Transcript Economic 157b - Yale University

Understanding the Great Recession
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Using macro to understand the current recession
Let’s analyze the history of the recession to illustrate some of the major
macro issues/tools
Underlying forces:
1. Increasing leverage with lower perceived risks
2. The housing bubble and …. not “pop” but “hissssssss”
3. A “run on the shadow banks” and the Lehman bankruptcy
4. The crash in asset prices in 2008
5. Huge decline in wealth, leading to declining housing I and C.
6. International transmissions
7. IS-MP curve interpretation
8. Liquidity trap!
9. Governmental response in monetary and fiscal policies
10. The trough in late 2009
11. The long stagnation is still with us ….
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The bubble economy
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Trends in volatility of US stock prices
Historical lows
Note: Implied volatility is a measure of the equity price variability implied by the market prices of call options
on equity futures. Historical volatility is calculated as a rolling 100-day annualized standard deviation of
equity price changes. Volatilities are expressed in percent rate of change. VIX is CBOE index.
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Leveraging the US economy
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Rising
leverage of US
economy
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10
8
3
6
2
4
1
2
Total financial assets/K
Total financial assets/GDP
0
1930
1940
1950
1960
1970
Source: Federal Reserve flow of funds data.
1980
1990
2000
0
2010
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Leverage for US economy
Gelain et al, San Francisco Fed Working Paper.
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The housing price bubble
1. Rising perceived
wealth of
households 19952006.
2. Then catastrophic
loss of wealth 20062009
3. Stabilized in last
four years
Case-Shiller housing price index
(CPI corrected)
1.2
1.1
1.0
0.9
0.8
0.7
0.6
0.5
0.4
86
88
90
92
94
96
98
00
02
04
06
08
10
12
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Then people wake up from the dream to
the nightmare of falling wealth …
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No one saw it coming: Fed projections, June 2008
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A disastrous forecast
= Fed forecasts
= Range of all 19 participants
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Mortgage delinquencies skyrocket
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Loss of Household Wealth in Recession
(billions of 2005$)
0
-2,000
Housing
Wealth loss of
$16 trillion
($140,000 per
household)
Net worth
-4,000
-6,000
-8,000
-10,000
-12,000
-14,000
-16,000
-18,000
2007Q1
2008Q1
2009Q1
2010Q1
2011Q1
2012Q1
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The impact on households and consumption
12,000
500
Dot.com
bubble
8,000
Housing burst
and financial
meltdown
400
4,000
300
0
200
-4,000
100
-8,000
0
-12,000
-100
Change in new worth
Change in consumption
-16,000
-200
-20,000
-300
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99
00
01
02
03
04
05
06
07
08
09
10
11
12
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Bank runs
Series of bank runs.
Different from earlier (Depression era) because was the run
by large depositors (run on the repo).
Bear Stearns and Lehman were wiped out in a week.
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Bank losses*
* Note that US bank equity was around $1000 billion in 2010.
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The Lehman Bankruptcy
A central event in the crisis.
Market fundamentalists worried that continued bailouts would
lead to “moral hazard” and worse future problems.
So on September 15, 2008, government decided to let Lehman go
bankrupt.
Catastrophic results:
- markets froze up (people could not make transactions)
- stock market went down 30 % in a month and US dollar ROSE
almost 20 %.
- “market fundamentalism lasted only 36 hours”
- then bailout of AIG, Citibank, BofA, TARP, GM, etc.
“An economy in free fall” in late 2008.
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Risk on Mature Govt Debt (US, etc.)
CDS = risk that security will default. These are US and similar Treasury bonds! 17
A risk measure on commercial paper
Source: Federal Reserve page on commercial paper. These are short-term promissory
note or unsecured money market obligation, issued by prime rated commercial firms
and financial companies. This shows medium-grade (A2/P2) minus top grade (AA).
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Policymakers respond
Panic of 2008: Financial markets hysterical; paranoia
everywhere about who was responsible and who should
pay.
Bush/Paulson: reluctantly saw that financial markets were
freezing up (Bernanke key to understanding this).
TARP: Started as buying toxic assets, then saw the light
and recapitalized banks.
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Macroeconomic impacts
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Impact of Credit Crunch on Investment
.18
9.5
Credit
crisis
.17
9.0
.16
8.5
.15
8.0
.14
7.5
.13
7.0
.12
6.5
.11
6.0
.10
5.5
2005
2006
2007
2008
2009
2010
Investment/Potential GDP
Baa bond rate
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Effect on output
Actual/potential industrial production
1.12
1.08
Bear
1.04
1.00
0.96
0.92
Lehman
0.88
0.84
2000
2002
2004
2006
2008
2010
2012
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Macroeconomic impacts
Rewrite augmented IS and MP curves as follows:
IS: Y = C(Y,W) +I(rb) + G + NX(Y,Yw)
Y = C(Y,W) +I(i - π + σ) + G + (X – M)
MP: i = f(Y, π)
rb = risky real rate = i - π + σ, where σ is the risk premium
Have adverse IS shifts to W, σ, and NX from Yw
Fed lowers i in standard manner, but real interest rate for
businesses goes up!
MP = Taylor rule
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Before crisis
MP
iff
IS(i ff - π + low
risk premium)
i*
2006
Y
After financial crisis
MP
iff
IS(i ff - π + low
risk premium)
i*
IS’(i ff - π +
high risk premium)
2008
Y
Policy Responses (thanks to Keynes’s theories)
Gwendolen Darwin Raverat
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Financial Market Support Measures 2007-2013
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Unconventional Fed Measures: the Fed Balance Sheet
Treasuries = normal stuff!; CPLF = commercial paper funding
facility; MBS = mortgage-backed securities
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Fed balance sheet before and after the crisis
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Before Fed expansion
MP
iff
IS’
i*
2008
Y
Fed expansion
MP
iff
IS’
i*
2009
Y
After TARP and other risk-reducing measures
iff
IS’’
MP
i*
2010
2009
Y
Fiscal Policy in the Liquidity Trap:
Components of US stimulus legislation
Source: CBO, presentation of Elmendorf, June 2009
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Without stimulus
MP
iff
IS(2008)
i*
Y
With stimulus
MP
iff
IS(2008)
IS(2010)
i*
Y
CBO’s estimate of impact of stimulus on economy
Source: CBO, presentation of Elmendorf, June 2009.
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CBO’s estimate of impact of stimulus on economy
Actual
Source: CBO, presentation of Elmendorf, June 2009.
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Lessons on the recent financial crisis
• Even with modern macro, globalized mature market
economies are subject to major risks; business cycles
have not disappeared.
• We are unlikely to reach full employment before 2016.
• Financial systems are inherently fragile because of their
maturity and liquidity transformation (K to M).
• Markets cannot manage themselves.
• The liquidity trap is a particularly nasty outcome
because monetary policy weak and fiscal policy
hampered by large deficits.
• The US benefitted from wise leadership this time. It
could have been much worse.
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