The Great Recession: How did it
Happen?
(OLLI Course, Week 1)
Stergios Skaperdas
Department of Economics
University of California, Irvine
October 29, 2010
Roadmap
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Basic information on the Great Recession
Correlates of the crisis
New finance (vs. old finance) and moral hazard
The centrality of governance and property rights
Persistent problems
Concluding remarks
Basic information about the Great
Recession
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Official Beginning: December 2007.
Official End: Mid-2009.
Long-lingering effects after official end.
In terms of GDP contraction and unemployment,
deepest recession in post WWII period.
• Unemployment rate has peaked at 10% but
could get worse.
• Employment barely increasing (need more than
100,000 jobs a month just to keep the
employment rate the same).
Graph credits:
www.calculatedriskblog.com
and
Saint Louis Fed
Gross National Product
Housing Starts
Capacity Utilization
Employment reduction
Unemployment rate by State
(August 2010)
Major Events
• House prices peak in 2006 (without most people
realizing it).
• Summer of 2007: Interbank lending in trouble.
• March 2008: Bear Stearns collapses, taken over by JP
Morgan Chase with Government guarantees.
• September 2008 (the BIG ONE): Fannie and Freddie
taken over by Govt; LEHMAN collapses without Govt
intervention; AIG taken over by Govt.
• October 2008: TARP voted by Congress on second
attempt.
Correlates of the crisis
• The real estate bubble.
• Very low (and negative) savings rate.
• Large current account deficits and global
imbalances.
• Change in the structure of banking and
finance.
• Wage income stagnation.
Correlates of the crisis (cont’d)
• Financialization of the economy.
• Low-interest Federal Reserve policy.
• “Moral Hazard” and the breakdown of the
New World of Finance.
• Non-enforcement of existing financial
regulations and deregulation.
Housing prices (Core Logic)
Real House prices
Savings rate
Current Account Deficit
“New” finance and banking
• Securitization: Loans sold to globalized markets
(packaged in bonds and sold to third parties like pension
funds, foreign governments, other institutional investors)
• Assessment of risk based on “objective” criteria (FICO
scores, Rating agencies)
• hedging, structured finance, derivatives (e.g., CDS
“credit default swaps”; synthetic CDOs) Supposed to
reduce or even eliminate risk.
• Possibility of making enormous profits through
“Leverage” (9 to 1, 15 to 1, 35 to 1, 45 to 1).
• “Moral hazard”
• Appearance (but not reality) of lower cost.
Median Household Income
Median Wages
Financialization of the economy
• Credit expansion as a way of
compensating for lost income.
• Mortgages, equity lines of credit, credit
cards, payday loans.
• Borrowing becomes a way of life; house
became another breadwinner in the family.
• Because of wage stagnation, expedient for
politicians and the Fed to help
financialization.
Consumer Credit
Low interest rate policy – 30-year
fixed rate
“Moral Hazard” and the breakdown
of the New World of Finance.
• Incentives for mortgage brokers and
commercial banks.
• Incentives for investment banks in
securitization.
• Rating agencies.
• The Alchemy of Mathematical Finance.
“Moral Hazard” and the breakdown
of the New World of Finance (cntd)
• Documentation and property rights.
• Incentives for servicers.
• Risk taking and The Too-Big-to-Fail
(TBTF) Problem.
Wall Street and its regulators
“There are thirteen bankers in my office.
They say if [the CFTC’s draft proposal for
the regulation of derivatives] is published
we’ll have the worst financial crisis since
World War II.”
From call of Larry Summers, then Deputy
Treasury Secretary (in 1995), to Brooksey
Born, then CFTC (“Commodity Futures
Trading Commission”) Chair.
The spirit of non-enforcement:
OTS Chief and Bank Executives
Legal and regulatory issues
• Fragmentation of responsibilities (Fed,
CFTC, OCC, FDIC, OTS, SEC)
• Shopping for your regulator.
• “Cognitive regulatory capture.”
• Partnership vs corporate organization for
investment banks.
• TBTF problem
The Relevance of Property Rights
• Adam Smith on corporations
• Shareholders vs managers and the SEC
• Property Rights in Land
(US and other rich countries vs the rest of
the world.)
• Property rights are necessary for a
modern economy but they are also
expensive.
• The state as third-party enforcer.
Responses to the crisis
• Facilitation of Bear Stearns takeover;
Fannie, Freddie, and AIG nationalizations.
• Lehman allowed to go bankrupt (politically
and ideologically difficult not to do so;
ostensibly as a moral-hazard lesson).
• TARP.
Responses to the crisis (cont’d)
• Fed “Quantitative easing;” and a slew of
other special programs to provide
emergency credit.
• Fiscal Stimulus package.
• Extension of unemployment benefits and
other similar measures.
• Dodd-Frank bill.
Monetary Base
M1 Money Multiplier
Persistent problems
• Continued high Unemployment rate and
low employment levels.
• Anemic growth.
• Foreclosures and the crisis of property
rights.
• Likelihood of continued reduction in real
estate prices.
• Mortgage markets on life support.
• TBTF problem as big as ever.
Real House prices
Persistent problems (cont’d)
• Continued current account deficits.
• Exchange rates and “beggar thy neighbor”
policies.
• Wages of average Americans.
Concluding Remarks
• Great Recession due to multiple failures in
finance and its regulation.
• “New” finance has been a complete failure
in allocating capital.
• Wall Street still dictates public policy and
against basic property rights enforcement.
• The Great Recession has hardly left us
(and could come back with a vengeance)
In two weeks: Future prospects
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Available policy choices
The limits of monetary policy
Helicopter drops and fiscal policy
Exchange rates and trade
Distributional and taxation issues
Regulation and moral hazard