The Income-Expenditure Model Y = (I + G + c 0 )/(1 – c y ) – 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 c 0 – Divide by 1 – c y – 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 + c y x Y – I = I(r)
The Underpinningd Y = (I + G + c 0 )/(1 – c y ) C = c 0 + 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”
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 well- established 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."
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
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