Transcript Why do crises like the Great Recession happen?

THE RECENT
FINANCIAL CRISIS
Professor Lawrence Summers
October 6, 2015
Ec 10
Agenda
• From last time: National Income
Accounting
• The Great Recession
• Why do crises like the Great Recession
happen?
Trade Balance = Saving - Investment
National income identity: Y = C + I + G + X – M
Rearranged: (Y – C – G) – I = X – M
Total national saving is output minus consumption and government
spending:
S =Y –C–G
So:
S–I=X–M
National Saving – National Investment = Trade Balance
Agenda
• From last time: National Income
Accounting
• The Great Recession
• Why do crises like the Great Recession
happen?
GDP growth still limited
GDP has fallen sharply relative to the economy’s
potential; here’s real GDP and the CBO’s estimate of
potential GDP before the crisis.
GDP growth still limited
GDP has fallen sharply relative to the economy’s
potential; here’s real GDP and the CBO’s estimate of
potential GDP over time.
Employment still lagging
Employment ratio dropped
during recent recession and
has barely increased
Employment still lagging
Employment ratio dropped
during recent recession and
has barely increased
Agenda
• From last time: National Income Accounting
• Money: why does it exist? How does it relate to
prices?
• The Great Recession
• Why do crises like the Great Recession happen?
• What can be done about them?
• Global consequences
Recap: function of financial markets
Recap: bank run game
(1) Win $1 if ALL play A, lose $10 otherwise
(2) Win $1 if MORE THAN 90% play A, lose $10 otherwise
(3) Win $1 if MORE THAN 80% play A, lose $10 otherwise
• What does the 80% signify?
Bank runs
Classic bank run, 1931
Modern bank run
happens
instantaneously with
use of computer
technology
Bank Run Effects
• Deposit run on a bank
• Liability run when collateral value is questioned
• Uncertainty about ability to defend a currency
• Race to the exit in an asset market
• Contagion  Banks with similar loan portfolios look the same to
depositors, so if one becomes insolvent, the others are questioned
What exactly happens when there is a bank run?
• Bank starts paying off depositors by selling liquid assets (those that
are easy to turn into cash)
• Next, fire-sale of non-liquid assets can mean selling at low values
• Bank even more insolvent – assets worth less relative to liabilities
Normal Economics: Negative Feedback
•
Negative feedback: self-equilibrating system.
Deviations from equilibrium are self-correcting
•
Analogies
• Thermostat
• Ball in bowl
•
Examples
• Supply and demand
Normal Economics: Negative Feedback
•
Negative feedback: self-equilibrating system.
Deviations from equilibrium are self-correcting
•
Analogies
• Thermostat
• Ball in bowl
•
Examples
• Supply and demand
Crisis Economics: Positive Feedback
•
Positive feedback: Deviations from equilibrium
perpetuate themselves
•
Analogy: Ball on bowl
•
Further it falls, faster it
travels from initial
position
Crisis Economics: Positive Feedback
•
Positive feedback: Deviations from equilibrium
perpetuate themselves
•
Analogy: Ball on bowl
•
Further it falls, faster it
travels from initial
position
The creation of leverage
• Without leverage, when you invest, your return is determined by the
asset price.
• Borrowing enables you to create leverage, so your return is a
multiple of the change in the asset price.
• Example: you buy $1000 of stock
(a) Stock rises by 40%
(b) Stock falls by 40%
(c) Stock falls by 60%
+$400
equity
$1,000
$1,000
in cash
Case 1: no leverage
$1,400
$400
loss
$1000
equity
40% return
$600
$600
equity
40% loss
$600
loss
$400
$400
equity
40% loss
The creation of leverage
• Borrowing enables you to create leverage.
• This enhances your possible return, but also your risk.
• And it creates risk for the lender
• To mitigate this risk, lenders (usually brokers) often have a “margin
requirement”
(a) Stock rises by 40%
+$400
equity
$500
cash
$1,000
$1,400
$500
debt
Case 2: 50% leverage
$500
equity
$500
debt
80% return
(b) Stock falls by 40%
$100
equity
left
$600
$400
loss
$500
debt
80% loss
(c) Stock falls by 60%
All
equity
gone
$400
$600
loss
$500
debt
Negative equity:
debt -$500.
assets +$400
Leverage can lead to cascading selling
Leveraged
investor’s
equity falls
Company A
stock falls
Broker makes
“margin call”:
investor
required to
deposit
additional
funds
Stock sales put
downward
pressure on
stock price
Investor forced
to sell stock to
do so
Background: what is
a margin call?
Brokers often require a
“maintenance margin”
to be deposited by
leveraged investors.
This is a certain % of
the total security value.
It is designed to reduce
the risk of the broker.
If the security price
falls below a threshold,
the broker makes a
“margin call”, requiring
the investor to deposit
more funds.
Elements of positive feedback during crisis
1. Liquidations driving prices down
2. Asset price decline hit bank capital
3. Financial strains exacerbate economic problems
4. Keynesian multiplier effects
5. Deflationary spiral
6. Fear raises borrowing costs