1 Understanding the Great Recession Economics 122: Fall 2010

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 3.A “run on the banks” and the Lehman bankruptcy 4.The crash in asset prices 5.Decline in wealth leading to declining I and C. 6.International transmissions 7.IS-TR curve interpretation 8.Liquidity trap! 9.Governmental response in monetary and fiscal policies 10.The trough in late The long stagnation to reach full employment (?) 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

The result on housing prices 6 1.Rising perceived wealth of households Then catastrophic loss of wealth

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

Mortgage delinquencies for subprime mortgages 8 Source: IMF, Global Financial Stability Report, Oct 2008 at imf.org

The loss of paper wealth 9 Wealth loss of $12 trillion ($100,000 per household)

The impact on households and consumption 10

Predictions of consumption theory 11 Consumption function: C t = β 1 Y p t + β 2 W t Savings rate: s = 1 – β 1 - β 2 W t /Y p t

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. 12

Bank losses* 13 * Note that US bank equity was around $1000 billion in 2010.

Chicken little 14

The Lehman Bankruptcy A central event in the crisis. Market fundamantalists 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 just 36 hours (!) - then bailout of AIG, Citibank, BofA, TARP, GM, etc. - Fed opened up several new facilities to steady markets “An economy in free fall” in the fall of

Risk on Mature Govt Debt (US, etc.) 16 CDS = risk that security will default. These are US and similar Treasury bonds!

A risk measure on commercial paper 17 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).

18 IMF Risk premiums on top-rated securities

Impact of Credit Crunch on Investment 19

Macroeconomic impacts 20

Macroeconomic impacts Rewrite augmented IS and TR curves as follows: IS: Y = C(Y,W) +I(rr) + G + NX Y = C(Y,W) +I(i - π + δ) + G + (X – M) TR: i = f(Y, π) rr = risky real rate = i - π + δ, where δ is the risk premium Have adverse IS shifts to W, δ, and NX Fed lowers i in standard manner, but real interest rate for businesses goes up! TR = Taylor rule (or LM in old-fashioned theory) 21

i ff Y IS(i ff - π + risk premium) i* Taylor Rule (TR) 2006 Before crisis

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

World output trends 24

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

Financial Market Support Measures

Unconventional Fed Measures: the Fed Balance Sheet 27 Treasuries = normal stuff!; CPLF = commercial paper funding facility; MBS = mortgage-backed securities

Fed balance sheet before and after the crisis 28

i ff Y IS(i ff - π + risk premium) i* LM IS’ 2008 Before Fed expansion

i ff Y IS(i ff - π + risk premium) i* LM IS’ LM’ 2009 After Fed expansion

31 i ff Y i* IS’ LM’ 2010 After Fed and Treasury recapitalization (TARP) and other measures which lowered the spread IS’’

Fiscal Policy in the Liquidity Trap: Components of US stimulus legislation 32 Source: CBO, presentation of Elmendorf, June 2009

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

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

CBO’s estimate of impact of stimulus on economy 35 My forecast Source: CBO, presentation of Elmendorf, June 2009,; Nordhaus, Nov 2010.

36 When will it ever end?