Financial Crisis, Recessions and the State of Macroeconomic Theory Melanie Fritz Thomas Schützenhofer Silvia Winter Department of Economics

Financial Crisis, Financial Crisis, Recessions and the Recessions and the

State of State of Macroeconomic Macroeconomic

TheoryTheory

Melanie Fritz

Thomas Schützenhofer

Silvia Winter

Department of Economics

Fritz, Schützenhofer, Winter

Economists: The current crisis Economists: The current crisis and macroeconomic theories and macroeconomic theories

Olivier Blanchard

Casey B. Mulligan

Paul Krugman

Alan Greenspan


Economists: The current crisis and macroeconomic theories: Economists: The current crisis and macroeconomic theories: Olivier Olivier BlanchardBlanchard

Three groups: The basic/traditional Keynesians The new-classicals want reconstruction: RBC- Model The new-Keynesians want reform and not revolution:

the previous vision of macroeconomics was right =>better foundations for imperfection


Economists: The current crisis and macroeconomic theories: Economists: The current crisis and macroeconomic theories: basic model of basic model of KeynesKeynes

Keynes: held a leading position for three main reasons: 1. models were simple, flexible, and easy to use and

seemed broadly consistent with observed patterns of economic activity

2. Second, Keynes and his disciples made a strong and effective critique of the alternative school

3. analytical Keynesian models provided a base for detailed statistical models of macroeconomic activity, used for economic forecasting and for evaluating alternative policies

Three ideas are central to the Keynesian view: The first is that there is little presumption that market

outcomes are desirable => great deal of scope for government intervention


Economists: The current crisis and macroeconomic Economists: The current crisis and macroeconomic theories: basic model of theories: basic model of KeynesKeynes

second is that changes in the supply side of markets are important mainly in the long run, which is taken to be very far away in most policy situations.

The third Keynesian view is that the fiscal and monetary authorities can control demand conditions for specific products and for the economy as a whole

These are differences to the new-Classical!!!



Keynesian economists of the 1960s often appealed to the Phillips curve , taking it to imply that monetary or fiscal policy that lowered the unemployment rate thus caused a higher inflation rate

The New-Classicals rejected this idea



Keynes: saw the price system in a free economy as

efficiently guiding the mutual adjustment of supply and demand in all markets, including the labor market

unemployment can only arise because of market imperfection (New classicals)

recessions occur when aggregate demand falls- largely as the result of a fall in private investment firms to produce below-causing their capacity. Producing less, firms need fewer workers


Economists: The current crisis and macroeconomic Economists: The current crisis and macroeconomic theories: The basic model of theories: The basic model of KeynesKeynes

Traditional Keynesian view of business cycles - according to which fluctuations are caused by a variety of types of real disturbances

which affect economic activity solely through their effects on aggregate demand, while aggregate supply instead evolves as a smooth trend

is no more confirmed by the modern models


Economists: The current crisis and macroeconomic Economists: The current crisis and macroeconomic theories: The New-Classicalstheories: The New-Classicals

The New-Classicals: an economic school of thoughts in the 1970s

uses the standard principles of economic analysis to understand how a nation's total output (gross domestic product, or GDP) is determined

construction of structural models of short-run fluctuations differed sharply from Keynesian modelers

According to Keynes the New-Classicals saw price system in a free economy efficiently guiding the mutual adjustment of supply and demand in all markets, including the labor market

Unemployment could arise only because of a market imperfection


Economists: The current crisis and Economists: The current crisis and macroeconomic theories: The New-Classicalsmacroeconomic theories: The New-Classicals

NCM view supply and demand result from the actions of economically rational households and firms. Macroeconomic quantities like GDP are the result of the general equilibrium of the markets in an economy.

It is surprising that this perspective is considered revolutionary in macroeconomics when we see the current nature of economic analysis in other fields, such as public finance, international trade, and labor economics



Lucas and Rapping applied the rule that in a market equilibrium occurs when quantity supplied equals quantity demanded

The two fundamental tenets of the New- classicals: Individuals are optimizers: given the prices Changing the incentives to individuals

NCM view a household's consumption in a specific time period depends on its current income and on the income it expects in the future, as well as on the interest rates at which it can borrow or lend (different from Keynesian)



Keynesian economists of the 1960s often appealed to the Phillips curve , taking it to imply that monetary or fiscal policy that lowered the unemployment rate thus caused a higher inflation rate

The New Classical rejected the idea that there was any useful trade-off

They argued that expansion of aggregate demand on unemployment only lowered because the acceleration in prices was not anticipated



Dynamic models have replaced static models: policy actions can not be evaluated

How are large fluctuations in output compatible with the two fundamental tenets of their doctrine?

RBC Model: In RBC-based monetary models, sticky wages

are often used to generate a high elasticity of labor supply



RBC - three principles: explicit micro foundation, defined as utility and profit

maximization; general equilibrium and the exploration with no or few imperfections

Shocks to aggregate demand Shocks to aggregate supply RBC-school regard changes in productivity as the driving

force in business cycles because of changes in technology may come in waves, therefore,

favorable or unfavorable runs of productivity (or technology) shocks may account for some of the characteristic persistence of business cycles


Economists: The current crisis and macroeconomic theories: Economists: The current crisis and macroeconomic theories: The New-Keynesian Model The New-Keynesian Model

The New-Keynesian-Model (NK-Model): It is an aggregate demand relation in which

output is determined by demand and demand depends in turn on anticipations of both future output and future real interest rates!

NK-Model became a workhorse for policy and welfare analysis. It starts from RBC without capital


Economists: The current crisis and macroeconomic theories: Economists: The current crisis and macroeconomic theories: The New-Keynesian ModelThe New-Keynesian Model

NK-Model: simple and replaced IS-LM-Model as basic model of fluctuation

NK-Model: monetary policy keeps inflation rate constant

assumes that households and firms have rational expectations


Economists: The current crisis and macroeconomic Economists: The current crisis and macroeconomic theories: theories: The New-Keynesian ModelThe New-Keynesian Model

NK assumes a variety of market failures (differ from New-Classical)

assume prices and wages are "sticky", which means they do not adjust to changes in economic conditions

Wage and price stickiness, and the other market failures imply that the economy may fail to attain full employment

NKs argue that macroeconomic stabilization by the government (using fiscal policy) or by the central bank (using monetary policy) can lead to a more efficient macroeconomic outcome than a laissez faire policy


Economists: The current crisis and macroeconomic Economists: The current crisis and macroeconomic theories: The New-Keynesian Modeltheories: The New-Keynesian Model

NK-Model lacks of many details to understand fluctuations

DMP-Model: consideration of unempolyment Two implications of the model:

Always unemployment Time for worker to find new work


Economists: The current crisis and macroeconomic Economists: The current crisis and macroeconomic theories: New Synthesis theories: New Synthesis

DSGEs – dynamic stochastic general equilibrium models

DSGE models with sticky wages and/or prices that wage- and price-setting decisions are made on the

basis of rational expectations think about the effects of policy included Keynesian thinking: ignore the role of financial

markets assume markets to be efficient and self-correcting and

not worthy of being included in the models


Economists: The current crisis and Economists: The current crisis and macroeconomic theoriesmacroeconomic theories

In contrast to classical macroeconomics, new and old, Keynesian macroeconomics did not begin with the assumption that an economy is made up of individually rational economic suppliers and demanders.

Instead of deriving demand from individual choices

For example the Keynesian procedure was to directly specify a behavioral rule

Keynes claimed that aggregate spending on consumption was governed by a "consumption function" in which consumption depended solely on current income.


Economists: The current crisis and Economists: The current crisis and macroeconomic theoriesmacroeconomic theories

Keynesian macroeconomics said that people followed fixed rules of thumb

with no presumption that firms and households made rational choices

this grew out of a suspicion on the part of Keynesian modelers that people did not typically act rationally

it was a pragmatic modeling decision: if people's economic behavior is purposeful, the task of specifying how they will act in various situations is more complicated and, therefore, more difficult to model.


Economists: The current crisis and macroeconomic Economists: The current crisis and macroeconomic theories: Olivier Blanchardtheories: Olivier Blanchard

Models are similar in structure Problem: same models for different

structures and shocks Great progress and excitement in

macroeconomics Three hopes of Blanchard:

Rehabilitation of partial equilibrium Huge micro data -> DSGE Re-legalization of shortcuts and simple models


Economists: The current crisis and Economists: The current crisis and macroeconomic theories: Kehoe - Solowmacroeconomic theories: Kehoe - Solow

Arrogate for little macro models

Understand mechanism of economy

Solow ignore heterogeneinity factors

Change models prospective and

Adapt it to challenges in macro-economy


Economists: The current crisis and Economists: The current crisis and macroeconomic theories: Luigi Spaventamacroeconomic theories: Luigi Spaventa

If not forecasting the crises, economists were aware of that the system had set on an unsustainable path?

Was the state of economics the problem or was it the economists using them to fail?

economists are unable to understand reality because of the abstraction of theories and models


Economists: The current crisis and Economists: The current crisis and macroeconomic theories: Luigi Spaventamacroeconomic theories: Luigi Spaventa

available tools were inadequate in the field of macroeconomics

Luigi Spaventa shows that nobody can provide precise forecast about the crisis

new business models known as “originated to distribute” (OTD)

macro- and microeconomic implications were never explored

Solution: general macroeconomic framework


Economists: The current crisis and macroeconomic theories: Economists: The current crisis and macroeconomic theories: Paul Paul KrugmanKrugman

Krugman and the current crisisKrugman and the current crisis

“the state of macro is good” (?)

criticism on economists

only few economists saw this crisis coming

economists were blended and ignored important facts


Economists: The current crisis and macroeconomic theories:Economists: The current crisis and macroeconomic theories: Paul Paul KrugmanKrugman

“The central cause of the profession’s failure was the desire

for an all-encompassing, intellectually elegant approach

that also gave economists the chance to show off their

mathematical prowess!”



Macroeconomics according to KeynesMacroeconomics according to Keynes

National and international programs

Policies to regulate booms and slumps

→ economic equilibrium resorted and maintained by

official action

→ no space for classical theory and its laissez-faire



Capitol Hill Baby-Sitting CooperativeCapitol Hill Baby-Sitting Cooperative

150 couples

20 coupons/couple

One coupon: half an hour baby-sitting

→ keep reserves

→ cooperative fell into recession



““saltwater” economistssaltwater” economists (mainly from universities in the

coastal area) who agree more or less with the Keynesian

theory of recessions.

““freshwater” economistsfreshwater” economists (mainly at interior universities)

who totally disagree to the Keynesian vision.



Freshwater economists:

bring demand and supply into balance to get out of recession

Unemployment is an consciously decision to take a time-out

Saltwater economists:

Recessions are demand-driven

Need for political activities



No one could have predicted...No one could have predicted...

general belief that bubbles just do not happen

vision of a perfect and frictionless market system

behavioural finance



Krugman‘s advice to economists:Krugman‘s advice to economists:

face up reality

recognize that the Keynesian economy illustrates the best

framework for recessions and depressions which we have

do the best to implicate the realities of finance into

macroeconomics


Economists: The current crisis and macroeconomic theories: Economists: The current crisis and macroeconomic theories: Alan Alan GreenspanGreenspan

Greenspan was chairman of the Federal Research Board

until 2006

→ The Times’ “25 People to Blame for the Financial Crisis” :

Greenspan as one of the top three people who are

responsible for the current crisis!


Economists: The current crisis and macroeconomic theories:Economists: The current crisis and macroeconomic theories: Alan Alan GreenspanGreenspan

Greenspan to the accusations:Greenspan to the accusations:

Roots lay in the quick global decline in nominal and real long-

term interest rates in the early part of the 2000s

I. Monetary policy does not bear any blame for the crisis

→ central banks are not at fault and were impotent

bystanders

II. Deny that house prices are driven upward by low short-term

rates

III. No correlation between looseness of monetary policy in

different countries and changes in house prices

We will never have a perfect model of risk


Financial Crisis in the PastFinancial Crisis in the Past

Chile and MexicoChile and Mexico

Both countries had the same financial problem

Their reaction was different

Mexico nationalized bank-system

Chile passed solvent banks into private hand


Mexico:Mexico:

Wanted to keep the investment activity and employment

Companies got cheaper loans

Firms which were threatened by insolvency could survive

Also unproductive firms survived

Chile:Chile:

Bank system was privatized

Unproductive firms got insolvent



Consequences:

Chile: decreasing GDP in 1982/83 but

in 1984 Chile had the biggest GDP in

Latin America

Mexico: economic disaster 1982 to

1985 and since this time the GDP growth

is very teeny

The difference between Chile and

Mexico was the productivity (high/low)




Financial crisis in the past: Finland and JapanFinancial crisis in the past: Finland and Japan

Similar to the crises in Chile and Mexico was Finland and Japan

Japan followed Mexico while

Finland followed Chile

The effects were similar the

crises in Chile and Mexico

Japan had a scarcely growth of

GDP

Finland's GDP growth increased

quite a lot



Conclusion: Development of financial crisesConclusion: Development of financial crises

Reaction of government and economy are important

Productivity is a important factor for growth and

depression

Government could influence productivity

Overreaction of government can cause regression

Giving examples Chile and Mexico / Finland and Japan


Financial CrisisFinancial Crisis

Current financial crisis: North America/EuropeCurrent financial crisis: North America/Europe

Now the same situation

Goal should be: The way of Finland and Chile

Force productivity

Support of productive companies

Unproductive firms should get insolvent?


The sequences of the financial crisesThe sequences of the financial crises

Now a overview about the Liquidity and Credit Crunch Now a overview about the Liquidity and Credit Crunch

in 2007-2008in 2007-2008

Banks get liquidity pressure

Mortgage crises

Asset backed financial products

Central bank

Monoline Insurers

Bear Stearns, Fannie Mae, Freddy Mac, Lehman Brothers,

etc.

Liquidity spiral


The sequences of the financial crises The sequences of the financial crises

Bank trends leading into liquidity pressureBank trends leading into liquidity pressure

The reason were bad loans which were write down

Amount of hundreds of billion dollars

At the same time the stock market lost more than half of value

The reason was high mortgage losses

Result in US Stock market lost more than eight trillion dollars

The followings were cry for liquidity

It was difficult to get money, consequently bailouts followed

Government saved companies of bailouts



Subprime mortgage crisesSubprime mortgage crises

Starting in Feb. 2007

Cause was the increasing

mortgage failures

Evident in ABX Indices swap

Indices decreased, costs of

insurance for mortgage-loss

increased



ConsequencesConsequences

Prices by mortgages dropped

Downgrading by moodies, Standard Poor and Fitch

Credit market got definitely out of balance in June 2007

26th July 2007 Index of National Association of Home

builders lost 6,6% (year on year)


Asset backed financial productsAsset backed financial products

Increasing popularity because:

Advantages: the big spread against many market partners

Asset Backed products were AAA-rated which affected low

mortgage and interest rates

This attracted also institutional investors

For example: Senior tranches was not include in Basel 1 and so

they don't need assets as collateralise minimum (8%)

!Product included the assumption, that housing prices couldn´t

drop!

The sequences of the financial crises The sequences of the financial crises


ConsequencesConsequences

Big supply of opportune credits

Decreasing collateralising standard

Ending in housing-madness

EffectsEffects

Borrowers normally cannot get credit get it

After a time they could not perform it

Liquidity and Credit Crunch 2007-2008Liquidity and Credit Crunch 2007-2008



Central bankCentral bank

European Central bank gave credit of 95 billion Euros

US Federal Reserve followed with 24 billion Euros

Discount rate for credits sunk for 0,5% to 5,75%

But more over 7000 banks didn't accept this credits → was a negative signal → creditworthiness

Oct. 2007 interest rate reduction to 5,25%

So British bank “Northern Rock” got liquidity support by Bank of England

Northern Rock was the first victim of bank-run in Great Britain since one century



Monoline InsurersMonoline Insurers

Insurance for Municipal Bonds and Guarantees for

mortgage market Securities

Due to the crises Monoline Insurers get under pressure

and Downgradings followed

Downgradings by their ratings (giving example: Fitch

took downgrading by Ambac)

World wide downgrades

Asia stock m. 15%, Down Jones and NASDAQ up 6%

Biggest cut since 1982



Bear Stearns, Fannie Mae, Freddy Mac,

Bearstearns:

Problems to operate the Margin calls

No money by Repo market (Liquidity)

Big rivals help to minimize the credit risk of Bear Stearns (systemic important)

Fannie Mae and Freddy Mac

Problems to get money → mortgage rate increased

Government gave guarantee

But stock market price decreased and the Government

took both companies in polity control

This caused large numbers of out-standings credit default swaps

Successions: Big Payments for buyers who bought this swaps



Lehman Brothers, Merril Lynch and AIGLehman Brothers, Merril Lynch and AIG

Also this banks get insolvent/bailouts

Lehman Brothers get bankruptcy

Take over by Merrill Lynch by the Bank of America

AIG also get liquidity problems after Lehman get

bankruptcy

Federal created a organisation for bailouts with a value

over 85 billion dollars

Raised by 37 billion in Oct. 2007 and 40 billion in Nov.

2007


Liquidity SpiralsLiquidity Spirals

Liquidity spirals are loss spirals which started when

deprecation of assets starts and net value decreases faster

than the gross value. The following is a lower credit

amount.

For example:For example:

Investor bought assets by 100 million, margin calls 10%

10 million own capital

90 million outside capital

Leverage ratio is 10%

Amplifying Mechanisms and Amplifying Mechanisms and Recurring ThemesRecurring Themes


Now:Now: Value decreased to 95 million

Loss of 5 million→ losses 5 million of his own capital

To get leverage ratio of 10 %, he must sell 45 million

These depress the price and he has to sell again (he need

leverage ratio 10)

This is the beginning of the liquidity spirals (more investors

had this problems)

Next problem:Next problem: Buyers wait, because it is better to start after liquidity spirals

Extreme cases → FiresalesFiresales

Amplifying Mechanisms and Recurring ThemesAmplifying Mechanisms and Recurring Themes


My own viewMy own view

Many factors which can influence financial crisesMany factors which can influence financial crises

Liquidity

Interrest rate

Mortgage rate

Productivity

Etc.

I believe, the most important thing of all factors is, that we

must take reaction over this financial crisis. So we need

stricter regulations and more controls.

Documents

Financial Crisis, Recessions and the State of Macroeconomic Theory Melanie Fritz Thomas Schützenhofer Silvia Winter Department of Economics