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: Increasing leverage with lower perceived risks The housing bubble and …. not “pop” but “hissssssss” A “run on the shadow banks” and the Lehman bankruptcy The crash in asset prices in 2008 Huge decline in wealth, leading to declining housing I and C. International transmissions IS-MP curve interpretation Liquidity trap! Governmental response in monetary and fiscal policies The trough in late 2009 The long stagnation is still with us ….

The bubble economy

Trends in volatility of US stock prices Historical lows 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.

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

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

The housing price bubble Rising perceived wealth of households 1995-2006. Then catastrophic loss of wealth 2006-2009 Stabilized in last four years

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

No one saw it coming: Fed projections, June 2008

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

Mortgage delinquencies skyrocket

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

The impact on households and consumption

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.

Bank losses* * 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 2008.

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

A risk measure on commercial paper 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.

Macroeconomic impacts

Impact of Credit Crunch on Investment

Effect on output Bear Lehman 22

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

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

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

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

Financial Market Support Measures 2007-2013

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

Fed balance sheet before and after the crisis

Before Fed expansion MP iff IS’ i* 2008 Y

Fed expansion MP iff IS’ i* Y 2009

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

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

Without stimulus MP iff IS(2008) i* Y

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

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

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

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 2016. 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.

Understanding the Great Recession