L f h Fi i l C i i fLessons from the Financial Crisis for Teaching Economicsg

John B TaylorJohn B. TaylorStanford University

June 2, 2011

National Conference on Teaching Economics and Research in Economic Education 

OutlineOutline• Narrative of the Financial Crisis

– Informs one’s views about lessons for teaching• Alternative Narratives

N t i i l i t di– Not surprisingly, economists disagree• Implications for Teaching

– Examples will be presented throughout talk based on– Examples will be presented throughout talk based on experience

– Graduate (1st year Ph.D. course at Stanford)– Undergraduate (Economics 1 at Stanford)– Textbook (Principles Book with Weerapana)

NarrativeE i li d i t d f b i i• Economic policy deviated from basic economic principles which had worked well

• Result? A great recession a financial panic and a• Result?  A great recession, a financial panic, and a very weak, nearly nonexistent, recovery.

• The deviations began with policies such asThe deviations began with policies such as – a monetary policy with interest rates too low for too long– a regulatory policy which failed to enforce existing rulesg y p y g

• The deviations from sound principles continued when government responded with an ad hoc bailout process and temporary stimulus programs 

• The good news: economic growth and stability can be restored by adopting policies consistent with basic economic principles. 

An illustration that basic principles work well, when followed

15

20Percent

Great Moderationperiod

10

15 period 

0

5

-5

0

G t R i

-15

-10Great Recession(End of Great Moderation?)

50 55 60 65 70 75 80 85 90 95 00 05 10

Growth Rate of Real GDP

Illustrative monetary policy chart from San Francisco Fed,  March 1995, Judd and Trehan

1965‐79

1987‐92

1993‐94

Illustrative monetary policy chart from St Louis FedFebruary 2007, Bill Poole  y

Policy Deviations Leading up to the d h llCrisis and the Panic in Fall 2008 

• Interest rates too low for too longg• Discretionary fiscal stimulus of Feb ‘08 ($152B)• On‐again off‐again bailouts financed by centralOn‐again, off‐again bailouts financed by central bank’s balance sheet– on for BSC creditors’ bailout off for Lehman creditors’on for BSC creditors  bailout, off for Lehman creditors  bailout, on for AIG creditors’ bailout, off for TARP role out

• Government regulators and supervisors deviatedGovernment regulators and supervisors deviated from sound regulatory rules, especially at large banks

Illustrative monetary policy chart from St Louis FedFebruary 2007, Bill Poole  y

Illustrative monetary policy chart from St Louis FedFebruary 2007, Bill Poole  y

Chart from Kansas City Fed, 2009, Tom Hoenig

(2000‐2009)

The Boom‐Bust in Housing Starts Compared with the CounterfactualCompared with the Counterfactual

Illustrative Chart from the OECD, March 2008  

Illustrative Chart from the OECD, March 2008  

Temporary stimulus meets permanent income hypothesisp yp

The Panic of Fall ‘08

Policy makers then doubled‐downPolicy makers then doubled down

• Discretionary fiscal stimulus of 2009 ($862 billion)sc et o a y sca st u us o 009 ($86 b o )– One‐time payments again – More government spending too

• Cash for clunkers program • Quantitative easing in 2009, now called QE1

– Purchases of $1.25 trillion of mortgage backed securities, $300 billion of longer term Treasury bonds

QE2 i 2010 d 2011• QE2 in 2010 and 2011– purchases of $600 billion of longer term Treasury bondsbonds.  

Temporary  stimulus meetspermanent income hypothesis againp yp g

Cash for clunkers: incentives really matter

400Billions of dollars, annual rates

300

350

200

250 --- Temporary transfer payments and credits

t

150

200

G t t t t d

to persons

50

100

F d l t ti

--- Grants to state and local governments

009Q1 09Q2 09Q3 09Q4 10Q1 10Q2 10Q3 10Q4

--- Federal government investment--- Federal government consumption

Two-Year Effect of ARRA on Major Federal Budget Categories (Source: Bureau of Economic Analysis)

2,300Billions of dollars, annual rates

2 100

2,200

,Total receipts of stateand local governments

2,000

2,100

Recepits less

1,800

1,900p

ARRA grants

1 600

1,700 Purchases by state and local governments

1,500

1,600

1,4002005 2006 2007 2008 2009 2010

State and local governments also consider permanent income

Compare with textbook discussion: Sharp drop in I causes expenditure lineSharp drop in I causes expenditure line 

to shift down 

45-degree line

SPENDING25_10

New E line

Original E lineOriginal point of spending balance

I falls by this amount

Income or real GDP falls by this amount (more than by amount I falls ).

New point of spending balance

Original income level

New income level

INCOME OR REAL GDP

(more than by amount I falls ).

Offset by Countercyclical fiscal policyIncrease in G raises GDP depending on size of the p g

multiplier and amount of crowding out 

45-degree line

SPENDING25_10

G rises

INCOME OR REAL GDP

But look what happened

6Percent, annual rate

Growth rate of real GDP

2

4

0Contribution of

-4

-2 government purchases

-6

-807Q1 07Q3 08Q1 08Q3 09Q1 09Q3 10Q1 10Q3

Quantitative Easing Financed by Monetary Base

2,800Billions of dollars

2,400Monetary base(currency plus reserves)

2,000

1,600

1,200

800Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11

A Wonderful Teaching Moment:The Money Multiplier and the Monetary BaseThe Money Multiplier and the Monetary Base

Percent

800

1,000CBO Outlook in 2010

600

800

Federal Debt as a

CBO Outlook in 2009

400

600 Federal Debt as aPercent of GDP

200

400

0

200

CBO Outlook in 2011??0

1800 1850 1900 1950 2000 2050

Teaching About Regulatory Capture:E l i f il t f l t lExplains failure to enforce regulatory rules

C ti b t• Cozy connections between government and the fi i l i d tfinancial industry. 

• Book shows government helping well‐connected individuals, who in turn helped the government officials. 

• Result: Reckless policy

Implication of Narrative for Basic Economics

• Needs a reformulation?– Paul Samuelson (January 2009) Paul Samuelson (January 2009) 

• “today we see how utterly mistaken was the Milton Friedman notion that a market system can regulate itself… This prevailing ideology of the last few decades has now beenprevailing ideology of the last few decades has now been reversed…I wish Friedman were still alive so he could witness how his extremism led to the defeat of his own ideas”. 

– Paul Krugman blames modern economics (especially macro) for the crisis. 

B t ti h i li b i i k• But narrative here implies basic economics works– The crisis was caused by a deviation from principles

f h h h d• But of course there is much research to do

Another NarrativeAnother Narrative

• US policy was not an issue leading up to theUS policy was not an issue leading up to the crisis and is not an issue now

• Global capital flows were and are the problem• Global capital flows were and are the problem– Caused emerging market crises in 1990sC d 2007 09 i i S i Gl– Caused 2007‐09 crisis: Saving Glut

– Cause of future crises: focus on global rebalancing 

• Much different policy implication

But chart from the IMF in 2005 Shows No Global Saving Glut 

So Why Do Economists Disagree?So Why Do Economists Disagree?

• Students and everyone else really want toStudents and everyone else really want to know the answer

• One reason is that the details of their models• One reason is that the details of their models are different, even though there is agreement about the basic principlesabout the basic principles

• The next three charts from the New York Ti d h ill hi llTimes and two others illustrate this well.

66

New KeynesianSmets ‐ ECB

Robert BarroHarvard

3

4

5With stimulus

3

4

5

With stimulus

0

1

2If nostimulus

0

1

2If nostimulus

-12009 2010

-12009 2010

“The accumulation of hard data and real-lifeThe accumulation of hard data and real life experience has allowed more dispassionate analysts to reach a consensus that the stimulus package, messy p g yas it is, is working”New York Times November 12, 2009

Implications for TeachingM ill t ti f b i i• Many new illustrations of basic economics 

• Interesting debates between economists R l di ti– Rules versus discretion

– But raise more questions about discretionary policy• More integration of micro and macro• More integration of micro and macro 

– interest rates too low for too long (macro)– housing markets including bubbles (micro)housing markets including bubbles (micro)– stimulus package (macro) – regulatory capture and moral hazard (micro)– new instruments of monetary policy (macro)– risk premia in interest rates(micro) – debate over size of multipliers (macro)– cash for clunkers, first time home‐buyer (micro)

Many New YouTube VideosQuantitative Easing Explained. 5 million downloads. Doesn't 

get it all right and brutal in places, but good for discussionThe Wrong Financial Adviser Created by Nobel prize winner 

Bill SharpeFed Chairman  on the Daily Show with Jon Stewart. From two 

different episodes of 60 Minutes, focus on whether quantitative easing is printing money.

Unmasking Interest Rates, Honky Tonk StyleMerle Hazard sings "Inflation or Deflation“Inside Job Trailer Christine Lagarde in clip from Inside JobChristine Lagarde in clip from Inside JobHayek‐Keynes rap videos "Fear the Boom and Bust“ and “Fight 

of the Century”

Lines from “Fight of the Century”Lines from  Fight of the Century

Keynes: “Even you must admit that the lessonKeynes:  Even you must admit that the lesson we’ve learned is that more oversight’s needed or else we’ll get burned”or else we ll get burned

Hayek: “Oversight? The government ‘s long been in bed with those Wall Street execs and thein bed with those Wall Street execs and the firms that they’ve led.”