What happened to the Financial Sector?

1. What happened to the Financial Sector? • Collapse of many financial institutions • Commercial banks • Investment banks • Insurance companies • Reduction in lending, credit crunch

2. What Happened to the Real Economy? • GDP down • Income down • Consumption and investment down • Wealth down • Real estate • Financial assets • Unemployment up • International recession • International trade down

3. Some Fed Actions • March 2008: Lent $30B to get JPMorgan Chase to buy Bear Stearns • August 2008: Seized Fannie Mae and Freddie Mac • Sept 2008: Let Lehman Brothers fail • Merged B of A with ML • All but nationalized AIG • Converted GS and MS into bank holding companies • Asked Congress to give Treasury $700B to prevent catastrophe.

4. 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

5. On the Other Hand • What 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%

6. Financial Issues • Investment banks • Commercial banks • End of Glass-Steagall • Repealed in 1999 by Gramm-Leach-Bliley Act • Capital standards • Leverage • Derivatives • Opaqueness

7. Derivatives • Exchange-traded • Futures • Options • OTC • Forward contracts • Swaps • Credit default swaps

8. Exchange-Traded Derivatives • Futures: 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 speculate • Speculation is risky

9. OTC Derivatives • Swap: an agreement to one type of payment for another • Bank or other financial institution acts as an intermediary between parties wanting to swap

10. Simple Interest Rate Swap • A has a floating rate $1M loan, LIBOR + 2% • B has a fixed rate $1M loan • A wants to convert to fixed rate loan • B wants to convert to a floating rate loan • Bank arranges a swap

11. Swap Example • A pays 4.25% on $1M monthly for a year to bank • A receives LIBOR on $1M monthly for a year from bank • B pays LIBOR plus .25% on $1M monthly for a year to bank • B receives 4 % on $1M monthly for a year from ban

12. Swap Example • A now has a fixed rate loan • B now has a floating rate loan • Bank makes .50 percent on $1M • No capital requirements • No risk, unless one party does not pay • Or if there is only one party, i.e., if bank is speculating

13. Business Practices • Rapid growth of leverage • Rapid growth of opaque derivatives, such as credit default swaps • Fraud • Poor governance

14. Trends • Falling house prices • Oil price shock • Global recession

15. What Has Been Done? • Fiscal policy • Increase spending • Cut taxes • Monetary policy • Low interest rates • Other actions by the Fed • Fourth branch of government? • In Fed We Trust, David Wessel

16. Some Other Fed Actions • March 2008: Lent $30B to get JPMorgan Chase to buy Bear Stearns • August 2008: Seized Fannie Mae and Freddie Mac • Sept 2008: Let Lehman Brothers fail • Merged B of A with ML • All but nationalized AIG • Converted GS and MS into bank holding companies • Asked Congress to give Treasury $700B to prevent catastrophe.

17. Policy Instruments • Fiscal policy • Monetary policy • Regulation • Other

18. Economic Theory and Policy • Was economic policy based on bad theory? • Should economic models have predicted collapse? • “Where Modern Economic Theory Went Wrong” TheEconomist, July 18, 2009 • Rational expectations • Efficient market hypothesis (EMH) • The Myth of the Rational Market” Justin Fox

19. 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?

20. 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

21. More • “One cannot find good, under-forty economists who identify themselves or their work as ‘Keynesian’ “ Robert Lucas, 1980

22. The Development of Modern Economic Theory • Classical • Keynesian • Monetarism • Rational Expectations • Now what?

23. Classical • Say’s Law • Supply creates its own demand • If there is unemployment, wages fall, employment rises • If there is a surplus of goods, prices fall, sales increase

24. Keynesian Economics • John Maynard Keynes • 1936 General Theory of Employment, Interest and Money • Beginning of macroeconomics (term first used in 1945) • Prices and wages do not fall when there is unemployment or a surplus • Unemployment can persist for a long time • “In the long run, we are all dead”

25. Keynesian Economics • Unemployment is due to low aggregate demand • Fiscal and monetary policy should be used to reduce unemployment • But primary reliance is on fiscal policy • Monetary policy is of limited value in reducing unemployment (pushing on a string)

26. The Ascent of Keynesianism • JFK First president to accept Keynesian Policy • Time The end of the business cycle • RMN “We are all Keynesians now” • But not for long • What happened?

27. Critique of Keynesianism • Not a coherent theory; it depends upon faulty assumptions (Friedman, Phelps) • Political reality prevents effective policy • Knowledge 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’s • Cannot explain events since 1970 • Samuelson et.al. wrong in 1981

28. Critique 2 • Supply side economics • Not all spending has same impact • Tax cuts have more impact • Tax rates affect incentives to supply (work, invest, entrepreneurial activity) • Did Kennedy, Reagan and Bush tax cuts affect demand or supply?

29. Monetarism • Quantity theory of money • Steady, 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”

30. Rational Expectations • Markets clear if left alone • Fiscal and monetary policies cannot stimulate the economy • Such policies cause inflationary expectations and are self-defeating

31. Salt Water v. Fresh Water Economists • Salt Water: Keynesian • Fresh Water: Rational Expectations

32. Financial Theory • Efficient markets? • Irrational behavior? • Bubbles do occur • “In some ways, we behavioral economists have won by default, because we have been less arrogant” Richard Thaler