1 understanding the great recession economics 122: fall 2010

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Understanding the Great RecessionEconomics 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 risks2. The housing bubble3. A “run on the banks” and the Lehman bankruptcy4. The crash in asset prices5. Decline in wealth leading to declining I and C.6. International transmissions7. IS-TR curve interpretation8. Liquidity trap!9. Governmental response in monetary and fiscal policies10.The trough in late 200911.The long stagnation to reach full employment (?)

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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

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

The result on housing prices

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1. Rising perceived wealth of households 1995-2006.

2. Then catastrophic loss of wealth 2006-2009

0

40

80

120

160

200

1985 1990 1995 2000 2005 2010

Real housing prices[1987-1995 = 100]

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Then people wake up from the dream to the nightmare of

falling wealth …

Mortgage delinquencies for subprime mortgages

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Source: IMF, Global Financial Stability Report, Oct 2008 at imf.org

The loss of paper wealth

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4.0

4.5

5.0

5.5

6.0

6.5

60 65 70 75 80 85 90 95 00 05 10

Household net worth/disposable income

Wealth loss of $12 trillion ($100,000 per household)

The impact on households and consumption

10

-16,000

-12,000

-8,000

-4,000

0

4,000

8,000

12,000

16,000

-300

-200

-100

0

100

200

300

400

500

00 01 02 03 04 05 06 07 08 09 10

Change in net worth (left scale)Change in consumption (right scale)

Techbubble

Financialbankcrisis

Billions of 2005 $

Predictions of consumption

theory

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Consumption function:Ct = β1 Y

pt + β2 Wt

Savings rate:s = 1 – β1 - β2 Wt /Y

pt

.14

.16

.18

.20

.22

.24

.26

0

2

4

6

8

10

12

60 65 70 75 80 85 90 95 00 05 10

Wealth-income ratio (inverted, left scale)Personal savings rate (right scale)

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*

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

Chicken little

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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 2008.15

Risk on Mature Govt Debt (US, etc.)

16CDS = 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).

18IMF

Risk premiums on

top-rated securities

Impact of Credit Crunch on Investment

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.10

.11

.12

.13

.14

.15

.16

.17

.18

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

Macroeconomic impacts

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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)

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iff

Y

IS(i ff - π + risk premium)

i*

Taylor Rule (TR)

2006

Before crisis

iff

Y

IS(i ff - π + low risk premium)

i*

TR

2008

After financial crisis

IS’(i ff - π + high risk premium)

World output trends

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25

Policy Responses (thanks to Keynes’s theories)

Gwendolen Darwin Raverat

Financial Market Support Measures 2007-2010

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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

IS(i ff - π + risk premium)

i*

LM

IS’

2008

Before Fed expansion

iff

Y

IS(i ff - π + risk premium)

i*

LM

IS’

LM’

2009

After Fed expansion

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iff

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

32Source: CBO, presentation of Elmendorf, June 2009

iff

Y

i*

TR

IS(2008)

Without stimulus

iff

Y

i*

TR

IS(2008) IS(2010)

With stimulus

CBO’s estimate of impact of stimulus on economy

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My forecast

Source: CBO, presentation of Elmendorf, June 2009,; Nordhaus, Nov 2010.

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When will it ever end?