Transcript Economics 1: Dealing with the Financial Crisis and the Downturn J. Bradford DeLong, Lanwei Wang, etc... April 16, 2012

Economics 1: Dealing with the
Financial Crisis and the Downturn
J. Bradford DeLong, Lanwei Wang, etc...
April 16, 2012
Logistics
• Friday 11 AM Wheeler Auditorium “Office
Hour” this week
• Draft Principles of Macroeconomics textbook
at Copy Central (southside on Bancroft)
• Problem Set 8 up
The Circular Flow of Economic Activity
Interruptions in the Circular Flow
Caused by Fall-Offs in the Pace of
Spending
The Income-Expenditure Model
• Y = (I + G + c0)/(1 – cy)
– Take the flow of “other spending”: business
investment I plus government purchases G
– Add to that the amount of consumption spending
that depends on “confidence” and like factors c0
– Divide by 1 – cy
– You are done. That’s the level of spending—and
incomes, and production—at which the economy is
going to settle.
• The underpinnings:
– C = c 0 + cy x Y
– I = I(r)
The Underpinningd
• Y = (I + G + c0)/(1 – cy)
• C = c0 + c y x Y
• I = I(r)
– r=i–π+ρ
• i is the short-term safe nominal interest rate the Federal
Reserve controls
• π is the expected inflation rate
• ρ is the “spread”
Here Is the “Spread”
Policies to Fight the Downturn
• Policies adopted
– The Federal Reserve
lowering interest rates
– The bank rescue
– The Recovery Act
– Quantitative easing
• Policies not adopted
– The Recovery Act II
– Mortgage refinancing
– Raising the inflation
target
– Nominal GDP targeting
– Bank nationalization
– A weak dollar is in
America’s interest
Policies Adopted
•
•
•
•
The Federal Reserve lowering interest rates
The bank rescue
The Recovery Act
Quantitative easing
The Federal Reserve Lowering
Interest Rates
• Lower interest rates to
zero
• Make it cheaper for
businesses to borrow
– Hence boost investment
spending
• Raise asset prices
– Increase household
wealth, and thus
consumer confidence
The Bank Rescue
• The TARP
– $700 billion dollars to be
used to backstop
financial institutions
– Restore confidence that
they will repay their
debts
– Give them the ability to
make and roll over loans
The Recovery Act
• The ARRA
– Predicted that $1.8
trillion would close the
aggregate demand gap
– Did not dare ask for
more than $1 trillion
– Got $600 billion
– The $1.8 trillion number
underestimated the size
of the problem
Quantitative Easing
• Even after interest rates
on short-term
government debt hit
zero, the Federal
Reserve can keep
buying bonds for cash
• Does it have any effect?
Policies Not Adopted
•
•
•
•
•
•
The Recovery Act II
Mortgage refinancing
Raising the inflation target
Nominal GDP targeting
Bank nationalization
A weak dollar is in America’s interest
The Recovery Act II?
• Christina Romer in
2009-10:
– “No repeat of 1937-38;
no premature
withdrawal of fiscal
support before the
recovery is wellestablished
• 60-vote points of order
in the Senate
• Reconciliation process
Mortgage Refinancing?
• People who owe on
mortgages and are
delinquent certainly are
not spending
• People who own
delinquent mortgages
aren’t spending either
• Rebalance mortgage
market—end
uncertainty—and boost
the economy
Mortgage Refinancing?
• The construction slump
has been much longer
and deeper than the
construction boom was
• Why hasn’t construction
restarted itself?
• Broken mortgage
financing system
• People living in their
sister’s basement…
Raising the Inflation Target?
• A higher rate of
expected inflation
would make it more
expensive to hold on to
cash
• It would give
households and
businesses more of an
incentive to spend
Nominal GDP Targeting?
• The importance of
changing the game if
you want to change
expectations
• Roosevelt in 1933
• Volcker in 1981
• Why not Bernanke in
2012?
Bank Nationalization?
• They—or at least many of
them—had no equity
value anyway
• Allowing them to survive
increased risk
• Allowing them to be
independent diminished
their willingness to lend
• Allowing them to survive
created bad optics
A Weaker Dollar Is in America’s
Interest?
• The “strong dollar policy”
• Good for global growth
and development
• Good for the U.S. when
desired capital flows to
finance Silicon Valley are
high
• Good for U.S. consumers
• Bad for:
– U.S. manufacturing
– U.S. financial stability
– U.S. demand in a recession
Forecasts
• “Lost decades”
• “Hysteresis”
• The Congressional
Budget Office is
optimistic
– Something really good is
supposed to happen to
the economy in 2015
– What, however?
Economics 1: Origins of the Financial
Crisis and the Downturn
J. Bradford DeLong, Lanwei Wang, etc...
April 16, 2012
Minskyites, “Irrational Exuberance,”
Panic, Revulsion, and Discredit
• A sudden excess-demand for high-quality assets
• Assets where people can park their wealth and be
sure it will still be there when they come back...
• This excess demand acts like...
– ...the excess demand for liquid cash money in monetarist
theories...
– ...the excess demand for bonds, the excess of (planned)
savings over investment in Keynesian theories...
• And generates the downturn
How Did We Get Here?
• Why is there, all of a sudden, a big excess demand for
safe high-quality assets?
– Why do people want to hold more?
– Why all of a sudden is there less for people to hold?
• People want to hold more for very logical reasons:
– There is a depression
– There is a big downturn
– There is a financial crisis
• Why all of a sudden is there less for people to hold?
– Because there were a whole bunch of assets around that people
thought were “safe,” “high quality,” “AAA”
– And they weren’t
– And people recognized that they weren’t
Mortgages
• Banks that make mortgages in their areas
– But what if something bad happens to the local real estate
market?
– The U.S. government—Fannie Mae—will buy up
“conforming” mortgages (20% down, stable income, low
principal, appraised value) and take on the risk
– But what about the others?
• Making “subprime” loans too risky to be a big
business
The Financial Accelerator
• DeLong’s reasoning in March
2008:
– 5M houses that should not have
been built in the desert between
Los Angeles and Albuquerque
– $100K in mortgage debt that will
not be paid and has to be eaten by
somebody
– Hence a $500B financial loss
• But the dot-com crash was a $4T
financial loss
• And that pushed the
unemployment rate up by only
1½%
• The market’s reasoning:
– There is $500B in losses that we
know of
– And all the trained professionals
who assured us that these were
safe
• Lied, or
• Don’t understand the world
– Therefore we need to dump our
risky assets—at any price—and buy
safer ones—at any price
• Very limited supply of truly safe
assets
• At trough, global value of
financial wealth down from $80T
to $60T
Mortgage-Backed Securities
• So let us take a huge number of mortgages from all over
the country
• Let us mix them together
• And let’s divide them into five
–
–
–
–
Tranche 1: the first 20% of payments: super, super, super safe
Tranche 2: the next 20% of payments: super, super safe
Tranche 3: the next 20% of payments: super safe
Tranche 4: the next 20% of payments: safe unless there is a big
nationwide housing downturn—which there never has been
– Tranche 5: risky
Financial Engineering
• You have taken a whole bunch of non-conforming
mortgages that are too risky for banks or insurance
companies, etc., to hold...
• And you have turned them into five piles—one of which
(T5) is risky, one of which (T4) is safe unless there is a big
nationwide housing downturn, and three of which are
safe no matter what...
• Or so your calculations show...
• This is an urgent problem because
– Global savings glut makes interest rates low
– Federal Reserve dealing with a (small) Keynesian downturn
makes interest rates low
– Hence bank profits are low
Implications of Financial
Engineering
• A whole bunch of people who could not afford to buy houses
can afford to buy houses
• Especially if they think that the price of housing is unlikely to
go down
• Especially if interest rates are historically low for other
reasons
• Kindleberger:
– “There is nothing so disturbing to one’s well-being and judgment as to
see a friend get rich...”
– When the number of firms and households indulging in these
practices grows large, bringing in segments of the population that are
normally aloof from such ventures, speculation for profit leads away
from normal, rational behavior to what has been described as
"manias" or "bubbles."
The Housing Bubble
The Dot-Com Bubble
Why the Difference?
• The dot-com bubble
– Securities held by venture
capitalists
– By rich investors
– As part of the portfolios of
large mutual funds
– By individuals
• Prices fall—but everybody
knew these securities were
risky anyway
• So the downturn was a mild
Keynesian one—people cut
back on spending in order to
try to save more to make up
their losses
• The housing bubble
– Securities supposed to be
distributed
– But they weren’t
• The originate-and-distribute
model was broken
• “But they are ‘AAA’!”
– That you convinced Moody’s to
rate them AAA does not mean
that they are AAA
– And so all the debts of all the
organizations that held MBSs
became suspect
Where Were the Regulators?
Is Financial Deregulation a Good Idea?
• Probably not
• Milton Friedman, “A Program for Monetary Stability”
– If you promise your depositors/creditors that they can get their money
quickly
– And if you promise your depositors/creditors that their money is safe
– And if there is any chance at all that this promise creates “systemic
risk”
– Then you should be regulated so tightly that you can only invest in U.S.
Treasury bonds
• John Maynard Keynes, “General Theory of Employment,
Interest, and Money”
– Perhaps all investments should be long-term and indissoluble—like a
marriage...
Lots of Blame
• Clinton administration: repeal of Glass-Steagall
– Depression law separating government-guaranteed commercial banks from other
investment banks
– Actually, not a cause of the problem...
• Big failures: Lehmann, Bear Stearns, AIG; near failures: Citi, BofA, Morgan Stanley, Goldman
Sachs
• Clinton administration: don’t regulate derivatives
– The CFTC the wrong place to regulate...
– A small market: not a big issue...
• Federal Reserve: value in exploring new models of providing credit
– And who am I, Alan Greenspan asked, to tell lenders who want to lend that they
cannot lend to borrowers who want to borrow?
– Underestimating the seriousness of the situation
• Bush administration: deregulation is best
• Bush administration: the people on Wall Street are much better at
assessing and managing risks than we are
– And their personal fortunes are at risk
Consequences: Safe Asset Supply
Consequence: The “Spread”