L f h Fi i l C i i fLessonsfromtheFinancialCrisisforTeachingEconomicsg

John B TaylorJohnB.TaylorStanfordUniversity

June2,2011

NationalConferenceonTeachingEconomicsandResearchinEconomicEducation

OutlineOutline NarrativeoftheFinancialCrisis

Informsonesviewsaboutlessonsforteaching AlternativeNarratives

N t i i l i t di Notsurprisingly,economistsdisagree ImplicationsforTeaching

Examples will be presented throughout talk based on Exampleswillbepresentedthroughouttalkbasedonexperience

Graduate(1styearPh.D.courseatStanford) Undergraduate(Economics1atStanford) Textbook(PrinciplesBookwithWeerapana)

NarrativeE i li d i t d f b i i Economicpolicydeviatedfrombasiceconomicprincipleswhichhadworkedwell

Result? A great recession a financial panic and a Result?Agreatrecession,afinancialpanic,andaveryweak,nearlynonexistent,recovery.

The deviations began with policies such asThedeviationsbeganwithpoliciessuchas amonetarypolicywithinterestratestoolowfortoolong aregulatorypolicywhichfailedtoenforceexistingrulesg y p y g

Thedeviationsfromsoundprinciplescontinuedwhengovernmentrespondedwithanadhocbailoutprocessandtemporarystimulusprograms

Thegoodnews:economicgrowthandstabilitycanberestoredbyadoptingpoliciesconsistentwithbasiceconomicprinciples.

Anillustrationthatbasicprinciplesworkwell,whenfollowed

15

20Percent

GreatModerationperiod

10

15 period

0

5

-5

0

G t R i

-15

-10GreatRecession(EndofGreatModeration?)

50 55 60 65 70 75 80 85 90 95 00 05 10

Growth Rate of Real GDP

IllustrativemonetarypolicychartfromSanFranciscoFed,March1995,JuddandTrehan

196579

198792

199394

IllustrativemonetarypolicychartfromStLouisFedFebruary2007,BillPooley

PolicyDeviationsLeadinguptothed h llCrisisandthePanicinFall2008

Interestratestoolowfortoolongg DiscretionaryfiscalstimulusofFeb08($152B) Onagain offagain bailouts financed by centralOnagain,offagainbailoutsfinancedbycentralbanksbalancesheet on for BSC creditors bailout off for Lehman creditorson forBSCcreditors bailout,off forLehmancreditors bailout,on forAIGcreditorsbailout,off forTARProleout

Government regulators and supervisors deviatedGovernmentregulatorsandsupervisorsdeviatedfromsoundregulatoryrules,especiallyatlargebanks

IllustrativemonetarypolicychartfromStLouisFedFebruary2007,BillPooley

IllustrativemonetarypolicychartfromStLouisFedFebruary2007,BillPooley

ChartfromKansasCityFed,2009,TomHoenig

(20002009)

TheBoomBustinHousingStartsCompared with the CounterfactualComparedwiththeCounterfactual

IllustrativeChartfromtheOECD,March2008

IllustrativeChartfromtheOECD,March2008

Temporarystimulusmeetspermanentincomehypothesisp yp

ThePanicofFall08

Policy makers then doubleddownPolicymakersthendoubled down

Discretionaryfiscalstimulusof2009($862billion)sc et o a y sca st u us o 009 ($86 b o ) Onetimepaymentsagain Moregovernmentspendingtoo

Cashforclunkersprogram Quantitativeeasingin2009,nowcalledQE1

Purchasesof$1.25trillionofmortgagebackedsecurities,$300billionoflongertermTreasurybonds

QE2 i 2010 d 2011 QE2in2010and2011 purchasesof$600billionoflongertermTreasurybondsbonds.

Temporarystimulusmeetspermanentincomehypothesisagainp yp g

Cashforclunkers:incentivesreallymatter

400Billions of dollars, annual rates

300

350

200

250 --- Temporary transfer payments and credits

t

150

200

G t t t t d

to persons

50

100

F d l t ti

--- Grants to state and local governments

009Q1 09Q2 09Q3 09Q4 10Q1 10Q2 10Q3 10Q4

--- Federal government investment--- Federal government consumption

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

2,300Billions of dollars, annual rates

2 100

2,200

,Total receipts of stateand local governments

2,000

2,100

Recepits less

1,800

1,900p

ARRA grants

1 600

1,700 Purchases by state and local governments

1,500

1,600

1,4002005 2006 2007 2008 2009 2010

Stateandlocalgovernmentsalsoconsiderpermanentincome

Comparewithtextbookdiscussion:Sharp drop in I causes expenditure lineSharpdropinIcausesexpenditureline

toshiftdown

45-degree line

SPENDING25_10

New E line

Original E lineOriginal point of spending balance

I falls by this amount

Income or real GDP falls by this amount (more than by amount I falls ).

New point of spending balance

Original income level

New income level

INCOME OR REAL GDP

(more than by amount I falls ).

OffsetbyCountercyclicalfiscalpolicyIncreaseinGraisesGDPdependingonsizeofthep g

multiplierandamountofcrowdingout

45-degree line

SPENDING25_10

G rises

INCOME OR REAL GDP

Butlookwhathappened

6Percent, annual rate

Growth rate of real GDP

2

4

0Contribution of

-4

-2 government purchases

-6

-807Q1 07Q3 08Q1 08Q3 09Q1 09Q3 10Q1 10Q3

QuantitativeEasingFinancedbyMonetaryBase

2,800Billions of dollars

2,400Monetarybase(currencyplusreserves)

2,000

1,600

1,200

800Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11

AWonderfulTeachingMoment:The Money Multiplier and the Monetary BaseTheMoneyMultiplierandtheMonetaryBase

Percent

800

1,000CBO Outlook in 2010

600

800

Federal Debt as a

CBO Outlook in 2009

400

600 Federal Debt as aPercent of GDP

200

400

0

200

CBO Outlook in 2011??0

1800 1850 1900 1950 2000 2050

TeachingAboutRegulatoryCapture:E l i f il t f l t lExplainsfailuretoenforceregulatoryrules

C ti b t Cozyconnectionsbetweengovernmentandthefi i l i d tfinancialindustry.

Bookshowsgovernmenthelpingwellconnectedindividuals,whointurnhelpedthegovernmentofficials.

Result:Recklesspolicy

ImplicationofNarrativeforBasicEconomics

Needsareformulation? PaulSamuelson(January2009)PaulSamuelson(January2009)

todayweseehowutterlymistakenwastheMiltonFriedmannotionthatamarketsystemcanregulateitselfThisprevailing ideology of the last few decades has now beenprevailingideologyofthelastfewdecadeshasnowbeenreversedIwishFriedmanwerestillalivesohecouldwitnesshowhisextremismledtothedefeatofhisownideas.

PaulKrugman blamesmoderneconomics(especiallymacro)forthecrisis.

B t ti h i li b i i k Butnarrativehereimpliesbasiceconomicsworks Thecrisiswascausedbyadeviationfromprinciples

f h h h d Butofcoursethereismuchresearchtodo

Another NarrativeAnotherNarrative

US policy was not an issue leading up to theUSpolicywasnotanissueleadinguptothecrisisandisnotanissuenow

Global capital flows were and are the problem Globalcapitalflowswereandaretheproblem Causedemergingmarketcrisesin1990sC d 2007 09 i i S i Gl Caused200709crisis:SavingGlut

Causeoffuturecrises:focusonglobalrebalancing Muchdifferentpolicyimplication

ButchartfromtheIMFin2005ShowsNoGlobalSavingGlut

So Why Do Economists Disagree?SoWhyDoEconomistsDisagree?

Students and everyone else really want toStudentsandeveryoneelsereallywanttoknowtheanswer

One reason is that the details of their models Onereasonisthatthedetailsoftheirmodelsaredifferent,eventhoughthereisagreementabout the basic principlesaboutthebasicprinciples

ThenextthreechartsfromtheNewYorkTi d h ill hi llTimes andtwoothersillustratethiswell.

66

NewKeynesianSmets ECB

RobertBarroHarvard

3

4

5With stimulus

3

4

5

With stimulus

0

1

2If nostimulus

0

1

2If nostimulus

-12009 2010

-12009 2010

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

ImplicationsforTeachingM ill t ti f b i i Manynewillustrationsofbasiceconomics

InterestingdebatesbetweeneconomistsR l di ti Rulesversusdiscretion

Butraisemorequestionsaboutdiscretionarypolicy More integration of micro and macro Moreintegrationofmicroandmacro

interestratestoolowfortoolong(macro) housing markets including bubbles (micro)housingmarketsincludingbubbles(micro) stimuluspackage(macro) regulatorycaptureandmoralhazard(micro) newinstrumentsofmonetarypolicy(macro) riskpremia ininterestrates(micro) debateoversizeofmultipliers(macro) cashforclunkers,firsttimehomebuyer(micro)

ManyNewYouTubeVideosQuantitativeEasingExplained.5milliondownloads.Doesn't

getitallrightandbrutalinplaces,butgoodfordiscussionTheWrongFinancialAdviser CreatedbyNobelprizewinner

BillSharpeFedChairmanontheDailyShowwithJonStewart.Fromtwo

differentepisodesof60Minutes,focusonwhetherquantitativeeasingisprintingmoney.

UnmaskingInterestRates,HonkyTonk StyleMerleHazardsings"InflationorDeflationInsideJobTrailerChristine Lagarde in clip from Inside JobChristineLagarde inclipfromInsideJobHayekKeynesrapvideos"FeartheBoomandBustandFight

oftheCentury

Lines from Fight of the CenturyLinesfrom FightoftheCentury

Keynes: Even you must admit that the lessonKeynes: Evenyoumustadmitthatthelessonwevelearnedisthatmoreoversightsneededor else well get burnedorelsewe llgetburned

Hayek:Oversight?Thegovernmentslongbeenin bed with those Wall Street execs and theinbedwiththoseWallStreetexecsandthefirmsthattheyveled.