Understanding the Financial Crisis Presentation to Students

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Understanding the Financial Crisis Presentation
to Students Friends of Rensselaer
HartfordHartford, CT
James Stodder, (Ph.D., Economics, Yale
1990) Lally School of Management
Technology Rensselaer Polytechnic Institute at
Hartford Hartford, Connecticut, USA
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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

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(1) Biz Credit Cycles J. M. Keynes 1883-1946
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US Macro-Stability Better, Room for Improvement
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55
66
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Source
http//www.nber.org/cycles.html
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Bad News Bubbles are Endemic
Arlington Williams, Price Bubbles www.indiana.ed
u/arlwilli/pdf20files/bigmkts.pdf
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Good News People Do Learn
V. Smith A. Williams, Experimental Market
Economics, Scientific American, Dec. 92
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The Wisdom of Keynes

• A sound banker, alas, is not one who foresees
  danger and avoids
• it, but one who, when he is ruined, is ruined
  in a conventional way, along with his fellows, so
  that no one can really blame him.
  - J.M. Keynes (1931)

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• 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, just when households
  and businesses most need credit ensuring more
  collapses and worsening the recession.

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Insurance gt Moral Hazard gtNecessity 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 ?

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www.economist.com/finance/displaystory.cfm?story_i
d12480887
www.nytimes.com/2008/10/03/business/03sec.html
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Limits of Fed Magic
New Yorker, Oct. 2008
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Currency Rises Slightly
Sept. 16, 2009
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But Bank Reserves up 100-fold
Sept. 16, 2009
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M0 Currency Reserves 16b
Sept. 16, 2009
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M1 16b Currency Bank Deposits
Sept. 16, 2009
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Money Multiplier M1/M0 1
Sept. 16, 2009
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Bank Money Multiplier

• If l loans, Reserve multiplier is
• D R(1 l l 2 l 8 ) R/(1- l )
• If M0 Reserves (R) Currency (C),
• M1 (Currency Deposits) multiplier is
• M1 C R/(1- l ) M0R R/(1- l )
• M1/M0 1-R R/(1- l )/M0
• So M1/M0 1 gt l 0

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The Zero Bound
Sept. 16, 2009
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Keyness Liquidity Trap
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Keyness Liquidity Trap
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Keyness Liquidity Trap
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Keyness Liquidity Trap
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Output Gap 20 GDP

• http//www.cbo.gov/ftpdocs/99xx/doc9958/01-08-Outl
  ook_Testimony.pdf
• A little Stimulus Math
• 20 14 tr. 2.8 tr.
• Stim1.5 2.8 gt Stim 1.87 tr.

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(2) 3 Reasons Bottom stillA Long Way Off

• Housing Recovery probably more than a year away.
• Credit Markets still very weak.
• Stock Market Valuation Ratios like P/E and
  Tobins Q are now only at historical averages.

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Housing Bottom A Long Way Off
http//www.nytimes.com/imagepages/2008/10/16/busin
ess/16housing.graphix.ready.html
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Why it Matters to Everyone
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Indicators of Credit Crisis
http//www.nytimes.com/interactive/2008/10/08/ bus
iness/economy/20081008-credit-chart-graphic.html
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TED-Spread Financial Crises
Subprime financial shock
LTCM
Y2K
SL crisis
Peso crisis
Thai baht
Tech bust
Orange County
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108 Years of P/E and Q
Shiller/Smithers - www.ft.com/cms/s/0/099f6380-bb1
f-11dd-bc6c-0000779fd18c.html
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(3) CT is Middle of the Pack

• Fairfield 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.

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• CTs Largest Private Employers, CT payroll
• United Technologies Corp. (UTC) 26,490
• The Stop Shop Cos. Inc. 14,049
• The Hartford Financial Services Group Inc.
  13,000
• Yale University 12,100
• Foxwoods Resort Casino 11,900
• Mohegan Sun Casino 10,000
• U.S. Naval Submarine Base 9,900
• Wal-Mart Stores, Inc. 9,038
• ATT Corporation 7,700
• General Dynamics Electric Boat 7,500
• General Electric Co. 7,500
• Aetna Inc. 7,252
• Pfizer Global Research and Development 7,000
• The Travelers Cos. Incorporated 6,500
• Hartford Hospital 6,377
• Bank of America 5,100
• Cigna 3,984

COLOR KEY Defense Health Education Insurance
Banking Counter-cyclical Pro-cyclical
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More Stable than US as a Whole
Source Economy.Com, Connecticut Precis, Sept.
2008
Monday, November 16, 2009
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State Income Growth Comparable
Source Economy.com, CT Precis, Sept. 2008
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State Unemployment Comparable
Source Economy.com, CT Precis, Sept. 2008
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Sun Belt, Rust Belt Concentration
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CT Suffered Less than Most in Northeast
Source Office of Federal Housing Enterprise
Oversight http//www.ofheo.gov/media/pdf/2q08hpi.
pdf
Monday, November 16, 2009
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What doesnt go up too far, Wont go down so far
Economy.com, CT State Report, Sep. 2008
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2006 Peak of Price-to-Rent
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(No Transcript)
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Source NY Times, May 28, 2008 Economy.com
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www.bos.frb.org
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US Vacant Homes for Sale (thousands)
Housing supply 900,000 Single 525,000 Multi
300,000 Manufactured 75,000 Housing
demand 1,400,000 Households 875,000 Obsolescen
ce 400,000 Second homes 125,000
Economy.com, Census, Nov. 2008
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(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 dont have big effect on those too poor
  to pay many taxes.
• Unmet needs in Energy, Environment, Health, and
  Education good reasons to spend.

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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)

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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.

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Long Term Fiscal Gap Unsustainable
http//www.cbo.gov/ftpdocs/93xx/doc9385/06-17-LTBO
_Testimony.pdf
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Sure as Debt and Taxes
http//www.cbo.gov/ftpdocs/93xx/doc9385/06-17-LTBO
_Testimony.pdf
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Inflation/Devaluation a Powerful Temptation for
Highly Indebted Governments

• Germany after WWI
• Russia after the Revolution
• Soviet Union after the Cold War
• Many Developing Countries after
• spending, investment binges
• (See L. Kotlikoff S. Burns,
• The Coming Generational Storm, 2004)

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Implications of Limited Pass-Through

• Linda Goldberg (FRBNY) has shown that
• Dollar Devaluation means
• Improved Earnings on Foreign Assets
• Easier Debt Servicing
• Smaller Trade Deficit
• And at the same time,
• Minimal Costs in further Inflation
• So - Whats Not to Like?
• FRBNY Governor Frederic Mishkin says
  Devaluation cannot be a policy. (I think he
  means an explicit policy.)

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Inflation/Devaluation Appears to be a Painless
Way Out of Debt
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Promising Investments?

• Short-Term Shorts (Aggressive)
• Shorts on the Dow, SP (DOG, SH, SDS
• en.wikipedia.org/wiki/Inverse_etf)
• Medium-Term Holds (Cautious)
• US Treasuries (but not long term remember
  inflation)
• Gold, Silver, other precious metals
• Long-Term Holds (Patient)
• Non-Dollar Assets in Emerging Markets
• Renewable Energy Technology
• Pharmaceuticals tied to global incomes, high
  dividends

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Summary of Conclusions

• Recession will be long and deep housing slump,
  interbank lending, financial markets likely to
  overshoot on low side.
• CT is middle of the pack for housing prices and
  employment stability.
• Greatly expanded federal spending is needed in
  the short-term.
• Long-term, however, US government debt is
  unsustainable.
• There are still some places to put your money!