The Current Economy: From an Economic Historian’s Perspective Price Fishback University of Arizona...

The Current Economy:From an EconomicHistorian’s Perspective

Price FishbackUniversity of Arizona

1Copyright, Price Fishback, April 26, 2012.

Spectacular Meltdown Last Fall

• in the Financial Sector in 2007-2008– Stock Market Halved in Value– Wall Street Investment Banks are gone or are now

Commercial Banks– Large slug of toxic assets on books of financial

institutions• Towers of MBSs, CDOs, CDSs built on mortgages, with

houses as collateral


Constant References to the Great Depression

• Worst Financial Crisis Since the Great Depression

• Worst Downturn since the Depression– Still Questionable

• Here is Why This is Not the Next Great Depression


Modern Unemployment Rates

• Since December 2007• Unemployment Rate has risen from 4.9 to

around 9.7 percent in July• Before Thinking About the Great Depression

Consider the Late 1970s and Early 1980s


Fed Chair Volker Wrings InflationOut of System


The Great Depression


1932 and 1933 GDP Output Loss Equivalent toShutting Down Production West of Mississippi


Civilian Unemployment Rate, Inflation, and Misery Index, 1965-2006

0.0

5.0

10.0

15.0

20.0

25.0

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010Year

Perc

ent

Misery Index

Inflation Rate

Unemployment Rate

Huge Success

Inflation rate around 3 percent

13

Compare to late 1970s early 1980s

Copyright, Price Fishback, April 26, 2012.

Is Stock Drop Similar?

• November 2007 through February 2009 Cut in Half.– Has Recovered to 90% of peak

• Stock Market Dropped by Half between October 1929 and October 1930 – 12 months

• Unlike Today– In the 1930s, Market Dropped to 11% of the 1929 peak

in the middle of 1932.– Corporate Profits were negative for U.S – Net Investment negative


15

Dow Jones Ind. Avg. Past 10 Years

www.bigcharts.com Copyright, Price Fishback, April 26, 2012.

16

http://stockcharts.com/charts/historical/djia1900.html

1920-1940

Rise is evenBigger than itLooks becauseOf the log scale


Date of Prior Peak

Date of Trough Peak Value

Trough Value

Percent Drop

Date Reached

Peak Again

Months to Reach

Next Peak

7/15/1957 10/22/1957 49.13 38.98 -20.7 9/16/1958 11

12/12/1961 6/26/1962 72.64 52.32 -28.0 9/3/1963 15

2/9/1966 10/7/1966 94.06 73.20 -22.2 5/4/1967 7

11/29/1968 5/26/1970 108.37 69.29 -36.1 4/15/1972 23

1/11/1973 10/3/1974 120.24 62.28 -48.2 7/17/1980 79

9/21/1976 3/6/1978 107.83 86.90 -19.4 8/15/1979 17

11/28/1980 8/12/1982 140.52 102.42 -27.1 11/3/1982 3

8/25/1987 12/14/1987 336.77 223.92 -33.5 7/26/1989 20

7/17/1998 10/8/1998 1186.75 959.44 -19.211/23/199

8 1.5

3/14/2000 10/9/2002 1527.46 776.76 -49.1 5/30/2007 43

10/9/2007 3/9/2009 1565.15 676.53 -56.8 Now 1400

Peaks and Troughs in S&P 500 Stock Index 1957-2011


Bank Failures and Fed Response in 1930s

• Bank Failures• 1920-1929 Average of 630 banks a year failed

– Small unit banks lost about 0.7 % of deposits

• 1930-1933 Lost 7,200 banks• Much bigger banks,• Major bank runs.

• FED Response• Ineffective discount rate cut--due to deflation• Waited until 1932 for large purchase of bonds


Comparison

• During Great Depression, It took the Federal Reserve – 3 years– a rise in unemployment to over 20 percent – and a decline in annual output of 25 percent– before the emergency moves were made?

• Fed Chair Bernanke is a Student of the Depression.

• What have he, Paulson, and Geithner Done?


Bernanke Policy

A federal funds rate near zeroFED has Flooded the System with Cash

FED and Treasury have taken ownership stakes in banks and AIG

Guarantees on Bear Stearns and in many other places.

This happened all before the unemployment rate made it to 7 percent.


Experimentation?

• Uncertainty Delays Long-Run Decisions• 1929 Crash and current Crash strong negative

effect on • Purchases of autos, houses, other consumer durables• Investments in new plant and equipment

• Serious problems with Constant Policy Change in 1930s– Higgs, Shlaes


Source: Federal Reserve Board

Federal Reserve Assets (Uses of Funds)$ billions

-

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

2,200

2,400

Dec-07 Feb-08 Apr-08 J un-08 Aug-08 Oct-08 Dec-08 Feb-09 Apr-09 J un-09

Agency & MBS

Lending to Nonbanks Credit Mkts

Short-term Lending to Financials

Misc.

Treasuries

INFLATION WORRIES FLOOD OF FED ASSETS


Auto Bailout Today/RFC Railroad Bailouts in 1930s

• RFC gave loans to some RRs, while some went into bankruptcy

• Guess which ones spent more on maintenance and improvements in capital stock


Challenges for the Future

• Search for Security • Gigantic Budget Deficit• Will the Stimulus Work?• Controlling Inflation• Social Security and Medicare• Health Care Issues


Side Note: New Deal was not Keynesian nor was WWII 25Copyright, Price Fishback, April 26, 2012.

Keynesian Deficit Multipliers

• Pre 1970s– Samuelson Text – 2 or 3.– Federal Deficit of $1, Real GDP up 2 or 3.

• Backlash from Friedman. Crowding out of Private Investment and Employment.

• Majority of Economists these Days would put multiplier between 0.5 and 1.5

• Christina Romer, Chair of Presidents CEA and Mark Zandi at Moodys.com around 1.5

• Robert Barro at Harvard around 0.8, long run zero.


New Deal Multiplier

• Fishback-Kachanovskaya Study of State Income and Net Federal Spending in 1933-1939

• Expect the largest multiplier in the Great Depression because unemployment over 14%

• Do Not Find a Robust Number• Range is 0.03 to 1.76 depending on

assumptions (all are reasonable).


Social Security Worries

• Pay-as-you-Go System– Current Tax Revenues Fund Soc. Sec. pensions– Have also been funding other govt. programs– With Soc. Sec. Tax collections, deficit much bigger.– Same True of Medicare collections


Iron Law of Pay-Gotax rate = Benefit Rate/Wage Rate * Recipients/Working Pop.

• Currently tax rate is = .12• Benefit Rate/Wage Rate is 0.4• Recipients/Working Population is 0.28• Still an annual surplus.

– t = .12 > 0.4 * 0.28

• 2030 Recipients/Working Population is 0.4– Current tax rate = .12 Less than (0.4) * (0.4) = 0.16


Solutions

• tax rate = Benefit Rate/Wage Rate * Recipients/Working Pop.

• Solutions – Raise tax rate to 0.16 (8% worker/ 8% employer)

• History of doing this (original 1%/1% now 5.5%/5.5%)

– Lower Benefit Rate • Done in 1970s

– Lower number of Recipients by raising retirement age• Rise from 65 to 67.• Lowers lifetime benefits

– Raise Working Population• Increase immigration


Medicare Problem

• People even more worried about the Medicare problem because of the great uncertainty about containing health costs


Does the Rest of the World Spend More on Social Welfare

• Social Welfare Spending– Health, unemployment, poverty relief, disability

pay, retirement, etc.

• Comparison to the Nordic Countries– Third Way

• Different Philosophies – Nordic Universal– U.S. Safety Net


USA


10th Percentile

90th Percentile

Finland 9,300 27,100

Sweden 9,300 27,600

United States 9,500 51,300

Estimate of Income per Equivalent Person in Households at the 10th Percentile and the 90th Percentile in 2000 U.S. Dollars, PPP


Problem for U.S. Arises in the Average for the HHs in Bottom 10 %

• U.S. average is $5,800 in 2005• Nordic Average is $8,000 in Finland to $12,000

in Norway.


Holes in the Safety Net

• Surprisingly large share of eligible not getting benefits– Why? – Is it lousy information flow from government?– Is it difficult barriers to eligibility?– Is it choice by eligible not to collect?


The Health Safety Net

– Personal Insurance – Employer-Based Insurance

• No taxes on health insurance

– Medicare for the Elderly– Medicaid for the Poor– Child Health Insurance Program (CHIP) for the Near

Poor– Direct Payment for Health Services– Hospital and Doctor Charity Care– Emergency Room


Facts About Health Care

• U.S. spent 15.8% of GDP on Health Care• Other countries• French spent 11, Swiss spent 10.8, Ger. 10.5• UK 8.5, Sweden 9.1, Finland 8.3• U.S. PUBLIC expenditures on Health Care were

7.1 % of GDP (45% of the 15.8% figure) – We spend almost as much on poor and elderly as

rest of world spends on


Ratio of Health Care Expenditures by AgeGroup Relate to ages 50-64 in 2002

US Spends a Lot for Elderly

Hagist and Kotlikoff, “Who’s Going Broke”, 2005


Who Are the Uninsured?

• Employment Policy Institute Study by June O’Neill and Dave O’Neill of Baruch College

• 47 million (16% of pop) uninsured by anybody• Elderly almost all covered by medicare• Children access at 200% of federal poverty line in AZ

• Focus on 18-64 38 million uninsured– Roughly 16 million have incomes > 2.5 times

poverty line – Described as voluntarily uninsured

http://www.epionline.org/studies/oneill_06-2009.pdf 45Copyright, Price Fishback, April 26, 2012.

Look at “Involuntary Uninsured”

• 21.6 million with less than 2.5 times poverty level are uninsured.

• Of those– 55 percent in households with no kids– 42.4 % White, 34.7% Hispanic, 16.6% black– 51.7 % 18-34, 22% 35-44– 38 % did not work in prior year– 58 % family income less than $20,000.– Less Educated


State Variation in 2006

• States with highest percentage of uninsured among people with incomes < 2.5 fed pov. Line

• NM 20, TX 18.4, OK 18.3, MS 18.3, AR 17.7• LA 16.4, AZ 15.9, FL 15.8 AL 15.3

• States with lowest %• MN 6.6, VT 5.6, HA 6.9, CT 5.9, MA 6.4


Effects on Probability of Having Insurance Holding All Else Constant

– Rise in health premium of $1000 • lowers the probability of insurance by 32% for

unmarrieds with no children• Lowers probability by only 2.7 % for marrieds with

children

– Hispanics • with children 10 % less likely than white non-Hispanics

to have insurance• without children 13 percent less likely


Fundamentals of Insurance

• Insurance works best when pool known risks that are similar and independent of each other

• Mutual arrangement of everyone in room.• If risks not known, works less well


Insurance Problems

• Adverse selection• End up with large share of high risks• Moral Hazard More protection allows people

to take more risks


Reforms

• Development of Universal Coverage in Other countries very Path Dependent

• Britain National Health care came out of WWII shift to National Hospital

• Netherlands employer private-insurer based.


Problems

• Problems stem from Asset Value Problems.• Large Share of Troubled Assets Based on

Mortgages– Assets because flow of payments

• House itself is collateral– Backed by the value of the House


Housing Problems

• Problems stem from Asset Value Problems.• Large Share of Trouble Assets Based on

Mortgages– Assets because flow of payments

• House itself is collateral– Backed by the value of the House


54

Housing Prices More than Doubled in Major Markets, 2000 to 2006. Have fallen back to 150% of 2000 peak


55WSJ 11/12/08


Key Assets Involved

• All were attempts to Spread Risk and Minimize it.– Mortgage Backed Securities (MBS)

• Just like a stock fund• Own a whole group of mortgages

– Collateralized Debt Obligation (CDO)• Fund made up of MBSs

– Credit Default Swaps (CDS)• Insurance on the CDOs


AIG Credit Default Swap

• Goldman owns a CDO and pays insurance premium to AIG to cover CDO

• If bunch of mortgages default and MBS and CDO fall sharply in value, AIG pays Goldman and takes over CDO


Posting Collateral for CDS

• The Big Risk that AIG never Expected with respect to Credit Default Swap

• If AIG’s market value falls, CDS requires that they post collateral to prove that they can cover the CDS.– AIG was so big, no one ever thought that they

would ever have to post collateral

•


The Perfect Storm

• Plenty of Blame to Go Around• Stock Bust early 2000s led People to Invest in

Housing as Asset• Greenspan interest cuts than rises• Increase in Federal Government pressures on

Freddie Mac and Fannie Mae to purchase subprime loans– subprimes from 5 to 20 percent of market


How Did We Get There?

• Change in lending standards• Ratings Agencies Overly Optimistic• Accounting Rules for Regulatory Purposes

– Shifts in Valuing Assets• Move from Book Value to Mark to Market


Was the Problem Deregulation?

• NO.• Nearly all of this occurred in Regulated

Markets.• Fannie and Freddie heavily regulated

• did they control the regulator?

• Credit Default Swaps and CDOs were never regulated– Calls for CDSs and CDOs to be traded on

exchanges might be good idea62Copyright, Price Fishback, April 26, 2012.

Was the Problem Deregulation?

• Repeal of Glass Steagall divided between investment banks and banks?

• Did more to save situation than make it worse.


The Current Economy: From an Economic Historian’s Perspective Price Fishback University of Arizona...

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