The Quiet 1990s, The Panic of 2008, and The Great Recession of AND MORE? LESS SERIOUSLY?

The 1990s, the “Belle Epoque” Brief Recession July 1990-March 1991 Longest Ever Boom: April 1991 to March 2001 –Inflation declines--- from 4% to an average of 2% –Unemployment falls from 8% to 4% –Rapid productivity growth, rapid growth of GDP but benefits not equally distributed –Bank failures disappear, very profitable, build up capital, “Prompt Corrective Action Seems to Work

The Dot.com Crash 2000 Collapse of stock market focused on computer/internet/biotech companies. DJ and S&P barely recover, Nasdaq never (yet) No Banking Collapse because banks don’t own stock---stocks widely held, decline in wealth causes consumption to fall But huge losses ($1.7 trillion) barely slow continued growth Recession: March 2001-November 2001 Economy recovers and grows quickly with low inflation and low unemployment Housing Boom begins 2002

The Panic of 2008 and the Great Recession Economy begins to slow December 2007 Gradually housing boom slows Financial crisis starts in late summer 2008 Panic 2008 Economy quickly declines Unemployment rises rapidly Some fear a new Great Depression.

Why Does It Seem Similar? Great Depression of (1939) Real estate market crash Stock market crash Bank failures Credit crunch Rapid Decline in GDP Rapid Rise in Unemployment Recession of ? Real estate market crash Stock market crash Bank failures Credit crunch Rapid Decline in GDP Rapid Rise in Unemployment

But on closer inspection….? How does the current recession compare to: –Great Depression –Last two recessions –Two worst prior recessions since the Great Depression Are & similar? Note: Conventional definition of a recession is two consecutive quarters of real GDP decline

Today and the Great Depression

A Close Up Note: 1980/ is a double dip

Unemployment % % % % % % % % % Nov % Nov % % % % % % %

How Did it Happen? Incentives NOT Symptoms Banks and Government Agencies (Fannie Mae, Freddie Mac too huge risks Why? Bankers more greedy than before? Are they more risk-taking (sky-divers v. librarians) What are the incentives to take risk? The perfect combination is: –Deposit Insurance, “Too Big to Fail” –Incentives to buy lower quality, more risky mortgages

How Did it Happen? Incentives NOT Symptoms

How Did It Happen? Chronology Housing Market Boom At peak prices are up 50%. July September 2007: High FFrate = 5.75% Peak of Business Cycle: December 2007: cutting FF rate  4.25%. Housing Market Collapse Begins 2007, decline in wealth  decline in consumption and investment. Direct effect on the banks via subprime mortgages  decline in lending as their balance sheets deteriorate.

Collapse Fed maintains tight monetary policy: –“new lending facilities” but sterilizes effects. –2% FF rate steady but too high April  October 2008  recession deepens PANIC –No panics on commercial banks because of deposit insurance –But huge uninsured sector of banking—the investment banks that depend on “Repo” market for funding. –Baer Stearns is bailed out. –Then Lehman Brothers allowed to fail September 15, Panic. Credit Crunch, huge interest rate spreads What should the Fed do?

Road to Recovery Turning Point: October 2008 Crisis—failure of Lehman and AIG, general financial panic Fed eases monetary policy –Cuts Fed Funds rates, beginning Oct, by Dec 2008, FF= 0.25% supplemented by TAF Term Auction Facility (Discount Window) Monetary Expansion: –Traditional Open Market Ops plus “Quantitative Easing: Fed buys $750 billion agency mortgage-backed securities and $300 long-term Treasury securities. March 18, 2009 Should Banks Be Allowed to Fail? Too Big to Fail. October 2008: TARP to buy preferred stock in financial institutions (Troubled Asset Relief Program)

Road to Recovery? Large Fiscal Stimulus: Federal Deficit Estimate to be 10% of GDP 2009 (size of the multiplier?) Financial Markets: Major intervention to influence credit flows: March 2009, TALF (Term Asset-Backed Securities Loan Facility) which include autos, credit cards and student loans…….TSLF (Term Securities Lending Facility), CPFF (commercial paper), MMIFF (money market mutual funds….etc.etc. Pushing all the buttons.

Road to Recovery? Banking Policy: Inconsistent Policy, “Too Big to Fail” Baer Yes, Lehman No, Bailout of Banks and MMMF Banking Policy: –The BIG Banks---May 7, 2009 “Stress Tests” for 19 largest BHCs, all “pass.” –Remove “toxic assets”??: Public-Private Investment Program for Legacy Assets (postponed) No one will buy them –Recapitalize—Treasury buys preferred shares, but too much –Rising smaller bank failures Banking Policy: –Policy makers: Banks should not take excessive risks/Banks should not hold excessive reserves? –Forbearance AGAIN!! Hope economy and subprime loans recover so don’t have to bail out more banks

Causes for Concern TODAY Recovery Just Beginning Now Fed (with a Trillion $ in new assets) concerned to reduce liquidity  too fast, recession continues, too slow inflation starts up Banking policy has not directly addressed the question of bank insolvency, curtailing lending Government continues to prop up the insolvent: Fannie Mae, Freddie Mac, Citibank, BA, AIG &GMAC Regulatory reaction: Dodd-Frank Act of will it revive or constrict financial system?

Prolonged High Levels of Unemployment? Yes. If the recession was brought about because we had overinvested in certain sectors—housing and finance, then, labor and other factors need to be reallocated Restructuring---Bankruptcies are important to reallocate If a bubble, then people thought they were wealthier than they were, long-time to adjust consumption patterns. We can help speed the transfer but we should not impede the flow. Monetary and Fiscal Policy are corrective actions that can be taken---but what reforms are needed? The right medicine requires the right diagnosis!

The Cost of 20 th C– 21 st C Crises 1930s –Depositors and stockholders lose $2.5 billion –2.4% of GDP –$38.7 billion in 2008$. 1980s –S&Ls lose $74 Billion and Commercial banks $52 billion. –3.4% of GDP –$200 billion in 2008$ –One estimate of the losses to the banks is $1.7 trillion –11.6% of 2008 GDP.

Can We Supervise Banks Better?

Free market failures or Government policy failures? Is it insurance of banks & housing policies? Or greedy/predatory bankers? Proposals –New Consumer Protection Agency –Cap banker compensation –Restrict investments –Force derivatives to be exchange trade –New Federal Council of Regulators But if root cause of crisis is moral hazard from deposit insurance/Too Big to Fail and policies to increase risky mortgage lending---these then treat the symptoms not the the disease.

OK…You fix the budget New York Times Interactive Puzzle w/deficits-graphic.html