Transcript Chapter 5

From the US subprime mortgage crisis to
European sovereign debt
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US fiscal and monetary policy to cope with
the Great Recession
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On December 18, 2013, the Federal Reserve and
the US Senate announced two historical
decisions:
1. The Fed announced the ending of its quantitative
easing (QE) program on October 14, 2014.
2. The US Senate (at approximately the same time)
approved a Federal Budget after operating without one
for four years.
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After a sequence of failures by the Democrats
and Republicans to reach an agreement on a
program to reduce the US public debt, the two
parties accepted sequestration.
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Sequestration consisted of an automatic tax
increase and a reduction in federal expenditures;
it was adopted by the US government on March
13, 2012.
Sequestration followed a previous fiscal threat
known as the “Fiscal Cliff.”
The Fiscal Cliff was expected to occur on
December 31, 2012, when several tax cuts were
set to expire and several expenditures were set
to be cut.
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The Fiscal Cliff was avoided after a last minute
compromise, thus the US avoided “falling off the
cliff.”
As a result, the simultaneous announcement of the
Fed to end QE and the Senate to approve a budget
marked the beginning of a new era, essentially
ending the aggressive monetary and fiscal policy
adopted to end the Great Recession.
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The US Fiscal Authorities, the President, and
Congress launched three fiscal stimulus plans.
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The first program was the Economic Stimulus Act
of 2008, known as “Bush’s Tax Rebates.”
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This Act provided a total of $152 billion in tax
rebates to individuals and married couples of up
to $600 and $1,200, respectively.
The government must have miscalculated the
severity of the US recession, as unemployment
kept increasing and GDP declined.
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In Figure 5.1(a), the US GDP is depicted in constant
2009 US dollars. The drop in the US GDP is shown
through 2009 Q3.
Similarly, in Figure 5.1(b), the US unemployment
rate is shown to be increasing from 2007 until
2010 when it reached its peak close to 10%.
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Starting in the fourth quarter of 2006, economic
conditions in the US began deteriorating.
The US housing bubble burst when home prices
begun tumbling. As interest rates began increasing,
homeowners were unable to refinance their homes.
As a result, the number of home foreclosures and
delinquencies at the end of 2006 began rising.
To cope with the US subprime mortgage crisis, on
October 3, 2008 the US Government introduced “The
Emergency Economic Stabilization Act of 2008”, a
$700-billion bill, during the George W. Bush
presidency.
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The initial aim of the US government was to remove
all toxic assets from the balance sheets of US
corporations. To achieve this objective, the Troubled
Asset Relief Program (TARP) was launched.
However, it was realized that it would have taken
trillions instead of billions of dollars to accomplish
this, thus the TARP was abandoned.
Instead of buying the toxic assets, the government
decided to help financial institutions directly by
lending them money at a predetermined agreed
interest rate.
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Many financial and nonfinancial institutions (934 in
total), received loans from the US government under
this program.
The most important recipients of TARP loans include
bank holding companies, investment banks,
automobile companies, and insurance companies.
The institution that received the largest bailout was
an insurance company: AIG (The American
International Group).
AIG had issued a vast number of CDSs insuring
private and public securities in the US and abroad.
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Since several of the insured institutions were
failing, AIG was itself in financial trouble, thus it
was bailed out by the government because it
constituted systemic risk.
The bailout recipient institutions and the amounts
they received are listed in Table 5.1.
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The American Reinvestment and Recovery Act (ARRA)
Source: http://www.recovery.gov/arra/Pages/default.aspx
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Despite an extraordinary expansionary monetary policy
and the two fiscal stimulus programs, the US recession
deepened and spread in the US.
The US government introduced the ARRA into law; this was
a massive fiscal bill of $787 billion to prevent the US
mortgage crisis from further spreading.
The fiscal program provided funding for 11 years
(2009-19) in terms of tax reductions and expenditures.
It provided $80 billion for each of the following:
Healthcare; Education; and Welfare; as well as funding for
renewable energy.
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This fiscal bill is divided into three major programs:
1.
Tax Incentives - $290.7 billion. This includes tax
reductions for individuals and businesses.
2.
Contracts and Grants - $257.8 billion. This is
discretionary spending in the real economy, aiming
to increase employment by 3.5 million people.
3.
Entitlements - $254.6 billion. This portion provides
for spending in Medicare and Medicaid,
unemployment insurance programs, and more.
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Table 5.2(a) and 5.2(b) below show a more detailed
list of Obama’s fiscal bill.
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The American Reinvestment and Recovery Act (ARRA)
Source: http://www.recovery.gov/arra/Pages/default.aspx
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The American Reinvestment and Recovery Act (ARRA)
Source: http://www.recovery.gov/arra/Pages/default.aspx
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Most of the funding provided by the ARRA
was designed to take place within the first
five years; indeed, this occurred.
Table A5.1 indicates both the spending and
revenues of the ARRA fiscal stimulus plan
from 2009 to 2019.
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Projected Budgetary Impact of the ARRA of Fiscal Year 2009-2019
Sources:
Congressional Budget Office, and own calculations. Recovery and Reinvestment Act of
2009, American Recovery and Reinvestment Act of 2009 (P.L. 111-5): Summary and
Legislative History Congressional Research Service
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The US has generated the world’s largest chronic public
deficits and debts.
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Figure 5.2 (below) shows the US Federal Government
deficit for the period 1995-2014.
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On the left-hand side of the axis, the government deficitto-GDP ratio is shown to have increased from a little
over1% in 2007 to over 10% in 2009.
Similarly, in the right-hand side of the axis the
government deficit is measured in terms of absolute dollar
amounts. It increased from a little over $100 billion to
approximately $1.4 trillion. This constitutes by far the
largest deficit of any country in the world.
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In Figure 5.3(a), both the nominal GDP and public
debt are shown for the period 1950-2014.
According to Figure 5.3(a), both nominal public
debt and GDP have been increasing.
For a long time, GDP has been exceeding and
rising faster than public debt. Nevertheless, this
changed in the first year of the crisis. In 2007,
the US public debt began rising faster than GDP.
Since 2012, the US public debt has exceeded
GDP.
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Figure 5.3(b) shows the US public debt-to-GDP
ratio from 1940 to 2015. It can be seen that the
public debt-to-GDP level has been increasing
since the early 1980s, but starting in 2007,public
debt almost exploded.
High public debt is a reason of concern for
investors who lose confidence and become
hesitant to buy the bonds of such countries.
Because of high US indebtedness, the US lost its
AAA rating in 2011 for the first time in the
country’s history.
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As a response to the crisis, the Fed applied an
exceptionally expansive monetary policy.
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The Fed employed its instruments, programs, and broader
policies to achieve its goal of stabilizing the economy.
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First, the Fed relied on its traditional monetary instrument
to apply monetary policy: the federal funds rate.
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Once it drove the federal funds rate down to the
unprecedented level of 0-0.25 of 1 percent and could not
reduce it further, the Fed launched other programs and
policies.
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Figure 5.4 shows the federal funds rate
together with two other long-term interest
rates:
1. The 10-year government bond, one of the
most important long-term interest rates.
2. The 30-year mortgage bond rate, the most
important US mortgage interest rate.
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It is clear from Figure 5.4 that the Fed was effective
through drastic reduction in the federal funds rate
to reduce the two long-term interest rates to cope
with the US subprime mortgage crisis starting in
September 2007.
The Fed had followed the same policy to cope with
the dot-com crisis starting in January 2001, when
it reduced the federal funds rate down to 1%, a 42year record low.
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After driving the Federal Funds Rate to zero-lower bound
and without being able to reduce it further, in October
2008, the Fed launched a new monetary policy: the “shortterm liquidity programs.”
The Fed exercised its authority as a lender of last resort by
lending liquidity to firms, markets, and foreign banks in
order to restore the lost confidence in the economy.
Through short-term lending, the Fed aimed to safeguard
and secure the smooth functioning of the US financial
system.
In Figure 5.6, five short-term liquidity programs are
depicted , showing the amounts of loans from January
2007 to January 2014.
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The five programs are:
1.
Other Assets
2.
Other Loans, which consisted of two main
components:
◦ (a) Term Asset Backed Securities Loan Facility (TALF), which
aimed to increase consumer loans. The New York Fed was
authorized to lend up to $200 billion.
◦ (b) Money Market Investor Funding Facility (MMIFF) provided
funding to money market investors. The New York Fed was
authorized to offer up to $540 billion.
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Foreign Central Bank Swap lines. The Fed offered
dollar short-term liquidity (loans) to 17 foreign
central banks to avoid knock-on affects from dollar
shortages overseas.
Commercial Paper Funding (lending to businesses).
The New York Fed provided short-term liquidity to
businesses by facilitating purchases of their
commercial paper.
Term Auction Facility (bailing out banks). The Fed
created the term auction facility to provide shortterm liquidity to financially stressed institutions.
Figure 5.7(a) and 5.7(b) show the amounts which US
and foreign banks borrowed.
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The Fed lent massive amounts to US and foreign bank
branches in the US. For example, Morgan Stanley,
Citigroup, and Bank of America received more than
$200 billion each. US banks also received large loans
from the US Treasury under the TARP program.
The US government was compelled to extend loans to
large financial institutions to avoid the “too big to fail
problem.”
However, US citizens became angry with large banks
when information leaked of their role in the crisis and
particularly in the proliferation of the toxic securities.
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The public became more outraged when
information leaked that some bank executives
pocketed large amounts of the government
bailouts as bonuses.
Nevertheless, big banks (both domestic and
foreign) paid back almost the entire amounts of
the bailouts to the US government by 2009-10.
All the Fed’s short-term liquidity programs did
not trigger inflation, however, as these shortterm loans were repaid to the government rather
quickly.
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Since the recession in the US persisted, the Fed
introduced a new, unorthodox monetary policy at
the end of 2008 known as Quantitative Easing (QE)
that focuses on the quantity of money in the
economy instead of the price of money, i.e.,
interest rates.
This program entailed purchases by the Fed of
both public and private securities.
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The Fed implemented the new QE policy by
launching three different programs, QE(1),
QE(2), and QE(3).
The Fed purchased:
1. Treasury bonds;
2. Fannie Mae and Freddie Mac debt;
3. Mortgage Backed Securities (MBSs) issued by
investment banks.
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(1) Quantitative Easing (QE1). This involved
purchase of:
A. $1.25 trillion MBSs;
B. $300 billion government securities;
C. $175 billion agency debt.
Figure 5.8(a): QE1 (December 16, 2008 – March 31, 2010)
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The Fed announced its second round of QE in
November 2011 to purchase $600 billion of
treasury securities.
Figure 5.8(b): QE2 (November 3, 2011 – June 30, 2012)
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The third round of QE was announced by the
Fed on September 13, 2012. This was an open
round and it was completed on October 31,
2014.
Figure 5.8 (c): QE3 (September 13, 2012 – October 31, 2014)
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Expensive monetary policy increased the
Fed’s excess reserve balances to over $2.5
trillion, and they still stand above this amount
as of June 2015, which is shown in Figure 5.5
below.
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The end result of these operations was an
increase in the balance sheet of the Fed to
the unprecedented amount of $4 trillion.
Then the Fed decided to reduce the monetary
stimulus that was injected during the
subprime mortgage crisis.
This began with the tapering of QE, starting
with the departure of Fed chairman Ben
Bernanke, and his successor, Janet Yellen.
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The short-term liquidity programs are shown
to have contributed to lending in mid-2008,
but by 2009 they were tapered off. However
the Fed, through QE3, purchased treasury
securities, agency debt, and MBSs.
Figure 5.9 shows all of the Fed’s operations
during the subprime mortgage crisis.
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Disentangling the effects of fiscal and
monetary policy is almost impossible because
the effects of the two policies occurred
simultaneously.
It is almost impossible to disentangle the
effects of the three fiscal stimuli from the
fiscal automatic, or built-in, stabilizers of the
US economic system.
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Some authors criticized the mega-stimulus of
the government as being ineffective.
One such critic of the US discretionary fiscal
and monetary policy during the crisis was
Professor John Taylor (2010, 2014) who
claimed that the two policies created
economic instability and thus he recommends
that the US returns to rules-based policies.
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Extraordinary expansionary fiscal and monetary
policies were not very effective during the crisis for
several reasons.
One major reason is that bailout recipient institutions
in the US decided not to spend a great share of the
bailouts to buy goods and services or to hire workers,
but instead used these funds to reduce their debt.
Furthermore, none of the programs had targeted a
direct reduction in unemployment. As a result, some
economists began speaking about the US “jobless
recovery” that took place after 2009.
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Figure 5.10(a) shows that employment was reduced
substantially as 8.7 million jobs were lost between
November 1, 2008, which was the peak of the
subprime mortgage crisis, and February 1, 2010.
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Figure 5.10(b) shows that from March 1,
2007 to October 1, 2009, 8.6 million
workers lost their jobs.
This is one way to measure the detrimental
effect of the subprime mortgage crisis on
the US economy.
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Figure A5.2(a) shows that the number of discouraged
workers who abandoned the labor force during the
recession increased substantially starting in the fall of
2007.
Although the number of discouraged workers began
declining in 2010, their numbers still remain much
higher than their pre-crisis level.
A similar story is conveyed by observing the labor
force participation rate (LFPR), which has been
continuously declining. This means the crisis has had
lasting effects on the US economy, a phenomenon
called hysteresis. See Figure A5.2(b).
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