The Great Recession - College of Business€¦ · The Great Recession Causes, Responses, and...

ECON 463 Spring 2011 1

The Great Recession

Causes, Responses, and Concerns

Elliott Parker, Ph.D.

Professor of Economics

University of Nevada, Reno

Financial Markets are Prone to Market Failure

• Market economies are most efficient when (1) there is competition, (2) everybody knows what they are buying and selling, and (3) external spillover effects are minimal.

• Finance fails on at least two: information and contagion.

• Basic problem: banks are lending somebody else’s money.

• Government insurance (FDIC) and private insurance (CDOs) both lead to moral hazard, excessive risk-taking for short-run profit. Bailouts are just an extreme form of insurance.


Prior Financial Crises

• There have been financial panics in the U.S. even before the

Great Depression: 1816-1819, 1825, 1837, 1857, 1873, 1893,

and 1907. Most resulted in recessions.

• Prior “depressions” included 1837, 1873, 1893, 1907, and

1920-21.

• Government intervention was very limited – there was not

even a central bank until 1913.

Inflation-Adjusted S&P 500 vs. DJIA

0

500

1000

1500

2000

2500

1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Monthly Data

Adjus

ted

Inde

x

The Double Bubble in

the U.S. Stock Market


0

5,000

10,000

15,000

1949

1951

1953

1955

1957

1959

1961

1963

1965

1967

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

Monthly Close

DJI

A /

CP

I

A Longer Look at the DJIA – Adjusting for Inflation

(1949-2009 Monthly Close)

By the 1990s, people came to think rapidly rising stock

prices were normal.

Boom through 1968, stagnation through 1984. Overall, the Dow just kept up with inflation for 40 years.

Rising Oil & Gas Prices

helped pop the bubble


Remember

the Bubble in

NASDAQ?

Remember the

Enron scandal?

Americans forgot.

7

The “Ownership

Society”

Between 1994-2004:

• Est. 15 million new

homes owned,

• 9 million at trend, plus

• 6 million more (5% rise).

• California and Nevada

started catching up to

rest of the country.


Mortgage debt grew

MUCH faster than

either income or

home ownership

First Wave (1950s)

– commercial banks

Second Wave (1980s)

– GSE-guaranteed securities

Third Wave (>2002)

– other mortgage-backed

securities

10


A Major

Cause/Effect

is Household

Spending

Over the last decade:

• a sharp rise in

consumption

• A fall in personal

domestic savings

58%

60%

62%

64%

66%

68%

70%

72%

74%

76%

78%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

U.S. Consumption Share

Consumption

Consumption plus trade balance

Consumption rose to unsustainable levels, and when it came down…


-2%

0%

2%

4%

6%

8%

10%

12%

14%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Real U.S. Investment

(Share of GDP)

Nonresidential Fixed Investment

Residential Investment

Inventories

Investment in new housing also crashed.

This is not likely to recover soon.

Spending as a Share of U.S. GDP

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

110%

1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008

Federal Purchases

State and Local Government Purchases

Private Consumption Spending

Private Investment Purchases

Trade Deficits

Putting them together, we were

spending more than we were producing.


Is another Great Depression likely?

Short Answer: No. Why Not?

• During the Hoover Administration, not only was any desire or effort to

intervene inadequate, the Federal Reserve responded by tightening the

money supply and made it much worse. It also failed to act as lender of last

resort for solvent banks with cash flow problems.

• Deflation resulted. Loans got harder to repay.

• The Gold Standard forced foreign central banks to reduce their money

supplies in response.

• The U.S. and other economies raised tariffs and world trade shrunk, leading

to a downward spiral.

15

Attitudes in 1929Andrew W. Mellon, Hoover’s Treasury Secretary:

- “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.”

- “It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people.”


Assigning Blame? Lots of Choices• Federal government

– – for encouraging more people to buy homes they could not afford and

socializing insurance.

• Fair Housing Act of 1968, Community Reinvestment Act (CRA) of 1977.

Congressman Barney Frank is seen as an advocate of this policy, and

since 2007 chairs House Financial Services Committee.

– – for removing regulations on derivative markets, and easing regulations

on mergers and bank lending practices.

• Senator Phil Gramm, Gramm-Leach-Bliley Act of 1999.

More Choices

• Federal Reserve System – for trusting markets to regulate

themselves.

• Mortgage brokers and lenders – for making bad loans and selling

them off to others.

• Fannie Mae and Freddie Mac – for using implicit government

guarantees to securitize bad loans, and for lobbying federal

government to let them do so.


More people to blame…

• New homebuyers – especially poor people, who bought houses

they could not afford, or who lacked the resources to pay their

mortgages if the economy turned sour.

• Existing homeowners – who used home equity loans to finance

their own consumption.

• Speculators – who bought houses as investments, with the

intent of renting them out and reselling them when prices rose.

19

And more…

• Wall Street firms – for underestimating and/or disguising

actual risks, and not taking responsibility for bad decisions.

• Derivative markets, investment banks, and hedge funds – for

selling insurance without capital requirements, in essence

making bets that they would fail to make good.

• Financial market consolidation – for creating big firms that

put others at greater risk from the effects of bad decisions.

20


Why are Derivatives a Problem?

21

� Insurance markets are regulated to make sure the insurer has adequate capital. Derivative markets are not.

� Derivative markets can be complex, and traders on both sides may not realize what they are doing.

� Derivatives are not transparent, often off-book, and huge.� You don’t have to own the asset to buy insurance on it. This

can leads to pyramiding of side bets. There are also often multiple generations far removed from the asset.

� All insurance markets have problems of moral hazard.

Let’s not forget Hubris.

• Some risks are not diversifiable.


The Federal Reserve chose not to regulate

derivatives or act to prevent bubbles

Alan Greenspan recently testified,

– “I made a mistake in presuming that the self-interests of organizations,

specifically banks and others, were such as that they were best

capable of protecting their own shareholders and their equity in the

firms.”

- Congressional testimony, October 22, 2008

23

0

24

68

1012

1416

1820

22

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

Monthly Data

Per

cent

age

30-Year Mortgage Rate

Prime Lending Rate

Federal Funds Rate

Inflation Rate

Mortgage Rates have been much more

Stable than either Prime or the FFR


Other views• Markets require both buyers and sellers. Mortgage lenders were willing to

lend to people, and people were willing to borrow, without serious

consideration of the risk that the bubble could pop.

• Americans stopped saving to finance higher consumption.

• There are limitations to our ability to see problems and analyze risk.

• Financial markets elsewhere fell for the same illusions.

• Be wary of simple answers or single causes (especially partisan ones). Be

similarly wary of simple philosophies or ideologies that ignore complex

interactions.

Three Questions Answered…

• Why isn’t the economic recovery more robust?

– It’s a depression, dummy. They last a while. Banks stopped lending, and

people stopped building houses. But the economy did not collapse.

• Is inflation a threat?

– No, the bigger concern has been deflation. However, the Fed must be

willing to unwind the monetary base, once banks start lending again.

• Has the overconsumption problem eased?

– Yes, consumption spending plus residential investment has fallen – though

as a nation we are still spending more than we make.


The Great “Balance-Sheet” Recession

• Recessions - less common than they used to be.

• Depressions – much less common, much longer and

deeper than normal recessions.

– A recession caused by a financial crisis

– A “balance sheet” recession: financial wealth collapses,

banks collect reserves to offset bad debt, government

becomes borrower of last resort, deflation and ZIR.

Response #1: Monetary InterventionFederal Reserve authorized:

• Quantitative easing: purchase of government bonds, helped drive yield to zero.

• Purchase of private mortgage-backed securities, central bank currency swaps, target federal funds rate near zero.

• Pushing vs. pulling on a rope. Effectiveness varies.

QE II: a “Hail Mary pass,” preventing deflationary expectations.


Monetary

Base

(Currency

plus Bank

Reserves)

Money

Stock

(M2)


But inflation

hasn’t been a

problem yet!

Low interest rates

and inflation have

increased money

demand.

Worries about Inflation

• Rise in Monetary Base would normally have been inflationary – but deposit expansion multiplier collapsed!

• Primary worry was Deflation, as during the Great Depression.

• M2 has not grown much, no sign of inflation yet.

• A Good Sign – worries have switched.

• Bernanke needs an exit strategy, to reduce reserves when banks start lending again.


Response #2: Bank BailoutsEmergency Economic Stabilization Act:

• $700 billion authorized in October 2008. Only $550B used.

• TARP funds first for purchase of troubled MBS, but changed to an equity purchases approach with executive pay restrictions.

• $270B went to AIG, GM, Wells Fargo, Citigroup, BoA, JPMorgan Chase, Morgan Stanley, and Goldman Sachs.

• $27B went to over 600 banks ($300K-$968M)

• Majority has already been paid back, with interest.

Response #3: Fiscal Intervention

• Economic Stimulus Act of Feb. 2008: – Tax rebates for 2008, estimated $150B cost (about 1% of GDP) in 2008.

• American Recovery and Reinvestment Act of 2009:– Estimated $800B cost over several years, with less than $200B spent in FY

2009, and $400B in FY 2010 (about 3% of GDP).

– About 40% in tax credits, 30% in state fiscal support, and 30% in infrastructure investment (education, energy, health care), and some extended benefit support.

– How effective was this stimulus?


Fiscal Skepticism?• Economists are very skeptical about fiscal policy

working when we are close to full-employment.– Higher real interest rates crowd out investment.

– Higher dollar crowds out exports.

– Higher debt leads to future deficits.

• But we are NOT near full employment, and monetary policy isn’t enough when banks are scared and interest rates are zero.

• What are our choices?

The Federal Deficit and the Debt• The Federal Debt is almost $14T, about our annual GDP ($10T

in 2008, less than $6T in 2000).

• About $8T is held by private, half of that by foreigners.

• The current deficit is temporary due to the recession, but

there are serious structural problems: tax cuts, the growth of

health care costs (i.e., Medicare).

• Borrowing for investment, or in bad times, makes sense.

Borrowing in good times for consumption does not – IBGYBG.


Federal Budget(as a Share GDP)

-20%

0%

20%

40%

60%

80%

100%

120%

1929 1934 1939 1944 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009 2014 2019

Annual Data (Actuals through 2008)

Sha

re o

f GD

P

Federal Expenditures

Federal Revenues

Federal Savings

Federal Public Debt


Was it Worth it?• The total economic loss from the Great Depression was perhaps

120% to 140% of 1929 GDP, worth about $20 Trillion now.

• The total economic loss from the 1980-1983 recessions was 15% to 17% of 1979 GDP, about $2.4 Trillion now.

• If $800 million in stimulus could prevent half of this latter decline, then it would be a very good investment.

• If it led us to decline 2.5% instead of 5.0%, it has paid for itself.

• But we don’t KNOW what would have happened without it.

Federal Budget and the U.S. Economy(as a Share of 1950-2000 Trend GDP)

-20%

0%

20%

40%

60%

80%

100%

120%

140%

1929 1934 1939 1944 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009 2014 2019

Annual Data (Actuals through 2008)

Sha

re o

f 195

0-20

00 T

rend

GD

P

Federal Expenditures

Federal Revenues

Federal Savings

GDP

Federal Public Debt


We are at a turning point…• Our government debt is large, and growing, but not yet

unsustainable. Will the current deficit be temporary or permanent?

• Our economic trajectory is not sustainable. We can’t keep our spending growing faster than our income, and depending on other countries to keep financing that spending.

• Similarly, many countries with high savings rates have seen us as an export market driving their growth AND a place to invest their savings.

How do we escape?

• Time – there is still significant deleveraging that still needs to occur. Housing prices must also stabilize.

• Confidence – consumers and investors no longer are as worried that we are in freefall.

• Restructuring – high consumption with trade deficits/foreign borrowing is not sustainable.

• Policy – difference between short-term intervention and long-term growth strategies.


Fifty Herbert Hoovers• State and local governments are often ignored in the analysis.

• SLGs purchase more goods and services, and employ more

people, than the federal government.

• Most SLGs have balanced budget requirements, which means

they must either cut spending or raise taxes during recessions.

• SLG financial crises lag the rest of the economy.

• Estimates: cuts to SLG lead to twice the fall in GSP the next year.

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

1929 1933 1937 1941 1945 1949 1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009

Government Purchases of Goods and Services

(Share of GDP)

Federal Purchases

SLG Purchases


Spending cuts have more

effect than tax increases.

It should therefore be no

surprise that when SLGs

are cutting as the Feds

are spending, the

economy does not

recover very fast.

What are the Implications for Nevada?• Gaming was a sustainable model, until monopoly ended.

• Las Vegas maintained growth by building new properties, but gaming/hotels/tourism still a falling share of state economy.

• Rapid construction was not sustainable: building homes for other construction workers, dependent on California bubble.

• Low educational attainment: supply and demand.

• Relatively undiversified economy: little public investment.

• State and local government revenues reliant on gaming tax, narrow-based sales tax.


Inflation-Adjusted Housing Price Index

0

100

200

1980 1984 1988 1992 1996 2000 2004 2008Quarterly FHFA Data

1980

= 1

00

USA Average

Nevada

California

- 16%

- 49%

- 37%

Nevada lagged California, and our initial housing stock was smaller.

They came here looking for deals.

Our construction sector was the country’s largest.

Underwater mortgages:�USA 23%�CAL 33%�NEV 66%

Personal Income Growth Rate

-10%

0%

10%

20%

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

USA

California

NevadaNevada was the fastest-growing state.

We became the fastest-falling economy (a net decline of 7.2%)


Because of its reliance on construction and gaming, Nevada’s economy declined more than any other state. We went from richer (mean, not median) to poorer.

Nevada’s unemployment rate became highest in the nation – and is only falling now because people are exiting the workforce, and the state.


What are the Global Implications?• Much of the savings being lent to Americans came from

foreign sources.

• Housing bubbles occurred in dozens of countries.

• Many foreign banks engaged in the same practices as U.S. firms.

• Markets for derivatives are often offshore.

• Foreign markets rely on exports to American consumers.

Real Direct Exchange Rates

0.6

0.7

0.8

0.9

1.0

1.1

1.2

1.3

1.4

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Monthly Data

Initi

al P

erio

d=1.

0

RMB Euro Pound


REER(Indirect)

U.S. International Trade

-10%

-5%

0%

5%

10%

15%

20%

1947.1 1951.1 1955.1 1959.1 1963.1 1967.1 1971.1 1975.1 1979.1 1983.1 1987.1 1991.1 1995.1 1999.1 2003.1 2007.1

Quarterly BEA Data

Sha

re o

f GD

P

Exports

Imports

Trade Balance


Balancing the Trade Deficit?• GDP is currently $15 trillion per year.

• Exports are currently $2.0 trillion per year (13%), Imports are

$2.6 trillion (17%).

• If short-run elasticities are roughly 0.5, any depreciation of Dollar

will increase the trade deficit since imports > exports.

• If one-year elasticities are roughly 1.0, a real depreciation of 30%

would lead to a trade surplus.

• Income elasticities matter too – will we grow faster than others?

What about our External Wealth?

• At end of 2009, we owned $18.4 trillion, and owed $21.1

trillion, a net liability of $2.7 trillion.

• A 30% depreciation of the Dollar would create a valuation

effect on our foreign assets of $5.5 trillion, converting our

external wealth into a net positive 2.8 trillion.

• Our foreign liabilities are denominated in Dollars.

• So what is the problem?


Real GDP

has not

been

keeping up

with its

trend.

$0

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

$14,000

$16,000

$18,000

1947 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007


What about Risk?• The U.S. Government lacks the political will to balance the budget:

Republicans won’t allow tax increases even though we pay a lower share of

federal taxes than anytime since 1949. Democrats won’t allow cuts to

Medicare even though medical costs keep skyrocketing.

• If the U.S. debt keeps growing faster than the U.S. economy (the real issue),

this may lead markets to fear our government bonds are no longer safe.

Defaulting on the debt would ensure this.

• Our risk premium would rise, increasing interest rates and slowing

investment. Trade deficits would become much harder to finance.

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