What happened to the Financial Sector?Collapse of many financial institutions

Commercial banksInvestment banksInsurance companies

Reduction in lending, credit crunch

What Happened to the Real Economy?GDP downIncome down

Consumption and investment downWealth down

Real estateFinancial assets

Unemployment upInternational recessionInternational trade down

Some Fed ActionsMarch 2008: Lent $30B to get JPMorgan Chase

to buy Bear StearnsAugust 2008: Seized Fannie Mae and Freddie

MacSept 2008: Let Lehman Brothers failMerged B of A with MLAll but nationalized AIGConverted GS and MS into bank holding

companies Asked Congress to give Treasury $700B to

prevent catastrophe.

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

On the Other HandWhat 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%

Financial IssuesInvestment banks Commercial banksEnd of Glass-Steagall

Repealed in 1999 by Gramm-Leach-Bliley ActCapital standardsLeverageDerivativesOpaqueness

DerivativesExchange-tradedFutures OptionsOTC Forward contractsSwapsCredit default swaps

Exchange-Traded DerivativesFutures: 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 speculateSpeculation is risky

OTC DerivativesSwap: an agreement to one type of payment

for anotherBank or other financial institution acts as an

intermediary between parties wanting to swap

Simple Interest Rate SwapA has a floating rate $1M loan, LIBOR + 2%B has a fixed rate $1M loan A wants to convert to fixed rate loanB wants to convert to a floating rate loanBank arranges a swap

Swap ExampleA pays 4.25% on $1M monthly for a year to

bankA receives LIBOR on $1M monthly for a year

from bankB pays LIBOR plus .25% on $1M monthly for

a year to bankB receives 4 % on $1M monthly for a year

from ban

Swap ExampleA now has a fixed rate loanB now has a floating rate loanBank makes .50 percent on $1MNo capital requirementsNo risk, unless one party does not payOr if there is only one party, i.e., if bank is

speculating

Business PracticesRapid growth of leverageRapid growth of opaque derivatives, such as

credit default swapsFraudPoor governance

TrendsFalling house pricesOil price shockGlobal recession

What Has Been Done?Fiscal policy

Increase spendingCut taxes

Monetary policyLow interest rates

Other actions by the FedFourth branch of government?In Fed We Trust, David Wessel

Some Other Fed ActionsMarch 2008: Lent $30B to get JPMorgan Chase

to buy Bear StearnsAugust 2008: Seized Fannie Mae and Freddie

MacSept 2008: Let Lehman Brothers failMerged B of A with MLAll but nationalized AIGConverted GS and MS into bank holding

companies Asked Congress to give Treasury $700B to

prevent catastrophe.

Policy Instruments Fiscal policyMonetary policyRegulationOther

Economic Theory and PolicyWas economic policy based on bad theory?Should economic models have predicted

collapse?“Where Modern Economic Theory Went

Wrong” The Economist, July 18, 2009Rational expectationsEfficient market hypothesis (EMH)The Myth of the Rational Market” Justin Fox

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?

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

More“One cannot find good, under-forty

economists who identify themselves or their work as ‘Keynesian’ “ Robert Lucas, 1980

The Development of Modern Economic TheoryClassicalKeynesianMonetarismRational ExpectationsNow what?

ClassicalSay’s LawSupply creates its own demandIf there is unemployment, wages fall,

employment risesIf there is a surplus of goods, prices fall, sales

increase

Keynesian EconomicsJohn Maynard Keynes1936 General Theory of Employment,

Interest and MoneyBeginning of macroeconomics (term first

used in 1945)Prices and wages do not fall when there is

unemployment or a surplusUnemployment can persist for a long time“In the long run, we are all dead”

Keynesian EconomicsUnemployment is due to low aggregate

demandFiscal and monetary policy should be used to

reduce unemploymentBut primary reliance is on fiscal policyMonetary policy is of limited value in

reducing unemployment (pushing on a string)

The Ascent of KeynesianismJFK First president to accept Keynesian

PolicyTime The end of the business cycleRMN “We are all Keynesians now”But not for longWhat happened?

Critique of KeynesianismNot a coherent theory; it depends upon faulty

assumptions (Friedman, Phelps)Political reality prevents effective policyKnowledge 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’sCannot explain events since 1970Samuelson et.al. wrong in 1981

Critique 2Supply side economicsNot all spending has same impactTax cuts have more impactTax rates affect incentives to supply (work,

invest, entrepreneurial activity)Did Kennedy, Reagan and Bush tax cuts affect

demand or supply?

MonetarismQuantity theory of moneySteady, 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”

Rational ExpectationsMarkets clear if left aloneFiscal and monetary policies cannot stimulate

the economySuch policies cause inflationary expectations

and are self-defeating

Salt Water v. Fresh Water EconomistsSalt Water: KeynesianFresh Water: Rational Expectations

Financial TheoryEfficient markets?Irrational behavior?Bubbles do occur“In some ways, we behavioral economists

have won by default, because we have been less arrogant” Richard Thaler