The DEPRESSION of 2008 09 (The Great Recession) Elliott Parker, Ph.D. Professor of Economics University of Nevada, Reno eparker@unr.edu Depression vs. Recession A recession is a significant decline in the nation s total economic output (measured by Gross Domestic Product), usually for two or more quarters in a row. It's a recession when your neighbor loses his job, Harry Truman said, it's a depression when you lose yours. Minsky defined a depression as a recession caused by a severe financial crisis. Depressions tend to be deeper, longer, and different than other recessions.
Recessions/Depressions in the U.S. NBER: 21 different recessions in the U.S. from 1854 1939. Average recession lasted almost two years, recovery the same. Nine or more qualified as depressions, including the Great Depression. GDP usually declined for about a year longer than other recessions, and the recovery afterwards was typically slow. After 1945, our recessions became less common, and except for the severe recession of the early 1980s they also became shorter and shallower. Recessions/Depressions Abroad IMF: postwar recessions caused by banking crises in other countries tend to follow a similar pattern. After a typical crisis, GDP falls for three straight years, and never fully recovers even after growth returns. Seven years later, GDP usually remains about 10 percent below its pre crisis trend.
In the Great Depression A recession led to a stock market crash but more importantly a banking crisis, which turned it into a depression. This was made much worse by tight monetary policy, which caused severe price deflation. It was compounded by states reducing spending in response to falling taxes. By 1932, the Hoover Administration was raising taxes and cutting spending to balance its budget. Attitudes in 1929 Andrew W. Mellon, Hoover s Treasury Secretary: Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people.
Comparisons to the Great Depression DJIA lost 46% of its value from 10/10/1929 to 10/9/1930. In 1929, 1.4% of homeowners lost home to foreclosure. In first ten months of decline alone, 744 banks failed. Then it got worse through Spring 1933. Depositors lost $140 billion, more than all of 1929 GDP. GDP declined by 1/3, unemployment rose to 25%. Depression spread from here to the rest of the world. 7 The current focus is on unemployment and budget deficits, but we also saw a credit crisis, a dramatic fall in the dollar, rising trade deficits, and a big jump in oil prices, commodity prices, and food prices. What led us here? The U.S. economy reached what Paul Krugman calls a Wile E. Coyote moment.
EP3 250 Monthly Housing Prices A Look at Housing Prices from 1975 to 2009 Adjusting for Inflation USA Las Vegas The Pop! 200 Reno-Sparks CS-LV Sacramento CS-C10 Adjusted for Inflation 150 100 The Bubble! 50 Why did we think that housing prices would continue to always rise faster than inflation? 0 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 HPI and Case-Shiller EP4 The Ownership Society Between 1994 2004: Est. 15 million new homes owned, 9 million at trend, plus 6 million more (5% rise). California and Nevada started catching up to rest of the country.
Slide 9 EP3 While San Francisco's bubble lead Nevada's, still the idea that housing prices would always rise faster than inflation was also not justified. We forget so quickly, and worry that others are getting rich when we are not. Note too that real Vegas prices are now lower than they were in 1987-1997. Elliott Parker, 7/6/2009 Slide 10 EP4 How ownership rates began to climb in the mid-1990s, but the numbers are not enough to explain the bubble. Elliott Parker, 7/6/2009
Mortgage debt grew MUCH faster than either income or home ownership First Wave (1950s) commercial banks Second Wave (1980s) GSE guaranteed securities Third Wave (>2002) other mortgage backed securities Real estate mortgages seemed like such good investments
Subprime lending had a much higher default rate, but it was less than ten percent of the mortgage market. 13 14
Inflation-Adjusted S&P 500 vs. DJIA EP19 2500 2000 The Double Bubble in the U.S. Stock Market 1500 Adjusted Index 1000 500 0 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 Monthly Data It is hard to believe the market was acting rationally.
Slide 15 EP19 From the historical point of view, the expectation that stock prices would keep rising much faster than the rate of inflation is not necessarily justified. Elliott Parker, 7/6/2009
DJIA / CPI EP21 15,000 10,000 5,000 0 A Longer Look at the DJIA Adjusting for Inflation (1949 2009 Monthly Close) Boom through 1968, stagnation through 1984. Overall, the Dow just kept up with inflation for 40 years. 1949 1951 1953 1955 1957 1959 1961 1963 1965 1967 1969 1971 1973 1975 1977 By the 1990s, people came to think rapidly rising stock prices were normal. 1979 Monthly Close 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 EP22 Remember the Bubble in NASDAQ? Remember the Enron scandal? How did we become so forgetful? 18
Slide 17 EP22 From the historical point of view, the expectation that stock prices would keep rising much faster than the rate of inflation is not necessarily justified. Elliott Parker, 7/6/2009 Slide 18 EP21 We should not have forgotten so soon what a speculative bubble is. Elliott Parker, 7/6/2009
What Caused all this Lending? New homebuyers, existing homeowners, and speculators. Mortgage brokers and predatory lenders. Financial market consolidation. Firms competing for highest returns. Short term incentives for financial managers. Investment banks, rating agencies, and hedge funds. EP7 Let s not forget Hubris. Some risks are not diversifiable.
Slide 20 EP7 Remember PMI? Where did all those premia go? Why are homeowners still paying for it? Elliott Parker, 7/6/2009
What are Derivatives? A derivative is a financial asset whose value is derived from other financial assets (e.g., futures, options, swaps). A derivative is financial insurance against price changes: a risk-averse person pays another party to take their risk from them. The most common type of derivative is an interest rate swap, but there are more types of derivatives than bets in a casino. 21 Why are Derivatives a Problem? Insurance markets are regulated to make sure the insurer has adequate capital. Derivative markets are not. Derivative markets can be complex, and traders on both sides may not realize what they are doing. Derivatives are not transparent, often off-book, and huge. You don t have to own the asset to buy insurance on it. This can leads to pyramiding of side bets. There are also often multiple generations far removed from the asset. All insurance markets have problems of moral hazard. 22
What Else Caused It? Fannie Mae (FNMA) and Freddie Mac (FHLMC) Privately owned, government sponsored enterprises responsible for the mortgage backed securities market for conforming loans. These were latecomers to the subprime debacle, but they also may have led many mortgage brokers to believe they would guarantee bad loans. Federal Reserve Bank Monetary policy made cheap credit available, creating incentive for combining short run borrowing and long term lending. Twelve FRBs are controlled by member banks, and failed to regulate bank involvement in the derivatives markets. The Federal Reserve chose not to regulate derivatives or act to prevent bubbles Alan Greenspan recently testified, I made a mistake in presuming that the self interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms. Congressional testimony, October 22, 2008 24
EP8 Mortgage Rates have been much more Stable than either Prime or the FFR Percentage 22 20 18 16 14 12 10 8 6 4 2 0 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 Monthly Data 30-Year Mortgage Rate Prime Lending Rate Federal Funds Rate Inflation Rate 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 Let s Not Forget the Federal Government Encouraged more people to buy homes, and pushed lenders to devote some portion of their lending for those who would normally not get loans. Removed regulations on lending practices and on derivative markets, and negligent in enforcing existing regulations. Pressure to turn a blind eye to emerging problems. Allowed financial mergers that made these firms too big to fail. The role of campaign contributions from financial sector
Slide 25 EP8 Interest changes had bigger effects on the incentives of lenders than on borrowers. Elliott Parker, 7/6/2009
Financial Markets are Prone to Market Failure Market economies are most efficient when (1) there is competition, (2) everybody knows what they are buying and selling, and (3) external spillover effects are minimal. Finance fails on at least two: information and contagion. Basic problem: banks are lending somebody else s money. Government insurance (FDIC) and private insurance (CDOs) both lead to moral hazard, excessive risk taking for short run profit. Bailouts are just an extreme form of insurance. Rising Oil & Gas Prices helped to pop the bubble.
A Major Cause/Effect is Household Spending Over the last decade: a sharp rise in consumption A fall in personal domestic savings The Great Recession This recession is estimated to be the biggest worldwide since the Great Depression. In 2008 2009, OECD says GDP fell by: 2.5% in the United States, 2.1% in Canada 13.7% in Turkey 8.5% in Japan, 8.6% in Mexico, 8.4% in Ireland 3.3% in Iceland, 4.9% in United Kingdom 4.8% in Euro area, including 6.9% in Germany
What are the Global Implications? Much of the savings being lent to Americans came from foreign sources. Housing bubbles occurred in dozens of countries. Many foreign banks engaged in the same practices as U.S. firms. Markets for derivatives are often offshore. Foreign markets rely on exports to American consumers. EP9 20% U.S. International Transactions 15% 10% Share of GDP 5% 0% 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008-5% -10% Quarterly Data Exports Imports Trade Balance FCB Purchases
Slide 32 EP9 The US trade deficit was falling already last year from its historic highs. Exports and imports both fell in the last two quarters. Foreign Central Banks had been purchasing a considerable amount of Dollar reserve assets, but this has dropped somewhat. Elliott Parker, 7/6/2009
Foreign Exchange Rates From 2006 2008, foreign currencies were becoming more expensive in Dollar terms, and this was starting to rein in the trade deficit. Falling demand for imports and troubles in other countries led this to reverse in the last three quarters. This is likely to be a temporary depreciation of foreign currency, with effects on the trade deficit. EP10 1.4 1.3 Real Direct Exchange Rates Initial Period=1.0 1.2 1.1 1.0 0.9 0.8 0.7 0.6 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 Monthly Data RMB Euro Pound
Slide 34 EP10 These are real exchange rates, adjusting for relative inflation rates. Note that China's devaluation in 1994 was quickly canceled out by inflation, and the currency appreciated by 25% from 2006-2008. Elliott Parker, 7/6/2009
EP13 40,000 Japan's Nikkei 225 Index (adjusted for inflation and exchange rate) 30,000 20,000 10,000 0 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 Real Dollar Value of Monthly Close Bank Bailouts Emergency Economic Stabilization Act: $700 billion authorized in October 2008. TARP funds began with plan for purchase of troubled MBS, but changed to a preferred stock model, with restrictions over executive pay. Many large financial institutions have begun to pay these amounts back.
Slide 35 EP13 This is a longer view from Japan, showing the bubble in the 1980s. This current drop in prices is NOT unprecedented, but the Japanese know about bubbles. Elliott Parker, 7/6/2009
Monetary Intervention Federal Reserve authorized: Purchase of government bonds, helped drive yield to zero. Purchase of private mortgage backed securities for the first time. Central bank currency swaps. Target federal funds rate near zero. 9000 8000 7000 MB Federal Reserve Monetary Aggregates 6000 5000 M1 4000 3000 2000 M2 The Fed doubled the monetary base 1000 0 Mont hly Fed Dat a
Worries about Inflation Rise in Monetary Base would normally have been inflationary but deposit expansion multiplier collapsed! Primary worry was deflation, as during the Great Depression. M2 has not grown much, no sign of inflation yet. A Good Sign worries have switched. Bernanke needs an exit strategy, to reduce reserves when banks start lending again. Fiscal Intervention Economic Stimulus Act of Feb. 2008: Tax rebates for 2008, estimated $150 billion cost (about 1% of GDP) in 2008. American Recovery and Reinvestment Act of 2009: Estimated $800 billion cost over several years, with less than $200 billion spent in FY 2009, and $400 billion in FY 2010 (about 3% of GDP). About 40% in tax credits, 30% in state fiscal support, and 30% in infrastructure investment (education, energy, health care), and some extended benefit support.
Fiscal Skepticism? Economists are very skeptical about fiscal policy working when we are close to full employment. Higher real interest rates crowd out investment. Higher dollar crowds out exports. Higher debt leads to future deficits. But we are NOT near full employment, and monetary policy isn t enough when banks are scared and interest rates are zero. What are our choices? Worries about the Debt Recent estimates have raised 2009 2019 cumulative federal deficit projections from around $7 trillion to $9 trillion. Falling revenues due to slower growth, assumption that tax cuts will be extended in 2012. Servicing growing federal debt. Additional tax cuts and expenditures from ARRA.
The Stimulus made big budget deficit projections even bigger. 120% 100% Federal Budget (as a Share GDP) Share of GDP 80% 60% 40% Federal Expenditures Federal Revenues Federal Savings Federal Public Debt 20% 0% 1929 1934 1939 1944 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009 2014 2019-20% Annual Data (Actuals through 2008)
Is it Worth it? The total economic loss from the Great Depression was perhaps 120% to 140% of 1929 GDP (about $20 trillion now). The total loss from the 1980 1983 recessions was 15% to 17% of 1979 GDP ($2.4 trillion). The IMF estimates a typical depression costs more than 50% of GDP cumulatively over 7 years ($7 trillion). The Stimulus added $1 Trillion to the Federal Debt If this spending could prevent only a fifth of the effect of a typical depression If GDP would have declined 8% instead of 4%... If the recovery would have begun in 2010:1 instead of 2009:3 then it would be a very good investment. But we don t KNOW what would have happened without it. And it probably wasn t done optimally.
140% 120% Federal Budget and the U.S. Economy (as a Share of 1950-2000 Trend GDP) 100% Share of 1950-2000 Trend GDP 80% 60% 40% 20% Federal Expenditures Federal Revenues Federal Savings GDP Federal Public Debt 0% 1929 1934 1939 1944 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009 2014 2019-20% Annual Data (Actuals through 2008) In the Current Depression A severe banking crisis led to a stock market crash, and a fall in GDP for four straight quarters, for a total drop of almost 4%. In the last two quarters, GDP has begun to grow again, though unemployment still remains high. Though states continued to follow their depressionera habits, the federal government helped to fill in part of the hole they were digging themselves into, to help prevent the typical downward spiral in spending.
Financial Regulation? How do we prevent this from happening again? The federal government seems afraid to shut the barn door while the horses are gone. Will Things Return to Normal? On one hand remember 9/11? Overconsumption is not sustainable Households too, not just government. Foreign countries did our saving for us. Nevada was particularly dependent on gaming, construction. Much of this was driven by Californians letting their housing investments do their savings for them.
16 14 12 Unemployment Rate Nevada, California and USA Average Nevada 14.4% 12.4% 10 8 California 9.6% USA 6 4 2 0 1980 1984 1988 1992 1996 2000 2004 2008 5% 4% Personal Income Growth by Quarter Unadjusted Rate of Change 3% 2% 1% 0% 1990.1-1% -2% -3% -4% 1990.4 1991.3 1992.2 Nevada was the fastest growing state. 1993.1 1993.4 1994.3 1995.2 1996.1 1996.4 1997.3 1998.2 1999.1 United States California Nevada 1999.4 2000.3 2001.2 2002.1 2002.4 2003.3 2004.2 2005.1 2005.4 2006.3 2007.2 2008.1 2008.4 2009.3 In 2008 09 it was the fastest shrinking.
We are at a turning point Our government debt is large, and growing, but not yet unsustainable. Will the current deficit be temporary or permanent? Our economic trajectory is not sustainable. We can t keep our spending growing faster than our income, and depending on other countries to keep financing that spending. Similarly, many countries with high savings rates have seen us as an export market driving their growth AND a place to invest their savings. How do we escape? Time there is still significant deleveraging that still needs to occur. Housing prices must also stabilize. Confidence consumers and investors no longer are as worried that we are in freefall. Restructuring high consumption with trade deficits/foreign borrowing is not sustainable. Policy difference between short term intervention and long term growth strategies.
What is the Prognosis Now? Housing prices are stabilizing nationwide but Nevada is still being wagged by California. There is still a significant inventory of foreclosures and forced sales which are waiting to go on the market. Recession is likely over now, but recovery may take a year or more to get started. Unemployment lags growth, and acts as a brake. This presentation will be available online http://www.business.unr.edu/faculty/parker or just Google Elliott Parker Look under Hot Topics on the right side. Thank you!