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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. ECON 463 Spring 2011 1 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 ECON 463 Spring 2011 2 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 ECON 463 Spring 2011 3 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. ECON 463 Spring 2011 4 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 ECON 463 Spring 2011 5 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 ECON 463 Spring 2011 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 ECON 463 Spring 2011 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.” ECON 463 Spring 2011 8 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. ECON 463 Spring 2011 9 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 ECON 463 Spring 2011 10 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. ECON 463 Spring 2011 11 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 ECON 463 Spring 2011 12 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. ECON 463 Spring 2011 13 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. ECON 463 Spring 2011 14 Monetary Base (Currency plus Bank Reserves) Money Stock (M2) ECON 463 Spring 2011 15 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. ECON 463 Spring 2011 16 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? ECON 463 Spring 2011 17 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. ECON 463 Spring 2011 18 120% 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) ECON 463 Spring 2011 19 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) ECON 463 Spring 2011 20 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. ECON 463 Spring 2011 21 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 ECON 463 Spring 2011 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. ECON 463 Spring 2011 23 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% ECON 463 Spring 2011 24 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. ECON 463 Spring 2011 25 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 ECON 463 Spring 2011 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 ECON 463 Spring 2011 27 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? ECON 463 Spring 2011 28 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 ECON 463 Spring 2011 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. ECON 463 Spring 2011 30