Financial Crisis, Recessions and the State of Macroeconomic Theory

1
Financial Crisis, Recessions and the State of
Macroeconomic Theory

• Melanie Fritz
• Thomas Schützenhofer
• Silvia Winter

Department of Economics
2
Economists The current crisis and macroeconomic
theories

• Olivier Blanchard
• Casey B. Mulligan
• Paul Krugman
• Alan Greenspan

3
Economists The current crisis and macroeconomic
theories Olivier Blanchard

• Three groups
• The basic/traditional Keynesians
• The new-classicals want reconstruction RBC-
  Model
• The new-Keynesians want reform and not
  revolution the previous vision of macroeconomics
  was right gtbetter foundations for imperfection

4
Economists The current crisis and macroeconomic
theories basic model of Keynes

• Keynes held a leading position for three main
  reasons
• 1. models were simple, flexible, and easy to use
  and seemed broadly consistent with observed
  patterns of economic activity
• 2. Second, Keynes and his disciples made a
  strong and effective critique of the alternative
  school
• 3. analytical Keynesian models provided a base
  for detailed statistical models of macroeconomic
  activity, used for economic forecasting and for
  evaluating alternative policies
• Three ideas are central to the Keynesian view
• The first is that there is little presumption
  that market outcomes are desirable gt great deal
  of scope for government intervention

5
Economists The current crisis and macroeconomic
theories basic model of Keynes

• second is that changes in the supply side of
  markets are important mainly in the long run,
  which is taken to be very far away in most policy
  situations.
• The third Keynesian view is that the fiscal and
  monetary authorities can control demand
  conditions for specific products and for the
  economy as a whole
• These are differences to the new-Classical!!!

6
Economists The current crisis and macroeconomic
theories basic model of Keynes

• Keynesian economists of the 1960s often appealed
  to the Phillips curve , taking it to imply that
  monetary or fiscal policy that lowered the
  unemployment rate thus caused a higher inflation
  rate
• The New-Classicals rejected this idea

7
Economists The current crisis and macroeconomic
theories basic model of Keynes

• Keynes
• saw the price system in a free economy as
  efficiently guiding the mutual adjustment of
  supply and demand in all markets, including the
  labor market
• unemployment can only arise because of market
  imperfection (New classicals)
• recessions occur when aggregate demand falls-
  largely as the result of a fall in private
  investment firms to produce below-causing their
  capacity. Producing less, firms need fewer
  workers

8
Economists The current crisis and macroeconomic
theories The basic model of Keynes

• Traditional Keynesian view of business cycles -
  according to which fluctuations are caused by a
  variety of types of real disturbances
• which affect economic activity solely through
  their effects on aggregate demand, while
  aggregate supply instead evolves as a smooth
  trend
• is no more confirmed by the modern models

9
Economists The current crisis and macroeconomic
theories The New-Classicals

• The New-Classicals an economic school of
  thoughts in the 1970s
• uses the standard principles of economic analysis
  to understand how a nation's total output (gross
  domestic product, or GDP) is determined
• construction of structural models of short-run
  fluctuations
• differed sharply from Keynesian modelers
• According to Keynes the New-Classicals saw price
  system in a free economy efficiently guiding the
  mutual adjustment of supply and demand in all
  markets, including the labor market
• Unemployment could arise only because of a
  market imperfection

10
Economists The current crisis and macroeconomic
theories The New-Classicals

• NCM view supply and demand result from the
  actions of economically rational households and
  firms. Macroeconomic quantities like GDP are the
  result of the general equilibrium of the markets
  in an economy.
• It is surprising that this perspective is
  considered revolutionary in macroeconomics when
  we see the current nature of economic analysis in
  other fields, such as public finance,
  international trade, and labor economics

11
Economists The current crisis and macroeconomic
theories The New-Classicals

• Lucas and Rapping applied the rule that in a
  market equilibrium occurs when quantity supplied
  equals quantity demanded
• The two fundamental tenets of the New-
  classicals
• Individuals are optimizers given the prices
• Changing the incentives to individuals
• NCM view a household's consumption in a specific
  time period depends on its current income and on
  the income it expects in the future, as well as
  on the interest rates at which it can borrow or
  lend (different from Keynesian)

12
Economists The current crisis and macroeconomic
theories The New-Classicals

• Keynesian economists of the 1960s often appealed
  to the Phillips curve , taking it to imply that
  monetary or fiscal policy that lowered the
  unemployment rate thus caused a higher inflation
  rate
• The New Classical rejected the idea that there
  was any useful trade-off
• They argued that expansion of aggregate demand on
  unemployment only lowered because the
  acceleration in prices was not anticipated

13
Economists The current crisis and macroeconomic
theories The New-Classicals

• Dynamic models have replaced static models
  policy actions can not be evaluated
• How are large fluctuations in output compatible
  with the two fundamental tenets of their
  doctrine?
• RBC Model
• In RBC-based monetary models, sticky wages are
  often used to generate a high elasticity of
  labor supply

14
Economists The current crisis and macroeconomic
theories The New-Classicals

• RBC - three principles
• explicit micro foundation, defined as utility and
  profit maximization general equilibrium and the
  exploration with no or few imperfections
• Shocks to aggregate demand
• Shocks to aggregate supply
• RBC-school regard changes in productivity as the
  driving force in business cycles because of
• changes in technology may come in waves,
  therefore, favorable or unfavorable runs of
  productivity (or technology) shocks may account
  for some of the characteristic persistence of
  business cycles

15
Economists The current crisis and macroeconomic
theories The New-Keynesian Model

• The New-Keynesian-Model (NK-Model)
• It is an aggregate demand relation in which
  output is determined by demand and demand depends
  in turn on anticipations of both future output
  and future real interest rates!
• NK-Model became a workhorse for policy and
  welfare analysis. It starts from RBC without
  capital

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Economists The current crisis and macroeconomic
theories The New-Keynesian Model

• NK-Model simple and replaced IS-LM-Model as
  basic model of fluctuation
• NK-Model monetary policy keeps inflation rate
  constant
• assumes that households and firms have rational
  expectations

17
Economists The current crisis and macroeconomic
theories The New-Keynesian Model

• NK assumes a variety of market failures (differ
  from New-Classical)
• assume prices and wages are "sticky", which means
  they do not adjust to changes in economic
  conditions
• Wage and price stickiness, and the other market
  failures imply that the economy may fail to
  attain full employment
• NKs argue that macroeconomic stabilization by the
  government (using fiscal policy) or by the
  central bank (using monetary policy) can lead to
  a more efficient macroeconomic outcome than a
  laissez faire policy

18
Economists The current crisis and macroeconomic
theories The New-Keynesian Model

• NK-Model lacks of many details
• to understand fluctuations
• DMP-Model consideration of unempolyment
• Two implications of the model
• Always unemployment
• Time for worker to find new work

19
Economists The current crisis and macroeconomic
theories New Synthesis

• DSGEs dynamic stochastic general equilibrium
  models
• DSGE
• models with sticky wages and/or prices
• that wage- and price-setting decisions are made
  on the basis of rational expectations
• think about the effects of policy
• included Keynesian thinking ignore the role of
  financial markets
• assume markets to be efficient and
  self-correcting and not worthy of being included
  in the models

20
Economists The current crisis and macroeconomic
theories

• In contrast to classical macroeconomics, new and
  old, Keynesian macroeconomics did not begin with
  the assumption that an economy is made up of
  individually rational economic suppliers and
  demanders.
• Instead of deriving demand from individual
  choices
• For example the Keynesian procedure was to
  directly specify a behavioral rule
• Keynes claimed that aggregate spending on
  consumption was governed by a "consumption
  function" in which consumption depended solely on
  current income.

21
Economists The current crisis and macroeconomic
theories

• Keynesian macroeconomics said that people
  followed fixed rules of thumb
• with no presumption that firms and households
  made rational choices
• this grew out of a suspicion on the part of
  Keynesian modelers that people did not typically
  act rationally
• it was a pragmatic modeling decision if people's
  economic behavior is purposeful, the task of
  specifying how they will act in various
  situations is more complicated and, therefore,
  more difficult to model.

22
Economists The current crisis and macroeconomic
theories Olivier Blanchard

• Models are similar in structure
• Problem same models for different structures and
  shocks
• Great progress and excitement in macroeconomics
• Three hopes of Blanchard
• Rehabilitation of partial equilibrium
• Huge micro data -gt DSGE
• Re-legalization of shortcuts and simple models

23
Economists The current crisis and macroeconomic
theories Kehoe - Solow

• Arrogate for little macro models
• Understand mechanism of economy
• Solow ignore heterogeneinity factors
• Change models prospective and
• Adapt it to challenges in macro-economy

24
Economists The current crisis and macroeconomic
theories Luigi Spaventa

• If not forecasting the crises, economists were
  aware of that the system had set on an
  unsustainable path?
• Was the state of economics the problem or was it
  the economists using them to fail?
• economists are unable to understand reality
  because of the abstraction of theories and models

25
Economists The current crisis and macroeconomic
theories Luigi Spaventa

• available tools were inadequate in the field of
  macroeconomics
• Luigi Spaventa shows that nobody can provide
  precise forecast about the crisis
• new business models known as originated to
  distribute (OTD)
• macro- and microeconomic implications were never
  explored
• Solution general macroeconomic framework

26
Economists The current crisis and macroeconomic
theories Paul Krugman

• Krugman and the current crisis
• the state of macro is good (?)
• criticism on economists
• only few economists saw this crisis coming
• economists were blended and ignored important
  facts

27
Economists The current crisis and macroeconomic
theories Paul Krugman

• The central cause of the professions failure
  was the desire for an all-encompassing,
  intellectually elegant approach that also gave
  economists the chance to show off their
  mathematical prowess!

28
Economists The current crisis and macroeconomic
theories Paul Krugman

• Macroeconomics according to Keynes
• National and international programs
• Policies to regulate booms and slumps
• ? economic equilibrium resorted and maintained
  by official action
• ? no space for classical theory and its
  laissez-faire

29
Economists The current crisis and macroeconomic
theories Paul Krugman

• Capitol Hill Baby-Sitting Cooperative
• 150 couples
• 20 coupons/couple
• One coupon half an hour baby-sitting
• ? keep reserves
• ? cooperative fell into recession

30
Economists The current crisis and macroeconomic
theories Paul Krugman

• saltwater economists (mainly from universities
  in the coastal area) who agree more or less with
  the Keynesian theory of recessions.
• freshwater economists (mainly at interior
  universities) who totally disagree to the
  Keynesian vision.

31
Economists The current crisis and macroeconomic
theories Paul Krugman

• Freshwater economists
• bring demand and supply into balance to get out
  of recession
• Unemployment is an consciously decision to take a
  time-out
• Saltwater economists
• Recessions are demand-driven
• Need for political activities

32
Economists The current crisis and macroeconomic
theories Paul Krugman

• No one could have predicted...
• general belief that bubbles just do not happen
• vision of a perfect and frictionless market
  system
• behavioural finance

33
Economists The current crisis and macroeconomic
theories Paul Krugman

• Krugmans advice to economists
• face up reality
• recognize that the Keynesian economy illustrates
  the best framework for recessions and depressions
  which we have
• do the best to implicate the realities of finance
  into macroeconomics

34
Economists The current crisis and macroeconomic
theories Alan Greenspan

• Greenspan was chairman of the Federal Research
  Board until 2006
• ? The Times 25 People to Blame for the
  Financial Crisis Greenspan as one of the top
  three people who are responsible for the current
  crisis!

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Economists The current crisis and macroeconomic
theories Alan Greenspan

• Greenspan to the accusations
• Roots lay in the quick global decline in nominal
  and real long-term interest rates in the early
  part of the 2000s
• Monetary policy does not bear any blame for the
  crisis
• ? central banks are not at fault and were
  impotent bystanders
• Deny that house prices are driven upward by low
  short-term rates
• No correlation between looseness of monetary
  policy in different countries and changes in
  house prices
• We will never have a perfect model of risk

36
Financial Crisis in the Past

• Chile and Mexico
• Both countries had the same financial problem
• Their reaction was different
• Mexico nationalized bank-system
• Chile passed solvent banks into private hand

37
Financial Crisis in the Past

• Mexico
• Wanted to keep the investment activity and
  employment
• Companies got cheaper loans
• Firms which were threatened by insolvency could
  survive
• Also unproductive firms survived
• Chile
• Bank system was privatized
• Unproductive firms got insolvent

38
Financial Crisis in the Past

• Consequences
• Chile decreasing GDP in 1982/83 but in 1984
  Chile had the biggest GDP in Latin America
• Mexico economic disaster 1982 to 1985 and since
  this time the GDP growth is very teeny
• The difference between Chile and Mexico was the
  productivity (high/low)

39
Financial Crisis in the Past
Financial crisis in the past Finland and
Japan Similar to the crises in Chile and Mexico
was Finland and Japan

• Japan followed Mexico while Finland followed
  Chile
• The effects were similar the crises in Chile and
  Mexico
• Japan had a scarcely growth of GDP
• Finland's GDP growth increased quite a lot

40
Financial Crisis in the Past

• Conclusion Development of financial crises
• Reaction of government and economy are important
• Productivity is a important factor for growth and
  depression
• Government could influence productivity
• Overreaction of government can cause regression
• Giving examples Chile and Mexico / Finland and
  Japan

41
Financial Crisis

• Current financial crisis North America/Europe
• Now the same situation
• Goal should be The way of Finland and Chile
• Force productivity
• Support of productive companies
• Unproductive firms should get insolvent?

42
The sequences of the financial crises

• Now a overview about the Liquidity and Credit
  Crunch in 2007-2008
• Banks get liquidity pressure
• Mortgage crises
• Asset backed financial products
• Central bank
• Monoline Insurers
• Bear Stearns, Fannie Mae, Freddy Mac, Lehman
  Brothers, etc.
• Liquidity spiral

43
The sequences of the financial crises

• Bank trends leading into liquidity pressure
• The reason were bad loans which were write down
• Amount of hundreds of billion dollars
• At the same time the stock market lost more than
  half of value
• The reason was high mortgage losses
• Result in US Stock market lost more than eight
  trillion dollars
• The followings were cry for liquidity
• It was difficult to get money, consequently
  bailouts followed
• Government saved companies of bailouts

44
The sequences of the financial crises

• Subprime mortgage crises
• Starting in Feb. 2007
• Cause was the increasing mortgage failures
• Evident in ABX Indices swap
• Indices decreased, costs of insurance for
  mortgage-loss increased

45
The sequences of the financial crises

• Consequences
• Prices by mortgages dropped
• Downgrading by moodies, Standard Poor and Fitch
• Credit market got definitely out of balance in
  June 2007
• 26th July 2007 Index of National Association of
  Home builders lost 6,6 (year on year)

46
The sequences of the financial crises

• Asset backed financial products
• Increasing popularity because
• Advantages the big spread against many market
  partners
• Asset Backed products were AAA-rated which
  affected low mortgage and interest rates
• This attracted also institutional investors
• For example Senior tranches was not include in
  Basel 1 and so they don't need assets as
  collateralise minimum (8)
• !Product included the assumption, that housing
  prices couldnt drop!

47
Liquidity and Credit Crunch 2007-2008

• Consequences
• Big supply of opportune credits
• Decreasing collateralising standard
• Ending in housing-madness
• Effects
• Borrowers normally cannot get credit get it
• After a time they could not perform it

48
The sequences of the financial crises

• Central bank
• European Central bank gave credit of 95 billion
  Euros
• US Federal Reserve followed with 24 billion Euros
• Discount rate for credits sunk for 0,5 to 5,75
• But more over 7000 banks didn't accept this
  credits ? was a negative signal ?
  creditworthiness
• Oct. 2007 interest rate reduction to 5,25
• So British bank Northern Rock got liquidity
  support by Bank of England
• Northern Rock was the first victim of bank-run in
  Great Britain since one century

49
The sequences of the financial crises

• Monoline Insurers
• Insurance for Municipal Bonds and Guarantees for
  mortgage market Securities
• Due to the crises Monoline Insurers get under
  pressure and Downgradings followed
• Downgradings by their ratings (giving example
  Fitch took downgrading by Ambac)
• World wide downgrades
• Asia stock m. 15, Down Jones and NASDAQ up 6
• Biggest cut since 1982

50
The sequences of the financial crises

• Bear Stearns, Fannie Mae, Freddy Mac,
• Bearstearns
• Problems to operate the Margin calls
• No money by Repo market (Liquidity)
• Big rivals help to minimize the credit risk of
  Bear Stearns (systemic important)
• Fannie Mae and Freddy Mac
• Problems to get money ? mortgage rate increased
• Government gave guarantee
• But stock market price decreased and the
  Government
• took both companies in polity control
• This caused large numbers of out-standings credit
  default swaps
• Successions Big Payments for buyers who bought
  this swaps

51
The sequences of the financial crises

• Lehman Brothers, Merril Lynch and AIG
• Also this banks get insolvent/bailouts
• Lehman Brothers get bankruptcy
• Take over by Merrill Lynch by the Bank of America
• AIG also get liquidity problems after Lehman get
  bankruptcy
• Federal created a organisation for bailouts with
  a value over 85 billion dollars
• Raised by 37 billion in Oct. 2007 and 40 billion
  in Nov. 2007

52
Amplifying Mechanisms and Recurring Themes

• Liquidity Spirals
• Liquidity spirals are loss spirals which started
  when deprecation of assets starts and net value
  decreases faster than the gross value. The
  following is a lower credit amount.
• For example
• Investor bought assets by 100 million, margin
  calls 10
• 10 million own capital
• 90 million outside capital
• Leverage ratio is 10

53
Amplifying Mechanisms and Recurring Themes

• Now
• Value decreased to 95 million
• Loss of 5 million? losses 5 million of his own
  capital
• To get leverage ratio of 10 , he must sell 45
  million
• These depress the price and he has to sell again
  (he need leverage ratio 10)
• This is the beginning of the liquidity spirals
  (more investors had this problems)
• Next problem
• Buyers wait, because it is better to start after
  liquidity spirals
• Extreme cases ? Firesales

54
My own view

• Many factors which can influence financial crises
• Liquidity
• Interrest rate
• Mortgage rate
• Productivity
• Etc.

I believe, the most important thing of all
factors is, that we must take reaction over this
financial crisis. So we need stricter regulations
and more controls.