Balance Sheet Recessions Oregon Economic Forum Portland, Oregon October 21, 2010 Mark Thoma Department of Economics University of Oregon

Introduction and Outline of Talk How did the financial panic occur? Will argue we had an old fashioned bank run in the modern banking sector What were the consequences? There are many, but will focus on the idea that financial panics cause balance sheet recessions, something that hasn’t received enough attention How can we cure balance sheet recessions? What are the remedies, and to what extent have we been successful at applying them? Lessons: What have we learned?

Bank Panics Prior to the Great Depression There were bank panics in 1819, 1837, 1857, 1873, 1893, and 1907, (and smaller panics in 1847, 1884, 1890, and 1896). The last, in 1907, was particularly severe and led to the creation of the Federal Reserve System in But, the bank panic problem was not solved. From , as the Great Depression took hold, 9,106 banks failed (4,004 in 1933 alone).

Bank Failures in the U.S. from

Response to Bank Panics Response was the Banking Acts of 1933 and The key feature of these acts was deposit insurance through the FDIC. Stopped bank failures due to bank runs for 75 years Recently, the problem of bank runs has reappeared. Crisis can be understood as an old fashioned bank run in the modern banking sector

The Rise of Shadow Banking Beginning around 1980, shadow banking began to grow A shadow bank is any institution that that takes deposits and makes investments/loans, but is outside traditional regulatory authority Particularly interested in banks that borrow short and lend long. Known as maturity transformation.

Percentage of Securitized Loans

Sources of Growth in the Financial Sector

The Bank Run Problem in Shadow Banking Unlike deposits in the traditional banking system, deposits in shadow banks are not insured Instead, they are backed by high quality collateral Unfortunately, the collateral was not as high quality as thought – a rating of AAA did not mean what it was supposed to mean When this was discovered, and when it became clear after Lehman that the government would not necessarily implicitly insure deposits, a bank run followed Concentration of risk on bank balance sheets was also a problem

Preventing Bank Runs in Shadow Banking Two main proposals Require better collateral, e.g limit to government backed securities such as Treasury Bills Extend deposit insurance to the shadow banking sector, only allow banks below a given risk threshold to borrow short, lend long. Solve moral hazard problem with insurance fees and first loss provisions. Would likely reduce securitization substantially.

Balance Sheet Recessions Recessions can be initiated in different ways, e.g. oil price shocks, stock market crashes, poor harvests, monetary shocks, housing market crashes The recovery period from recessions induced by financial panics is typically very long, e.g. Japan’s Lost Decade One of the difficulties is that these are Balance Sheet Recessions, and balance sheets take time to repair

Damaged Balance Sheets Financial Institutions: Total write-downs estimated to be in the $1.8 - $2.5 trillion range.

Damaged Balance Sheets Households: Losses in home equity, retirement savings, and other savings and investments from $8-13 trillion depending upon the estimate, though most are at the high end of that range.

Household Net Worth During Recessions

Damaged Balance Sheets Businesses: Numerical figures for total losses are hard to come by, but the toll on businesses has been large. To get some idea on this, note that About 4.3 million businesses with 19 or fewer employees closed during the fourth quarter of 2007 through the fourth quarter of 2008, according to the Bureau of Labor Statistics

Change in Small Business Lending

Damaged Balance Sheets Federal Government: Hard to estimate exactly but independent of stimulus, bailouts, recession has added approximately one trillion to the national debt.

Government Receipts and Expenditures Note that net government expenditures across all levels of government (federal, state, and local) has been near zero due to large cutbacks at the state and local level

Damaged Balance Sheets State and Local Governments: Revenues plunged, demand for services increased leading to budget problems. States had to address fiscal year 2011 gaps totaling over $125 billion, or 19 percent of budgets 46, no relief in sight for Combined state gaps since recession started over $425 billion

Total Tax Collections in Oregon

State Revenue Projections The state’s general fund revenues dropped by $3.1 billion in the current budget period from the level that had been projected in 2007

Additional State Expenditures Due to the Recession

Did the Bailouts and Stimulus Packages Repair Damaged Balance Sheets? Federal government can help. It can run deficits, and print money Did the government do enough to help? Financial Sector: Considerable help from the $700 billion bailout. But, smaller banks could have been helped more. Businesses: Business tax cuts $51 billion in ARRA, auto bailout, low interest rate loans. Do more for small businesses. Households: Bush Tax cuts, tax cuts 40% of stimulus package, significant portion saved, but still large hole in budget State and Local government: Some help from $144 billion in the $787 billion ARRA, and $26 billion in supplemental help, but far from enough.

The Tax Rebates and Consumption Did the Rebates Work? The tax rebates were mostly saved (67%) This was expected since the rebates were temporary. There was little effect on employment But balance sheet rebuilding may not be so bad in a balance sheet recession

US Personal Saving Rate

Important Lessons from the Crisis The shadow banking sector needs to be brought under the traditional regulatory umbrella. We need a form of deposit insurance to stop shadow bank runs. Households need more help repairing their balance sheets. This will help to end recessions sooner. State and local governments did not have sufficient reserves – a rainy day fund – to cushion the shock. The federal government did not provide enough help to state and local governments. George Evans has ideas on how to fix this problem