Need for Reform

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Lecture 8 — Need for Reform (The Two Gorillas and the Future ofDownload

Lecture 8 — Need for Reform (The Two Gorillas and the Future of Crises)

0) Big Idea

Since 1980, banking crises have been ten times more frequent and five times more severe than in earlier eras.
Two central drivers — the “two gorillas in the room”:

  1. Bank protection (deposit insurance, bailouts, recapitalization).
  2. Mortgage/real estate subsidization (subprime, cajas, thrifts).
    These gorillas are married: governments often use protected banks to deliver subsidized housing credit.
    → Result: systemic risk, twin crises, and repeated fiscal collapse.

1) The Global Shift After 1980

  • Median banking crisis loss: 16% of GDP (vs. 3% in 1930s US).
  • Frequency and severity unprecedented in modern history.
  • Not just banks: exchange rate collapses + sovereign fiscal crises = twin crises.

2) The Two Gorillas (and Sometimes a Third)

Gorilla #1 — Bank Protection

  • Deposit insurance expansion globally (often IMF/EU driven).
  • Bailouts beyond insurance (e.g., US TARP 2009, preferred & common equity injections).
  • Political bargains: banks shielded from market discipline in exchange for cooperation.

Gorilla #2 — Mortgage Subsidization

  • Longstanding U.S. example: 1934 thrifts + deposit insurance enabled the 30-yr fixed-rate mortgage.
  • Reappears in:
  • U.S. Subprime (2008)
  • Spain (2008, cajas-driven housing bubble)

Gorilla #3 — Conglomerate Alliances (select countries)

  • Mexico (grupos) and Korea (chaebols): political-industrial families backed by state credit.
  • Subsidized credit + implicit guarantees fueled collapses (1994, 1997).
  • Similar dynamics in Indonesia, Thailand, Iceland.

3) Case Studies

Mexico, 1994

  • Banks re-privatized to elites with 100% liability guarantees, no capital down.
  • Exchange rate peg + fiscal expansion + sterilization → unsustainable.
  • Collapse: peso maxi-devaluation, twin crisis. Fiscal bailout ≈ 25% GDP.

Korea, 1997

  • Chaebols over-leveraged, protected by banks & implicit sovereign backing.
  • Issued cheap foreign bonds despite junk fundamentals (markets knew gov’t backstop via IMF).
  • Collapse cost ≈ 30% GDP, twin crisis with sharp devaluation.
  • Crisis predictable — FT/Economist forecasted months in advance.

U.S. Subprime, 2008

  • Political bargains: GSE Act (1992) → Fannie/Freddie required to buy risky mortgages.
  • Bank mergers tied to activist group deals ($4.5T in commitments).
  • By 2006: ~40% of new mortgages had ≤3% down payment; many were no-doc loans.
  • Market equity prices of banks showed looming insolvency long before official crisis.
  • Fed’s 2002–06 ultra-loose policy lowered risk premia, fueling bubble.

Spain, 2008

  • Euro entry → interest rate spreads collapsed.
  • Cajas de Ahorros (local political banks) expanded housing credit recklessly.
  • Real estate bust → systemic banking crisis.

4) Twin Crises & Predictability

  • Twin crises (banking + FX collapse) frequent in emerging markets post-1980.
  • Mechanism: fiscal costs of bank bailouts overwhelm gov’t → debt monetization → currency collapse.
  • Often forecastable (e.g., Dornbusch on Mexico, Economist on East Asia).

5) Global Statistical Evidence

  • More generous deposit insurance →
  • ↑ Loans/Assets (riskier balance sheets)
  • ↓ Equity/Assets (thinner buffers)
  • ↑ Mortgage lending share (amplifies housing risk)
  • Strong evidence: deposit insurance both raises crisis probability and increases severity.

6) Policy Lessons

  • Deposit insurance ≠ safer banks → it incentivizes systemic risk.
  • Risk subsidies (insurance, guarantees, GSE mandates) amplify housing credit cycles.
  • Prudential regulation often complicit (rules opaque, capital measures phony).
  • Reform prospects are slim: political coalitions depend on these subsidies.
  • Best hope: transparency, market-based capital measures, less off-budget subsidization.

7) Looking Forward

  • Developed world faces fiscal dominance: debt levels imply future inflation/taxation crises.
  • U.S., Japan, EU, China all vulnerable.
  • Likely outcomes:
  • EMs → sovereign defaults
  • Developed economies → inflation >10% within decades (if unreformed)
  • Dollar likely to remain reserve currency — not from strength, but lack of alternatives (China not convertible, Euro weak, BRICS not credible).

8) Discussion Prompts

  1. Are deposit insurance & bailouts politically irreversible?
  2. Could we design mortgage markets without implicit subsidies?
  3. Should central banks practice macroprudential targeting (bubble-bursting) despite past failures?
  4. How does geopolitics (IMF, G7, BRICS) interact with crisis vulnerability?
  5. Are we destined for continued crises, or could democratic accountability shift incentives?
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