A Students Guide to the Current Economic Crisis

1
A Students Guide to the Current Economic Crisis

• Dave Colander
• Middlebury College

2
Outline of Talk

• Explain the current crisis in pictures, words,
  and models.
• Discuss the three stages of the crisis, and where
  we are in those stages
• Discuss why the crisis is scary and the problems
  inherent in the governments attempt to get us
  out of the crisis.

3
Explaining the Current crisis in a Picture

• A 450 pound 5 ft 10 inch man has a heart
  attack.

4
Explaining the current crisis in words

• Structural economy changed in 1990sinflation
  ended due to global competition
• Starting in the late 1980s, the government
  expanded money supply private sector expanded
  leverage. Times were good.
• Bubbles in asset markets were created by leverage
  and expectations.
• Not noticed because there was no goods market
  inflation due to structural change.
• We forgot the No Free Lunch Proposition in Macro
  Nominal wealth cannot increase faster than real
  wealth.

5
Causes of the Current Crisis

• Too Easy Monetary Policy
• Too Easy regulation
• Too much leverage.
• Too strong reliance on models and past history

6
Explaining the Current Crisis in the Quantity
Theory

• MV PY
• Global competition changed the connection asset
  price bubble
• Failure to distinguish between real wealth and
  nominal wealth
• Money no longer the relevant issuethe quantity
  theory of credit.

7
Explaining the Current Crisis in the AS/AD Model

• The Use and Abuse of the AS/AD model Alfred
  Marshalls one thing at a time approach
• Whats being held constant?
• Standard Story is an equilibrium story
• Whats missing? Dynamic disequilibrium problems

8
Adjustment story when all other things remain
constant Dynamic relationships (first order
difference equations)
9
The Dynamic Disequilibrium Story When Other
Things Dont Remain Constant
10
Understanding the Policy response of Government
to the Crisis

• Triage Policy
• Treatment Policy
• Rehabilitation

11
Triage Policy

• Why is the financial sector different. It is the
  economic equivalent to the heart.
• If the financial sector stops beating, the
  economy stops.
• The Troubled Asset Rescue Package (TARP)the 700
  billion triage policy. Keep the financial sector
  going.

12
Treatment policy

• Monetary policy
• Liquidity trap
• Quantitative easing
• Fiscal policy
• Fiscal stimulus
• Automatic stabilizers
• Expectations policy

13
Rehabilitation Stage

• Repairing the Damage Done in the Triage and
  Treatment Stage
• Eliminating the Deficit
• Creating a sense of fairness
• Countering the sense of unfairness from the
  bailout programs.
• Too big to fail and the moral hazard problem
• The Problem waiting in the Wings International
  Financial Crisis
• Trade deficit
• Dollar overhang

14
Three Ideas to Keep in Mind in Structuring new
Regulation

• The golden rule of economics Him who has the
  money makes the rules.
• If you will bail out, you have to regulate avoid
  the moral hazard problem
• Law of Diminishing Regulation Technological
  change and leaning by sneaking around undermines
  regulation