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Understanding the Financial Crisis Presentation to Students & Friends of Rensselaer Hartford Hartford, CT. James Stodder, (Ph.D., Economics, Yale 1990) Lally School of Management & Technology Rensselaer Polytechnic Institute at Hartford Hartford, Connecticut, USA. Outline of Talk.
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Understanding the Financial CrisisPresentation toStudents & Friends of Rensselaer HartfordHartford, CT James Stodder, (Ph.D., Economics, Yale 1990) Lally School of Management & Technology Rensselaer Polytechnic Instituteat Hartford Hartford, Connecticut, USA
Outline of Talk • Keynes on Credit Cycles: - Why we need Regulation • Where is the Bottom? • Connecticut is “Middle of the Pack” • Government Deficit Spending • Needed in the Short-term • But a Big Problem Long-term
US Macro-Stability: Better, Room for Improvement 45% 55% 34% 66% Source: http://www.nber.org/cycles.html
Bad News: Bubbles are Endemic Arlington Williams, “Price Bubbles” www.indiana.edu/~arlwilli/pdf%20files/bigmkts.pdf
Good News: People Do Learn V. Smith & A. Williams, “Experimental Market Economics,” Scientific American, Dec. ‘92
Price/10 Year Avg. Earnings Source: http://www.econ.yale.edu/~shiller/data.htm
The Wisdom of Keynes “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, isruined in a conventional way,along with his fellows, so that no one can really blame him.” - J.M. Keynes (1931)
“Paradox of Thrift” Keynes noted: Consumers cut back on their spending and save more during a recession. This only makes the recession worse. Similarly for Banks, Loan Loss Reserves (LLR)are often raised in a recession, justwhen households and businesses most need credit –ensuring more collapses and worsening the recession.
Insurance => Moral Hazard =>Necessity of Regulation • Moral Hazard of Insurance: • If you had a car that is less damaged by any given car crash – would that make you drive faster? • If you (and everybody else) drove faster, could this actually wind up making you less safe ?
www.economist.com/finance/displaystory.cfm?story_id=12480887 www.nytimes.com/2008/10/03/business/03sec.html
Currency & Reserves Up 4x Oct. 17, 2012 http://research.stlouisfed.org/fred2/series/BASE
But Bank Reserves up 100x Oct. 17, 2012 http://research.stlouisfed.org/fred2/series/WRESBAL
M0 = Currency + Bank Reserves ≈ $2.6t Oct. 17, 2012 http://research.stlouisfed.org/fred2/series/BASE
M1 ≈ $2.4t = Currency + Bank Deposits Oct. 17, 20112 http://research.stlouisfed.org/fred2/series/M1
Money Mult. = M1/M0 ≈ 2.4/2.6 = 0.92 Oct. 17, 2012 http://research.stlouisfed.org/fred2/series/MULT
Bank Money Multiplier If l= % loans, Reserve multiplier is D = R(1+l + l 2+… + l ∞ )=R/(1- l ) If M0 = Currency (C) + Reserves (R), M1=Currency + Deposits, so: M1 = C + R/(1- l ) = M0–R+ R/(1- l ) M1/M0 = 1+{-R + R/(1- l )}/M0 So M1/M0 < 1 => l < 0
Limits of Fed Magic New Yorker, Oct. 2008
The Zero Bound Oct. 17, 2012 http://research.stlouisfed.org/fred2/series/TB3MS
The Zero Bound (2) Oct. 17, 2012 http://research.stlouisfed.org/fred2/series/FEDFUNDS
Quantity of Money Equation M*V ≡ P*Y Money * Velocity ≡ Price * Output => ln(M) + ln(V) = ln(P) + ln(Y) => i.e., %∆M + %∆V = %∆P + %∆Y over time
%∆ Money Turnover [ = %∆ (Money x Velocity) ] is Too Pro-Cyclical because of Velocity % ∆M • % ∆ (M x V) % ∆ V
Keynesian Multiplier: Evidence Source: IMF World Economic Outlook and IMF Fiscal Monitor, Oct. 2012
Another Illustration: Multiplier > 1 NY Times, Oct. 23, 2012
Okun’s Law (1): Unemployment Gap Oct. 24, 2012
Okun’s Law (2):Output Gap Oct. 24, 2012
Okun’s Law (4) Oct. 17, 2012
Output Gap ≈ 20% GDP http://www.cbo.gov/ftpdocs/99xx/doc9958/01-08-Outlook_Testimony.pdf A little Stimulus Math: 20% * $14 tr. = $2.8 tr. Stim*1.5 = $2.8 => Stim = $1.87 tr.
(2) Bottom Still a Ways Off Okun’s Law, and Slow Recovery Housing Recovery probably still a year away. Credit Markets still very weak. Stock Market Valuation Ratios like P/E and Tobin’s Q are now only at historical averages. Unemployment Trend: http://cr4re.com/charts/charts.html
HousingBottom– A LongWayOff http://www.nytimes.com/imagepages/2008/10/16/business/16housing.graphix.ready.html
Worst Long-Term Unemployment Oct. 17, 2012 http://research.stlouisfed.org/fred2/series/UEMPMEAN
Long Unemployment Dip http://cr4re.com/charts/charts.html
(3) CT & NY in “Middle of Pack” Financial Sector down, but .. Conventional Banking and Insurance less vulnerable than Investment Banks, Financial Insurance Defense industries well insulated Pharmaceuticals and Biotech have good long-term prospects House Price Increases near US Avg.
(4) More Federal Deficit Spending (not Tax Cuts) Necessary Tax cuts to the rich more likely to be saved, not spent or invested. Tax cuts don’t have big effect on those too poor to pay many taxes. Unmet needs in Energy, Environment, Health, and Education: good reasons to spend.
Government Must Increase Spending in Severe Recession “ If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coal mines … It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.” (Keynes, General Theory, 1937)
But We Need Foreign Coordination for US Expansion to be Successful Benefits of lone expansion “leak out,” other countries free ride. Alternatives to joint expansion are protectionism and competitive devaluations. US long-term “Fiscal Gap” makes lone expansion untenable.
Long Term Fiscal Gap: Unsustainable http://www.cbo.gov/ftpdocs/93xx/doc9385/06-17-LTBO_Testimony.pdf
Sure asDebt and Taxes http://www.cbo.gov/ftpdocs/93xx/doc9385/06-17-LTBO_Testimony.pdf