Z **Inactive** Brad DeLong's Slides

Dealing with Financial Crises

• A full-scale financial crisis happens when there is a sharp fall in the prices of a large set of assets

  • We have such a crisis ongoing now
    • Over the past seven years housing prices in the United States have risen by more than 50% in real terms
    • Americans have built three million houses over and above trend.
    • Now prices are coming down
    • And construction won't recover for a long time

• 3 million houses: roughly $900 billion of investment in housing.

  • If those who bought them can afford on average to pay not $300,000 but $250,000, there are $150 billion of financial losses to be allocated.
  • If they can afford to pay only $150,000, then there are $450 billion of financial losses to be allocated and absorbed.

• There are three potential ways that are appropriate to handle and to cure a full-fledged financial crisis, depending on the type of crisis:

• Liquidity crisis
  • Investors fear panic fire sales
  • But nobody large is bankrupt if fire sales can be avoided
  • Bagehot rule
  • Central bank should
    • Lend freely
    • At a penalty rate to punish the feckless
    • And the crisis will pass once fear of fire sales diminishes
• Solvency crisis
  • Bagehot rule makes things worse
  • Large institutions are bankrupt
  • Penalty interest rates push down asset values and make institutions even more bankrupt
  • Solution is the inverse
    • Lend freely
    • At a discount rate
    • And so push asset prices up enough to keep large financial institutions above water
      • "Bernanke put"
      • Socialization of current losses (and privatization of past profits)
      • Don Kohn: it is equally if not more unjust to hold the jobs of millions of workers hostage in order to teach lessons to a few financiers.
• "Meltdown"
  • What if even the loosest monetary policy will not make the financial system solvent?
  • Three possibilities
    • Dither
    • Inflation
    • Nationalization
• Last summer, the U.S. Federal Reserve assumed that it was facing a first-mode crisis -- a mere "liquidity" crisis
• This month the Federal Reserve has shifted decisively toward policies aimed at curing a "solvency" crisis

Housing Construction

• When credit becomes "tight" and hard to get--"why do you want to borrow money? are you broke?"--housing construction collapses: witness the 1966 credit crunch and the 1990-1001 S&L crisis
• When the Federal Reserve stimulates the economy--pushes the Federal Funds rate toward or below the inflation rate--housing construction booms; witness Nixonomics
• When the Federal Reserve changes its tune and decides that controlling inflation is Job #1, housing construction collapses: witness "whip inflation now" and the Volcker disinflation
• The current unpleasantness
  • A credit crunch
  • Caused and amplified by the bursting of a speculative bubble
  • In an environment here we have roughly 3 million extra houses
• The housing boom of the 2000s was in large part due to the Federal Reserve's reaction to the collapse of the dot-com bubble: if computer, internet, and other forms of business investment were going to be low in that collapse's aftermath, why not lower interest rates to boost housing investment in order to try to keep employment on an even keel?
• It worked--perhaps too well--for quite a while
  • But now...

Recent Monetary Policy

• The Federal Funds rate has been on a relatively wild ride since August
• The Fed is not controlling it minute-by-minute or even day by day
  • But it is buying and selling cash for bonds on a week-by-week scale in order to try to keep the rate close to its "target"
  • And it has been cutting the target rate--most recently by 1.25% in the past two weeks down to 3.00%

Monetary Policy

• The Federal Reserve primarily affects spending by raising and lowering the short-term interest rate at which banks borrow from each other overnight
• This lowers and raises net incentives to invest, and lowers and raises the value of the dollar
  • Thus business investment spending rises when the Federal Reserve cuts interest rates
  • And construction tends to rise when the Federal Reserve cuts interest rates
  • And next exports rise when the Federal Reserve cuts interest rates
• The hope is to keep total spending on a smooth growth track as the forces pushing for spending in different sectors rise and fall
• Sometimes the Fed succeeds; sometimes it fails
• It has been doing a lot better recently...

The Inflation Rate

• The Federal Reserve is also the guardian of price stability
• Why care about price stability?
  • Belief that unstable prices disrupt the market system's ability to function well
  • Fact that voters really dislike high inflation
  • Belief that you gain nothing in the long run in terms of lower unemployment--that in fact you lose in the long run--if a central bank gets a reputation as an organization that tolerates inflation
• But in the short run higher inflation goes with lower unemployment

Business Cycles since World War II

• Why these steep and sudden rises in the unemployment rate?
• Not due to any sudden outbreak of laziness.
• Federal Reserve exists to manage--and try to prevent--such episodes.

Greg Clark: Malawi in 2000 vs. England in 1800

Greg Clark: England in 1800 vs. The Stone Age

Telephone Use

Source: http://gapminder.org

Fertility Rates

Source: http://gapminder.org

Infant and Child Mortality

Source: http://gapminder.org

Adam Smith: Vanity, Vanity, All Is Vanity!

From Adam Smith, The Theory of Moral Sentiments: Riches "may save him from some smaller inconveniencies, [but] can protect him from none of the severer inclemencies of the season. They keep off the summer shower, not the winter storm, but leave him always as much, and sometimes more exposed than before, to anxiety, to fear, and to sorrow; to diseases, to danger, and to death..."

A watch... that falls behind above two minutes in a day, is despised by one curious in watches. He sells it perhaps for a couple of guineas, and purchases another at fifty, which will not lose above a minute in a fortnight. The sole use of watches however, is to tell us what o'clock it is, and to hinder us from breaking any engagement, or suffering any other inconveniency by our ignorance in that particular point. But the person so nice with regard to this machine, will not always be found either more scrupulously punctual than other men, or more anxiously concerned upon any other account, to know precisely what time of day it is.... How many people ruin themselves by laying out money on trinkets of frivolous utility?...

The poor man's son, whom heaven in its anger has visited with ambition, when he begins to look around him, admires the condition of the rich. He finds the cottage of his father too small for his accommodation, and fancies he should be lodged more at his ease in a palace. He is displeased with being obliged to walk a-foot, or to endure the fatigue of riding on horseback. He sees his superiors carried about in machines, and imagines that in one of these he could travel with less inconveniency....

He is enchanted with the distant idea of this felicity. It appears in his fancy like the life of some superior rank of beings, and, in order to arrive at it, he devotes himself for ever to the pursuit of wealth and greatness. To obtain the conveniencies which these afford, he submits in the first year, nay in the first month of his application, to more fatigue of body and more uneasiness of mind than he could have suffered through the whole of his life from the want of them.... Through the whole of his life he pursues the idea of a certain artificial and elegant repose which he may never arrive at, for which he sacrifices a real tranquillity that is at all times in his power, and which, if in the extremity of old age he should at last attain to it, he will find to be in no respect preferable to that humble security and contentment which he had abandoned for it....

Power and riches appear then to be, what they are, enormous and operose machines contrived to produce a few trifling conveniencies to the body, consisting of springs the most nice and delicate, which must be kept in order with the most anxious attention, and which in spite of all our care are ready every moment to burst into pieces, and to crush in their ruins their unfortunate possessor. They are immense fabrics, which it requires the labour of a life to raise, which threaten every moment to overwhelm the person that dwells in them, and which while they stand, though they may save him from some smaller inconveniencies, can protect him from none of the severer inclemencies of the season. They keep off the summer shower, not the winter storm, but leave him always as much, and sometimes more exposed than before, to anxiety, to fear, and to sorrow; to diseases, to danger, and to death....

Our imagination... in times of ease and prosperity expands itself to every thing around us.... The pleasures of wealth and greatness, when considered in this complex view, strike the imagination as something grand and beautiful and noble, of which the attainment is well worth all the toil and anxiety which we are so apt to bestow upon it.

And it is well that nature imposes upon us in this manner. It is this deception which rouses and keeps in continual motion the industry of mankind.... The earth by these labours of mankind has been obliged to redouble her natural fertility, and to maintain a greater multitude of inhabitants.... [T]he proud and unfeeling landlord views his extensive fields, and without a thought for the wants of his brethren... [but the] capacity of his stomach bears no proportion to the immensity of his desires, and will receive no more than that of the meanest peasant. The rest he is obliged to distribute.... The rich... consume little more than the poor, and in spite of their natural selfishness and rapacity, though they mean only their own conveniency... they divide with the poor the produce of all their improvements. They are led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants, and thus without intending it, without knowing it, advance the interest of the society, and afford means to the multiplication of the species...

Global Poverty

• What do we mean by "global poverty"? Who is poor?

• Back before the industrial revolution everybody was--by our standards, at least--desperately poor.

• Even the rich were poor. Consider Nathan Meyer Rothschild:

  • Nathan Meyer Rothschild was the richest man in the world in the first half of the nineteenth century. Nathan Meyer Rothschild died in his fifties of an infected abscess in his back--an abscess that we oils have cured by lancing and antibiotics without even a hospital admission for day surgery.
  • Nathan Meyer Rothschild did not live to see his grandchildren grow up--something that the guys working the loading dock at Target expect as a matter of course, as their birthright.
  • Who is richer: Nathan Meyer Rothschild or America's working poor today?

The World in 2004

Source: http://gapminder.org

The World in 1975

Source: http://gapminder.org

Divergence: Once-Rich Twenty-Two

• 1980 as the high point of global income inequality
• Since 1980? Convergence or divergence depends on whether you count countries or people
  • China
  • India

Convergence: Maddison's Sixteen

Remember? Longest-Run Economic Growth

The Success of the Solow Model II

From Mankiw, Romer, and Weil (1992)

Notes:

• The R² of growth is not so good: the model does significantly better at predicting levels than it does at predicting growth rates.

• A very large role for produced means of production:

  • The capital share parameter is 0.48
  • The education parameter is 0.23
  • This leaves only a small role--0.29 for raw labor and for resources.

• Which way does causation run?

  • Are countries poor because they have high rates of population growth or do they have high rates of population growth because they are poor?
  • Do countries have high rates of investment because they are rich, or are they rich because they have high rates of investment?

• Biased and unreliable regression results? Or

• Deep poverty traps

• Conditional vs. unconditional convergence

• And, of course, the Solow model has nothing to say about the rate of long-run growth.

• And, of course, the Solow model has nothing to say about the transition from the old days to the new days
  • And little to say about when and why that transition is made
• And nothing to say about when or if these new days will come to an end.

The Success of the Solow Model I

From Mankiw, Romer, and Weil (1992).

• Is the residual big or small?