Autocatalytic process : the outcome of the process is itself a catalyst for the process  Chain Reaction! Viking success

1. Autocatalytic process: the outcome of the process is itself a catalyst for the process  Chain Reaction! • Viking success propelled Viking success. … but then came Collapse (Jared Diamond) • Realized profits repay debts … propel more debt … but then comes collapse (Hyman Minsky)

2. Minsky’s World Quasi – rents: cash flows available to pay debts PI– [supply] price of investment goods PK– [demand] price of kapital goods Borrower’s risk Lenders risk Hedge finance: E(cash flows) > Payment commitment Speculative finance: E(cash flows)<Commitment … but > Interest commitment  Roll over debt Ponzi finance: E(cash flows)<Interest commitment … Expect to increase debt Financial fragility: mix of Hedge – Spec – Ponzi Good times  Confidence  Risk-taking  Fragility

3. Minsky’s World – Keynes’ World Y = C + I Fluctuations in I  Fluctuations in Y • Expectations and degree of confidence • Animal spirits • Subject to sudden and violent change • Complex interactions of decisions/outcomes/liquidity/confidence Booms and Busts

4. The Minsky FootprintRealized expectations  Increased profits & Reduced risk  BOOMDisappointed expectations  Reduced profits & Confidence BustRush to liquidity  Debt deflation Pk Borrower’s Risk Internal funds Marginal lender’s risk Lender’s Risk PI Investment

5. Stabilizing an Unstable Economy • Financial Instability Hypothesis: • Hedge finance • Speculative finance • Ponzi finance Two types of risk affect the volume of investment. …The first is the entrepreneur's or borrower's risk and arises out of doubts in his own mind as to the probability of his actually earning the prospective yield for which he hopes. If a man is venturing his own money, this is the only risk which is relevant. …But where a system of borrowing and lending exists, a second type of risk is relevant which we may call the lender's risk. GT, Chapter 11. Hyman Minsky 1919 - 1996 Student of Simons/Schumpeter • A Minsky Cycle • Displacement (invention, easy money) • Boom…successful speculation • Euphoria…financial innovation • Profit taking • Panic PK Borrower’s Risk Price of capital assets Lender’s Risk PI When expectations are disappointed, investment collapses … but debts remain Internal funds Io I1 Investment

6. Akerlof and Shiller, Animal Spirits • Confidence – Keynes-Minsky • Hopes, Exuberance, Fears • Waves of optimism and pessimism • Corruption - Bad Faith  Loss of Trust • S&Ls – Enron – Sub-prime crisis – Goldman Sachs • Fairness • Punish cheaters, even at own expense • Relative position • Money illusion • “Illusion” is real in view of nominal contracts/accounts • Money illusion  Inflation – unemployment tradeoff “So long as money retains its age-old power to deceive, inflation can be used to resolve economic conflict.” James Tobin • Stories • New eras – Irrational exuberance Downward wage rigidity

7. Akerlof and Shiller: A brief history of macroeconomics • Pre – Keynes: Say’s Law  Automatic adjustment to full employment • Keynes: Animal spirits  Excesses Inherent instability Minsky, JMK, Stabilizing an Unstable Economy, Can “It” Happen Again? • Hicks: IS – LM  Keynes without animal spirits • Consumption function – Liquidity preference function • Hydraulic Keynesians • Original Phillips Curve  Policy Menu • Friedman: Monetarist counter-revolution • Dispense with money illusion/enter expectations/natural rate  Wage Setting: W = PeF(u,z) • New Classical Economics • Rational expectations • Real business cycles (dynamic stochastic general equilibrium) • New Keynesian Economics • Rational expectations – but sticky adaptation

8. Akerlof and Shiller: Prescription for Today • A Second Target – A Credit Target “It is fairly easy now to project the fiscal and monetary stimulus necessary for aggregate demand to be at full employment—if financial markets are freely flowing…But, with the loss of confidence in the financial sector, macroeconomic planners must have a second target…—the amount of credit that would normally be given [to qualified borrowers] if the economy were at full employment.” Methods: Discount window (TALF)/Capital injections/GSEs • Gotta replace the fallen Humpty-Dumpty (Securitization) • A Credit Target—Whom to credit? • Bernanke and Blinder (1988) Credit, Money and Aggregate Demand, AER, May. • In liquidity trap, expansion of credit is effective stimulus Aside: Also in AER, May 1988. Akerlof and Yellen, Fairness and Unemployment “…where it is advantageous to pay some employees highly, it is also … fair to pay other employees well.” Unfair pay  shirking

9. Back to Minsky – Keynes • Variables: PK = volatile demand price of kapital asset PI = sluggish supply price of investment goods q = expected quasi-rent from the asset M = quantity of money  ease of credit c = cash-flow commitment from finance arrangements ĉ = “acceptable” cash flow commitments Then, PK = K(q, M, ĉ – c) “If the demand price of a capital asset … is not less than its replacement costs, new investment will take place.”

10. The Minsky FootprintRealized expectations  Increased profits & Reduced risk  BOOMDisappointed expectations  Reduced profits & Confidence BustRush to liquidity  Debt deflation Pk Borrower’s Risk Internal funds Marginal lender’s risk Lender’s Risk PI Investment

11. A “Global Saving Glut” The best of times Capital Inflows Easy Money Policy Escalating House Prices Eager Home Buyers Ambitious Mortgage Brokers Developer Clout Innovative Banks Securitization MBSs Rating Agencies Gov’t Sponsored Enterprises Bank Regulators

12. The best of times Capital Inflows Escalating House Prices Easy Money Policy Eager Home Buyers Ambitious Mortgage Brokers Developer Clout Innovative Banks Rating Agencies Securitization MBSs Gov’t Sponsored Enterprises Bank Regulators

13. Financial System Meltdown At home Interventions/ Nationalizations/ Pre-privatizations Bankruptcies • Gov’t Supported Takeovers • Countrywide  BofA • Bear Stearns  JPMorgan Chase • Silver State Bank Nevada State • Merrill Lynch  BofA • Washington Mutual  JPM Chase • Wachovia  Wells Fargo • Security Saving  Bank of Nevada • IndyMac • Fannie Mae/ • Freddie Mac • AIG • New Century Financial • Lehman Brothers • Washington Mutual Inc. Abroad • Northern Rock • Royal Bank of Scotland • Dexia • Glitnir/Kaupthing/ • Landsbanki • HBOS  Lloyds Bank • Fortis  PNB Paribus

14. Baa-AAA Interest Differential The Good News: 1932 was worseThe Bad News: This downturn isn’t over until 2010

15. Responses Lender of Last Resort / Spender of Last Resort • Tax Rebate $124 bil. • Fed Fund Rate Cuts • Fannie/Freddie $200 bil. • Bear-Stearns $29 bil. • AIG $174 bil. Fed “Facilities” • Primary Dealer Credit Facility (PDCF) $58 bil. • Treasury Security Loan Facility (TSLF) $133 bil. • Term Auction Facility (TAF) $416 bil. • Asset- Backed Commercial Paper Funding Facility (CPFF) $1,777 bil. • Money Market Investor Funding Facility (MMIFF) $540 bil. • More Fed Fund Rate Cuts … Hold At ~0% • Fed Purchases of Long-Term Securities: GSEs & MBSs $600 bil. • Term Asset-Backed Securities Loan Facility (TALF) $200 bil. • Emergency Economic Stabilization Act/TARP $700 bil. Government Loans Government Equity • Stimulus Package $787 bil. aka The American Recovery and Reinvestment Act • TARP II • Stress Tests