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Understanding the Financial Crisis Presentation to Students & Friends of Rensselaer Hartford Hartford, CT James Stodder, (Ph.D., Economics, Yale 1990) Lally School of Management & Technology Rensselaer Polytechnic Institute at Hartford Hartford, Connecticut, USA Tuesday, May 23, 2017 1 Outline of Talk 1. Keynes on Credit Cycles: - Why we need Regulation 2. 3. 4. Where is the Bottom? Connecticut is “Middle of the Pack” Government Deficit Spending a. b. Needed in the Short-term But a Big Problem Long-term Tuesday, May 23, 2017 2 (1) Biz & Credit Cycles J. M. Keynes: 1883-1946 Tuesday, May 23, 2017 3 US Macro-Stability: Better, Room for Improvement Average U.S. Business Cycle, 1854 to 2006 Contraction 1854-1919 (16 cycles) 45% 1919-1945 (6 cycles) 55% 34% 1945-2006 (10 cycles) 66% 15% 0 Expansion 85% 10 20 30 40 50 60 70 Months Source: Tuesday, May 23, 2017 http://www.nber.org/cycles.html 4 Bad News: Bubbles are Endemic Tuesday, May 23, 2017 Arlington Williams, “Price Bubbles” www.indiana.edu/~arlwilli/pdf%20files/bigmkts.pdf 5 Good News: People Do Learn V. Smith & A. Williams, “Experimental Market Economics,” Scientific American, Dec. ‘92 Tuesday, May 23, 2017 6 The Wisdom of Keynes “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way, along with his fellows, so that no one can really blame him.” - J.M. Keynes (1931) Tuesday, May 23, 2017 7 “Paradox of Thrift” Keynes noted: Consumers cut back on their spending and save more during a recession. This only makes the recession worse. Similarly for Banks, Loan Loss Reserves (LLR) are often raised in a recession, just when households and businesses most need credit –ensuring more collapses and worsening the recession. Tuesday, May 23, 2017 8 Insurance => Moral Hazard => Necessity of Regulation Moral Hazard of Insurance: If you had a car that is less damaged by any given car crash – would that make you drive faster? If you (and everybody else) drove faster, could this actually wind up making you less safe ? Tuesday, May 23, 2017 9 www.economist.com/finance/displaystory.cfm?story_id=12480887 www.nytimes.com/2008/10/03/business/03sec.html Tuesday, May 23, 2017 10 Availability of Bank Loans Tuesday, May 23, 2017 11 Currency Rises Slightly Aug. 2010 Tuesday, May 23, 2017 12 But Bank Reserves up 100-fold Sept.2010 16, 2009 Aug. Tuesday, May 23, 2017 13 M0 = Currency + Bank Reserves ≈ $2.0t Aug. 2010 Tuesday, May 23, 2017 14 M1 ≈ $1.7t = Currency + Bank Deposits Aug. 2010 Tuesday, May 23, 2017 15 Money Mult. = M1/M0 ≈ 1.7/2.0 = 0.85 Aug. 2010 Tuesday, May 23, 2017 16 Bank Money Multiplier If l = % loans, Reserve multiplier is D = R(1+ l + l +… + l 2 ∞ )= R/(1- l) If M0 = Currency (C) + Reserves (R), M1=Currency + Deposits, so: M1 = C + R/(1- l ) = M0–R+ R/(1- l ) M1/M0 = 1+{-R + R/(1- l )}/M0 Tuesday, May 23, 2017 So M1/M0 < 1 => l<0 17 Limits of Fed Magic Tuesday, May 23, 2017 New Yorker, Oct. 2008 18 The Zero Bound (1) Aug. 2010 Tuesday, May 23, 2017 19 The Zero Bound (2) Aug. 2010 Tuesday, May 23, 2017 20 Keynes’s Liquidity Trap: FISCAL Expansion: Investment Demand = Savings interest rate FISCAL Expansion: Money Demand = Supply GDP Tuesday, May 23, 2017 21 Keynes’s Liquidity Trap: FISCAL Expansion: Investment Investment Demand = Savings interest interest rate rate MONETARY Expansion: Money Demand = Supply Supply GDP GDP Tuesday, May 23, 2017 22 Keynes’s Liquidity Trap: FISCAL Expansion: Investment Demand = Savings interest rate FISCAL Expansion: Money Demand = Supply GDP Tuesday, May 23, 2017 23 Keynes’s Liquidity Trap: FISCAL Expansion: Investment Demand = Savings interest rate FISCAL Expansion: Money Demand = Supply GDP Tuesday, May 23, 2017 24 Output Gap ≈ 20% GDP http://www.cbo.gov/ftpdocs/99xx/doc9958/01-08Outlook_Testimony.pdf A little Stimulus Math: 20% * $14 tr. = $2.8 tr. Stim*1.5 = $2.8 => Stim = $1.87 tr. Tuesday, May 23, 2017 25 (2) 3 Reasons Bottom still A Long Way Off Housing Recovery probably still more than a year away. Credit Markets still very weak. Stock Market Valuation Ratios like P/E and Tobin’s Q are now only at historical averages. Tuesday, May 23, 2017 26 Housing Bottom – A Long Way Off http://www.nytimes.com/imagepages/2008/10/16/business/16housing.graphix.ready.html Tuesday, May 23, 2017 27 Why it Matters to Everyone Tuesday, May 23, 2017 28 TED-Spread & Financial Crises 3.00 2.50 Subprime financial shock 2.00 1.50 S&L crisis 1.00 Orange County Peso crisis LTCM Thai baht Y2K Tech bust 0.50 0.00 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 Tuesday, May 23, 2017 29 108 Years of P/E and Q Shiller/Smithers - www.ft.com/cms/s/0/099f6380-bb1f-11dd-bc6c-0000779fd18c.html Tuesday, May 23, 2017 30 (3) CT & NY in “Middle of Pack” Financial Sector down, but .. Conventional Banking and Insurance less vulnerable than Investment Banks, Financial Insurance Defense industries well insulated Pharmaceuticals and Biotech have good long-term prospects House Price Increases near US Avg. Tuesday, May 23, 2017 31 International Housing Prices Tuesday, May 23, 2017 32 Sun Belt, Rust Belt Concentration Tuesday, May 23, 2017 33 2006 Peak of Price-to-Rent Tuesday, May 23, 2017 34 Tuesday, May 23, 2017 Source: NY Times, April 20, 2010 35 Housing Prices in Northeast Tuesday, May 23, 2017 36 Median Price, Existing Single-Family Homes, Metropolitan Area NY & CT ($1,000) 2007 2008 2009 2010.II p $ Since '07 % Since '07 Albany-Schenectady-Troy, NY $199 $198 $189 $194 -$5 -2% Binghamton, NY $111 $114 $116 $111 $0 0% Buffalo-Niagara Falls, NY $104 $105 $114 $121 $17 17% Elmira, NY $82 $88 $87 $99 $18 22% Glens Falls, NY $168 $161 $154 $148 -$19 -12% Kingston, NY $258 $242 $208 $208 -$50 -19% NY: Nassau-Suffolk, NY $477 $436 $383 $395 -$82 -17% Rochester, NY $118 $117 $116 $121 $4 3% Syracuse, NY $122 $120 $121 $125 $4 3% Bridgeport-Stamford-Norwalk, CT $487 $438 $379 $419 -$67 -14% Hartford-West Hartford-East Hartford, CT $263 $246 $232 $236 -$27 -10% New Haven-Milford, CT $287 $264 $236 $238 -$49 -17% Norwich-New London, CT $268 $237 $212 $224 -$44 -16% http://www.realtor.org/research/research/metroprice Tuesday, May 23, 2017 www.bos.frb.org 37 (4) More Federal Deficit Spending (not Tax Cuts) Necessary Tax cuts to the rich more likely to be saved, not spent or invested. Tax cuts don’t have big effect on those too poor to pay many taxes. Unmet needs in Energy, Environment, Health, and Education: good reasons to spend. Tuesday, May 23, 2017 38 Government Must Increase Spending in Severe Recession “ If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coal mines … 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.” (Keynes, General Theory, 1937) Tuesday, May 23, 2017 39 But We Need Foreign Coordination for US Expansion to be Successful Benefits of lone expansion “leak out,” other countries free ride. Alternatives to joint expansion are protectionism and competitive devaluations. US long-term “Fiscal Gap” makes lone expansion untenable. Tuesday, May 23, 2017 40 Long Term Fiscal Gap: Unsustainable http://www.cbo.gov/ftpdocs/93xx/doc9385/06-17-LTBO_Testimony.pdf Tuesday, May 23, 2017 41 Sure as Debt and Taxes http://www.cbo.gov/ftpdocs/93xx/doc9385/06-17-LTBO_Testimony.pdf Tuesday, May 23, 2017 42 Inflation/Devaluation a Powerful Temptation for Highly Indebted Governments • • • • Germany after WWI Russia after the Revolution Soviet Union after the Cold War Many Developing Countries after spending, investment binges (See L. Kotlikoff & S. Burns, The Coming Generational Storm, 2004) Tuesday, May 23, 2017 43 Implications of Limited Pass-Through Linda Goldberg (FRBNY) has shown that Dollar Devaluation means: • Improved Earnings on Foreign Assets • Easier Debt Servicing • Smaller Trade Deficit And at the same time, • Minimal Costs in further Inflation So - What’s Not to Like? • FRBNY Governor Frederic Mishkin says “Devaluation cannot be a policy.” (I think he means an explicit policy.) Tuesday, May 23, 2017 44 Inflation/Devaluation Appears a “Painless” Way Out of Debt Tuesday, May 23, 2017 45 Promising Investments? Medium-Term Holds (Very Cautious): US Treasuries (but not long term – remember inflation) Gold, Silver, other precious metals Long-Term Holds (Patient): Non-Dollar Assets in Emerging Markets Renewable Energy Technology Pharmaceuticals: tied to incomes in emerging markets Tuesday, May 23, 2017 46 Summary of Conclusions Recession will be long and deep: housing slump, interbank lending, financial markets likely to “overshoot” on low side. CT, NY are “middle of the pack” for housing prices and employment stability. Greatly expanded federal spending is needed in the short-term. Long-term, however, US government debt is unsustainable. There are still some places to put your money Tuesday, May 23, 2017 47