LessonsfromtheFinancialCrisisand SlowRecoveryforTeachingEconomics

JohnB.Taylor StanfordUniversity
October27,2011 7th AnnualEconomicTeachingConference Cengage Learning,GulfCoastEconomicsAssociation NewOrleans,Louisiana

Outline
Differentviewsofthefinancialcrisis,recession,and recovery
Notsurprisingly,economistsdisagree!

Differentimplicationsforteaching Exampleswillbepresentedthroughouttalkbasedon
EmpiricalResearch UndergraduateTeaching
Economics1atStanford

Textbook
PrinciplesofEconomics,7e,withWeerapana atWellesley

FirsttoincorporatetheFinancialCrisis,
First2eonthefinancialcrisis

Narrative
Economicpolicydeviatedfrombasiceconomic principleswhichhadworkedwell Result?Agreatrecession,afinancialpanic,anda veryweak,nearlynonexistentrecovery. Thedeviationsbeganwithpoliciessuchas
amonetarypolicywithinterestratestoolowfortoolong aregulatorypolicywhichfailedtoenforceexistingrules

Thedeviationsfromsoundprinciplescontinued whengovernmentrespondedwithanadhocbailout processandtemporarystimulusprograms Thegoodnews:economicgrowthandstabilitycan berestoredbyadoptingpoliciesconsistentwith basiceconomicprinciples.

OtherNarrative
USpolicywasnotanissueleadinguptothe crisis Globalcapitalflowsweretheproblem
Caused200709crisis:globalsavingsglut

Oreconomicsfailed
Toomuchfaithinmarkets Notenoughpsychology

Slowrecoverybecausetheinterventionswere toosmall;needmore

ImplicationofTwoViewsforBasicEconomics
1.Basicallysound,butstillamajorteaching moment 2.Needsareformulation
PaulSamuelson(January2009)
todayweseehowutterlymistakenwastheMilton Friedmannotionthatamarketsystemcanregulate itselfThisprevailingideologyofthelastfewdecades hasnowbeenreversed.

PaulKrugman blamesmoderneconomics (especiallymacro)forthecrisis.

Butofcourseneedtopresentbothviews

EKGfortheAmericanEconomy

IllustrativemonetarypolicychartfromSan FranciscoFed,March1995,JuddandTrehan
196579

198792

199394

IllustrativemonetarypolicychartfromStLouisFed February2007,BillPoole

PolicyDeviationsLeadinguptothe CrisisandthePanicinFall2008
Interestratestoolowfortoolong DiscretionaryfiscalstimulusofFeb08($152B) Onagain,offagainbailoutsfinancedbycentral banksbalancesheet
on forBSCcreditorsbailout,off forLehmancreditors bailout,on forAIGcreditorsbailout,off forTARProleout

Governmentregulatorsandsupervisorsdeviated fromsoundregulatoryrules,especiallyatlarge banks

IllustrativemonetarypolicychartfromStLouisFed February2007,BillPoole

IllustrativemonetarypolicychartfromStLouisFed February2007,BillPoole

ChartfromThe Economist (NowinEconomicsinActionbox)

TheBoomBustinHousing (nowinEconomicsinActionbox)

HousingBoomandBust

Temporarystimulusmeets permanentincomehypothesis

Stock PricesDuringthePanic

TeachingAboutRegulatoryCapture:
Explainsfailuretoenforceregulatoryrules

Cozyconnectionsbetween governmentandthe financialindustry. Thisbookshows governmenthelpingwell connectedindividuals,who inturnhelpedthe governmentofficials. Result:Recklesspolicy

LinesfromFightoftheCentury
Keynes:Evenyoumustadmitthatthelesson wevelearnedisthatmoreoversightsneeded orelsewellgetburned Hayek:Oversight?Thegovernmentslongbeen inbedwiththoseWallStreetexecsandthe firmsthattheyveled.

Policymakersthendoubleddown
Discretionaryfiscalstimulusof2009($862billion)
Onetimepaymentsagain Moregovernmentspendingtoo

Cashforclunkersprogram Quantitativeeasingin2009,nowcalledQE1
Purchasesof$1.25trillionofmortgagebacked securities,$300billionoflongertermTreasurybonds

QE2in2010and2011
purchasesof$600billionoflongertermTreasury bonds.

IncomeandConsumptionduringtheTwo DiscretionaryStimulusPrograms

Cashforclunkers:incentivesreallymatter (NowinEconomicsinActionbox)

Comparewithtextbookdiscussion: SharpdropinIcausesexpenditurelinetoshiftdown
25_10

SPENDING 45-degree line

Original point of spending balance

Original E line New E line

I falls by this amount

New point of spending balance Income or real GDP falls by this amount (more than by amount I falls ). New income level Original income level INCOME OR REAL GDP

OffsetbyCountercyclicalfiscalpolicy IncreaseinGraisesGDPdependingonsizeofthe multiplierandamountofcrowdingout

25_10

SPENDING 45-degree line

G rises

INCOME OR REAL GDP

Billions of dollars, annual rates 400 350 300 250 200 150 100 50 0 09Q1 09Q2 09Q3 09Q4 10Q1 10Q2 10Q3 10Q4 --- Federal government consumption --- Federal government investment --- Grants to state and local governments --- Temporary transfer payments and credits to persons

Two-Year Effect of ARRA on Major Federal Budget Categories (Source: Bureau of Economic Analysis)

Billions of dollars, annual rates 2,300 2,200 2,100 2,000 1,900 1,800 1,700 1,600 1,500 1,400 2005 2006 2007 2008 2009 2010 Purchases by state and local governments Recepits less ARRA grants Total receipts of state and local governments

A Legacy:ExplodingFederalDebt (ChartnowinFiscalPolicyChapter)

TowardtheZeroInterestRate

TheLiquidityTrap

TheMonetaryBaseandtheSize oftheFedsBalanceSheet

InternationalEconomicsIssues

IllustrativeChartfromtheOECD,March2008

IllustrativeChartfromtheOECD,March2008

Chinaspurchasesofforeignreserves

SoWhyDoEconomistsDisagree?
Studentsandeveryoneelsereallywantto knowtheanswer Onereasonisthatthedetailsoftheirmodels aredifferent,eventhoughthereisagreement aboutthebasicprinciples ThenextthreechartsfromtheNewYork Times illustratethiswell.

NewKeynesian Smets ECB 6

5

RobertBarro Harvard 6
5

With stimulus
4 3 2 1 0 -1 2009 2010

With stimulus
4 3 2

If no stimulus

1 0 -1 2009

If no stimulus

2010

The accumulation of hard data and real-life experience has allowed more dispassionate analysts to reach a consensus that the stimulus package, messy as it is, is working New York Times November 12, 2009

ImplicationsforTeaching
Manynewillustrationsofbasiceconomics Interestingdebatesbetweeneconomists
Rulesversusdiscretion Basicroleofgovernment

Moreintegrationofmicroandmacro
interestratestoolowfortoolong(macro) housingmarketsincludingbubbles(micro) stimuluspackage(macro) regulatorycaptureandmoralhazard(micro) newinstrumentsofmonetarypolicy(macro) riskpremia ininterestrates(micro) debateoversizeofmultipliers(macro) cashforclunkers,firsttimehomebuyer(micro)

ManyNewYouTubeVideos
QuantitativeEasingExplained.5milliondownloads.Doesn't getitallrightandbrutalinplaces,butgoodfordiscussion TheWrongFinancialAdviser CreatedbyNobelprizewinner BillSharpe FedChairmanontheDailyShowwithJonStewart.Fromtwo differentepisodesof60Minutes,focusonwhether quantitativeeasingisprintingmoney. UnmaskingInterestRates,HonkyTonk Style MerleHazardsings"InflationorDeflation InsideJobTrailer ChristineLagarde inclipfromInsideJob HayekKeynesrapvideos"FeartheBoomandBustandFight oftheCentury