cc  >> Today's Global Hot Spot  speaker is Professor Mark  Copelovitch from the Department  of Political Science and the La  Follette School of Public  Affairs.  He teaches International  Political Economy with a focus  on global financial governance,  exchange rates and monetary  institutions, the effects of  global capital flows on national  economic policies.  Holy smokes.  [LAUGHTER]  Important stuff.  Relevant stuff.  Some of you may have heard him  speak as part of a panel with  WAGE last semester.  WAGE being World Affairs in the  Global Economy.  You may have heard him speak and  those folks are always offering  other lectures and opportunities  to learn more about global  finance and what's going on.  Professor Copelovitch is working  on a book manuscript that  actually he tells me is ready  for publishing and will be out  in the fall of 2009.  It is called Banks, Bonds and  Bailouts: Global Finance and the  International Monetary Fund. 

 He's a graduate of Yale  University and Harvard  University where he received his  Ph. D. in 2005.  Prior to coming here to  Wisconsin he was a postdoctoral  fellow at the Center for  Globalization and Governance at  Princeton University and he  joined the faculty here in 2006.  Will you please join me in  welcoming Professor Mark  Copelovitch.  [APPLAUSE]  >> Thank you.  Thank you, Sarah.  It's a pleasure to be here.  I have the thankless task of  trying to discuss both the  causes and possible responses to  the global financial crisis in  less than an hour.  [LAUGHTER]  Which probably can't  be done but I'll give it the  college try.  My talk today is In Search of  Stability: The Economics and  Politics of the Global Financial  Crisis.  I want to try and do two things  or at least see how much of  these two things we can do. 

 First I want to think about the  causes of the crisis, the  economics of the crisis.  What has happened so far.  What the timeline looks like.  What are the effects both on the  financial system and on the real  economy.  And then I want to think about  the politics of financial  stability.  This is what I study, I'm a  political scientist, not an  economist so I like to think  about how economic factors and  phenomena affect politics,  affect government policymaking  and international relations.  So I want to talk a little bit  about the policy responses,  what's happened to date, what  might happen, and think about a  set of difficult tradeoffs.  There are really no optimal  policies here.  Lots of experts like Mr. Geitner  and Mr. Summers and everyone  else are in some ways flying  blind trying to figure out how  to best manage the problems  we're facing.  And the reason why they're  flying blind to some extent is  that there's no right answer. 

 And so I want to talk about why  there is no right answer and how  we might think about making some  difficult choices, and then  think about what the road ahead  looks like.  But let me start by thinking  about what went wrong.  Up until about a year and a half  ago we thought that the system  of international financial  integration was accelerating,  was ever more stable, there were  lots of benefits both for  individuals and for countries.  It turns out there's some faulty  assumptions about 21st century  global finance that we're now  learning in the wake of the  crisis.  The first has to do with what is  known as securitization.  The idea that capital markets  are now so advanced that banks  can lend more aggressively while  offloading risk through debt  securities.  I'll talk about the subprime  mortgage crisis but in a  nutshell what has happened is  there's much less bank lending  nowadays relative to bond  financing, derivatives, debt  obligations, things that are  made up of other financial  instruments.  And we thought that was a way to  distribute risk.  So banks wouldn't fail so we  wouldn't have financial crises.  The second assumption has to do  with credit ratings agencies. 

 We thought that in this world of  securitized international  finance that credit agencies  like Standard & Poor's and  Moody's would help us navigate  this more complex world of  financial instruments.  Provide us an easy and cheap  compass for investors to assess  the risk of these securities.  If Moody's says that a bond is  rated AAA, we can believe them  even if we don't know  necessarily what goes into  making up that bond.  And if we put those two things  together what we thought about  financial stability,  particularly global financial  stability, was we were now  managing risk better.  Slicing and dicing of risk,  securities, taking assets off  banks' balance sheets that we  would have fewer financial  crises and they would be less  severe when they happened.  It turns out, as we know now,  that that's not necessarily the  case.  So let's start at the beginning.  The initial problem, subprime  mortgage lending.  I knew nothing about real estate  until I bought my house three  years ago.  I now know more about real  estate, both because of that and  because of the financial crisis,  than I care to. 

 [LAUGHTER]  The world of buying  houses, of real estate, was very  simple for many years.  One went to a bank, one applied  for a 30 year fixed rate loan  and one paid that back to the  bank over the course of 30  years.  During which the bank held the  claim on your assets, on your  house on its balance sheet.  So if you stopped paying your  loan, if you defaulted on your  mortgage the bank could  foreclose and take your house  but it also might take a  financial hit.  So what's happened over time in  the more complex world of  securitized finance now is that  banks don't like to hold these  mortgages on their balance  sheets anymore.  So what happens is you and I  still go to a bank, we still  apply for a mortgage, it's not  always a 30 year fixed rate  mortgage which I'll talk about  in a minute.  Usually what happens is within  two or three weeks, and this  happened to me when I got my  mortgage from M&I bank, within  three weeks of closing on your  house, the bank offloaded my  mortgage, along with thousands  of others to Countrywide.  And what happened was  Countrywide issued bonds that  were backed by mortgages,  mortgage backed securities.  Some of which, it turns out, are  prime mortgages and many of  which, it turns out, were  subprime mortgages.  So we have intermediation now. 

 One of the problems that comes  up then is no one necessarily,  knows aside from those  individual banks, about the  quality of the borrowers.  M&I bank did their credit check  on me.  They decided to give me money  which may or may not have been a  good decision, but Countrywide  knew nothing about me.  And individuals who bought  Countrywide's mortgage backed  securities knew nothing about  the thousands of individuals  that went into security with  their mortgages.  And it turns out that many of  the borrowers were not prime  borrowers they were known as  subprime borrowers.  Borrowers with bad credit.  And we can define bad as a  relative term but less than 620  on the FICO credit scale.  Most of these borrowers were  known as ninjas.  No income, no jobs no assets.  [LAUGHTER]  Approximately 20% of  borrowers. 

 So what kind of loans do these  subprime borrowers get?  They don't get the low 30 year  fixed rate mortgages.  They get what are known as ARMs.  Adjustable rate mortgage.  Which often have lower rates to  start but kick in at much higher  rates anywhere from three to  seven years down the line.  Banks don't want to make a 30  year commitment on a very low  interest rate mortgage to  someone who is a ninja.  So we might ask, before what  went wrong, why did this happen,  what's in it for the lenders,  for the banks of the issuers?  Well, it's profitable.  If you charge higher interest  rates to borrowers, as long as  they're repaying, you're making  more money.  And many of these ninjas were  people like myself.  People starting out their  careers who 20-30 years down the  line one could project they were  possibly moving up the income  ladder.  So it makes sense that one might  offer a teaser rate that would  kick in higher or that one might  offer a loan to someone with a  650 credit rating if 15 years  from now they might have a 770  credit rating. 

 It also makes sense if housing  prices keep rising.  Which I'll talk more about in a  moment.  For about 25 years there was a  secular increase in the United  States for the rise of housing  prices.  And so pretty much everyone had  convinced themselves that the  way the world worked was that  housing prices went up  regardless of the performance of  the economy.  The other thing that makes this  attractive is the idea of  securitization.  So if one is issuing mortgages  that are more risky, if you can  get them off your balance sheet  than it's not your problem  anymore.  It's not M&I bank's problem  anymore if Countrywide is now  holding the assets.  So there's no default risk on  the bank's balance sheet  anymore.  And what happens is these  mortgages, as I said, were  bundled into mortgage backed  securities.  Wall street loves acronyms, the  acronym of choice here is  Collateralized Debt Obligations  or CDOs. 

 The collateral is the mortgages  and the houses.  This is what a CDO looks like.  And what a mortgage backed  security looks like.  You see that what we have here  is a bunch of collateral in the  form of houses.  A lot of it is actually AAA,  prime mortgages.  But we move down the ladder here  and the letters don't matter so  much.  What matters here is as you move  down towards the bottom you're  getting farther and farther and  farther down into subprime  territory.  And so the ratings agencies play  a key role here.  Because Moody's and Standard &  Poor's would label these  mortgage back securities as AAA  if they had a certain percentage  of AAA loans.  But that percentage was not  100%. 

 So it turns out what's in this  security is not all prime own  though the security as a whole  is labeled prime.  And if you look at issuance of  mortgages, you see that the boom  in mortgage lending over the  last few years was in Alt-A,  which is slightly below prime,  but especially in subprime.  But subprime mortgages,  everybody knew that the default  rate would be slightly higher.  If we go back again.  People thought that the default  rate would be higher here.  But housing prices are going up.  So if you lose a little bit on  some defaults and subprime  mortgages you're making so much  off of the prime mortgages and  the Alt-A mortgages that it  doesn't matter.  And this is why people convince  themselves that we can do that.  If you look at this is a US  housing price trends from '88 to  '98, annual percentage change  pretty much since the beginning  of the Clinton administration.  A straight line up. 

 This looks different for  different markets.  Madison is certainly different  from San Francisco or New York.  But no one expected this.  No one expected the crash in  housing prices.  And as the crash in housing  prices happened over the last  few years, you see what happens  with default rates particularly  on subprime mortgages.  So these mortgage backed  securities and this idea of  subprime lending is profitable  if what we're talking about is  default rates down here.  But it's no longer profitable  and it becomes a problem for the  stability of both banks and the  financial system if mortgages,  if more and more people default.  So that's how the housing crisis  started.  That's what subprime mortgage  lending is.  The question is how do we go  from that to a systemic  financial crisis first in the  United States and then more  globally. 

 One might imagine that some  banks would fail.  Some mortgage lenders like  Countrywide might go under but  this wouldn't be a problem for  the financial system as a whole.  The problem is as these defaults  went up, there's a lot of  uncertainty.  Lots of institutions are engaged  in subprime lending and no one  knows how many bad mortgages are  in these collateralized debt  obligations.  Is it 8%?  Is it 15%?  Is it 60%?  Because we don't know what went  into that security, in terms of  the quality of the borrowers, we  don't know the risk on the  balance sheets of financial  institutions, and if one doesn't  know what's on the balance sheet  of financial institutions then  one is not going to lend to  those institutions.  So no one wants to lend to banks  or institutions with heavy  exposure for subprime mortgages.  So what happens?  The first thing that happens is  what's known as the flight to  quality.  If you're invested in risky  securities like subprime  mortgage collateralized debt  obligations.  Then you sell those and you buy  something stable.  You buy US treasuries which are  backed by the full faith and  credit of the US government. 

 You say I want a lower interest  rate but it's guaranteed.  The government is not going to  default on treasury securities.  The second thing that happens is  a spike in market lending rates.  So if there are fewer, fewer  investors lending to financial  institutions, then interest  rates go up in order to try and  attract more capital.  The other thing that happens is  it if you are worried about the  stability and balance sheets of  financial institutions you don't  want it invest in their stocks.  So we see a stock market crash,  as well as money comes out of  the financial sector.  And if we put all of that  together, we see a credit  freeze.  What we see now is frozen credit  markets.  So what does that look like in a  couple slides.  One way to look at that is  what's known as the TED Spread. 

 This spread between interbank  market rates, the rate at which  banks will lend to each other on  a short-term basis, and US  treasuries.  As I said, if there's a flight  to quality and everybody wants  treasuries that's going to drive  the interest rates on treasuries  down.  And if no one wants to lend to  banks anymore, that's going to  increase the rate that banks  have to charge in order to  attract capital.  And we see a widening of that  spread.  So historically what we see over  the last 10-15 years is there's  usually somewhere between a 1%  and 2% premium.  The government can say pay 3% on  a bond and a bank will have to  offer 5%.  Well, that spread went up to  almost 5%.  Because everyone wanted to be  down here and no one wanted to  be here anymore.  So that's one way to think what  the credit freeze looks like.  These are in some ways maybe  easier ways to look at it. 

 The first here is the US  commercial paper market, bonds  issued by corporations.  And you see the collapse.  This is in billions of dollars  of outstanding commercial paper  in 2006, 2007 and 2008.  Absolutely no one wants to hold  corporate bonds right now.  Which means that firms can't  borrow on capital markets.  They don't have access to  credit, people are worried about  their assets.  Financial and otherwise.  The other thing with the stock  market crash is I talked about  if we look at share prices of US  investment banks, there's a  complete collapse of the  financial sector, the stock  market and the financial sector.  No one wants to hold the assets  of these financial institutions  and no one wants to be invested  in these financial institutions  either.  So a case study. 

 One institution, how this  happened.  It turns out actually that the  first major institution that  failed during the subprime  crisis wasn't a US institution  even though the problem started  in the United States.  Its a bank called Northern Rock  in the UK which many of you have  probably heard of by now.  The -- bank in the UK in 2007.  Relatively large.  800,000 mortgage holders,  180,000 shareholders.  Where is the money coming from  that Northern Rock is lending?  It's getting about 60% of its  money by borrowing on the money  markets.  That interbank lending that I  was talking about before.  Borrowing from one bank, lending  out and paying back your  creditors.  And who is it lending to?  It's lending out to subprime  mortgage borrowers. 

 So Northern Rock is borrowing  from Citibank, for example, on  the financial markets in London  and then lending out to ninja  borrowers.  Well, this is what happens when  the credit freeze hits.  Northern Rock, because of the  subprime mortgage crisis, has  more and more of its borrowers  defaulting on its mortgages, and  it can't borrow new capital to  offset those losses because the  credit market has frozen.  And effectively what happens is  it becomes insolvent.  Now, in the United States,  Northern Rock would fail but we  wouldn't see the picture on the  right.  And the picture on the right is  something we haven't seen really  in an advanced industrialize  country since the great  depression.  It's run on the bank.  It's a bunch of deposit holders  lining up, I believe this is New  Castle, at Northern Rock around  the block to get their money out  because they're worried about  Northern Rock failing.  So it turns out the British  deposit insurance, and not that  many people realize this, only  insures about 30% of your  initial deposit and you can get  the rest back but it takes about  a year or two.  And so what happened was rather  than the FDIC, all of our money  is insured, we don't need to  worry about if the banks fails  we'll get our money back and it  will be quick, people wanted to  go and get their money out. 

 And there were runs on Northern  Rock retail outlets all around  the country.  Eventually the Bank of England  steps in and bails out Northern  Rock to the tune of $55 billion.  Ultimately, when that really  doesn't seem to stem the bank  run, effectively Northern Rock  is nationalized.  It's now part of the Bank of  England.  All of these bad assets are now  on the United Kingdom  government's balance sheet.  I like cartoons as a way to  think about how we pull these  problems together.  This effectively is what  happened to Northern Rock.  The subprime borrower would love  to borrow from a lender who is  willing to lend not only to  prime borrowers, but it can only  do that if it can continually  access capital.  So once the interbank lending  market collapses, Northern Rock  has no capital left, more and  more of these fine folks are  defaulting and we end up with  the collapse of an institution.  So after Northern Rock, the  crisis comes back and hits home  in the United States. 

 This is probably a familiar  story to you now.  Bear Stearns was the fifth  largest investment bank, also  had massive subprime losses.  There were various discussions  and attempts to deal with this.  The first was JP Morgan buying  up Bear Stearns backed with  money from the Feds.  And that happened but it  happened with a price of $240  million in March of '08.  And you look at what Bear  Stearns market capitalization  was a year before that.  So you can imagine that Bear  Stearns shareholders were not at  all happy about that deal.  The initial reaction to Bear  Stearns though was that Bear  Stearns, Northern Rock, these  were isolated cases.  There were a handful of  institutions that were engaging  in this risky behavior.  Again institutions might fail  individually but not a systemic  crises. 

 Well, it turns out in April a  series of banks, Union Bank of  Switzerland, HSBC, Citibank,  start announcing very, very  large billions of dollars of  losses in the wake of Bear  Stearns.  And we have quite the catalog of  further events over the last  seven months now.  So IndyMac was the American  equivalent of Northern Rock, a  bank that kind of came out of  nowhere, grew very quickly  through subprime mortgage  lending.  The FDIC took it over in July.  We know about Fannie Mae and  Freddie Mac being taken over by  the US government.  Lehman Brothers is in many ways  the big one.  Bear Stearns was a relatively  small investment bank.  Lehman Brothers was a much  bigger investment bank, a more  prominent investment bank.  There was talk of a government  bailout.  It was decided that Lehman   Brothers wouldn't be bailed out,  and they filed for bankruptcy. 

 That triggered another series of  questions about the stability of  major financial institutions.  If Lehman Brothers can fail what  about AIG?  One of the largest insurers in  the world.  What about Citibank?  What about Merrill Lynch?  You and I now own approximately  70% of America International  Group as taxpayers.  The Fed loaned $85 billion to  AIG not necessarily because AIG  was a bank that should be bailed  out but because AIG had ties to  so many other financial  institutions that it was seen as  too interconnected to fail.  If AIG went under than claims,  what's known as counterparty  risk, the risk of its creditors  and borrowers going under, was  so severe that we needed to bail  it out.  Washington Mutual, the largest  savings and loan taken over by  the FDIC, eventually  taken over by JP Morgan.  We had the bailout bill in  October.  I'll talk a little bit more  about what went into that.  Over the last month or so  there's been a sense that the  worst had passed.  And it turns out that we're not  necessarily certain the worst  has passed now. 

 Citigroup just announced that it  has lost $8. 3 billion  this quarter.  Additional losses on subprime  lending that we thought we had  found everything already.  It also announced that it's  splitting into two.  So up until the late 1990s one  couldn't be a commercial bank  and an investment bank.  One of the regulations that came  out of the Great Depression was  the Glass-Steagall Act,  separating commercial banking  from investment banking.  That separation was dismantled  in the '90s.  Citigroup brought Salomon  Brothers, Citibank bought  Salomon Brothers, became this  financial supermarket.  Everything from bank lending,  deposit taking to you and me to  underwriting investments,  securities, stocks and bonds on  Wall Street.  It turns out as we know from the  faulty assumptions about  securitization and slicing and  dicing of risk, that model  doesn't necessarily work and  Citibank has now decided to go  back separate ways with the  commercial banking side and the  investment banking side.  So the catalog of institutional  failures eventually starts to  affect markets. 

 All of you probably know this  better than me because you're  closer to retirement age.  What's happened to the stock  market over the last few months,  but also now what's happening  with the real economy.  This is real gross domestic  product.  Growth and trends both in the  advanced industrialized  countries and in the developing  world and emerging markets.  And in many ways the bottom has  fallen out.  If we look at annual percentage  change very sharp collapses in  real economic activity.  So what we thought was initially  a crisis about the stability of  individual institutions, became  a crisis about the stability of  financial markets as a whole and  is now a crisis about the  stability of the international  economic system.  The real economy in terms of  growth and output and employment  we're now worrying about the  knock on effects of the collapse  of the financial system.  So in short, we have a mess and  then the question is what to do  about it.  What are the sorts of policy  responses that governments might  put in place, both domestically  and internationally to try and  deal with this. 

 And when we think about  responses to financial crises we  tend to think about it as a  two-step process.  The first is the short-term.  The short-term can be long in  the sense that it can be many  years.  But it has to do with the  management or the fire fighting  of the crisis and the  resolution.  How do we fight the fire, how do  we put the fire out, how do we  get to the point that we can say  the crisis is over.  There's a series of policies.  I'll talk about more in a  second.  Crisis lending, interest rate  cuts, bailouts which is  preventing bank runs or  collapse, bailing out individual  institutions.  But then also trying to deal  with the systemic problem,  right?  The frozen credit markets.  What's come to be known quite  extravagantly, I think, as toxic  debt. 

 We're using the analogy of toxic  waste clean up now.  We need to try to figure out how  to clean up the toxic waste here  and how to dispose of it.  The longer term, and in many  ways given the things I study  somewhat more interesting  because it has longer lasting  effects on the future financial  crises and financial stability  is once the crisis is over what  do we do to prevent future  crises.  And there's discussions about  new regulation.  There's discussions about new  institutions.  There's discussion about both  national policies and  international policies, which  I'll talk about in a moment.  But first the short term policy  responses.  So the first set of responses  was really the bailouts money.  Money directly to individual  financial institutions.  To try and cover their losses. 

 The TARP, the Troubled Asset  Relief Program, part of the  bailout package, the idea behind  this was that the Fed would lend  money to major financial  institutions to offset its  losses, therefore people  wouldn't worry about the  solvency of the institution, we  wouldn't have the bank runs.  These institutions wouldn't  collapse.  So providing liquidity,  financial assets.  Back-stopping individual  institutions.  The systemic issue dealing with  toxic debt is about not doing  this piecemeal.  Not helping out Citibank,  helping out AIG, helping out  Fannie Mae.  As we see, this gets very  expensive as you're bailing out  individual institutions.  So the discussion now has really  shifted towards dealing with  this problem at the systemic  level.  But there's several different  ways one can do that.  One is what's known as an  aggregator bank or a bad bank. 

 You all probably remember the  savings and loan crisis better  than I do from the 1980s.  The Resolution Trust Corporation  was just such an organization  created by the government.  We will create an institution, a  bank, a government owned bank  that will soak up all of the bad  debt.  And the idea is individuals  institutions would basically  come and give all of their bad  debt to the government,  therefore, they could go back to  the private markets and say look  our balance sheet is clean now,  you should lend to us.  Once and for all, the problem is  done.  We know exactly how much money  there is.  The problem with that is it's  extremely hard to price these  things.  So if we have these worthless  mortgage backed securities now  what dollar value do you put on  these?  If the government is going to  buy them up, and then hold them  for a little while and maybe try  to sell them off at a later  date.  But we don't know what these  assets are worth anymore.  We thought they were worth a lot  of money because Moody's had  stamped them AAA, but we  actually don't know if they're  worth anything anymore. 

 An alternative way to do it is  what the UK has actually done  and as of last week they  actually extended this model so  with the US bailout in October  was a lot of liquidity.  The TARP was a pot of money that  individual institutions could  come and borrow.  The British government took a  different tact.  They effectively set up an  insurance model where they took  stakes in banks.  If you come, it's sort of a  halfway house between the TARP  and the bad bank.  If you come and you tell us how  much debt you have, we will  insure that for a price.  And the price is effectively a  tax on your future returns for X  number of years.  So we'll take the bad debt off  your books, but we get a stake  in the bank.  The British government now owns  about 80% of the Royal Bank of  Scotland and several other large  banks.  So if those banks go back and  their stock prices go up, the  government's going to make money  off of that. 

 And they get money off of all of  the interbank lending that those  banks are going to make for X  number of years, and I forget  the exact number but I think  it's somewhere between three and  five years.  So it's a more direct stake in  the banking sector, but there's  also more strings attached in  some ways.  The third thing in terms of  short-term policy responses then  is not protecting individual  institutions, not protecting the  market stability as a whole but  protecting the individuals.  The extension of the deposit  insurance.  So instead of $250,000 maybe it  goes up to $500,000.  The first thing the British  government did in the wake of  Northern Rock was adopt US style  deposit insurance where they  fully guarantee deposits.  The idea there being that even  if individual banks are going  under, we're not going to have a  bank run.  Because if we have a bank run on  one institution people start to  worry about bank runs on other  institutions and then the world  does really start to look at the  Great Depression where everybody  is running to the corner,  getting their money and hiding  it under their mattress because  no one wants to have banks  holding their money.  So a series of short-term policy  responses.  But the question of which of  these, if any, and on what  scale, should be done are very  difficult. 

 There's a lot of questions that  come up here.  Why not let troubled  institutions fail?  If a financial institution, even  a large one, has engaged in  risky behavior, why not let if  go under?  Or on the other hand, why not  bailout everybody?  Why is it that we would bailout  Citibank and AIG but not Bear  Stearns, not Lehman Brothers.  Who should be saved is not  necessarily an easy question to  answer.  And the question about the  aggregator banks and the bad  banks and insurance, what should  the government get in return?  If with going to agree to  bailout individual institutions,  what are the strings that are  going to be attached?  How far should the safety net be  extended?  This is the big one that we've  been talking about recently with  General Motors.  Most people agree that the  financial system is special in  some way because it's the oil of  the economy.  Without a functioning financial  system, real economic activity  in terms of production and trade  can't take place.  But if we are bailing out the  financial sector on such a grand  scale, what about the real  economy?  What about other corporations  that are hurting?  What about Detroit, for example.  So should non-financial firms  get bailouts too?  And the big one I'm interested  in because I study international  relations and international  cooperation is how much of it  should be done at the national  level versus the international  level.  I'll get to that in a second.  So this is where the politics  comes in. 

 There are no optimal economic  answers to any of these  difficult questions.  And what I thought would be  useful to discuss a little bit  is the set of difficult  tradeoffs.  The inevitable tradeoffs that a  government faces when it's  making these decisions.  So one is what's known as  liquidity versus moral hazard.  Which I'll get to in a second.  Financial crises versus other  goals.  One we like to think about in  political science is aggregate  welfare.  What's best for taxpayers versus  what's best for special  interest.  We know that government policy  is the not always reflective of  some benevolent policymakers  doing what's best as a country  as a whole.  Often it reflects lobbying  groups, corporations,  nongovernmental organizations,  etc. 

 Accountability versus  effectiveness.  We can think about at the  international level giving lots  of new authority to say the  International Monetary Fund to  deal with the crisis might be  highly effective but there's a  democratic accountability issue  with delegating national  sovereignty to an international  institution.  There's also a question when  we're thinking about domestic  versus international about  confidence versus  competitiveness.  So the first one, this idea of  liquidity versus moral hazard.  So these bailouts, the Fed  providing money to the markets,  to institutions helps banks to  pay their debts, it may unfreeze  credit markets it may do what  Ben Bernanke and Tim Geitner and  Larry Summers and everyone else  wanted to do.  It may get us through the  crisis.  But there's a cost.  And the cost is what we think of  in economics as moral hazard.  Moral hazard is incentives for  actors in the economy to engage  in future risky behavior in the  expectation of more bailouts.  This a concept that comes from  insurance. 

 The classic example for moral  hazard is with fire insurance  that if you have very good fire  insurance, perhaps well in  excess of the value of your  house, you might have incentives  to burn your house down and  collect the money.  Particularly if housing prices  are doing what they're doing  right now.  So we can think about a bailout  working in the same way.  If Citibank gets a bailout in  this crisis, well, the next time  there's a crisis they might also  get a bailout.  I study the International  Monetary Fund and we think about  this with countries as well.  Argentina is a classic case  here.  So the IMF has been lending to  Argentina more or less  continuously with a few gaps  since the early 1980s, and  there's a sense that moral  hazard is at work.  If every time Argentina has  difficulty paying its debts it  can go to the IMF and get money  to pay back those debts.  It just borrows hand over fist  in international financial  markets.  So what do we do about this?  What do we do about that  bailouts have both of these  affects?  Well, we can think about  attaching strings. 

 The size of the bailout but also  what are the conditions.  If we're not so worried about  moral hazard, well more money  and fewer strings.  If it really is about short-term  liquidity.  Maybe it's a bank that had no  subprime lending but people  associate with it for some  reason with Countrywide or  IndyMac or Northern Rock and  there's a run on that bank as  well, they're sort of an  innocent bystander, we can bail  them out with fewer strings.  But if the bank really was doing  something wrong than maybe they  get less money.  That less money might come in  the form of the government  taking a stake or there might be  strings attached.  You have to pay us back some of  your interbank lending profits  for the next five years, for  example.  The problem with this is there's  no clear economic answer.  Where is the cut point?  Which banks are insolvent, which  banks just have a liquidity  problem?  Very, very hard to say.  It might be in the eye of the  beholder. 

 The government decides that AIG  or Citibank are too big to fail,  but are they too big to fail  because they're too large?  Are they too big to fail because  they're too politically  connected.  There's no optimal policy choice  here.  And different governments will  make different decisions about  this.  The second tradeoff has to do  with financial stability and we  can also think about economic  stimulus here.  And other goals.  So we're talking about ever more  amounts of money here.  With both the stimulus package  that we're now talking about  $825 billion.  We still don't know how many  toxic assets are on the book if  we are going to do something  like set up a bad bank.  But the latest estimates now are  they might be $3 billion to $4  billion.  So what I put up here, this is  from the New York Times a couple  weeks ago, the cost of some  other things that we might care  about that we want to the  government to do or the  government is currently doing. 

 So the Iraq war, universal  healthcare and preschool which  are both now on the agenda in  the Obama administration.  $10 billion to implement the  9/11 recommendations which  haven't been fully implemented  yet.  We can even think about things  like the NIH budget, cancer  research, Center for Disease  Control, etc.  So when you're talking about  the Fed temporarily  lending $30 billion or $40  billion.  That's one thing.  When we're talking about  trillions of dollars, right, it  has to come from somewhere.  It can come from increased  taxes, it can come from other  parts of the federal government  budget but the point is there  might be difficult tradeoffs  here between financial stability  and other goals.  And, again, different  governments might make different  choices about.  One can imagine that the Bush  administration as opposed to the  Obama administration has  different views of deficit,  different time horizons,  different political connections.  So it's not all about just  trying to price this debt and  figure out how much we actually  need. 

 There's a question of who is  politically most deserving, as  well.  That's all just the short-term.  Or the short to medium term.  We can also think about the  long-term here.  And, again, we can do this  domestically or internationally.  With new regulation and new  institutions.  So a lot of people now both  inside the new administration  and in academia and think-tanks  are thinking about what sorts of  regulations need to be in place.  So the if the ratings agencies  were part of the problem, we  need to better regulate the  ratings agencies.  If derivatives like  collateralized debt obligations  are completely unregulated and  hedge funds are completely  unregulated in investing in  subprime mortgages, well, maybe  we need to regulate that sector  of the economy.  If the Fed is going to bailout  large institutions that are not  commercial banks, the Fed is the  supervisor of commercial banks  but not of investment banks. 

 Well, AIG is not a commercial  bank, AIG is an insurance  company.  Lehman Brothers was not an  invest machine bank and one of  the reasons the Fed decided not  to bailout Lehman Brothers was  they weren't a commercial bank.  Well, basically there are no  investment banks anymore.  All of the sudden what's  happened is everyone has applied  to be a commercial bank.  Goldman Sachs, Merrill Lynch was  just bought by Bank of America.  So in anticipation of more  stringent regulation most major  financial institutions have now  decide to become commercial  banks.  Partly because they new they  were going to be regulated  anyway so there wasn't an  advantage to staying an  investment bank.  Partly because they wanted to  guarantee access to Fed credit.  And so all of the sudden if the  Fed is going to extend this  safety net as lender of last  resort, it's going to more  strictly regulate a lot more  major financial institutions.  But there's also discussion  about reform of institutions. 

 So most of the problem started  in the securities sector.  The Federal Reserve does not  regulate securities, the  Securities and Exchange  Commission regulates securities.  And the SEC has had a very bad  series of months between the  subprime mortgage crises and the  Madoff affair.  Not doing very well right now.  One of the discussions is we  need to create a superregulater.  If the world has become so  complex, it's not banks, it's  banks and securities and  derivatives and insurance and  all major institutions are doing  all of these things at the same  time, we need one regulator.  Maybe it should be the Federal  Reserve, maybe it should be a  separate institution.  In the UK they have the  Financial Services Authority  which is separate from the Bank  of England.  There are a lot of archean  academic reasons why one might  prefer one over the other.  The tradeoff here, that I think  is important to think about, is  one of states versus markets. 

 So, again, there's no optimal  rule for how much of a stake the  government should have in the  financial sector in terms  nationalization or state  ownership of the banking sector  or how stringently it should be  regulating.  But individuals, governments,  countries have very different  preferences about this.  And the British government  nationalized two-thirds of its  banking sector, and there was  almost no public outcry about  this.  But you can imagine the public  outcry in the republican party  if the US government decided to  nationalize the banking sector,  would be huge.  So there are ideological  differences in the relative role  of government in markets.  And there's a tradeoff here.  It might be highly effective to  completely nationalize the  banking sector and overregulate  to prevent future financial  crises.  But we might not want to do  that.  We have the same set of issues  with some different tradeoffs at  the international level.  So this is a global crisis now. 

 It started in the US, it spread  to the UK, it's now spreading to  emerging markets.  It's pretty unlikely after two  years of almost purely national  responses that national  responses are going to solve the  problem.  We think of Citibank, for  example, as an American bank but  about half of Citibank's  operations, if not more, are  actually over seas.  So Citibank or an American bank  or a Japanese bank or a German  bank, it's hard to enter.  It's hard to peg a financial  institution as belonging to one  country anymore, given the  globalization of finance.  So a lot of what's on the table  now at the international level  is regulatory harmonization.  The European Central Bank just  announced that it wants to take  over EU level banking  regulation.  Banking regulation in the Euro  zone even though there's a  supernational monetary  authority, the European Central  Bank in Frankfurt, regulation  still takes place with the  national central banks and  national financial regulators.  So with the G-20 summit that  happened back in November and  there's another one in April,  what's on the table now is more  regulatory harmonization.  Possibly through the Bank of  International Settlements in  Basel, Switzerland, which is a  club for central bankers of the  major world economies. 

 The tradeoff here is one of  confidence versus  competitiveness.  The reason why we might want  international or regional  harmonization and not purely a  national response is national  regulation makes banks  uncompetitive in world markets.  If you the US increased  regulation on its banks, but the  Japanese and the British and the  Germans don't, then they have a  price advantage.  One of the main regulations is  what's known as capital  adequacy.  Banks have to keep a certain  amount of money in reserve,  adequate capital, in case people  show up at the deposit window.  It's usually somewhere between  8% and 10%.  What if the US raised capital  adequacy to 20%, but no one else  did.  All the sudden Citibank has to  hold more of its assets, and it  has less to lend out, it might  be less profitable.  It might have to charge higher  interest rates, whereas German  banks don't.  So if we want to increase  confidence but not undermine  competitiveness we need  everybody to increase capital  adequacy so we need some kind of  international standard instead  of a national policy. 

 In terms of new institutions, we  can think about reforming the  International Monetary Fund.  There the tradeoff is about  accountability versus  effectiveness.  So the crisis is spreading  through emerging markets.  You see capital flow to emerging  markets has dried up over the  last couple of years.  What the IMF does is it lends  money to developing countries  that have trouble paying their  debts back.  Well, the fund only has about  $250 billion of resources right  now.  Its five largest shareholders  are the US, the UK, Germany,  Japan, and France.  They're all in the midst of this  financial crisis.  People think that the fund needs  anywhere from three to ten times  more money to be affective right  now.  But the question is where is the  money going to come from. 

 There aren't that many places  where the money can come from.  The Japanese have kicked in $100  billion.  It could come from China.  But the problem is that voting  in the IMF and power within the  IMF is a function of how much  money you put into the IMF's  pot.  The IMF is like a global credit  union basically.  You have voting shares that are  proportional to your deposits  with the IMF.  Well, what if China decided to  throw in $700 billion into the  IMF?  All the sudden it would be the  largest shareholder and have the  largest voice in the IMF's  lending policies to developing  countries all around the world.  There might be an accountability  problem versus an effectiveness.  That might be really effective,  a well capitalized IMF can now  deal with financial crises  around the world.  None of us might like the fact  that the IMF is now accountable  not to the United States and the  European countries but to China. 

 So, again, is difficult tradeoff  here.  In order to make the fund more  effective, it needs more money,  but where is the money going to  come from.  So, as I said, this is where  politics comes in and not just  economics.  Lots of policies here.  Possible conflicts between good  economics and good politics.  If you think about bailing out  well-connected financial  institutions rather than  deserving financial  institutions.  What we think about in political  science is a set of factors or  variables that might lead  different governments to make  different choices.  Domestic politics, interest in  institutions, democratic  governments, for example,  left-wing governments may do  something different than  right-wing governments or  non-democratic governments.  When we're talking about  something lake IMF lending power  and geopolitics come into the  equation.  Will the IMF bailout a country  like Pakistan that has nuclear  weapons even if financially the  case isn't there to bail them  out. 

 Are there non-economic reasons  why we might do this.  There are also collective action  and bargaining problems.  One of the reasons that  governments are responsive to  organized lobbying groups is  they're small, they're well  organized, they're well financed  and it's harder for average  citizens, a large group of  average citizens to organize to  lobby the government.  In American politics we think  about this as votes versus  campaign contributions.  And politicians don't  necessarily just aim for votes,  they also aim for money and they  respond to money.  And, again, ideology, as I said,  with states versus markets.  There might be different views  by different governments about  the relative role of the  government in the banking  sector.  Even if we think what is it best  is nationalization, in terms of  economic effectiveness, that  might be politically hard to  sell at home.  So let me conclude just by  thinking about looking ahead.  Where is all of this going?  So the first question with the  short-term response is with the  bailouts and what not is are  they working?  And this is something we  actually haven't heard very much  yet because the sense is that  the financial crisis is still  raging and we're not making any  head way. 

 But this is the that TED spread  that I talked before.  The difference between the rates  at which banks lend to each  other and the US treasury rate.  Well, it's all the way back down  from the peak.  So if we think about has the  bailout worked?  By this measure at least it has.  The credit markets are starting  to unfreeze.  But, there's always a but,  right?  So but Citibank just announced  $8. 3 billion  in losses again.  Bank of American bought Merrill  Lynch and all of the sudden is  finding lots of what was on  Merrill Lynch's books turns out  to be a lot worse.  Mr. Thane just lost his job  yesterday, the former CEO of  Merrill Lynch.  The British government, as I  said, just took a larger stake  in the Royal Bank of Scotland.  It turns out that we still don't  know how many of these toxic  assets are on the books. 

 So it's possible that spread  could go back up if we don't  figure that out.  There's also no evidence that  the TARP funds are being used to  lend.  Again, the idea behind the  bailout was you give banks this  money and they have capital and  they're going to start to lend  it out to unfreeze the credit  markets.  Well, the banks basically held  onto that money to shore up  their balance sheets.  But if they're not lending out  then no one can get loans.  Auto loans, mortgage loans, etc.  So the effect on the sort of --  for the real economy  hasn't happened even if we  stabilize the financial sector.  And we still have the spill  over.  We're now seeing the spill over  to the real economy, in terms of  recession and unemployment.  And you can pick up the  newspaper and see pretty much  everyday the news is worse. 

 The thing we haven't seen yet  that we're about to see is the  crisis really hitting home in  developing countries.  Unlike the major financial  crisis of the 1980s and 1900s  this has been almost exclusively  an advanced industrialized  story.  But commodity prices have  crashed, many developing  countries are highly dependent  on commodity exports.  And if you look at the bond  spreads.  These are bond spreads over US  treasuries.  This is emerging markets.  100 basis points is a percent.  This is sovereign bonds for  developing countries.  No one wants to lend to them.  Their borrowing costs are going  up. 

 It's the same sort of freeze we  saw in the commercial markets.  This was the Asian financial  crisis.  So we're starting to see, again,  developing countries that might  be back at the IMF.  We might have another global  financial crisis on our hand.  It's not just the advanced  industrialized country.  And this is the really scary  one.  This is from the New York Times  this past weekend.  The collapse in world trade.  Global slow down in exports.  Almost every country around the  world. 

 This is when people start to  talk about a new Great  Depression, this is what they're  worried about sort of spiraling  collapse of the real economy.  But let me try to end on a  little more positive note.  [LAUGHTER]  So the extent that  one can find silver linings  here.  So some perspective.  We've been here before.  Everyone right now is talking  about how this is the new Great  Depression.  And in many ways it's not.  In fact, the severity of these  crises looks a lot like recent  crises in the last 20 years in  terms of losses.  The numbers have gotten bigger  but the world economy has grown  as well so when we think in  percentage terms this isn't that  much different than the Japanese  crisis or the savings and loan  crisis.  This brings is home a little bit  better, I think. 

 This is what happened in the  Great Depression.  Half the banks in the United  States failed.  Half of everybody's wealth  disappeared and unemployment  went up to 25%.  So we've gotten used to, over  the last 30 years, unemployment  of about 4. 5%  or 5% or maybe 6%.  So now that unemployment is  about 7. 5%  we're talking about a Great  Depression.  A Great Depression is an order  of magnitude difference in terms  of the erosion in national  wealth, the collapse of the  financial system of the  disappearance of savings,  unemployment and it lasted for a  very long time.  It was almost ten years really  before we were out of the Great  Depression.  So it's not to say that this is  not a severe crisis.  But if we think about what sorts  of policy responses should be  put in place, the new deal was  an extraordinary set of  policies.  Complete reorganization of the  way the federal government was  involved in the economy. 

 If the crisis isn't on the order  of the magnitude of the Great  Depression than maybe we don't  want to go down that route.  We want to be careful about how  much we fundamentally alter the  systems of regulation and  government involvement in the  economy and what not.  The other way to get perspective  on this is to look at  employment.  This is total non-farm payrolls  in the US.  And the decline, the shaded bars  are recessions.  And this is flat.  This is employment being flat.  So if you look at where we are,  we're about where we've been in  terms of declining employment  for every recession over the  last 20 years.  Now the $64,000 question is, of  course, what happens down the  road?  Do we go back up like we've done  with other recessions or to we  have a Great Depression sized  decline.  Again, keeping things in  perspective in terms of how bad  the crisis is right now I think  is useful. 

 Because it informs questions  about how big the stimulus  should be.  How big tax cuts should be.  What sorts of government works  projects should we put in place.  It's a question of how severe we  think the crisis is going to be  and what the timeline for fixing  it is.  And again, because I like to end  on cartoons, there is a G-20  summit, the second G-20 summit,  and lots of international  initiatives, lots of thoughts  about national policies.  With Obama coming into office,  there's a lot of enthusiasm in  sense that all of the sudden  even though we're not sure how  big the problem is, we know what  needs to be done.  This is the set of policy,  short-term and long-term.  There are political tradeoffs  but we're going to sort of put  those in place over the next  couple of years and we'll come  out.  At that G-20 summit in November  and in the run up to the new  one, there's a lot of sort of  back padding,  self-congratulating going on by  governments saying an impressive  display of international  cooperation.  We've mobilized in the crisis,  the US has elected a new  president who's now going to  reengage with the world  community and things are going  to get better. 

 Well, the plane is still going  down and we're doing this so  quickly and on the fly that we  might not have the parachutes.  There's no margin for failure  and we don't actually know where  this is going.  So it will be interesting to see  what happens six months from  now, a year from now.  We'll have a better sense of  both have these short-term  policies worked but also what  are the long-term policy that is  are going to be in play.  So part of the difficulty here  is chasing a moving target and  trying to prognosticate.  And unfortunately again, in  November this is videotaped so  people will be able to say  Copelovitch was wrong in his  forecast.  [LAUGHTER]  So we will see what  happens over the next few  months.  I'll stop there, I've one over  but I'm happy to take questions.  [APPLAUSE]  >> I'll carry the mic  around so we can be sure to hear  your question so just raise your  hand and I will come find you.  >> Hi. 

 You haven't really talked much  about the real estate market  other than the subprime.  My understanding is that there's  a lot more involved with the  pattern of mortgages, and I'm  just wondering if you have any  ideas about whether we're going  to deal with the mortgage  crisis, the whole array of  things because it seems to me  that we're not going to see an  end to a lot of what's going on  until we begin to stabilize the  housing industry.  >> So the big problem I think  actually that we don't know how  big it is yet is not the  residential real estate market.  Default rates are also going up  on all day mortgages and prime  mortgages, who that hurts is new  borrowers.  It hurts people like me, for  example, who qualified, when I  borrowed three years ago, for a  conventional 30 year mortgage  even though my sort of assets  and balance sheets didn't look  like yours did perhaps.  So new young borrowers who used  to have good credit.  The bar for what qualifies as  good credit has gone up.  The bigger problem that's really  scary actually is we don't know  about the crisis in the real  estate market.  You can see that if you look  downtown at the Overture  building or that Whole Foods has  stopped building.  If you go and look at real  estate in New York or Boston or  San Francisco you see it even  more starkly that the same sort  of subprime lending was  happening not just at the  residential level but also the  commercial level. 

 So what happens if you and I  default on a half million  dollars house is one thing but  if it developer defaults on a  $30 million loan, it's certainly  another.  And if that cascades that can  also have real effects on the  economy.  So you're right.  It's a serious problem and I  don't think anybody actually  knows how severe that's going to  be yet.  >> I don't need the microphone.  You did mention two factors that  I wonder about that might impact  on this or have caused, in part,  this global crisis.  One is the concentration of  wealth within a few or a small  number of persons or  institutions.  And that seems to be a predictor  of recessions.  Secondly, the impact of the  dominance of the financial  institutions as part of the  total economy in the United  States and in the world.  I don't know if those are  factors or not. 

 >> Well, it's certainly a  factor, the latter one is  certainly a factor for how  governments are deciding what to  do about this.  So if we think about the US  versus the UK again the British  government has been much more  aggressive.  As a percentage of the economy's  spending money, nationalizing  the banking sector partly  because the city of London is  really the economic driver for  the entire country in the UK.  As big as we think Wall Street  is, Wall Street relative to the  whole US economy is not the same  thing at the financial sector in  London relative to the entire UK  economy.  Or the financial sector in  Singapore relative to all of its  economy.  So the aggressiveness with which  governments might be engaging in  bailout packages and rescues is  partly a function of that.  On the first point, I think by  now, I think we've belatedly  learned the lesson that the wave  of mergers in the financial  sector in the '80s and '90s was  a bad thing because it did  create so many very, very large  institutions.  And it's not necessarily that  they're unaccountable, it's that  what qualified as a bank that  was too big to fail.  There used to be a handful of  banks in this country.  There used to be Citibank, Bank  of America, maybe Wells Fargo. 

 But if you roll up all of the  investment banks and insurance  companies and commercial banks  together and you create four or  five financial supermarkets that  dominate 50% or 60% of the  industry, they're all too big to  fail.  And they're all so connected  with each other.  The other side is  securitization, this slicing and  dicing and distribution of risk,  makes everybody so connected  that size almost doesn't matter.  It's how connected are you.  So if you remember long term  capital management back in the  late 1990s was a very, very  small hedge fund that the Fed  bailed out.  The reason why was LTCM was tied  up to so many major banks on  Wall Street even though it was  tiny that we worried about the  systemic risk of letting LTCM  fail.  So that creates a problem  because maybe then we have to  bail out everybody because  everybody is interconnected.  And again that leads to moral  hazard.  So there is a problem with  consolidation.  I think part of what we've seen  with Goldman Sachs becoming a  commercial bank, with Bank of  America buying Merrill Lynch and  the investment banking sector  disappearing but also  organizations like Citibank now  breaking into two is this  recognition that you're not  going to get bailed out if  you're so big anymore. 

 You're going to be more tightly  regulated.  You need to be smaller.  You need to be more focused in  order to be profitable and to be  stable.  >> We'll take one more question,  but you can feel free, if we  don't get to yours, to come up  and ask when we're done.  >> So Iceland was melting.  >> Yes.  >> What's become of Iceland?  >> What's become of Iceland.  Well, Iceland effectively had  become a hedge fund.  [LAUGHTER]  So Iceland was  borrowing enormous amounts of  money from British banks.  And its growth rate was very  high, its economy was very  stable, it had easy access to  credit. 

 It effectively over borrowed.  And what happened was as its  exports crashed, as people  worried about the stability of  its economy, it got hit.  So in some ways you can think  about Iceland as an innocent  bystander.  Iceland actually wasn't involved  in any subprime mortgage  lending, but think about Iceland  as a small bank that's trying to  compete for capital as that TED  spread is going up.  So the mortgage crisis, right,  doesn't just hit the bad  borrowers, it hits everybody.  And British banks don't want to  lend to Iceland anymore.  And so Iceland doesn't have any  access to credit but it's run up  all of external debt which it  was using to fuel domestic  investment in its economy and  the only way it can pay it back  was to borrow more to from the  banks and lend it.  And when that spout gets turned  off, Iceland is left going to  the IMF.  So actually Iceland is the first  advanced industrialized country  since Britain, I believe, in  1967 to go the to IMF.  We think about the IMF as an  institution that only bails out  developing countries now. 

 Iceland is there now.  A bunch of the new eastern  European EU members are there.  So what's happening with Iceland  actually is serious talks about  joining both the Euro zone and  the European Union.  That an economy that small can't  survive on its own anymore.  Iceland sort of thought it had  the best of both worlds.  National sovereignty,  independence, but effectively  part of the free trade agreement  with the European union so you  get the access to the largest  market in the world.  Well, if Iceland is going to  have to go to the IMF they  probably would rather go to the  European central bank for the  money if they really needed to  get bailed out but in order to  do that they have to be a member  of the EU, be part of the Euro  zone.  So Iceland's now going to lose  its national currency, it's  probably going to join the  European Union and it will have  a very hard time getting credit  from private banks on the same  easy terms it has over the last  ten years.  >> Thank you, so much for  walking us through this issue.  >> Thank you. 

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