DOMESTIC CRISES: POLICY RESPONSE TO THE GREAT RECESSION Professor Lawrence Summers October 13, 2015

Agenda Domestic crisis response: the Great Recession Supporting the financial system Fiscal and monetary policy

Cumulative defaults on subprime 2/28 loans by year of origination, Between 4 th quarter of 2005 and 1 st quarter of 2006, median US housing prices fall by 3.3%. Decline accelerates in 2007, leading to collapse of subprime mortgage industry More than 25 subprime lending firms declare bankruptcy in February and March New Century Financial Corporation, the largest subprime lender, declared bankruptcy in April 2007 Source: Phillip Swagel, The Financial Crisis: An Inside View, Brookings Papers on Economic Activity, Downturn in US housing market triggers beginning of financial crisis

Crisis Spread – High grade and high yield corporate bonds over 10-year Treasury Note

Stages of 2008 financial crisis Subprime problems hit in 2007 Bear Stearns fails and is rescued in March 2008 Lehman files for bankruptcy in September 2008 AIG fails and is rescued in September 2008 Money market funds “break the buck” in September 2008 and commercial paper market collapses TARP is legislated in October 2008 Government makes capital investments in major banks in October 2008 TARP is renewed in January 2009 Stress tests completed in April 2009 Banks raise capital and pay back TARP through 2009

Healthy banks can experience destabilizing runs Solution: deposit insurance and/or lender of last resort But - Moral hazard: behavior can be distorted when risk-taker is not the one to bear the costs. Banks incentivized to take more risks when lender of last resort exists. Lender of last resort must distinguish liquidity from solvency problems Liquidity problems can be addressed by government lending Liquidity problems: with time and confidence, all liabilities can be paid Solvency problems require debt restructuring or government bailouts Solvency problems: even with time, all liabilities cannot be paid. Institution has negative net worth Preventing Bank Runs

Reassure Liability Holders: Raise deposit insurance caps Facilities for issuing government guaranteed debt Money market fund guarantees Commercial paper guarantees Support Leveraged Asset Purchases: Expanded use of discount window TALF (Term Asset-backed Securities Lending Facility) PPIP (Public Private Investment Program) Strengthened Bank Examination: Stress tests Required conversion of common to preferred Required equity issuance Key financial crisis steps

Troubled Asset Relief Program Signed into law Oct Gave Treasury Department authority to purchase illiquid, hard-to-value assets from banks and other financial institutions Intended to improve liquidity of these assets by purchasing them through secondary market, allowing financial institutions to stabilize balance sheets and avoid further losses Initially authorized $700 billion in expenditure. As of March 2015, Congressional Budget Office estimates total disbursement of $440 billion at cost of $28 billion Source: Congressional Budget Office, Report on the Troubled Asset Relief Program, March 2015; Treasury TARP Tracker.

Supervisory Capital Assessment Program (bank stress tests) Assessment by Federal Reserve to determine if largest US financial institutions had sufficient capital (Tier 1 common capital) to withstand recession and financial market turmoil Tested banks against two macroeconomic situations, baseline case and pessimistic case Key Question: Would stress tests increase confidence in financial institutions? Stress test results:

Agenda Domestic crisis response: the Great Recession Supporting the financial system Fiscal and monetary policy

The Great Recession: Private savings versus private investment

The Great Recession: Interest rates near zero

Macroeconomics of Crisis wedge r r* LM IS y Sources of wedge: 1.Maturity 2.Credit Availability 3.Expected inflation r = 0 Zero interest rate on safe government assets sets a floor on real interest rate at r* y*

Expansionary fiscal policy wedge 1 r r = 0 LM IS y Wedge gets smaller because greater inflation is a further source of expansion IS’ wedge 2

Fiscal Stimulus: American Recovery and Reinvestment Act 2009 Passed Feb. 2009, provides $787 billion expenditure toward 3 goals: Create new jobs and save existing ones Spur economic activity and invest in long-term growth Foster accountability and transparency in government spending Main instruments of Recovery Act: Tax cuts and benefits for households and businesses Funding for entitlement programs, such as unemployment benefits Funding for federal contracts, grants and loans

Quantitative easing and asset purchases wedge 1 r r = 0 LM IS y QE and asset purchases reduce wedge wedge 2

Reduction of long-term rates through quantitative easing The Fed’s balance sheet topped $4 trillion for the first time in December 2013.