1 Understanding the Great Recession

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 and …. not “pop” but “hissssssss” 3.A “run on the shadow banks” and the Lehman bankruptcy 4.The crash in asset prices in Huge decline in wealth, leading to declining housing I and C. 6.International transmissions 7.IS-MP curve interpretation 8.Liquidity trap! 9.Governmental response in monetary and fiscal policies 10.The trough in late The long stagnation is still with us …. 2

3 The bubble economy

Trends in volatility of US stock prices 4 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. Historical lows

Leveraging the US economy 5 Source: Federal Reserve flow of funds data. Rising leverage of US economy

Leverage for US economy 6 Gelain et al, San Francisco Fed Working Paper.

The housing price bubble 7 1.Rising perceived wealth of households Then catastrophic loss of wealth Stabilized in last four years

8 Then people wake up from the dream to the nightmare of falling wealth …

No one saw it coming: Fed projections, June

10 = Fed forecasts = Range of all 19 participants A disastrous forecast

Mortgage delinquencies skyrocket 11

12 Wealth loss of $16 trillion ($140,000 per household)

The impact on households and consumption 13

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. 14

Bank losses* 15 * Note that US bank equity was around $1000 billion in 2010.

The Lehman Bankruptcy A central event in the crisis. Market fundamentalists 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 only 36 hours” - then bailout of AIG, Citibank, BofA, TARP, GM, etc. “An economy in free fall” in late

Risk on Mature Govt Debt (US, etc.) 17 CDS = risk that security will default. These are US and similar Treasury bonds!

A risk measure on commercial paper 18 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).

Policymakers respond Panic of 2008: Financial markets hysterical; paranoia everywhere about who was responsible and who should pay. Bush/Paulson: reluctantly saw that financial markets were freezing up (Bernanke key to understanding this). TARP: Started as buying toxic assets, then saw the light and recapitalized banks. 19

Macroeconomic impacts 20

Impact of Credit Crunch on Investment 21

22 Effect on output 22 Lehman Bear

Macroeconomic impacts Rewrite augmented IS and MP curves as follows: IS: Y = C(Y,W) +I(r b ) + G + NX(Y,Y w ) Y = C(Y,W) +I(i - π + σ) + G + (X – M) MP: i = f(Y, π) r b = risky real rate = i - π + σ, where σ is the risk premium Have adverse IS shifts to W, σ, and NX from Y w Fed lowers i in standard manner, but real interest rate for businesses goes up! MP = Taylor rule 23

i ff Y IS(i ff - π + low risk premium) i* MP 2006 Before crisis

i ff Y IS(i ff - π + low risk premium) i* MP 2008 After financial crisis IS’(i ff - π + high risk premium)

26 Policy Responses (thanks to Keynes’s theories) Gwendolen Darwin Raverat

Financial Market Support Measures

Unconventional Fed Measures: the Fed Balance Sheet 28 Treasuries = normal stuff!; CPLF = commercial paper funding facility; MBS = mortgage-backed securities

Fed balance sheet before and after the crisis 29

i ff Y i* MP 2008 Before Fed expansion IS’

i ff Y i* MP 2009 Fed expansion IS’

i ff Y i* MP 2009 After TARP and other risk-reducing measures 2010 IS’’

Fiscal Policy in the Liquidity Trap: Components of US stimulus legislation 33 Source: CBO, presentation of Elmendorf, June 2009

i ff Y i* MP IS(2008) Without stimulus

i ff Y i* MP IS(2008) IS(2010) With stimulus

CBO’s estimate of impact of stimulus on economy 36 Source: CBO, presentation of Elmendorf, June 2009.

CBO’s estimate of impact of stimulus on economy 37 Source: CBO, presentation of Elmendorf, June Actual

Lessons on the recent financial crisis Even with modern macro, globalized mature market economies are subject to major risks; business cycles have not disappeared. We are unlikely to reach full employment before Financial systems are inherently fragile because of their maturity and liquidity transformation (K to M). Markets cannot manage themselves. The liquidity trap is a particularly nasty outcome because monetary policy weak and fiscal policy hampered by large deficits. The US benefitted from wise leadership this time. It could have been much worse. 38