The crisis compendium
How can you make sense of the ongoing financial crisis? Two briefings by London Business School faculty helped shed light on what happens next.
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Andrew Scott | Helene Rey | Lucrezia Reichlin
James Dow | Julian Franks | Stephen Schaefer | Elroy Dimson
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In an economics briefing, Professors Andrew Scott, Helene Rey and Lucrezia Reichlin contemplated the economic options on offer to stop the economies of the world going from bad to worse. In the second briefing, Professors James Dow, Julian Franks, Stephen Schaefer and Elroy Dimson, surveyed the world of finance, identified what's wrong with the financial markets and came up with far-reaching prescriptions for their cure. This crisis compendium distils the debate.
First briefing
Andrew Scott, Professor of Economics
- Of 122 recessions over the last half century in rich countries, only four combined a recession, credit crunch, a house price crisis and an equity market crisis. So, while this isn't unique, it's not a frequent event
- Two key differences this time: global scope and the scale of the borrowing (though relative to GDP, the numbers don't seem quite so dramatic).
- We're still not talking about huge levels of government debt and governments have over 50 years in which to pay back debt. So, although there will be some modest inflation implications, it is not going to threaten inflation longer term.
"The Bank of England is forecasting a big fall in GDP in 2009 of 1.5 to 2%, but on the back of four or five years of 2 and 3% growth that doesn't seem a terrible outcome. It's like having a short hangover after a week long party, but still there's this terrible fear about how things are going to get worse."
"Statistically, we don't see Great Depressions very often. Recessions are very common. This may be the worst recession the US has had for 70 years, but the chances are it's still going to be a recession, not a slump. The return of a risk premium will keep asset prices low, and a weak economy will also keep asset prices low, so perhaps we will see a U-shaped recession, in terms of GDP. But we may see something like an L-shaped recession in terms of house prices and stock."
"In 2007 and the first half of 2008 it was about the banking crisis. From the second half of 2008 to 2009 it is about the macro crisis. There's not enough focus upon what the world will be like when we get to recovery."
"It's not obvious that cutting interest rates when the banking system is in such a mess is a very effective way of boosting the economy. We know that cutting interest rates in the best of times takes around nine to 18 months to really have a big effect."
Listen to Andrew Scott's podcast.
Helene Rey, Professor of Economics
- There have been a series of bubbles over recent years - from the Japanese bubble in 1986 to the emerging markets bubble.
- The US was particularly prone to the development of these bubbles because of excess savings in Asia.
- If financial structures and policy doesn't change, more bubbles will emerge.
"I think this current crisis is special because the scale of the current bubble is bigger than we have seen. It's a bubble which originated in the centre of the international financial system, the United States. The global imbalances -- if we look at absolute values of amount of capital flows, current account deficits -- are unprecedented. It's really a centre country crisis, and since the US is such a financial hub, it becomes widespread, the international financial multiplier."
"There are remarkable similarities between the bursting of the bubble in Japan and what has happened in this present crisis."
"If you have massive re-pricing on your balance sheet and you are very highly leveraged, then you are really in trouble. I think we have already seen that the most leveraged financial institutions have been seriously hit."
"Iceland had gross external assets which were around 674% of GDP, gross external liabilities which were above 700% of GDP. That was at the end of 2007. My estimate for 2006 at market value the gross external assets of the UK were about 450% of GDP, and the gross external liabilities were around 460% of GDP. In the US the numbers were 141% of GDP and 126% of GDP. When we have this massive balance sheet, having an independent currency, there's huge potential for destabilising valuation effects, depending on the exact structure of assets and liabilities."
"In the medium run, if nothing changes in the structure of world financial markets, there will be other bubbles, and if the role of monetary policy doesn't change and there is very cheap financing for financial intermediaries, then again that will bring some further bubbles. They may not be necessarily in the US, if sovereign wealth funds have preferences which are not as heavily dollar-biased as China was. The game will be to spot the next one. If you see an inflating asset price category somewhere, coupled with some current account deficit, then you would have a candidate. We will have to watch for these things, or take the appropriate policy reaction."
Listen to Helene Rey's podcast.
Lucrezia Reichlin, Professor of Economics
- The latest statistics suggest the US has been in recession since the end of 2007 with potential for growth to pickup in 2009.
- Recent recessions - in 2001 and the early 1990s - were short (8 months). This is already longer.
- Lending data is important but difficult to decipher.
- A second dip in 2009 is possible.
"The decline in employment puts this recession in line with the average of the 1970s or 1980s - though it is not yet quite as bad yet. So, for all the catastrophic stuff we read in the press, I think we should be a little bit calmer."
"Once the US gets a recession, the Euro area gets it as well -- except a little later -- and the Euro area's recessions tend to be longer and milder than US recessions."
"I think understanding the credit market is at the centre of the discussion, but it's very hard to read lending data and you have to look not just at lending data, but you at new lending. Banks are locked up in contracts and firms are using credit lines. This leads to a sort of involuntary lending. Banks are now buffering loans flows by selling their holdings of liquid securities, or flowing rollover holdings of short term debt securities. The optimistic view says that this kind of buffering will continue until things get better, the US will get out of recession and we will avoid a banking crisis and a huge multiplier effect. Then there is a pessimistic view which says that at some point capital constraints will kick in, and it will not be possible to buffer in this way, and then there will be a double dip - we're going to get hit hard again at some point in 2009. This is what I see in the data right now."
Listen to Lucrezia Reichlin's podcast.
Second briefing
James Dow, Professor of Finance
- Notable that there is no contingency plan to deal with a financial crisis.
- Similar crises in recent years didn't affect rich countries, so weren't seen as important.
- There is an underlying stock market crisis with potential implications for pensions and more.
"There's a hidden crisis and that's a stock market crisis which has been going on for a long time. I think we're still suffering from the after effects of the tech bubble, and the bad stock market performance that started there. For the past eight years the stock market mostly hasn't looked like a brilliant investment. But, our whole economy depends on the stock market being a good investment."
"What's happened in the last two years is that people are saving less for their pensions. The net result is that the amount of saving that people are doing for pensions is much less than it was ten years ago, and it's not enough. Where's that going to leave us? That's a serious problem."
Listen to James Dow's podcast.
Julian Franks, Professor of Finance
- Fundamentally, this is a profitability crisis: banks were inherently unprofitable.
- A long term solution is the government must charge for guarantees.
"Were the banks irrational in gearing up to the eyeballs? The answer is no. They had subsidised debt in the form of a government guarantee on many of their loans, if not all of them, explicit or implicit. And they stayed very cheap. If something is cheap, you buy more and more, and that is what the banks did. Governments should have charged banks for deposits, depending on the risk or the leverage of the banks."
"It's amazing how banks can expand their balance sheet. An industrial company cannot triple its balance sheet in months or a year, but a bank can."
"Most people who lent to banks, or who analysed banks, knew about the government guarantee. You didn't have to analyse the balance sheet of a bank. If you're a rating agency, how do you evaluate a bank? Whether the guarantee will stand or not. So, it's a real problem when you give free guarantees away to institutions, basically the incentives to monitor are very low indeed."
Listen to Julian Franks' podcast.
Stephen Schaefer, Professor of Finance
- Basel Two has been a failure and the pressure for action will be on the US to replace it. But, unlikely to be a consensus.
- Regulation needs not only to include the banking system but to look more broadly.
"One of the problems with inconsistency of regulation across countries is that you get financial services that move and you get the so-called race to the bottom."
"The focus of regulation has been largely around the banking system, but what is clear is that the origin of this crisis has an awful lot to do with the way in which the different bits in the financial system connect with each other. The regulatory system wasn't up to speed with this. It is too narrowly focused on simply banks."
"I think we've got to take a much more serious approach to liquidity. The number of references to liquidity in the Basel document are minimal."
Listen to Stephen Schaefer's podcast.
Elroy Dimson, BGI Professor of Investment Management
- High economic growth does not guarantee attractive stock investments.
- Invest in distressed securities.
"In our work, based on 108 years of data for 17 countries, we're creating a trading rule in which you allocate money towards low or higher growth economies. The story is consistent. You shouldn't believe that, if you put your savings into high economic growth countries, you will get richer. Maybe the population will - that seems quite likely - but by the time you purchase securities it's too late, and equity prices will already reflect growth opportunities."
"The story within stock markets is if you go for companies which have lots of future growth prospects, that has not historically been a recipe for making money. A recipe for making money is to find distressed securities - that is companies on a low price to earnings, low price to sales, whatever you want - which have tended to produce higher returns."
"I side with the financial advisors who have a slogan: In investment, timing the market is not what you should be doing, you should be focusing on time in the market. Buying and holding, with an appropriate asset mix, makes sense."
Listen to Elroy Dimson's podcast.
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