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Financial Crisis on

Infinite Earths: TheGreat Recession of

2007-2009

John VoorheisECON 479

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"The job of financial sector regulator is suddenly akin to joining the Justice League, or maybe the G.I.Joes. You're containing the maniacs who could destroy the world economy."

- Ezra Klein, "Will Regulation Work When We Stop Wanting It?," Washington Post Online, 6/19/2009.

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Financial Crisis on Infinite EarthsECON 479John Voorheis

On September 15, 2008, Lehman Brothers, the fourth largest investment bank in the United

States, filed for Chapter 11 bankruptcy. In the weeks that followed, there was a very real sense that the

US economy was on the verge of collapse. It was at this point that the 2008-9 recession, which had

been until then chiefly a financial crisis, broke out from the financial sector into the real economy. This

recession, it now seems, is not like other recessions. Its origins are multitude, its future uncertain, its

pattern atypical. This paper is an attempt to put forth a unified theory of the 2008-9 recession, in seven

parts - the current recession in historical context; the origins and evolution of the financial crisis; policy

options and outcomes for addressing the financial crisis; economic analysis of the recession's impact on

a variety of sectors; monetary policy responses and outcomes; fiscal policy responses and outcomes;

and the outlook for future growth. The current recession, we will see, was caused by a perfect storm of

deliberate malfeasance, lax regulation, laziness exhibited by over-reliance on quantitative models, an

exaggerated self-regard on the part of the "masters of the universe," an unwillingness to address a

growing speculative bubble, and a general, overarching failure of firms, individuals and government

authorities to look beyond short term outcomes. The policy response to the crisis has been almost

universally insufficient and tepid, hindered by ideological rigidity, partisan conflict and the breakdown

of cherished economic frameworks.

Part I: In Blackest Night: The Great Recession in Historical Context

The proximate cause of the current recession lies in a large asset bubble in the real estate

market, which itself has its origins in the last recession of 2001. The Federal Reserve engaged in fairly

standard monetary policy, engaging in open market operations and pushing down short term interest

rates. These lower interest rates had two effects - first, they lowered the cost of borrowing for

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homeowners, and they lowered yields on traditionally safe Treasuries. The second effect led many

financial institutions to move investments from Treasuries to Real Estate market instruments such as

Mortgage Backed Securities, a move which increased available mortgage funding at a time when

borrowers were most likely to take out new mortgages due to historically low interest rates. The result

was a massive run up in real estate prices. This soon became self reinforcing, as homeowners took

advantage of the appreciation of their homes by taking out lines of credit on the increased equity. In

2006, home prices peaked, and soon took a rather dramatic downturn. This downturn decreased the real

wealth of homeowners. In cases where homeowners had taken out loans on the assumption of

continued appreciation, a practice concentrated in the subprime sector, default and foreclosure rates

rose. The financial sector, which had invested heavily in the bubble and especially in the risky

subprime sector, began to experience substantial losses beginning by 2007.1

The National Bureau of Economic Research is a non-profit agency that, amongst other things,

determines the beginning and end of business cycles. The NBER's Business Cycle Dating Committee

uses four monthly data series(employment, industrial production, real sales and personal income less

transfers,) as well as the quarterly released GDP reports to determine the months in which economic

activity reached peak and trough, marking the beginning and end of a recession. Real GDP data is only

released quarterly, so the month of peak or trough must be estimated from the monthly indicators.

These indicators do not generally peak or trough simultaneously; however, they are usually clustered in

around a given month. The Business Cycle Dating Committee dates the start of the current recession at

December 2007.2 As shown by Fig. A, this determination is still subject to some doubt, as two of the

four monthly data series, real sales and personal income, peaked significantly after December 2007,

while Employment and Industrial Production peaked quite close to the determined month. The current

recession is atypical of recessions since World War II; indeed, comparisons to the Great Depression are

quite apt. In virtually every metric, the current recession is not only worse than the average of previous

recessions - it is very often worse than the worst of previous recessions. Overall real GDP has fallen

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from its peak by 3.3%, compared to an average of decline of 2.0%. Only one post-war recession has

seen large GDP decreases, the recession of 1973-5, which saw a total decline of 3.4% peak to trough.

Given that most economists forecast a trough in the current recession late in 2009 at the earliest, it is

very likely that the current recession may yet over take 1973-5. Looking at the 4 monthly series used

by the NBER Business Cycle Dating Committee, the current recession is worse than the peak to trough

average of post war recessions for each indicator. Employment is down 4% thus far, compared to the

average of 2%; industrial production is down 15% compared to the average of 4%; real sales are down

8% compared to the average of 2%; and real income is down 4% compared to the average of 1%. The

current recession is in its 18th month, making it the longest recession since the Great Depression. Both

the 1973-5 and the 1981-2 recessions lasted 16 months; both were regarded as the worst recessions

since the 1930s before the current recession. The unemployment rate is (as of May 2009) 9.4%. This is

well above the average maximum unemployment rate of 6.8% for post-war recessions. The 1981-2

recession saw a maximum unemployment rate of 10.7%; however, the next highest unemployment rate

was 8.4% in the 1973-5 recession. Additionally, the 1981-2 recession was atypical in that it was

preceded by a very short expansion of only 12 months; the 1981-2 recession is often referred to as a

"double dip" recession for this reason.3

The Conference Board, a non-profit economic research firm compiles and analyzes data about

macroeconomic performance. They have divided 21 different economic data series into three indices:

the leading economic indicators, coincident economic indicators, and lagging economic indicators. The

leading indicators are perhaps the most commonly used of these indices, since it can be used to predict

future economic activity. Generally speaking, the LEI will reach a peak about 6 months before the start

of a recession, and will reach a trough about 3 months after a recession. The LEI for May 2009 showed

the first significant upward motion since peak.4 While it remains to be seen if this will be sustained

economic growth or merely a false positive, this would suggest that the current recession may come to

an end sometime in the third quarter of 2009. Macroeconomic forecasters have generally concurred

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with this view. The consensus of private sector forecasts, as gathered by the Congressional Budget

Office, predict that GDP growth will be positive by the third quarter of 2009. Even the pessimistic

forecasts predict that growth will turn around by the fourth quarter. However, the unemployment rate is

not likely to peak until well into 2010, and the labor market will probably continue to be soft, even as

GDP begins to grow.5

Recessions since World War II have generally followed one of two patterns. First, there are the

so-called "Inventory Recessions," of which the 1960 and 1969 recessions are classic examples, where

the proximate cause of economic downturn is a sharp decrease in inventory investment in response to

falling sales. Second, there are recessions caused by excess tightening by an inflation fighting Federal

Reserve, where high interest rates lead to a collapse in consumption and investment. The classic

example of this type of recession is the "double dip recession" of the early 1980s. The current recession

does not fit either of these two patterns. Rather, it is more closely related to both pre-World War I

financial panics and the Great Depression. The downturn began and has been primarily concentrated in

the financial sector - the real economy did not begin to see serious ill effects until well into 2008. Like

the Great Depression, there was a large, speculative real estate bubble, with decreasing lending

standards and increased leverage and risk taking in the years before the recession. Once the bubble

burst, losses taken by highly leveraged firms lead to a credit freeze. In the Great Depression, these sorts

of losses led to cascading bank failures. The current recession has seen cascading failures, but in the

"shadow banking" sector rather than in commercial banks.

The current recession is truly global in reach, although, it is not the case that every country is in

recession simultaneously. Nonetheless, total world output is forecasted to drop precipitously, especially

when compared to other world recessions in the last 50 years. Previous recessions (1973, 1982, 1991)

have seen only a very small decline or a flattening in world GDP. In contrast, the current recession is

projected to see world GDP declines of about 4%. Looking at important indicators, it appears to be the

case that the current global recession is at least as bad, if not worse, than previous global recessions.

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Real per capita GDP is forecasted to fall by 2.5%, compared to an average decline of prior recessions

of less than 0.5%. Industrial Production is projected to fall by 6%, compared to an average of 2%.

Unemployment is projected to top out at around 9% compared to an average of 7%. Trade volumes are

projected to fall by 12% compared to a flat average. In addition to being the worst global recession in

memory, the current recession is also the most global of global recessions. Previous global recessions

have seen a peak of around 50% of countries (PPP-weighted) experiencing recession simultaneously.

The current recession is projected to see a maximum of around 75% of countries. So, not only is the

current recession the deepest in the last 50 years, it is also the broadest.6

Part II: The Secret Origins of the Great Recession

The origins of the current recession can be traced most directly to the previous recession of

2001. The 2001 recession was relatively brief and shallow in comparison to the post-World War II

average. Nonetheless, even as the recession came to an official end, the Federal Open Market

Committee continued to engage in expansionary monetary policy. The FOMC had lowered the Federal

Funds rate target all the way to 1% by 2003, and kept it at this very low level for an entire year, until

July 2004. This extended period of historically low interest rates fueled a massive increase in real estate

investment. This, in turn, soon became a self-reinforcing bubble. As the bubble inflated, lending

standards were steadily loosened, and subprime mortgages increased in importance. Financial

institutions began experimenting with structured finance and derivative instruments based on real estate

assets in an attempt to eke out a higher yield than Treasuries, while minimizing risk. Armed with these

derivative instruments (many of which were rated AAA, safe as Treasuries,) banks and other financial

institutions increased their leverage, backing these assets with less and less capital. Once home prices

peaked in 2006, this was revealed to be a very foolish plan of action. By the Summer of 2007, major

financial institutions were beginning to take massive losses on assets based on subprime mortgages.

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The bursting of a bubble caused, in part, by the central bank response to the bursting of a previous

bubble led to the worst financial crisis since the Great Depression.

Of course, if the extent of the crisis was subprime defaults driven by a collapse in home prices,

it would have been just another real estate boom and bust cycle, and nothing more. But since subprime

mortgages were repackaged and sold off as Mortgage Backed Securities, which were in turn structured

into Collaterallized Debt Obligations, the bursting of the housing bubble had systemic consequences.

The first signs of the systemic impact could be seen as early as June 2007, when two Bear Stearns

managed hedge funds that were heavily invested in subprime MBSs failed. The assets of these hedge

funds were seized by creditors in hopes of recouping losses. However, these assets proved to be

illiquid. Financial institutions held large amounts of these now illiquid and possibly worthless assets.

As more and more of the underlying assets - subprime mortgages - defaulted, financial institutions were

forced to take large writedowns on the securities on their books. By the end of 2007, it was clear that a

crisis had gripped the financial sector. The stock market suffered a severe drop, but the broader

economy was largely unaffected. In March 2008, a new phase began in the financial crisis. Bear

Stearns, one of the big five investment banks, faced the very real prospect of failure. The Federal

Reserve facilitated an emergency takeover by JP Morgan Chase, absorbing the worst, most risky assets

on Bear Stearn's balance sheet in the process. This caused a severe credit event. The TED spread, which

is the spread between three month LIBOR rates and 3 month t-bill yields, is a measure of the risk

premium that banks are charging when loaning money to other firms. It is, in other words, a market

prediction of the risk of default. The TED spread, which had spiked during the stock market drop at the

end of 2007 and then returned to more normal levels, once again spiked upward.

In the months following, economic conditions continued to worsen. It became clear that there

were widespread liquidity problems in the financial system, especially in the so-called "shadow

banking" sector, chiefly the large investment banks. In September 2008, a number of crises came to a

head, marking the darkest time in the downturn. On September 7, the Government Sponsored

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Enterprises (GSEs) Fannie Mae and Freddie Mac were placed in conservatorship. The GSEs were the

originators of securitization in the mortgage market, but had, until recently, chiefly dealt only in safe,

30 year fixed mortgages. As the housing bubble expanded, Fannie and Freddie began to dabble in the

more risky asset classes based on sub-prime mortgages. The next weekend, two important events

occurred that would send the economy to the brink. First, Lehman Brothers, another of the big five

investment banks, was unable to find emergency funding or a buyer for its operations, and declared

bankruptcy on September 15. Second, under pressure from Treasury and the Fed, Bank of America

bought another big five investment bank, Merrill Lynch, which was itself close to collapse. These two

events sent a shock through the financial system. American International Group, a large insurance

company with a large portfolio of CDSs, including many with Lehman, was forced to turn to the

government for assistance, and on September 16, received $85 billion in loans from the Fed in return

for 79.9% ownership. The same day, a major money market mutual fund, the Reserve Primary Fund,

"broke the buck," downgrading the nominal value of shares to 97 cents (money market funds keep

attempt to keep shares at or slightly above $1.) This was an almost unprecedented event - only one

money market fund had ever broken the buck before, and it caused what can be called a non-bank bank

run, as consumers rushed to take their money out of these funds. In response, the Fed issued $105

billion in emergency liquidity on September 18, and the Treasury announced plans to back stop losses

from Money Market Funds on September 19. The following Sunday, September 21, the remaining large

investment banks, Goldman Sachs and Morgan Stanley, converted themselves to bank holding

companies. Later in September, Washington Mutual failed and was liquidated by the FDIC and

Wachovia was sold, under distressed conditions, to Wells Fargo. The TED spread, which had tightened

some after the Bear Stearns failure failed to caused an economic collapse, reacted violently to the

events of September 2008, spiking to unheard of levels and briefly reaching above 400 basis points.7

The root of the current recession lies in the sub-prime mortgage market. Before the 1980's,

borrowers who had less than perfect credit, or who had lower incomes were left out of the mortgage

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market, since banks and thrifts were governed by usury laws. These usury laws set an upper limit on

the interest rate charged on loans. When the usury laws were phased out as part of the 1980's move

towards financial de-regulation, banks had the ability to price the risk of loaning to more marginal

consumers. This is where the sub-prime market begins. However, given the economic circumstances of

the individuals taking out sub-prime mortgages, and certain features of the most common sub-prime

mortgages, there are certain risks in these loans that ultimately led to the current financial crisis. The

most common sub-prime loans are what is known as a 2/28 and 3/27, which are hybrid mortgages - for

the first two or three years of repayment the interest rate is fixed, after which the rate is regularly

adjusted based on LIBOR or some other baseline interest rate. These types of loans have an implicit

payment shock once the interest rate adjusts. Additionally, many sub-prime mortgages feature pre-

payment penalties, which make it harder for borrowers to refinance. Combined with the borrowers'

economic circumstances, the risk of default for sub-prime mortgages is much higher than that for prime

mortgages.8 Around 2005, when home prices were nearing their peak, delinquencies and defaults

started increasing dramatically, and fixed rate and adjustable rates began to diverge. By 2008,

delinquency rates for sub-prime adjustable rate mortgages stood at 35%, whereas sub prime fixed rate

delinquencies stood at around 12%. This compares to prime mortgage delinquencies of 9% for

adjustable rates and 2% for fixed rates in 2008.9

These subprime mortgages, then, form the core of the financial crisis. The effect of the collapse

in the subprime market, though, was magnified by irresponsible behavior by both financial sector firms

and government agencies. Banks and thrifts are required by regulators to meet certain standards in

terms of capital adequacy in order to continue functioning. These regulatory capital requirements are

necessary to ensure that the banking system has adequate liquidity and stability to weather any adverse

economic events. If the bank suddenly faces an adverse situation - for instance, if some of its loans go

into default - the initial losses are absorbed by the capital buffer. The regulatory capital requirements

are designed so that banks have a large enough buffer to absorb any reasonable losses without

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becoming insolvent. The capital requirement is determined via a formula, where the required capital

must be at a fixed ratio to the bank's risk weighted assets. Riskier assets, like subprime mortgages, must

be backed by more capital than safer assets, like treasuries or other AAA rated securities. Banks have

been able to reduce their effective capital requirements through two. The first is to transfer riskier

assets off balance sheet (for example, to a structured investment vehicle,) decreasing the amount of

regulatory required capital. The second approach was simply to shift from traditional assets such as

mortgages, to more complex, but AAA rated, investments in derivative securities, chiefly CDOs.

Because these assets were AAA rated, the capital required to back them was much lower than for a

conventional loan. This process has been dubbed regulatory arbitrage.10

This regulatory arbitrage was significant because it increased banks' leverage. Leverage is

usually measured as the ratio of assets to capital. Leverage is lucrative to banks since it allows them to

increase returns without raising new capital. By lowering effective capital requirements, banks are

essentially increasing their leverage ratio in hopes of creating greater returns. But, increasing leverage,

in addition to magnifying gains on the upside, has a parallel effect on the downside. Leverage will

magnify the losses on the downside in the same way it magnifies returns on the upside. This presents a

significant risk to the system if there are large losses on leveraged assets. These losses, magnified by

leverage, can quickly consume the bank's capital (this is especially true if the bank has been avoiding

capital requirements) creating the possibility of bank failure. Other things being equal, increased

leverage achieved through regulatory arbitrage reduces stability and increases the risk of a systemic

event. This is especially true in the case of the so called large, complex financial institutions (also

referred to as tier 1 LHCs.) These large, too big to fail, institutions are in a prime position to not only

engage in regulatory arbitrage on capital requirements, but also can avoid regulation altogether. No

comprehensive regulations exist that govern the whole of institutions such as Bank of America and

Citigroup, which consist of subsidiaries engaging in commercial and investment banking, broker dealer

activities,mortgage origination and insurance. Each subsidiary has a separate regulator, and these

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regulators have varied in strictness. Some subsidiaries, the notable example being the financial

products division of AIG, went completely unsupervised.11

An additional factor that magnified the financial crisis was the peculiar position of the

Government Sponsored Entities Fannie Mae and Freddie Mac. The GSEs were originally government

agencies - the Federal National Mortgage Agency was set up as part of the New Deal to set up a

secondary mortgage market. In order to remove the obligations from the federal government's balance

sheet, FNMA was spun off and chartered as a private corporation (Fannie Mae) in 1968. To increase

competition, a second entity, the Federal Home Loan Mortgage Corporation (Freddie Mac,) was

chartered in 1970. These newly created corporations were, and continue to be, strange hybrids. They

are private, profit seeking corporations, answerable only to their shareholders. However, they are also

tasked with the important social goal of improving mortgage credit availability through fostering a

secondary market. Although there is no formal link or recourse between the federal government and the

GSEs, financial markets perceived an implicit government guarantee. This assumption of implicit

guarantee allowed the GSEs to borrow at rates almost as low as Treasury yields. The GSEs, as private

corporations, increasingly have, in addition to securitizing mortgages, purchased mortgages and

retained them on balance sheet. This has resulted in a large amount of leveraging and risk-shifting

behavior. The GSEs funded themselves through short term borrowing at the preferential rates available

to them, and purchased 30-year mortgages. This is a form of interest rate arbitrage known as "riding the

yield curve."12

In short, at every step of the way, individuals were lazy and short sighted. Rather than a more

thorough test of ability to pay, mortgage bankers relied on FICO scores. Rather than investigate the

actual riskiness of new derivative assets, government regulators relied on the ratings of the credit

ratings agencies. Rather than develop strategies that would ensure long term profitability, investment

bankers engaged in risky investment schemes that netted them large performance bonuses. Neither

government nor private industry was willing to look at the large negative externality that these risky,

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lazy, short sighted behaviors caused - the very real risk of a systemic collapse. This externality will

continue to exist as long as the large complex financial institutions exist that are too big to fail, and that

can engage in regulatory arbitrage.

Part III: March of the Zombie Banks: Towards a "Bailout Nation?"

The earliest signs of a liquidity crisis in the financial sector were apparent by the Summer of

2007. However, the policy response to the financial crisis did not come to bear significantly until

March 2008. Bear Stearns was near collapse. Fearing severe market repercussions, the Federal Reserve

stepped in, negotiating a quick takeover by JP Morgan. The Fed took on much of Bear Stearns' most

illiquid assets, setting up a holding company, Maiden Lane, to administer them. This would be the first

of many "bailouts" of American financial companies to come. Bear Stearns was not the first bailout in

the world, however. The British Government extending liquidity support to Northern Rock, a major

British bank specializing in mortgage finance, in September 2007. In February 2008, Northern Rock

was nationalized after no private buyer was found for the failing bank.

The quick resolution of Bear Stearns calmed the markets. Insofar as it did not result in the

imminent collapse of global capitalism, it was a success. The summer of 2008 was a period of slow

economic deterioration, punctuated by a few major events. Chief amongst these was the failure of

Indymac Bank, a large California bank that had been a large player in the subprime market there. The

Indymac failure was, at the time, the third largest bank failure in US history. Nonetheless, the FDIC

was able to provide relatively quick resolution, although it would ultimately cost the FDIC some $8.9

billion. There were other bank failures in 2008, generally involving small regional banks. All were

resolved smoothly. This offers a contrast to the ad hoc, messy and often destructive attempts to resolve

failing shadow banking sector institutions. Lehman Brothers, as previously noted, was forced into

bankruptcy on September 15, 2008. This set off a chain of further failures and an acceleration of

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economic deterioration. It is clear that, whatever the problems with resolving large complex financial

institutions, letting a failing LCFI go bankrupt is a worst case scenario.

After the collapse of Lehman, the Treasury Secretary, Hank Paulson, pushed hard for

appropriation of some $750 billion to purchase "toxic assets" and restore stability to the financial

system. The Troubled Asset Relief Program never fulfilled its original purpose. Rather, it morphed into

a large capital injection to essentially all of the major banks and bank holding companies in the United

States. Alongside the TARP, the FDIC increased the limit for insured deposits to $250,000 and

implemented the Temporary Liquidity Guarantee Program, which provided a FDIC guarantee for newly

issued debt instruments in an effort to keep interbank markets from freezing. Additionally, the Treasury

Department set up a program to offer FDIC-like insurance for investments in money market mutual

funds starting on September 19, 2008. The government response to the crisis has been increasingly

forceful, especially in the period after the collapse of Lehman. But perhaps the most important policy

actions have been taken not by Executive Branch agencies, but rather by the Federal Reserve, which

has acted in a swift and in unprecedented manner to address the financial crisis. 13

The Federal Reserve responded to the emerging crisis by engaging in conventional monetary

policy, starting in August 2007. As is usually the case when the economy falls into recession, the Fed

engaged in Open Market Operations - selling short term Treasuries in an effort to drive down the Fed

Funds Rate. Figure D shows the target Fed Funds Rate from 2006-present. At each crisis point (the

initial liquidity crisis, the Bear Stearns collapse, Lehman) the Fed has reacted by slashing short term

rates. By December 2008, the Fed had exhausted its conventional ammunition, having cut the Federal

Funds rate to essentially zero. Additionally, the Federal Reserve serves as the lender of last resort for

the banking system through the Primary Credit Window, through which banks can borrow reserves on

an emergency overnight basis. The Fed has augmented this LOLR support by cutting the spreads

between the Federal Funds rate and the Primary Credit rate from 100 basis points prior to August 2007,

to 50 basis points, and then, in March 2008, to 25 basis points.

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The Federal Reserve, having used all available options in its conventional monetary policy

arsenal, was not content to merely stand still and do nothing. The Fed has extended the range of its

policies in two key ways - it has expanded the scope and size of its liquidity operations (which can be

thought of as an extension of its LOLR capacity) and it has engaged in quantitative easing (which can

be seen as an extension of its open market operations capacity.) In December 2007, the Fed instituted

the Term Auction Facility, a new lending facility designed to inject liquidity through longer term (28,

and later, 84 days) emergency reserve loans. The collapse of Bear Stearns in March 2008 led to the

creation of two additional similar facilities, this time aimed at the "shadow banking" sector rather than

at commercial banks - Term Securities Lending Facility and the Primary Dealer Credit Facility. After

the collapse of Lehman, the Federal Reserve dramatically increased the size of its balance sheet. The

Fed created a number of new lending facilities to maintain liquidity in markets that had frozen up.

Included are the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility and

the Commercial Paper Funding Facility, which are intended to back stop the commercial paper market.

The Money Market Investor Funding Facility was enacted in response to the run on mutual funds

following the Reserve Primary fund breaking the buck. Finally, as mentioned above, the Fed has

engaged in direct purchases of assets. The Fed began purchasing short term GSE debt on September 19,

2008. In November 2008, the Fed announced plans to purchase $100 billion of GSE debt, and up to

$500 billion in GSE MBSs. Foreign Central Banks have generally been as active as the Fed has in

engaging in liquidity operations. The European Central Bank, the Bank of Japan, and the Bank of

England have all aggressively cut short term rates, and acted swiftly to extend liquidity to frozen credit

markets.14

As the policymaking in response to the crisis has become more muscular, there has been an

increasing call for a complete revamp of the current regulatory structure for the financial sector. This

call has become more urgent as the crisis has eased in recent months. It is clear that the current system

has large flaws. Some of these flaws, such as the reliance on risk-weighting based on credit rating

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agency assessments, have been major drivers in the severity of the current crisis. More broadly, there is

no single supervisor for large complex financial institutions, and no regulation whatsoever for some

derivatives, leaving large parts of the financial sector opaque. The move towards deregulation from

1980 on has not, on net, been terribly successful. It would now appear that, empirically speaking, the

financial sector cannot be trusted to act in a social optimal manner without government supervision. It

would rather appear that, left unsupervised, the financial sector will eventually blow up the economy.

The question, then becomes not whether to regulate, but how wide ranging and punitive the new

regulations will be.

The most complete vision of a possible new world of banking regulation is contained in the

just-released Treasury Department white paper entitled "Financial Regulatory Reform." This Treasury

Department proposal outlines five goals for regulatory reform, and specific proposals for achieving

these goals. The first goal is to reform the supervision regime of the financial sector, focusing on the

LCFIs. The chief proposals to achieve this include: the formation of a systemic risk council composed

of various government agencies; the designation of the Federal Reserve as the senior regulator for any

too big to fail bank holding company, and allows the Fed to regulate all subsidiaries of BHCs;

increasing capital requirements for LCFIs to compensate for increased systemic risk; and closing

various regulatory loopholes as well as streamlining regulation by eliminating the Office of Thrift

Supervision (the regulator for Indymac, AIG and Washington Mutual.) The second goal is to make sure

that the regulation of the financial system is comprehensive. The chief proposals include stricter and

more comprehensive regulation of the securitization market and a complete overhaul of the regulation

of over the counter (OTC) derivatives, specifically the credit default swaps that played prominently in

the failure of AIG. The third goal is to enhance consumer protection; this is to be accomplished through

the establishment of a Consumer Financial Protection Agency tasked with ensuring that retail financial

products are "safe" for consumers. The fourth goal is to create a system for resolving failed LCFIs. This

is to be modeled on the FDIC. Finally, international cooperation on bank supervision must be

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increased, and the international capital framework (Basel II) should be strengthened.15

The Treasury white paper as a way forward has been made possible by the largely successful

Supervisory Capital Assessment Program, which has given policymakers a better handle on the current

health of the banking system. The Treasury Department, as well as the major bank regulators, as part of

the Troubled Asset Relief Program, required the largest 19 bank holding companies to undergo a "stress

test" The SCAP is an attempt to simulate the effects of two scenarios of continued economic weakness

on the biggest 19 banks. The focus of the SCAP is on the capital bases of these banks, and how well

these would hold up under a range of loan losses. The results of the SCAP suggest that 10 of the 19

BHCs will require more capital in order to maintain an adequate buffer. As of the writing of this paper,

almost all of the additional capital required by the SCAP has been raised. The SCAP has been largely

successful in shoring up faith in the banking system. However, the underlying assumptions of the

SCAP seem unrealistically optimistic in hindsight. The more adverse scenario in the SCAP involves an

average unemployment rate of 8.9% for 2009, a number dwarfed by the actual unemployment rate of

9.4% as of May 2009.16

The response to the crisis has achieved some degree of success - risk premiums, as represented

by the TED spread (Figure C) have come down from their extraordinarily high levels following the fall

of Lehman. The major banks have built up a significant and hopefully adequate capital buffer to absorb

future losses through the TARP infusions and the additional capital requirements of the SCAP. The

enduring failure of the response to the crisis has been the fateful decision to allow Lehman to fail. Had

the Fed or the Treasury intervened and found some resolution short of bankruptcy, much of the

extraordinary measures taken since may not have been necessary. The crisis appears to have abated in

the months since Lehman. Unless the regulations on the financial sector are overhauled and

strengthened, though, the system will not truly recover. The biggest need, going forward, is to ensure

that the recovery from this recession does not lead to another, more severe crisis down the road.

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Part IV: Maximum Carnage: The Great Recession in the Real Economy

What started as a liquidity crisis in the shadow banking sector in August 2007 was recognized

as a full blown recession by the NBER in December 2007, and by the end of 2008 had spread well

beyond the financial sector into the "real" economy. The recession in the real economy can be best

illuminated by examining changes in real GDP and its components, starting from immediately before

the previous recession. These figures are summarized in Figure E. GDP growth in the years before the

2001 recession was robust, 4.5% in 1999 and 3.7% in 2000. Growth was slower in 2001 (0.8%) and

2002 (1.6%), as the economy was suffering from the aftermath of the dot-com crash. Growth increased

in 2003 (2.5%) and peaked in 2004 at 3.6%, below the growth rates of the late 1990's. GDP growth

then decreased in each year until 2008. The average GDP growth rate from 2002-2007 (which

corresponds to the post-2001 expansion) was 2.57%, compared to an average of 3.68% from 1992-

2000 (which corresponds to the Clinton era expansion.) The current recession began in the fourth

quarter of 2007. However, Q4 2007 saw only a small decline in GDP (-0.2%.) GDP then actually grew

in the first quarter (0.9%) and second quarter (2.8%) of 2008, followed by a smaller decline in the third

quarter (-0.5%) and precipitous declines in the fourth quarter of 2008 (-6.3%) and the first quarter of

2009 (-5.7%.)

The 2001 recession was, as stated, largely caused by the dot-com bubble bursting. This is

readily apparent in the declines in Business Equipment and Software Investment in 2001 (-4.9%) and

2002 (-6.2%). Business investment in structures also declined in the period during and after the 2001

recession, declining by 2.3% in 2001, 17.1% in 2002 and 4.1% in 2003. However, the 2001 recession

had two novel features when compared to previous recessions - residential investment did not decline

in the recession (it increased by 0.4% in 2001 and 4.8% in 2002.) Additionally, consumption broadly,

and consumption of durable goods actually increased during the recession. Consumption overall

increased by 2.5% in 2001 and 2.7% in 2002, and consumption of durable goods increased by 4.3% in

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2001, and 7.1% in 2002. These two phenomena are interrelated. Both are a product of the unusually

loose monetary policy that the Federal Reserve engaged in from 2001-2004, wherein the Federal

Reserve kept short term interest rates very low (see Figure D.) These low interest rates had the effect of

increasing the availability of credit. This, in turn, allowed households to continue to expand

consumption and to purchase more housing. In retrospect, the Federal Reserve's monetary policy was

probably too expansionary. The St. Louis Fed tracks actual Federal Open Market Committee action

versus the range provided by Taylor's rule, and 2002-2004, the Federal Funds rate was much lower than

the Taylor's rule range. This suggests that the Federal Reserve was able to fight the continued economic

malaise after the dot-com bubble only through blowing up another bubble - this one in real estate.

Considering that the growth rate in residential investment was an astounding 8.4% in 2003 and 10.3%

in 2004, this story of bubble-led growth would seem to have substantial merit.17

As is consistent with an expansion based on an asset bubble, the first sector to see significant

declines was the residential investment. In point of fact, residential investment began to decrease well

before the official start of recession, seeing quarterly decreases of -20.7% in the third quarter of 2007.

In fact, residential investment had been decreasing since 2006, when home prices peaked. As home

prices peaked and the real estate bubble popped, households bought fewer homes, and, as prices began

to fall quite steeply, households often took substantial capital losses as their homes depreciated in

value. This decline in home values was followed by weakness in imports, which began declining in the

second quarter of 2008, and in consumption, which began to decline in the third quarter of 2008. There

is probably at least some relationship between the fall in consumption and imports and the severe drop

in residential investment. There are two major factors in this relationship. First, since many households

were experiencing home value depreciation, there was a negative wealth effect, wherein households

decreased consumption as their real wealth decreased. Second, falling home values made access to

home equity lines of credit, an important tool used recently by households to bolster consumption

expenditures, much more difficult. In contrast to the declines in consumption and investment

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(specifically residential investment,) exports continued to be an area of relative strength until the fourth

quarter of 2008. The strength in the export sector can be largely attributed to the relative weakness of

the US dollar versus other major currencies during this period. This relatively weak dollar increased

demand for US products at the margin. The strong growth in exports through much of 2008 helps

explain why real GDP overall did not see significant declines until the fourth quarter.

The fourth quarter of 2008 is the pivotal point at which the Great Recession transformed from a

relatively mild downturn focused in the real estate and financial sectors, into a full fledged severe

recession. This fourth quarter downturn coincides with the events of September 2008, where, amongst

other things, the GSEs Fannie Mae and Freddie Mac were placed in receivership, Lehman Brothers was

forced into bankruptcy, AIG was essentially nationalized, and the failure of the Reserve Primary Fund

led to a run on money market mutual funds. These events led to a severe credit crisis. Firms and

households found it much harder to borrow as risk premiums increased to extraordinary levels (see

Figure C.) This in turn led to further declines in Consumption, which went from a quarterly change of

-3.8% in Q3 2008 to -4.3% in Q4 2008, and overall investment, which went from a quarterly growth

rate of 0.4% in Q3 2008 to a decline of -23% in Q4 2008. The first quarter of 2009 saw continued

deterioration, as investment declined at an annual rate of 49.3%, and residential investment saw a

decline of 38.7%, the largest decline since the beginning of the recession. Exports, which had been a

growth sector, had turned negative in the fourth quarter (shrinking by 23.6%) and saw further

worsening in the first quarter of 2009, declining by 28.7%. This was somewhat mitigated by an even

faster decline in imports (-34.1% in Q1 2009,) resulting in an increase in net exports. The deterioration

in the net exports sector is indicative of the fact that by the fourth quarter of 2008, the Great Recession

was a global event, affecting essentially the entire developed world.

Another significant factor in the current recession has been the behavior of prices. The legacy of

the 1970's is that large increases in the price level can interact with an economic downturn to make the

economic downturn worse. This interaction was dubbed "stagflation," an evocative neologism

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capturing the core of why the 1973-5 recession was so miserable - it combined the stagnation of a

recession with the erosion of wealth and purchasing power of an inflationary period. The stagflation of

the 1973-5 recession was driven in large part by a significant oil price shock, caused in large part by an

OPEC oil embargo. The current recession looked as if it might follow the path of the 1973-5 recession,

at least for the first several months. The interaction between increased demand for natural resources

generally and oil in particular, and the depreciation of the US dollar from 2007-8 has resulted in

dramatically higher oil prices (oil is denominated in dollar terms, so a depreciation in the dollar leads to

higher nominal prices, holding other things equal.) Figure F shows the CPI and inflation rates for both

the all items and core measures of CPI. Driven chiefly by oil prices, the all item Consumer Price Index

measure of inflation moved up to around 4% in the second half of 2007. In 2008, the all item inflation

rate stayed around 4% for most of the winter before spiking up above 5% in September 2008. The fear

of stagflation is probably overblown, since the core inflation rate (which measures only the prices of

non-food and non-energy items) shows much lower increases in the inflation rate. From 2007 until the

peak just before the collapse of Lehman, the core inflation rate increased only 0.5%, from 2% to 2.5%.

After the collapse of Lehman, oil prices collapsed, and both core and all item inflation rates

plummeted. In fact, 2009 has seen negative year over year all item inflation rates. This deflationary

pressure is a result of the greatly worsened economic conditions in the post-Lehman period - a collapse

of demand is bringing with it a collapse in prices.

Part V: Panic In The Sky: The Monetary Policy Response to the Great Recession

The chief duty of the Federal Reserve is to engage in monetary policy. The Federal Reserve has

three chief goals, the so-called macro trilogy: price stability, economic growth and full employment.

Looking at the period from 2000 through August 2007, we can see excellent examples of all three goals

driving policy. In 2000, the target for the Federal Funds Rate, the key policy rate on which the Federal

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Reserve focuses its monetary policy efforts, stood at 6.5%. In response to the weakening of the

economy in the wake of the bursting of the dot-com bubble, the Federal Reserve began engaging in

expansionary monetary policy, lowering the Fed Funds Rate target to 2% by November 2001, which

was the official end of the recession. Despite this, the Federal Reserve saw continued weakness in the

economy, most notably in the continued declines in employment. In response, the Federal Reserve

continued to lower the Fed Funds rate target, albeit at a slower pace, down to 1%, where it stayed for a

full year from July 2003 to July 2004. In July 2004, the Federal Reserve shifted policy - the economy

had returned to near full employment level of output, and so the most important policy goal became

inflation control. In order to keep inflation at a targeted level, the Federal Reserve implemented a tight

money policy, increasing the target Federal Funds rate. The Federal Reserve steadily increased its Fed

Funds target until July 2006, arriving at a high of 5.25%. From July 2006, through August 2007, the

Federal Reserve kept the Fed Funds rate constant.

In addition to the Federal Reserve's open market operations - buying and selling securities in

order to set the Federal Funds rate and influence other interest rates - the Federal Reserve acts as the

lender of last resort for banks in the United States. Until February 2003, the Fed used an instrument

known as the discount rate to not only set the rate at which banks can borrow emergency overnight

loans from the Fed, but also influence the amount of liquidity in the financial system. The discount rate

was nominally pegged to the Fed Funds rate, although for the period between 2000 and 2003, it was

generally lower than the Federal Funds rate; the spread was 50 basis points. In February 2003, the

discount rate was replaced with the Primary Credit rate, which was still pegged to the Fed Funds rate,

but at a spread of 100 basis points above FFR. Figure D summarizes the changes in Federal Reserve

policy both for open market operations and lender of last resort operations.

The policy of the Federal Reserve is largely set at meetings of the Federal Open Market

Committee, which is to say, its policy is left to the judgement of FOMC members. In an attempt to

quantify these judgement calls, Taylor's rule has been proposed. Taylor's rule starts from an assumption

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of the long term equilibrium real interest rate (2.5%,) and then allows this to be modified by two factors

- the difference between the target rate of inflation and actual inflation, and the difference between

actual GDP and potential GDP. Where Fed policy deviates from the Taylor's rule baseline, it is likely to

be too contractionary or too expansionary, depending on whether the target fed fund rate is above or

below the Taylor's rule baseline. From early 2001, when the FOMC began lowering the Fed Funds rate

target, until the middle of 2002, the Fed's policy was much more expansionary than the Taylor's rule

baseline. In the middle months of 2002, Fed policy was consistent with Taylor's rule at higher inflation

rate targets. However, Taylor's rule then diverges from actual Fed policy, as the FOMC continued to

lower the chief interest rate. From late 2002 all the way to mid 2006, Fed policy was more

expansionary than the Taylor's rule baseline. Starting in 2006, the Fed reversed course and instituted a

tight money policy which was more contractionary than the baseline.

Starting in August 2007, the Fed began engaging in an expansionary policy, dropping the

Federal Funds rate to an eventual low of a band between 0 and 25 basis points. At several moments, the

Fed dropped the Federal Funds rate by larger than usual amounts (compared to a "normal" rate cut of

25 basis points,) in response to events in the economy. The initial drop from 5.25% to 4.75% was a

response to the first signs of the subprime crisis, as large financial institutions began taking losses. In

January 2008, the stock market took a steep downturn. In response, the FOMC dropped the Federal

Funds rate 75 basis points in an emergency inter-meeting action, and then a further 50 basis points at

the scheduled meeting later in January. After the failure of Bear Stearns, an event that set off a major

credit crisis, the FOMC dropped the Fed Funds rate by 75 basis points. During the October 2008

turmoil, the FOMC dropped the Fed Funds rate 50 basis points in an inter-meeting action in response to

the GSEs being placed in conservatorship, and then a further 50 basis points at the scheduled meeting.

In December, the FOMC moved to a Zero Interest Rate Policy, dropping the Fed Funds rate to

essentially zero. Concomitant with the changes in the Fed Funds rate, the FOMC made two changes to

the Primary credit rate. The spread between the Fed Funds rate and the primary credit rate was 100

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basis points previous to August 2007, when the FOMC decreased the spread to 50 basis points. In

March 2008, as part of the response to the Bear Stearns failure, the FOMC decreased the spread a

further 25 basis points, to the 25 b.p. where it stands currently.18

John Maynard Keynes originated the idea of the liquidity trap. The theory holds that, at very

low interest rates, monetary policy will lose effectiveness - it will not be able to inject the necessary

liquidity into the economy to stimulate a return to full employment levels of output. In an IS-LM

framework, at low interest rates, Money demand is likely to be rather high, which results in a realtively

flat LM curve. This flat LM curve suggests that monetary policy will be relatively ineffective, and

fiscal policy will relatively more effective. The current situation certainly fits the definition of the

liquidity trap - short term rates are very close to zero. There is no further room for traditional monetary

policy to expand. However, the Federal Reserve has begun to engage in more unorthodox monetary

policy (so-called quantitative easing) which may allow some further monetary policy. Nonetheless, it

does appear that we are in a liquidity trap, since even these unorthodox policies have not yet been

effective. Part and parcel of this is the flight to safety that has occurred, especially in the final months

of 2008.

As risk sensitivity has increased, at least partly in response to the financial system's inability to

accurately price risk in the subprime crisis, investors have been moving into the safest asset class - US

government securities. This has had the effect of driving down interest rates on treasuries, creating a

liquidity trap-like effect. Again, at very low interest rates on US bonds, money demand will be

relatively high, again resulting in a relatively flat LM curve. The flight to safety and concomitant drop

in short term treasury interest rates has also resulting in generally higher interest rates for anything not

perfectly safe. Even AAA-rated corporate bonds, supposedly almost as safe as Treasuries, have seen

spreads twice the historical norm. For less safe assets, the spreads have widened even more. Compared

to a baseline spread of between 2 and 4% over 10 year Treasuries, BAA rated corporate bonds had a

spread of over 6% in late 2008. Mortgage Backed Securities, which had spreads of around 2% over 10

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year Treasuries, saw spreads as high as 10% in 2008. The rate at which banks charge each other for

overnight loans, LIBOR, has seen a similar explosion in spreads when compared to OIS or Treasuries

from September 2008 until very recently. The LIBOR-OIS spread has been only a few basis points over

zero. Starting at the end of 2007, these spreads have increased, spiking up to 100 b.p. in October 2007,

at the onset of the subprime crisis and to 100 b.p. again in January and April 2008, after a stock market

crash and the collapse of Bear Stearns respectively. After the events of September 2008, the spreads

exploded to 325 basis points. These spreads have since returned much closer to normal. A related

spread, the Treasury-Eurodollar (TED) spread, which measure the difference between rates on similar

maturities of LIBOR and Treasuries, has returned to its historical norm of around 50 basis points from a

high of over 450 basis points in October 2008.19

In a liquidity trap situation, where short term interest rates are at or near zero, the Federal

Reserve has essentially no further conventional options for monetary policy. Open market operations

have pushed down short term rates to a few basis points above zero and the discount rate has been

lowered along with it. The Federal Reserve, recognizing this fact, has engaged in a number of

unconventional policies. The first is to set up new facilities to maintain liquidity and or backstop

certain sectors of the financial system that are usually outside of the Fed's normal purview. An example

is the Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, which was an

attempt to backstop the Money Market Mutual Fund market, which experienced a severe "non-bank

bank run" following the near-failure of the Reserve Primary Fund in September 2008. When lending to

banks or other financial entities, the Federal Reserve has, in the past, generally accepted collateral in

the form of US Treasuries. However, these new facilities often accept essentially any AAA rated

securities. In addition to these facilities, the Fed has engaged in quantitative easing, wherein it directly

purchases long term securities (chiefly Mortgage Backed Securities.) The Fed does this with money

created "ex-nihilo" - as it does with conventional Open Market Operations. This process theoretically

allows the Fed to continue to provide liquidity to stimulate the economy even at the zero bound. The

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Fed has succeeded in pushing down the average conventional 30 year fixed rate mortgage from 6.09%

in November 2008, around the time when the Federal Reserve began purchasing MBSs, to 4.86% in

May 2009. This has at least partially contributed to the recent improvements in economic indicators.

Combined with Treasury Department programs to help homeowners refinance, this lower interest rate

has certainly done some good towards stemming the tide of the economic downturn. 20

The Federal Reserve now faces a challenge in the medium term, as the economy turns around

and begins this expansion. Judging by leading indicators, this could begin later this year. The Fed will

then have to find a way to wind down the massive amount of novel securities on its balance sheet.

Some of the new facilities have "expiration dates" and should be relatively easy to wind down. On the

other hand, if the market for MBSs remains soft and or frozen, the Fed may have a harder time

offloading these securities. The Fed should be able to return to a more normal sized balance sheet, but

it may take some time. Additionally, the Federal Reserve must remain vigilant in ensuring that the

massive liquidity it is providing to the market does not result in another asset bubble, as it did after the

2001 recession.

Part VI: Days of Future Past: Fiscal Policy Response to the Great Recession.

Given that the economy very probably has entered into liquidity trap territory, discussions of

government intervention have focused on fiscal policy as a means of maintaining falling aggregate

demand. The liquidity trap, after all, was the situation that prevailed during much of the Great

Depression, which gave rise to Keynes' General Theory, and Hicks' IS-LM model. It is unsurprising,

then, that not only the United States, but also most other industrialized countries have enacted sizable

fiscal stimulus packages in the wake of the current financial crisis. Simply put, since conventional

monetary policy has exhausted all of its options, fiscal policy is the only game in town. This runs

counter to the trends of the last 30+ years, where the primary response to recessions has been monetary

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policy. We have gotten out of the habit of using fiscal policy for aggregate demand management.

The United States has now engaged in two separate rounds of fiscal stimulus. In February 2008,

a majority Democratic US Congress passed, and Republican president George W. Bush signed into law

a stimulus package composed almost entirely of tax changes. The total cost of this stimulus package in

2008-9 is estimated by the CBO to be $168 billion, $151.7 billion in 2008 and $16.3 billion in 2009.

The key provisions include a number of changes in the corporate tax code totaling $44.8 billion in 2008

and $6.2 billion in 2009, as well as income tax rebates to households totaling $105.7 billion in 2008

and $9.7 billion in 2009.21 After the election of 2008, in which Democrat Barack Obama and large

Democratic majorities, in the House and Senate were elected. The first order of business was the

passage of a second stimulus package, the American Recovery and Reinvestment Act (ARRA), which

was enacted on February 17, 2009, almost exactly a year after the 2008 package. In contrast to the 2008

stimulus package, the ARRA consisted of both tax cuts and spending provisions, as well as aid to state

and local governments. The ARRA's total cost is estimated by the CBO to be $787.242 billion over ten

years.

Since the 2008 stimulus package chiefly consisted of lump sum transfers to households in the

form of tax rebates, its effectiveness can be determined by looking at changes in personal income over

the period 2007-2009, since by 2009 almost all of the transfers have been sent out. Changes in

components of personal are summarized in Figure G. The 2008 stimulus package was successful, in

that it served as a backstop for personal income as the economy was beginning to deteriorate. As Figure

G shows, however, 65% of the change in disposable income from the first to second quarters of 2008

was saved, while only 35% was spent on household outlays. This suggests that the stimulus package of

2008 was relatively ineffective at jump starting aggregate demand - only 35% of the increase in

government deficits was re-spent. This fits well with evidence for a relatively low multiplier for tax

cuts vis a vis direct government purchases. The 2009 ARRA, in contrast, should have more success at

stimulating aggregate demand. First, the ARRA is simply larger than the 2008 stimulus. Second, the

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ARRA contains proportionally less lower-multiplier items such as tax cuts, and proportionally more

higher-multiplier items such as government purchases. A crude characterization would be that the

ARRA is the bigger, better and much improved stimulus.

The ARRA represents a large outlay - about 5% of one year's GDP. It will, however, take

months or years for the full amount of the appropriated funds to be spent. Some measures, such as the

decrease in FICA withholding, have already been implemented. Others involving, for example,

infrastructure spending, will not be implemented until well into 2010. The impact of the ARRA, then,

must take into account the timing of different provisions. The CBO estimates that the ARRA will

increase US GDP over the no stimulus baseline estimate by between 1.4-3.8% in 2009, 1.1%-3.4% in

2010, and 0.4%-1.2% in 2011. The CBO estimates that the ARRA will decrease unemployment

compared to the baseline by 0.5-1.3% in 2009, 0.6%-1.5% in 2010, and 0.3%-1.0% in 2011. The

ARRA's effects will also depend on the relative effectiveness of its various components. The

effectiveness of a fiscal policy proposal can be measured by the Keynesian multiplier, which gives the

total change to GDP per dollar spent for a given policy. So, a multiplier of 2.5 implies that the policy

would increase GDP by $2.5 for each dollar spent on the policy. Generally speaking tax rebates and tax

cuts have lower multipliers than direct government purchases do. The CBO's estimate for the multiplier

on direct government purchases is between 1-2.5; the estimate for transfer payments is 0.8-2.2; the

estimate for tax cuts is 0.5-1.7 for lower and middle income households, 0.1-0.5 for upper income

households. The ARRA is likely to have an effect closer to the high end of the CBO estimates. This

due, again, to the liquidity trap. As the Federal Reserve has lowered short term rates to the zero lower

bound, and moved on to quantitative monetary policy, the effectiveness of fiscal policy can be expected

to increase. There is very little crowding out in a liquidity trap. The current recession has also seen a

large increase in savings and a massive decrease in private borrowing. The deficit funded stimulus

package can then be thought of as a way of replacing some private borrowing as well as soaking up

some excess savings. If anything, the limiting factor on the ARRA's effectiveness may be its size.

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While $787 billion seems like a very large price tag indeed, the CBO's models suggest that even this

will not be sufficient to bridge the GDP gap.22

Beyond the short term challenge of returning the economy to a full employment level of output,

policymakers in Congress and the White House face longer term challenges that, while not as

immediate, are no less important. These challenges are the intertwined issues of the structural deficit in

the Federal budget, demographic changes in the American population, the ballooning cost of health

care, and the fiscal future of the large entitlement programs. The current deficits are in large part a

result of the recession - as incomes, taxes levied on income likewise decline. At the same time, as the

unemployment rate increases, demand for social services increases, resulting in more spending.

However, beneath the cyclical deficit lies a structural problem - revenues are simply to small for the

amount of government services provided. Substantial enough cuts to government spending to balance

the budget are probably politically impossible, leaving tax increases as the only option. Likewise,

reform of the health care system, and of Medicare and Medicaid, will probably require some amount of

tax increases, since benefit cuts are also politically impossible. However necessary these tax increases

are, they should be put off until the economy is well on its way to recovery. Imposing too much

additional tax burden before the economy is back on firm ground is likely to retard or choke off

eventual recovery.

Part VII: One Year Later: Outlook for the Future

Eight months after the events of September 2008, the economic outlook has decidedly

improved. The spectre of an economic downturn on the magnitude of the Great Depression has

diminished. As the credit crisis has calmed, the possibility of a return to normal growth has returned;

the question becomes when rather than whether a recovery will begin. Even with the improvement in

some important sectors (such as the recent stock market rally and smaller net job loss numbers,) the

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uncertainty about the future disposition of economic activity is weighted toward the downside.

Although the possibility of an experience mirroring Japan's "Lost Decade" seems much less likely now

than it did last September, its probability remains non-zero.

A number of private sector firms, nonprofit and government agencies have released forecasts for

near term growth recently. Despite the generally favorable movement in forward looking data, these

forecasts have tended to be more pessimistic than those released earlier in 2009. This change is largely

due to the realization that the post-Lehman collapse was much more severe than previously thought.

The economy may be reaching a trough; however, that trough is likely to be lower than earlier

predictions. Figure H summarizes the projections of three recent forecasts: the outlook of the FOMC,

the IMF's forecast of US growth, and the CBO's survey of private sector forecasting firms. All three

predict a trough sometime towards the end of 2009, with a return to growth in 2010. However, the

growth from the trough is predicted to be relatively anemic by historic standards. All three predict

average growth rates in the negative through 2009, with the CBO's estimate of -3.3% to -2.3% being

the most pessimistic, and the FOMC's forecast being a relatively more optimistic -2% to -1.3%.

Unemployment is predicted to continue rising through 2010; again, the CBO's predictions are relatively

more pessimistic compared to the FOMC's, forecasting an average rate of 9-10.4% in 2010, versus the

FOMC's 9-9.5% prediction. Even after the peak, however, the forecasts agree that the labor market is

likely to remain soft, with unemployment in 2011 remaining above 9.5% in the IMF forecast, and in the

7.7%-8.5% range in the FOMC forecast.

It seems prudential to use the more pessimistic predictions in these forecast for policy planning

purposes. Again, this is related to the fact that the uncertainty about these predictions is weighted

towards the downside. As such, the relatively more pessimistic CBO numbers are likely to be closer to

correct. The Conference Board's Leading Indicators Index can also be a useful guide for policy going

forward. In April 2009, the LEI appears to have reached a trough, having seen two months of strong

increases since. Turning points in the LEI generally precede turning points in GDP and the real

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economy by around 3 months. The LEI then, suggests a business cycle trough occurring around July

2009. This is slightly earlier than the three forecasts previously mentioned. There has also been some

signs of hope in the related Coincident Indicators Index, which mirrors the data series used by the

NBER to date recessions. Here, two data points - employment and real sales - have begun to see slower

declines. They have, in other words, positive second derivatives. This suggests that a bottom may be

near.

There is, however, still tremendous uncertainty in the outlook for future economic activity. The

uncertainty stems from two interrelated fears - that the financial sector will remain in turmoil, and that

the policy response to the crisis will be insufficient. The SCAP's overly optimistic assumptions are a

strong piece of evidence that the financial sector may be far from out of the woods. Home prices have

not yet reached a bottom, and foreclosures and defaults are still increasing. If banks, even with the

additional capital acquired as part of SCAP, are unable to absorb additional mortgage losses, credit

conditions could well begin to deteriorate again. The policy response to the crisis has been increasingly

muscular, especially after September 2008, the possibility remains that even this more robust response

may be insufficient to return the economy to sustained economic growth. This is especially true of

fiscal policy - if consumer uncertainty continues to be high, a higher savings rate may result, which

will, in turn, retard the stimulative effect of fiscal policy.

Summary & Conclusions

The current recession, despite its origins as a financial crisis concentrated in the shadow

banking sector, has become the worst economic downturn since the Great Depression. While it is no

longer confined to the subprime mortgage brokers (which have largely been driven out of business) and

large investment banks (which have disappeared altogether,) the shadow banking sector nonetheless

remains central to any recovery that will occur. More and stricter regulation is necessary to not only

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prevent another crisis of this magnitude, but to contain the current damage that the shadow banking

sector might still wreak on the economy. Such regulations can be seen as punitive. The rejoinder of

course, is that to allow the very individuals and firms that brought the economy to its knees to escape

unscathed is socially sub-optimal. The shadow banking sector has, through a combination of deliberate

malfeasance, laziness and ignorance, proliferated risky derivatives (which Warren Buffet has called

"Financial Weapons of Mass Destruction") throughout the economy. This imposes a large external cost

(systemic risk) on the rest of society, which has not consented to take on this level of risk. There will be

villains in the future narrative of the Great Recession, and these villains will be the investment bankers

and derivative traders that, in pursuit of short term selfish benefit, committed negligence and

malpractice.

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Figure A: December 2007 Peak in select data series (generated usingwww.economagic.com)

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Figure C

Jun 2007 Sep 2007 Dec 2007 Mar 2008 Jun 2008 Sep 2008 Dec 2008 Mar 2009

0.500%

0.750%

1.000%

1.250%

1.500%

1.750%

2.000%

2.250%

2.500%

2.750%

3.000%

3.250%

3.500%

TED Spread, June 2007-June 2009

(spread = 3 month LIBOR - 3 month T-bill, data from bloomberg.com)

TED Spread (%)

Figure B: Current Recession compared to post-WWII recessions, select data series. (source: St. Louis

Federal Reserve Bank, "Tracking the Global Recession: United States")

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Figure D: Fed Funds & Primary Credit rates (2001-present)

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Figure E: Real GDP and components (annual change,) 1999-2008; quarterly change Q3 2007-present.

Source: Bureau of Economic Analysis

Year GDP Cons. Cons. (D) C (ND) Cons. (S) Inv. (BS) Inv. (BE) Inv. (Res.) Exports Imports Fed. Gov. S&L Gov.

1999 4.5% 5.1% 11.7% 4.6% 4.0% -0.4% 12.7% 6.0% 4.3% 11.5% 2.2% 4.7%

2000 3.7% 4.7% 7.3% 3.8% 4.5% 6.8% 9.4% 0.8% 8.7% 13.1% 0.9% 2.7%

2001 0.8% 2.5% 4.3% 2.0% 2.4% -2.3% -4.9% 0.4% -5.4% -2.7% 3.9% 3.2%

2002 1.6% 2.7% 7.1% 2.5% 1.9% -17.1% -6.2% 4.8% -2.3% 3.4% 7.0% 3.1%

2003 2.5% 2.8% 5.8% 3.2% 1.9% -4.1% 2.8% 8.4% 1.3% 4.1% 6.8% 0.2%

2004 3.6% 3.6% 6.3% 3.5% 3.2% 1.3% 7.4% 10.0% 9.7% 11.3% 4.2% -0.2%

2005 2.9% 3.0% 4.6% 3.4% 2.6% 1.3% 9.3% 6.3% 7.0% 5.9% 1.2% -0.1%

2006 2.8% 3.0% 4.5% 3.7% 2.5% 8.2% 7.2% -7.1% 9.1% 6.0% 2.3% 1.3%

2007 2.0% 2.8% 4.8% 2.5% 2.6% 12.7% 1.7% -17.9% 8.4% 2.2% 1.6% 2.3%

2008 1.1% 0.2% -4.3% -0.6% 1.5% 11.2% -3.0% -20.8% 6.2% -3.5% 6.0% 1.1%

Source: Bureau of Economic Analysis and Dr. David Crary, Eastern Michigan University, May 2009.

Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008 Q1 2009

Real GDP 4.8% -0.2% 0.9% 2.8% -0.5% -6.3% -5.7%

Consumption 2.0% 1.0% 0.9% 1.2% -3.8% -4.3% 1.5%

Investment 3.5% -11.9% -5.8% -11.5% 0.4% -23.0% -49.3%-Residential Inv. -20.6% -27.0% -25.0% -13.3% -16.0% -22.8% -38.7%

Exports 23.0% 4.4% 5.1% 12.3% 3.0% -23.6% -28.7%

Imports 3.0% -2.3% 0.8% -7.3% -3.5% -17.5% -34.1%

Government 3.8% 0.8% 1.9% 3.9% 5.8% 1.3% -3.5%

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Figure F: CPI & inflation rate 2005-present

Figure G: Measures of Personal Income 2007-2009 (source: Bureau of Economic Analysis)

Change 2007-2008 Change 2008-2009

11473 11960.5 12060.6 4.25% 0.84%

Employee Comp. 7734 8009.7 8024 3.56% 0.18%

1695.7 1778.1 1988.1 4.86% 11.81%

Unemployment Benefits 31.3 38.2 94.6 22.04% 147.64%

592.6 611.5 659.5 3.19% 7.85%1459.5 1535 1276.7 5.17% -16.83%

10013.5 10425.5 10783.9 4.11% 3.44%

109.3 20.6 475.5 -81.15% 2208.25%

Savings Rate 1.09% 0.20% 4.41%

2007

I

2008

I

2009

I

Personal income

Personal transfer receipts

OtherPersonal current taxes

Disposable personal income

Personal saving

change as % of DI change

10404.9 10538.2 35%

20.6 267.9 65%

2008

I

2008

II

Personal outlays

Personal saving

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Figure H: Summary of near term economic forecasts (sources: IMF's World Economic Outlook, April

2009, CBO Director's Testimony before the House, 5/21/2009, Minutes of the 4/29/2009 meeting of the

FOMC)

Figure I: The Conference Board's Leading and Coincident Indicators

Federal Reserve

2009 2010 2011

GDP growth rate -2% to -1.3% 2% to 3% 3.5% to 4.8%

Unemployment 9.2% to 9.6% 9% to 9.5% 7.7% to 8.5%

Core Inflation 1% to 1.5% 0.7% to 1.3% 0.8% to 1.6%

CBO

2009 2010

GDP growth rate -3.3% to -2.3% 1.0% to 2.8%

Unemployment 8.8% to 9.4% 9% to 10.4%

IMF (est.)

2009 2010 2011

GDP growth rate -3.0% 0.0% 2.5%

Unemployment 9.5% 10% 9.5%

Inflation rate -1% -0.3% 1%

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Notes

1. Acharya, Viral, et al. "Prologue: A Bird's Eye View." InRestoring Financial Stability., ed. ViralAcharya, and Matthew Richardson, p. 1-3.

2.Determination of the December 2007 Peak in Economic Activity, NBER.http://www.nber.org/cycles/dec2008.html, accessed 20 June 2009.

3. Determination of the Business Cycle Peak of March 2001,NBER.http://www.nber.org/cycles/july2003.html, accessed 20 June 2009.4. The Conference Board's Leading Economic Index For the US Improves Again. The Conference

Board. http://www.conference-board.org/economics/bci/pressRelease_output.cfm?cid=1,accessed 21 June 2009.

5. Elmendorf, Douglas. "The State of the Economy," Testimony before the US House ofRepresentatives, May 21, 2009. Congressional Budget Office, Washington, DC.

6. World Economic Outlook April 2009, International Monetary Fund.7. Acharya, 7-11, 23-4.8. Gramlich, Edward. Subprime Mortgages: America's Latest Boom and Bust. Urban Institute Press:

Washington, DC, p. 1-12.9. Monetary Policy Report to the Congress, Federal Reserve Board of Governors, February 24, 2009.10. Acharya, Viral and Philipp Schnabl, "How Banks Played the Leverage Game." InRestoring

Financial Stability. , ed. Viral Acharya, and Matthew Richardson, p. 83-93.11. Saunder, Anthony, et al. "Enhanced Regulation of Large, Complex Financial Institutions." In

Restoring Financial Stability., ed. Viral Acharya, and Matthew Richardson, p. 139-145.12. Jaffee, Dwight, et al. "What to Do about the Government-Sponsored Enterprises?" InRestoring

Financial Stability. , ed. Viral Acharya, and Matthew Richardson, p. 121-2, 128-130.13. Acharya et al., 51-56.14. Monetary Policy Report to the Congress.15.Financial Regulatory Reform, A New Foundation: Rebuilding Financial Supervision and

Regulation, Department of the Treasury.16. The Supervisory Capital Assessment Program: Overview of Results, Board of Governors of the

Federal Reserve System.17. Monetary Trends, June 2009, St. Louis Federal Reserve Bank, p. 10.18. Monetary Policy Report to the Congress.19. Monetary Trends, p. 8.20. Duke, Elizabeth, "Containing the Crisis and Promoting Economic Recovery," Speech given at the

Women in Housing and Finance Annual Meeting, Washington, DC, June 15, 2009.21. Congressional Budget Office, Cost Estimate of H.R. 5140, Economic Stimulus Act of 2008.22. Elmendorf, Douglas, "Estimated Macroeconomic Impacts of the American Recovery and

Reinvestment Act of 2009," Congressional Budget Office.