Understanding the Financial Crisis Presentation to Members of the Town & County Club Hartford, CT

1. Understanding the Financial CrisisPresentation toMembers of the Town & County ClubHartford, CT James Stodder, (Ph.D., Economics, Yale 1990) Lally School of Management & Technology Rensselaer Polytechnic Instituteat Hartford Hartford, Connecticut, USA

2. Outline of Talk • Keynes on Credit Cycles: - Why we need Regulation • Where is the Bottom? • Connecticut is “Middle of the Pack” • Government Deficit Spending • Needed in the Short-term • But a Big Problem Long-term

3. (1) Biz & Credit Cycles J. M. Keynes: 1883-1946

4. US Macro-Stability: Better, Room for Improvement 45% 55% 34% 66% Source: http://www.nber.org/cycles.html

5. Bad News: Bubbles are Endemic Arlington Williams, “Price Bubbles” www.indiana.edu/~arlwilli/pdf%20files/bigmkts.pdf

6. Good News: People Do Learn V. Smith & A. Williams, “Experimental Market Economics,” Scientific American, Dec. ‘92

7. The Wisdom of Keynes “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, isruined in a conventional way,along with his fellows, so that no one can really blame him.” - J.M. Keynes (1931)

8. “Paradox of Thrift” Keynes noted: Consumers cut back on their spending and save more during a recession. This only makes the recession worse. Similarly for Banks, Loan Loss Reserves (LLR)are often raised in a recession, justwhen households and businesses most need credit –ensuring more collapses and worsening the recession.

9. Insurance => Moral Hazard =>Necessity of Regulation • Moral Hazard of Insurance: • If you had a car that is less damaged by any given car crash – would that make you drive faster? • If you (and everybody else) drove faster, could this actually wind up making you less safe ?

10. www.economist.com/finance/displaystory.cfm?story_id=12480887 www.nytimes.com/2008/10/03/business/03sec.html

11. Limits of Fed Magic New Yorker, Oct. 2008

12. Currency Rises Slightly

13. But Bank Reserves up 100-fold

14. M0 = Currency + Reserves ≈ $16b

15. M1 ≈ $16b = Currency + Bank Deposits

16. Money Multiplier = M1/M0 ≈ 1

17. Bank Money Multiplier If l= % loans, Reserve multiplier is D = R(1+l + l 2+… + l ∞ )=R/(1- l ) If M0 = Reserves (R) + Currency (C), M1 (Currency + Deposits) multiplier is: M1 = C + R/(1- l ) = M0–R+ R/(1- l ) M1/M0 = 1{-R + R/(1- l )}/M0 So M1/M0 = 1 => l = 0

18. The Zero Bound

19. Keynes’s Liquidity Trap:

20. Keynes’s Liquidity Trap:

21. Keynes’s Liquidity Trap:

22. Keynes’s Liquidity Trap:

23. Output Gap ≈ 20% GDP http://www.cbo.gov/ftpdocs/99xx/doc9958/01-08-Outlook_Testimony.pdf A little Stimulus Math: 20% * $14 tr. = $2.8 tr. Stim*1.5 = $2.8 => Stim = $1.87 tr.

24. (2) 3 Reasons Bottom stillA Long Way Off Housing Recovery probably more than a year away. Credit Markets still very weak. Stock Market Valuation Ratios like P/E and Tobin’s Q are now only at historical averages.

25. HousingBottom– A LongWayOff http://www.nytimes.com/imagepages/2008/10/16/business/16housing.graphix.ready.html

26. Why it Matters to Everyone

27. Indicators of Credit Crisis http://www.nytimes.com/interactive/2008/10/08/ business/economy/20081008-credit-chart-graphic.html

28. TED-Spread & Financial Crises Subprime financial shock LTCM Y2K S&L crisis Peso crisis Thai baht Tech bust Orange County

29. 108 Years of P/E and Q Shiller/Smithers - www.ft.com/cms/s/0/099f6380-bb1f-11dd-bc6c-0000779fd18c.html

30. (3) CT is “Middle of the Pack” Fairfield Financial Sector down, but .. Conventional Banking and Insurance less vulnerable than Investment Banks, Financial Insurance Defense industries well insulated Pharmaceuticals and Biotech have good long-term prospects House Price Increases near US Avg.

31. COLOR KEY Defense Health & Education Insurance & Banking Counter-cyclical Pro-cyclical CT’s Largest Private Employers, CT payroll • United Technologies Corp. (UTC)26,490 • The Stop & Shop Cos. Inc. 14,049 • The Hartford Financial Services Group Inc. 13,000 • Yale University 12,100 • Foxwoods Resort Casino 11,900 • Mohegan Sun Casino 10,000 • U.S. Naval Submarine Base 9,900 • Wal-Mart Stores, Inc. 9,038 • AT&T Corporation 7,700 • General Dynamics Electric Boat 7,500 • General Electric Co. 7,500 • Aetna Inc. 7,252 • Pfizer Global Research and Development 7,000 • The Travelers Cos. Incorporated 6,500 • Hartford Hospital 6,377 • Bank of America 5,100 • Cigna 3,984 • Northeast Utilities 3,947 • Saint Francis Hospital and Medical Center 3,892 • United States Surgical 3,800 Source: Economy.Com, Connecticut State Precis, Sept., 2008

32. More Stable than US as a Whole Source: Economy.Com, Connecticut Precis, Sept. 2008 Sunday, July 13, 2014 32

33. State Income Growth Comparable Source: Economy.com, CT Precis, Sept. 2008

34. State Unemployment Comparable Source: Economy.com, CT Precis, Sept. 2008

35. Sun Belt, Rust Belt Concentration

36. CT Suffered Less than Most in Northeast Source: Office of Federal Housing Enterprise Oversight: http://www.ofheo.gov/media/pdf/2q08hpi.pdf Sunday, July 13, 2014 36

37. What doesn’t go up too far, Won’t go down so far Economy.com, CT State Report, Sep. 2008

38. 2006 Peak of Price-to-Rent

40. Source: NY Times, May 28, 2008; Economy.com

41. www.bos.frb.org

42. US Vacant Homes for Sale (thousands) Housing supply 900,000 Single 525,000 Multi 300,000 Manufactured 75,000 Housing demand 1,400,000 Households 875,000 Obsolescence 400,000 Second homes 125,000 Economy.com, Census, Nov. 2008

43. (4) More Federal Deficit Spending (not Tax Cuts) Necessary Tax cuts to the rich more likely to be saved, not spent or invested. Tax cuts don’t have big effect on those too poor to pay many taxes. Unmet needs in Energy, Environment, Health, and Education: good reasons to spend.

44. Government Must Increase Spending in Severe Recession “ If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coal mines … It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.” (Keynes, General Theory, 1937)

45. But We Need Foreign Coordination for US Expansion to be Successful Benefits of lone expansion “leak out,” other countries free ride. Alternatives to joint expansion are protectionism and competitive devaluations. US long-term “Fiscal Gap” makes lone expansion untenable.

46. Long Term Fiscal Gap: Unsustainable http://www.cbo.gov/ftpdocs/93xx/doc9385/06-17-LTBO_Testimony.pdf

47. Sure asDebt and Taxes http://www.cbo.gov/ftpdocs/93xx/doc9385/06-17-LTBO_Testimony.pdf

48. Inflation/Devaluation a Powerful Temptation for Highly Indebted Governments • Germany after WWI • Russia after the Revolution • Soviet Union after the Cold War • Many Developing Countries after • spending, investment binges • (See L. Kotlikoff & S. Burns, • The Coming Generational Storm, 2004)

49. Implications of Limited Pass-Through Linda Goldberg (FRBNY) has shown that Dollar Devaluation means: • Improved Earnings on Foreign Assets • Easier Debt Servicing • Smaller Trade Deficit And at the same time, • Minimal Costs in further Inflation So - What’s Not to Like? • FRBNY Governor Frederic Mishkin says “Devaluation cannot be a policy.” (I think he means an explicit policy.)

50. Inflation/Devaluation Appears to be a “Painless” Way Out of Debt