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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). Rick Eichhorn 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. Rick Eichhorn 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. Rick Eichhorn 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. Rick Eichhorn 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 Rick Eichhorn 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). Rick Eichhorn 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. Rick Eichhorn 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. Rick Eichhorn 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. Rick Eichhorn 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. Rick Eichhorn A Tempestuous Season The Inverted House of Cards Rick Eichhorn A Tempestuous Season 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. Rick Eichhorn 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 Rick Eichhorn 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.” Rick Eichhorn A Tempestuous Season How Does a Bubble Form? Low interest rates (Enabled) Creative financing Animal spirits Competition Rick Eichhorn 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? Rick Eichhorn 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. Rick Eichhorn 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.” Rick Eichhorn 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 Rick Eichhorn 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 Rick Eichhorn 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? Rick Eichhorn 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 Rick Eichhorn 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 Rick Eichhorn A Tempestuous Season Net Savings across the Business Cycle Rick Eichhorn A Tempestuous Season Remember how banks create money? Rick Eichhorn A Tempestuous Season Shaky Ground Rick Eichhorn A Tempestuous Season Let’s zoom in Rick Eichhorn A Tempestuous Season Shakier Ground Rick Eichhorn A Tempestuous Season Animal Spirits, Lemons Problem, Paradox of Thrift, Liquidity Trap Rick Eichhorn A Tempestuous Season The Results of a Perfect Storm Rick Eichhorn A Tempestuous Season A Tempestuous Season Rick Eichhorn 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). Rick Eichhorn 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