Transcript Financial Crisis, Recessions and the State of
Financial Crisis, Recessions and the State of Macroeconomic Theory
Melanie Fritz Thomas Schützenhofer Silvia Winter
Department of Economics
Economists: The current crisis and macroeconomic theories
Olivier Blanchard Casey B. Mulligan Paul Krugman Alan Greenspan Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: Olivier Blanchard
Three groups: The basic/traditional Keynesians The new-classicals want reconstruction: RBC- Model The new-Keynesians want reform and not revolution: the previous vision of macroeconomics was right =>better foundations for imperfection Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: basic model of Keynes
Keynes: held a leading position for three main reasons: 1. models were simple, flexible, and easy to use and seemed broadly consistent with observed patterns of economic activity 2. Second, Keynes and his disciples made a strong and effective critique of the alternative school 3. analytical Keynesian models provided a base for detailed statistical models of macroeconomic activity, used for economic forecasting and for evaluating alternative policies Three ideas are central to the Keynesian view: The first is that there is little presumption that market outcomes are desirable => great deal of scope for government intervention Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: basic model of Keynes
second is that changes in the supply side of markets are important mainly in the long run, which is taken to be very far away in most policy situations.
The third Keynesian view is that the fiscal and monetary authorities can control demand conditions for specific products and for the economy as a whole These are differences to the new-Classical!!!
Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: basic model of Keynes
Keynesian economists of the 1960s often appealed to the Phillips curve , taking it to imply that monetary or fiscal policy that lowered the unemployment rate thus caused a higher inflation rate The New-Classicals rejected this idea Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: basic model of Keynes
Keynes: saw the price system in a free economy as efficiently guiding the mutual adjustment of supply and demand in all markets, including the labor market unemployment can only arise because of market imperfection (New classicals) recessions occur when aggregate demand falls- largely as the result of a fall in private investment firms to produce below-causing their capacity. Producing less, firms need fewer workers Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: The basic model of Keynes
Traditional Keynesian view of business cycles according to which fluctuations are caused by a variety of types of real disturbances which affect economic activity solely through their effects on aggregate demand, while aggregate supply instead evolves as a smooth trend is no more confirmed by the modern models Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: The New Classicals
The New-Classicals: an economic school of thoughts in the 1970s uses the standard principles of economic analysis to understand how a nation's total output (gross domestic product, or GDP) is determined construction of structural models of short-run fluctuations differed sharply from Keynesian modelers According to Keynes the New-Classicals saw price system in a free economy efficiently guiding the mutual adjustment of supply and demand in all markets, including the labor market Unemployment could arise only because of a market imperfection Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: The New-Classicals
NCM view supply and demand result from the actions of economically rational households and firms. Macroeconomic quantities like GDP are the result of the general equilibrium of the markets in an economy. It is surprising that this perspective is considered revolutionary in macroeconomics when we see the current nature of economic analysis in other fields, such as public finance, international trade, and labor economics Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: The New-Classicals
Lucas and Rapping applied the rule that in a market equilibrium occurs when quantity supplied equals quantity demanded The two fundamental tenets of the New classicals: Individuals are optimizers: given the prices Changing the incentives to individuals NCM view a household's consumption in a specific time period depends on its current income and on the income it expects in the future, as well as on the interest rates at which it can borrow or lend (different from Keynesian) Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: The New-Classicals
Keynesian economists of the 1960s often appealed to the Phillips curve , taking it to imply that monetary or fiscal policy that lowered the unemployment rate thus caused a higher inflation rate The New Classical rejected the idea that there was any useful trade-off They argued that expansion of aggregate demand on unemployment only lowered because the acceleration in prices was not anticipated Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: The New-Classicals
Dynamic models have replaced static models: policy actions can not be evaluated How are large fluctuations in output compatible with the two fundamental tenets of their doctrine?
RBC Model: In RBC-based monetary models, sticky wages are often used to generate a high elasticity of labor supply Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: The New-Classicals
RBC - three principles: explicit micro foundation, defined as utility and profit maximization; general equilibrium and the exploration with no or few imperfections Shocks to aggregate demand Shocks to aggregate supply RBC-school regard changes in productivity as the driving force in business cycles because of changes in technology may come in waves, therefore, favorable or unfavorable runs of productivity (or technology) shocks may account for some of the characteristic persistence of business cycles Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: The New Keynesian Model
The New-Keynesian-Model (NK-Model):
It is an aggregate demand relation in which output is determined by demand and demand depends in turn on anticipations of both future output and future real interest rates!
NK-Model became a workhorse for policy and welfare analysis. It starts from RBC without capital Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: The New Keynesian Model
NK-Model: simple and replaced IS-LM Model as basic model of fluctuation NK-Model: monetary policy keeps inflation rate constant assumes that households and firms have rational expectations Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: The New Keynesian Model
NK assumes a variety of market failures (differ from New-Classical) assume prices and wages are "sticky", which means they do not adjust to changes in economic conditions Wage and price stickiness, and the other market failures imply that the economy may fail to attain full employment NKs argue that macroeconomic stabilization by the government (using fiscal policy) or by the central bank (using monetary policy) can lead to a more efficient macroeconomic outcome than a laissez faire policy Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: The New Keynesian Model
NK-Model lacks of many details to understand fluctuations DMP-Model: consideration of unempolyment Two implications of the model: Always unemployment Time for worker to find new work Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: New Synthesis
DSGEs – dynamic stochastic general equilibrium models DSGE models with sticky wages and/or prices that wage- and price-setting decisions are made on the basis of rational expectations think about the effects of policy included Keynesian thinking: ignore the role of financial markets assume markets to be efficient and self-correcting and not worthy of being included in the models Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories
In contrast to classical macroeconomics, new and old, Keynesian macroeconomics did not begin with the assumption that an economy is made up of individually rational economic suppliers and demanders. Instead of deriving demand from individual choices For example the Keynesian procedure was to directly specify a behavioral rule Keynes claimed that aggregate spending on consumption was governed by a "consumption function" in which consumption depended solely on current income.
Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories
Keynesian macroeconomics said that people followed fixed rules of thumb with no presumption that firms and households made rational choices this grew out of a suspicion on the part of Keynesian modelers that people did not typically act rationally it was a pragmatic modeling decision: if people's economic behavior is purposeful, the task of specifying how they will act in various situations is more complicated and, therefore, more difficult to model. Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: Olivier Blanchard
Models are similar in structure Problem: same models for different structures and shocks Great progress and excitement in macroeconomics Three hopes of Blanchard: Rehabilitation of partial equilibrium Huge micro data -> DSGE Re-legalization of shortcuts and simple models Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: Kehoe - Solow
Arrogate for little macro models Understand mechanism of economy Solow ignore heterogeneinity factors Change models prospective and Adapt it to challenges in macro-economy Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: Luigi Spaventa
If not forecasting the crises, economists were aware of that the system had set on an unsustainable path?
Was the state of economics the problem or was it the economists using them to fail?
economists are unable to understand reality because of the abstraction of theories and models Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: Luigi Spaventa
available tools were inadequate in the field of macroeconomics Luigi Spaventa shows that nobody can provide precise forecast about the crisis new business models known as “originated to distribute” (OTD) macro- and microeconomic implications were never explored Solution: general macroeconomic framework Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: Paul Krugman Krugman and the current crisis
“the state of macro is good” (?) criticism on economists only few economists saw this crisis coming economists were blended and ignored important facts Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: Paul Krugman
“The central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists the chance to show off their mathematical prowess!” Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: Paul Krugman Macroeconomics according to Keynes
National and international programs Policies to regulate booms and slumps → economic equilibrium resorted and maintained by official action → no space for classical theory and its laissez-faire Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: Paul Krugman Capitol Hill Baby-Sitting Cooperative
150 couples 20 coupons/couple One coupon: half an hour baby-sitting → keep reserves → cooperative fell into recession Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: Paul Krugman
“saltwater” economists (mainly from universities in the coastal area) who agree more or less with the Keynesian theory of recessions.
“freshwater” economists (mainly at interior universities) who totally disagree to the Keynesian vision.
Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: Paul Krugman
Freshwater economists: bring demand and supply into balance to get out of recession Unemployment is an consciously decision to take a time-out Saltwater economists: Recessions are demand-driven Need for political activities Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: Paul Krugman No one could have predicted...
general belief that bubbles just do not happen vision of a perfect and frictionless market system behavioural finance Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: Paul Krugman Krugman‘s advice to economists:
face up reality recognize that the Keynesian economy illustrates the best framework for recessions and depressions which we have do the best to implicate the realities of finance into macroeconomics Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: Alan Greenspan
Greenspan was chairman of the Federal Research Board until 2006 → The Times’ “25 People to Blame for the Financial Crisis” : Greenspan as one of the top three people who are responsible for the current crisis!
Fritz, Schützenhofer, Winter
Economists: The current crisis and macroeconomic theories: Alan Greenspan Greenspan to the accusations:
I.
Roots lay in the quick global decline in nominal and real long term interest rates in the early part of the 2000s Monetary policy does not bear any blame for the crisis II.
→ central banks are not at fault and were impotent bystanders Deny that house prices are driven upward by low short-term rates III.
No correlation between looseness of monetary policy in different countries and changes in house prices We will never have a perfect model of risk Fritz, Schützenhofer, Winter
Financial Crisis in the Past Chile and Mexico
Both countries had the same financial problem Their reaction was different Mexico nationalized bank-system Chile passed solvent banks into private hand Fritz, Schützenhofer, Winter
Financial Crisis in the Past Mexico:
Wanted to keep the investment activity and employment Companies got cheaper loans Firms which were threatened by insolvency could survive Also unproductive firms survived
Chile:
Bank system was privatized Unproductive firms got insolvent Fritz, Schützenhofer, Winter
Financial Crisis in the Past
Consequences: Chile: decreasing GDP in 1982/83 but in 1984 Chile had the biggest GDP in Latin America Mexico: economic disaster 1982 to 1985 and since this time the GDP growth is very teeny The difference between Chile and Mexico was the productivity (high/low) Fritz, Schützenhofer, Winter
Financial Crisis in the Past Financial crisis in the past: Finland and Japan
Similar to the crises in Chile and Mexico was Finland and Japan Japan followed Mexico while Finland followed Chile The effects were similar the crises in Chile and Mexico Japan had a scarcely growth of GDP Finland's GDP growth increased quite a lot Fritz, Schützenhofer, Winter
Financial Crisis in the Past Conclusion: Development of financial crises
Reaction of government and economy are important Productivity is a important factor for growth and depression Government could influence productivity Overreaction of government can cause regression Giving examples Chile and Mexico / Finland and Japan Fritz, Schützenhofer, Winter
Financial Crisis Current financial crisis: North America/Europe
Now the same situation Goal should be: The way of Finland and Chile Force productivity Support of productive companies Unproductive firms should get insolvent?
Fritz, Schützenhofer, Winter
The sequences of the financial crises Now a overview about the Liquidity and Credit Crunch in 2007-2008
Banks get liquidity pressure Mortgage crises Asset backed financial products Central bank Monoline Insurers Bear Stearns, Fannie Mae, Freddy Mac, Lehman Brothers, etc.
Liquidity spiral Fritz, Schützenhofer, Winter
The sequences of the financial crises Bank trends leading into liquidity pressure
The reason were bad loans which were write down Amount of hundreds of billion dollars At the same time the stock market lost more than half of value The reason was high mortgage losses Result in US Stock market lost more than eight trillion dollars The followings were cry for liquidity It was difficult to get money, consequently bailouts followed Government saved companies of bailouts Fritz, Schützenhofer, Winter
The sequences of the financial crises Subprime mortgage crises
Starting in Feb. 2007 Cause was the increasing mortgage failures Evident in ABX Indices swap Indices decreased, costs of insurance for mortgage-loss increased Fritz, Schützenhofer, Winter
The sequences of the financial crises Consequences
Prices by mortgages dropped Downgrading by moodies, Standard Poor and Fitch Credit market got definitely out of balance in June 2007 26 th July 2007 Index of National Association of Home builders lost 6,6% (year on year) Fritz, Schützenhofer, Winter
The sequences of the financial crises
Asset backed financial products
Increasing popularity because:
Advantages: the big spread against many market partners Asset Backed products were AAA-rated which affected low mortgage and interest rates This attracted also institutional investors For example: Senior tranches was not include in Basel 1 and so they don't need assets as collateralise minimum (8%) !Product included the assumption, that housing prices couldn ´ t drop!
Fritz, Schützenhofer, Winter
Liquidity and Credit Crunch 2007-2008 Consequences
Big supply of opportune credits Decreasing collateralising standard Ending in housing-madness
Effects
Borrowers normally cannot get credit get it After a time they could not perform it Fritz, Schützenhofer, Winter
The sequences of the financial crises Central bank
European Central bank gave credit of 95 billion Euros US Federal Reserve followed with 24 billion Euros Discount rate for credits sunk for 0,5% to 5,75% But more over 7000 banks didn't accept this credits → was a negative signal → creditworthiness Oct. 2007 interest rate reduction to 5,25% So British bank “Northern Rock” got liquidity support by Bank of England Northern Rock was the first victim of bank-run in Great Britain since one century Fritz, Schützenhofer, Winter
The sequences of the financial crises Monoline Insurers
Insurance for Municipal Bonds and Guarantees for mortgage market Securities Due to the crises Monoline Insurers get under pressure and Downgradings followed Downgradings by their ratings (giving example: Fitch took downgrading by Ambac) World wide downgrades Asia stock m. 15%, Down Jones and NASDAQ up 6% Biggest cut since 1982 Fritz, Schützenhofer, Winter
The sequences of the financial crises Bear Stearns, Fannie Mae, Freddy Mac,
Bearstearns:
Problems to operate the Margin calls No money by Repo market (Liquidity) Big rivals help to minimize the credit risk of Bear Stearns (systemic important)
Fannie Mae and Freddy Mac
Problems to get money → mortgage rate increased Government gave guarantee But stock market price decreased and the Government took both companies in polity control This caused large numbers of out-standings credit default swaps Successions: Big Payments for buyers who bought this swaps Fritz, Schützenhofer, Winter
The sequences of the financial crises Lehman Brothers, Merril Lynch and AIG
Also this banks get insolvent/bailouts Lehman Brothers get bankruptcy Take over by Merrill Lynch by the Bank of America AIG also get liquidity problems after Lehman get bankruptcy Federal created a organisation for bailouts with a value over 85 billion dollars Raised by 37 billion in Oct. 2007 and 40 billion in Nov. 2007 Fritz, Schützenhofer, Winter
Amplifying Mechanisms and Recurring Themes
Liquidity Spirals
Liquidity spirals are loss spirals which started when deprecation of assets starts and net value decreases faster than the gross value. The following is a lower credit amount.
For example:
Investor bought assets by 100 million, margin calls 10% 10 million own capital 90 million outside capital Leverage ratio is 10% Fritz, Schützenhofer, Winter
Amplifying Mechanisms and Recurring Themes Now:
Value decreased to 95 million Loss of 5 million → losses 5 million of his own capital To get leverage ratio of 10 %, he must sell 45 million These depress the price and he has to sell again (he need leverage ratio 10) This is the beginning of the liquidity spirals (more investors had this problems)
Next problem:
Buyers wait, because it is better to start after liquidity spirals Extreme cases →
Firesales
Fritz, Schützenhofer, Winter
My own view Many factors which can influence financial crises
Liquidity
Interrest rate
Mortgage rate
Productivity
Etc.
I believe, the most important thing of all factors is, that we must take reaction over this financial crisis. So we need stricter regulations and more controls.
Fritz, Schützenhofer, Winter