The First Global Financial Crisis of the 21st Century Part ll June – December 2008 A VoxEU.org Publication 2009 ISBN 978-0-9557009-9-6 Centre for Economic Policy Research 2ND FLOOR • 53-56 GREAT SUTTON STREET • LONDON EC1V ODG TEL: +44 (0)20 7183 8801 FAX: +44 (0)20 7183 8820 • EMAIL: CEPR@CEPR.ORG www.cepr.org Since the first compilation of VoxEU columns on the global crisis was published in June 2008, the ‘subprime crisis’ has metastasized in September 2008 causing credit markets to seize up worldwide. The world is now in the midst of an unprecedented economic crisis – a global event that is unfolding at extraordinary speed and in unexpected directions. Wall Street and the City of London have been changed forever. In keeping with Vox's motto of 'research-based policy analysis and commentary', our columnists have applied research insights in bolstering our understanding events and pointing the way forward. These articles, it has to be understood, were written ‘in the moment’ over the past six months and so incorporate, to a varying extent, the history we have lived through. To help place individual contributions within this historical sequence, an appendix updates the timeline of events from our June publication up to December 2008. Another appendix provides a glossary of technical terms. The columns are grouped under three headings: How did the crisis spread around the world? How has the crisis upended traditional thinking about financial economics? How should we fix the economy and financial system? VoxEU.org is a portal for research-based policy analysis and commentary written by leading economists. It was launched in June 2007 with the aim of enriching the economic policy debate by making it easier for serious researchers to contribute and making their contributions more accessible to the public. A VoxEU.org Publication The First Global Financial Crisis of the 21st Century Part ll June-December 2008 Edited by: Andrew Felton and Carmen M. Reinhart The First Global Financial Crisis of the 21st Century Part II: June – December, 2008 A VoxEU.org Publication Centre for Economic Policy Research (CEPR) Centre for Economic Policy Research 2nd Floor 53–56 Great Sutton Street London EC1V 0DG UK Tel: +44 (0)207 183 8801 Fax: +44 (0)207 183 8820 Email: cepr@cepr.org Website: www.cepr.org © January 2009 Centre for Economic Policy Research British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN: 978-0-9557009-9-6 Edited by Andrew Felton and Carmen M. Reinhart The First Global Financial Crisis of the 21st Century Part II: June – December, 2008 A VoxEU.org Publication Centre for Economic Policy Research (CEPR) The Centre for Economic Policy Research is a network of over 700 Research Fellows and Affiliates, based primarily in European universities. The Centre coordinates the research activities of its Fellows and Affiliates and communicates the results to the public and private sectors. CEPR is an entrepreneur, developing research initiatives with the producers, consumers and sponsors of research. Established in 1983, CEPR is a European economics research organization with uniquely wide-ranging scope and activities. The Centre is pluralist and non-partisan, bringing economic research to bear on the analy- sis of medium- and long-run policy questions. CEPR research may include views on policy, but the Executive Committee of the Centre does not give prior review to its publications, and the Centre takes no institutional policy positions. The opinions expressed in this report are those of the authors and not those of the Centre for Economic Policy Research. CEPR is a registered charity (No. 287287) and a company limited by guarantee and registered in England (No. 1727026). Chair of the Board Guillermo de la Dehesa President Richard Portes Chief Executive Officer Stephen Yeo Research Director Mathias Dewatripont Policy Director Richard Baldwin Preface xi Introduction 1 1. The spread of the crisis to the rest of the world 1 2. What is wrong with the traditional economic/financial viewpoint and models? 3 3. The proper governmental response 4 Section 1 The spread of the crisis to the rest of the world 7 The first casualty of the crisis: Iceland 9 Jon Danielsson Iceland: The future is in the EU 15 Philip Lane Iceland faces the music 19 Gylfi Zoega The collapse of Iceland’s banks: the predictable end of a non-viable business model 23 Willem Buiter and Anne Sibert The fallout from the global credit crisis: Contagion – emerging markets under stress 27 Helmut Reisen From capital flow bonanza to financial crash 31 Carmen M Reinhart and Vincent Reinhart Rapid and large liquidity funding for emerging markets 37 Guillermo Calvo and Ruby Loo-Kung Stock market wealth effects in emerging market countries 41 Heiko Hesse The political economy of debt relief 45 Andreas Freytag and Gernot Pehnelt India’s credit crunch conundrum 49 Arv ind Subramanian Preserving financial sector confidence, not monetary easing, is key 53 Arv ind Subramanian Contents The folly of the central banks of Europe 57 John N Muellbauer Crisis management tools for the euro-area 61 Daniel Gros and Stefano Micossi A proposal on financial regulation in Europe for the next European Council 65 Carmine Di Noia The European response to the crisis: Not quite there yet 69 Marco Pagano Finance, market, globalisation: a plot against mankind? 73 Salvatore Rossi Can Europe take care of its own financial crisis? 77 Daniel Gros The financial crisis may hasten European integration but slow global banking 81 Avin ash Persaud A call for a European Financial Stability Fund 85 Daniel Gros and Stefano Micossi Governance of banks 89 Luc Laeven and Ross Levine Finance, redistribution, globalisation 93 Giuseppe Bertola an d An na Lo Prete What Next for the Dollar? The Role of Foreigners 97 Kristin Forbes Is the US too big to fail? 103 Carmen M Reinhart and Vincent Reinhart Can the IMF save the world? 109 Barry Eichengreen Section 2 What is wrong with the traditional economic/ financial viewpoint and models? 113 The financial meltdown is an academic crisis too 115 Richard Dale European securitisation and the possible revival of financial innovation 119 John Kiff, Paul Mills, and Carolyne Spackman vi The First Global Financial Crisis of the 21st Century Part II The price of transparency 123 Marco Pagano The Panglossian World of Finance 127 Daniel Cohen What can be learned from the banking crisis 131 Hans-Wener Sinn Do reputational concerns lead to reliable ratings? 135 Beatriz Mariano The Financial Economists Roundtable’s statement on reforming the role of SROs in the securitisation process 137 Charles A. E. Goodhart Liquidity risk and the current crisis 147 Lasse Heje Pedersen How risk sensitivity led to the greatest financial crisis of modern times 153 Avin ash Persaud Transmission of liquidity shocks: Evidence from the 2007 subprime crisis 155 Nathaniel Frank, Brenda González-Hermosillo and Heiko Hesse The lender of last resort of the 21st century 163 Xavier Freixas and Bruno M Parigi Reason with the messenger; don’t shoot him: value accounting, risk management and financial system resilience 169 Avin ash Persaud Escaping from a Combined Liquidity Trap and Credit Crunch 171 Frank Hein em ann Complexity kills 179 Jon Danielsson Will the credit crunch lead to recession? 183 Nicholas Bloom The credit crunch may cause another great depression 187 Nicholas Bloom The procyclical effects of Basel II 191 Rafael Repullo and Javier Suarez Contents vii Central banks’ function to maintain financial stability: An uncompleted task 195 Charles A. E. Goodhart Let banks be banks, let investors be investors 199 Alberto Giovannini Stormy Weather in the Credit Default Swap Market 203 Virginie Coutert and Mathieu Gex Why does the spread between LIBOR and expected future policy rates persist, and should central banks do something about it? 207 Francesco Giavazzi Section 3 The proper governmental response 213 Anatomy of the financial crisis 215 Barry Eichengreen The subprime turmoil: What’s old, what’s new, and what’s next 219 Charles W. Calomiris An international perspective on the US bailout 227 Rancière Not the end of capitalism 231 Erik Berglöf and Howard Rosenthal The effectiveness of fiscal policy depends on the financing and monetary policy mix 233 Giancarlo Corsetti and Müller Fiscal policy and the credit crunch: What will work? 239 Daniel Gros Episode V: Expectations strike back 243 Micael Castanheira Germany needs high wage settlements and a serious fiscal stimulus 245 Andrea Boltho and Wendy Carlin Plan B 251 Luigi Zingales Why Paulson is (maybe) right 257 Charles Wyplosz viii The First Global Financial Crisis of the 21st Century Part II [...]... we get here? Inflation targeting gone wrong The original reasons for Iceland’s failure are series of policy mistakes dating back to the beginning of the decade 9 10 The First Global Financial Crisis of the 21st Century Part II The first main cause of the crisis was the use of inflation targeting Throughout the period of inflation targeting, inflation was generally above its target rate In response,... for producing this primer on what is probably the worst financial crisis of our generation Richard Baldwin, VoxEU.org, Editor -in- Chief and CEPR Policy Director December 2008 xi Introduction Sadly, our previous compilation of VoxEU columns, ‘The First Global Financial Crisis of the 21st Century, ’ was not the last word on the subject Since the publication of that volume in June 2008, the global crisis has... Acharya and Raghu Sundaram The beginning of the end game… Daniel Gros and Stefano Micossi 283 285 291 293 297 301 305 309 317 x The First Global Financial Crisis of the 21st Century Part II Financial crisis resolution: It’s all about burden-sharing Charles Wyplosz 321 Is the euro area facing a credit crunch or a credit squeeze? Guillermo de la Dehesa 325 Global financial crisis: How long? How deep? Stijn... 28th 2008 ‘Testing Times for the International Financial System: Inflation, Global Turmoil, New Challenges for Small Open Economies’ 15 16 The First Global Financial Crisis of the 21st Century Part II hold more diversified loan books, reducing exposure to country-specific and sector-specific shocks For this to happen, national governments will have to agree ex ante on burden sharing rules in order to... against suspending mark-to-market accounting and proposes mark-to-funding accounting instead, which would weight market prices of assets by the durations of their offsetting liabilities The complexity, rapid growth, and interconnection of markets has prevented analysts from producing either a simple explanation of the crisis or a simple way to restart economic growth Heinemann discussesed the crisis in. .. ‘The Icelandic banking crisis and what to do about it,’ CEPR Policy Insight No 26; and ‘The collapse of Iceland’s banks: the predictable end of a non-viable business model,’ VoxEU, 30 October; also Jon Danielsson, (2008), ‘The first casualty of the crisis: Iceland,’ VoxEU, 12 November 19 20 The First Global Financial Crisis of the 21st Century Part II a pending liquidity squeeze by wiping out the shareholders... a non-viable business model.’ 1 2 The First Global Financial Crisis of the 21st Century Reisen predicted that emerging markets are still vulnerable to contagion and that they would try to rely less on private debt in the future Reinhart and Reinhart identified a systematic predictor of a variety of crises in a large set of countries over the past few decades Economies receiving large inflows of capital,... The First Global Financial Crisis of the 21st Century Part II group’s interests Clearly, political parties need to reward their members in order to motivate them and ensure their loyalty The same applies to labour unions and business empires But the smaller the country, the smaller the total surplus income that can be used in this way, while the amount needed to guarantee the loyalty of any given individual... Financial Crisis of the 21st Century Part II Landsbanki operated these saving accounts under local UK and Dutch branches of the Icelandic entity, meaning they were primarily regulated and insured in Iceland, although also falling under local authorities in the UK and the Netherlands Hence the Icelandic, British and Dutch regulators approved its operations and allowed it to continue attracting substantial inflows... uncertainty, which will deter investment and likely lead to a severe recession that monetary and fiscal policy are powerless to avoid One of the driving regulatory 4 The First Global Financial Crisis of the 21st Century Part II forces toward complexity was Basel II, which Repullo and Suarez found reinforced pro-cyclical capital requirements Goodhart agreed that counter-cyclical policy is needed, although . Publication The First Global Financial Crisis of the 21st Century Part ll June-December 2008 Edited by: Andrew Felton and Carmen M. Reinhart The First Global Financial Crisis of the 21st Century Part II: . In keeping with Vox's motto of 'research-based policy analysis and commentary', our columnists have applied research insights in bolstering our understanding events and pointing. The First Global Financial Crisis of the 21st Century Part ll June – December 2008 A VoxEU.org Publication 2009 ISBN 97 8-0 -9 55700 9-9 -6 Centre for Economic Policy Research 2ND FLOOR • 5 3-5 6 GREAT