Download The Great Recession - The College of Business UNR

The Great Recession
Causes, Responses, and Concerns
Elliott Parker, Ph.D.
Professor of Economics
University of Nevada, Reno
Financial Markets are Prone to Market Failure
• Market economies are most efficient when (1) there is
competition, (2) everybody knows what they are buying and
selling, and (3) external spillover effects are minimal.
• Finance fails on at least two: information and contagion.
• Basic problem: banks are lending somebody else’s money.
• Government insurance (FDIC) and private insurance (CDOs)
both lead to moral hazard, excessive risk-taking for short-run
profit. Bailouts are just an extreme form of insurance.
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Prior Financial Crises
• There have been financial panics in the U.S. even before the
Great Depression: 1816-1819, 1825, 1837, 1857, 1873, 1893,
and 1907. Most resulted in recessions.
• Prior “depressions” included 1837, 1873, 1893, 1907, and
1920-21.
• Government intervention was very limited – there was not
even a central bank until 1913.
Inflation-Adjusted
S&P 500 vs. DJIA
2500
2000
The Double Bubble in
the U.S. Stock Market
Index
Adjusted
1500
1000
500
0
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
Monthly Data
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A Longer Look at the DJIA – Adjusting for Inflation
(1949-2009 Monthly Close)
15,000
DJIA / CPI
By the 1990s, people came to
think rapidly rising stock
prices were normal.
10,000
Boom through 1968, stagnation
through 1984. Overall, the Dow just
kept up with inflation for 40 years.
5,000
19
4
19 9
51
19
5
19 3
5
19 5
57
19
5
19 9
61
19
6
19 3
65
19
6
19 7
6
19 9
7
19 1
7
19 3
75
19
7
19 7
7
19 9
81
19
8
19 3
8
19 5
87
19
8
19 9
91
19
9
19 3
95
19
9
19 7
99
20
0
20 1
0
20 3
05
20
0
20 7
09
0
Monthly Close
Rising Oil & Gas Prices
helped pop the bubble
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Remember
the Bubble in
NASDAQ?
Remember the
Enron scandal?
Americans forgot.
7
The “Ownership
Society”
Between 1994-2004:
• Est. 15 million new
homes owned,
• 9 million at trend, plus
• 6 million more (5% rise).
• California and Nevada
started catching up to
rest of the country.
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Mortgage debt grew
MUCH faster than
either income or
home ownership
First Wave (1950s)
– commercial banks
Second Wave (1980s)
– GSE-guaranteed securities
Third Wave (>2002)
– other mortgage-backed
securities
10
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A Major
Cause/Effect
is Household
Spending
Over the last decade:
• a sharp rise in
consumption
• A fall in personal
domestic savings
U.S. Consumption Share
78%
76%
74%
72%
70%
68%
Consumption
66%
Consumption plus trade balance
64%
62%
Consumption rose to unsustainable levels, and when it came down…
60%
58%
1995
1996
1997
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1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
6
Real U.S. Investment
(Share of GDP)
14%
12%
Nonresidential Fixed Investment
Residential Investment
10%
Inventories
8%
6%
Investment in new housing also crashed.
This is not likely to recover soon.
4%
2%
0%
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
-2%
Spending as a Share of U.S. GDP
110%
Trade Deficits
100%
Private Investment Purchases
90%
80%
Putting them together, we were
spending more than we were producing.
70%
60%
Private Consumption Spending
50%
40%
30%
20%
Federal Purchases
10%
State and Local Government Purchases
0%
1960
1964
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1968
1972
1976
1980
1984
1988
1992
1996
2000
2004
2008
7
Is another Great Depression likely?
Short Answer: No. Why Not?
• During the Hoover Administration, not only was any desire or effort to
intervene inadequate, the Federal Reserve responded by tightening the
money supply and made it much worse. It also failed to act as lender of last
resort for solvent banks with cash flow problems.
• Deflation resulted. Loans got harder to repay.
• The Gold Standard forced foreign central banks to reduce their money
supplies in response.
• The U.S. and other economies raised tariffs and world trade shrunk, leading
to a downward spiral.
15
Attitudes in 1929
Andrew W. Mellon, Hoover’s Treasury Secretary:
- “Liquidate labor, liquidate stocks, liquidate the farmers,
liquidate real estate.”
- “It will purge the rottenness out of the system. High
costs of living and high living will come down. People will
work harder, live a more moral life. Values will be
adjusted, and enterprising people will pick up the wrecks
from less competent people.”
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Assigning Blame? Lots of Choices
• Federal government
– – for encouraging more people to buy homes they could not afford and
socializing insurance.
• Fair Housing Act of 1968, Community Reinvestment Act (CRA) of 1977.
Congressman Barney Frank is seen as an advocate of this policy, and
since 2007 chairs House Financial Services Committee.
– – for removing regulations on derivative markets, and easing regulations
on mergers and bank lending practices.
• Senator Phil Gramm, Gramm-Leach-Bliley Act of 1999.
More Choices
• Federal Reserve System – for trusting markets to regulate
themselves.
• Mortgage brokers and lenders – for making bad loans and selling
them off to others.
• Fannie Mae and Freddie Mac – for using implicit government
guarantees to securitize bad loans, and for lobbying federal
government to let them do so.
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More people to blame…
• New homebuyers – especially poor people, who bought houses
they could not afford, or who lacked the resources to pay their
mortgages if the economy turned sour.
• Existing homeowners – who used home equity loans to finance
their own consumption.
• Speculators – who bought houses as investments, with the
intent of renting them out and reselling them when prices rose.
19
And more…
• Wall Street firms – for underestimating and/or disguising
actual risks, and not taking responsibility for bad decisions.
• Derivative markets, investment banks, and hedge funds – for
selling insurance without capital requirements, in essence
making bets that they would fail to make good.
• Financial market consolidation – for creating big firms that
put others at greater risk from the effects of bad decisions.
20
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Why are Derivatives a Problem?
Insurance markets are regulated to make sure the insurer has
adequate capital. Derivative markets are not.
Derivative markets can be complex, and traders on both sides
may not realize what they are doing.
Derivatives are not transparent, often off-book, and huge.
You don’t have to own the asset to buy insurance on it. This
can leads to pyramiding of side bets. There are also often
multiple generations far removed from the asset.
All insurance markets have problems of moral hazard.
21
Let’s not forget Hubris.
• Some risks are not diversifiable.
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The Federal Reserve chose not to regulate
derivatives or act to prevent bubbles
Alan Greenspan recently testified,
– “I made a mistake in presuming that the self-interests of organizations,
specifically banks and others, were such as that they were best
capable of protecting their own shareholders and their equity in the
firms.”
- Congressional testimony, October 22, 2008
23
22
20
18
16
14
12
10
8
6
4
2
0
30-Year Mortgage Rate
Prime Lending Rate
Federal Funds Rate
Inflation Rate
19
71
19
73
19
75
19
77
19
79
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
19
97
19
99
20
01
20
03
20
05
20
07
20
09
Percentage
Mortgage Rates have been much more
Stable than either Prime or the FFR
Monthly Data
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Other views
• Markets require both buyers and sellers. Mortgage lenders were willing to
lend to people, and people were willing to borrow, without serious
consideration of the risk that the bubble could pop.
• Americans stopped saving to finance higher consumption.
• There are limitations to our ability to see problems and analyze risk.
• Financial markets elsewhere fell for the same illusions.
• Be wary of simple answers or single causes (especially partisan ones). Be
similarly wary of simple philosophies or ideologies that ignore complex
interactions.
Three Questions Answered…
• Why isn’t the economic recovery more robust?
– It’s a depression, dummy. They last a while. Banks stopped lending, and
people stopped building houses. But the economy did not collapse.
• Is inflation a threat?
– No, the bigger concern has been deflation. However, the Fed must be
willing to unwind the monetary base, once banks start lending again.
• Has the overconsumption problem eased?
– Yes, consumption spending plus residential investment has fallen – though
as a nation we are still spending more than we make.
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The Great “Balance-Sheet” Recession
• Recessions - less common than they used to be.
• Depressions – much less common, much longer and
deeper than normal recessions.
– A recession caused by a financial crisis
– A “balance sheet” recession: financial wealth collapses,
banks collect reserves to offset bad debt, government
becomes borrower of last resort, deflation and ZIR.
Response #1: Monetary Intervention
Federal Reserve authorized:
• Quantitative easing: purchase of government bonds, helped
drive yield to zero.
• Purchase of private mortgage-backed securities, central bank
currency swaps, target federal funds rate near zero.
• Pushing vs. pulling on a rope. Effectiveness varies.
QE II: a “Hail Mary pass,” preventing deflationary expectations.
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Monetary
Base
(Currency
plus Bank
Reserves)
Money
Stock
(M2)
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But inflation
hasn’t been a
problem yet!
Low interest rates
and inflation have
increased money
demand.
Worries about Inflation
• Rise in Monetary Base would normally have been
inflationary – but deposit expansion multiplier collapsed!
• Primary worry was Deflation, as during the Great
Depression.
• M2 has not grown much, no sign of inflation yet.
• A Good Sign – worries have switched.
• Bernanke needs an exit strategy, to reduce reserves when
banks start lending again.
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Response #2: Bank Bailouts
Emergency Economic Stabilization Act:
• $700 billion authorized in October 2008. Only $550B used.
• TARP funds first for purchase of troubled MBS, but changed to an
equity purchases approach with executive pay restrictions.
• $270B went to AIG, GM, Wells Fargo, Citigroup, BoA, JPMorgan
Chase, Morgan Stanley, and Goldman Sachs.
• $27B went to over 600 banks ($300K-$968M)
• Majority has already been paid back, with interest.
Response #3: Fiscal Intervention
• Economic Stimulus Act of Feb. 2008:
– Tax rebates for 2008, estimated $150B cost (about 1% of GDP) in 2008.
• American Recovery and Reinvestment Act of 2009:
– Estimated $800B cost over several years, with less than $200B spent in FY
2009, and $400B in FY 2010 (about 3% of GDP).
– About 40% in tax credits, 30% in state fiscal support, and 30% in
infrastructure investment (education, energy, health care), and some
extended benefit support.
– How effective was this stimulus?
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Fiscal Skepticism?
• Economists are very skeptical about fiscal policy
working when we are close to full-employment.
– Higher real interest rates crowd out investment.
– Higher dollar crowds out exports.
– Higher debt leads to future deficits.
• But we are NOT near full employment, and monetary
policy isn’t enough when banks are scared and
interest rates are zero.
• What are our choices?
The Federal Deficit and the Debt
• The Federal Debt is almost $14T, about our annual GDP ($10T
in 2008, less than $6T in 2000).
• About $8T is held by private, half of that by foreigners.
• The current deficit is temporary due to the recession, but
there are serious structural problems: tax cuts, the growth of
health care costs (i.e., Medicare).
• Borrowing for investment, or in bad times, makes sense.
Borrowing in good times for consumption does not – IBGYBG.
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120%
Federal Budget
(as a Share GDP)
100%
Federal Expenditures
80%
Federal Revenues
Share of GDP
Federal Savings
60%
Federal Public Debt
40%
20%
0%
1929
1934
1939
1944
1949
1954
1959
1964
1969
1974
1979
1984
1989
1994
1999
2004
2009
2014
2019
-20%
Annual Data (Actuals through 2008)
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Was it Worth it?
• The total economic loss from the Great Depression was perhaps
120% to 140% of 1929 GDP, worth about $20 Trillion now.
• The total economic loss from the 1980-1983 recessions was
15% to 17% of 1979 GDP, about $2.4 Trillion now.
• If $800 million in stimulus could prevent half of this latter
decline, then it would be a very good investment.
• If it led us to decline 2.5% instead of 5.0%, it has paid for itself.
• But we don’t KNOW what would have happened without it.
140%
Federal Budget and the U.S. Economy
(as a Share of 1950-2000 Trend GDP)
120%
Share of 1950-2000 Trend GDP
100%
80%
Federal Expenditures
Federal Revenues
Federal Savings
60%
GDP
Federal Public Debt
40%
20%
0%
1929
1934
1939
1944
1949
1954
1959
1964
1969
1974
1979
1984
1989
1994
1999
2004
2009
2014
2019
-20%
Annual Data (Actuals through 2008)
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We are at a turning point…
• Our government debt is large, and growing, but not yet
unsustainable. Will the current deficit be temporary or
permanent?
• Our economic trajectory is not sustainable. We can’t keep our
spending growing faster than our income, and depending on
other countries to keep financing that spending.
• Similarly, many countries with high savings rates have seen us
as an export market driving their growth AND a place to invest
their savings.
How do we escape?
• Time – there is still significant deleveraging that still
needs to occur. Housing prices must also stabilize.
• Confidence – consumers and investors no longer are
as worried that we are in freefall.
• Restructuring – high consumption with trade
deficits/foreign borrowing is not sustainable.
• Policy – difference between short-term intervention
and long-term growth strategies.
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Fifty Herbert Hoovers
• State and local governments are often ignored in the analysis.
• SLGs purchase more goods and services, and employ more
people, than the federal government.
• Most SLGs have balanced budget requirements, which means
they must either cut spending or raise taxes during recessions.
• SLG financial crises lag the rest of the economy.
• Estimates: cuts to SLG lead to twice the fall in GSP the next year.
45%
Government Purchases of Goods and Services
(Share of GDP)
40%
35%
30%
25%
Federal Purchases
20%
SLG Purchases
15%
10%
5%
0%
1929
1933
1937
1941
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1945
1949
1953
1957
1961
1965
1969
1973
1977
1981
1985
1989
1993
1997
2001
2005
2009
22
Spending cuts have more
effect than tax increases.
It should therefore be no
surprise that when SLGs
are cutting as the Feds
are spending, the
economy does not
recover very fast.
What are the Implications for Nevada?
• Gaming was a sustainable model, until monopoly ended.
• Las Vegas maintained growth by building new properties, but
gaming/hotels/tourism still a falling share of state economy.
• Rapid construction was not sustainable: building homes for other
construction workers, dependent on California bubble.
• Low educational attainment: supply and demand.
• Relatively undiversified economy: little public investment.
• State and local government revenues reliant on gaming tax,
narrow-based sales tax.
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Inflation-Adjusted
Housing Price Index
Nevada lagged
California, and our
initial housing stock
was smaller.
California
200
They came here
looking for deals.
1980 = 100
- 37%
- 16%
100
USA Average
Our construction
sector was the
country’s largest.
- 49%
Nevada
Underwater
mortgages:
USA 23%
CAL 33%
NEV 66%
0
1980
1984
1988
1992
1996
2000
2004
2008
Quarterly FHFA Data
Personal Income Growth Rate
20%
USA
California
Nevada was the fastest-growing
state.
Nevada
10%
0%
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
We became the fastest-falling
economy (a net decline of
7.2%)
-10%
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Because of its
reliance on
construction
and gaming,
Nevada’s
economy
declined more
than any other
state. We went
from richer
(mean, not
median) to
poorer.
Nevada’s
unemployment
rate became
highest in the
nation – and is
only falling
now because
people are
exiting the
workforce, and
the state.
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What are the Global Implications?
• Much of the savings being lent to Americans came from
foreign sources.
• Housing bubbles occurred in dozens of countries.
• Many foreign banks engaged in the same practices as
U.S. firms.
• Markets for derivatives are often offshore.
• Foreign markets rely on exports to American consumers.
1.4
Real Direct Exchange Rates
Initial P eriod= 1.0
1.3
1.2
1.1
1.0
0.9
0.8
0.7
0.6
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
Monthly Data
RMB
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Euro
Pound
26
REER
(Indirect)
U.S. International Trade
20%
15%
Exports
Imports
Share of GDP
10%
Trade Balance
5%
0%
1947.1 1951.1 1955.1 1959.1 1963.1 1967.1 1971.1 1975.1 1979.1 1983.1 1987.1 1991.1 1995.1 1999.1 2003.1 2007.1
-5%
-10%
Quarterly BEA Data
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Balancing the Trade Deficit?
• GDP is currently $15 trillion per year.
• Exports are currently $2.0 trillion per year (13%), Imports are
$2.6 trillion (17%).
• If short-run elasticities are roughly 0.5, any depreciation of Dollar
will increase the trade deficit since imports > exports.
• If one-year elasticities are roughly 1.0, a real depreciation of 30%
would lead to a trade surplus.
• Income elasticities matter too – will we grow faster than others?
What about our External Wealth?
• At end of 2009, we owned $18.4 trillion, and owed $21.1
trillion, a net liability of $2.7 trillion.
• A 30% depreciation of the Dollar would create a valuation
effect on our foreign assets of $5.5 trillion, converting our
external wealth into a net positive 2.8 trillion.
• Our foreign liabilities are denominated in Dollars.
• So what is the problem?
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Real GDP
has not
been
keeping up
with its
trend.
$18,000
$16,000
$14,000
$12,000
$10,000
$8,000
$6,000
$4,000
$2,000
$0
1947
1952
1957
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1962
1967
1972
1977
1982
1987
1992
1997
2002
2007
29
What about Risk?
• The U.S. Government lacks the political will to balance the budget:
Republicans won’t allow tax increases even though we pay a lower share of
federal taxes than anytime since 1949. Democrats won’t allow cuts to
Medicare even though medical costs keep skyrocketing.
• If the U.S. debt keeps growing faster than the U.S. economy (the real issue),
this may lead markets to fear our government bonds are no longer safe.
Defaulting on the debt would ensure this.
• Our risk premium would rise, increasing interest rates and slowing
investment. Trade deficits would become much harder to finance.
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