2007 Financial Crisis

Section One To be completed by the student Please tick as appropriate Name (s) Ospina, Juan Francisco MBA PT □ MSc □ Diploma □ Certificate □ Specialization MBA Intake n° 5 Student ID Number (s) 122582 Grenoble Campus □ Off site (state which one) X Subject: International Macroeconomics …London………………… Assignment X Oral Presentation □ Exam □ 1. Title: International Macroeconomics- Was faulty monetary policy responsible for the 2007 US subprime financial crisis?
I hereby declare that the attached assignment is my own work and understand that if I am suspected of plagiarism or other form of cheating; my work will be referred to the Disciplinary Committee which may result in my exclusion from the program. Signature Juan Francisco Ospina Date 05 / 02 / 2013 Section One To be completed by the student Please tick as appropriate Name (s) Ospina, Juan Francisco MBA PT □ MSc □ Diploma □ Certificate □ Specialization MBA Intake n° 5 Student ID Number (s) 122582 Grenoble Campus □ Off site (state which one) X Subject: International Macroeconomics …London………………… Assignment X Oral Presentation □ Exam □ 2. Title: International Macroeconomics- Was faulty monetary policy responsible for the 2007 US subprime financial crisis?
I hereby declare that the attached assignment is my own work and understand that if I am suspected of plagiarism or other form of cheating; my work will be referred to the Disciplinary Committee which may result in my exclusion from the program. Signature Juan Francisco Ospina Date 05 / 02 / 2013
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Table of Content

Introduction………………………………………………………………….……………..……….. 3
Overview of the 2007 US Financial Crisis…...………………………………………………….3
What is Monetary Policy?....………………………………………………………………………4
Chronology of US Monetary Policy around 2007 Financial Crisis……………………………5
Causes of the 2007 US subprime financial crisis…………………..……………………………8
Conclusion…………………………………………………………………………………………….9
References…………………………………………………………………………………………….10

Was faulty monetary policy responsible for the 2007 US subprime financial crisis?
Introduction

Many articles have been written about the causes of the 2007 US subprime financial crisis and the lack of regulation by the government to the country’s main financial actors’ practices and the US monetary policy are pointed out as determining factors that germinated the crisis. This paper focuses particularly in the relationship of US monetary policy and the 2007 subprime financial crisis and seeks to determine if whether it was a cause of the crisis or not.

A description of the 2007 US Financial Crisis is exposed and detailed explanation of what monetary policy means and its scope is provided. Monetary policy has been a determining factor for US economic performance along its history and the outcome reached in 2007 with the financial crisis is probably no exception.

Overview of the 2007 US Financial Crisis

Following is a brief overview of the 2007 US Financial Crisis for the purpose of providing context to this dissertation.

During the early 2000’s cash availability in the US financial system was abundant. By nature, banks seek to allocate these resources in the hands of the public in the form of loans charging them with interest rates which would obviously enrich the bank’s wealth by collecting back the capital loaned plus interests. The predominant way in which banks distributed cash among the public was through mortgages. The mortgages business was going very well, households were keen on acquiring self-owned properties by borrowing money with affordable interest rates. The demand for real state was unstoppably rising as were its prices. Banks generally didn’t keep this mortgages to collect back the capital and interests “slowly” in the normal terms of a mortgage, instead they sold these mortgages to investment banks. Investment banks then commercialized the mortgages all over the world by selling them to other banks and hedge funds through innovative financial instruments called CDO or derivatives. To mitigate investment risk, these financial products were usually insured with insurance companies with credit default swaps and also were rated by the recognized rating agencies which normally gave the highest possible levels in the rating scale. Initially, all the actors involved in the scheme were satisfied with their economic outcome and everyone was obtaining high returns on their investments, much higher than the ones offered by central banks. By middle of the 2000 decade, the desire of the global markets to participate in this profitable business was high. The great investment banks of Wall Street still disposed of large amounts of cash to be loaned and encouraged lenders to keep on with the mortgages to the public. The market of prime borrowers was already saturated, so they started lending to almost everyone without the proper assessment procedures, hence, mortgages were provided to households without real paying capacity- subprime mortgages. These subprime mortgages were commercialized worldwide under the same scheme as before, with high ratings by the rating agencies and through insured derivatives. When actually householders failed to cover their mortgages payments, the whole system collapsed in a chain reaction and the real state price plummeted. What is even worse is that responsible householders (prime mortgages) also decided not to keep paying their mortgages as the value of their property suddenly became much less than what they still owed of the mortgage. By 2007 and early 2008, the investment banks or any of the actors along the scheme that owned these mortgages, ended up in possession of worthless real state properties. Savings from investors all over the world were lost, the financial system paralyzed and bankruptcy was a common denominator for the major investment banks in the US and other countries. (Jarvis, 2009)

What is Monetary Policy?

Monetary Policy are measures taken by the central bank of a country to change the money supply of a nation’s economy in order to achieve macroeconomic goals. In the case of the US, the central bank is called the Federal Reserve who is in charge of determining monetary policy.

Making more money available (expansionary policy) makes it easier for the public to get money and therefore the aggregate demand increases. From a Keynesian perspective, this stimulates the economy as manufacturers are encouraged to invest and to grow their businesses, therefore more working force required and a natural decrease of unemployment. From a Classical point of view, an increase in aggregate demand would represent an increase in inflation, rather than growth of the economy.

On the other hand, making less money available (contractionary policy) makes it more difficult for the public to get money and therefore the aggregate demand decreases, hence, the economy “slows” down. This policy is usually adopted to control inflation as with low aggregate demand, prices tend to go down.

There are various mechanisms through which the Federal Reserve implants a determined monetary policy:

1. OMO (Open Market Operations): represents the buying and selling of government securities by the Federal Reserve.

Commercial banks’ assets composition has two important components which are cash reserves and securities (or treasury bonds). Banks cannot loan securities to the public as can be done with cash. As more cash a bank has available, more money supply is available to the market, hence expansionary policy. Whereas, as less cash a bank has available, less money supply for the market which represents contractionary policy.

If the Federal Reserve buys securities from a bank, the bank’s asset composition varies as there is a decrease in securities and an increase of cash reserves, therefore more money supply to the market. If the Federal Reserve sells securities to a bank, it experiments an increase in securities but a decrease in cash which is a decrease in money supply.

2. Required Reserve Ratio: it is a rate that regulates the proportion of its cash reserves a bank can release into the market. It traduces to the following formula:

Maximum vM = (1/r) x vR

Maximum vM: Maximum variation in supply to the market, or the maximum cash a bank can withdraw from its assets to lend it to the public. vR: Variation in bank’s cash reserves r: Required reserve ratio.

The higher the Required Reserve Ratio, the less money a bank can release into the market- contractionary policy. The less the Required Reserve Ratio, the more money a bank can release into the market- expansionary policy. The Monetary Control Act of 1980 establishes that the Required Reserve Ratio fixed by the Federal Reserve has to range between 8% and 14%.

3. Discount Rate: It is the interest rate at which commercial banks can borrow from the Federal Reserve. Discount Rate variation tends to be translated proportionally to the rate at which a commercial bank lends to the public. The lower the Discount Rate, the cheaper a commercial bank access to money, thus more money supply for the market- expansionary policy. If the Discount Rate rises, the money supply decreases- contractionary policy. (McGlasson, 2009)

4. Federal Fund Rate: is the interest rate that commercial banks charge to each other when one burrows money from another. The Effective Federal Fund Rate which is the weighted average rate of the operations made under this modality. The Effective Federal Fund Rate is definitely influenced by the Target Federal Fund Rate which is determined by the Federal Open Market Committee (FOMC) which is basically composed of members of the Federal Reserve System. This committee is in charged by the US law of looking after the open market financial operations, the federal bonds trading and determining the interest rates in the market. (Federal Reserve, 2009). The lower the Federal Fund Rate, the cheaper a commercial bank access to money, thus more money supply for the market- expansionary policy. If the Discount Rate rises, the money supply decreases- contractionary policy.

Chronology of US Monetary Policy around 2007 Financial Crisis

It is adequate to observe US monetary policy behaviour in the years before and during the 2007 financial crisis to determine its relationship. The following analysis focuses on the Federal Funds Rate and the M2.

M0, M1, M2 and M3 are categories through which the money supply is measured in the economy. M2 in particular is the category that combines: Any liquid or cash assets held within the Federal Reserve and the amount of physical currency circulating in the economy (M0); All physical money such as coins and currency, it also includes demand deposits, which are checking accounts, and Negotiable Order of Withdrawal (NOW) Accounts (M1); All time-related deposits, savings deposits, and non-institutional money-market funds. (Investopedia.com, 2013) M2 seen as an indicator quantifies the amount of money circulating in the economy, in other words, M2 quantifies the money supply in the economy which is the primary driver of monetary policy. (Investopedia.com)

Exhibits 1 and 2 are a chart and a table respectively, showing how two crucial indicators of monetary policy such as M2 and the Real Federal Fund Rate behaved in the years before and during the 2007 financial crisis.

Exhibit 1- The Real Federal Funds Rate and the M2 Growth
Lothian (2009)

Lothian (2009)

Exhibit 2- Period Averages of the Real Federal Funds Rate and Year-over-year Growth in M2

Lothian (2009)

These two variables represent the behaviour of US monetary policy along these periods as explained here:

Real Federal Funds Rates * Year 2000 shows higher interest rates and a low M2 (low money supply), which denotes a contractionary monetary policy. * Period 2001-2003 shows substantial decrease in interest rates and substantial growth in money supply which denotes expansionary monetary policy. * Period 2004-2005 shows still low interest rates hence and yet a moderate growth in money supply expansionary monetary policy. These two readings can seem contradictory but it is fair to say that are due to transitional phases of the economy between one type of policy to the other. (Author’s perception) * Period 2006-2007 shows a “steep” increase in interest rates and a correspondent decrease in money supply, therefore contractionary monetary policy. * Period 2008-2009 “relocates” the interest rates at its lower level in recent times which once again denotes a clear expansionary policy.

The crucial years before the 2007 subprime financial crisis, 2001 to 2005 make evident a clear expansionary policy with the lowest interest rates the US economy had experienced since the 1950’s as shown on Exhibit 3.

Exhibit 3- Chart of the Effective Federal Funds Rates since 1952 to 2009

(Wikipedia, 2009)

It shows the US Federal Reserve following the Keynesian economic model on monetary policy which states that stimulating the economy by increasing money supply, in this case through a decrease in interest rates, would increase aggregate demand and therefore increase aggregate supply which is a main engine of GDP growth. It has widely been debated that this Keynesian principle is valid in the short term, but in the long term it derives on an inflationary effect which is precisely what occurred with the real estate prices in the US during the first half of the 2000 decade.

Here is an explanation of the background and mechanisms that entailed this expansionary US monetary policy in the early 2000’s. After 9/11 (September 11, 2001 attacks) the so called .com crisis rose putting the US in the verge of a recession. The Federal Reserve chairman Alan Greenspan lowered interest rates to nearly 1% in order to stimulate the economy. As a result, burrowing money became very cheap for banks which took the opportunity to add more and more leverage to their investments. This overwhelming excess in cash availability for banks took them to enhance their ways of allocating loans in the market and it was then that the mortgages business grew uncontrollably and the demand for real estate shot up. This generated a real estate “bubble” with prices of properties rising to disproportionate levels. The excess in money supply which entailed these unprecedented levels of leverage by the banks was the main factor that carried them to “reinvent” their business with creative, yet risky, financial products such as the CDOs. Even more, this excess of cash exceeded the regular market’s demand for money- prime mortgages- so the banks had no problem in then giving away mortgages to inadequate debtors- subprime mortgages- which were “fated” to fail their payments. The government poor regulatory measures towards banks were ineffective to control the situation. Yes, faulty monetary policy was a major cause of the 2007 US subprime financial crisis. Although it is prudent to say that monetary policy was not the only cause of the crisis, there were multiple causes that entailed such critical phenomenon in the world’s economy.

Moreover, going back to analysing the chart and table of Exhibit 1 and 2, it’s evident a major shift in US monetary policy in the period of 2006-2007 towards a contractionary monetary policy by increasing constantly along the period the real federal fund rates. It seems as if Alan Greenspan, Federal Reserve chairman, foreseeing the potential financial crisis just around the corner made an attempt to amend the faulty monetary policy from previous years. Just as the captain of the Titanic trying to correct the course of the ship after they detected the iceberg, but it was too late, the situation was much more serious that it seemed preliminarily and there was no way to prevent chaos.

In 2003, Milton Friedman, expressed his unconformity with the monetary policy undertaken by the Federal Reserve in recent years that focused on economic growth with expansionary policy but no measures had been taken to decrease inflation (deflation) which he was convinced was only achieved through contractionary monetary policy. (Nelson, 2007) This reflects Friedman’s classical economic tendency.

Causes of the 2007 US subprime financial crisis

In April 2010, the Congressional Research Service published an article called Causes of the Financial Crisis by Mark Jickling, Specialist in Financial Economics. The article presents a list and analysis of all the causes that contributed to the 2007 US subprime financial crisis. A summary of the causes is presented as follows:

Imprudent Mortgage Lending, Housing Bubble caused by the Federal Reserve with its easy money policies, Global Imbalances, Securitization, Lack of Transparency and Accountability in Mortgage Finance, Rating Agencies, Mark-to-market Accounting, Deregulatory Legislation, Shadow Banking System, Non-Bank Runs, Off-Balance Sheet Finance, Government-Mandated Subprime Lending, Failure of Risk Management Systems, Financial Innovation, Complexity, Human Frailty, Bad Computer Models, Excessive Leverage, Relaxed Regulation of Leverage, Credit Default Swaps (CDS), Over-the-Counter Derivatives, Fragmented Regulation, No Systemic Risk Regulator, Short-term Incentives, Tail Risk, Black Swan Theory.

It is not of the purpose of this paper to expand on each of this causes but it is relevant to the matter as it provides the analysis with the wider scope of the causes of the crisis.

The Black Swan Theory refers to the fact that “this crisis is a once-in-a-century event, caused by a confluence of factors so rare that it is impractical to think of erecting regulatory barriers against recurrences. According to Alan Greenspan, such regulation would be “so onerous as to basically suppress the growth rate of the economy and ... [U.S.] standards of living.” Testimony before the House Oversight and Government Reform Committee, Oct. 23, 2008.” (Jickling, 2010)

Conclusion

Faulty monetary policy is responsible for the 2007 US subprime financial crisis as it provided the perfect environment and the main nourishment which was excessive money supply to the chaotic financial crisis.

This thesis can further more transcend into concluding that indeed Keynesian principles about monetary policy apply only in the short term, and by no means in the long term as excessive and permanent increase in money supply will derive in undesirable levels of inflation, and in dangerous economic “bubbles” which is precisely what occurred during the period that preceded the 2007 financial crisis.

What should be done so that this kind of situation won’t happen again? It is true that the 2007 financial crisis was caused by many factors, but this is no reason to conclude that no clear improvements by governments can be done to prevent this from happening as Alan Greenspan implied in 2008 in the congress of the US. Strong regulatory measures need to be put in place through legislation and more moderate and grounded monetary policy should be managed.

The classical economic principles should be followed as these really show a way in which economies grow sustainably, realistically and step by step by the growth of labour, industry, agriculture, education and innovation. By no means through fictitious economic bubbles generated through the multiplication of money done in computers.
The American Recovery and reinvestment act. of 2009, enacted by the US Congress and signed into law in February 2009 by President Obama (Wikipedia) marks the beginning of a new path for sustainable economic growth.

References

D. E. Moggridge and Susan Howson, (1974). Keynes on Monetary Policy, 1910-1946.
Oxford Economic Papers. Oxford University Press. Oxford, UK.
"Federal Open Market Committee:About the FOMC". Board of Governors of the Federal Reserve System. Federal Reserve. February 18, 2009.
Dr. Mary J. McGlasson, is licensed under a Creative Commons Attribution-NonCommercial-NoDerivs 3.0 Unported License. (2009) (Macro) Episode 32: Monetary Policy.
"The Implementation of Monetary Policy". The Federal Reserve System: Purposes & Functions. Washington, D.C.: Federal Reserve Board. 24 August 2011
Jarvis, Jonathan (2009). The Short & Simple Story of the Credit Crisis. Crisisofcredit.com.
Lothian, James R. (2009). U.S. Monetary Policy and the Financial Crisis. The Journal of Economic Asymmetries. Fordham University. New York.
Nelson, Edward. (2007). Milton Friedman and U.S. Monetary History: 1961-2006. Federal Reserve Bank of St. Louis Review, May/June 2007.
Jickling, Mark. (2010). Causes of the Financial Crisis. The Congressional Research Service. USA.

References: D. E. Moggridge and Susan Howson, (1974). Keynes on Monetary Policy, 1910-1946. Oxford Economic Papers. Oxford University Press. Oxford, UK. "Federal Open Market Committee:About the FOMC". Board of Governors of the Federal Reserve System. Federal Reserve. February 18, 2009. Dr. Mary J. McGlasson, is licensed under a Creative Commons Attribution-NonCommercial-NoDerivs 3.0 Unported License. (2009) (Macro) Episode 32: Monetary Policy. "The Implementation of Monetary Policy". The Federal Reserve System: Purposes & Functions. Washington, D.C.: Federal Reserve Board. 24 August 2011 Jarvis, Jonathan (2009). The Short & Simple Story of the Credit Crisis. Crisisofcredit.com. Lothian, James R. (2009). U.S. Monetary Policy and the Financial Crisis. The Journal of Economic Asymmetries. Fordham University. New York. Nelson, Edward. (2007). Milton Friedman and U.S. Monetary History: 1961-2006. Federal Reserve Bank of St. Louis Review, May/June 2007. Jickling, Mark. (2010). Causes of the Financial Crisis. The Congressional Research Service. USA.