Understanding the Financial Crisis
Presentation to
Members of the Town & County Club
Hartford, CT
James Stodder, (Ph.D., Economics, Yale 1990)
Lally School of Management & Technology
Rensselaer Polytechnic Institute at Hartford
Hartford, Connecticut, USA
Tuesday, July 12, 2016
1
Outline of Talk
1.
Keynes on Credit Cycles:
- Why we need Regulation
2.
3.
4.
Where is the Bottom?
Connecticut is “Middle of the Pack”
Government Deficit Spending
a.
b.
Needed in the Short-term
But a Big Problem Long-term
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2
(1) Biz & Credit Cycles
J. M. Keynes: 1883-1946
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3
US Macro-Stability:
Better, Room for Improvement
Average U.S. Business Cycle, 1854 to 2006
Contraction
1854-1919
(16 cycles)
45%
1919-1945
(6 cycles)
55%
34%
1945-2006
(10 cycles)
66%
15%
0
Expansion
85%
10
20
30
40
50
60
70
Months
Source:
Tuesday, July 12, 2016
http://www.nber.org/cycles.html
4
Bad News: Bubbles are Endemic
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Arlington Williams, “Price Bubbles”
www.indiana.edu/~arlwilli/pdf%20files/bigmkts.pdf
5
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 => Moral Hazard =>
Necessity 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_id=12480887
www.nytimes.com/2008/10/03/business/03sec.html
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Limits of Fed Magic
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New Yorker, Oct. 2008
11
Currency Rises Slightly
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But Bank Reserves up 100-fold
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M0 = Currency + Reserves ≈ $16b
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14
M1 ≈ $16b = Currency + Bank Deposits
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Money Multiplier = M1/M0 ≈ 1
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Bank Money Multiplier
If l = % loans, Reserve multiplier is
D = R(1+ l
+ l +… + l
2
∞ )= R/(1-
l)
If M0 = Reserves (R) + Currency (C),
M1 (Currency + Deposits) multiplier is:
M1 = C + R/(1- l ) = M0–R+ R/(1- l )
M1/M0 = 1{-R + R/(1- l )}/M0
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So M1/M0 = 1 =>
l=0
17
The Zero Bound
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Keynes’s Liquidity Trap:
FISCAL Expansion:
Investment Demand = Savings
interest
rate
FISCAL Expansion:
Money Demand = Supply
GDP
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Keynes’s Liquidity Trap:
FISCAL Expansion:
Investment
Investment Demand = Savings
interest
interest
rate
rate
MONETARY Expansion:
Money Demand = Supply
Supply
GDP
GDP
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Keynes’s Liquidity Trap:
FISCAL Expansion:
Investment Demand = Savings
interest
rate
FISCAL Expansion:
Money Demand = Supply
GDP
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Keynes’s Liquidity Trap:
FISCAL Expansion:
Investment Demand = Savings
interest
rate
FISCAL Expansion:
Money Demand = Supply
GDP
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Output Gap ≈ 20% GDP

http://www.cbo.gov/ftpdocs/99xx/doc9958/01-08Outlook_Testimony.pdf
A little Stimulus Math:
20% * $14 tr. = $2.8 tr.
Stim*1.5 = $2.8 => Stim = $1.87 tr.
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(2) 3 Reasons Bottom still
A Long Way Off



Housing Recovery probably more
than a year away.
Credit Markets still very weak.
Stock Market Valuation Ratios like
P/E and Tobin’s 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/business/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/
business/economy/20081008-credit-chart-graphic.html
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TED-Spread & Financial Crises
3.00
2.50
Subprime
financial
shock
2.00
1.50
S&L crisis
1.00
Orange
County
Peso
crisis
LTCM
Thai
baht
Y2K
Tech
bust
0.50
0.00
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08
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108 Years of P/E and Q
Shiller/Smithers - www.ft.com/cms/s/0/099f6380-bb1f-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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CT’s Largest Private Employers, CT payroll
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
United Technologies Corp. (UTC)
The Stop & Shop Cos. Inc.
The Hartford Financial Services Group Inc.
Yale University
Foxwoods Resort Casino
Mohegan Sun Casino
U.S. Naval Submarine Base
Wal-Mart Stores, Inc.
AT&T Corporation
General Dynamics Electric Boat
General Electric Co.
Aetna Inc.
Pfizer Global Research and Development
The Travelers Cos. Incorporated
Hartford Hospital
Bank of America
Cigna
Northeast Utilities
Saint Francis Hospital and Medical Center
United States Surgical
26,490
14,049
13,000
12,100
11,900
10,000
9,900
9,038
7,700
7,500
7,500
7,252
7,000
6,500
6,377
5,100
3,984
3,947
3,892
3,800
COLOR KEY
Defense
Health & Education
Insurance & Banking
Counter-cyclical
Pro-cyclical
Source: Economy.Com, Connecticut State Precis, Sept., 2008
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More Stable than US as a Whole
Fig. 3: Employment Volatility, US and CT
100%
US
91%
CT
Source: Economy.Com, Connecticut Precis, Sept. 2008
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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
Fig. 2b: Annual Change in House Prices,
2007Q2-2008Q2
2.2%
1.8%
RI
NJ
MA
NH
US
CT
NY
VT
ME
-0.8%
-1.7%
-1.4%
-2.1%
-2.9%
-2.9%
-4.8%
Source: Office of Federal Housing Enterprise Oversight: http://www.ofheo.gov/media/pdf/2q08hpi.pdf
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What doesn’t go up too far,
Won’t 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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39
Fig. 1c: Price to Rent Ratio, US MSAs, Peak to 2008, Q1
45
Columbus
Pittsburgh
Indianapolis
Kansas City
Dallas
Cincinnati
Austin
Memphis
Oklahoma
Houston
Salt Lake City
Denver
Philadelphia
Chicago
Milwaukee
Portland
Seattle
San Antonio
17.4
HARTFORD, 18.2
Raleigh
Atlanta
Charlotte
Baltimore
Jacksonville
Minneapolis
17.5
New Orleans
UNITED STATES, 21.0
Tampa-St.
Phoenix
Washington
Oakland,
Nassau-Suffolk
Riverside-San Bernadino
San Jose
Las Vegas
St. Louis
15
40
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Orlando
20
Fort Lauderdale
Boston
25
New York
Miami
Sacramento
San Diego
Orange County
Los Angeles
30
West Palm Beach
35
San Francisco
40
P/R 2008
P/R Peak
10
Source: NY Times, May 28, 2008; Economy.com
Tuesday, July 12, 2016
www.bos.frb.org
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US Vacant Homes for Sale (thousands)
2,250
2,000
1,750
Housing supply
Single
Multi
Manufactured
900,000
525,000
300,000
75,000
Housing demand
Households
Obsolescence
Second homes
1,400,000
875,000
400,000
125,000
1,500
1,250
1,000
00
01
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02
03
04
05
06
Economy.com, Census, Nov. 2008
07
08
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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 don’t 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 - What’s 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, S&P (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!
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