Last month, the Federal Reserve Bank of Dallas published a staff paper estimating the costs of the 2007-2009 financial crisis. The conservative estimate came out at 40 to 90 per cent of 2007 output, roughly US$6 to US$14 trillion.
Central bank research work has been the most interesting and innovative in recent years. Bank of England executive director, Andy Haldane, wrote one of the most original papers, entitled “The Dog and the Frisbee”, arguing why complex regulations need to keep it simple. Unfortunately, Haldane was not subsequently promoted to the post of deputy governor (financial stability).
The Dallas Fed paper argued why it is important to measure the costs of the crisis in order to weigh against the cost of policies intended to prevent similar episodes in the future. After all, the running cost of financial regulation is like the price of an insurance premium against future disaster. If the premium is too high, you might not want to insure against the risks of an uncertain future cost. However, if the future costs of crisis are disastrous, then you might be willing to pay a high insurance premium. The only problem with more complex regulations today is that they may also slow down the whole economy tomorrow, which is also another “lost opportunity”.
The Dallas Fed researchers used three metrics to estimate the cost of the crisis. The first was lost output; the second the cost of national trauma and lost opportunity; and lastly, the extraordinary government support required. The first dimension is the common “output gap”, on how much goods and services were not produced due to the crisis. Various measures come out at roughly US$7 to US$12 trillion, but using a discount rate of 3.5 per cent, the 2007 output loss was estimated at somewhere between 40 to 90 per cent of GDP.
The second estimate was the cost of reduced wealth. From the third quarter of 2007 to the first quarter of 2009, US household net wealth dropped by US$16 trillion. However, the Dallas researchers wanted to look at the loss of human capital, due to unemployment, which rose to a peak of 10 per cent during the crisis and was still high at 7.6 per cent in June this year. This estimate also came up to a high of 90 per cent of 2007 output.
The third estimate was the unintended consequences of government intervention. How big was the unprecedented stimulus? The federal Troubled Asset Relief Program in 2009 disbursed US$418 billion, but including guarantees and liquidity supports, the Special Inspector General for the Troubled Asset Relief Program estimated that the potential exposure from the financial rescue could be as high as US$23.7 trillion in 2009.
From 2008 to 2012, the federal debt rose by US$11.3 trillion. Of course, not all the federal debt increase was attributable to the financial crisis, but there was no doubt that by 2012 the U.S. gross national debt was already around 105 per cent of GDP, significantly higher than the 80-90 per cent of GDP debt threshold considered safe. Of course, these debt levels are sustainable under the current low interest rates generated by quantitative easing.
The above study supplemented an important piece of data released through the latest Fed Flow of Funds tables, which revealed the changes in net worth by sector. The data showed that the household sector lost US$12.7 trillion in 2008, mostly through the decline in share prices and real estate value. The business sector lost US$1.6 trillion in 2008 and US$6.1 trillion in 2009. The government sector went into deficit by US$0.7 trillion in 2008, and has lost roughly US$1.3 to US$1.5 trillion yearly since then.
How much did the financial business sector lose? Its net worth rose US$1.6 trillion in 2008, lost US$0.7 trillion in 2009 and US$0.5 trillion in 2010, and was in the black again by 2011. In sum, almost everyone lost during the financial crisis, with households losing most, but Wall Street lost least. The reason is that its losses were covered by capital injection by the corporate and household sector, and there was huge government support. No wonder there was an Occupy Wall Street movement.
No discussion of the cost of the financial crisis can ignore the role of central banks in bailing out the financial sector. The Federal Reserve’s balance sheet has more than tripled since 2007, with major changes in the composition of its balance sheet. Instead of holding mostly short-dated Treasury paper, today the bulk of Fed holdings are long-dated Treasuries, mortgage-backed and agency securities and other support. This means that the Fed will be exposed to capital losses if and when interest rates rise. The BIS has estimated this at 10 per cent of GDP if interest rates rise by 4 percentage points.
The above research suggests that the true cost of the current financial crises is significant, but the damage is not immediately apparent. The Dallas paper implied that unemployment may be extended longer than before, and the ability of the government and central bank to respond to future downturns may be impaired.
One reason why the Dallas Fed has been so bold in its research may be the stance of its president, Richard Fisher, who has been outspoken on monetary policy and on financial regulatory reform. In an important testimony to the U.S. Congress Committee on Financial Services on June 26, he had this to say about Dodd-Franks, which is, “despite its best intentions, ineffective, burdensome, imposes a prohibitive cost burden on the non-TBTF banking institutions and needs to be amended. It is an example of the triumph of hope over experience”.
Five years after Lehman, the world is still working on hope over experience. It reminds me of the famous paper by Harvard economist Carlo Diaz-Alejandro on the experience of Latin America in the 1980s, “Goodbye Financial Repression, Hello Financial Crash.”