1

The Financial Crisis and Its Consequences

Edward C. Prescott

June 23, 2009

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Most Discussions are Incoherent

• General equilibrium: People on both sides of all transactions

• Total lending must equal total borrowing

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My Definition of a Bank

• A financial intermediary borrows from one group and lends to another and is highly leveraged

• I use the word bank to denote a financial intermediary

• I use the words commercial bank to denote banks that have payable-upon-demand deposits

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Long-Run Picture

• Relatively steady growth over the last 150 years

• Some fluctuations about trend (HP filtered)

Source of following pictures is Robert E. Lucas, Jr.

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6

Deviations From Trend

• Relative to trend, GDP lost 40% between 1929 and 1933

• Recently the loss has been about 5%, and most of this is in 2008-IV and 2009-I

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8

How Bad Are Things?

Not that bad, so far

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• Using a simple 1.9% trend

• These numbers are per person 15-64

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Detrended GDP per Person 16-64 1959-I to 2009-I

90

95

100

105

110

1959-I 1965-I 1971-I 1977-I 1983-I 1989-I 1995-I 2001-I 2007-I

* Quarterly trend growth: 0.45%

Period Average = 100

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Contractions (Recessions)

• Recession is not an economic concept

• An economy can’t be in one or not in one

• Prior to the development of modern macro, these time series were represented as cycles

• This was totally discredited by Nobel Laureate T. J. Koopmans in his devastating critique of Burns and Mitchell (the NBER definitions) as measurement without theory

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Now There Is Hard Theory

• Given productivity, population, and taxes:

– Predicted and actual paths of the aggregate variables coincide

– All using dynamic economic theory to construct models consistent with national account and other data find same thing

– Monetary policy had little consequence

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Modern Definition of a Contraction

• Any sensible definition corrects for population and trend growth

• A flat line is neither losing nor gaining ground relative to the industrial leaders

• A flat line means living standards double every generation

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Contractions: Detrended GDP per Person 16-64 1959-I to 2009-I

90

95

100

105

110

1959-I 1965-I 1971-I 1977-I 1983-I 1989-I 1995-I 2001-I 2007-I

* Quarterly trend growth: 0.45%

Period Average = 100

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Contractions

• Biggest contraction was 11.2% from 1978 IV to 1982 IV– First two years of it money was loose – low real interest rate

– Last two years and beyond money was tight

• The contraction beginning 1999-IV was bigger than figure indicates because– There was a huge amount of unmeasured investment in the second half of the 1990s

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Expansions

• Big expansion of early 1960s was technology driven

• The 1995-2000 expansion was technology driven

– And in fact was significantly bigger and longer than standard statistics indicate

– Reason: Huge unmeasured intangible investment (R&D, launching new products)

• The second biggest and the longest expansion was in the 1980s and was due to cuts in tax rates

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Expansions: Detrended GDP per Person 16-64 1959-I to 2009-I

90

95

100

105

110

1959-I 1965-I 1971-I 1977-I 1983-I 1989-I 1995-I 2001-I 2007-I

* Quarterly trend growth: 0.45%

Period Average = 100

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What Depressed the U.S. Economy in 2008-IV and 2009-I?

• Not lack of borrowing

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Liabilities of Households and of Their Nonfinancial Businesses

Total Liabilities (billions $) 31,875 32,341

Composition Share

Mortgages 44.9% 44.4%

Other Loans 18.0% 18.5%

Corporate Bonds 11.2% 12.0%

Security credit 1.0% 0.5%

Trade payable 8.2% 8.5%

Other 16.8% 16.1%

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Then What Depressed the U.S. Economy in

2008-IV and 2009-I-II?• Fact was the investment was depressed

• There are 25 million small businesses in the U.S. – 5 million of them have employees

• Their owners feared higher tax rates in future and rationally cut investment now

• They also rationally cut employment

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Fears Are Being Realized

• Tax rates are being increased

• These increases lower amount of capital a firms chooses to have

• Reason for low investment is not problem of getting loans – it is expected high tax rates

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What Happened After Financial Crises?

Sometimes bad thingsand

Sometimes good things

Numbers are trend corrected so flat line is growing at trend

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Experiences Very Different

GDP per Capita Detrended at 2% 1992 = 100

80

90

100

110

120

1990 1994 1998 2002 2006

Source: GGDC (PPP-EKS)Japan

Finland

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GDP per Capita Detrended at 2% 1980 = 100

60

80

100

120

140

1980 1984 1988 1992 1996 2000 2004

Chile

Mexico

Source: GGDC (GK-PPP)

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Cost of Current Crisis

• Huge bailout of lenders to financial intermediaries by taxpayers

• This means higher tax rates in future and depresses the economy now

• The so-called stimulus plan is a depressant plan

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Evidence that High Tax Rates Depress an Economy

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Predicted vs. Actual Weekly Hours

GermanyFranceItaly

Canada

U.K.

Japan

U.S.Spain

IrelandIcelandNew Zeland

Australia

Denmark

Portugal Romania

16.0

18.0

20.0

22.0

24.0

26.0

28.0

30.0

16.0 18.0 20.0 22.0 24.0 26.0 28.0 30.0

actual

predicted

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Summers’ Misguided Advice to Japan

• Repeatedly said to spend and stimulate the economy in 1990s

• What happened? Japan lost a decade of growth

• Geithner, who is not an economist, is now advising China to spend in order to stimulate its economy

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Why Japan’s Lost Decade of Growth?

• Some blamed China

• Others blamed the Bank of Japan

• Still others blamed fiscal policy

– Said Japan needed even bigger deficits

• Hayashi and Prescott in “Japan’s Lost Decade of Growth” find the problem was

lack of productivity growth!

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Why Low Productivity Growth?

• Hayashi and I conjectured: banks subsidizing inefficiencies– Loans were being made to pay interest on

existing loans– Banks’ liabilities exceeded assets

• Subsidizing inefficient businesses deters productivity growth

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Japan’s Reaction

• Cabinet Research Office invited me to talk in 2002

• Signaled Prime Minister Koizumi was buying into the productivity story

• Takenaka, new head of financial services, instituted banking reforms

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Banking Reforms

• Write off bad loans

• Refinance insolvent banks

• Require honest accounting when meeting

capital requirements

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What Happened After Reforms

• Productivity growth rebounded

– No helicopter drops of money

– No big increases in spending

– No Chinese collapse

• Reason for rebound

– Making the banking system sound again

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How to reform financial system so that it is efficient and crisis-free

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Good Financial Regulation

• Friedman argues for 100% reserve banking with interest on reserves

• Justification is stability

• I argue for Friedman’s system for the commercial banking system

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Good Financial Regulation

• Freidman argues for 100% reserve banking

• Justification is stability

• I argue for 100% reserve commercial banking system (with interest on reserves)

• AND a ban on financial intermediation, which rules out Bear Stearns and Lehman Brothers

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Problems with Regulation

• Actions are often taken for political reasons

• Recent financial crisis and earlier S&L crisis due to policies designed to increase home ownership

• Fannie Mae and Freddie Mac, two GSEs, began holding subprime mortgages because politicians forced them to

• Congress passed laws that effectively required banks to make subprime mortgage loans when enforced

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Financial Intermediation Serves No Purpose

• People save a lot for retirement

• Half of this is in the form of equity in real assets they own

• Half is lending to other people who use it to finances houses and businesses

• Remember if there is borrowing, there must be lenders – the lenders are mutual retirement accounts, share holders of mutual bond funds, mutual insurance companies, etc.

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A Difficult Problem

• People want insurance against uninsurable aggregate risk

• If permitted limited liability financial intermediaries provide it, get too big to fail, and when they fail, the taxpayers bail them out

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Solution

• Restrict insurance to partnerships, which are not limited liability partnerships – e.g., Lloyds of London in the reinsurance market

• Do not permit AIG to insure debt

• Prohibit the insurance of retirement plans by non mutual insurance companies

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Conclusion

• Need mutual saving arrangements– Corporate stocks– Mutual insurance companies– Mutual bond funds

• Aggregate risk is nondiversifiable

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Large Loses Can be Shared by People Without Government Intervention

• Let’s look at the two big falls in household net worth relative to GDP

• There was a huge drop in the value of the stock market early in this decade – nearly one GDP

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Current U.S. Financial Crisis: All Numbers Relative to GDP

Period Change in Value of Equity

Change in Value of Household Tangible Assets

Total

2000.1–2002.3

- 0.95 + 0.20 - 0.75

2007.2–2008.4

- 0.80 - 0.30 - 1.10

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Only Fed Can Issue Money

• Money (definition I use) is deposits that are payable on demand plus currency

• It is used for transaction/liquidity purposes

• No danger of bank failures with 100% reserves

• Fed has tight control on the money supply and can maintain price stability – a good thing

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How Are Investments Financed?

• Currently 75 percent financed by equity and mutual lending

• Other 25 percent financed by bank lending

• The part currently financed by bank lending would have to be financed other ways

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What Other Ways?

• Use more equity

• Use more mutual lending– Mutual insurance companies– Venture capital group– REITS– Mutual pension funds

• With this reform, all bank lending to government

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Capital Investments Should Be Financed by Sharing Arrangements

• We have the stock market, which is a sharing arrangement

• State & local government bonds are guaranteed by taxpayers, which is a sharing arrangement

• Mutual funds and defined benefit pension funds are sharing arrangements as well

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Investment Banking

• Handles acquisitions, mergers, IPOs etc.

• Handles brokerage

• Not trying to make profits by borrowing short at a low rate and lending long at a higher rate

• As we now know, mortgage-backed securities are not riskless

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Can Avoid Financial Crises by Having System with large Regulatory Rents

• Canada had such a system in the 1930s

• Canada had no bank crises

• Canada had a Great Depression, one as big as that of U.S. and Germany

• Losers were the households who borrowed at higher rates and lent at lower rates

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Good Regulatory Policies

• Truth in lending with clear contracting rules that are enforced by courts

• Honest accounting– U.S. this time around has been honest– Not like Japan after its 1992 crisis– And U.S. after many S&Ls became insolvent

• Make easier to sell foreclosed properties

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Recapitalize the System

• Easy to do

• Value of toxic mortgage-backed securities not large– Relative to GDP value is one-quarter of the drop in stock market at the end of the IT boom in 2000-2001

– And these securities are not worthless– Let noninsured lenders to banks bear some losses

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What About the Fed?

• Did what it should given the situation

• Big increase in reserves

• Fed is not the cause of the recent drop in U.S. GDP (4.0% trend corrected and probably another 0.9% this quarter)

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Don’t Increase Tax Rates

• European hours per working-age person 70% of other advanced industrial countries

• Why? Their marginal effective tax rate is 60% versus 40% elsewhere

• In early 1970s tax rate was 40%, and they worked the same amount

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• European hours per working-age person 70% of other advanced industrial countries

• Why? Their marginal effective tax rate is 60% versus 40% elsewhere

• In early 1970s tax rate was 40% and they worked the same amount

•Danger: U.S. will increase its tax rate

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Raising Tax Rates Will

• Not increase revenue in the U.S.

• Will decrease revenue in France, Italy, and Germany

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GDP and Tax Revenue per Person

00.20.40.60.8

11.21.41.6

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

Tax Rate, t

GDP

Tax Revenue

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Welfare

• Nonmarket time is valuable

• Because of taxes, the value of time on margin is twice as high as in the market sector

Welfare gains of cutting tax rates are …

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Welfare Gains and Losses

-20%

-10%

0%

10%

0 0.1 0.2 0.3 0.4 0.5 0.6

Current U.S.

Europe

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Healthy Productivity Growth in U.S. and EU

Decade Productivity Growths

1984-1994 1994-2004

Europe 20% 15%

U.S. 15% 21%

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Problems Are Real

• What matters are real factors

– Tax RATES – low rates good– Openness – more is better– Productivity – higher is better

•Subsidies depress productivity•Protecting vested interests does as well

• Problem is not lack of borrowing

• Some banks are refusing deposits in the U.S.

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Detrended GDP per Capita

60

70

80

90

100

110

1991 1993 1995 1997 1999 2001 2003 2005

Japan

US

EU - 15

Source: GGDC

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Summary

• The Fed should prevent the banking system from subsidizing inefficiencies

• Further evidence:

– Chile and Mexico– Both had banking system collapses– Chile reformed and recovered– Mexico did not reform and stagnated

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The Future

• With good policies the U.S. and E.U. will boom like Chile and Finland did

• With bad policies these economies will stagnate like Mexico and Japan did

• I hope we follow Chile’s and Finland’s examples

• I am forecasting a lost decade of growth for the U.S.

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Examples of Bad Policies

• Abandonment of cost-benefit analysis for evaluation of new regulations– Instituted by Executive Order 1981– Abandoned by Executive Order in Spring 2009

• Proposed increase in tax rates– Increase personal income tax rates– Increase corporate income taxes, which are among the highest in the world

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Expectations Matter

• Some recovery between FDR election and inauguration

• Some depression of economy between Obama election and his taking office

• People expected improved policies in the first case and worse policies in the second

• Productivity, but not employment, recovered under FDR

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• Overbuilding in 1929 and in 2008, which depresses employment and output, but not welfare

• If mistake made and worked too much in the past building too many houses, best to enjoy more leisure

• Sizable net immigrations became negative– 2006 and before: 1.0 million per year– 2008: 0.1 million

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Why Did the Mild Depression of 1929 Become the Great One?

• There was overbuilding in real estate, and immigration shut off– Stock market crash small relative to three post-1960 crashes and same size as three others

• Businesses cut investment and it wasn’t because they didn’t have the money to invest– They were paying big dividends

• Hoover’s anti-free market policies that turned a mild adjustment into the Great Depression

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Are we in for another Great Depression?

• The current planned policies in U.S. resemble those followed in 1929-32

– Anti immigration– Anti globalization– Pro tax increase– Pro White House managing the economy– Pro bailout of businesses– Pro cartelization

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Are we in for another Great Depression?

I expect not

• Things were going well for the U.S. economy until the fourth quarter of 2008 – rapid productivity growth

• Economic knowledge has advanced so much that it will effectively constrain the policymakers