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LessonsfromtheFinancialCrisisand

SlowRecovery

for

Teaching

Economics

JohnB.

Taylor

StanfordUniversity

October27,

2011

7th AnnualEconomicTeachingConference

Cengage Learning,Gulf

Coast

Economics

Association

NewOrleans,Louisiana

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Outline Differentviewsofthefinancialcrisis,recession,and

recovery Not

surprisingly,

economists

disagree!

Differentimplicationsforteaching Exampleswillbepresentedthroughouttalkbasedon

EmpiricalResearch

UndergraduateTeaching Economics1atStanford

Textbook PrinciplesofEconomics,7e,withWeerapana atWellesley FirsttoincorporatetheFinancialCrisis,

First2eonthefinancialcrisis

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Narrative Economic

policy

deviated

from

basic

economic

principleswhichhadworkedwell

Result? Agreatrecession,afinancialpanic,andavery

weak,

nearly

nonexistent

recovery.

Thedeviationsbeganwithpoliciessuchas amonetarypolicywithinterestratestoolowfortoolong

aregulatory

policy

which

failed

to

enforce

existing

rules

Thedeviationsfromsoundprinciplescontinuedwhengovernmentrespondedwithanadhocbailout

processand

temporary

stimulus

programs

Thegoodnews:economicgrowthandstabilitycanberestoredbyadoptingpoliciesconsistentwith

basiceconomic

principles.

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OtherNarrative

USpolicywasnotanissueleadinguptothe

crisis Globalcapitalflowsweretheproblem

Caused200709crisis:globalsavingsglut

Oreconomics

failed

Toomuchfaithinmarkets

Notenoughpsychology

Slowrecoverybecausetheinterventionsweretoosmall;needmore

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ImplicationofTwoViewsforBasicEconomics

1.Basicallysound,butstillamajorteaching

moment

2.Needs

areformulation

PaulSamuelson(January2009)

todayweseehowutterlymistakenwastheMiltonFriedman

notion

that

amarket

system

can

regulate

itselfThisprevailingideologyofthelastfewdecades

hasnowbeenreversed.

PaulKrugman blames

modern

economics

(especiallymacro)forthecrisis.

Butofcourseneedtopresentbothviews

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EKGfortheAmericanEconomy

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IllustrativemonetarypolicychartfromSan

Francisco

Fed,

March

1995,

Judd

and

Trehan

198792

199394

196579

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IllustrativemonetarypolicychartfromStLouisFed

February

2007,

Bill

Poole

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PolicyDeviationsLeadinguptothe

Crisisand

the

Panic

in

Fall

2008

Interestratestoolowfortoolong

Discretionaryfiscal

stimulus

of

Feb

08

($152B)

Onagain,offagainbailoutsfinancedbycentralbanksbalancesheet

on forBSCcreditorsbailout,off forLehmancreditorsbailout,on forAIGcreditorsbailout,off forTARProleout

Governmentregulatorsandsupervisorsdeviatedfromsoundregulatoryrules,especiallyatlargebanks

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IllustrativemonetarypolicychartfromStLouisFed

February

2007,

Bill

Poole

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IllustrativemonetarypolicychartfromStLouisFed

February

2007,

Bill

Poole

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ChartfromThe Economist

(Nowin

Economics

in

Action

box)

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TheBoomBustinHousing

(nowin

Economics

in

Action

box)

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HousingBoomandBust

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Temporarystimulusmeets

permanentincome

hypothesis

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Stock PricesDuringthePanic

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TeachingAboutRegulatoryCapture:Explains

failure

to

enforce

regulatory

rules

Cozyconnectionsbetweengovernment

and

the

financialindustry.

Thisbook

shows

governmenthelpingwell

connectedindividuals,who

inturn

helped

the

governmentofficials.

Result:Recklesspolicy

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Linesfrom

Fight

of

the

Century

Keynes:Evenyoumustadmitthatthelessonwevelearnedisthatmoreoversightsneededorelsewellgetburned

Hayek:Oversight?ThegovernmentslongbeeninbedwiththoseWallStreetexecsandthe

firmsthattheyveled.

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Policymakers

then

doubled

down

Discretionaryfiscalstimulusof2009($862billion)

Onetime

payments

again

Moregovernmentspendingtoo

Cashforclunkersprogram

Quantitativeeasing

in

2009,

now

called

QE1

Purchasesof$1.25trillionofmortgagebackedsecurities,$300billionoflongertermTreasurybonds

QE2in

2010

and

2011

purchasesof$600billionoflongertermTreasurybonds.

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IncomeandConsumptionduringtheTwo

Discretionary

StimulusPrograms

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Cashforclunkers:incentivesreallymatter

(Nowin

Economics

in

Action

box)

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Comparewithtextbookdiscussion:

Sharpdrop

in

Icauses

expenditure

line

to

shift

down

45-degree line

NewE line

Original E line

Original

incomelevel

New

incomelevel

INCOME OR REAL GDP

SPENDING

Income or real GDP falls by this amount

(more than by amount I falls ).

I falls by this

amount

Original point

of spending

balance

New point of spending balance

25_10

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OffsetbyCountercyclicalfiscalpolicy

Increasein

G

raises

GDP

depending

on

size

of

the

multiplierandamountofcrowdingout

45-degree line

INCOME OR REAL GDP

SPENDING

G rises

25_10

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0

50

100

150

200

250

300

350

400

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

Billions of dollars, annual rates

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

--- 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)

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1,400

1,500

1,600

1,700

1,800

1,900

2,000

2,100

2,200

2,300

2005 2006 2007 2008 2009 2010

Total receipts of state

and local governments

Recepits less

ARRA grants

Purchases by state

and local governments

Billions of dollars, annual rates

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A Legacy:ExplodingFederalDebt

(Chartnow

in

Fiscal

Policy

Chapter)

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TowardtheZeroInterestRate

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TheLiquidityTrap

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TheMonetaryBaseandtheSize

ofthe

Feds

Balance

Sheet

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InternationalEconomicsIssues

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IllustrativeChartfromtheOECD,March2008

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IllustrativeChartfromtheOECD,March2008

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Chinaspurchasesofforeignreserves

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SoWhy

Do

Economists

Disagree?

Studentsandeveryoneelsereallywantto

knowthe

answer

Onereasonisthatthedetailsoftheirmodelsaredifferent,eventhoughthereisagreement

aboutthe

basic

principles

ThenextthreechartsfromtheNewYorkTimes illustrate

this

well.

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-1

0

1

2

3

4

5

6

2009 2010

With stimulus

If no

stimulus

-1

0

1

2

3

4

5

6

2009 2010

With st imulus

If no

stimulus

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 TimesNovember 12, 2009

NewKeynesian

Smets ECB

RobertBarro

Harvard

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ImplicationsforTeaching

Manynew

illustrations

of

basic

economics

Interestingdebatesbetweeneconomists Rulesversusdiscretion

Basicrole

of

government

Moreintegrationofmicroandmacro interestratestoolowfortoolong(macro)

housingmarkets

including

bubbles

(micro)

stimuluspackage(macro)

regulatorycaptureandmoralhazard(micro)

newinstruments

of

monetary

policy

(macro)

riskpremia ininterestrates(micro)

debateoversizeofmultipliers(macro)

cashfor

clunkers,

first

time

home

buyer

(micro)

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ManyNewYouTubeVideos

QuantitativeEasingExplained.5milliondownloads.Doesn'tgetitallrightandbrutalinplaces,butgoodfordiscussion

TheWrongFinancialAdviser CreatedbyNobelprizewinner

BillSharpe

FedChairman ontheDailyShowwithJonStewart.Fromtwodifferentepisodesof60Minutes,focusonwhetherquantitativeeasingisprintingmoney.

UnmaskingInterest

Rates,

Honky

Tonk Style

MerleHazardsings"InflationorDeflation

InsideJobTrailer

ChristineLagarde inclipfromInsideJobHayek

Keynes

rap

videos

"Fear

the

Boom

and

Bust

and

Fight

oftheCentury