what happened to the financial sector? collapse of many financial institutions commercial banks...
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What happened to the Financial Sector?Collapse of many financial institutions
Commercial banksInvestment banksInsurance companies
Reduction in lending, credit crunch
What Happened to the Real Economy?GDP downIncome down
Consumption and investment downWealth down
Real estateFinancial assets
Unemployment upInternational recessionInternational trade down
Some Fed ActionsMarch 2008: Lent $30B to get JPMorgan Chase
to buy Bear StearnsAugust 2008: Seized Fannie Mae and Freddie
MacSept 2008: Let Lehman Brothers failMerged B of A with MLAll but nationalized AIGConverted GS and MS into bank holding
companies Asked Congress to give Treasury $700B to
prevent catastrophe.
Another Depression?If we don’t act in a very huge way, you can
expect another Great Depression, and this is going to be worse. The financial system is only a matter of days away from a meltdown. Ben Bernanke, Sept 2008
On the Other HandWhat happened to the Depression? The facts
we face today are very different than the grim reality Americans confronted between 1929 and 1932. Allan Meltzer, WSJ, Sept 1, 2009
Unemployment 9.5% v. 25%GDP down 3.8% v. 18.2%
Financial IssuesInvestment banks Commercial banksEnd of Glass-Steagall
Repealed in 1999 by Gramm-Leach-Bliley ActCapital standardsLeverageDerivativesOpaqueness
Exchange-Traded DerivativesFutures: a contract to buy or sell a specified
quantity of a good at a specified price at some future date
Option: the right but not the obligation to buy or sell a specified quantity of a good at a specified price at some future date
Exchange-traded options and futures are guaranteed by the exchange
Can be used to hedge or speculateSpeculation is risky
OTC DerivativesSwap: an agreement to one type of payment
for anotherBank or other financial institution acts as an
intermediary between parties wanting to swap
Simple Interest Rate SwapA has a floating rate $1M loan, LIBOR + 2%B has a fixed rate $1M loan A wants to convert to fixed rate loanB wants to convert to a floating rate loanBank arranges a swap
Swap ExampleA pays 4.25% on $1M monthly for a year to
bankA receives LIBOR on $1M monthly for a year
from bankB pays LIBOR plus .25% on $1M monthly for
a year to bankB receives 4 % on $1M monthly for a year
from ban
Swap ExampleA now has a fixed rate loanB now has a floating rate loanBank makes .50 percent on $1MNo capital requirementsNo risk, unless one party does not payOr if there is only one party, i.e., if bank is
speculating
Business PracticesRapid growth of leverageRapid growth of opaque derivatives, such as
credit default swapsFraudPoor governance
What Has Been Done?Fiscal policy
Increase spendingCut taxes
Monetary policyLow interest rates
Other actions by the FedFourth branch of government?In Fed We Trust, David Wessel
Some Other Fed ActionsMarch 2008: Lent $30B to get JPMorgan Chase
to buy Bear StearnsAugust 2008: Seized Fannie Mae and Freddie
MacSept 2008: Let Lehman Brothers failMerged B of A with MLAll but nationalized AIGConverted GS and MS into bank holding
companies Asked Congress to give Treasury $700B to
prevent catastrophe.
Economic Theory and PolicyWas economic policy based on bad theory?Should economic models have predicted
collapse?“Where Modern Economic Theory Went
Wrong” The Economist, July 18, 2009Rational expectationsEfficient market hypothesis (EMH)The Myth of the Rational Market” Justin Fox
Economics Gone Wrong?Most macroeconomics of the past 30 years
“was spectacularly useless at best and positively harmful at worst” Paul Krugman
Why couldn’t the Fed and others predict the real estate collapse?
On the Other Hand“One thing we are not going to have, now or
ever, is a set of models that forecasts sudden falls in the value of financial assets like the declines that followed the failure of Lehman Brothers in September 2008” Robert Lucas
The main lesson of the EMH is the futility of trying to deal with crises and recessions by finding central bankers and regulators who can identify and puncture bubbles. If these people exist, we will not be able to afford them” Lucas
More“One cannot find good, under-forty
economists who identify themselves or their work as ‘Keynesian’ “ Robert Lucas, 1980
ClassicalSay’s LawSupply creates its own demandIf there is unemployment, wages fall,
employment risesIf there is a surplus of goods, prices fall, sales
increase
Keynesian EconomicsJohn Maynard Keynes1936 General Theory of Employment,
Interest and MoneyBeginning of macroeconomics (term first
used in 1945)Prices and wages do not fall when there is
unemployment or a surplusUnemployment can persist for a long time“In the long run, we are all dead”
Keynesian EconomicsUnemployment is due to low aggregate
demandFiscal and monetary policy should be used to
reduce unemploymentBut primary reliance is on fiscal policyMonetary policy is of limited value in
reducing unemployment (pushing on a string)
The Ascent of KeynesianismJFK First president to accept Keynesian
PolicyTime The end of the business cycleRMN “We are all Keynesians now”But not for longWhat happened?
Critique of KeynesianismNot a coherent theory; it depends upon faulty
assumptions (Friedman, Phelps)Political reality prevents effective policyKnowledge that government will try to prevent
unemployment leads to inflationary wage and price increases (UAW-GM, for example)
Thus leading to more and more stimulus and inflation with no reduction in unemployment
Stagflation of the 1970’sCannot explain events since 1970Samuelson et.al. wrong in 1981
Critique 2Supply side economicsNot all spending has same impactTax cuts have more impactTax rates affect incentives to supply (work,
invest, entrepreneurial activity)Did Kennedy, Reagan and Bush tax cuts affect
demand or supply?
MonetarismQuantity theory of moneySteady, slow growth of the money supply is
the key to economic growth and controlling inflation
Stimulative fiscal policy ineffective due to “crowding out”
Barro, “Keynesian Economics vs. Regular Economics”
Rational ExpectationsMarkets clear if left aloneFiscal and monetary policies cannot stimulate
the economySuch policies cause inflationary expectations
and are self-defeating