L f h Fi i l C i i fLessons from the Financial Crisis for Teaching Economicsg
John B TaylorJohn B. TaylorStanford University
June 2, 2011
National Conference on Teaching Economics and Research in Economic Education
OutlineOutline• Narrative of the Financial Crisis
– Informs one’s views about lessons for teaching• Alternative Narratives
N t i i l i t di– Not surprisingly, economists disagree• Implications for Teaching
– Examples will be presented throughout talk based on– Examples will be presented throughout talk based on experience
– Graduate (1st year Ph.D. course at Stanford)– Undergraduate (Economics 1 at Stanford)– Textbook (Principles Book with Weerapana)
NarrativeE i li d i t d f b i i• Economic policy deviated from basic economic principles which had worked well
• Result? A great recession a financial panic and a• Result? A great recession, a financial panic, and a very weak, nearly nonexistent, recovery.
• The deviations began with policies such asThe deviations began with policies such as – a monetary policy with interest rates too low for too long– a regulatory policy which failed to enforce existing rulesg y p y g
• The deviations from sound principles continued when government responded with an ad hoc bailout process and temporary stimulus programs
• The good news: economic growth and stability can be restored by adopting policies consistent with basic economic principles.
An illustration that basic principles work well, when followed
15
20Percent
Great Moderationperiod
10
15 period
0
5
-5
0
G t R i
-15
-10Great Recession(End of Great Moderation?)
50 55 60 65 70 75 80 85 90 95 00 05 10
Growth Rate of Real GDP
Illustrative monetary policy chart from San Francisco Fed, March 1995, Judd and Trehan
1965‐79
1987‐92
1993‐94
Illustrative monetary policy chart from St Louis FedFebruary 2007, Bill Poole y
Policy Deviations Leading up to the d h llCrisis and the Panic in Fall 2008
• Interest rates too low for too longg• Discretionary fiscal stimulus of Feb ‘08 ($152B)• On‐again off‐again bailouts financed by centralOn‐again, off‐again bailouts financed by central bank’s balance sheet– on for BSC creditors’ bailout off for Lehman creditors’on for BSC creditors bailout, off for Lehman creditors bailout, on for AIG creditors’ bailout, off for TARP role out
• Government regulators and supervisors deviatedGovernment regulators and supervisors deviated from sound regulatory rules, especially at large banks
Illustrative monetary policy chart from St Louis FedFebruary 2007, Bill Poole y
Illustrative monetary policy chart from St Louis FedFebruary 2007, Bill Poole y
Chart from Kansas City Fed, 2009, Tom Hoenig
(2000‐2009)
The Boom‐Bust in Housing Starts Compared with the CounterfactualCompared with the Counterfactual
Illustrative Chart from the OECD, March 2008
Illustrative Chart from the OECD, March 2008
Temporary stimulus meets permanent income hypothesisp yp
The Panic of Fall ‘08
Policy makers then doubled‐downPolicy makers then doubled down
• Discretionary fiscal stimulus of 2009 ($862 billion)sc et o a y sca st u us o 009 ($86 b o )– One‐time payments again – More government spending too
• Cash for clunkers program • Quantitative easing in 2009, now called QE1
– Purchases of $1.25 trillion of mortgage backed securities, $300 billion of longer term Treasury bonds
QE2 i 2010 d 2011• QE2 in 2010 and 2011– purchases of $600 billion of longer term Treasury bondsbonds.
Temporary stimulus meetspermanent income hypothesis againp yp g
Cash for clunkers: incentives really matter
400Billions of dollars, annual rates
300
350
200
250 --- Temporary transfer payments and credits
t
150
200
G t t t t d
to persons
50
100
F d l t ti
--- Grants to state and local governments
009Q1 09Q2 09Q3 09Q4 10Q1 10Q2 10Q3 10Q4
--- Federal government investment--- Federal government consumption
Two-Year Effect of ARRA on Major Federal Budget Categories (Source: Bureau of Economic Analysis)
2,300Billions of dollars, annual rates
2 100
2,200
,Total receipts of stateand local governments
2,000
2,100
Recepits less
1,800
1,900p
ARRA grants
1 600
1,700 Purchases by state and local governments
1,500
1,600
1,4002005 2006 2007 2008 2009 2010
State and local governments also consider permanent income
Compare with textbook discussion: Sharp drop in I causes expenditure lineSharp drop in I causes expenditure line
to shift down
45-degree line
SPENDING25_10
New E line
Original E lineOriginal point of spending balance
I falls by this amount
Income or real GDP falls by this amount (more than by amount I falls ).
New point of spending balance
Original income level
New income level
INCOME OR REAL GDP
(more than by amount I falls ).
Offset by Countercyclical fiscal policyIncrease in G raises GDP depending on size of the p g
multiplier and amount of crowding out
45-degree line
SPENDING25_10
G rises
INCOME OR REAL GDP
But look what happened
6Percent, annual rate
Growth rate of real GDP
2
4
0Contribution of
-4
-2 government purchases
-6
-807Q1 07Q3 08Q1 08Q3 09Q1 09Q3 10Q1 10Q3
Quantitative Easing Financed by Monetary Base
2,800Billions of dollars
2,400Monetary base(currency plus reserves)
2,000
1,600
1,200
800Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11
A Wonderful Teaching Moment:The Money Multiplier and the Monetary BaseThe Money Multiplier and the Monetary Base
Percent
800
1,000CBO Outlook in 2010
600
800
Federal Debt as a
CBO Outlook in 2009
400
600 Federal Debt as aPercent of GDP
200
400
0
200
CBO Outlook in 2011??0
1800 1850 1900 1950 2000 2050
Teaching About Regulatory Capture:E l i f il t f l t lExplains failure to enforce regulatory rules
C ti b t• Cozy connections between government and the fi i l i d tfinancial industry.
• Book shows government helping well‐connected individuals, who in turn helped the government officials.
• Result: Reckless policy
Implication of Narrative for Basic Economics
• Needs a reformulation?– Paul Samuelson (January 2009) Paul Samuelson (January 2009)
• “today we see how utterly mistaken was the Milton Friedman notion that a market system can regulate itself… This prevailing ideology of the last few decades has now beenprevailing ideology of the last few decades has now been reversed…I wish Friedman were still alive so he could witness how his extremism led to the defeat of his own ideas”.
– Paul Krugman blames modern economics (especially macro) for the crisis.
B t ti h i li b i i k• But narrative here implies basic economics works– The crisis was caused by a deviation from principles
f h h h d• But of course there is much research to do
Another NarrativeAnother Narrative
• US policy was not an issue leading up to theUS policy was not an issue leading up to the crisis and is not an issue now
• Global capital flows were and are the problem• Global capital flows were and are the problem– Caused emerging market crises in 1990sC d 2007 09 i i S i Gl– Caused 2007‐09 crisis: Saving Glut
– Cause of future crises: focus on global rebalancing
• Much different policy implication
But chart from the IMF in 2005 Shows No Global Saving Glut
So Why Do Economists Disagree?So Why Do Economists Disagree?
• Students and everyone else really want toStudents and everyone else really want to know the answer
• One reason is that the details of their models• One reason is that the details of their models are different, even though there is agreement about the basic principlesabout the basic principles
• The next three charts from the New York Ti d h ill hi llTimes and two others illustrate this well.
66
New KeynesianSmets ‐ ECB
Robert BarroHarvard
3
4
5With stimulus
3
4
5
With stimulus
0
1
2If nostimulus
0
1
2If nostimulus
-12009 2010
-12009 2010
“The accumulation of hard data and real-lifeThe accumulation of hard data and real life experience has allowed more dispassionate analysts to reach a consensus that the stimulus package, messy p g yas it is, is working”New York Times November 12, 2009
Implications for TeachingM ill t ti f b i i• Many new illustrations of basic economics
• Interesting debates between economists R l di ti– Rules versus discretion
– But raise more questions about discretionary policy• More integration of micro and macro• More integration of micro and macro
– interest rates too low for too long (macro)– housing markets including bubbles (micro)housing markets including bubbles (micro)– stimulus package (macro) – regulatory capture and moral hazard (micro)– new instruments of monetary policy (macro)– risk premia in interest rates(micro) – debate over size of multipliers (macro)– cash for clunkers, first time home‐buyer (micro)
Many New YouTube VideosQuantitative Easing Explained. 5 million downloads. Doesn't
get it all right and brutal in places, but good for discussionThe Wrong Financial Adviser Created by Nobel prize winner
Bill SharpeFed Chairman on the Daily Show with Jon Stewart. From two
different episodes of 60 Minutes, focus on whether quantitative easing is printing money.
Unmasking Interest Rates, Honky Tonk StyleMerle Hazard sings "Inflation or Deflation“Inside Job Trailer Christine Lagarde in clip from Inside JobChristine Lagarde in clip from Inside JobHayek‐Keynes rap videos "Fear the Boom and Bust“ and “Fight
of the Century”
Lines from “Fight of the Century”Lines from Fight of the Century
Keynes: “Even you must admit that the lessonKeynes: Even you must admit that the lesson we’ve learned is that more oversight’s needed or else we’ll get burned”or else we ll get burned
Hayek: “Oversight? The government ‘s long been in bed with those Wall Street execs and thein bed with those Wall Street execs and the firms that they’ve led.”