Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.1
INTRODUCTION
Goals of the course:
 Expand your knowledge of macroeconomics, building on material
covered in the first-year course
 Enable you to understand and analyze recent economic events
We will illustrate the topics of the course in a two part introduction:
 Part one: the Great Lockdown Recession
 Part two: the Great Recession
The goal of part one is to bring you up to date with current events
which are the most dramatic since the Great Depression in 1930s
The goal of part two is to have a look at a more regular recession, the
effects of which still lingered when the coronavirus hit.
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.2
INTRODUCTION PART 1: THE GREAT LOCKDOWN
RECESSION
Great lockdown – term used by Gita Gopinath, Chief Economist of the International
Monetary Fund (or: the coronavirus recession, or the current recession).
Constantly changing situation.
Different than regular recessions
 Supply shock
 Lower demand (loss of jobs, precautionary savings)
 Breakdown of supply chains
Plan of introduction:
 Will look at data and compare the behaviour of the Canadian economy during
the coronavirus recession with the Great Recession (2008-9)
 Why?
- to learn what happened
- it is an unusual recession; the Great Recession followed the usual pattern
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
A BRIEF HISTORY
First case in Canada – end of January 2020
Local transmission – beginning of March
March 12 – schools closed
March 16 – Laurier closed
March 21 – land border with the US closed
Provincial responsibility – no uniform federal schedule
May 19 – first stage of reopening, mid June – second, July-third
1.3
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
THE EFFECT ON THE CANADIAN ECONOMY, AND A COMPARISON
WITH THE GREAT RECESSION
PART 1: MACROECONOMIC VARIABLES
What you should know: What happened with
- output
- hours worked
- inflation
- labour force and employment
- employment and earnings
- unemployment
- foreign trade
1.4
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.5
THE EFFECT ON THE CANADIAN ECONOMY, AND A COMPARISON
WITH THE GREAT RECESSION
OUTPUT
- much bigger drop than in the Great Recession
- services fell 15%; in the Great Recession fell 0.7%
- output fell 17%, in the Great Recession fell 5%
We describe how Real GDP and other measures of output in chapter 2: “Calculating
Output”.
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
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Two extremes: public sector and retail trade output
- big drop in retail trade (shut down stores): 30%; in the Great Recession 5%
drop
- decline in the public sector (12% in April) – furloughed workers; in the Great
Recession little change in the public sector
Imputations: public services are included in GDP at cost
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.7
HOURS WORKED
10%
10%
5%
5%
0%
0%
-5%
-5%
-10%
-10%
-15%
-15%
-20%
-25%
-30%
Total actual hours worked, all industries
-20%
Goods-producing sector
-25%
Services-producing sector
-35%
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
-30%
-35%
Oct-19 Nov-19 Dec-19
Total actual hours worked, all industries
Goods-producing sector
Services-producing sector
Jan-20
Feb-20 Mar-20 Apr-20 May-20 Jun-20
Jul-20
- usually – hours fall less than output: labour hoarding
- current recession: drop in hours (27%) bigger than output (17%)
(large proportion of jobs lost in low-productivity sectors)
We describe the labour market, employment and unemployment in chapters 7: The
Labour Market and chapter 8: Unemployment.
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.8
INFLATION
4%
3%
2%
1%
0%
-1%
All-items
All-items excluding food and energy
-2%
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
- Inflation fell from 2% in January to -0.4% in April
Main driver – energy prices (as in the Great Recession)
2008: huge increase in oil prices, followed by a collapse
2020: Russia – Saudi Arabia oil war, combined with demand decrease because of
the pandemic.
 Price of Canadian oil – negative!
In addition: changes in the composition of purchased goods (towards food and
other necessities)
We discuss inflation in chapter 3: Money, Inflation and Real and Nominal Variables
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.9
LABOUR FORCE AND EMPLOYMENT
3%
3%
1%
1%
-1%
-1%
-3%
-3%
-5%
-5%
-7%
-7%
-9%
-11%
-13%
-9%
Labour force
Employment
-15%
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
-11%
-13%
Labour force
Employment
-15%
Oct-19 Nov-19 Dec-19
Jan-20
Feb-20 Mar-20 Apr-20 May-20 Jun-20
Jul-20
- big drop in labour force in the current recession
In a regular recession – some people drop out, but not many since recessions are relatively short. In the
Great Recession labour force was increasing
In April 2020 – labour force fell by 8%
- big drop in employment
In the Great Recession: by 2% (smaller than drop in output because of labour hoarding)
In April 2020 – by 15%
Reason: Canadian government provided support directly to workers
Alternative: provide support to firms to keep people on payroll (in Europe)
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.10
FULL-TIME VERSUS PART-TIME EMPLOYMENT
5%
5%
0%
0%
-5%
-5%
-10%
-10%
-15%
-15%
-20%
-25%
Full-time employment
Part-time employment
-30%
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
-20%
-25%
Full-time employment
Part-time employment
-30%
Oct-19 Nov-19 Dec-19
Jan-20
Feb-20 Mar-20 Apr-20 May-20 Jun-20
Jul-20
Great Recession: part-time employment actually increased; full-time employment fell 3.5%
April 2020: much bigger drop in part-time (30%) than in full-time employment (12%)
Caused by the selection of businesses under lockdown: restaurants, hotels, service places.
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.11
UNEMPLOYMENT RATE
70,00%
70%
19%
19%
17%
65% 17%
65,00%
15%
60%
15%
60,00%
13%
13%
11%
Unemployment rate (left axis)
Participation rate (right axis)
55%
50% 9%
9%
7%
5%
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
11%
7%
55,00%
Unemployment rate (left axis)
Participation rate (right axis)
50,00%
45,00%
45%
5%
40,00%
40%
During the Great Recession, the unemployment rate increased by less than 3%, from
around 6% to below 9%
During the current recession, the unemployment rate increased by over 7%, from under
6% to over 13%
The increase in unemployment in the current recession was much bigger.
During the current recession the unemployment rate increased faster and started falling
faster.
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
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EMPLOYMENT AND EARNINGS
15%
15%
10%
10%
5%
5%
0%
0%
-5%
-5%
-10%
-10%
-15%
Employment for all employees
Average weekly earnings including overtime
-20%
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
-15%
-20%
окт.19
Employment for all employees
Average weekly earnings including overtime
ноя.19
дек.19
янв.20 фев.20 мар.20 апр.20 май.20 июн.20
- Paradox: Total employment falls by 15%; average earnings increase by 9%
In a regular recession: employment falls, earnings fall or grow at a slower rate.
In the coronavirus recession: job losses are in sectors where pay is low.
We can check that, by looking only at goods production: employment falls, wages do not
change
Note: Employment falls by 15% and earnings increase by 9% -> pay per person rises 28%:
85% of workers get 109% of earnings: 109/85-1=28%
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
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FOREIGN TRADE
20%
20%
10%
10%
0%
0%
-10%
-10%
-20%
-20%
-30%
-30%
Imports
Exports
-40%
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Imports
Exports
-40%
Oct-19 Nov-19 Dec-19 Jan-20 Feb-20 Mar-20 Apr-20 May-20 Jun-20
Jul-20
- Exports and imports fell as much as in the Great Recession
Trade remained open so even though drop in output was bigger than in the Great
Recession, the drop in trade was similar.
- Exports fell more than imports, both in 2020 and in 2008.
Why? US was more affected than Canada; US is by far our biggest trading partner.
We will talk about factors determining foreign trade in chapters 4: Exchange Rates
and chapter 9:
The IS-IC Model: the Basic Framework to Understand
Macroeconomic Policy
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
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SUMMARY
Great Recession
Great Lockdown
What is different at present
Output
Fell 5%, drop bigger in
Fell 17%; big drop in
goods production than in services (15%)
services (0.7%)
Much bigger drop in services
because of closures
Hours
Smaller drop than output Bigger drop than in
(4%)
output (27%)
Hours fell more in lowproductivity sectors
Inflation
Fell below zero (-1%)
Similar to Great Recession
Lab. Force
Labour force increased a Fell 8%
little
Big decline in labour force
Employment
Fell 2%
Fell 15%
Big drop in part-time employment
Unemployment Rose to almost 9%
rate
Rose to over 13%
Much bigger increase in
unemployment
Earnings
Slower growth as
employment fell
Increased!
Employment fell in low-paying
businesses
Foreign trade
Exports, imports both fell, Exports, imports both
exports fell more
fell, exports fell more
Fell below zero: -0.4%
Similar to Great Recession
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
PART 2: POLICY RESPONSE
- Fiscal policy
- Monetary policy
1.15
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.16
PUBLIC POLICY RESPONSE
FISCAL POLICY
Numerous fiscal measures:
The Canada Emergency Response Benefit (CERB): $2000 per 4 weeks to unemployed
Canada Emergency Student Benefit (CESB): summer support for students up to $5000
Canada Emergency Wage Subsidy (CEWS) funds for employers to cover 75% of employee
wages.
Programs for seniors, Indigenous peoples, businesses, tax deferrals, specific programs for
various sectors and many others.
Record deficit: in July projected to be $343bln; in 2008-9 it was $67bln
Two reasons for deficit: lower revenue (as income and profits fell), greater spending
Net debt (the sum of all past deficits) until 2019: $720bln. So the projected deficit is almost
50% of the total before 2020.
But interest payments on debt fell, because of lower interest rates.
We discuss the fiscal policy issues in Chapter 11: Fiscal Policy, Deficits and Debts
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
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MONETARY POLICY
- Main tool: target for overnight rate - may affect other interest rates
Target for overnight rate
5,0%
4,0%
3,0%
2,0%
1,0%
0,0%
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
In the Great Recession – reduced by 4%
In March 2020 – reduced by 1.5% - the fastest reduction in history
Zero lower bound – problem with reducing nominal interest rate below zero
We discuss monetary policy in Chapter 10: Monetary Policy and the Bank of Canada
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
Bank of Canada Liabilities
600
500
400
300
200
100
0
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Bank of Canada started buying assets on unprecedented scale
Why?
- Zero lower bound: could not reduce the overnight rate enough
- asset purchases raise asset prices and lower their interest rates
1.18
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
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Summary
Fiscal policy
Great Recession Great Lockdown
$67 billion deficit $343 billion
deficit; may end
up higher
Monetary policy
Bank of Canada Fell 4%
policy rate
Asset purchases Minimal
Fell 1.5%
What is different
Much bigger deficit
Could not reduce as much
because of zero lower bound
Huge: BofC assets Bought huge amounts of
increased fivefold assets to increase their prices
and lower their interest rates
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
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INTRODUCTION PART 2: THE GREAT RECESSION .
We will spend a lot of time discussing the Great Recession and its
aftermath. The goal is twofold:
 it will provide you with the knowledge and understanding of, and the
ability to intelligently discuss, macroeconomics. This may prove
invaluable in your future careers.
 It will show you what a usual recession looks like (as opposed to the
current recession).
The pandemic is a very unusual event; the previous one was 100 years
ago. On the other hand, recessions happen much more often.
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.21
The effects of the Great Recession in 2020:
low interest rates – limited monetary policy
Target for overnight rate
5,0%
4,5%
4,0%
3,5%
3,0%
2,5%
2,0%
1,5%
1,0%
0,5%
0,0%
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
PART 3. LEHMAN BROTHERS BANKRUPTCY AND CREDIT PANIC
 Surprise – as before other companies saved
 Moral hazard
 Silver lining: AIG rescued
Credit panic
 Tangled web of financial obligations
 How we define recessions?
 How bad was it?
1.22
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
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The Great Recession started 11 years ago this week! Around 1am Sep 15,
2008. Lehman Brothers filed for liquidation
At that time fourth largest investment bank in the US.
Note: recession in the US started in December 2017. Lehman bankruptcy
made it Great (not a good thing).
Three points:
1. Dates of recessions – determined by independent bodies (NBER in the
US, CD Howe in Canada), not governments
2. Takes time to figure out recession has started (NBER determined it a
year later)
3. Canadian recessions need not coincide with US recessions.
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
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A BRIEF HISTORY
1.1. LEHMAN BROTHERS BANKRUPTCY.
Lehman Brothers - in trouble for some time.
Bad investments in real estate; rapidly deteriorating assets
The general expectation was that the government and the Federal Reserve
(FED) will step in and find a buyer who will save the firm from bankruptcy
- March 2008 – FED arranged a purchase of Bear Sterns by JP Morgan
- September 8, 2008 – rescue of Fannie Mae and Freddie Mac: private
companies created by the US government to improve the liquidity in the
housing market and availability of mortgages.
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.25
WHY WAS LEHMAN BROTHERS ALLOWED TO FAIL?
- Concern about moral hazard.
Moral hazard arises when a company (or an individual) does not
have to bear all consequences of its actions.
- Treasury and Fed officials concerned that, if they save another failing
investment bank, the pattern of government intervention will be
established and moral hazard will be a big problem
- Later they claimed they did not have legal authority to bail out
Lehman because it did not have sufficient collateral. But recently it
was argued that they did not try to assess the collateral.
- Largest bankruptcy ever: $700 bln in assets.
- The largest previous bankruptcy was Worldcom, 2002, $100bln in
assets
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.26
- Investment banks borrow large amounts; have little capital; owed
lenders $650bln;
- long-term assets, short-term liabilities
Silver lining: two days later, AIG, an insurance company, was collapsing.
Assets – three times bigger than Lehman
Sold credit default swaps – private contracts
Concerned by market panic, policymakers bailed out AIG
Scary scenario: Lehman – bailed out, AIG allowed to fail. Would have
been much worse
Markets - caught unprepared.
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
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1.2. CREDIT PANIC
- tangled web of financial obligations between financial institutions
- derivatives, credit default swaps
- obligations not traded on organized exchanges
→ creditworthiness of potential borrowers difficult to assess
→ banking system froze – very difficult to obtain credit
George Soros: “the economy fell off the cliff”.
Recession - usually defined as two consecutive quarters of falling
output. Actual definition – more complex.
NBER (National Bureau of Economic Research): the recession started in
December 2007. In September 2008 it got much worse
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.28
Most economic activities require credit. Without credit:
- decline in investment
- decline in output
- rapid rise of unemployment
- consumer pessimism – decline in consumption
How bad did it look: Bernanke: “the worst financial crisis in global
history, including the Great Depression”
All but one of the largest US financial institutions were a week or two
from collapse.
Why call it the Great Recession? To distinguish from lesser (ordinary)
recessions and from the Great Depression
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
PART 4. POLICY RESPONSE
Monetary policy
 Reduce policy rates
 Zero lower bound
 Quantitative easing – purchases of new types of assets
 Forward guidance
 Recently – negative nominal interest rates
Fiscal policy
 Discretionary
 Automatic
 Deficits and debt
1.29
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.30
1.3. THE POLICY RESPONSE
In the end – not as bad as feared.
Unemployment peaked at 8.8% in Canada, 10.6% in the US (in the Great
Depression it was over 20%).
We will talk about factors affecting unemployment in chapter 8: “Unemployment”.
Active macroeconomic policies to counteract the Great Recession:
expansionary monetary and fiscal policies.
- used lessons from the Great Depression.
Main monetary policy: reduce short-term nominal interest rates.
Central bank has direct control of those rates.
Reduced nominal interest rates to near zero.
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.31
Policy rates in Canada and the US
Zero lower bound – difficult to reduce nominal interest rates below zero
Limited by zero lower band – at that time belief that nominal interest
rates cannot be negative
Recall that low interest rates limited monetary policy in the current
recession
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.32
Subsequently central banks employed alternative policies
- quantitative easing - purchases of assets of longer
maturity, also non-government assets – in the US; in
Canada only now
- forward guidance - affecting expectations by
promising to keep interest rates low for extended
periods
This – still not enough. In the last few years – negative nominal interest rates
How low can the nominal interest rate go?
A negative rate – absurd. But around $17 trillion of
assets have negative yields
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.33
Alternative: safety deposit box. How big?
$1million US weighs 10kg; about 2 cubic feet.
$17 trillion = around 30 million cubic feet. That is 1/15th of the volume
of the Boeing Everet Factory – the world’s largest building by volume.
Fiscal policies: discretionary and automatic
- Discretionary: raise gov purchases and transfers, cut taxes
- Automatic: changes in spending and taxation that take place
without government action: higher unemployment and welfare
payments, lower income taxes as income falls.
Both active and automatic fiscal policies raise deficit and debt →
concerns about debt level and drive to reduce spending in several
countries.
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
PART 5. HOW THE GREAT RECESSION CAME ABOUT
 Low interest rates -> High housing demand
Developments in the financial system
 Loan securitization
- Rating companies
- Decline in lending standards
 Sub-prime loans
 Adjustable rate mortgages (ARM)
 Leverage
Rising house prices
 Higher wealth and consumption
 Bubble?
1.34
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.35
1.4 HOW THE GREAT RECESSION CAME ABOUT
- 2001 recession – low interest rates
- Low interest rates – encourage house buying
- Low inflation subsequently – the Fed kept interest rates low
Fed goal: “to promote effectively the goals of maximum employment,
stable prices, and moderate long-term interest rates
Bank of Canada – targets inflation between 1% and 3%
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.36
1.4.1 DEVELOPMENTS IN THE FINANCIAL SECTOR
Profitable innovations in the financial system in 1980s
LOAN SECURITIZATION.
Mortgages from many properties are put together (pooled) into a
security (called a Mortgage-Backed Security) which is then sold to
investors
- removes the risk of nonperforming loans from the bank that gave
the mortgage → moral hazard
If the borrower defaults- someone else loses money
- provides the bank with funds to give more mortgages
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.37
Evaluated by rating companies - paid by issuers of securities. The higher
the rating, the higher is the profit of the issuer who may then choose to
rate more securities with the rating company. What could go wrong?!
Profitable process:
- individual mortgages pay high interest rates
- risk appears diversified – it is unlikely that many mortgages in a
pool default at the same time
- pools of mortgages appear less risky, so a mortgage- backed
security has high yield and perceived low risk
Decline in lending standards due to moral hazard
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.38
SUB-PRIME LOANS.
Demand exceeded supply –banks increased loans to riskiest borrowers
Sub-prime: loan to borrower who does not qualify for a regular (prime)
loan
- higher default risk and pay higher interest rates
Pooling sub-prime loans with prime loans created securities with high
yield and relatively low risk
Adjustable rate mortgages (ARM).
- the initial interest rate is low
- it increases significantly after 2 or 3 years
- borrower expects to take advantage of house appreciation and
refinance
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.39
LEVERAGE.
Leverage - based on using borrowed money to acquire assets.
Definition: Leverage is equal to the ratio of assets to the difference
between assets and liabilities (excluding capital).
LEVERAGE EXAMPLE.
Assets
Loans
Mortgages
Liabilities
900
Short-term
deposits
300
1 000
Long-term
deposits
1 600
Vault cash and
reserves at the central 100
bank
Leverage = 20
Capital
100
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.40
Why leverage?
- Multiplies gains and losses.
- Financial institutions around the world were very heavily leveraged.
Leverage of 33 was not uncommon; some institutions had leverage
of 50.
- Extent of leverage – hidden by accounting tricks.
Why leverage? Higher profits if things work out well
But big losses when things do not work out well
High leverage makes the banking system risky
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.41
1.4.2. RISING HOUSE PRICES
Sub-prime and ARM mortgages - ok in a rising market:
- when the value of the house increases, the borrower can refinance
- the proceeds from refinancing can be used to make mortgage
payments.
So even borrowers with weak credit history are expected to be able to
service their mortgage
Too much sub-prime loans:
Loan securitization → moral hazard → sub-prime loans profitable →
easy to obtain
Self-reinforcing process:
- higher house prices →lower risk of default→ higher demand and
supply of mortgages →more house purchases → higher house prices
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.42
250
200
150
Figure 1.1. US house
prices
Source:
S&P/Case-Shiller
National Home Price Index, 10
cities, seasonally adjusted,
nominal
100
50
0
1990
1994
1998
2002
2006
2010
2014
2018
1.4.3. WEALTH EFFECT OF HIGHER HOUSE PRICES
The increase in house prices makes homeowners feel wealthier.
We discuss the effect of wealth on consumption in chapter 5: “Consumption”
When households feel wealthier, they increase spending.
So; Higher house prices → higher consumption, lower savings
Favourable business conditions:
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.43
Consumption – 2/3 of GDP in the US . When consumption rises, so does
investment and output. Higher output leads to higher demand for
housing, higher house prices and higher consumption.
WAS IT A BUBBLE?
A bubble is a situation when the asset is overvalued (relative to fundamentals)
but people continue to buy it in the expectation that its price will increase even
more.
- In retrospect, yes.
- Bubbles - easy to identify after the fact: a rapid increase in prices is
followed by a rapid decrease. - Difficult to identify contemporaneously
Fundamentals may have changed:
- financial deregulation reduced the cost of financing.
- securitization reduced the risk of sub-prime lending.
So the increase in house prices could be viewed at the time as justified by
changed fundamentals
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
PART 6. THE FINANCIAL CRASH
 Overbuilding
 Rising interest rates
 Mortgage defaults
 Foreclosures and house price decreases
 Financial institution losses
 Credit market freezes
1.44
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.45
1.5 THE FINANCIAL CRASH
1.5.1. THE DECLINE IN HOUSE PRICES.
- large, speculative supply of housing (overbuilding)
- Fed raises interest rates → demand falls
High supply, low demand → prices start falling (in the second half of
2006).
250
200
150
Figure 1.1. US house
prices
Source:
S&P/Case-Shiller
National Home Price Index, 10
cities, seasonally adjusted,
nominal
100
50
0
1990
1994 1998 2002 2006 2010 2014 2018
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.46
1.5.2. MORTGAGE DEFAULTS
- No longer possible to refinance – homeowners “under water”
- Non-recourse loans → limited penalty for defaulting
FORECLOSURES AND FURTHER DECREASE IN HOUSE PRICES.
Owner does not pay interest, the mortgage owner can foreclose
Vicious circle: House prices fall →owners are unable to refinance and
default on loans → bank forecloses → bank sells the property → with
the extra supply house prices fall further
FINANCIAL INSTITUTION LOSSES.
- Defaults and foreclosures → the value of mortgage-based securities falls.
- Financial institutions incur losses, sell securities, reducing prices further
Complex web of interrelationships – uncertainty about solvency of the
potential borrower → credit market freezes
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.47
PART 7. EFFECT ON THE REAL ECONOMY
 Credit problems
 Lower household wealth - > lower consumption
 Lower investment
Three channels of transmission abroad
 Financial markets
 International trade and integrated supply chains
 The effect of the crash in the US on business and consumer attitudes
in other countries.
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1.6. EFFECT ON THE REAL ECONOMY.
Financial crisis →
- reduced the availability of credit
- lower consumer confidence
- unemployment concerns
Decline in house prices →
- lower household wealth
So:
- lower consumption
- big drop in demand for things bought on credit (cars, large ticket
items)
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Big decline in investment, typical in recessions.
Main reasons: lower demand, uncertainty about the future
- business fixed investment – falls as firms postpone projects
- inventory investment falls since demand is lower and firms reduce
operational costs
- residential construction falls as people stop buying new homes
We discuss factors affecting investment in chapter 6: “Investment”.
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1.7. THE CRISIS SPREADS ABROAD.
US – about 20% of the world economy; world’s biggest importer.
Typical effect of a recession in the US - through international trade.
- US output falls → US imports fall.
- Recession in the US need not cause a recession in other countries
(for example 2001 – did not cause a recession even in Canada).
- Other countries – less affected as have weaker trade links
Note: different way GDP and international trade are calculated
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1.7.1. THREE CHANNELS OF TRANSMISSION IN THE GREAT
RECESSION.
1. Through financial markets
The most important channel
- Mortgage-based securities - sold around the world (to German
banks, Spanish pension funds, Argentinean insurance companies
etc).
- Derivative exposure – unknown and so creditworthiness of financial
institutions – suspect.
- High leverage in European institutions.
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2. International trade and interconnected supply chains
Unprecedented trade decline: world trade fell by over 20%; in Taiwan,
it fell over 40%.
- Complex goods - rarely produced in a single country.
- Production - organized through international, interconnected supply
chains: components are made in many different countries, final
assembly somewhere else.
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Note: imagine US tariffs on iphones from China
3. The effect of the crash in the US on business and consumer attitudes
in other countries.
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
PART 8. THE CRISIS IN CANADA
 Economy before – in good shape
 Solid banking system
 Strong export channel
 Big effect on business and consumer attitudes
Comparison with the US
 Output
 Unemployment
 Exchange rate
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Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
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1.8 THE CRISIS IN CANADA
Before the Great Recession, the Canadian economy was in good shape.
- Low unemployment, fast growth, government budget surpluses
(both federal and provincial), high resource prices.
Limited effect on financial markets: Solid banking system
- Lower leverage, High capital ratios, Less securitization of mortgages,
Few high – ratio mortgages; need to be insured
World Economic Forum – called Canadian banks the best in the world
Export channel - particularly strong in Canada.
- The US economy is our largest trading partner, by far.
- US: 75% of Canadian exports
- Britain: 3% of exports
- Especially hard hit: the car industry - Canadian automobile exports
fell 40%.
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
Effect on business and consumer attitudes: important.
- Canadian households became concerned about the severe
recession in the US and reduced spending.
- Investment fell as firms took a “wait and see” approach and
delayed projects.
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1.8.1. OUTPUT
Real GDP in Canada and the US,
Q4 2007=100
104
102
100
98
Output decline in Canada
- started a quarter later
- about as deep
- the economy rebounded
faster
96
94
92
Q1
2005
Q1
2006
Q1
2007
Q1
2008
Q1
2009
Q1
2010
Canada
US
0
4
Canada
8
US
Q1
2011
Q1
2012
104
102
GDP by quarter
0=Q3 2008, Canada
0=Q2 2008, US
100
98
96
94
-8
-4
12
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1.8.2. UNEMPLOYMENT
- Historically – US unemployment lower (around 2% lower)
- just prior to the Great Recession – similar rates (around 6%)
- increase in Canada – smaller (to 8.8%; in the US to 10.6%)
- by 2012 declines to 7% in
Canada,
to 9% in the US
- in March 2020: 5.6% in
Canada,
3.5% in the US
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1.8.3. EXCHANGE RATE
- reached parity in October 2007,
- depreciated 20% during the recession as there was flight to US
bonds – biggest and most liquid market
- has appreciated after crisis subsided
1.05
1.00
0.95
0.90
0.85
0.80
0.75
2007-01 2008-01 2009-01 2010-01 2011-01 2012-01
We discuss exchange rates in Chapter 4: “Exchange Rates”.
Ec250 2020 Class notes Introduction: The Great Lockdown Recession and the Great Recession
1.9. SUMMARY
 The Great Recessions
 Caused by financial market developments and credit panic
o Financial crisis and the real economy
o How the crisis spread abroad
 Policy response
o Monetary – traditional and new approaches
o Fiscal – automatic and discretionary
 The crisis in Canada
o Output
o Unemployment
o Exchange rates
 Lessons?
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