The Subprime Triggered Crisis: A Perfect StormConfluence of causes

– Past bailouts Bulletproof system!?!??– Financial innovations: Finance as end in itself

– Income lagging spending: Household debt…National debt– Easy credit– Market fundamentalism– Weak global aggregate demand

The Players– Mortgage brokers/Banks—Securitizers/GSEs/Rating Agencies

Trigger and collapse

Bailouts: Wall Street, not Main Street

Stimulus

Slump: Koo—Balance Sheet Recession

Kindleberger—Minsky—Fisher

Akerlof-Shiller: Animal Spirits

The Subprime Triggered Crisis: A Perfect StormFinding Fault

• Past bailouts Too big/Too interconnected to Fail– Black Monday (October 19, 1987)– Asian CrisisContagionLongTermCapitalManagement

(1997-8)– dot.com bubble … it takes a bubble

• Financial innovations– Overnight funding– Off-balance sheet vehicles – no capital requirements– Default insurance– Collateralized Debt Obligation (CDOs) Chemistry:

JunkAAAFinancial Engineering

The Subprime Triggered Crisis: A Perfect Storm

Finding fault• Easy Credit– Global saving glut– Fed policy: fear of deflationcheap raw material for

banks• Market fundamentalism– Greenspan “put”—we’ll clean up the mess– Lax regulation

• Weak global aggregate demand—saving glut– Accumulation of reserves—memories of ‘97

Easy MoneyPolicy

Capital Inflows

Eager Home Buyers

InnovativeBanks

Rating Agencies

AmbitiousMortgage Brokers

SecuritizationMBSs

EscalatingHouse Prices

Gov’t SponsoredEnterprises

Developer Clout

Bank Regulators

The best of times

A “Global Saving Glut”

Easy MoneyPolicy

Capital Inflows

Eager Home Buyers

InnovativeBanks

Rating Agencies

AmbitiousMortgage Brokers

SecuritizationMBSs

EscalatingHouse Prices

Gov’t SponsoredEnterprises

Developer Clout

Bank Regulators

The best of times

Responses Lender of Last Resort / Spender of Last Resort• Tax Rebate $124 bil.• Fed Fund Rate Cuts• Fannie/Freddie $200 bil.• Bear-Stearns $29 bil.• AIG $174 bil.

Fed “Facilities”• Primary Dealer Credit Facility (PDCF) $58 bil.• Treasury Security Loan Facility (TSLF) $133 bil.• Term Auction Facility (TAF) $416 bil.• Asset- Backed Commercial Paper Funding Facility (CPFF) $1,777 bil.• Money Market Investor Funding Facility (MMIFF) $540 bil.• More Fed Fund Rate Cuts … Hold At ~0%• Fed Purchases of Long-Term Securities: GSEs & MBSs $600 bil.• Term Asset-Backed Securities Loan Facility (TALF) $200 bil.• Emergency Economic Stabilization Act/TARP $700 bil.

Government LoansGovernment Equity

• Stimulus Package $787 bil. aka The American Recovery and Reinvestment Act

• TARP II• Stress Tests

The Subprime Triggered Crisis: The Players

Charles Kindleberger, Manias, Panics and CrashesA Minsky Story in Five Acts: In general…in particular

1. Displacement—A breakthrough– Financial innovation: securitization—sell off risk

2. Credit Expansion & BOOM– Low interest rates—defend against deflation– Shadow banking/SIVs/MBSs/CDOs/CDSs

3. Speculative Mania—self-fulfilling Euphoria– Teaser loans/ARMs/Home equity loans/Flipp’n’ to the bank

4. Distress—a Minsky/Wile E. Coyote moment

The Subprime Triggered Crisis: The PlayersCharles Kindleberger, Manias, Panics and CrashesA Minsky Story in Five Acts: In general; in particular1. Displacement—A breakthrough

– Financial innovation: securitization—sell off risk

2. Credit Expansion & BOOM– Low interest rates—defend against deflation– Shadow banking/SIVs/MBSs/CDOs/CDSs

3. Speculative Mania—self-fulfilling Euphoria– Teaser loans/ARMs/Home equity loans/Flipp’n’ to the bank

4. Distress—a Minsky/Wile E. Coyote moment– House prices plateau—Disappointed expectations

5. Panic & Crash—rush to liquidity…but there’s no liquidity– Firesale

• Foreclosures– Contagion

» Debt Deflation

– Bailout Helicopter Ben

Minsky’s World•Quasi – rents: cash flows available to pay debts•PI – [supply] price of investment goods

•PK – [demand] price of kapital goods•Borrower’s risk•Lenders risk•Hedge finance: E(cash flows) > Payment commitment•Speculative finance: E(cash flows)<Commitment

… but > Interest commitment Roll over debt•Ponzi finance: E(cash flows)<Interest commitment

… Expect to increase debt•Financial fragility: mix of Hedge – Spec – Ponzi

Good times Confidence Risk-taking Fragility

The Minsky FootprintRealized expectations Increased profits & Reduced risk BOOMDisappointed expectations Reduced profits & Confidence Bust

Rush to liquidity Debt deflation

Pk

PI

Borrower’s Risk

Lender’s Risk

Marginal lender’s risk

Investment

Internal funds

“If the demand price of a capital asset … is not less than its replacement costs, new investment will take place.”

Akerlof and Shiller, Animal Spirits• Confidence – Keynes-Minsky

• Hopes, Exuberance, Fears• Waves of optimism and pessimism

• Corruption - Bad Faith Loss of Trust• S&Ls – Enron – Sub-prime

• Fairness• Punish cheaters, even at own expense• Relative position

• Money illusion• “Illusion” is real in view of nominal contracts/accounts

• Stories• New eras – Irrational exuberance

Downward wage rigidity

•The built-in mechanism that can lift economies out of recessions is this:

– Output below the natural level of output leads to lower inflation.

– Lower inflation leads in turn to higher real money growth.

– Higher real money growth leads to an increase in output over time.• (M/P) up i down I up Y up … until full employment is

restored•This mechanism, however, is not foolproof.

Disinflation, Deflation, and the Liquidity Trap

A Long Slump•Spending decisions depend on real interest rate•Demand for real balances depends on nominal rate

When inflation decreases in response to low output, there are two effects: (1) The real money stock increases, leading the LM curve to shift down, and (2) expected inflation decreases, leading the IS curve to shift to the left. The result may be a further decrease in output.

The Effects of Lower Inflation on Output

A Long SlumpThe Liquidity Trap

When the nominal interest rate is equal to zero, and once people have enough money for transaction purposes, they become indifferent between holding money and holding bonds. The demand for money becomes horizontal. This implies that, when the nominal interest rate is equal to zero, further increases in the money supply have no effect on the nominal interest rate.

Money Demand, Money Supply, and the Liquidity Trap

A Long Slump:Liquidity Trap and Deflation

In words: The economy caught in a vicious cycle: Low output leads to more deflation. More deflation leads to a higher real interest rate and even lower output, and there is nothing monetary policy can do about it.

In the presence of a liquidity trap, there is a limit to how much monetary policy can increase output. Monetary policy may not be able to increase output back to its natural level. Suppose the economy is in a liquidity trap, and there is deflation. Output below the natural level of output leads to more deflation over time, which leads to a further increase in the real interest rate, and leads to a further shift of the IS curve to the left. This shift leads to a further decrease in output, which leads to more deflation, and so on.

The Liquidity Trap and Deflation

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The Great Depression

29.580.95.316.91936

25.980.113.920.11935

30.582.28.619.01938

30.983.85.014.31937

39.681.816.114.61940

34.181.08.517.21939

46.585.912.99.91941

21.978.19.921.71934

24.188.814.715.91931

21.179.71.823.61932

19.975.69.124.91933

55.3

25.7

Nominal Money Stock

95.1

97.4

Price Level

U.S. Unemployment, Output Growth, Prices, and Money, 1929 to 1942

13.24.71942

7.68.71930

Output Growth Rate (%)

UnemploymentRate (%)

Year

26.6100.09.83.21929

1/1/1

929

4/1/1

929

7/1/1

929

10/1/1

929

1/1/1

930

4/1/1

930

7/1/1

930

10/1/1

930

1/1/1

931

4/1/1

931

7/1/1

931

10/1/1

931

1/1/1

932

4/1/1

932

7/1/1

932

10/1/1

932

1/1/1

933

4/1/1

933

7/1/1

933

10/1/1

933

1/1/1

934

4/1/1

934

7/1/1

934

10/1/1

934

1/1/1

935

4/1/1

935

7/1/1

935

10/1/1

935

1/1/1

936

4/1/1

936

7/1/1

936

10/1/1

936

1/1/1

937

4/1/1

937

7/1/1

937

10/1/1

937

1/1/1

938

4/1/1

938

7/1/1

938

10/1/1

938

1/1/1

939

4/1/1

9390.00

20.00

40.00

60.00

80.00

100.00

120.00

140.00

50.00

60.00

70.00

80.00

90.00

100.00

110.00

120.00

djia, left scale $/pound, right scale producer price index, right scale mfg employment, right scale

DJIA

Manufacturing Employment

Producer Price Index

$/pound

Stimulus and Retrenchment: Recession in Depression

Table 22-2 Money, Nominal and Real, 1929 to 1933

YearNominal Money

Stock, M1MonetaryBase, H

MoneyMultiplier, M1/H

Real MoneyStock, M1/P

1929 26.6 7.1 3.7 26.4

1930 25.7 6.9 3.7 26.0

1931 24.1 7.3 3.3 26.5

1932 21.1 7.8 2.7 25.8

1933 19.4 8.2 2.4 25.6

The Contraction in Nominal MoneyThe Great Depression

Table 22-3 The Nominal Interest Rate, Inflation, and the Real Interest Rate, 1929 to 1933

Year

One-Year Nominal Interest

Rate (%), i Inflation Rate (%), One-Year Real

Interest Rate (%), r

1929 5.3 0.0 5.3

1930 4.4 2.5 6.9

1931 3.1 9.2 12.3

1932 4.0 10.8 14.8

1933 2.6 5.2 7.8

•The puzzle is why deflation ended in 1933.– One proximate

cause may be the set of measures taken by the Roosevelt administration such as establishing the National Industrial Recovery Act (NIRA) of 1933.

– Another factor may be that while unemployment was still high, output growth was high as well.

– Another factor may be the perception of a “regime change” associated with the election of Roosevelt.

•The robust growth that Japan had experienced since the end of World War II came to an end in the early 1990s.•Since 1992, the economy has suffered from a long period of low growth—what is called the Japanese slump.•Low growth has led to a steady increase in unemployment, and a steady decrease in the inflation rate over time.

The Japanese Slump

Table 22-4 GDP, Consumption, and Investment Growth, Japan, 1988-1993

Year GDP (%) Consumption (%) Investment (%)

1988 6.5 5.1 15.5

1989 5.3 4.7 15.0

1990 5.2 4.6 10.1

1991 3.4 2.9 4.3

1992 1.0 2.6 7.1

1993 0.2 1.4 10.3

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22-3 The Japanese Slump

From 1992 to 2002, average GDP growth in Japan was less than 1%.

The Japanese Slump: Output Growth since 1990 (percent)

Figure 22 – 9

22 of 43

22-3 The Japanese Slump

Low growth in output has led to an increase in unemployment. Inflation has turned into deflation.

Unemployment and Inflation in Japan since 1990 (percent)

Figure 22 – 10

23 of 43

Table 22-4 GDP, Consumption, and Investment Growth, Japan, 1988-1993

Year GDP (%) Consumption (%) Investment (%)

1988 6.5 5.1 15.5

1989 5.3 4.7 15.0

1990 5.2 4.6 10.1

1991 3.4 2.9 4.3

1992 1.0 2.6 7.1

1993 0.2 1.4 10.3

22-3 The Japanese Slump

The numbers in Table 22-4 raise an obvious set of questions:

What triggered Japan’s slump? Why did it last so long? Were monetary and fiscal policies misused, or did they fail? What are the factors behind the current recovery?

The Rise and Fall of the Nikkei

The increase in stock prices in the 1980s and the subsequent decrease were not associated with a parallel movement in dividends.

Stock Prices and Dividends in Japan since 1980

•The fact that dividends remained flat while stock prices increased strongly suggests that a large bubble existed in the Nikkei.

•The rapid fall in stock prices had a major impact on spending—consumption was less affected, but investment collapsed.

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Fiscal policy was used as well. Taxes decreased at the start of the slump, and there was a steady increase in government spending throughout the decade.

Fiscal policy helped, but it was not enough to increase spending and output.

22-3 The Japanese SlumpThe Failure of Monetary and Fiscal Policy

The Failure of Monetary and Fiscal Policy

Government spending increased and government revenues decreased steadily throughout the 1990s, leading to steadily larger deficits.

Government Spending and Revenues (as a percentage of GDP) in Japan since 1990

•Output growth has been higher since 2003, and most economists cautiously predict that the recovery will continue. This raises the last set of questions. What are the factors behind the current recovery? •There appear to be two main factors. A Regime Change in

Monetary Policy

The Cleanup of the Banking System