Using macro to understand the current recession
Let’s analyze the history of the recession to illustrate some of the major macro issues/tools
Underlying forces:1. Increasing leverage with lower perceived risks2. The housing bubble and …. not “pop” but “hissssssss”3. A “run on the shadow banks” and the Lehman bankruptcy4. The crash in asset prices in 20085. Huge decline in wealth, leading to declining housing I and
C.6. International transmissions7. IS-MP curve interpretation8. Liquidity trap!9. Governmental response in monetary and fiscal policies10. The trough in late 200911. The long stagnation is still with us ….
2
Trends in volatility of US stock prices
4
Note: Implied volatility is a measure of the equity price variability implied by the market prices of call options on equity futures. Historical volatility is calculated as a rolling 100-day annualized standard deviation of equity price changes. Volatilities are expressed in percent rate of change. VIX is CBOE index.
Historical lows
Leveraging the US economy
5
0
1
2
3
4
5
0
2
4
6
8
10
1930 1940 1950 1960 1970 1980 1990 2000 2010
Total financial assets/ KTotal financial assets/ GDP
Source: Federal Reserve flow of funds data.
Rising leverage of US economy
The housing price bubble
7
1. Rising perceived wealth of households 1995-2006.
2. Then catastrophic loss of wealth 2006-2009
3. Stabilized in last four years
0.4
0.5
0.6
0.7
0.8
0.9
1.0
1.1
1.2
86 88 90 92 94 96 98 00 02 04 06 08 10 12
Case-Shiller housing price index (CPI corrected)
12
-18,000
-16,000
-14,000
-12,000
-10,000
-8,000
-6,000
-4,000
-2,000
0
2007Q1 2008Q1 2009Q1 2010Q1 2011Q1 2012Q1
Loss of Household Wealth in Recession(billions of 2005$)
Housing
Net worthWealth loss of
$16 trillion ($140,000 per household)
The impact on households and consumption
13
-20,000
-16,000
-12,000
-8,000
-4,000
0
4,000
8,000
12,000
-300
-200
-100
0
100
200
300
400
500
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Change in new worthChange in consumption
Dot.combubble
Housing burstand financialmeltdown
Bank runs
Series of bank runs.Different from earlier (Depression era) because was
the run by large depositors (run on the repo).Bear Stearns and Lehman were wiped out in a week.
14
The Lehman Bankruptcy
A central event in the crisis.Market fundamentalists worried that continued bailouts
would lead to “moral hazard” and worse future problems.
So on September 15, 2008, government decided to let Lehman go bankrupt.
Catastrophic results:- markets froze up (people could not make transactions)- stock market went down 30 % in a month and US dollar ROSE almost 20 %.- “market fundamentalism lasted only 36 hours” - then bailout of AIG, Citibank, BofA, TARP, GM, etc.
“An economy in free fall” in late 2008.
16
Risk on Mature Govt Debt (US, etc.)
17CDS = risk that security will default. These are US and similar Treasury bonds!
A risk measure on commercial paper
18
Source: Federal Reserve page on commercial paper. These are short-term promissory note or unsecured money market obligation, issued by prime rated commercial firms and financial companies. This shows medium-grade (A2/P2) minus top grade (AA).
Policymakers respond
Panic of 2008: Financial markets hysterical; paranoia everywhere about who was responsible and who should pay.
Bush/Paulson: reluctantly saw that financial markets were freezing up (Bernanke key to understanding this).
TARP: Started as buying toxic assets, then saw the light and recapitalized banks.
19
Impact of Credit Crunch on Investment
21
.10
.11
.12
.13
.14
.15
.16
.17
.18
5.5
6.0
6.5
7.0
7.5
8.0
8.5
9.0
9.5
2005 2006 2007 2008 2009 2010
Investment/ Potential GDPBaa bond rate
Creditcrisis
22
0.84
0.88
0.92
0.96
1.00
1.04
1.08
1.12
2000 2002 2004 2006 2008 2010 2012
Actual/potential industrial production
Effect on output
22
Lehman
Bear
Macroeconomic impacts
Rewrite augmented IS and MP curves as follows:
IS: Y = C(Y,W) +I(rb) + G + NX(Y,Yw)
Y = C(Y,W) +I(i - π + σ) + G + (X – M)
MP: i = f(Y, π)
rb = risky real rate = i - π + σ, where σ is the risk premium
Have adverse IS shifts to W, σ, and NX from Yw
Fed lowers i in standard manner, but real interest rate for businesses goes up!
MP = Taylor rule
23
iff
Y
IS(i ff - π + low risk premium)
i*
MP
2008
After financial crisis
IS’(i ff - π + high risk premium)
Unconventional Fed Measures: the Fed Balance Sheet
28
Treasuries = normal stuff!; CPLF = commercial paper funding facility; MBS = mortgage-backed securities
Fiscal Policy in the Liquidity Trap:Components of US stimulus legislation
33Source: CBO, presentation of Elmendorf, June 2009
CBO’s estimate of impact of stimulus on economy
36Source: CBO, presentation of Elmendorf, June 2009.
CBO’s estimate of impact of stimulus on economy
37Source: CBO, presentation of Elmendorf, June 2009.
Actual
Lessons on the recent financial crisis• Even with modern macro, globalized mature
market economies are subject to major risks; business cycles have not disappeared.
• We are unlikely to reach full employment before 2016.
• Financial systems are inherently fragile because of their maturity and liquidity transformation (K to M).
• Markets cannot manage themselves.• The liquidity trap is a particularly nasty outcome
because monetary policy weak and fiscal policy hampered by large deficits.
• The US benefitted from wise leadership this time. It could have been much worse. 38