Transcript Regulation

The Financial Crisis and Its
Consequences
Edward C. Prescott
June 23, 2009
1
Most Discussions are Incoherent
• General
equilibrium: People on both sides of
all transactions
• Total
lending must equal total borrowing
2
My Definition of a Bank
•A
financial intermediary borrows from one
group and lends to another and is highly
leveraged
•I
use the word bank to denote a financial
intermediary
•I
use the words commercial bank to denote
banks that have payable-upon-demand deposits
3
Long-Run Picture
• Relatively
steady growth over the last 150
years
• Some
fluctuations about trend (HP filtered)
Source of following pictures is Robert E. Lucas, Jr.
4
5
Deviations From Trend
• Relative
to trend, GDP lost 40% between 1929
and 1933
• Recently
the loss has been about 5%, and most
of this is in 2008-IV and 2009-I
6
7
How Bad Are Things?
Not that bad, so far
8
• Using
a simple 1.9% trend
• These
numbers are per person 15-64
9
Detrended GDP per Person 16-64 1959-I to
2009-I
110
Period Average = 100
105
100
95
* Quarterly trend growth: 0.45%
90
1959-I 1965-I 1971-I 1977-I 1983-I 1989-I 1995-I 2001-I 2007-I
10
Contractions (Recessions)
• Recession
• An
is not an economic concept
economy can’t be in one or not in one
• Prior
to the development of modern macro,
these time series were represented as cycles
• This
was totally discredited by Nobel
Laureate T. J. Koopmans in his devastating
critique of Burns and Mitchell (the NBER
definitions) as measurement without theory
11
Now There Is Hard Theory
• Given
productivity, population, and taxes:
– Predicted and actual paths of the aggregate
variables coincide
– All using dynamic economic theory to
construct models consistent with national
account and other data find same thing
– Monetary policy had little consequence
12
Modern Definition of a Contraction
• Any
sensible definition corrects for
population and trend growth
•A
flat line is neither losing nor gaining
ground relative to the industrial leaders
•A
flat line means living standards double
every generation
13
Contractions: Detrended GDP
per Person 16-64 1959-I to 2009-I
110
Period Average = 100
105
100
95
90
* Quarterly trend growth: 0.45%
1959-I 1965-I 1971-I 1977-I 1983-I 1989-I 1995-I 2001-I 2007-I
14
Contractions
• Biggest
contraction was 11.2% from 1978 IV to
1982 IV
– First two years of it money was loose – low
real interest rate
– Last two years and beyond money was tight
• The
contraction beginning 1999-IV was bigger
than figure indicates because
– There was a huge amount of unmeasured
investment in the second half of the 1990s
15
Expansions
• Big
expansion of early 1960s was technology
driven
• The
1995-2000 expansion was technology driven
– And in fact was significantly bigger and
longer than standard statistics indicate
– Reason: Huge unmeasured intangible
investment (R&D, launching new products)
• The
second biggest and the longest expansion
was in the 1980s and was due to cuts in tax
rates
16
Expansions: Detrended GDP
per Person 16-64 1959-I to 2009-I
110
Period Average = 100
105
100
95
* Quarterly trend growth: 0.45%
90
1959-I 1965-I 1971-I 1977-I 1983-I 1989-I 1995-I 2001-I 2007-I
17
What Depressed the U.S. Economy in
2008-IV and 2009-I?
• Not
lack of borrowing
18
Liabilities of Households and of
Their Nonfinancial Businesses
Total Liabilities
(billions $)
31,875
32,341
Mortgages
44.9%
44.4%
Other Loans
18.0%
18.5%
Corporate Bonds
11.2%
12.0%
Security credit
1.0%
0.5%
Trade payable
8.2%
8.5%
16.8%
16.1%
Composition Share
Other
19
Then What Depressed the U.S. Economy in
2008-IV and 2009-I-II?
• Fact
was the investment was depressed
• There
are 25 million small businesses in the
U.S. – 5 million of them have employees
• Their
owners feared higher tax rates in
future and rationally cut investment now
• They
also rationally cut employment
20
Fears Are Being Realized
• Tax
rates are being increased
• These
increases lower amount of capital a
firms chooses to have
• Reason
for low investment is not problem of
getting loans – it is expected high tax rates
21
What Happened After Financial Crises?
Sometimes bad things
and
Sometimes good things
Numbers are trend corrected so flat line is
growing at trend
22
Experiences Very Different
GDP per Capita Detrended at 2% 1992 = 100
120
Finland
110
100
90
Japan
Source: GGDC (PPP-EKS)
80
1990
1994
1998
2002
2006
23
GDP per Capita Detrended at 2% 1980 = 100
140
Chile
120
100
Mexico
80
Source: GGDC (GK-PPP)
60
1980
1984
1988
1992
1996
2000
2004
24
Cost of Current Crisis
• Huge
bailout of lenders to financial
intermediaries by taxpayers
• This
means higher tax rates in future and
depresses the economy now
• The
so-called stimulus plan is a depressant
plan
25
Evidence that High Tax Rates Depress an
Economy
26
Predicted vs. Actual Weekly Hours
predicted
30.0
Japan
Australia
28.0
New Zeland
26.0
Ireland
Portugal
Spain
24.0
Romania
U.S.
U.K.
Canada
22.0
20.0
Iceland
France
Germany
Denmark
Italy
18.0
16.0
16.0
18.0
20.0
22.0
actual
24.0
26.0
28.0
30.0
27
Summers’ Misguided Advice to Japan
• Repeatedly
said to spend and stimulate the
economy in 1990s
• What
happened? Japan lost a decade of growth
• Geithner,
who is not an economist, is now
advising China to spend in order to stimulate
its economy
28
Why Japan’s Lost Decade of Growth?
•
•
•
Some blamed China
Others blamed the Bank of Japan
Still others blamed fiscal policy
– Said Japan needed even bigger deficits
•
Hayashi and Prescott in “Japan’s Lost
Decade of Growth” find the problem was
lack of productivity growth!
29
Why Low Productivity Growth?
•
Hayashi and I conjectured: banks subsidizing
inefficiencies
– Loans were being made to pay interest on
existing loans
– Banks’ liabilities exceeded assets
•
Subsidizing inefficient businesses deters
productivity growth
30
Japan’s Reaction
•
Cabinet Research Office invited me to talk in
2002
•
Signaled Prime Minister Koizumi was buying
into the productivity story
•
Takenaka, new head of financial services,
instituted banking reforms
31
Banking Reforms
•
•
•
Write off bad loans
Refinance insolvent banks
Require honest accounting when meeting
capital requirements
32
What Happened After Reforms
•
Productivity growth rebounded
– No helicopter drops of money
– No big increases in spending
– No Chinese collapse
•
Reason for rebound
– Making the banking system sound again
33
How to reform financial system so that it
is efficient and crisis-free
34
Good Financial Regulation
• Friedman
argues for 100% reserve banking with
interest on reserves
• Justification
is stability
•I
argue for Friedman’s system for the
commercial banking system
35
Good Financial Regulation
• Freidman
argues for 100% reserve banking
• Justification
is stability
•I
argue for 100% reserve commercial banking
system (with interest on reserves)
• AND
a ban on financial intermediation, which
rules out Bear Stearns and Lehman Brothers
36
Problems with Regulation
•
Actions are often taken for political reasons
•
Recent financial crisis and earlier S&L crisis due to
policies designed to increase home ownership
•
Fannie Mae and Freddie Mac, two GSEs, began holding
subprime mortgages because politicians forced them to
•
Congress passed laws that effectively required banks to
make subprime mortgage loans when enforced
37
Financial Intermediation Serves No
Purpose
• People
save a lot for retirement
• Half
of this is in the form of equity in
real assets they own
• Half
is lending to other people who use it to
finances houses and businesses
• Remember
if there is borrowing, there must be
lenders – the lenders are mutual retirement
accounts, share holders of mutual bond funds,
mutual insurance companies, etc.
38
A Difficult Problem
• People
want insurance against uninsurable
aggregate risk
• If
permitted limited liability financial
intermediaries provide it, get too big to
fail, and when they fail, the taxpayers bail
them out
39
Solution
• Restrict
insurance to partnerships, which are
not limited liability partnerships – e.g.,
Lloyds of London in the reinsurance market
• Do
not permit AIG to insure debt
• Prohibit
the insurance of retirement plans by
non mutual insurance companies
40
Conclusion
• Need
mutual saving arrangements
– Corporate stocks
– Mutual insurance companies
– Mutual bond funds
• Aggregate
risk is nondiversifiable
41
Large Loses Can be Shared by People
Without Government Intervention
• Let’s
look at the two big falls in household
net worth relative to GDP
• There
was a huge drop in the value of the
stock market early in this decade – nearly
one GDP
42
Current U.S. Financial Crisis: All
Numbers Relative to GDP
Period
Change in
Value of
Equity
Change in
Value of
Household
Tangible
Assets
Total
2000.1–2002.3
- 0.95
+ 0.20
- 0.75
2007.2–2008.4
- 0.80
- 0.30
- 1.10
43
Only Fed Can Issue Money
• Money
(definition I use) is deposits that are
payable on demand plus currency
• It
is used for transaction/liquidity purposes
• No
danger of bank failures with 100% reserves
• Fed
has tight control on the money supply and
can maintain price stability – a good thing
44
How Are Investments Financed?
• Currently
75 percent financed by equity and
mutual lending
• Other
25 percent financed by bank lending
• The
part currently financed by bank lending
would have to be financed other ways
45
What Other Ways?
• Use
more equity
• Use
–
–
–
–
more mutual lending
Mutual insurance companies
Venture capital group
REITS
Mutual pension funds
• With
this reform, all bank lending to
government
46
Capital Investments Should Be Financed by
Sharing Arrangements
• We
have the stock market, which is a sharing
arrangement
• State
& local government bonds are guaranteed
by taxpayers, which is a sharing arrangement
• Mutual
funds and defined benefit pension
funds are sharing arrangements as well
47
Investment Banking
• Handles
acquisitions, mergers, IPOs etc.
• Handles
brokerage
• Not
trying to make profits by borrowing short
at a low rate and lending long at a higher
rate
• As
we now know, mortgage-backed securities
are not riskless
48
Can Avoid Financial Crises by Having System
with large Regulatory Rents
• Canada
had such a system in the 1930s
• Canada
had no bank crises
• Canada
had a Great Depression, one as big as
that of U.S. and Germany
• Losers
were the households who borrowed at
higher rates and lent at lower rates
49
Good Regulatory Policies
• Truth
in lending with clear contracting rules
that are enforced by courts
• Honest
accounting
– U.S. this time around has been honest
– Not like Japan after its 1992 crisis
– And U.S. after many S&Ls became insolvent
• Make
easier to sell foreclosed properties
50
Recapitalize the System
• Easy
• Value
to do
of toxic mortgage-backed securities not
large
– Relative to GDP value is one-quarter of the
drop in stock market at the end of the IT
boom in 2000-2001
– And these securities are not worthless
– Let noninsured lenders to banks bear some
losses
51
What About the Fed?
• Did
what it should given the situation
• Big
increase in reserves
• Fed
is not the cause of the recent drop in
U.S. GDP (4.0% trend corrected and probably
another 0.9% this quarter)
52
Don’t Increase Tax Rates
• European
hours per working-age person 70% of
other advanced industrial countries
• Why?
Their marginal effective tax rate is 60%
versus 40% elsewhere
• In
early 1970s tax rate was 40%, and they
worked the same amount
53
•
European hours per working-age person 70% of other
advanced industrial countries
•
Why? Their marginal effective tax rate is 60% versus
40% elsewhere
•
In early 1970s tax rate was 40% and they worked the
same amount
• Danger:
U.S. will increase its tax rate
54
Raising Tax Rates Will
• Not
increase revenue in the U.S.
• Will
decrease revenue in France, Italy, and
Germany
55
GDP and Tax Revenue per Person
1.6
1.4
1.2
1
0.8
0.6
0.4
0.2
0
GDP
Tax Revenue
0
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
Tax Rate, t
1
56
Welfare
•
Nonmarket time is valuable
•
Because of taxes, the value of time on
margin is twice as high as in the
market sector
Welfare gains of cutting tax rates are …
57
Welfare Gains and Losses
10%
Current U.S.
0%
-10%
Europe
-20%
0
0.1
0.2
0.3
0.4
0.5
58
0.6
Healthy Productivity Growth in U.S. and
EU
Decade Productivity Growths
1984-1994
1994-2004
Europe
20%
15%
U.S.
15%
21%
59
Problems Are Real
• What
matters are real factors
– Tax RATES – low rates good
– Openness – more is better
– Productivity – higher is better
• Subsidies depress productivity
• Protecting vested interests does as well
• Problem is
• Some banks
not lack of borrowing
are refusing deposits in the U.S.
60
Detrended GDP per Capita
110
US
100
90
Japan
80
70
EU - 15
60
1991
1993
1995
1997
1999
2001
2003
2005
61
Summary
•
The Fed should prevent the banking system
from subsidizing inefficiencies
•
Further evidence:
–
–
–
–
Chile and Mexico
Both had banking system collapses
Chile reformed and recovered
Mexico did not reform and stagnated
62
The Future
• With
good policies the U.S. and E.U. will
boom like Chile and Finland did
• With
bad policies these economies will
stagnate like Mexico and Japan did
•I
hope we follow Chile’s and Finland’s
examples
•I
am forecasting a lost decade of growth for
the U.S.
63
Examples of Bad Policies
• Abandonment
of cost-benefit analysis for
evaluation of new regulations
– Instituted by Executive Order 1981
– Abandoned by Executive Order in Spring 2009
• Proposed
increase in tax rates
– Increase personal income tax rates
– Increase corporate income taxes, which are
among the highest in the world
64
Expectations Matter
• Some
recovery between FDR election and
inauguration
• Some
depression of economy between Obama
election and his taking office
• People
expected improved policies in the
first case and worse policies in the second
• Productivity,
but not employment, recovered
under FDR
65
• Overbuilding
in 1929 and in 2008, which
depresses employment and output, but not
welfare
• If
mistake made and worked too much in the
past building too many houses, best to enjoy
more leisure
• Sizable
net immigrations became negative
– 2006 and before: 1.0 million per year
– 2008: 0.1 million
66
Why Did the Mild Depression of 1929
Become the Great One?
• There
was overbuilding in real estate, and
immigration shut off
– Stock market crash small relative to three
post-1960 crashes and same size as three
others
• Businesses
cut investment and it wasn’t
because they didn’t have the money to invest
– They were paying big dividends
• Hoover’s
anti-free market policies that
turned a mild adjustment into the Great
Depression
67
Are we in for another Great Depression?
• The
current planned policies in U.S. resemble
those followed in 1929-32
–
–
–
–
–
–
Anti immigration
Anti globalization
Pro tax increase
Pro White House managing the economy
Pro bailout of businesses
Pro cartelization
68
Are we in for another Great Depression?
I expect not
• Things
were going well for the U.S. economy
until the fourth quarter of 2008 – rapid
productivity growth
• Economic
knowledge has advanced so much that
it will effectively constrain the
policymakers
69