Lecture 10: The Hitchhiker s Guide to Economic Policy Debates

Transcription

1 Lecture 10: The Hitchhiker s Guide to Economic Policy Debates Ming-sen Wang Department of Economics University of Arizona June 20, 2013

2 Overview The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. John M. Keynes

3 The Great Depression: Beginning: The U.S. stock market crashed on October 29th, Ending: The U.S. entered the World War II after the attack on the Pearl Harbor in 1941.

4 The Great Depression: Real GDP

5 The Great Depression: Unemployment Rate

6 Figure: High Unemployment Rate

7 Figure: Financial Panic: Bank Runs

8 What happened? Also, the election of Adolf Hitler in Germany in 1933

9 What possibly caused the Great Depression? International Gold Standard Stock market bubbles in 1920s Financial panic And... the government... The Fed did not ease monetary policy: raised interest rate to prevent money from flowing out of the U.S. The Fed did not act as lender of last resort

10 Potential Solutions John M. Keynes Increase government spending on infrastructure Lower interest rate Friedrich Hayek Price system is a system for transmitting and coordinating knowledge. Prices communicate signals that enable individuals to coordinate plans. Broken Window Fallacy (Frederic Bastiat)

11 Keynes v.s. Hayek

12 Franklin Roosevelt s New Deal abandoned Gold Standard established the Federal Deposit Insurance Corporation Social Security System Securities and Exchange Commission... etc.

13 The Great Stagflation: 1970s Unemployment rate can be kept as low as 3 or 4 percent. Permanent trade-off between inflation and unemployment Vietnam War: increased government spending and increased deficits OPEC oil embargo (October 1973): price of oil quadrupled

14 CPI Inflation Rate: Annual Inflation Rate (%) Year

15 Unemployment Rate: Annual Inflation Rate (%) Year

16 Stagflation AD-AS model for stagflation Inflation is always and everywhere a monetary phenomenon. Milton Friedman A sharp recession in and the early 1980s U.S. government responded with wage-price control in the early 1970s. (A good idea?) The Fed chairman Paul Volcker sharply raised interest rate in 1979.

17 Figure: Two-by-fours: Stop killing construction or Save the farmer

18 Supply-side economics Economic growth can be most effectively created by lowering barriers for people to produce goods and services. Taxation and regulation distort the price signal as well as the incentive to produce. Stagflation in 1970s was partially caused by Keynesian economic policy. Representative: Reaganomics

19 Great Moderation Alan Greenspan held the Fed chairmanship from 1987 to A feature of this period is greater economic stability

20 Inflation 9 6 Percent Change, Annual Rate Real GDP Growth Year

21 Why was the economy much more stable? Inflation was under control: stable price level more confidence on business and households The financial system was stable. Some minor exceptions: Stock market crashed in Bust in the dot-com stocks in the late 1990s A mild recession in 2001

22 Prelude to the Financial Crisis Increase in house prices Worse standards for underwriting new mortgage Higher leverage Non-prime mortgage

23 Housing Prices: Source: Project America

24 Mortgage Delinquency Rates U.S. Residential Mortgage Delinquency Rates Seasonally Adjusted Data, 1998Q2 to 2011Q1 Source: Mortgage Bankers Association / Haver Analytics Delinquency Rate (%) 5 0 Recession Period Prime Fixed-Rate Mortgages Prime Adjustable-Rate Mortgages Subprime Fixed-Rate Mortgages Subprime Adjustable-Rate Mortgages

25 The Crisis A financial crisis occurs when the financial institutions have illiquid assets (such as long-term loans) but liquid short-term liabilities (such as deposits). Decline in the housing price in 2006 and 2007 led to mortgage losses (the trigger for the Crisis) Mortgage delinquencies and defaults led to losses on the financial firms and credit insurers. This led to money market run

26 Financial Crisis Financial Crisis Timeline 2 Merrill Lynch acquired by the Bank of America Washington Mutual was closed by regulators Fannie and Freddie insolvent 0 AIG were provided emergency liquidity assitance by the Fed 2 Lehman Brothers filed bankruptcy Wachovia was acquired by Wells Fargo 09/01 09/08 09/15 09/22 09/29 10/06 10/13

27 Weaknesses that caused the Financial Crisis People took on too much debt and too much leverage. Financial transaction became too complex for risk management. Financial firms relied too much on short-term funding. New financial instruments and complex derivatives were ahead of the financial regulatory structure.

28 Government Response to the Crisis bailed out some large firms, such as Bear Stearns and AIG Too big to fail problem lender of last resort increased government spending Expansionary monetary policy

29 By December 2008, the federal funds rate was basically reduced to zero. 5 Federal funds rate (%) Year

30 Quantitative Easing In order to provide additional support to the economy, the Fed would like to affect long-term rates. large-scale purchase of Treasury and Government-sponsored enterprise mortgage-related securities (such as government debt, or Fannie and Freddie securities) QE1: March 2009 QE2: November 2010

31 The Aftermath: Public Debt Gross Federal Debt (Billions of dollars) president Bush Carter Clinton Eisenhower Ford Johnson Kennedy Nixon Obama Reagan Roosevelt Truman W. Bush Year

32 References Bernanke, Ben S., The Federal Reserve and the Financial Crisis Heilbroner, Robert L., The Worldly Philosophers: The Lives, Times And Ideas Of The Great Economic Thinkers Yergin, Daniel and Joseph Stanislaw, The Commanding Heights : The Battle for the World Economy

33 Debate still goes on