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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:1. Increasing leverage with lower perceived risks2. The housing bubble and …. not “pop” but “hissssssss”3. A “run on the shadow banks” and the Lehman bankruptcy4. The crash in asset prices in 20085. Huge decline in wealth, leading to declining housing I and

C.6. International transmissions7. IS-MP curve interpretation8. Liquidity trap!9. Governmental response in monetary and fiscal policies10. The trough in late 200911. The long stagnation is still with us ….

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3

The bubble economy

Trends in volatility of US stock prices

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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

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0

1

2

3

4

5

0

2

4

6

8

10

1930 1940 1950 1960 1970 1980 1990 2000 2010

Total financial assets/ KTotal financial assets/ GDP

Source: Federal Reserve flow of funds data.

Rising leverage of US economy

Leverage for US economy

6Gelain et al, San Francisco Fed Working Paper.

The housing price bubble

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1. Rising perceived wealth of households 1995-2006.

2. Then catastrophic loss of wealth 2006-2009

3. Stabilized in last four years

0.4

0.5

0.6

0.7

0.8

0.9

1.0

1.1

1.2

86 88 90 92 94 96 98 00 02 04 06 08 10 12

Case-Shiller housing price index (CPI corrected)

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Then people wake up from the dream to the nightmare of

falling wealth …

No one saw it coming: Fed projections, June 2008

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10= Fed forecasts = Range of all 19 participants

A disastrous forecast

Mortgage delinquencies skyrocket

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-18,000

-16,000

-14,000

-12,000

-10,000

-8,000

-6,000

-4,000

-2,000

0

2007Q1 2008Q1 2009Q1 2010Q1 2011Q1 2012Q1

Loss of Household Wealth in Recession(billions of 2005$)

Housing

Net worthWealth loss of

$16 trillion ($140,000 per household)

The impact on households and consumption

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-20,000

-16,000

-12,000

-8,000

-4,000

0

4,000

8,000

12,000

-300

-200

-100

0

100

200

300

400

500

98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Change in new worthChange in consumption

Dot.combubble

Housing burstand financialmeltdown

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.

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Bank losses*

15* 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.

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Risk on Mature Govt Debt (US, etc.)

17CDS = risk that security will default. These are US and similar Treasury bonds!

A risk measure on commercial paper

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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.

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Macroeconomic impacts

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Impact of Credit Crunch on Investment

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5.5

6.0

6.5

7.0

7.5

8.0

8.5

9.0

9.5

2005 2006 2007 2008 2009 2010

Investment/ Potential GDPBaa bond rate

Creditcrisis

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0.84

0.88

0.92

0.96

1.00

1.04

1.08

1.12

2000 2002 2004 2006 2008 2010 2012

Actual/potential industrial production

Effect on output

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Lehman

Bear

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

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iff

Y

IS(i ff - π + low risk premium)

i*

MP

2006

Before crisis

iff

Y

IS(i ff - π + low risk premium)

i*

MP

2008

After financial crisis

IS’(i ff - π + high risk premium)

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Policy Responses (thanks to Keynes’s theories)

Gwendolen Darwin Raverat

Financial Market Support Measures 2007-2013

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Unconventional Fed Measures: the Fed Balance Sheet

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Treasuries = normal stuff!; CPLF = commercial paper funding facility; MBS = mortgage-backed securities

Fed balance sheet before and after the crisis

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iff

Y

i*

MP

2008

Before Fed expansion

IS’

iff

Y

i*

MP

2009

Fed expansion

IS’

iff

Y

i*

MP

2009

After TARP and other risk-reducing measures

2010

IS’’

Fiscal Policy in the Liquidity Trap:Components of US stimulus legislation

33Source: CBO, presentation of Elmendorf, June 2009

iff

Y

i*

MP

IS(2008)

Without stimulus

iff

Y

i*

MP

IS(2008) IS(2010)

With stimulus

CBO’s estimate of impact of stimulus on economy

36Source: CBO, presentation of Elmendorf, June 2009.

CBO’s estimate of impact of stimulus on economy

37Source: CBO, presentation of Elmendorf, June 2009.

Actual

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. 38