Econ 479 Final 1

Financial Crisis on Infinite Earths: The Great Recession of 2007-2009 John Voorheis ECON 479

"The job of financial sector regulator is suddenly akin to joining the Justice League, or maybe the G.I. Joes. You're containing the maniacs who could destroy the world economy. " - Ezra Klein, "Will Regulation Work When We Stop Wanting It?," Washington Post Online, 6/19/2009.

Financial Crisis on Infinite Earths ECON 479 John Voorheis On September 15, 2008, Lehman Brothers, the fourth largest investment bank in the United States, filed for Chapter 11 bankruptcy. In the weeks that followed, there was a very real sense that the US economy was on the verge of collapse. It was at this point that the 2008-9 recession, which had been until then chiefly a financial crisis, broke out from the financial sector into the real economy. This recession, it now seems, is not like other recessions. Its origins are multitude, its future uncertain, its pattern atypical. This paper is an attempt to put forth a unified theory of the 2008-9 recession, in seven parts - the current recession in historical context; the origins and evolution of the financial crisis; policy options and outcomes for addressing the financial crisis; economic analysis of the recession's impact on a variety of sectors; monetary policy responses and outcomes; fiscal policy responses and outcomes; and the outlook for future growth. The current recession, we will see, was caused by a perfect storm of deliberate malfeasance, lax regulation, laziness exhibited by over-reliance on quantitative models, an exaggerated self-regard on the part of the "masters of the universe," an unwillingness to address a growing speculative bubble, and a general, overarching failure of firms, individuals and government authorities to look beyond short term outcomes. The policy response to the crisis has been almost universally insufficient and tepid, hindered by ideological rigidity, partisan conflict and the breakdown of cherished economic frameworks.

Part I: In Blackest Night: The Great Recession in Historical Context

The proximate cause of the current recession lies in a large asset bubble in the real estate market, which itself has its origins in the last recession of 2001. The Federal Reserve engaged in fairly standard monetary policy, engaging in open market operations and pushing down short term interest rates. These lower interest rates had two effects - first, they lowered the cost of borrowing for

homeowners, and they lowered yields on traditionally safe Treasuries. The second effect led many financial institutions to move investments from Treasuries to Real Estate market instruments such as Mortgage Backed Securities, a move which increased available mortgage funding at a time when borrowers were most likely to take out new mortgages due to historically low interest rates. The result was a massive run up in real estate prices. This soon became self reinforcing, as homeowners took advantage of the appreciation of their homes by taking out lines of credit on the increased equity. In 2006, home prices peaked, and soon took a rather dramatic downturn. This downturn decreased the real wealth of homeowners. In cases where homeowners had taken out loans on the assumption of continued appreciation, a practice concentrated in the subprime sector, default and foreclosure rates rose. The financial sector, which had invested heavily in the bubble and especially in the risky subprime sector, began to experience substantial losses beginning by 2007.1 The National Bureau of Economic Research is a non-profit agency that, amongst other things, determines the beginning and end of business cycles. The NBER's Business Cycle Dating Committee uses four monthly data series(employment, industrial production, real sales and personal income less transfers,) as well as the quarterly released GDP reports to determine the months in which economic activity reached peak and trough, marking the beginning and end of a recession. Real GDP data is only released quarterly, so the month of peak or trough must be estimated from the monthly indicators. These indicators do not generally peak or trough simultaneously; however, they are usually clustered in around a given month. The Business Cycle Dating Committee dates the start of the current recession at December 2007.2 As shown by Fig. A, this determination is still subject to some doubt, as two of the four monthly data series, real sales and personal income, peaked significantly after December 2007, while Employment and Industrial Production peaked quite close to the determined month. The current recession is atypical of recessions since World War II; indeed, comparisons to the Great Depression are quite apt. In virtually every metric, the current recession is not only worse than the average of previous recessions - it is very often worse than the worst of previous recessions. Overall real GDP has fallen

from its peak by 3.3%, compared to an average of decline of 2.0%. Only one post-war recession has seen large GDP decreases, the recession of 1973-5, which saw a total decline of 3.4% peak to trough. Given that most economists forecast a trough in the current recession late in 2009 at the earliest, it is very likely that the current recession may yet over take 1973-5. Looking at the 4 monthly series used by the NBER Business Cycle Dating Committee, the current recession is worse than the peak to trough average of post war recessions for each indicator. Employment is down 4% thus far, compared to the average of 2%; industrial production is down 15% compared to the average of 4%; real sales are down 8% compared to the average of 2%; and real income is down 4% compared to the average of 1%. The current recession is in its 18th month, making it the longest recession since the Great Depression. Both the 1973-5 and the 1981-2 recessions lasted 16 months; both were regarded as the worst recessions since the 1930s before the current recession. The unemployment rate is (as of May 2009) 9.4%. This is well above the average maximum unemployment rate of 6.8% for post-war recessions. The 1981-2 recession saw a maximum unemployment rate of 10.7%; however, the next highest unemployment rate was 8.4% in the 1973-5 recession. Additionally, the 1981-2 recession was atypical in that it was preceded by a very short expansion of only 12 months; the 1981-2 recession is often referred to as a "double dip" recession for this reason.3 The Conference Board, a non-profit economic research firm compiles and analyzes data about macroeconomic performance. They have divided 21 different economic data series into three indices: the leading economic indicators, coincident economic indicators, and lagging economic indicators. The leading indicators are perhaps the most commonly used of these indices, since it can be used to predict future economic activity. Generally speaking, the LEI will reach a peak about 6 months before the start of a recession, and will reach a trough about 3 months after a recession. The LEI for May 2009 showed the first significant upward motion since peak.4 While it remains to be seen if this will be sustained economic growth or merely a false positive, this would suggest that the current recession may come to an end sometime in the third quarter of 2009. Macroeconomic forecasters have generally concurred

with this view. The consensus of private sector forecasts, as gathered by the Congressional Budget Office, predict that GDP growth will be positive by the third quarter of 2009. Even the pessimistic forecasts predict that growth will turn around by the fourth quarter. However, the unemployment rate is not likely to peak until well into 2010, and the labor market will probably continue to be soft, even as GDP begins to grow.5 Recessions since World War II have generally followed one of two patterns. First, there are the so-called "Inventory Recessions," of which the 1960 and 1969 recessions are classic examples, where the proximate cause of economic downturn is a sharp decrease in inventory investment in response to falling sales. Second, there are recessions caused by excess tightening by an inflation fighting Federal Reserve, where high interest rates lead to a collapse in consumption and investment. The classic example of this type of recession is the "double dip recession" of the early 1980s. The current recession does not fit either of these two patterns. Rather, it is more closely related to both pre-World War I financial panics and the Great Depression. The downturn began and has been primarily concentrated in the financial sector - the real economy did not begin to see serious ill effects until well into 2008. Like the Great Depression, there was a large, speculative real estate bubble, with decreasing lending standards and increased leverage and risk taking in the years before the recession. Once the bubble burst, losses taken by highly leveraged firms lead to a credit freeze. In the Great Depression, these sorts of losses led to cascading bank failures. The current recession has seen cascading failures, but in the "shadow banking" sector rather than in commercial banks. The current recession is truly global in reach, although, it is not the case that every country is in recession simultaneously. Nonetheless, total world output is forecasted to drop precipitously, especially when compared to other world recessions in the last 50 years. Previous recessions (1973, 1982, 1991) have seen only a very small decline or a flattening in world GDP. In contrast, the current recession is projected to see world GDP declines of about 4%. Looking at important indicators, it appears to be the case that the current global recession is at least as bad, if not worse, than previous global recessions.

Real per capita GDP is forecasted to fall by 2.5%, compared to an average decline of prior recessions of less than 0.5%. Industrial Production is projected to fall by 6%, compared to an average of 2%. Unemployment is projected to top out at around 9% compared to an average of 7%. Trade volumes are projected to fall by 12% compared to a flat average. In addition to being the worst global recession in memory, the current recession is also the most global of global recessions. Previous global recessions have seen a peak of around 50% of countries (PPP-weighted) experiencing recession simultaneously. The current recession is projected to see a maximum of around 75% of countries. So, not only is the current recession the deepest in the last 50 years, it is also the broadest.6

Part II: The Secret Origins of the Great Recession

The origins of the current recession can be traced most directly to the previous recession of 2001. The 2001 recession was relatively brief and shallow in comparison to the post-World War II average. Nonetheless, even as the recession came to an official end, the Federal Open Market Committee continued to engage in expansionary monetary policy. The FOMC had lowered the Federal Funds rate target all the way to 1% by 2003, and kept it at this very low level for an entire year, until July 2004. This extended period of historically low interest rates fueled a massive increase in real estate investment. This, in turn, soon became a self-reinforcing bubble. As the bubble inflated, lending standards were steadily loosened, and subprime mortgages increased in importance. Financial institutions began experimenting with structured finance and derivative instruments based on real estate assets in an attempt to eke out a higher yield than Treasuries, while minimizing risk. Armed with these derivative instruments (many of which were rated AAA, safe as Treasuries,) banks and other financial institutions increased their leverage, backing these assets with less and less capital. Once home prices peaked in 2006, this was revealed to be a very foolish plan of action. By the Summer of 2007, major financial institutions were beginning to take massive losses on assets based on subprime mortgages.

The bursting of a bubble caused, in part, by the central bank response to the bursting of a previous bubble led to the worst financial crisis since the Great Depression. Of course, if the extent of the crisis was subprime defaults driven by a collapse in home prices, it would have been just another real estate boom and bust cycle, and nothing more. But since subprime mortgages were repackaged and sold off as Mortgage Backed Securities, which were in turn structured into Collaterallized Debt Obligations, the bursting of the housing bubble had systemic consequences. The first signs of the systemic impact could be seen as early as June 2007, when two Bear Stearns managed hedge funds that were heavily invested in subprime MBSs failed. The assets of these hedge funds were seized by creditors in hopes of recouping losses. However, these assets proved to be illiquid. Financial institutions held large amounts of these now illiquid and possibly worthless assets. As more and more of the underlying assets - subprime mortgages - defaulted, financial institutions were forced to take large writedowns on the securities on their books. By the end of 2007, it was clear that a crisis had gripped the financial sector. The stock market suffered a severe drop, but the broader economy was largely unaffected. In March 2008, a new phase began in the financial crisis. Bear Stearns, one of the big five investment banks, faced the very real prospect of failure. The Federal Reserve facilitated an emergency takeover by JP Morgan Chase, absorbing the worst, most risky assets on Bear Stearn's balance sheet in the process. This caused a severe credit event. The TED spread, which is the spread between three month LIBOR rates and 3 month t-bill yields, is a measure of the risk premium that banks are charging when loaning money to other firms. It is, in other words, a market prediction of the risk of default. The TED spread, which had spiked during the stock market drop at the end of 2007 and then returned to more normal levels, once again spiked upward. In the months following, economic conditions continued to worsen. It became clear that there were widespread liquidity problems in the financial system, especially in the so-called "shadow banking" sector, chiefly the large investment banks. In September 2008, a number of crises came to a head, marking the darkest time in the downturn. On September 7, the Government Sponsored

Enterprises (GSEs) Fannie Mae and Freddie Mac were placed in conservatorship. The GSEs were the originators of securitization in the mortgage market, but had, until recently, chiefly dealt only in safe, 30 year fixed mortgages. As the housing bubble expanded, Fannie and Freddie began to dabble in the more risky asset classes based on sub-prime mortgages. The next weekend, two important events occurred that would send the economy to the brink. First, Lehman Brothers, another of the big five investment banks, was unable to find emergency funding or a buyer for its operations, and declared bankruptcy on September 15. Second, under pressure from Treasury and the Fed, Bank of America bought another big five investment bank, Merrill Lynch, which was itself close to collapse. These two events sent a shock through the financial system. American International Group, a large insurance company with a large portfolio of CDSs, including many with Lehman, was forced to turn to the government for assistance, and on September 16, received $85 billion in loans from the Fed in return for 79.9% ownership. The same day, a major money market mutual fund, the Reserve Primary Fund, "broke the buck," downgrading the nominal value of shares to 97 cents (money market funds keep attempt to keep shares at or slightly above $1.) This was an almost unprecedented event - only one money market fund had ever broken the buck before, and it caused what can be called a non-bank bank run, as consumers rushed to take their money out of these funds. In response, the Fed issued $105 billion in emergency liquidity on September 18, and the Treasury announced plans to back stop losses from Money Market Funds on September 19. The following Sunday, September 21, the remaining large investment banks, Goldman Sachs and Morgan Stanley, converted themselves to bank holding companies. Later in September, Washington Mutual failed and was liquidated by the FDIC and Wachovia was sold, under distressed conditions, to Wells Fargo. The TED spread, which had tightened some after the Bear Stearns failure failed to caused an economic collapse, reacted violently to the events of September 2008, spiking to unheard of levels and briefly reaching above 400 basis points.7 The root of the current recession lies in the sub-prime mortgage market. Before the 1980's, borrowers who had less than perfect credit, or who had lower incomes were left out of the mortgage

market, since banks and thrifts were governed by usury laws. These usury laws set an upper limit on the interest rate charged on loans. When the usury laws were phased out as part of the 1980's move towards financial de-regulation, banks had the ability to price the risk of loaning to more marginal consumers. This is where the sub-prime market begins. However, given the economic circumstances of the individuals taking out sub-prime mortgages, and certain features of the most common sub-prime mortgages, there are certain risks in these loans that ultimately led to the current financial crisis. The most common sub-prime loans are what is known as a 2/28 and 3/27, which are hybrid mortgages - for the first two or three years of repayment the interest rate is fixed, after which the rate is regularly adjusted based on LIBOR or some other baseline interest rate. These types of loans have an implicit payment shock once the interest rate adjusts. Additionally, many sub-prime mortgages feature prepayment penalties, which make it harder for borrowers to refinance. Combined with the borrowers' economic circumstances, the risk of default for sub-prime mortgages is much higher than that for prime mortgages.8 Around 2005, when home prices were nearing their peak, delinquencies and defaults started increasing dramatically, and fixed rate and adjustable rates began to diverge. By 2008, delinquency rates for sub-prime adjustable rate mortgages stood at 35%, whereas sub prime fixed rate delinquencies stood at around 12%. This compares to prime mortgage delinquencies of 9% for adjustable rates and 2% for fixed rates in 2008.9 These subprime mortgages, then, form the core of the financial crisis. The effect of the collapse in the subprime market, though, was magnified by irresponsible behavior by both financial sector firms and government agencies. Banks and thrifts are required by regulators to meet certain standards in terms of capital adequacy in order to continue functioning. These regulatory capital requirements are necessary to ensure that the banking system has adequate liquidity and stability to weather any adverse economic events. If the bank suddenly faces an adverse situation - for instance, if some of its loans go into default - the initial losses are absorbed by the capital buffer. The regulatory capital requirements are designed so that banks have a large enough buffer to absorb any reasonable losses without

becoming insolvent. The capital requirement is determined via a formula, where the required capital must be at a fixed ratio to the bank's risk weighted assets. Riskier assets, like subprime mortgages, must be backed by more capital than safer assets, like treasuries or other AAA rated securities. Banks have been able to reduce their effective capital requirements through two. The first is to transfer riskier assets off balance sheet (for example, to a structured investment vehicle,) decreasing the amount of regulatory required capital. The second approach was simply to shift from traditional assets such as mortgages, to more complex, but AAA rated, investments in derivative securities, chiefly CDOs. Because these assets were AAA rated, the capital required to back them was much lower than for a conventional loan. This process has been dubbed regulatory arbitrage.10 This regulatory arbitrage was significant because it increased banks' leverage. Leverage is usually measured as the ratio of assets to capital. Leverage is lucrative to banks since it allows them to increase returns without raising new capital. By lowering effective capital requirements, banks are essentially increasing their leverage ratio in hopes of creating greater returns. But, increasing leverage, in addition to magnifying gains on the upside, has a parallel effect on the downside. Leverage will magnify the losses on the downside in the same way it magnifies returns on the upside. This presents a significant risk to the system if there are large losses on leveraged assets. These losses, magnified by leverage, can quickly consume the bank's capital (this is especially true if the bank has been avoiding capital requirements) creating the possibility of bank failure. Other things being equal, increased leverage achieved through regulatory arbitrage reduces stability and increases the risk of a systemic event. This is especially true in the case of the so called large, complex financial institutions (also referred to as tier 1 LHCs.) These large, too big to fail, institutions are in a prime position to not only engage in regulatory arbitrage on capital requirements, but also can avoid regulation altogether. No comprehensive regulations exist that govern the whole of institutions such as Bank of America and Citigroup, which consist of subsidiaries engaging in commercial and investment banking, broker dealer activities,mortgage origination and insurance. Each subsidiary has a separate regulator, and these

regulators have varied in strictness. Some subsidiaries, the notable example being the financial products division of AIG, went completely unsupervised.11 An additional factor that magnified the financial crisis was the peculiar position of the Government Sponsored Entities Fannie Mae and Freddie Mac. The GSEs were originally government agencies - the Federal National Mortgage Agency was set up as part of the New Deal to set up a secondary mortgage market. In order to remove the obligations from the federal government's balance sheet, FNMA was spun off and chartered as a private corporation (Fannie Mae) in 1968. To increase competition, a second entity, the Federal Home Loan Mortgage Corporation (Freddie Mac,) was chartered in 1970. These newly created corporations were, and continue to be, strange hybrids. They are private, profit seeking corporations, answerable only to their shareholders. However, they are also tasked with the important social goal of improving mortgage credit availability through fostering a secondary market. Although there is no formal link or recourse between the federal government and the GSEs, financial markets perceived an implicit government guarantee. This assumption of implicit guarantee allowed the GSEs to borrow at rates almost as low as Treasury yields. The GSEs, as private corporations, increasingly have, in addition to securitizing mortgages, purchased mortgages and retained them on balance sheet. This has resulted in a large amount of leveraging and risk-shifting behavior. The GSEs funded themselves through short term borrowing at the preferential rates available to them, and purchased 30-year mortgages. This is a form of interest rate arbitrage known as "riding the yield curve."12 In short, at every step of the way, individuals were lazy and short sighted. Rather than a more thorough test of ability to pay, mortgage bankers relied on FICO scores. Rather than investigate the actual riskiness of new derivative assets, government regulators relied on the ratings of the credit ratings agencies. Rather than develop strategies that would ensure long term profitability, investment bankers engaged in risky investment schemes that netted them large performance bonuses. Neither government nor private industry was willing to look at the large negative externality that these risky,

lazy, short sighted behaviors caused - the very real risk of a systemic collapse. This externality will continue to exist as long as the large complex financial institutions exist that are too big to fail, and that can engage in regulatory arbitrage.

Part III: March of the Zombie Banks: Towards a "Bailout Nation?"

The earliest signs of a liquidity crisis in the financial sector were apparent by the Summer of 2007. However, the policy response to the financial crisis did not come to bear significantly until March 2008. Bear Stearns was near collapse. Fearing severe market repercussions, the Federal Reserve stepped in, negotiating a quick takeover by JP Morgan. The Fed took on much of Bear Stearns' most illiquid assets, setting up a holding company, Maiden Lane, to administer them. This would be the first of many "bailouts" of American financial companies to come. Bear Stearns was not the first bailout in the world, however. The British Government extending liquidity support to Northern Rock, a major British bank specializing in mortgage finance, in September 2007. In February 2008, Northern Rock was nationalized after no private buyer was found for the failing bank. The quick resolution of Bear Stearns calmed the markets. Insofar as it did not result in the imminent collapse of global capitalism, it was a success. The summer of 2008 was a period of slow economic deterioration, punctuated by a few major events. Chief amongst these was the failure of Indymac Bank, a large California bank that had been a large player in the subprime market there. The Indymac failure was, at the time, the third largest bank failure in US history. Nonetheless, the FDIC was able to provide relatively quick resolution, although it would ultimately cost the FDIC some $8.9 billion. There were other bank failures in 2008, generally involving small regional banks. All were resolved smoothly. This offers a contrast to the ad hoc, messy and often destructive attempts to resolve failing shadow banking sector institutions. Lehman Brothers, as previously noted, was forced into bankruptcy on September 15, 2008. This set off a chain of further failures and an acceleration of

economic deterioration. It is clear that, whatever the problems with resolving large complex financial institutions, letting a failing LCFI go bankrupt is a worst case scenario. After the collapse of Lehman, the Treasury Secretary, Hank Paulson, pushed hard for appropriation of some $750 billion to purchase "toxic assets" and restore stability to the financial system. The Troubled Asset Relief Program never fulfilled its original purpose. Rather, it morphed into a large capital injection to essentially all of the major banks and bank holding companies in the United States. Alongside the TARP, the FDIC increased the limit for insured deposits to $250,000 and implemented the Temporary Liquidity Guarantee Program, which provided a FDIC guarantee for newly issued debt instruments in an effort to keep interbank markets from freezing. Additionally, the Treasury Department set up a program to offer FDIC-like insurance for investments in money market mutual funds starting on September 19, 2008. The government response to the crisis has been increasingly forceful, especially in the period after the collapse of Lehman. But perhaps the most important policy actions have been taken not by Executive Branch agencies, but rather by the Federal Reserve, which has acted in a swift and in unprecedented manner to address the financial crisis.13 The Federal Reserve responded to the emerging crisis by engaging in conventional monetary policy, starting in August 2007. As is usually the case when the economy falls into recession, the Fed engaged in Open Market Operations - selling short term Treasuries in an effort to drive down the Fed Funds Rate. Figure D shows the target Fed Funds Rate from 2006-present. At each crisis point (the initial liquidity crisis, the Bear Stearns collapse, Lehman) the Fed has reacted by slashing short term rates. By December 2008, the Fed had exhausted its conventional ammunition, having cut the Federal Funds rate to essentially zero. Additionally, the Federal Reserve serves as the lender of last resort for the banking system through the Primary Credit Window, through which banks can borrow reserves on an emergency overnight basis. The Fed has augmented this LOLR support by cutting the spreads between the Federal Funds rate and the Primary Credit rate from 100 basis points prior to August 2007, to 50 basis points, and then, in March 2008, to 25 basis points.

The Federal Reserve, having used all available options in its conventional monetary policy arsenal, was not content to merely stand still and do nothing. The Fed has extended the range of its policies in two key ways - it has expanded the scope and size of its liquidity operations (which can be thought of as an extension of its LOLR capacity) and it has engaged in quantitative easing (which can be seen as an extension of its open market operations capacity.) In December 2007, the Fed instituted the Term Auction Facility, a new lending facility designed to inject liquidity through longer term (28, and later, 84 days) emergency reserve loans. The collapse of Bear Stearns in March 2008 led to the creation of two additional similar facilities, this time aimed at the "shadow banking" sector rather than at commercial banks - Term Securities Lending Facility and the Primary Dealer Credit Facility. After the collapse of Lehman, the Federal Reserve dramatically increased the size of its balance sheet. The Fed created a number of new lending facilities to maintain liquidity in markets that had frozen up. Included are the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility and the Commercial Paper Funding Facility, which are intended to back stop the commercial paper market. The Money Market Investor Funding Facility was enacted in response to the run on mutual funds following the Reserve Primary fund breaking the buck. Finally, as mentioned above, the Fed has engaged in direct purchases of assets. The Fed began purchasing short term GSE debt on September 19, 2008. In November 2008, the Fed announced plans to purchase $100 billion of GSE debt, and up to $500 billion in GSE MBSs. Foreign Central Banks have generally been as active as the Fed has in engaging in liquidity operations. The European Central Bank, the Bank of Japan, and the Bank of England have all aggressively cut short term rates, and acted swiftly to extend liquidity to frozen credit markets.14 As the policymaking in response to the crisis has become more muscular, there has been an increasing call for a complete revamp of the current regulatory structure for the financial sector. This call has become more urgent as the crisis has eased in recent months. It is clear that the current system has large flaws. Some of these flaws, such as the reliance on risk-weighting based on credit rating

agency assessments, have been major drivers in the severity of the current crisis. More broadly, there is no single supervisor for large complex financial institutions, and no regulation whatsoever for some derivatives, leaving large parts of the financial sector opaque. The move towards deregulation from 1980 on has not, on net, been terribly successful. It would now appear that, empirically speaking, the financial sector cannot be trusted to act in a social optimal manner without government supervision. It would rather appear that, left unsupervised, the financial sector will eventually blow up the economy. The question, then becomes not whether to regulate, but how wide ranging and punitive the new regulations will be. The most complete vision of a possible new world of banking regulation is contained in the just-released Treasury Department white paper entitled "Financial Regulatory Reform." This Treasury Department proposal outlines five goals for regulatory reform, and specific proposals for achieving these goals. The first goal is to reform the supervision regime of the financial sector, focusing on the LCFIs. The chief proposals to achieve this include: the formation of a systemic risk council composed of various government agencies; the designation of the Federal Reserve as the senior regulator for any too big to fail bank holding company, and allows the Fed to regulate all subsidiaries of BHCs; increasing capital requirements for LCFIs to compensate for increased systemic risk; and closing various regulatory loopholes as well as streamlining regulation by eliminating the Office of Thrift Supervision (the regulator for Indymac, AIG and Washington Mutual.) The second goal is to make sure that the regulation of the financial system is comprehensive. The chief proposals include stricter and more comprehensive regulation of the securitization market and a complete overhaul of the regulation of over the counter (OTC) derivatives, specifically the credit default swaps that played prominently in the failure of AIG. The third goal is to enhance consumer protection; this is to be accomplished through the establishment of a Consumer Financial Protection Agency tasked with ensuring that retail financial products are "safe" for consumers. The fourth goal is to create a system for resolving failed LCFIs. This is to be modeled on the FDIC. Finally, international cooperation on bank supervision must be

increased, and the international capital framework (Basel II) should be strengthened.15 The Treasury white paper as a way forward has been made possible by the largely successful Supervisory Capital Assessment Program, which has given policymakers a better handle on the current health of the banking system. The Treasury Department, as well as the major bank regulators, as part of the Troubled Asset Relief Program, required the largest 19 bank holding companies to undergo a "stress test" The SCAP is an attempt to simulate the effects of two scenarios of continued economic weakness on the biggest 19 banks. The focus of the SCAP is on the capital bases of these banks, and how well these would hold up under a range of loan losses. The results of the SCAP suggest that 10 of the 19 BHCs will require more capital in order to maintain an adequate buffer. As of the writing of this paper, almost all of the additional capital required by the SCAP has been raised. The SCAP has been largely successful in shoring up faith in the banking system. However, the underlying assumptions of the SCAP seem unrealistically optimistic in hindsight. The more adverse scenario in the SCAP involves an average unemployment rate of 8.9% for 2009, a number dwarfed by the actual unemployment rate of 9.4% as of May 2009.16 The response to the crisis has achieved some degree of success - risk premiums, as represented by the TED spread (Figure C) have come down from their extraordinarily high levels following the fall of Lehman. The major banks have built up a significant and hopefully adequate capital buffer to absorb future losses through the TARP infusions and the additional capital requirements of the SCAP. The enduring failure of the response to the crisis has been the fateful decision to allow Lehman to fail. Had the Fed or the Treasury intervened and found some resolution short of bankruptcy, much of the extraordinary measures taken since may not have been necessary. The crisis appears to have abated in the months since Lehman. Unless the regulations on the financial sector are overhauled and strengthened, though, the system will not truly recover. The biggest need, going forward, is to ensure that the recovery from this recession does not lead to another, more severe crisis down the road.

Part IV: Maximum Carnage: The Great Recession in the Real Economy

What started as a liquidity crisis in the shadow banking sector in August 2007 was recognized as a full blown recession by the NBER in December 2007, and by the end of 2008 had spread well beyond the financial sector into the "real" economy. The recession in the real economy can be best illuminated by examining changes in real GDP and its components, starting from immediately before the previous recession. These figures are summarized in Figure E. GDP growth in the years before the 2001 recession was robust, 4.5% in 1999 and 3.7% in 2000. Growth was slower in 2001 (0.8%) and 2002 (1.6%), as the economy was suffering from the aftermath of the dot-com crash. Growth increased in 2003 (2.5%) and peaked in 2004 at 3.6%, below the growth rates of the late 1990's. GDP growth then decreased in each year until 2008. The average GDP growth rate from 2002-2007 (which corresponds to the post-2001 expansion) was 2.57%, compared to an average of 3.68% from 19922000 (which corresponds to the Clinton era expansion.) The current recession began in the fourth quarter of 2007. However, Q4 2007 saw only a small decline in GDP (-0.2%.) GDP then actually grew in the first quarter (0.9%) and second quarter (2.8%) of 2008, followed by a smaller decline in the third quarter (-0.5%) and precipitous declines in the fourth quarter of 2008 (-6.3%) and the first quarter of 2009 (-5.7%.) The 2001 recession was, as stated, largely caused by the dot-com bubble bursting. This is readily apparent in the declines in Business Equipment and Software Investment in 2001 (-4.9%) and 2002 (-6.2%). Business investment in structures also declined in the period during and after the 2001 recession, declining by 2.3% in 2001, 17.1% in 2002 and 4.1% in 2003. However, the 2001 recession had two novel features when compared to previous recessions - residential investment did not decline in the recession (it increased by 0.4% in 2001 and 4.8% in 2002.) Additionally, consumption broadly, and consumption of durable goods actually increased during the recession. Consumption overall increased by 2.5% in 2001 and 2.7% in 2002, and consumption of durable goods increased by 4.3% in

2001, and 7.1% in 2002. These two phenomena are interrelated. Both are a product of the unusually loose monetary policy that the Federal Reserve engaged in from 2001-2004, wherein the Federal Reserve kept short term interest rates very low (see Figure D.) These low interest rates had the effect of increasing the availability of credit. This, in turn, allowed households to continue to expand consumption and to purchase more housing. In retrospect, the Federal Reserve's monetary policy was probably too expansionary. The St. Louis Fed tracks actual Federal Open Market Committee action versus the range provided by Taylor's rule, and 2002-2004, the Federal Funds rate was much lower than the Taylor's rule range. This suggests that the Federal Reserve was able to fight the continued economic malaise after the dot-com bubble only through blowing up another bubble - this one in real estate. Considering that the growth rate in residential investment was an astounding 8.4% in 2003 and 10.3% in 2004, this story of bubble-led growth would seem to have substantial merit.17 As is consistent with an expansion based on an asset bubble, the first sector to see significant declines was the residential investment. In point of fact, residential investment began to decrease well before the official start of recession, seeing quarterly decreases of -20.7% in the third quarter of 2007. In fact, residential investment had been decreasing since 2006, when home prices peaked. As home prices peaked and the real estate bubble popped, households bought fewer homes, and, as prices began to fall quite steeply, households often took substantial capital losses as their homes depreciated in value. This decline in home values was followed by weakness in imports, which began declining in the second quarter of 2008, and in consumption, which began to decline in the third quarter of 2008. There is probably at least some relationship between the fall in consumption and imports and the severe drop in residential investment. There are two major factors in this relationship. First, since many households were experiencing home value depreciation, there was a negative wealth effect, wherein households decreased consumption as their real wealth decreased. Second, falling home values made access to home equity lines of credit, an important tool used recently by households to bolster consumption expenditures, much more difficult. In contrast to the declines in consumption and investment

(specifically residential investment,) exports continued to be an area of relative strength until the fourth quarter of 2008. The strength in the export sector can be largely attributed to the relative weakness of the US dollar versus other major currencies during this period. This relatively weak dollar increased demand for US products at the margin. The strong growth in exports through much of 2008 helps explain why real GDP overall did not see significant declines until the fourth quarter. The fourth quarter of 2008 is the pivotal point at which the Great Recession transformed from a relatively mild downturn focused in the real estate and financial sectors, into a full fledged severe recession. This fourth quarter downturn coincides with the events of September 2008, where, amongst other things, the GSEs Fannie Mae and Freddie Mac were placed in receivership, Lehman Brothers was forced into bankruptcy, AIG was essentially nationalized, and the failure of the Reserve Primary Fund led to a run on money market mutual funds. These events led to a severe credit crisis. Firms and households found it much harder to borrow as risk premiums increased to extraordinary levels (see Figure C.) This in turn led to further declines in Consumption, which went from a quarterly change of -3.8% in Q3 2008 to -4.3% in Q4 2008, and overall investment, which went from a quarterly growth rate of 0.4% in Q3 2008 to a decline of -23% in Q4 2008. The first quarter of 2009 saw continued deterioration, as investment declined at an annual rate of 49.3%, and residential investment saw a decline of 38.7%, the largest decline since the beginning of the recession. Exports, which had been a growth sector, had turned negative in the fourth quarter (shrinking by 23.6%) and saw further worsening in the first quarter of 2009, declining by 28.7%. This was somewhat mitigated by an even faster decline in imports (-34.1% in Q1 2009,) resulting in an increase in net exports. The deterioration in the net exports sector is indicative of the fact that by the fourth quarter of 2008, the Great Recession was a global event, affecting essentially the entire developed world. Another significant factor in the current recession has been the behavior of prices. The legacy of the 1970's is that large increases in the price level can interact with an economic downturn to make the economic downturn worse. This interaction was dubbed "stagflation," an evocative neologism

capturing the core of why the 1973-5 recession was so miserable - it combined the stagnation of a recession with the erosion of wealth and purchasing power of an inflationary period. The stagflation of the 1973-5 recession was driven in large part by a significant oil price shock, caused in large part by an OPEC oil embargo. The current recession looked as if it might follow the path of the 1973-5 recession, at least for the first several months. The interaction between increased demand for natural resources generally and oil in particular, and the depreciation of the US dollar from 2007-8 has resulted in dramatically higher oil prices (oil is denominated in dollar terms, so a depreciation in the dollar leads to higher nominal prices, holding other things equal.) Figure F shows the CPI and inflation rates for both the all items and core measures of CPI. Driven chiefly by oil prices, the all item Consumer Price Index measure of inflation moved up to around 4% in the second half of 2007. In 2008, the all item inflation rate stayed around 4% for most of the winter before spiking up above 5% in September 2008. The fear of stagflation is probably overblown, since the core inflation rate (which measures only the prices of non-food and non-energy items) shows much lower increases in the inflation rate. From 2007 until the peak just before the collapse of Lehman, the core inflation rate increased only 0.5%, from 2% to 2.5%. After the collapse of Lehman, oil prices collapsed, and both core and all item inflation rates plummeted. In fact, 2009 has seen negative year over year all item inflation rates. This deflationary pressure is a result of the greatly worsened economic conditions in the post-Lehman period - a collapse of demand is bringing with it a collapse in prices.

Part V: Panic In The Sky: The Monetary Policy Response to the Great Recession

The chief duty of the Federal Reserve is to engage in monetary policy. The Federal Reserve has three chief goals, the so-called macro trilogy: price stability, economic growth and full employment. Looking at the period from 2000 through August 2007, we can see excellent examples of all three goals driving policy. In 2000, the target for the Federal Funds Rate, the key policy rate on which the Federal

Reserve focuses its monetary policy efforts, stood at 6.5%. In response to the weakening of the economy in the wake of the bursting of the dot-com bubble, the Federal Reserve began engaging in expansionary monetary policy, lowering the Fed Funds Rate target to 2% by November 2001, which was the official end of the recession. Despite this, the Federal Reserve saw continued weakness in the economy, most notably in the continued declines in employment. In response, the Federal Reserve continued to lower the Fed Funds rate target, albeit at a slower pace, down to 1%, where it stayed for a full year from July 2003 to July 2004. In July 2004, the Federal Reserve shifted policy - the economy had returned to near full employment level of output, and so the most important policy goal became inflation control. In order to keep inflation at a targeted level, the Federal Reserve implemented a tight money policy, increasing the target Federal Funds rate. The Federal Reserve steadily increased its Fed Funds target until July 2006, arriving at a high of 5.25%. From July 2006, through August 2007, the Federal Reserve kept the Fed Funds rate constant. In addition to the Federal Reserve's open market operations - buying and selling securities in order to set the Federal Funds rate and influence other interest rates - the Federal Reserve acts as the lender of last resort for banks in the United States. Until February 2003, the Fed used an instrument known as the discount rate to not only set the rate at which banks can borrow emergency overnight loans from the Fed, but also influence the amount of liquidity in the financial system. The discount rate was nominally pegged to the Fed Funds rate, although for the period between 2000 and 2003, it was generally lower than the Federal Funds rate; the spread was 50 basis points. In February 2003, the discount rate was replaced with the Primary Credit rate, which was still pegged to the Fed Funds rate, but at a spread of 100 basis points above FFR. Figure D summarizes the changes in Federal Reserve policy both for open market operations and lender of last resort operations. The policy of the Federal Reserve is largely set at meetings of the Federal Open Market Committee, which is to say, its policy is left to the judgement of FOMC members. In an attempt to quantify these judgement calls, Taylor's rule has been proposed. Taylor's rule starts from an assumption

of the long term equilibrium real interest rate (2.5%,) and then allows this to be modified by two factors - the difference between the target rate of inflation and actual inflation, and the difference between actual GDP and potential GDP. Where Fed policy deviates from the Taylor's rule baseline, it is likely to be too contractionary or too expansionary, depending on whether the target fed fund rate is above or below the Taylor's rule baseline. From early 2001, when the FOMC began lowering the Fed Funds rate target, until the middle of 2002, the Fed's policy was much more expansionary than the Taylor's rule baseline. In the middle months of 2002, Fed policy was consistent with Taylor's rule at higher inflation rate targets. However, Taylor's rule then diverges from actual Fed policy, as the FOMC continued to lower the chief interest rate. From late 2002 all the way to mid 2006, Fed policy was more expansionary than the Taylor's rule baseline. Starting in 2006, the Fed reversed course and instituted a tight money policy which was more contractionary than the baseline. Starting in August 2007, the Fed began engaging in an expansionary policy, dropping the Federal Funds rate to an eventual low of a band between 0 and 25 basis points. At several moments, the Fed dropped the Federal Funds rate by larger than usual amounts (compared to a "normal" rate cut of 25 basis points,) in response to events in the economy. The initial drop from 5.25% to 4.75% was a response to the first signs of the subprime crisis, as large financial institutions began taking losses. In January 2008, the stock market took a steep downturn. In response, the FOMC dropped the Federal Funds rate 75 basis points in an emergency inter-meeting action, and then a further 50 basis points at the scheduled meeting later in January. After the failure of Bear Stearns, an event that set off a major credit crisis, the FOMC dropped the Fed Funds rate by 75 basis points. During the October 2008 turmoil, the FOMC dropped the Fed Funds rate 50 basis points in an inter-meeting action in response to the GSEs being placed in conservatorship, and then a further 50 basis points at the scheduled meeting. In December, the FOMC moved to a Zero Interest Rate Policy, dropping the Fed Funds rate to essentially zero. Concomitant with the changes in the Fed Funds rate, the FOMC made two changes to the Primary credit rate. The spread between the Fed Funds rate and the primary credit rate was 100

basis points previous to August 2007, when the FOMC decreased the spread to 50 basis points. In March 2008, as part of the response to the Bear Stearns failure, the FOMC decreased the spread a further 25 basis points, to the 25 b.p. where it stands currently.18 John Maynard Keynes originated the idea of the liquidity trap. The theory holds that, at very low interest rates, monetary policy will lose effectiveness - it will not be able to inject the necessary liquidity into the economy to stimulate a return to full employment levels of output. In an IS-LM framework, at low interest rates, Money demand is likely to be rather high, which results in a realtively flat LM curve. This flat LM curve suggests that monetary policy will be relatively ineffective, and fiscal policy will relatively more effective. The current situation certainly fits the definition of the liquidity trap - short term rates are very close to zero. There is no further room for traditional monetary policy to expand. However, the Federal Reserve has begun to engage in more unorthodox monetary policy (so-called quantitative easing) which may allow some further monetary policy. Nonetheless, it does appear that we are in a liquidity trap, since even these unorthodox policies have not yet been effective. Part and parcel of this is the flight to safety that has occurred, especially in the final months of 2008. As risk sensitivity has increased, at least partly in response to the financial system's inability to accurately price risk in the subprime crisis, investors have been moving into the safest asset class - US government securities. This has had the effect of driving down interest rates on treasuries, creating a liquidity trap-like effect. Again, at very low interest rates on US bonds, money demand will be relatively high, again resulting in a relatively flat LM curve. The flight to safety and concomitant drop in short term treasury interest rates has also resulting in generally higher interest rates for anything not perfectly safe. Even AAA-rated corporate bonds, supposedly almost as safe as Treasuries, have seen spreads twice the historical norm. For less safe assets, the spreads have widened even more. Compared to a baseline spread of between 2 and 4% over 10 year Treasuries, BAA rated corporate bonds had a spread of over 6% in late 2008. Mortgage Backed Securities, which had spreads of around 2% over 10

year Treasuries, saw spreads as high as 10% in 2008. The rate at which banks charge each other for overnight loans, LIBOR, has seen a similar explosion in spreads when compared to OIS or Treasuries from September 2008 until very recently. The LIBOR-OIS spread has been only a few basis points over zero. Starting at the end of 2007, these spreads have increased, spiking up to 100 b.p. in October 2007, at the onset of the subprime crisis and to 100 b.p. again in January and April 2008, after a stock market crash and the collapse of Bear Stearns respectively. After the events of September 2008, the spreads exploded to 325 basis points. These spreads have since returned much closer to normal. A related spread, the Treasury-Eurodollar (TED) spread, which measure the difference between rates on similar maturities of LIBOR and Treasuries, has returned to its historical norm of around 50 basis points from a high of over 450 basis points in October 2008.19 In a liquidity trap situation, where short term interest rates are at or near zero, the Federal Reserve has essentially no further conventional options for monetary policy. Open market operations have pushed down short term rates to a few basis points above zero and the discount rate has been lowered along with it. The Federal Reserve, recognizing this fact, has engaged in a number of unconventional policies. The first is to set up new facilities to maintain liquidity and or backstop certain sectors of the financial system that are usually outside of the Fed's normal purview. An example is the Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, which was an attempt to backstop the Money Market Mutual Fund market, which experienced a severe "non-bank bank run" following the near-failure of the Reserve Primary Fund in September 2008. When lending to banks or other financial entities, the Federal Reserve has, in the past, generally accepted collateral in the form of US Treasuries. However, these new facilities often accept essentially any AAA rated securities. In addition to these facilities, the Fed has engaged in quantitative easing, wherein it directly purchases long term securities (chiefly Mortgage Backed Securities.) The Fed does this with money created "ex-nihilo" - as it does with conventional Open Market Operations. This process theoretically allows the Fed to continue to provide liquidity to stimulate the economy even at the zero bound. The

Fed has succeeded in pushing down the average conventional 30 year fixed rate mortgage from 6.09% in November 2008, around the time when the Federal Reserve began purchasing MBSs, to 4.86% in May 2009. This has at least partially contributed to the recent improvements in economic indicators. Combined with Treasury Department programs to help homeowners refinance, this lower interest rate has certainly done some good towards stemming the tide of the economic downturn.20 The Federal Reserve now faces a challenge in the medium term, as the economy turns around and begins this expansion. Judging by leading indicators, this could begin later this year. The Fed will then have to find a way to wind down the massive amount of novel securities on its balance sheet. Some of the new facilities have "expiration dates" and should be relatively easy to wind down. On the other hand, if the market for MBSs remains soft and or frozen, the Fed may have a harder time offloading these securities. The Fed should be able to return to a more normal sized balance sheet, but it may take some time. Additionally, the Federal Reserve must remain vigilant in ensuring that the massive liquidity it is providing to the market does not result in another asset bubble, as it did after the 2001 recession.

Part VI: Days of Future Past: Fiscal Policy Response to the Great Recession.

Given that the economy very probably has entered into liquidity trap territory, discussions of government intervention have focused on fiscal policy as a means of maintaining falling aggregate demand. The liquidity trap, after all, was the situation that prevailed during much of the Great Depression, which gave rise to Keynes' General Theory, and Hicks' IS-LM model. It is unsurprising, then, that not only the United States, but also most other industrialized countries have enacted sizable fiscal stimulus packages in the wake of the current financial crisis. Simply put, since conventional monetary policy has exhausted all of its options, fiscal policy is the only game in town. This runs counter to the trends of the last 30+ years, where the primary response to recessions has been monetary

policy. We have gotten out of the habit of using fiscal policy for aggregate demand management. The United States has now engaged in two separate rounds of fiscal stimulus. In February 2008, a majority Democratic US Congress passed, and Republican president George W. Bush signed into law a stimulus package composed almost entirely of tax changes. The total cost of this stimulus package in 2008-9 is estimated by the CBO to be $168 billion, $151.7 billion in 2008 and $16.3 billion in 2009. The key provisions include a number of changes in the corporate tax code totaling $44.8 billion in 2008 and $6.2 billion in 2009, as well as income tax rebates to households totaling $105.7 billion in 2008 and $9.7 billion in 2009.21 After the election of 2008, in which Democrat Barack Obama and large Democratic majorities, in the House and Senate were elected. The first order of business was the passage of a second stimulus package, the American Recovery and Reinvestment Act (ARRA), which was enacted on February 17, 2009, almost exactly a year after the 2008 package. In contrast to the 2008 stimulus package, the ARRA consisted of both tax cuts and spending provisions, as well as aid to state and local governments. The ARRA's total cost is estimated by the CBO to be $787.242 billion over ten years. Since the 2008 stimulus package chiefly consisted of lump sum transfers to households in the form of tax rebates, its effectiveness can be determined by looking at changes in personal income over the period 2007-2009, since by 2009 almost all of the transfers have been sent out. Changes in components of personal are summarized in Figure G. The 2008 stimulus package was successful, in that it served as a backstop for personal income as the economy was beginning to deteriorate. As Figure G shows, however, 65% of the change in disposable income from the first to second quarters of 2008 was saved, while only 35% was spent on household outlays. This suggests that the stimulus package of 2008 was relatively ineffective at jump starting aggregate demand - only 35% of the increase in government deficits was re-spent. This fits well with evidence for a relatively low multiplier for tax cuts vis a vis direct government purchases. The 2009 ARRA, in contrast, should have more success at stimulating aggregate demand. First, the ARRA is simply larger than the 2008 stimulus. Second, the

ARRA contains proportionally less lower-multiplier items such as tax cuts, and proportionally more higher-multiplier items such as government purchases. A crude characterization would be that the ARRA is the bigger, better and much improved stimulus. The ARRA represents a large outlay - about 5% of one year's GDP. It will, however, take months or years for the full amount of the appropriated funds to be spent. Some measures, such as the decrease in FICA withholding, have already been implemented. Others involving, for example, infrastructure spending, will not be implemented until well into 2010. The impact of the ARRA, then, must take into account the timing of different provisions. The CBO estimates that the ARRA will increase US GDP over the no stimulus baseline estimate by between 1.4-3.8% in 2009, 1.1%-3.4% in 2010, and 0.4%-1.2% in 2011. The CBO estimates that the ARRA will decrease unemployment compared to the baseline by 0.5-1.3% in 2009, 0.6%-1.5% in 2010, and 0.3%-1.0% in 2011. The ARRA's effects will also depend on the relative effectiveness of its various components. The effectiveness of a fiscal policy proposal can be measured by the Keynesian multiplier, which gives the total change to GDP per dollar spent for a given policy. So, a multiplier of 2.5 implies that the policy would increase GDP by $2.5 for each dollar spent on the policy. Generally speaking tax rebates and tax cuts have lower multipliers than direct government purchases do. The CBO's estimate for the multiplier on direct government purchases is between 1-2.5; the estimate for transfer payments is 0.8-2.2; the estimate for tax cuts is 0.5-1.7 for lower and middle income households, 0.1-0.5 for upper income households. The ARRA is likely to have an effect closer to the high end of the CBO estimates. This due, again, to the liquidity trap. As the Federal Reserve has lowered short term rates to the zero lower bound, and moved on to quantitative monetary policy, the effectiveness of fiscal policy can be expected to increase. There is very little crowding out in a liquidity trap. The current recession has also seen a large increase in savings and a massive decrease in private borrowing. The deficit funded stimulus package can then be thought of as a way of replacing some private borrowing as well as soaking up some excess savings. If anything, the limiting factor on the ARRA's effectiveness may be its size.

While $787 billion seems like a very large price tag indeed, the CBO's models suggest that even this will not be sufficient to bridge the GDP gap.22 Beyond the short term challenge of returning the economy to a full employment level of output, policymakers in Congress and the White House face longer term challenges that, while not as immediate, are no less important. These challenges are the intertwined issues of the structural deficit in the Federal budget, demographic changes in the American population, the ballooning cost of health care, and the fiscal future of the large entitlement programs. The current deficits are in large part a result of the recession - as incomes, taxes levied on income likewise decline. At the same time, as the unemployment rate increases, demand for social services increases, resulting in more spending. However, beneath the cyclical deficit lies a structural problem - revenues are simply to small for the amount of government services provided. Substantial enough cuts to government spending to balance the budget are probably politically impossible, leaving tax increases as the only option. Likewise, reform of the health care system, and of Medicare and Medicaid, will probably require some amount of tax increases, since benefit cuts are also politically impossible. However necessary these tax increases are, they should be put off until the economy is well on its way to recovery. Imposing too much additional tax burden before the economy is back on firm ground is likely to retard or choke off eventual recovery.

Part VII: One Year Later: Outlook for the Future

Eight months after the events of September 2008, the economic outlook has decidedly improved. The spectre of an economic downturn on the magnitude of the Great Depression has diminished. As the credit crisis has calmed, the possibility of a return to normal growth has returned; the question becomes when rather than whether a recovery will begin. Even with the improvement in some important sectors (such as the recent stock market rally and smaller net job loss numbers,) the

uncertainty about the future disposition of economic activity is weighted toward the downside. Although the possibility of an experience mirroring Japan's "Lost Decade" seems much less likely now than it did last September, its probability remains non-zero. A number of private sector firms, nonprofit and government agencies have released forecasts for near term growth recently. Despite the generally favorable movement in forward looking data, these forecasts have tended to be more pessimistic than those released earlier in 2009. This change is largely due to the realization that the post-Lehman collapse was much more severe than previously thought. The economy may be reaching a trough; however, that trough is likely to be lower than earlier predictions. Figure H summarizes the projections of three recent forecasts: the outlook of the FOMC, the IMF's forecast of US growth, and the CBO's survey of private sector forecasting firms. All three predict a trough sometime towards the end of 2009, with a return to growth in 2010. However, the growth from the trough is predicted to be relatively anemic by historic standards. All three predict average growth rates in the negative through 2009, with the CBO's estimate of -3.3% to -2.3% being the most pessimistic, and the FOMC's forecast being a relatively more optimistic -2% to -1.3%. Unemployment is predicted to continue rising through 2010; again, the CBO's predictions are relatively more pessimistic compared to the FOMC's, forecasting an average rate of 9-10.4% in 2010, versus the FOMC's 9-9.5% prediction. Even after the peak, however, the forecasts agree that the labor market is likely to remain soft, with unemployment in 2011 remaining above 9.5% in the IMF forecast, and in the 7.7%-8.5% range in the FOMC forecast. It seems prudential to use the more pessimistic predictions in these forecast for policy planning purposes. Again, this is related to the fact that the uncertainty about these predictions is weighted towards the downside. As such, the relatively more pessimistic CBO numbers are likely to be closer to correct. The Conference Board's Leading Indicators Index can also be a useful guide for policy going forward. In April 2009, the LEI appears to have reached a trough, having seen two months of strong increases since. Turning points in the LEI generally precede turning points in GDP and the real

economy by around 3 months. The LEI then, suggests a business cycle trough occurring around July 2009. This is slightly earlier than the three forecasts previously mentioned. There has also been some signs of hope in the related Coincident Indicators Index, which mirrors the data series used by the NBER to date recessions. Here, two data points - employment and real sales - have begun to see slower declines. They have, in other words, positive second derivatives. This suggests that a bottom may be near. There is, however, still tremendous uncertainty in the outlook for future economic activity. The uncertainty stems from two interrelated fears - that the financial sector will remain in turmoil, and that the policy response to the crisis will be insufficient. The SCAP's overly optimistic assumptions are a strong piece of evidence that the financial sector may be far from out of the woods. Home prices have not yet reached a bottom, and foreclosures and defaults are still increasing. If banks, even with the additional capital acquired as part of SCAP, are unable to absorb additional mortgage losses, credit conditions could well begin to deteriorate again. The policy response to the crisis has been increasingly muscular, especially after September 2008, the possibility remains that even this more robust response may be insufficient to return the economy to sustained economic growth. This is especially true of fiscal policy - if consumer uncertainty continues to be high, a higher savings rate may result, which will, in turn, retard the stimulative effect of fiscal policy.

Summary & Conclusions

The current recession, despite its origins as a financial crisis concentrated in the shadow banking sector, has become the worst economic downturn since the Great Depression. While it is no longer confined to the subprime mortgage brokers (which have largely been driven out of business) and large investment banks (which have disappeared altogether,) the shadow banking sector nonetheless remains central to any recovery that will occur. More and stricter regulation is necessary to not only

prevent another crisis of this magnitude, but to contain the current damage that the shadow banking sector might still wreak on the economy. Such regulations can be seen as punitive. The rejoinder of course, is that to allow the very individuals and firms that brought the economy to its knees to escape unscathed is socially sub-optimal. The shadow banking sector has, through a combination of deliberate malfeasance, laziness and ignorance, proliferated risky derivatives (which Warren Buffet has called "Financial Weapons of Mass Destruction") throughout the economy. This imposes a large external cost (systemic risk) on the rest of society, which has not consented to take on this level of risk. There will be villains in the future narrative of the Great Recession, and these villains will be the investment bankers and derivative traders that, in pursuit of short term selfish benefit, committed negligence and malpractice.

Figure A: December 2007 Peak in select data series (generated using www.economagic.com)

Figure B: Current Recession compared to post-WWII recessions, select data series. (source: St. Louis Federal Reserve Bank, "Tracking the Global Recession: United States") Figure C

TED Spread, June 2007-June 2009 3.500%

(spread = 3 month LIBOR - 3 month T-bill, data from bloomberg.com)

3.250% 3.000% 2.750% 2.500% 2.250% 2.000% 1.750% 1.500% 1.250% 1.000% 0.750% 0.500% Jun 2007 Sep 2007 Dec 2007 Mar 2008 Jun 2008 Sep 2008 Dec 2008 Mar 2009

TED Spread (%)

Figure D: Fed Funds & Primary Credit rates (2001-present)

Figure E: Real GDP and components (annual change,) 1999-2008; quarterly change Q3 2007-present. Year 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

GDP 4.5% 3.7% 0.8% 1.6% 2.5% 3.6% 2.9% 2.8% 2.0% 1.1%

Cons. 5.1% 4.7% 2.5% 2.7% 2.8% 3.6% 3.0% 3.0% 2.8% 0.2%

Cons. (D) C (ND) 11.7% 4.6% 7.3% 3.8% 4.3% 2.0% 7.1% 2.5% 5.8% 3.2% 6.3% 3.5% 4.6% 3.4% 4.5% 3.7% 4.8% 2.5% -4.3% -0.6%

Cons. (S) 4.0% 4.5% 2.4% 1.9% 1.9% 3.2% 2.6% 2.5% 2.6% 1.5%

Inv. (BS) Inv. (BE) Inv. (Res.) Exports Imports Fed. Gov. S&L Gov. -0.4% 12.7% 6.0% 4.3% 11.5% 2.2% 4.7% 6.8% 9.4% 0.8% 8.7% 13.1% 0.9% 2.7% -2.3% -4.9% 0.4% -5.4% -2.7% 3.9% 3.2% -17.1% -6.2% 4.8% -2.3% 3.4% 7.0% 3.1% -4.1% 2.8% 8.4% 1.3% 4.1% 6.8% 0.2% 1.3% 7.4% 10.0% 9.7% 11.3% 4.2% -0.2% 1.3% 9.3% 6.3% 7.0% 5.9% 1.2% -0.1% 8.2% 7.2% -7.1% 9.1% 6.0% 2.3% 1.3% 12.7% 1.7% -17.9% 8.4% 2.2% 1.6% 2.3% 11.2% -3.0% -20.8% 6.2% -3.5% 6.0% 1.1%

Source: Bureau of Economic Analysis and Dr. David Crary, Eastern Michigan University, May 2009.

Real GDP Consumption Investment -Residential Inv. Exports Imports Government

Q3 2007 4.8% 2.0% 3.5% -20.6% 23.0% 3.0% 3.8%

Q4 2007 -0.2% 1.0% -11.9% -27.0% 4.4% -2.3% 0.8%

Q1 2008 Q2 2008 Q3 2008 Q4 2008 Q1 2009 0.9% 2.8% -0.5% -6.3% -5.7% 0.9% 1.2% -3.8% -4.3% 1.5% -5.8% -11.5% 0.4% -23.0% -49.3% -25.0% -13.3% -16.0% -22.8% -38.7% 5.1% 12.3% 3.0% -23.6% -28.7% 0.8% -7.3% -3.5% -17.5% -34.1% 1.9% 3.9% 5.8% 1.3% -3.5%

Source: Bureau of Economic Analysis

Figure F: CPI & inflation rate 2005-present

Figure G: Measures of Personal Income 2007-2009 (source: Bureau of Economic Analysis) Personal income Employee Comp. Personal transfer receipts Unemployment Benefits Other Personal current taxes Disposable personal income Personal saving Savings Rate

Personal outlays Personal saving

2007 I 11473 7734 1695.7 31.3 592.6 1459.5 10013.5 109.3 1.09%

2008 2009 I I Change 2007-2008 Change 2008-2009 11960.5 12060.6 4.25% 0.84% 8009.7 8024 3.56% 0.18% 1778.1 1988.1 4.86% 11.81% 38.2 94.6 22.04% 147.64% 611.5 659.5 3.19% 7.85% 1535 1276.7 5.17% -16.83% 10425.5 10783.9 4.11% 3.44% 20.6 475.5 -81.15% 2208.25% 0.20% 4.41%

2008 I 10404.9 20.6

2008 II change as % of DI change 10538.2 35% 267.9 65%

Figure H: Summary of near term economic forecasts (sources: IMF's World Economic Outlook, April 2009, CBO Director's Testimony before the House, 5/21/2009, Minutes of the 4/29/2009 meeting of the FOMC) Federal Reserve 2009 2010 2011 GDP growth rate -2% to -1.3% 2% to 3% 3.5% to 4.8% Unemployment 9.2% to 9.6% 9% to 9.5% 7.7% to 8.5% Core Inflation 1% to 1.5% 0.7% to 1.3% 0.8% to 1.6% CBO 2009 2010 GDP growth rate -3.3% to -2.3% 1.0% to 2.8% Unemployment 8.8% to 9.4% 9% to 10.4% IMF (est.) 2009 2010 2011 GDP growth rate -3.0% 0.0% 2.5% Unemployment 9.5% 10% 9.5% Inflation rate -1% -0.3% 1%

Figure I: The Conference Board's Leading and Coincident Indicators

Notes 1. Acharya, Viral, et al. "Prologue: A Bird's Eye View." In Restoring Financial Stability., ed. Viral Acharya, and Matthew Richardson, p. 1-3. 2. Determination of the December 2007 Peak in Economic Activity, NBER. http://www.nber.org/cycles/dec2008.html, accessed 20 June 2009. 3. Determination of the Business Cycle Peak of March 2001, NBER. http://www.nber.org/cycles/july2003.html, accessed 20 June 2009. 4. The Conference Board's Leading Economic Index For the US Improves Again. The Conference Board. http://www.conference-board.org/economics/bci/pressRelease_output.cfm?cid=1, accessed 21 June 2009. 5. Elmendorf, Douglas. "The State of the Economy," Testimony before the US House of Representatives, May 21, 2009. Congressional Budget Office, Washington, DC. 6. World Economic Outlook April 2009, International Monetary Fund. 7. Acharya, 7-11, 23-4. 8. Gramlich, Edward. Subprime Mortgages: America's Latest Boom and Bust. Urban Institute Press: Washington, DC, p. 1-12. 9. Monetary Policy Report to the Congress, Federal Reserve Board of Governors, February 24, 2009. 10. Acharya, Viral and Philipp Schnabl, "How Banks Played the Leverage Game." In Restoring Financial Stability., ed. Viral Acharya, and Matthew Richardson, p. 83-93. 11. Saunder, Anthony, et al. "Enhanced Regulation of Large, Complex Financial Institutions." In Restoring Financial Stability., ed. Viral Acharya, and Matthew Richardson, p. 139-145. 12. Jaffee, Dwight, et al. "What to Do about the Government-Sponsored Enterprises?" In Restoring Financial Stability., ed. Viral Acharya, and Matthew Richardson, p. 121-2, 128-130. 13. Acharya et al., 51-56. 14. Monetary Policy Report to the Congress. 15. Financial Regulatory Reform, A New Foundation: Rebuilding Financial Supervision and Regulation, Department of the Treasury. 16. The Supervisory Capital Assessment Program: Overview of Results, Board of Governors of the Federal Reserve System. 17. Monetary Trends, June 2009, St. Louis Federal Reserve Bank, p. 10. 18. Monetary Policy Report to the Congress. 19. Monetary Trends, p. 8. 20. Duke, Elizabeth, "Containing the Crisis and Promoting Economic Recovery," Speech given at the Women in Housing and Finance Annual Meeting, Washington, DC, June 15, 2009. 21. Congressional Budget Office, Cost Estimate of H.R. 5140, Economic Stimulus Act of 2008. 22. Elmendorf, Douglas, "Estimated Macroeconomic Impacts of the American Recovery and Reinvestment Act of 2009," Congressional Budget Office.