Schedule and Readings

Schedule and Readings

Brad DeLong: delong@econ.berkeley.edu: 925 708 0467: W 2-4 Evans 601, M 1:30-2 Evans 601
Marc Gersen: mgersen@econ.berkeley.edu: aim:mgersen08: 510-541-2326: ??

  • Lecture: 247 Cory 9-10 AM M, W, and most F
  • Section: MW 8-9 AM 237 Cory
  • Section: WF 11-12 AM 61 Evans
  • Section: ??

Introduction

W Jan 23: INTRODUCTION: The Problems of Macroeconomics

Theory (with Examples and Illustrations)

The Long Run: Economic Growth

F Jan 25: The Solow Model: Capital and Equilibrium

M Jan 28: The Solow Model: Dynamics and Feedback

W Jan 30: How Much of Today's World Can We Explain with the Solow Growth Model?

F Feb 1: Current Events

  • Problem Set 2 out (due Fed 8)

M Feb 4: From Malthus to Modernity

W Feb 6: Understanding the Industrial Revolution

F Feb 8: Current Events

M Feb 11: Measuring Economic Growth

W Feb 13: The Productivity Slowdown of the 1970s

F Feb 15: PROFESSORIAL REALITY CHECK EXAM Midterm I Summary

The Medium Run: Economic Fluctuations with Flexible Prices

W Feb 20: Components of Aggregate Demand

F Feb 22: Full-Employment Equilibrium

M Feb 25: The International Side--Plus Government Budgets and Investment Booms

W Feb 27: The Monetary Side: The Quantity Theory of Money, Inflation, and Expectations

F Feb 29: Quantity Theory Continued; Current Events

The Short Run: Economic Fluctuations with Sticky Prices

M Mar 3: Sticky Prices and Aggregate Demand

W Mar 5: The IS Curve and Employment

F Mar 7: What happened this week in the macroeconomy?

M Mar 10: CLASS CANCELLED--PROFESSOR SICK

W Mar 12: The Phillips Curve, Inflation, and Monetary Policy

F Mar 14: Tying Up the Short-Run and the Medium Run

F Mar 14: What happened this week in the macroeconomy?

M Mar 17: Loose Ends

  • Notes: Core Theory Loose Ends

W Mar 19: CORE THEORY EXAM

  • Problem Set out (due Apr 7) Stabilization Policy and Central Banking

APPLICATIONS

March 31: Markets for "Lemons"

Notes: Lecture Audio. Adverse Selection in Lending Markets.

Readings:

April 2: Models of Financial Crises

Notes: Lecture Audio
Readings: David Greenlaw (Morgan Stanley), Jan Hatzius (Goldman Sachs), Anil Kashyap (Chicago GSB) and Hyun Shin (2008), "Leveraged Losses Lessons from the Mortgage Market Meltdown" http://www.chicagogsb.edu/usmpf/docs/usmpf2008confdraft.pdf

April 4: Ways of Dealing with Financial Crises

Lecture Audio
Readings:

Problem set: Adverse selection and financial markets. Clean Version

Memo: Midterm 2 Grading Scale

April 7: How Are We Dealing with This Financial Crisis?

Notes: Lecture Audio http://delong.typepad.com/berkeley_econ_101b_spring/2008/04/what-we-are-doi.html

April 9: What Should We Be Doing in This Financial Crisis that We Are Not?

Notes: Lecture Audio: http://www.j-bradford-delong.net/2008_MOV/20080409_123925.mp3

Readings:

April 11: International Finance and "Global Imbalances": Introduction

Notes: Lecture Audio http://www.j-bradford-delong.net/2008_mov/20080411_091301.mp3

Readings:

April 14: Risks of International Financial Crisis

Notes:

Readings:

April 16: Risks of International Financial Crisis II

April 21: Why Is Asia Gambling on Bretton Woods II?

Notes: Slides: http://delong.typepad.com/delongslides/2008/04/econ-101b-april.html; Lecture Audio: http://www.j-bradford-delong.net/2008_mov/20080421_091146.mp3

Readings:

April 23: The Chinese Economy

Notes: Slides: http://delong.typepad.com/delongslides/2008/04/econ-101b-april.html; Lecture Audio: http://www.j-bradford-delong.net/2008_mov/20080423_091349.mp3

Readings:

April 25: Long-Run Growth Revisited: Endogenous Growth

Notes: Lecture Audio; “Infant Industries,” Industrial Policy, and Development in a Model of Productive Variety http://www.j-bradford-delong.net/2008_pdf/20080424_industrial_policy.pdf

Readings:

April 30: "Conservative" Central Bankers

Notes: Lecture Audio

Readings:

May 2: The Long-Run Fiscal Situation

Notes: Lecture Audio

Readings:

May 5: The Long-Run Fiscal Situation: Theory and Practice

Notes: Lecture Audio

Readings:

May 7: The Long-Run Fiscal Situation: Theory and Practice II

Notes: Lecture Audio; Solow and Ramsey

May 9: "Applications" Exam

May 12: Review

May 14: Review

May 16: FINAL EXAM 8-11 277 Cory

DROPPED AND REPLACED...

Applications (with Additional Theory)

Domestic Monetary and Fiscal Policies

M Mar 31: Stabilization Policy since WWII

  • Macroeconomics, review 10.3, review 12.4, 13, 14.1, 16.1-16.4

W Apr 2: Should Conservatives Be Central Bankers? * Notes: Central Bankers: Stabilizers, Credible Inflation-Fighters, and Lenders of Last Resort * Central Bank Consistency and Credibility: The Analytics * Macroeconomics, review 13.6, review 13.7

F Apr 4: What happened this week in the macroeconomy?

M Apr 7: Looking Back at the Great Depression: What Went So Wrong?

  • Macroeconomics, 16.3, 16.5
  • Notes on the Great Depression
  • Notes on Liquidity Traps
  • Problem Set out (due Apr 14) Credit Channels

W Apr 9: Is There a Political Business Cycle?

  • Macroeconomics, review 13.6

F Apr 11: What happened this week in the macroeconomy?

M Apr 14: U.S. Long-Run Budget Balance

W Apr 16: "Fixing" Social Security

  • Notes on Social Security

F Apr 18: What happened this week in the macroeconomy?

Growth and Distribution

M Apr 21: Productivity Speed-Ups and Slow-Downs

W Apr 23: U.S. Income Distribution

  • Notes: American Income Distribution

F Apr 25: What happened this week in the macroeconomy?

M Apr 28: European Youth and Structural Unemployment

  • Macroeconomics, 16.5
  • Notes: The Western European Macroeconomy
  • Web Assignment out (due May 5) Behavioral Finance

Domestic and International Finance

W Apr 30: "Animal Spirits": Understanding the Stock and Real Estate Markets

F May 2: What happened this week in the macroeconomy?

M May 5: Global Imbalances

W May 7: APPLICATIONS EXAM

Summary and Review

F May 9: What happened this week in the macroeconomy?

  • Web Assignment out (due May 16) Feedback and Recommendations

M May 12: FINAL REVIEW

F May 16: FINAL EXAM 8-11

Posted at 02:02 PM in Administration | | Comments (0)

May 11, 2008

Practice Final for Econ 101b

Practice final for econ 101b: http://www.j-bradford-delong.net/2008_pdf/mock_final_101b.pdf

Posted at 06:49 PM in Exams | | Comments (0)

May 07, 2008

May 7: The Long-Run Fiscal Situation: Theory and Practice II

May 7: The Long-Run Fiscal Situation: Theory and Practice II

Notes: Lecture Audio; Solow and Ramsey

Posted at 11:07 AM in Lecture Notes | | Comments (0)

Notes: From Solow to Ramsey

Posted at 11:03 AM in Lecture Notes | | Comments (0)

May 05, 2008

May 5: The Long-Run Fiscal Situation: Theory and Practice

May 5: The Long-Run Fiscal Situation: Theory and Practice

Notes: Lecture Audio

Readings:

Posted at 10:59 AM in Lecture Notes | | Comments (0)

May 04, 2008

Practice Exam for May 9

Apologies. This should have gone up on Friday, but for some reason was not copied over:

http://www.j-bradford-delong.net/2008_pdf/101bpracticeexammay9.pdf

Posted at 03:25 PM in Exams | | Comments (0)

May 02, 2008

May 2: The Long-Run Fiscal Situation: Theory

May 2: The Long-Run Fiscal Situation: Theory

Notes: Lecture Audio

Readings:

Posted at 10:54 AM in Lecture Notes | | Comments (2)

May 01, 2008

April 30: "Conservative" Central Bankers

April 30: "Conservative" Central Bankers

Notes: Lecture Audio

Readings:

Posted at 12:40 PM in Lecture Notes | | Comments (0)

April 30, 2008

Econ 101b Final Exam

UCB Online Schedule of Final Exams: Search Results: Displaying 1 match to your request for Spring 2008 Final Exams:

Course:  ECONOMICS 101B P 001 LEC
Course Title:  Economic Theory--Macro
Date/Time:  FRIDAY, MAY 16, 2008   8-11A
Location:  277 CORY
Instructor:  DELONG, J B
Course Control Number:  22579
Final Exam Group:  4

Posted at 08:32 PM in Exams | | Comments (0)

April 25, 2008

April 25: Long-Run Growth Revisited: Endogenous Growth

April 25: Long-Run Growth Revisited: Endogenous Growth

Notes: Lecture Audio; “Infant Industries,” Industrial Policy, and Development in a Model of Productive Variety http://www.j-bradford-delong.net/2008_pdf/20080424_industrial_policy.pdf

Readings:

Posted at 04:22 PM in Lecture Notes | | Comments (0)

April 24, 2008

Auxiliary Reading Problem Set

Auxiliary Reading Problem Set

For each of the six articles below, write one paragraph--one hundred to two hundred words--explaining to somebody who has not read the article what its main point is:

Posted at 01:06 PM in Problem Sets |

April 23, 2008

April 23: The Chinese Economy

April 23: The Chinese Economy

Notes: Slides: http://delong.typepad.com/delongslides/2008/04/econ-101b-april.html; Lecture Audio: http://www.j-bradford-delong.net/2008_mov/20080423_091349.mp3

Readings:

Posted at 10:38 AM in Lecture Notes | | Comments (0)

April 21, 2008

April 21: Why Is Asia Gambling on Bretton Woods II?

April 21: Why Is Asia Gambling on Bretton Woods II?

Notes: Slides: http://delong.typepad.com/delongslides/2008/04/econ-101b-april.html; Lecture Audio: http://www.j-bradford-delong.net/2008_mov/20080421_091146.mp3

Readings:

Posted at 05:22 PM in Lecture Notes | | Comments (0)

April 16: Risks of International Financial Crisis II

April 16: Risks of International Financial Crisis II

Posted at 05:21 PM in Lecture Notes | | Comments (0)

April 16, 2008

Econ 101b International Financial Crises Problem Set

Econ 101b International Financial Crises Problem Set: Algebra

Clean Version

(1) Start with our consensus flexible-price business cycle model, in "differences" form:

Untitled 1

Add the exchange rate equation:

Untitled 1

and suppose that the government increases purchases, and that that increase in purchases makes foreign exchange speculators scared about the long-run value of the currency and causes a depreciation--an increase in speculators' beliefs about the long-run fundamental price of foreign currency e0:

Untitled 1

In this model with flexible prices and with output fixed and equal to potential, analyze the impact of such an increase in government purchases on the economy's equilibrium: what happens to the interest rate, to the exchange rate, to government purchases, to investment, and to gross exports?

(2) In the same setup as problem (1), change the investment function to allow investment to depend on the intensity of financial crisis C, like so:

Untitled 1

Restrict your attention to only cases in which the change in the exchange rate e--in the price of foreign currency--are positive. Now solve for the impact on the increase in government purchases on the economy's equilibrium: what happens to the interest rate, to the exchange rate, to government purchases, to investment, and to gross exports?

(3) Go back to problem 1, only solve it in the sticky-price model, where output can change and where the interest rate is a policy variable chosen by the Federal Reserve. What happens to the interest rate, to the exchange rate, to government purchases, to investment, and to gross exports as functions of the change in government purchases and the change in the interest rate? Assuming that the central bank cannot affect the change in government purchases--that that is set in stone by politics--what, in your view, should the central bank do in the way of monetary policy?

(4) Go back to problem 2, only solve it in the sticky-price model, where output can change and where the interest rate is a policy variable chosen by the Federal Reserve. What happens to the interest rate, to the exchange rate, to government purchases, to investment, and to gross exports as functions of the change in government purchases and the change in the interest rate? Assuming that the central bank cannot affect the change in government purchases--that that is set in stone by politics--what, in your view, should the central bank do in the way of monetary policy?

Posted at 06:14 AM in Problem Sets | | Comments (1) | TrackBack (0)

April 15, 2008

Revised Schedule for Econ 101b: Post-Spring Break

March 31: Markets for "Lemons"

Notes: Lecture Audio. Adverse Selection in Lending Markets.

Readings:

April 2: Models of Financial Crises

Notes: Lecture Audio
Readings: David Greenlaw (Morgan Stanley), Jan Hatzius (Goldman Sachs), Anil Kashyap (Chicago GSB) and Hyun Shin (2008), "Leveraged Losses Lessons from the Mortgage Market Meltdown" http://www.chicagogsb.edu/usmpf/docs/usmpf2008confdraft.pdf

April 4: Ways of Dealing with Financial Crises

Lecture Audio
Readings:

Problem set: Adverse selection and financial markets. Clean Version

Memo: Midterm 2 Grading Scale

April 7: How Are We Dealing with This Financial Crisis?

Notes: Lecture Audio http://delong.typepad.com/berkeley_econ_101b_spring/2008/04/what-we-are-doi.html

April 9: What Should We Be Doing in This Financial Crisis that We Are Not?

Notes: Lecture Audio: http://www.j-bradford-delong.net/2008_MOV/20080409_123925.mp3

Readings:

April 11: International Finance and "Global Imbalances": Introduction

Notes: Lecture Audio http://www.j-bradford-delong.net/2008_mov/20080411_091301.mp3

Readings:

April 14: Risks of International Financial Crisis

Notes:

Readings:

April 16: Risks of International Financial Crisis II

April 21: Why Is Asia Gambling on Bretton Woods II?

Notes: Slides: http://delong.typepad.com/delongslides/2008/04/econ-101b-april.html; Lecture Audio: http://www.j-bradford-delong.net/2008_mov/20080421_091146.mp3

Readings:

April 23: The Chinese Economy

Notes: Slides: http://delong.typepad.com/delongslides/2008/04/econ-101b-april.html; Lecture Audio: http://www.j-bradford-delong.net/2008_mov/20080423_091349.mp3

Readings:

April 25: Long-Run Growth Revisited: Endogenous Growth

Notes: Lecture Audio; “Infant Industries,” Industrial Policy, and Development in a Model of Productive Variety http://www.j-bradford-delong.net/2008_pdf/20080424_industrial_policy.pdf

Readings:

April 30: "Conservative" Central Bankers

Notes: Lecture Audio

Readings:

May 2: The Long-Run Fiscal Situation

Notes: Lecture Audio

Readings:

May 5: The Long-Run Fiscal Situation: Theory and Practice

Notes: Lecture Audio

Readings:

May 7: The Long-Run Fiscal Situation: Theory and Practice II

Notes: Lecture Audio; Solow and Ramsey

May 9: "Applications" Exam

May 12: Review

May 14: Review

May 16: FINAL EXAM 8-11 277 Cory

Posted at 06:48 PM in Administration | | Comments (0) | TrackBack (0)

April 14, 2008

Adverse Selection Answer Key

Adverse Selection Problem Set Answers

 

1. a) π = -24r^2 + 6r - x

b) solving for r, and picking the lesser interest rate,
r= [3 - √(9-24x)]/24

c) Setting the quantity under the radical to zero, so that we obtain a unique real root,
x=9/24

2. a) π = -24r^2 + 10r – x
b) r= [5 - √(25-24x)]/24

c) x=25/24. Note that this is greater than one, so a collapse is impossible.

3. a) π = -24r^2 + 2r – x

b) r= [1 - √(1-24x)]/24

c) x=0. The market cannot support any background probability of default.  So if we think at least a few borrowers will probably default, regardless of what the interest rate is, then the market will always collapse.

4, 5, 6.
Here is a general solution.

Assume perfect competition, so equilibrium profits are zero.

π = Revenue – Costs

Recall that R=P*Q and costs are both fixed and variable

So we can write π = Q*(P-VC) – FC

Recall that in banking, the interest rate is a price, and the bank’s cost of funds is the variable cost.

Losses due to bad borrowers are a fixed cost, and equal the number of bad loans * cost of funds (bad borrowers in this model default on the interest, but not the principle).

 

D = 4000* (.1 –r) (given; this is quantity demanded).

P-VC is the interest rates banks charge, r, minus the cost of funds, which I will call c.

 

Therefore, π = 4000*(.1-r)*(r-.c) – y*c

 

Note that r is a variable, and y and c are parameters of the model.

Using the quadratic equation to solve for r, and picking the lesser interest rate,

r = {100(c+.1) + √[1000(c+0.1)²-(y*c+400c)]}/200

 

Notice that stability of the market depends on the parameters y and c only.

 

So the maximum value of c for which the market does not collapse is a function of y

c = [-√(y²+400y)+y+200]/2000

 

c(1000) = .839%

c(2000) = .455%

c(3000) = .312%

 

So whether at 1%, 2%, or 3% cost of funds, the market collapses.

If y=2000, then c=.455%, and banks will charge the interest rate r=5.28%

If y=1000, then c=.839% and banks will charge the interest rate r=5.44%

If y=3000, then c=.312%, and banks will charge the interest rate r=5.23%

 

Posted at 11:00 AM | | Comments (0)

April 14: Risks of International Financial Crisis

April 14: Risks of International Financial Crisis

Notes:

Readings:

Posted at 10:41 AM in Lecture Notes | | Comments (0)

April 11, 2008

April 11: Econ 101b: International Finance and "Global Imbalances"

April 11: International Finance and "Global Imbalances": Introduction

Notes: Lecture Audio http://www.j-bradford-delong.net/2008_mov/20080411_091301.mp3

Readings:

Posted at 10:36 AM in Lecture Notes | | Comments (0)

April 09, 2008

April 9 Lecture: Econ 101b: Arguments Against Lender-of-Last Resort Operations

Lecture Audio

Arguments Against Standard Central Bank Lender-of-Last Resort Operations:

  • Since at least 1844, central banks have been trying to avoid great depressions by acting as lenders-of-last-resort in times of financial crisis
    • Stage I: provide liquidity (at a penalty rate)
    • Stage II: lower interest rates on safe assets (via open market operations)
    • Stage III: direct market support of some kind

The critics say...

  • This is immoral

    • We have a system in which the Princes of Wall Street earn great fortunes by virtue of their analytical skills, entrepreneurial vision, and willingness to take and bear risks
    • The lender-of-last-resort function provides them with a safety net, and so turns them from economic heroes into villains
    • Response I: There are no Randites in a panic...
    • Response II: Exactly: if it's good to have a safety net for rich financiers, it's better to have a safety net for the middle class and the poor as well--and a progressive income tax to fund it...

  • This is unfair

    • Rich, feckless financiers who ought to be punished escape with their wealth to their yachts
    • Thriftless, feckless, imprudent borrowers who ought to have known better escape loss--and live more lavishly than the thrifty and prudent who played by the rules
    • Response: Markets aren't fair--the lucky prosper, and this is a form of luck. Markets are about productivity and efficiency, politics is about justice--see above re progressive income tax, etc.

  • This won't work in the long run

    • I: Moral Hazard:
      • Financiers in the future, knowing that the central bank has always shown up in the past, will be even more imprudent and feckless
      • Thus the rescue doesn't cure the current financial crisis so much as create future ones
      • Response I: Yes, this is a danger to guard against--but the risks we want to guard against are those of running the real economy into an iceberg, not an unfair rearranging of the chairs on the pool deck
      • Response II: The principals of Bear Stearns lost the bulk of their wealth; the principals of LTCM lost their fortunes as well; how much additional moral hazard is created by LoLR?
    • II: Adverse Selection
      • You need big depressions and their losses to clean the the ranks of the entrepreneurs...
    • III. Overinvestment
      • The financial crisis is a reflection of a real disequilibrium--of an overinvestment. Boosting the prices of financial assets simply generates more overinvestment--and a bigger problem, because the bigger amount of overinvestment then has to be worked off...

This is a very old argument indeed: Karl Marx and Friedrich Engels made it.

It is, I think, a matter of time and scale: we want investment spending to decline as rapidly as workers can be redeployed to other potential leading sectors--but no faster. The bubble needs to "deflate," not "pop"...

Paul Krugman has, I think, the best answer:

THE HANGOVER THEORY: Are Recessions the inevitable payback for good times?: A few weeks ago, a journalist devoted a substantial part of a profile of yours truly to my failure to pay due attention to the "Austrian theory" of the business cycle--a theory that I regard as being about as worthy of serious study as the phlogiston theory of fire. Oh well. But the incident set me thinking--not so much about that particular theory as about the general worldview behind it. Call it the overinvestment theory of recessions, or "liquidationism," or just call it the "hangover theory." It is the idea that slumps are the price we pay for booms, that the suffering the economy experiences during a recession is a necessary punishment for the excesses of the previous expansion.

The hangover theory is perversely seductive--not because it offers an easy way out, but because it doesn't. It turns the wiggles on our charts into a morality play, a tale of hubris and downfall. And it offers adherents the special pleasure of dispensing painful advice with a clear conscience, secure in the belief that they are not heartless but merely practicing tough love.... The many variants of the hangover theory all go something like this: In the beginning, an investment boom gets out of hand... all that investment leads to the creation of too much capacity--of factories that cannot find markets, of office buildings that cannot find tenants... reality strikes--investors go bust and investment spending collapses. The result is a slump whose depth is in proportion to the previous excesses. Moreover, that slump is part of the necessary healing process: The excess capacity gets worked off, prices and wages fall from their excessive boom levels, and only then is the economy ready to recover.

Except for that last bit about the virtues of recessions, this is not a bad story about investment cycles.... But let's ask a seemingly silly question: Why should the ups and downs of investment demand lead to ups and downs in the economy as a whole?... Here's the problem: As a matter of simple arithmetic, total spending in the economy is necessarily equal to total income (every sale is also a purchase, and vice versa). So if people decide to spend less on investment goods, doesn't that mean that they must be deciding to spend more on consumption goods--implying that an investment slump should always be accompanied by a corresponding consumption boom? And if so why should there be a rise in unemployment?

Most modern hangover theorists probably don't even realize this is a problem for their story. Nor did those supposedly deep Austrian theorists answer the riddle. The best that von Hayek or Schumpeter could come up with was the vague suggestion that unemployment was a frictional problem created as the economy transferred workers from a bloated investment goods sector back to the production of consumer goods. (Hence their opposition to any attempt to increase demand: This would leave "part of the work of depression undone," since mass unemployment was part of the process of "adapting the structure of production.") But in that case, why doesn't the investment boom--which presumably requires a transfer of workers in the opposite direction--also generate mass unemployment? And anyway, this story bears little resemblance to what actually happens in a recession, when every industry--not just the investment sector--normally contracts.... The hangover theory, then, turns out to be intellectually incoherent; nobody has managed to explain why bad investments in the past require the unemployment of good workers in the present. Yet the theory has powerful emotional appeal. Usually that appeal is strongest for conservatives.... But moderates and liberals are not immune to the theory's seductive charms--especially when it gives them a chance to lecture others on their failings...

Karl Marx and Friedrich Engels, 1848:

The bourgeoisie, during its rule of scarce one hundred years, has created more massive and more colossal productive forces than have all preceding generations together. Subjection of Nature's forces to man, machinery, application of chemistry to industry and agriculture, steam-navigation, railways, electric telegraphs, clearing of whole continents for cultivation, canalisation of rivers, whole populations conjured out of the ground - what earlier century had even a presentiment that such productive forces slumbered in the lap of social labour?...

Modern bourgeois society with its relations of production, of exchange and of property, a society that has conjured up such gigantic means of production and of exchange, is like the sorcerer, who is no longer able to control the powers of the nether world whom he has called up by his spells.... It is enough to mention the commercial crises that by their periodical return put on its trial, each time more threateningly, the existence of the entire bourgeois society. In these crises a great part not only of the existing products, but also of the previously created productive forces, are periodically destroyed. In these crises there breaks out an epidemic 10 that, in all earlier epochs, would have seemed an absurdity - the epidemic of over-production. Society suddenly finds itself put back into a state of momentary barbarism; it appears as if a famine, a universal war of devastation had cut off the supply of every means of subsistence; industry and commerce seem to be destroyed; and why? Because there is too much civilization, too much means of subsistence, too much industry, too much commerce.... The conditions of bourgeois society are too narrow to comprise the wealth created by them. And how does the bourgeoisie get over these crises? On the one hand by enforced destruction of a mass of productive forces; on the other, by the conquest of new markets, and by the more thorough exploitation of the old ones. That is to say, by paving the way for more extensive and more destructive crises, and by diminishing the means whereby crises are prevented...

Karl Marx and Friedrich Engels, 1851:

The years 1843-5 were years of industrial and commercial prosperity, a necessary sequel to the almost uninterrupted industrial depression of 1837-42. As is always the case, prosperity very rapidly encouraged speculation. Speculation regularly occurs in periods when overproduction is already in full swing. It provides overproduction with temporary market outlets, while for this very reason precipitating the outbreak of the crisis and increasing its force. The crisis itself first breaks out in the area of speculation; only later does it hit production. What appears to the superficial observer to be the cause of the crisis is not overproduction but excess speculation, but this is itself only a symptom of overproduction. The subsequent disruption of production does not appear as a consequence of its own previous exuberance but merely as a setback caused by the collapse of speculation....

In the years of prosperity from 1843 to 1845, speculation was concentrated principally in railways, where it was based upon a real demand.... The extension of the English railway system... 1845... the number of bills presented for the formation of railway companies [i.e., IPOs] amounted to 1,035.... The heyday of this speculation was the summer and autumn of 1845. Stock prices rose continuously, and the speculators' profits soon sucked all social classes into the whirlpool. Dukes and earls competed with merchants and manufacturers for the lucrative honour of sitting on the boards of directors of the various companies; members of the House of Commons, the legal profession and the clergy were also represented in large numbers. Anyone who had saved a penny, anyone who had the least credit at his disposal, speculated in railway stocks. The number of railway journals rose from three to twenty. The large daily papers often each earned £14,000 per week from railway advertisements and prospectuses. Not enough engineers could be found, and they were paid enormous salaries. Printers, lithographers, bookbinders, paper-merchants and others, who were mobilized to produce prospectuses, plans, maps, etc; furnishing manufacturers who fitted out the mushrooming offices of the countless railway boards and provisional committees — all were paid splendid sums. On the basis of the actual extension of the English and continental railway system and the speculation which accompanied it, there gradually arose in this period a superstructure of fraud.... Hundreds of companies were promoted without the least chance of success, companies whose promoters themselves never intended any real execution of the schemes, companies whose sole reason for existence was the directors' consumption of the funds deposited and the fraudulent profits obtained from the sale of stocks.

In October 1848 a reaction ensued, soon becoming a total panic.... The railway crisis lasted into the autumn of 1848, prolonged by the successive bankruptcies of less unsound schemes as they were gradually affected by the general pressure and as demands for payment were made. This crisis was also aggravated by developments in other areas of speculation, and in commerce and industry; the prices of the older, better-established stocks were gradually forced down, until in October 1848 they reached their lowest level....

If the new cycle of industrial development which began in 1848 takes the same course as that of 1843-7, the crisis will break out in 1852. As a symptom that the excess speculation which is caused by overproduction, and which precedes each crisis, will not be long in coming, we can quote the fact that the discount rate of the Bank of England has not risen above 3 per cent for two years. But when the Bank of England keeps its interest rates down in times of prosperity, the other money dealers have to reduce their rates even more, just as in times of crisis when the Bank raises the rate considerably, they have to raise their rates above the Bank's. The additional capital which, as we have seen above, is always unloaded onto the bond market in times of prosperity, is enough by itself to force down the interest rate, as a result of the laws of competition; but the interest rate is reduced to a much larger extent by the enormous expansion of credit produced by general prosperity, which lowers the demand for capital. In these periods a government is in a position to reduce the interest rate on its funded debts, and the landowner is able to renew his mortgage on more favourable terms. The capitalists with investments in loan capital thus see their income reduced by a third or more, at a time when the income of all other classes is rising. The longer this situation lasts, the more they will be under pressure to look for more profitable capital investments. Overproduction gives rise to numerous new projects, and the success of a few of them is sufficient to attract a whole mass of capital in the same direction, until gradually the bubble becomes general. But, as we have seen, speculation has at this point of time only two outlets; cotton growing and the new world market routes created by the development of California and Australia. It is evident that this time the scope for speculation will assume far greater dimensions than in any earlier period of prosperity....

Sir Robert Peel... has been apotheosized in the most exaggerated fashion by almost all parties as England's greatest statesman. One thing at least distinguished him from the European 'statesmen' — he was no mere careerist. Beyond this, the statesmanship of this son of the bourgeoisie who rose to be leader of the aristocracy consisted in the view that there is today only one real aristocracy: the bourgeoisie.... Catholic emancipation and the reform of the police, by means of which he increased the bourgeoisie's political power... the Bank Acts of 1818 and 1844, which strengthened the financial aristocracy... the tariff reform of 1842 and the free trade legislation of 1846, with which the aristocracy was nothing short of sacrificed to the industrial bourgeoisie.... His power over the House of Commons was based upon the extraordinary plausibility of his eloquence. If one reads his most famous speeches, one finds that they consist of a massive accumulation of commonplaces, skillfully interspersed with s large amount of statistical data. Almost all the towns in England want to erect a monument to the man who repealed the Corn Laws. A Chartist journal has remarked, referring to the police trained by Peel in 1829: 'What do we want with these monuments to Peel? Every police officer in England and Ireland is a living monument to Peel...

From BobbyK's Paul Krugman Archive:

: THE HANGOVER THEORY: Are Recessions the inevitable payback for good times?

SYNOPSIS: The constantly occuring idea of helpful Recessions is incoherent and faulty

A few weeks ago, a journalist devoted a substantial part of a profile of yours truly to my failure to pay due attention to the "Austrian theory" of the business cycle--a theory that I regard as being about as worthy of serious study as the phlogiston theory of fire. Oh well. But the incident set me thinking--not so much about that particular theory as about the general worldview behind it. Call it the overinvestment theory of recessions, or "liquidationism," or just call it the "hangover theory." It is the idea that slumps are the price we pay for booms, that the suffering the economy experiences during a recession is a necessary punishment for the excesses of the previous expansion.

The hangover theory is perversely seductive--not because it offers an easy way out, but because it doesn't. It turns the wiggles on our charts into a morality play, a tale of hubris and downfall. And it offers adherents the special pleasure of dispensing painful advice with a clear conscience, secure in the belief that they are not heartless but merely practicing tough love.

Powerful as these seductions may be, they must be resisted--for the hangover theory is disastrously wrongheaded. Recessions are not necessary consequences of booms. They can and should be fought, not with austerity but with liberality--with policies that encourage people to spend more, not less. Nor is this merely an academic argument: The hangover theory can do real harm. Liquidationist views played an important role in the spread of the Great Depression--with Austrian theorists such as Friedrich von Hayek and Joseph Schumpeter strenuously arguing, in the very depths of that depression, against any attempt to restore "sham" prosperity by expanding credit and the money supply. And these same views are doing their bit to inhibit recovery in the world's depressed economies at this very moment.

The many variants of the hangover theory all go something like this: In the beginning, an investment boom gets out of hand. Maybe excessive money creation or reckless bank lending drives it, maybe it is simply a matter of irrational exuberance on the part of entrepreneurs. Whatever the reason, all that investment leads to the creation of too much capacity--of factories that cannot find markets, of office buildings that cannot find tenants. Since construction projects take time to complete, however, the boom can proceed for a while before its unsoundness becomes apparent. Eventually, however, reality strikes--investors go bust and investment spending collapses. The result is a slump whose depth is in proportion to the previous excesses. Moreover, that slump is part of the necessary healing process: The excess capacity gets worked off, prices and wages fall from their excessive boom levels, and only then is the economy ready to recover.

Except for that last bit about the virtues of recessions, this is not a bad story about investment cycles. Anyone who has watched the ups and downs of, say, Boston's real estate market over the past 20 years can tell you that episodes in which overoptimism and overbuilding are followed by a bleary-eyed morning after are very much a part of real life. But let's ask a seemingly silly question: Why should the ups and downs of investment demand lead to ups and downs in the economy as a whole? Don't say that it's obvious--although investment cycles clearly are associated with economywide recessions and recoveries in practice, a theory is supposed to explain observed correlations, not just assume them. And in fact the key to the Keynesian revolution in economic thought--a revolution that made hangover theory in general and Austrian theory in particular as obsolete as epicycles--was John Maynard Keynes' realization that the crucial question was not why investment demand sometimes declines, but why such declines cause the whole economy to slump.

Here's the problem: As a matter of simple arithmetic, total spending in the economy is necessarily equal to total income (every sale is also a purchase, and vice versa). So if people decide to spend less on investment goods, doesn't that mean that they must be deciding to spend more on consumption goods--implying that an investment slump should always be accompanied by a corresponding consumption boom? And if so why should there be a rise in unemployment?

Most modern hangover theorists probably don't even realize this is a problem for their story. Nor did those supposedly deep Austrian theorists answer the riddle. The best that von Hayek or Schumpeter could come up with was the vague suggestion that unemployment was a frictional problem created as the economy transferred workers from a bloated investment goods sector back to the production of consumer goods. (Hence their opposition to any attempt to increase demand: This would leave "part of the work of depression undone," since mass unemployment was part of the process of "adapting the structure of production.") But in that case, why doesn't the investment boom--which presumably requires a transfer of workers in the opposite direction--also generate mass unemployment? And anyway, this story bears little resemblance to what actually happens in a recession, when every industry--not just the investment sector--normally contracts.

As is so often the case in economics (or for that matter in any intellectual endeavor), the explanation of how recessions can happen, though arrived at only after an epic intellectual journey, turns out to be extremely simple. A recession happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves at the same time. Yet, for all its simplicity, the insight that a slump is about an excess demand for money makes nonsense of the whole hangover theory. For if the problem is that collectively people want to hold more money than there is in circulation, why not simply increase the supply of money? You may tell me that it's not that simple, that during the previous boom businessmen made bad investments and banks made bad loans. Well, fine. Junk the bad investments and write off the bad loans. Why should this require that perfectly good productive capacity be left idle?

The hangover theory, then, turns out to be intellectually incoherent; nobody has managed to explain why bad investments in the past require the unemployment of good workers in the present. Yet the theory has powerful emotional appeal. Usually that appeal is strongest for conservatives, who can't stand the thought that positive action by governments (let alone--horrors!--printing money) can ever be a good idea. Some libertarians extol the Austrian theory, not because they have really thought that theory through, but because they feel the need for some prestigious alternative to the perceived statist implications of Keynesianism. And some people probably are attracted to Austrianism because they imagine that it devalues the intellectual pretensions of economics professors. But moderates and liberals are not immune to the theory's seductive charms--especially when it gives them a chance to lecture others on their failings.

Few Western commentators have resisted the temptation to turn Asia's economic woes into an occasion for moralizing on the region's past sins. How many articles have you read blaming Japan's current malaise on the excesses of the "bubble economy" of the 1980s--even though that bubble burst almost a decade ago? How many editorials have you seen warning that credit expansion in Korea or Malaysia is a terrible idea, because after all it was excessive credit expansion that created the problem in the first place?

And the Asians--the Japanese in particular--take such strictures seriously. One often hears that Japan is adrift because its politicians refuse to make hard choices, to take on vested interests. The truth is that the Japanese have been remarkably willing to make hard choices, such as raising taxes sharply in 1997. Indeed, they are in trouble partly because they insist on making hard choices, when what the economy really needs is to take the easy way out. The Great Depression happened largely because policy-makers imagined that austerity was the way to fight a recession; the not-so-great depression that has enveloped much of Asia has been worsened by the same instinct. Keynes had it right: Often, if not always, "it is ideas, not vested interests, that are dangerous for good or evil."

Posted at 10:24 AM in Lecture Notes | | Comments (0) | TrackBack (0)

April 07, 2008

April 7: How Are We Dealing with This Financial Crisis?

April 7: How Are We Dealing with This Financial Crisis?

Notes: Lecture Audio http://delong.typepad.com/berkeley_econ_101b_spring/2008/04/what-we-are-doi.html

Posted at 11:10 AM in Lecture Notes | | Comments (0)

Econ 101b: April 4: Ways of Dealing with Financial Crises

April 4: Ways of Dealing with Financial Crises

Notes: Lecture Audio
Readings: "Fedspeak": Janet Yellen, "The U.S. Economy: Prospects and Puzzles" Problem set: Adverse selection and financial markets. Clean Version

Posted at 11:05 AM in Lecture Notes | | Comments (0)

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