraging process in many countries and lack of global demand. Wessel closed the session by stating that we should not talk about the crisis in the past tense as we are currently entering the next phase.

Global Contagion
Mark Spiegel introduced the second panel and focused on the various channels by which contagion occurred during the crisis. Several papers looked at the role of banks. Cetorelli and Goldberg document how globally-active banks spread shocks internationally by managing liquidity across their entire banking organization. Hale shows that the crisis had a large negative impact on global banking networks by slowing the formation of new banking relationships. Kalemli-Ozcan, Sorensen, and Yesiltas find a significant increase in leverage in large U.S. commercial banks and investment banks worldwide during the early 2000s, but also document that excessive risk taking before the crisis was not easily detectable outside of investment banks. Rose and Spiegel find evidence that dollar liquidity provisions by the U.S. Federal Reserve Board helped to improve liquidity across borders during the crisis. Fratzscher finds that common factors (such as global liquidity and risk) were the main drivers of investor flows during the crisis, and Raddatz and Schmukler find that the volatility of mutual fund investments is driven by both the underlying investors and fund managers. Claessens, Tong, and Wei use firm-level data to show that "real" channels of contagion through trade flows and aggregate demand were important in spreading the crisis, as well as the financial channels that are the focus of the other papers.

Sebastian Mallaby chaired the panel discussion. Guillermo Ortiz highlighted how leverage made funding interrelations grow exponentially and played a role in transmitting the crisis from the financial to the real sectors. He also emphasized the role of better fundamentals in many countries, and especially of stronger financial supervision and lower leverage in emerging markets, in providing support during the crisis. He drew parallels between the current tensions in markets and what happened in 2008. Marcel Fratzscher focused on liquidity issues and the role played by central banks. During the financial crisis, central banks have been very proactive and provided massive liquidity domestically. This has stabilized some banks but has complicated the task of achieving price stability and can create negative externalities in emerging markets. Joyce Chang offered a market perspective. She discussed how the ratings of many emerging markets are now stronger than for many developed countries, suggesting we need a new system of classifying risks. She considered the increased correlation between assets and strong links around the world; nowadays good fundamentals are not enough to protect countries. Chang also asserted that capital controls could be a part of a solution to capital flow volatility in emerging markets-especially politically in the short term for policymakers worried about the level of the exchange rate.

The discussion began by focusing on the role of pro-cyclicality in financial institutions. Fratzscher argued that the degree of pro-cyclicality changes over time and differs across countries-but it is unclear how it differs across different types of investors. Mallaby remarked remarked that if the shadow market (including hedge funds) can provide a more stable source of financing, especially during downturns, then paradoxically deepening financial markets by supporting the shadow market may make the system more stable. Mallaby also prodded panelists to consider policy responses, particularly to problems of asset quality rather than leverage. Fratzscher argued that before the crisis, there were no macro-prudential regulators, and there is a real need to understand systemic risk rather than to just look at individual institutions. Ortiz agreed that using time-varying macro-prudential regulation is of great importance. There was disagreement, however, on whether accumulating reserves could play a role-with Fratzscher questioning the benefits of large accumulations of foreign exchange reserves while Ortiz felt they could help when a role when a crisis hits.

Reducing Country Vulnerability: Capital Controls, Reserves, the IMF, or Something New?
Jeffrey Frankel introduced the final panel. Over the past few decades, countries have relied more heavily on large emergency lending packages to stabilize economies during crises. As the size of the packages increases and contagion has become more virulent, this approach is becoming increasing costly. This panel explored options to reduce country vulnerability. Dominguez, Hashimoto, and Ito show that having measured reserves after appropriately adjusting for exchange rate movements and emergency assistance packages, they served as an important counter-cyclical policy tool for a number of emerging markets during the crisis. Chamon, Ghosh, Ostry, and Qureshi find that certain types of prudential regulations and capital controls can help to strengthen a country's liability structures and to restrain overall credit booms. They show that this helped to stabilize output declines during the crisis. Barkbu, Eichengreen and Mody argue that more innovative approaches need to be considered and they focused in particular on "sovereign cocos": contingent debt securities that automatically reduce payment obligations in the event of debt-sustainability problems.

Zanny Minton-Beddoes chaired the final discussion in which Erdem Basci stressed the importance of exchange rate flexibility, moving towards the greater use of equity-like contracts to share risks, and reducing currency exposure, to stabilize countries during a crisis. He also discussed the measures undertaken by Turkey to manage capital flows, highlighting the innovative use of volatile interest rates, and argued that because of its successful policy management, Turkey did not need to use capital controls. Olivier Blanchard reminded us of the challenges of large capital inflows-from bubbles and overheating to "sudden stops". He suggested that value of more borrowing in domestic currency and macro-prudential measures in response to these inflows-which would include a continuum of measures ranging from domestic macro-prudential measures to broad capital controls aimed directly at foreigners. He questioned the effectiveness of reserve accumulation. Kathryn Dominguez discussed the challenges in measuring reserve accumulation and the need to distinguish between passive valuation changes and active management of the assets. She showed that many countries depleted their reserves during the crisis and that this active management helped economies recover.

In the discussion, panelists debated the appropriate level of reserves. Basci suggested that the best use of reserves is to help with short-term financing for domestic firms and the banking sector. The appropriate level of reserves should be time-varying, with an increase in reserve requirements in good times. Blanchard was skeptical about having a precise answer as we only know the "safe" level of reserves ex-post and often underestimate what is needed (as in the case of Russia). Dominguez explained that the availability of swap lines can reduce reliance on reserves (as seen in Korea) during a crisis. Blanchard discussed the reasons countries hesitate to use reserves during a crisis. Panelists then discussed other options-such as IMF liquidity windows and swap lines. Blanchard argued that swap lines have the fundamental problem that it is not easy to know ex-ante who will be able to get them. IMF liquidity windows are therefore potentially more useful. Beddoes raised the objection, however, that there is conditionality to use the IMF liquidity windows and also proposed a greater use of sovereign Cocos and GDP-indexed bonds to make the system safer. Dominguez agreed there was a need to look at additional instruments, as countries that have done well have access to swap lines, but countries with weaker fundamentals are more likely to need support and not eligible. The discussion ended with participants highlighting a fundamental disconnect: reserve accumulation and capital controls actually might make sense for individual countries as a means of reducing their vulnerability to volatile capital flows. If large countries or many small countries follow these strategies, however, it could lead to an increase in global imbalances and might amplify the crisis in the end, thereby destabilizing the entire system.

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