1 Recession Prof. Henry Chappell University of South Carolina

2 What Causes Recessions? Shocks to: Productivity Money supply and demand Government spending Taxes Expectations Wealth Animal spirits

3 What About These? Are these important? Housing market bubble Mortgage defaults Banking panics Asymmetric information Moral hazard

4 And What are These? Hedge funds The shadow banking system Subprime mortgages Securitization Collateralized debt obligations Credit default swaps Structured investment vehicles

5 Paper Content Recession Facts What’s Up? What’s Down? Review of Theory Classical Keynesian Recession Causes I Textbook Shocks? Housing: Bubble and Panic Mortgage Market Institutions Chronology of Events Institutional Failure Principal-Agent Problems Moral Hazard Asymmetric Information Bank Runs Recession Causes II Animal Spirits Financial Market Supply Shock Policy Responses Ordinary Fiscal and Monetary Policies Monetary Policy under Zero Interest Rates Extraordinary Policy Responses (Bailouts) Evaluation of Policy Responses

6 Recession Facts See the paper for more!

7 Overview of Theory Basics of the Textbook Theory The model has three sectors Supply side Goods market Money market Consider two theoretical perspectives Keynesian Classical We employ the IS-LM AD-AS framework

8 Classical vs. Keynesian Theories In the Classical view, business cycle fluctuations arise on the supply side Productivity shocks are the source of most cyclical movements In the Keynesian view cycles can result from: Changes in monetary and fiscal policies Instability of private sector spending

9 Shocks Causing Cycles A list of possible shocks: Technology shocks and related expectations Oil prices Institutional change Government spending Taxation Money growth and interest rates Money demand shocks Animal spirits

10 Shocks Causing Cycles A list of possible shocks: Technology shocks and related expectations Oil prices Institutional change Government spending Taxation Money growth and interest rates Money demand shocks Animal spirits

11 Housing Markets Institutions and History “Old-fashioned mortgages” Securitization Slicing and dicing: CDOs Boom and Bust Leverage and the Shadow Banking System

12 Panic! What Happened and When? See Table 2. Home prices peak in 2006 Premonitions: UBS, Bear-Stearns, BNP Paribas, Countrywide, Northern Rock Bear bailout Fannie and Freddie in trouble Lehman bankruptcy! AIG, WaMu, Wachovia follow quickly Treasury buys equity in 9 big banks Dow drops below 8000 after peaking at

13 Institutional Failure Why the breakdown? Principle-agent problems Moral hazard problems Asymmetric information Bank runs (and non-bank runs) Political support for housing Bad monetary policy Greed?

14 Shocks Causing Cycles II Animal spirits A financial markets supply shock

15 A Supply Shock? How can financial market events be interpreted as a supply shock? Efficient financial markets support higher output and productivity. A “trust break-down” reduces aggregate output. Asymmetric information: financial market “lemons.”

16 Evans on Supply Shocks Charles Evans says: “A financial market shock may have some characteristics of a DSGE TFP shock: The cost of producing an intermediate input—credit intermediation—has become more expensive.” “Can markets easily work around the disruptions to the credit intermediation process that channels funds from savers to borrowers? Or have we experienced a permanent destruction in something we might want to think about as the financial sector capital stock?”

17 The Correct Theory? Which theory best accounts for the recession? An excellent unanswered question

18 Policy Responses Types of Responses Ordinary fiscal and monetary policies Monetary policy in a zero-interest rate environment Financial sector bailouts Regulatory reform

19 Fiscal Policy Actions American Recovery and Reinvestment Act of 2009 Stimulus: Spending increases and tax cuts valued at $787 billion. Cash for Clunkers Inefficient and inequitable?

20 Deficits and Debt Debt facts Deficits are high. The U.S. debt-to-GDP ratio is high, but probably not yet crisis-inducing. There is no free lunch.

21 Conventional Monetary Policy Recession Policy Prescription: Increase the money supply while lowering the Federal funds rate. The funds rate is near-zero.

22 Is the Fed Guilty? Did monetary ease cause the bubble? Low interest rates preceded the housing bubble. Rules vs. discretion: The Taylor rule

23 Zero-Interest Rate Policies When interest rates cannot go lower: Convince the public that rates will stay low for a long time. Influence the yield curve by purchasing longer term securities. Expand the size of the central bank balance sheet.

24 Reducing Counterparty Risk Special Fed programs to “unclog” financial markets One institution will lend more freely to another if it knows that the borrower has high quality collateral or can borrow from the Fed in order to repay.

25 Bailouts Emergency loans and asset purchases Article 13.3 of the Federal Reserve Act: “unusual and exigent” circumstances The Emergency Economic Stabilization Act of 2008 (the “Bailout” bill).

26 The Rationale for Bailouts Why bailouts were appropriate: Lender of last resort can forestall a bank run. Avoid contagion of failure. Without bailouts, the government would be obliged to cover huge losses anyway. Costs of the bailout may turn out not to be terribly high.

27 What About GM? Bailouts for Auto Companies? The failure of an auto company has less potential for systemic contagion as the collapse of financial institutions.

28 Monindustrial Policy What is monindustrial policy? John Taylor uses the term to refer to monetary policy actions that favor specific industries Lacking neutrality monetary policy may be more politicized

29 Moral Hazard Revisited Heads I win; Tails you lose What happens when bailouts are anticipated by large financial sector firms?

30 Future Inflation? Avoid collapse now, but what about the Fed in the future? Sell off accumulated assets. Reduce the money supply. Let interest rates rise. Avoid political pressure to monetize debt.

31 Regulatory Reform Possible reforms Designate responsibility for systemic risk Greater transparency of financial products. Limit leverage; increase capital requirements. Enforce and strengthen mortgage requirements.

32 An Excellent Recession! At least for teaching! Business Cycles Keynesian and Classical Theories Financial Panic Expectations Principal-Agent Problems Asymmetric Information and Moral Hazard Appropriate Monetary and Fiscal Policies Bailouts

33 The End