James Stodder, (Ph.D., Economics, Yale 1990) Lally School of Management & Technology

1. Understanding the Financial CrisisPresentation toStudents & Friends of Rensselaer HartfordHartford, CT James Stodder, (Ph.D., Economics, Yale 1990) Lally School of Management & Technology Rensselaer Polytechnic Instituteat Hartford Hartford, Connecticut, USA

2. Outline of Talk • Keynes on Credit Cycles: - Why we need Regulation • Where is the Bottom? • Connecticut is “Middle of the Pack” • Government Deficit Spending • Needed in the Short-term • But a Big Problem Long-term

3. (1) Biz & Credit Cycles J. M. Keynes: 1883-1946

4. US Macro-Stability: Better, Room for Improvement 45% 55% 34% 66% Source: http://www.nber.org/cycles.html

5. Bad News: Bubbles are Endemic Arlington Williams, “Price Bubbles” www.indiana.edu/~arlwilli/pdf%20files/bigmkts.pdf

6. Good News: People Do Learn V. Smith & A. Williams, “Experimental Market Economics,” Scientific American, Dec. ‘92

7. Price/10 Year Avg. Earnings Source: http://www.econ.yale.edu/~shiller/data.htm

8. The Wisdom of Keynes “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, isruined in a conventional way,along with his fellows, so that no one can really blame him.” - J.M. Keynes (1931)

9. “Paradox of Thrift” Keynes noted: Consumers cut back on their spending and save more during a recession. This only makes the recession worse. Similarly for Banks, Loan Loss Reserves (LLR)are often raised in a recession, justwhen households and businesses most need credit –ensuring more collapses and worsening the recession.

10. Insurance => Moral Hazard =>Necessity of Regulation • Moral Hazard of Insurance: • If you had a car that is less damaged by any given car crash – would that make you drive faster? • If you (and everybody else) drove faster, could this actually wind up making you less safe ?

11. www.economist.com/finance/displaystory.cfm?story_id=12480887 www.nytimes.com/2008/10/03/business/03sec.html

12. Availability of Bank Loans

13. Currency & Reserves Up 4x Oct. 17, 2012 http://research.stlouisfed.org/fred2/series/BASE

14. But Bank Reserves up 100x Oct. 17, 2012 http://research.stlouisfed.org/fred2/series/WRESBAL

15. M0 = Currency + Bank Reserves ≈ $2.6t Oct. 17, 2012 http://research.stlouisfed.org/fred2/series/BASE

16. M1 ≈ $2.4t = Currency + Bank Deposits Oct. 17, 20112 http://research.stlouisfed.org/fred2/series/M1

17. Money Mult. = M1/M0 ≈ 2.4/2.6 = 0.92 Oct. 17, 2012 http://research.stlouisfed.org/fred2/series/MULT

18. Bank Money Multiplier If l= % loans, Reserve multiplier is D = R(1+l + l 2+… + l ∞ )=R/(1- l ) If M0 = Currency (C) + Reserves (R), M1=Currency + Deposits, so: M1 = C + R/(1- l ) = M0–R+ R/(1- l ) M1/M0 = 1+{-R + R/(1- l )}/M0 So M1/M0 < 1 => l < 0

19. Limits of Fed Magic New Yorker, Oct. 2008

20. The Zero Bound Oct. 17, 2012 http://research.stlouisfed.org/fred2/series/TB3MS

21. The Zero Bound (2) Oct. 17, 2012 http://research.stlouisfed.org/fred2/series/FEDFUNDS

22. The Zero Bound (3)T.I.P.S.

23. Quantity of Money Equation M*V ≡ P*Y Money * Velocity ≡ Price * Output => ln(M) + ln(V) = ln(P) + ln(Y) => i.e., %∆M + %∆V = %∆P + %∆Y over time

24. %∆ Money Turnover [ = %∆ (Money x Velocity) ] is Too Pro-Cyclical because of Velocity % ∆M • % ∆ (M x V) % ∆ V

25. Keynes’s Liquidity Trap:

26. Keynes’s Liquidity Trap:

27. Keynes’s Liquidity Trap:

28. Keynes’s Liquidity Trap:

29. Keynesian Multiplier: Evidence Source: IMF World Economic Outlook and IMF Fiscal Monitor, Oct. 2012

30. Another Illustration: Multiplier > 1 NY Times, Oct. 23, 2012

31. Okun’s Law (1): Unemployment Gap Oct. 24, 2012

32. Okun’s Law (2):Output Gap Oct. 24, 2012

33. Okun’s Law (3)

34. Okun’s Law (4) Oct. 17, 2012

35. Output Gap ≈ 20% GDP http://www.cbo.gov/ftpdocs/99xx/doc9958/01-08-Outlook_Testimony.pdf A little Stimulus Math: 20% * $14 tr. = $2.8 tr. Stim*1.5 = $2.8 => Stim = $1.87 tr.

36. (2) Bottom Still a Ways Off Okun’s Law, and Slow Recovery Housing Recovery probably still a year away. Credit Markets still very weak. Stock Market Valuation Ratios like P/E and Tobin’s Q are now only at historical averages. Unemployment Trend: http://cr4re.com/charts/charts.html

37. HousingBottom– A LongWayOff http://www.nytimes.com/imagepages/2008/10/16/business/16housing.graphix.ready.html

38. Why it Matters to Everyone

39. Worst Long-Term Unemployment Oct. 17, 2012 http://research.stlouisfed.org/fred2/series/UEMPMEAN

40. Long Unemployment Dip http://cr4re.com/charts/charts.html

41. (3) CT & NY in “Middle of Pack” Financial Sector down, but .. Conventional Banking and Insurance less vulnerable than Investment Banks, Financial Insurance Defense industries well insulated Pharmaceuticals and Biotech have good long-term prospects House Price Increases near US Avg.

42. International Housing Prices

43. Sun Belt, Rust Belt Concentration

44. 2006 Peak of Price-to-Rent

45. Source: NY Times, April 20, 2010

46. (4) More Federal Deficit Spending (not Tax Cuts) Necessary Tax cuts to the rich more likely to be saved, not spent or invested. Tax cuts don’t have big effect on those too poor to pay many taxes. Unmet needs in Energy, Environment, Health, and Education: good reasons to spend.

47. Government Must Increase Spending in Severe Recession “ If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coal mines … It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.” (Keynes, General Theory, 1937)

48. But We Need Foreign Coordination for US Expansion to be Successful Benefits of lone expansion “leak out,” other countries free ride. Alternatives to joint expansion are protectionism and competitive devaluations. US long-term “Fiscal Gap” makes lone expansion untenable.

49. Long Term Fiscal Gap: Unsustainable http://www.cbo.gov/ftpdocs/93xx/doc9385/06-17-LTBO_Testimony.pdf

50. Sure asDebt and Taxes http://www.cbo.gov/ftpdocs/93xx/doc9385/06-17-LTBO_Testimony.pdf