Download A Tempestuous Season

A Tempestuous Season:
The 2008 Financial Crisis
and its Aftermath
Rick Eichhorn
Associate Professor of Economics
Coe College
October 1, 8, 15, 22, 2009
Rick Eichhorn
A Tempestuous Season
Welcome
Introduction
October 1, 2009
My Background
A Tempestuous Season: The 2008 Financial Crisis and its
Aftermath
The Plan
Today - Some Basic Macroeconomics
To Come - The Special Case of Financial Markets, Connecting
the Financial Economy to the Real Economy, Instability,
Recovery and Reform, Macroeconomic Policy Debates
Rick Eichhorn
A Tempestuous Season
A Bit of Introduction
A note on perspective: What am I?
An Economist, with an economist’s perspective. We say that
economics is a social science concerned with studying how
economic agents best satisfy their unlimited wants with
limited resources - how individuals, firms or societies deal with
scarcity. So we observe these agents, as if from outside the
system. However, we are in the system. This makes things
messy. There is a distinction in economic analysis - positive v.
normative - that we are often forget.
A Macroeconomist, with a macroeconomist’s perspective. We
think about the economy as a complex system culminating in
large scale outcomes like GDP, unemployment (UR) and
inflation (INF).
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A Tempestuous Season
A Bit of Introduction, cont.
A Monetary Macroeconomist, with a monetary perspective.
[Not a monetarist’s perspective, that term was already taken.]
We study financial institutions, instruments and markets in
order to ask what role financial innovation and regulation play
in determining macroeconomic outcomes.
An Econometrician, with an econometrician’s perspective. We
use evidence, economic data, to evaluate the theories
developed to explain how economic agents behave.
A Time Series Econometrician, with a time series perspective.
We study the peculiarities in some data as it evolves over
time. Random Walks live in Time Series Econometrics.
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A Tempestuous Season
A Tempestuous Season?
“The Quantity Theory is often stated in this, or a similar form.
Now ‘in the long run’ this is probably true. If, after the American
Civil War, the American dollar had been stabilised and defined by
law at 10 per cent below its present value, it would be safe to
assume that n and p would now be just 10 per cent greater than
they actually are and that the present values of k, r , and k 0 would
be entirely unaffected. But this long run is a misleading guide to
current affairs. In the long run we are all dead. Economists set
themselves too easy, too useless a task if in tempestuous seasons
they can only tell us that when the storm is long past the ocean is
flat again.”
John Maynard Keynes, A Tract on Monetary Reform, 1924, p. 80.
Rick Eichhorn
A Tempestuous Season
Anatomy of a Tempestuous Season
The economy is inherently unstable, and is prone to fluctuations
which we call business cycles. A business cycle has 2 phases and 2
turning points:
Phases
Recession - a decline in economic activity.
Expansion - an increase in economic activity.
Turning Points
Trough - the end of a recession and start of an expansion.
Peak - the end of an expansion and start of a recession.
A complete cycle is measured from peak to peak or trough to
trough.
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A Tempestuous Season
Some Notable Tempestuous Seasons
Let’s look at some data. The best source for macroeconomic data
is the St. Louis Federal Reserve Bank: http://www.stlouisfed.org.
GDP - http://research.stlouisfed.org/fred2/series/GDPC1/
UR - http://research.stlouisfed.org/fred2/series/UNRATE/
INF - http://research.stlouisfed.org/fred2/series/CPIAUCSL/
Rick Eichhorn
A Tempestuous Season
Great Depression II?
What about the tempestuous season we find ourselves in? What
happened? Basically, this is what happened:
Lots of Financial Innovation
Housing Bubble Forms, Bursts
Credit Crunch
Spillover into Real Economy
Confidence Crisis
Feedback
Policy
Recovery and Reform?
For the next 4 weeks, we’ll dig into the details. For now we need a
little bit of macro.
Rick Eichhorn
A Tempestuous Season
A Little Bit of Macro
It is convenient, and instructive, to model the economy as a
Circular Flow.
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A Tempestuous Season
Banks
Financial Intermediaries (Banks) provide an essential function to a
capitalist economy - efficiently channeling savings from depositors
(consumers) into investment from borrowers (firms). The banks in
the process make profits:
π = iL Loans − iD Deposits
(1)
When Deposits come in, the banks have Reserves (R) which are
either required (by law now) or excess, which can be loaned out. In
the process of making loans in order to make profits, banks create
money:
1
s
∆M =
∆R
(2)
r
Rick Eichhorn
A Tempestuous Season
Welcome Back
Introduction
October 8, 2009
The Savings-Investment Channel
The Nobel Prize in Economics (2001)
Money Creation: Inherent Instability
Regulation and the Absence of Regulation
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A Tempestuous Season
Flow of Loanable Funds
Ultimately the loanable funds available go from savers
(households) to borrowers (households, firms, government). There
are two basic ways this can happen:
Direct Finance: Savers → Borrowers
Indirect Finance: Savers → Financial Intermediaries →
Borrowers
Up until the 80s, this was basically a story of direct finance through
Commercial Banks, which were part of the Federal Reserve System,
with deposits insured by the FDIC. In the 80s, deregulation and
financial innovation began to blur the lines between banks and
near-banks, and these near-banks grew in importance (other names
include non-banks, parallel banks, and shadow banks).
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A Tempestuous Season
The 2001 Nobel Prize in Economics: Asymmetric
Information
Why Direct Finance?
Adverse Selection [ex ante]: Agents who are the most
undesirable from the other Agent’s point of view are the ones
who are most likely to want to participate in a financial
transaction.
Moral Hazard [ex post]: The risk that one party to a
transaction will engage in behavior that is undesirable from
the other party’s point of view.
The Lemons Problem: A result of adverse selection, where an
agent can predict that undesirable parties are among the
parties with whom it might engage in financial transactions,
resulting in an apprehension to participate at all, stymying the
ability of desirable parties to make transactions.
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A Tempestuous Season
Near-Banking, Parallel Banking or Shadow Banking
Source: Paul Krugman, “Still Chasing Shadows”, NYTimes Blog: The Conscience of a Liberal, October 7, 2009.
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A Tempestuous Season
Where were we?
Remember, spending and economic outcomes occur in the Real
Economy. This crisis originated in the Financial Economy. Why
does the Financial Economy affect the Real Economy?
Banks connect savers (households) with borrowers (firms,
government) through the savings-investment channel.
Savings leaves the Real Economy and re-enters in an expanded
form as credit expansion leads to money creation and supports
multiple new lines of spending.
Rick Eichhorn
A Tempestuous Season
The Money Multiplier Process
S → D → R = RR + ER
RR stay in the bank (or go to the Fed)
ER → L → D → R and R → RR and R → ER → L → D → ...
Culminating in an expansion of money in credit form according to:
∆M =
1
r
∆R
And what happens to that new money? It gets spent. If
∆R = $100, and r = 10%, ∆M = $1, 000! $100 of diverted
savings leads to new spending of $1000, a gain of $900.
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A Tempestuous Season
Faith
What is the ultimate source of this new money? Faith. The new
money is not previously created economic value, which is then
saved. It is economic value that is promised to be created in IOU
form. So, it is backed by faith that the borrower will, at some
point, create economic value and pay it back - at interest, to
compensate for the risk of default.
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A Tempestuous Season
The Inverted House of Cards
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Faith, again
So what holds the inverted house of cards together? Faith. But
what happens when faith wanes?
Rick Eichhorn
A Tempestuous Season
Crash, or Regulation
Well the system crashes. Unless it is adequately regulated. Two
pieces of regulation have held the system up since the Great
Depression:
The Federal Reserve Act of 1913 - The Fed
The Glass-Steagall Act of 1933 - The FDIC
These two Acts essentially ended recurrent banking crises and
there were basically no bank failures until the S&L crisis - which
was a failure of regulation, most believe. Oh yeah, and the
Financial Crisis of 2008. Why?
The Fed requires reserves, and serves as Lender of Last Resort
The FDIC provides the safety net for depositors
But, don’t these institutions create moral hazard? Yes.
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A Tempestuous Season
Welcome Back
Introduction
October 15, 2009
Inherent Instability
A Butterfly Flaps Its Wings ...
Bubbles Burst
A Sort of Timeline
... A Tempestuous Season Results
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A Tempestuous Season
Absence of Regulation - Inherent Instability
Without regulation, the self-fulfilling nature of these markets
(based on faith and IOUs) can amplify the instability in a feedback
loop:
Strong Economy → Confidence High → Stronger Economy
Weak Economy → Confidence Low → Weaker Economy
Faith in the system reinforces itself (positive feedback), but so
does lack of faith (negative feedback). When faith wanes,
regulation is necessary to prevent a crash, due to feedback.
Rick Eichhorn
A Tempestuous Season
Great Depression II?
Remember: What happened? Basically, this is what happened:
Lots of Financial Innovation
Housing Bubble Forms, Bursts
Credit Crunch - August 9, 2007, September 14, 2008
Spillover into Real Economy
Confidence Crisis
Feedback
Policy
Fed, beginning in 2007
Fiscal Policy, eventually in 2009
Recovery and Reform?
Rick Eichhorn
A Tempestuous Season
The Perfect Storm
A confluence of events is responsible. As Mark Zandi, chief
economist and co-founder of Moody’s Economy.com, and author of
Financial Shock, 2009, puts it:
“The reality is that there is plenty of blame to go
around. A financial calamity of this magnitude could not
have taken root without a great many hands tilling the
soil and planting the seeds. Among the elements that fed
the crisis were a rapidly evolving financial system, an
eroding sense of responsibility in the lending process
among both lenders and borrowers, the explosive growth
of new, emerging economies amassing cash for their
low-cost goods, lax oversight by policymakers skeptical of
market regulation, incorrect ratings, and of course, what
economists call the “animal spirits” of investors and
entrepreneurs.”
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A Tempestuous Season
How Does a Bubble Form?
Low interest rates
(Enabled) Creative financing
Animal spirits
Competition
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A Tempestuous Season
Q: What Happens When a Bubble Bursts?
It is clear that the monetary authorities were aware of the housing
bubble problem as early as 2007. Housing prices started to decline
(and assets tied to them which were spread throughout the system
started to lose value rapidly) in 2006. On August 9, 2007, BNP
Paribas announced it was suspending withdrawls. On December
12, 2007, the Fed announced the creation of the Term Auction
Facility, and many amazing announcements were to follow. But
there wasn’t that much exposure was there?
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A Tempestuous Season
The Curious Case of CDOs
Traditionally, before the 80s, mortgages were between a bank and
a homebuyer. In the 80s, financial innovation took off.
Securitization gained popularity as financial innovation created new
ways to spread risk and sell newly created assets. The
securitization of mortgages as collateralized debt obligations
(CDOs) greatly increased in the 2000s, leading up to the crash in
2007. This, of course, increased the ease with which homeowners
could find a lender willing to loan. An even more curious
instrument is the credit default swap.
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A Tempestuous Season
A: The Inverted House of Cards Falls Down
In short, highly leveraged shadow banks get caught with these
CDOs and other rapidly devaluing assets on their balance sheets,
threatening their solvency. Since everyone is trying to divest
simultaneously, asset prices fall across the board and everyone gets
caught. A giant lemons problem is developing. Only the lender of
last resort is left to clean up the mess.
The ultimate blame? According to Zandi: “Of the places you can
point the finger for the housing bubble and subprime financial
shock, perhaps the most deserving is the removal of responsibility
from the financial system. ... Securitization undermined this
incentive for responsibility.”
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A Tempestuous Season
“Let ‘em fail!”
There is a general belief that the market disciplines imprudence:
Only the strong survive, the weak perish, etc. Many prudent
agents are wrapped up in this one, especially when it spreads out
of the financial economy and into the real economy...
Rick Eichhorn
A Tempestuous Season
Meet Ted
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A Tempestuous Season
Get to know Ted
Rick Eichhorn
A Tempestuous Season
Welcome Back
Introduction
October 22, 2009
Savings 6= Investment
The Real Economy
Classical Assumptions
Animal Spirits
The Ocean is not Flat
Policy
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A Tempestuous Season
Where were we?
Let’s just review a little:
Credit Crunch - August 9, 2007, September 14, 2008 Lemons Problem
Spillover into Real Economy
Confidence Crisis - Animal Spirits
Feedback - Paradox of Thrift
Policy
Fed, beginning in 2007 - Liquidity Trap
Fiscal Policy, eventually in 2009
Recovery and Reform?
Rick Eichhorn
A Tempestuous Season
Maybe No One Will Notice
The fall in housing sales, followed by the fall in housing prices,
followed by the fall in mortgage-based asset values, followed by the
increasing likelihood that major financial institutions would fail,
generated a response by the Federal Reserve System, in reaction to
this giant lemons problem. Could the Fed keep this in the financial
economy?
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A Tempestuous Season
We Noticed (after Lehman failed).
Nope. The Fed engaged in aggressive Lender of Last Resort
lending, but the problem required more. TARP, Re-capitalization,
and Nationalization. Now the scope of the problem is out in front
of us. And it is an election year.
⇓
Animal Spirits
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A Tempestuous Season
No More Bullets
On August 10, 2007 the federal funds rate target was 5 14 %. Over
the course of the next year and a half or so, the Fed’s aggressive
(and absolutely necessary) actions to provide liquidity pump
massive funds into the economy. By January, 2009, the “range” for
the federal funds rate is now between 0 and 14 %. The actions as
lender of last resort have used up all the ammunition normally
reserved for managing demand in the economy. This is known as a
liquidity trap.
Rick Eichhorn
A Tempestuous Season
Meanwhile, back in the Real Economy
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Net Savings across the Business Cycle
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Remember how banks create money?
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Shaky Ground
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Let’s zoom in
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Shakier Ground
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Animal Spirits, Lemons Problem, Paradox of Thrift,
Liquidity Trap
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The Results of a Perfect Storm
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A Tempestuous Season
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A Tempestuous Season
When the ocean is flat:
Classical Assumptions:
The economy is inherently stable.
The economy is self-regulating.
If demand is low, prices will fall to stimulate spending.
Government interference will block these price signals.
Government is less efficient than private enterprise.
Market discipline punishes imprudent behavior.
Rick Eichhorn
A Tempestuous Season
In tempestuous seasons:
In 1936, Keynes wrote of the “Classical” Theory - “the
characteristics of the special case assumed by the classical theory
happen not to be those of the economic society in which we
actually live, with the result that its teaching is misleading and
disastrous if we attempt to apply to the facts of experience.”
(The General Theory, p. 3).
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A Tempestuous Season
In tempestuous seasons, cont.:
Keynesian Assumptions:
The economy is inherently unstable.
The economy is not self-regulating.
If demand is low, prices may fall, yet spending may still be
constrained by negative animal spirits.
Government interference can be effective to increase spending.
Government is less efficient than private enterprise.
Imperfect markets can invalidate market discipline.
Rick Eichhorn
A Tempestuous Season
So what about the stimulus?
I can’t help it. Another great quote from Keynes:
”If the Treasury were to fill old bottles with banknotes, bury them
at suitable depths in disused coalmines, which are then filled up to
the surface with town rubbish, and leave it to private enterprise on
well-tried principles of laissez-faire to dig the notes up again...,
there need be no more unemployment, ..., the real income of the
community ... would probably become a good deal greater than it
actually is. It would, indeed, be more sensible to build houses and
the like; but if there are political and practical difficulties in the
way of this, the above would be better than nothing.”
(The General Theory, p. 129).
Rick Eichhorn
A Tempestuous Season
Thank You for being a great audience!
Questions?
Rick Eichhorn
A Tempestuous Season