For this one, the content of this post is required. The links are optional, but would make great reading for the intensely interested student.
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I forgot a sixth point in my reply to GS’s question. This is, that financial crises and recessions are two different things, and that they do not have to occur together. For example, the 1987 stock market crash was a financial crisis, but there was no recession from 1982 to 1990. Part of what made the last recession so bad was that the financial crisis overlapped it. We saw the first signs of declining home prices in southwestern Florida in early 2006, followed by the first signs of financial trouble in April 2007 with the bankruptcy filing by New Century. The recession itself began 8 months later with a December 2007 peak. The first 9 months of the recession were relatively mild, before the bankruptcy filing of the large financial firm Lehman Brothers in September 2008 sent the economy into steep decline. Arguably, the next 4 months’ decline was steep enough to be comparable to part of the Great Depression, although not nearly as sustained. In the Spring 2009 version of your class, we kept an eye on the data and started seeing brighter signs in late January. The economy troughed in July. The financial crisis went on for some time after that, but as early as March 2009, stronger banks were already trying to pay back their “bailout” because it wasn’t (and in some cases hadn’t been) needed.†
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I put the above into a post because the new issue of the Journal of Economic Perspectives just came out. This is freely accessible. In this issue they have a symposium of 3 articles on the post-crisis financial regulation.
Former Fed Governor Tarullo writes that improved regulations have made the biggest banks stronger, but that “… the current regulatory framework does not deal effectively with threats to financial stability outside the perimeter of regulated banking organizations, notably from forms of shadow banking.” Shadow banks are financial institutions with some bank-like operations, but which are not banks at all. Examples include … hmmm … New Century (which was a REIT), and Lehman Brothers (which was an investment bank). Shadow banks get into banking-like operations in the first place because they can offer services which banking regulation prevents. There’s clearly a demand for these services, and they can clearly create crises, but we’ve done little about them.
Duffie (a big name in finance) partially uses the language I used in class the other day. He calls the housing crisis a shock rather than an impulse (shock might be more common terminology than impulse, and I use both). But he specifically argues that the financial system “became a key channel of propagation”. In parallel to Tarullo, Duffie argues that we still have a “too big to fail” mentality towards certain firms in the financial industry, but our new regulations don’t cover whole industries which are viewed this way.
Aikman, Bridge, Kashyap, and Siegert argue that better financial regulation could have prevented the financial crisis from making the recession worse (this is called macroprudential regulation). These include better monitoring of risk in real time, forcing financial firms to reduce leverage, providing liquidity for institutions to get out of funding mismatches — like borrowing short and lending long, and helping households reduce their stock of debt. They then contrast the U.S. and the U.K., and argue that the U.K.’s new institutions are well-equipped to address these problems. However, the U.S. institution, Dodd-Frank’s Financial Stability Oversight Council lacks authority to address these problems directly, and can be circumvented through regulatory capture. Ugh.
† I heard about the financial crisis vicariously, two separate times, but didn’t know what to make of it at the time.
In one case, a professor you all know brought me a consulting project to potentially work on (we were a candidate, and ultimately didn’t get the job). It was from a huge international bank. They were having problems because mortgage loans were going delinquent (by 30 days). That’s the normal part. Some of those get back on track, and some go delinquent by 60 days, and here was the new thing: the rate of ones that were getting worse was going up, and they didn’t know why. I still have that project’s files on my computer, and they’re dated December 2, 2006.
In the second case, SUU hired a new professor. I happened to run into this guy at a restaurant over the summer, and got to talking. He had left Florida Gulf Coast University, a new-ish school, south of Fort Myers, in the then booming southwestern corner of the peninsula. He got out because the housing market there had crashed, and and he didn’t want to lose a bundle on the home he owned. That was in August 2007 … 4 months before the recession started, 7 months before Bear Stearns was merged to avoid a crisis, and 13 months before Lehman Brothers went bankrupt. That’s pretty close to the top of this extensive timeline of the financial crisis.
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