Economics 435The Financial System

Lecture 19/2/2014

Instructor: Prof. Menzie ChinnUW Madison

Fall 2014

Administrative Issues

• Course website: http://www.ssc.wisc.edu/~mchinn/web435_f14.html

• OH: TuTh 1-2, 7418 Soc Sci• Textbook: Chinn/Frieden, Lost Decades• Cecchetti/Schoenholtz, or Mishkin• Additional Readings: from web,

Econbrowser, CBO• NYT, FT, WSJ, Economist

Administrative Issues• Grading: 10% PS, 50% 2×MT, 40% paper• Dates:

- MT on 10/14, 11/20- Paper due on Fri, 12/11

• Make-ups: None. Points are re-allocated if you have a legitimate excuse. No late assignments accepted (must be handed in during lecture)

Outline

• The Financial Crisis of 2008-09• The Great Recession of 2007-09 and the

slow recovery• Extraordinary monetary policies• Europe

Risk and Crisis

Motivating Questions• Why did the financial crisis occur?• Was it all financial?• How did financial problems get transmitted

to the real side?• What are the similarities and differences

between the past episodes (e.g., the 1929 crash) and this crisis.

Government and national borrowing

Note: Fed. Budget balance is net lending. Source: BEA

-.12

-.10

-.08

-.06

-.04

-.02

.00

.02

70 75 80 85 90 95 00 05 10

Budget balanceto GDP ratio

Current accountto GDP ratio

Real interest rates

Source: Federal Reserve Board, Philadelphia Fed SPF

-4

0

4

8

12

16

70 75 80 85 90 95 00 05 10

Ten year Treasuryyields, %

Ten year TIPSyields, %

Ten year Treasuryyields minus exp'd infl., %

The “Disappearance” of Risk

Source: IMF, WEO update, 11/6/08

Household debt (I)

Source: BIS, Annual Report (2011)

50

60

70

80

90

100

110

120

2000 2001 2002 2003 2004 2005 2006 2007 2008

US

GreatBritain

Ireland

Spain

Household debtto GDP (BIS)

Household debt (II)

Source: BIS, Annual Report (2011)

60

70

80

90

100

110

2000 2001 2002 2003 2004 2005 2006 2007 2008

US

Germany

Japan

Household debtto GDP (BIS)

Housing boom (I)

0.8

1.0

1.2

1.4

1.6

1.8

2.0

00 01 02 03 04 05 06 07 08 09 10 11

US

GreatBritain

Ireland

Spain

Real residentialprices (BIS)

Note: Rescaled to 2001Q4=1. Source: BIS, Annual Report (2011)

Housing boom (II)

0.7

0.8

0.9

1.0

1.1

1.2

1.3

1.4

1.5

00 01 02 03 04 05 06 07 08 09 10 11

US

Germany

Japan

Real residentialprices (BIS)

Note: Rescaled to 2001Q4=1. Source: BIS, Annual Report (2011)

Leverage (as of 2007)

0

5

10

15

20

25

30

Comm. Savings Credit Brokers/ GSEsbanks banks unions hedge funds

Average

Asse

ts a

s a

Mul

tiple

of C

apita

l

Source: Greenlaw, Hatzius, Kashyap, and Shin (2008)

Boom and Bust in the Shadow Financial System

Source: Federal Reserve Board

Leading to Recession/Depression

Source: BEA, 2012Q3 3rd release, CBO (Aug. 2012), WSJ

14,000

14,500

15,000

15,500

16,000

16,500

17,000

17,500

18,000

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

GDP,bn Ch.09$SAAR

CBO potentialGDP (Feb 2014)

CBO potentialGDP (Aug 2014)

Actual

CBO f'cast

Consumption and Wealth

Source: BEA, 2014Q2 2nd release, Fed Flow of Funds

8.6

8.7

8.8

8.9

9.0

9.1

9.2

9.3

9.4

10.0

10.2

10.4

10.6

10.8

11.0

11.2

11.4

11.6

90 92 94 96 98 00 02 04 06 08 10 12

Consumption,SAAR[left scale]

Householdnet worth[right scale]

In logs,in bn. Ch09$

Investment

Source: BEA, 2013Q3 3rd release

9.0

9.1

9.2

9.3

9.4

9.5

9.6

9.7

6.8

7.0

7.2

7.4

7.6

7.8

8.0

8.2

90 92 94 96 98 00 02 04 06 08 10 12

GDP[left scale]

Fixed investment[right scale]

In logs,bn. Ch09$SAAR

Conventional Monetary Policy

Source: St. Louis Fed FRED system

0

2

4

6

8

10

12

90 92 94 96 98 00 02 04 06 08 10 12 14

Fed fundsThree monthTreasurys

Ten yearTreasurys

BAA

Quantitative Easing, Operation Twist

http://www.clevelandfed.org/research/data/credit_easing/index.cfm

The Other Side of the Fed Balance Sheet

http://www.econbrowser.com/archives/2012/08/us_monetary_pol.html

Policy Uncertainty

Source: Policy Uncertainty, http://www.policyuncertainty.com

Europe

ECB Drives Down Sovereign Yields

0

5

10

15

20

25

30

2007 2008 2009 2010 2011 2012 2013

Germany

Ireland

Greece

SpainFrance

Italy

Portugal

Ten yeargov't bondyields, %

OMTformallyannounced

Source: ECB

The Current Puzzle

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

-.02

.00

.02

.04

.06

.08

.10

.12

.14

.16

70 75 80 85 90 95 00 05 10

Federal debtheld by public,to GDP ratio[left scale]

Ten yearTreasurys[right scale]

TIPS

Ten yearminus exp'dinflation