1. The Global Recession
The Global Recession. World GDP Growth,
Emerging market countries hoped that they could avoid a similar fate, that there would be in effect decoupling between advanced countries and emerging market countries. As Figure 1 shows, these hopes were dashed.

2. The Global Recession Stock Prices and the Recession, 2007-2009.
From early 2007 to the end of 2008, stock prices lost more than half of their value. While they have recovered, they are still far below their peak.

3. The Trigger. U.S. House Price declines
U.S. housing prices,
Housing prices increased sharply from 2000 to 2006, only to decline, equally sharply, from 2006 on.

4. The Trigger. U.S. House Price declines
These developments were much less benign than most economists thought.
First, housing prices could go down.
Second, in many cases, the mortgages were in fact much riskier than either the lender pretended, or the borrower understood.
The estimated output cost of the crisis is around $30 trillion, roughly 1/2 of annual world GDP, and 100 times the initial mortgage losses!
While the trigger was the U.S. housing price decline, its effects were enormously amplified.

5. The Subprime Triggered Crisis: A Perfect Storm
Confluence of causes
Past bailouts + Greenspan Put  Bulletproof system!?? Moral Hazard
Financial innovations: Finance as end in itself
Income lagging spending: Household debt…National debt
Easy credit...Fed Funds Rate kept low
Market fundamentalism...Lax regulation ... Let ‘er rip
Weak global aggregate demand
The Players
Mortgage brokers/Banks—Securitizers/GSEs/Rating Agencies
Trigger and collapse
Bailouts: Wall Street, not Main Street
Stimulus
Slump: Koo—Balance Sheet Recession
Kindleberger—Minsky—Fisher
Akerlof-Shiller: Animal Spirits
Eggertsson-Krugman: Debt, Deleveraging and the Liquidity Trap
Krugman: End This Depression Now!

6. The Subprime Triggered Crisis: A Perfect Storm
Finding Fault
Past bailouts  Too big/Too interconnected to Fail
Black Monday (October 19, 1987)
Tequila Crisis ( ) Asian Crisis ( ) Contagion  Long Term Capital Management (1998)
dot.com bubble … it takes a bubble to survive a bubble
Financial innovations
Overnight funding
Off-balance sheet vehicles – no capital requirements
Default insurance (Credit Default Swaps)
Collateralized Debt Obligation (CDOs)
Chemistry: JunkAAA
Financial Engineering

7. The Subprime Triggered Crisis: A Perfect Storm
Finding fault
Easy Credit
Global saving glut
Fed policy: fear of deflationcheap raw material for banks
Market fundamentalism
Greenspan “put”—we’ll clean up the mess
Lax regulation
Weak global aggregate demand—saving glut
Legacy of ‘97 Accumulation of reserves

8. A “Global Saving Glut”
The best
of times
Capital Inflows
Easy Money
Policy
Escalating
House Prices
Eager Home Buyers
Ambitious
Mortgage Brokers
Developer Clout
Innovative
Banks
Securitization
MBSs
Rating
Agencies
Gov’t Sponsored
Enterprises
Bank Regulators

9. The best
of times
Capital Inflows
Escalating
House Prices
Easy Money
Policy
Eager Home Buyers
Ambitious
Mortgage Brokers
Developer Clout
Innovative
Banks
Securitization
MBSs
Rating
Agencies
Gov’t Sponsored
Enterprises
Bank Regulators

10. Amplification Mechanisms: Leverage, Complexity, and Liquidity
When housing prices declined, and some mortgages went bad
High leverage implied a sharp decline in the capital of banks.
This forced them to sell some of their assets that were often hard to value.
They had to sell them at very low prices—often referred to as re sale prices.
The complexity of the securities (MBSs, CDOs) and of the true balance sheets of banks (banks, and their SIVs) made it very difficult to assess the solvency of banks, and their risk of bankruptcy.
Interbank lending froze.
On September 15, 2008, Lehman Brothers, a major bank with more than $600 billion in assets, declared bankruptcy.
Leading financial participants concluded that many, if not most, other banks and financial institutions were indeed at risk.
These guys knew the shape they themselves were in...if they couldn’t trust themselves, how could they trust counterparties???
INTERBANK LENDING FROZE

12. Amplification Mechanisms. Leverage, Complexity, and Liquidity
The Ted Spread,
The rate spread, which reflects the risk banks perceived in lending to each other, went sharply up in September 2008.
Banks became very reluctant to lend to each other.
The TED Spread: The difference between the riskless rate (measured by the rate of 3-month government bonds) and the rate at which banks are willing to lend to each other (known as the Libor rate...which we now know was understated!)

13. From a Financial to a Macroeconomic Crisis
The Decrease in U.S. GDP
U.S. Consumer and Business Confidence,
The financial crisis led to a sharp drop in confidence, which bottomed in early 2009.

14. Responses Lender of Last Resort / Spender of Last Resort
Tax Rebate $124 bil.
Fed Fund Rate Cuts
Fannie/Freddie $200 bil.
Bear-Stearns $29 bil.
AIG $174 bil.
Fed “Facilities”
Primary Dealer Credit Facility (PDCF) $58 bil.
Treasury Security Loan Facility (TSLF) $133 bil.
Term Auction Facility (TAF) $416 bil.
Asset- Backed Commercial Paper Funding Facility (CPFF) $1,777 bil.
Money Market Investor Funding Facility (MMIFF) $540 bil.
More Fed Fund Rate Cuts … Hold At ~0%
Fed Purchases of Long-Term Securities: GSEs & MBSs $600 bil.
Term Asset-Backed Securities Loan Facility (TALF) $200 bil.
Emergency Economic Stabilization Act/TARP $700 bil.
Government Loans
Government Equity
Stimulus Package $787 bil.
aka The American Recovery and Reinvestment Act
TARP II
Stress Tests

15. The Subprime Triggered Crisis: The Players
Charles Kindleberger, Manias, Panics and Crashes
A Minsky Story in Five Acts: In general…in particular
Displacement—A breakthrough
Financial innovation: securitization—sell off risk
Credit Expansion & BOOM
Low interest rates—defend against deflation
Shadow banking/SIVs/MBSs/CDOs/CDSs
Speculative Mania—self-fulfilling Euphoria
Teaser loans/ARMs/Home equity loans/Flipp’n’ to the bank
Distress—a Minsky/Wile E. Coyote moment

16. The Subprime Triggered Crisis: The Players
Charles Kindleberger, Manias, Panics and Crashes
A Minsky Story in Five Acts: In general; in particular
Displacement—A breakthrough
Financial innovation: securitization—sell off risk
Credit Expansion & BOOM
Low interest rates—defend against deflation
Shadow banking/SIVs/MBSs/CDOs/CDSs
Speculative Mania—self-fulfilling Euphoria
Teaser loans/ARMs/Home equity loans/Flipp’n’ to the bank
Distress—a Minsky/Wile E. Coyote moment
House prices plateau—Disappointed expectations
Panic & Crash—rush to liquidity…but there’s no liquidity
Firesale
Foreclosures
Contagion
Debt Deflation
Bailout Helicopter Ben

18. Good times  Confidence  Risk-taking  Fragility
Minsky’s World
Quasi – rents: cash flows available to pay debts
PI – [supply] price of investment goods
PK – [demand] price of kapital goods
Borrower’s risk
Lenders risk
Hedge finance: E(cash flows) > Payment commitment
Speculative finance: E(cash flows)<Commitment
… but > Interest commitment  Roll over debt
Ponzi finance: E(cash flows)<Interest commitment
… Expect to increase debt
Financial fragility: mix of Hedge – Spec – Ponzi
Good times  Confidence  Risk-taking  Fragility

19. The Minsky Footprint Realized expectations  Increased profits & Reduced risk  BOOM Disappointed expectations  Reduced profits & Confidence Bust Rush to liquidity  Debt deflation Pk
Borrower’s Risk
Internal funds
Marginal lender’s risk
Lender’s Risk PI
Investment
“If the demand price of a capital asset … is not less than its replacement costs, new investment will take place.”

20. Akerlof and Shiller, Animal Spirits
Confidence – Keynes-Minsky
Hopes, Exuberance, Fears
Waves of optimism and pessimism
Corruption - Bad Faith  Loss of Trust
S&Ls – Enron – Sub-prime – Libor
Fairness
Punish cheaters, even at own expense
Relative position
Money illusion
“Illusion” is real in view of nominal contracts/accounts
Stories
New eras – Irrational exuberance
Downward wage rigidity

21. Disinflation, Deflation, and the Liquidity Trap
According to your textbook, the built-in mechanism that can lift economies out of recessions is this:
Output below the natural level of output leads to lower inflation.
Lower inflation leads to higher real money growth.
Higher real money growth leads to an increase in output over time.
(M/P) up i down I up Y up…until full employment restored
This mechanism, however, is not foolproof.

22. Spending decisions depend on real interest rate
A Long Slump
Spending decisions depend on real interest rate
Demand for real balances depends on nominal rate
The Textbook Effects of Lower Inflation on Output
When inflation decreases in response to low output, there are two effects: (1) The real money stock increases, leading the LM curve to shift down, and (2) expected inflation decreases, leading the IS curve to shift to the left. The result may be a further decrease in output.

23. A Long Slump The Liquidity Trap
Money Demand, Money Supply, and the Liquidity Trap
When the nominal interest rate is equal to zero, and once people have enough money for transaction purposes, they become indifferent between holding money and holding bonds. The demand for money becomes horizontal. This implies that, when the nominal interest rate is equal to zero, further increases in the money supply have no effect on the nominal interest rate.

24. Liquidity Trap and Deflation
A Long Slump:
Liquidity Trap and Deflation
The Liquidity Trap and Deflation
In the presence of a liquidity trap, there is a limit to how much monetary policy can increase output. Monetary policy may not be able to increase output back to its natural level.
Suppose the economy is in a liquidity trap, and there is deflation. Output below the natural level of output leads to more deflation over time, which leads to a further increase in the real interest rate, and leads to a further shift of the IS curve to the left. This shift leads to a further decrease in output, which leads to more deflation, and so on.
In words: The economy caught in a vicious cycle: Low output leads to more deflation. More deflation leads to a higher real interest rate and even lower output, and there is nothing monetary policy can do about it.

31. Topsy Turvy Economics: Debt Deflation at Zero Lower Bound
Monetary stimulus doesn’t matter when interest rate on bonds is zero:
Currency Up but Deposits Down  M up a little
H up $GDP unaffected or down
Reserves Up  Bank Credit Down
It’s like “pushing on a string”
Paradox of thrift:
Deleveraging: S up  Y down  P down  (M/P) up ... But i can’t fall so no recovery
Paradox of deleveraging: Fire sale of assets only lowers their prices  Deflation
The more debtors pay the more they owe.
Perverse Aggregate Demand (upward sloping: falling price reduces spending)
Debtors can’t spend and creditors won’t spend (unless real interest rate is negative)
Paradox of toil: Increased supply drives down price and reduces output and employment
Paradox of flexibility: The more wages and prices fall in slump, the worse things get
Prescriptions:
Fiscal stimulus
Increased gov’t debt  inflationary expectations (inflation benefits debtor)
Central bank commitment to irresponsible stance  inflationary expectations
Debt forgiveness: principal reductions

32. The Great Depression
29.5
80.9
5.3
16.9
1936
25.9
80.1
13.9
20.1
1935
30.5
82.2
8.6
19.0
1938
30.9
83.8
5.0
14.3
1937
39.6
81.8
16.1
14.6
1940
34.1
81.0
8.5
17.2
1939
46.5
85.9
12.9
9.9
1941
21.9
78.1
21.7
1934
24.1
88.8
14.7
15.9
1931
21.1
79.7
1.8
23.6
1932
19.9
75.6
9.1
24.9
1933
55.3
25.7
Nominal Money Stock
95.1
97.4
Price Level
U.S. Unemployment, Output Growth, Prices, and Money, 1929 to 1942
13.2
4.7
1942
7.6
8.7
1930
Output Growth Rate (%)
Unemployment Rate (%)
Year
26.6
100.0
9.8
3.2
1929

33. Stimulus and Retrenchment: Recession in Depression

34. The Great Depression The Contraction in Nominal Money
The puzzle is why deflation ended in 1933.
- New Deal measures, e.g., establishing the National Industrial Recovery Act (NIRA) of 1933.
- Perception of a “regime change”:
election of Roosevelt
abandoning gold
The Contraction in Nominal Money
Money, Nominal and Real, 1929 to 1933
Year
Nominal Money Stock, M1
Monetary Base, H
Money Multiplier, M1/H
Real Money Stock, M1/P
1929
26.6
7.1
3.7
26.4
1930
25.7
6.9
26.0
1931
24.1
7.3
3.3
26.5
1932
21.1
7.8
2.7
25.8
1933
19.4
8.2
2.4
25.6
Nominal Interest Rate, Inflation, and Real Interest Rate, 1929 to 1933
Year
One-Year Nominal Interest Rate (%), i
Inflation Rate (%), 
One-Year Real Interest Rate (%), r
1929
5.3
0.0
1930
4.4
2.5
6.9
1931
3.1
9.2
12.3
1932
4.0
10.8
14.8
1933
2.6
5.2
7.8

35. GDP, Consumption, and Investment Growth, Japan, 1988-1993
The Japanese Slump
The robust growth that Japan had experienced since the end of World War II came to an end in the early 1990s.
Since 1992, the economy has suffered from a long period of low growth—what is called the Japanese slump.
Low growth has led to a steady increase in unemployment, and a steady decrease in the inflation rate over time.
GDP, Consumption, and Investment Growth, Japan,
Year
GDP (%)
Consumption (%)
Investment (%)
1988
6.5
5.1
15.5
1989
5.3
4.7
15.0
1990
5.2
4.6
10.1
1991
3.4
2.9
4.3
1992
1.0
2.6
7.1
1993
0.2
1.4
10.3

36. The Japanese Slump
The Japanese Slump: Output Growth since 1990 (percent)
From 1992 to 2002, average GDP growth in Japan was less than 1%.

37. The Japanese Slump
Unemployment and Inflation in Japan since 1990 (percent)
Low growth in output has led to an increase in unemployment. Inflation has turned into deflation.

38. GDP, Consumption, and Investment Growth, Japan, 1988-1993
The Japanese Slump
GDP, Consumption, and Investment Growth, Japan,
Year
GDP (%)
Consumption (%)
Investment (%)
1988
6.5
5.1
15.5
1989
5.3
4.7
15.0
1990
5.2
4.6
10.1
1991
3.4
2.9
4.3
1992
1.0
2.6
7.1
1993
0.2
1.4
10.3
The numbers above raise an obvious set of questions:
What triggered Japan’s slump?
Why did it last so long?
Were monetary and fiscal policies misused, or did they fail?
What are the factors behind the modest recovery?

39. The Rise and Fall of the Nikkei
Stock Prices and Dividends in Japan since 1980
The increase in stock prices in the 1980s and the subsequent decrease were not associated with a parallel movement in dividends.
The fact that dividends remained flat while stock prices increased strongly suggests that a large bubble existed in the Nikkei.
The rapid fall in stock prices had a major impact on spending—consumption was less affected, but investment collapsed.

40. The Japanese Slump The Failure of Monetary and Fiscal Policy
Fiscal policy was used as well. Taxes decreased at the start of the slump, and there was a steady increase in government spending throughout the decade.
Fiscal policy helped, but it was not enough to increase spending and output.

41. The Failure of Monetary and Fiscal Policy
Government Spending and Revenues (as a percentage of GDP) in Japan since 1990
Government spending increased and government revenues decreased steadily throughout the 1990s, leading to steadily larger deficits.
Output growth has been higher since 2003, and most economists cautiously predict that the recovery will continue. This raises the last set of questions. What are the factors behind the current recovery?
There appear to be two main factors.
A Regime Change in Monetary Policy
The Cleanup of the Banking System