20100913+slides - Economics 1: Fall 2010 J. Bradford...

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Unformatted text preview: Economics 1: Fall 2010 J. Bradford DeLong, Michael Urbancic, and a cast of thousands... hAp://delong.typepad.com/econ_1_fall_2010/ Economics 1: Fall 2010: The Housing Bubble, the Crash, and the Downturn J. Bradford DeLong September 13, 2010, 12 ­1 Wheeler Auditorium, U.C. Berkeley The Employment ­to ­PopulaQon RaQo, Seasonally Adjusted Associated with Fall ­Offs in the Pace of Spending Ladies and Gentlemen, to Your i>Clickers... •  The three types of financial excess demand are excess demand for (a) liquid cash money; (b) bonds (i.e., savings ahead of investment); (c) safety (i.e., demand for high ­quality assets) •  Which sects of economists focus on excess demands for money, for bonds, and for safety, respecQvely? –  –  –  –  –  A. Keynesians, Monetarists, and Wicksellians B. Monetarists, Keynesians, and Minskyites C. Wicksellians, Austrians, and New Classicals D. Real Business Cycles, Keynesians, and Monetarists E. Monetarists, Keynesians, and Credit ­Channelers Keynesians and Monetarists •  Keynesians: people aren’t spending because they want to save more: 2002 –  –  –  –  –  –  •  An excess demand for bonds So people try to switch spending from currently ­produced goods and services to bonds And so employment and producQon in currently ­produced goods and services industries fall With nothing (potenQally) to pick up the slack RepresentaQve members: Knut Wicksell, John Maynard Keynes (in some of his moods), John Hicks, James Tobin Cures: •  •  •  Government spend (and issue bonds to finance it) Businesses decide to invest more (and issue bonds to finance it) Foreigners buy more exports (and borrow—issue bonds—to finance it) People aren’t spending because they want to hold more liquid cash money: 1982 –  –  –  –  –  –  An excess demand for cash So people try to switch spending from currently ­produced goods and services to build up their cash And so employment and producQon in currently ­produced goods and services industries fall With nothing (potenQally) to pick up the slack RepresentaQve members: John Stuart Mill, Irving Fisher, John Maynard Keynes (in some of his moods), Milton Friedman Cures •  •  Central bank buy government ­bonds for cash Banks accept more deposits Minskyites •  People aren’t spending because they want to build up their holdings of high ­quaity safe assets: today –  An excess demand for AAA assets –  So people try to switch spending from currently ­produced goods and services to building up their safe asset holdings –  And so employment and producQon in currently ­produced goods and services industries fall –  With nothing (potenQally) to pick up the slack –  RepresentaQve members: Walter Bagehot, John Maynard Keynes (in some of his moods), Hyman Minsky, Charles Kindleberger, Ben Bernanke, Ricardo Caballero –  Cures: •  Ease the panic—reduce market demand for high ­quality assets by restoring the confidence and the risk ­bearing capacity of the market •  Have the government buy up risky assets and transform them into safe ones— if people trust the government’s promises Keynesians and Monetarist Cures? •  The Monetarist cures –  Have the central bank sell (safe) government bonds for cash •  This does nothing... –  Have banks extend themselves and accept more deposits •  But will the deposits be regarded as safe? •  The Keynesian cures –  Have the government spend more •  But will this undermine confidence in the safety of the government’s liabiliQes? –  Induce private businesses to spend more on investment goods and issue bonds •  But the bonds aren’t safe assets Minskyite Cures •  “Lend freely on collateral good in normal Qmes...” –  Have the government buy up risky assets in exchange for its own safe promises •  Fiscal policy •  Banking policy •  Non ­standard monetary policy –  Create expectaQons of a liAle inflaQon? •  NaQonalizaQons •  But only as long as people trust the government: Austria 1931; Greece today •  “But at a penalty rate...” –  Make those who caused the problem—who issued the assets formerly regarded as safe and now regarded as risky—are very sorry •  Shareholders and managers of Bear Stearns, Lehman Brothers, AIG... How Are We Doing? •  BeAer than we might be: –  The Alan Blinder ­Mark Zandi baseline: what if the government had done nothing? –  Then unemployment would probably be at 16% right now –  Rather than 9.6% •  Not enough: –  Unemployment is, when the economy is running smoothly, at 4 ­6% –  Not at 9.6% –  And not looking like it is stuck at 9.6% for quite a while to come Ladies and Gentlemen, to Your i>Clickers... •  Why does the monetarist cure—the central bank buys short ­term government bonds for cash—for a Minskyite downturn fail? –  A. It doesn’t increase the liquid cash money in people’s pockets. –  B. It doesn’t do anything to bring planned savings down to the level of investment. –  C. It doesn’t increase the inadequate supply of safe high ­ quality assets that is the big problem. –  D. It does nothing to increase the confidence of investors and shrink their demand for safe high ­quality investments. –  E. The right way to deal with a Minskyite downturn is for the government to step back and let it burn itself out. How Did We Get Here? •  Why is there, all of a sudden, a big excess demand for safe high ­quality assets? –  Why do people want to hold more? –  Why all of a sudden is there less for people to hold? •  People want to hold more for very logical reasons: –  There is a depression –  There is a big downturn –  There is a financial crisis •  Why all of a sudden is there less for people to hold? –  Because there were a whole bunch of assets around that people thought were “safe,” “high quality,” “AAA” –  And they weren’t –  And people recognized that they weren’t Mortgages •  Banks that make mortgages in their areas –  But what if something bad happens to the local real estate market? –  The U.S. government—Fannie Mae—will buy up “conforming” mortgages (20% down, stable income, low principal, appraised value) and take on the risk –  But what about the others? •  Making “subprime” loans too risky to be a big business Mortgage ­Backed SecuriQes •  So let us take a huge number of mortgages from all over the country •  Let us mix them together •  And let’s divide them into five Tranche 1: the first 20% of payments: super, super, super safe Tranche 2: the next 20% of payments: super, super safe Tranche 3: the next 20% of payments: super safe Tranche 4: the next 20% of payments: safe unless there is a big naQonwide housing downturn—which there never has been –  Tranche 5: risky –  – –  –  Financial Engineering •  You have taken a whole bunch of non ­conforming mortgages that are too risky for banks or insurance companies, etc., to hold... •  And you have turned them into five piles—one of which (T5) is risky, one of which (T4) is safe unless there is a big naQonwide housing downturn, and three of which are safe no maAer what... •  Or so your calculaQons show... ImplicaQons of Financial Engineering •  A whole bunch of people who could not afford to buy houses can afford to buy houses •  Especially if they think that the price of housing is unlikely to go down •  Especially if interest rates are historically low for other reasons •  Kindleberger: –  “There is nothing so disturbing to one’s well ­being and judgment as to see a friend get rich...” –  When the number of firms and households indulging in these pracQces grows large, bringing in segments of the populaQon that are normally aloof from such ventures, speculaQon for profit leads away from normal, raQonal behavior to what has been described as "manias" or "bubbles." The Housing Bubble The Dot ­Com Bubble Why the Difference? •  The dot ­com bubble –  SecuriQes held by venture capitalists –  By rich investors –  As part of the porrolios of large mutual funds –  By individuals •  Prices fall—but everybody knew these securiQes were risky anyway •  The housing bubble –  SecuriQes supposed to be distributed –  But they weren’t •  The originate ­and ­distribute model was broken •  “But they are ‘AAA’!” –  That you convinced Moody’s to rate them AAA does not mean that they are AAA –  And so all the debts of all the organizaQons that held MBSs became suspect The Financial Accelerator •  DeLong’s reasoning in March 2008: –  5M houses that should not have been built in the desert between Los Angeles and Albuquerque –  $100K in mortgage debt that will not be paid and has to be eaten by somebody –  Hence a $500B financial loss •  But the dot ­com crash was a $3T financial loss •  And that pushed the unemployment rate up by only 1½% •  The market’s reasoning: –  There is $500B in losses that we know of –  And all the trained professionals who assured us that these were safe •  Lied, or •  Don’t understand the world –  Therefore we need to dump our risky assets—at any price—and buy safer ones—at any price •  Very limited supply of truly safe assets •  At trough, global value of financial wealth down from $80T to $60T Ladies and Gentlemen, to Your i>Clickers... •  What is the principal source of our current downturn? –  A. A government that made too many mortgage loans –  B. A sudden rush for cash on the part of households that created an excess demand for money. –  C. A sudden fall in perceived wealth on the part of households that led them to cut back on spending and try to save more by buying more bonds. –  D. A great fear on the part of investors that every single private asset in the world economy was much, much riskier than they had thought. –  E. A failure of the government to properly regulate the financial sector, especially derivaQves like mortgage ­backed securiQes, to make sure that bankers were not fooling themselves and everybody else into thinking that risky assets were safe. Where Were the Regulators? Is Financial DeregulaQon a Good Idea? •  Probably not •  Milton Friedman, “A Program for Monetary Stability” –  If you promise your depositors/creditors that they can get their money quickly –  And if you promise your depositors/creditors that their money is safe –  And if there is any chance at all that this promise creates “systemic risk” –  Then you should be regulated so Qghtly that you can only invest in U.S. Treasury bonds •  John Maynard Keynes, “General Theory of Employment, Interest, and Money” –  Perhaps all investments should be long ­term and indissoluble—like a marriage... Lots of Blame •  Clinton administraQon: repeal of Glass ­Steagall –  Depression law separaQng government ­guaranteed commercial banks from other investment banks –  Actually, not a cause of the problem... •  Big failures: Lehmann, Bear Stearns, AIG; near failures: CiQ, BofA, Morgan Stanley, Goldman Sachs •  Clinton administraQon: don’t regulate derivaQves –  The CFTC the wrong place to regulate... –  A small market: not a big issue... •  Federal Reserve: value in exploring new models of providing credit –  And who am I, Alan Greenspan asked, to tell lenders who want to lend that they cannot lend to borrowers who want to borrow? –  UnderesQmaQng the seriousness of the situaQon •  Bush administraQon: deregulaQon is best •  Bush administraQon: the people on Wall Street are much beAer at assessing and managing risks than we are –  And their personal fortunes are at risk Ladies and Gentlemen, to Your i>Clickers... •  How fragile was our financial system? –  A. So fragile that every single large bank in the United States— Bear Stearns, Lehman Brothers, AIG, Fannie, Freddie, Goldman Sachs, Morgan Stanley, CiQgroup, BofA, Wells Fargo, JPMorganChase, Wachovia, WaMu, and a host of others—would now be bankrupt were it not for the TARP and other government financial rescue packages. –  B. PreAy solid: in spite of the enormous financial turmoil only three very large firms—Bear Stearns, Lehman Brothers, and AIG —have gone bankrupt –  C. So fragile that a $500B loss in mortgage lending could trigger a $20T global decline in the value of financial assets. –  D. So fragile that a $3T financial loss with the collapse of the dot ­com bubble could trigger a near Great Depression. Same Hairdresser? Ladies and Gentlemen, to Your i>Clickers... •  How many people think this lecture went... –  A. Too fast? –  B. Too slowly? –  C. Just right? Ladies and Gentlemen, to Your i>Clickers... •  Which are the least important things to know from this secQon of the course? –  A. That John Stuart Mill’s hairdo looks like Princess Leia’s, and that most of the Qme Say’s Law—the supply creates its own demand—works reasonably well. –  B. JSM’s hairdo, and the three ways to break Say’s Law— excess demand for money, for bonds, and for safety –  C. The monetarist and Keynesian ways to cure economic downturns –  D. The Minskyite and monetarist ways to cure economic downturns –  E. The origins of our current Minskyite crisis in the housing bubble and in financial deregulaQon, and JSM’s hairdo. Test Your Knowledge •  Why were bankers so eager to hold the AAA ­ rated MBS created by other bankers? Didn’t they know how their own originaQon departments created MBS? •  Why did $500B of losses in mortgage loans trigger a $20T decline in global financial asset values? •  Why did we fear at the end of 2007 that the “monetarist’ remedy of expansionary open market operaQons would not be enough to keep the economy on an even keel? Economics 1: Fall 2010: InflaQon Economics J. Bradford DeLong September 13, 2010, 12 ­1 Wheeler Auditorium, U.C. Berkeley InflaQon Economics •  Y = (M/P) • V •  P = (M • V)/Y •  And let us say Y = Y*, the economy is at full employment –  Or near full employment: there is some wiggle room—overQme, extra vacancies, etc.... •  So what happens when something boosts M or V? –  P = (M • V)/Y* The Phillips Curve π: inflaQon Eπ: expected inflaQon: (P(t) ­P(t ­1))/P(t ­1) = π(t) u: unemployment rate u*: the “natural” rate of unemployment, the NAIRU •  π = Eπ + β(u*  ­ u) •  •  •  •  •  The Phillips Curve II •  π = Eπ + β(u*  ­ u) •  Usually Eπ will be just what inflaQon was last year –  SomeQmes not –  President MiAerand of France at the start of the 1980s •  Usually u* will be very stable (say, 5% in the U.S. today) –  SomeQmes not: varieQes of “structural” unemployment The Phillips Curve: The 1950s The Phillips Curve: The 1960s The Phillips Curve: The 1970s The Phillips Curve: The Early 1980s The Phillips Curve: From the Late 1980s Test Your Knowledge •  What happens to the quanQty equaQon Y = (M/P) • V when you are at “full employment”, when Y = Y*? •  Why does the Phillips Curve slope down? •  What is the natural rate of unemployment u*? •  How many significant shi~s in inflaQon expectaQons have there been in the post ­ WWII U.S.? •  When did they occur? Ladies and Gentlemen, to Your i>Clickers... •  Which Star Trek movie grossed the most, controlling for inflaQon? –  A. Star Trek: The MoQon Picture –  B. Star Trek (2009) –  C. Galaxy Quest –  D. Star Trek II: The Wrath of Kahn –  E. Star Trek IV: Star Trek at the Monterey Acquarium ...
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