Download Economic 157b - Yale University

Understanding the Great Recession
Economics 122: Fall 2010
1
Using macro to understand the current recession
Let’s analyze the history of the recession to illustrate some of the major
macro issues/tools
Underlying forces:
1. Increasing leverage with lower perceived risks
2. The housing bubble
3. A “run on the banks” and the Lehman bankruptcy
4. The crash in asset prices
5. Decline in wealth leading to declining I and C.
6. International transmissions
7. IS-TR curve interpretation
8. Liquidity trap!
9. Governmental response in monetary and fiscal policies
10. The trough in late 2009
11. The long stagnation to reach full employment (?)
2
The bubble economy
3
Trends in volatility of US stock prices
Historical lows
Note: Implied volatility is a measure of the equity price variability implied by the market prices of call options
on equity futures. Historical volatility is calculated as a rolling 100-day annualized standard deviation of
equity price changes. Volatilities are expressed in percent rate of change. VIX is CBOE index.
4
Leveraging the US economy
5
Rising
leverage of US
economy
4
10
8
3
6
2
4
1
2
Total financial assets/K
Total financial assets/GDP
0
1930
1940
1950
1960
1970
Source: Federal Reserve flow of funds data.
1980
1990
2000
0
2010
5
The result on housing prices
Real housing prices
[1987-1995 = 100]
200
1. Rising perceived
wealth of
households 19952006.
2. Then catastrophic
loss of wealth 20062009
160
120
80
40
0
1985
1990
1995
2000
2005
2010
6
Then people wake up from the dream to
the nightmare of falling wealth …
7
Mortgage delinquencies for subprime mortgages
8
Source: IMF, Global Financial Stability Report, Oct 2008 at imf.org
The loss of paper wealth
Household net worth/disposable income
6.5
Wealth loss of
$12 trillion
($100,000 per
household)
6.0
5.5
5.0
4.5
4.0
60
65
70
75
80
85
90
95
00
05
10
9
The impact on households and consumption
Billions of 2005 $
16,000
12,000
500
Financial
bank
crisis
Tech
bubble
400
8,000
300
4,000
200
0
100
-4,000
0
-8,000
-100
-12,000
-200
Change in net worth (left scale)
Change in consumption (right scale)
-16,000
00
01
02
03
04
05
06
07
-300
08
09
10
10
Predictions of
consumption theory
Consumption function:
p
Ct = β1 Y t + β2 Wt
Savings rate:
p
s = 1 – β1 - β2 Wt /Y t
.26
12
.24
10
.22
8
.20
6
.18
4
.16
2
Wealth-income ratio (inverted, left scale)
Personal savings rate (right scale)
.14
60
65
70
75
80
85
90
95
00
0
05
10
11
Bank runs
Series of bank runs.
Different from earlier (Depression era) because was the run
by large depositors (run on the repo).
Bear Stearns and Lehman were wiped out in a week.
12
Bank losses*
* Note that US bank equity was around $1000 billion in 2010.
13
Chicken little
14
The Lehman Bankruptcy
A central event in the crisis.
Market fundamantalists worried that continued bailouts would
lead to “moral hazard” and worse future problems.
So on September 15, 2008, government decided to let Lehman go
bankrupt.
Catastrophic results:
- markets froze up (people could not make transactions)
- stock market went down 30 % in a month and US dollar ROSE
almost 20 %.
- market fundamentalism lasted just 36 hours (!)
- then bailout of AIG, Citibank, BofA, TARP, GM, etc.
- Fed opened up several new facilities to steady markets
“An economy in free fall” in the fall of 2008.
15
Risk on Mature Govt Debt (US, etc.)
CDS = risk that security will default. These are US and similar Treasury bonds! 16
A risk measure on commercial paper
Source: Federal Reserve page on commercial paper. These are short-term promissory
note or unsecured money market obligation, issued by prime rated commercial firms
and financial companies. This shows medium-grade (A2/P2) minus top grade (AA).
17
Risk premiums
on top-rated
securities
IMF
18
Impact of Credit Crunch on Investment
.18
9.5
Credit
crisis
.17
9.0
.16
8.5
.15
8.0
.14
7.5
.13
7.0
.12
6.5
.11
6.0
.10
5.5
2005
2006
2007
2008
2009
2010
Investment/Potential GDP
Baa bond rate
19
Macroeconomic impacts
20
Macroeconomic impacts
Rewrite augmented IS and TR curves as follows:
IS: Y = C(Y,W) +I(rr) + G + NX
Y = C(Y,W) +I(i - π + δ) + G + (X – M)
TR: i = f(Y, π)
rr = risky real rate = i - π + δ, where δ is the risk premium
Have adverse IS shifts to W, δ, and NX
Fed lowers i in standard manner, but real interest rate for
businesses goes up!
TR = Taylor rule (or LM in old-fashioned theory)
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Before crisis
Taylor Rule (TR)
iff
IS(i ff - π + risk premium)
i*
2006
Y
After financial crisis
TR
iff
IS(i ff - π +
low risk premium)
i*
IS’(i ff - π +
high risk premium)
2008
Y
World output trends
24
Policy Responses (thanks to Keynes’s theories)
Gwendolen Darwin Raverat
25
Financial Market Support Measures 2007-2010
26
Unconventional Fed Measures: the Fed Balance Sheet
Treasuries = normal stuff!; CPLF = commercial paper funding
facility; MBS = mortgage-backed securities
27
Fed balance sheet before and after the crisis
28
Before Fed expansion
LM
iff
IS(i ff - π + risk premium)
IS’
i*
2008
Y
After Fed expansion
LM
iff
LM’
IS(i ff - π + risk premium)
IS’
i*
2009
Y
After Fed and Treasury recapitalization (TARP) and
other measures which lowered the spread
iff
LM’
IS’’
IS’
i*
2010
Y
31
Fiscal Policy in the Liquidity Trap:
Components of US stimulus legislation
Source: CBO, presentation of Elmendorf, June 2009
32
Without stimulus
TR
iff
IS(2008)
i*
Y
With stimulus
TR
iff
IS(2008)
IS(2010)
i*
Y
CBO’s estimate of impact of stimulus on economy
My forecast
35
Source: CBO, presentation of Elmendorf, June 2009,; Nordhaus, Nov 2010.
When will it ever end?
36