Introduction and Current Situation.

Hopeful Signs Seen in GDP’s Fall:

Inventories Decreased, Consumption Spending Increased.

The Fed to buy more government bonds and other debt in order to
pump credit.
Bond Prices Increases, while the yields decrease. Ten year bond up a
tenth of a percentage to 3.1% five month high.
GDP decreased, inflation adjusted, 6.1% first quarter, matched 6.3%
decline of 2008 fourth quarter. First time since 1975 a recession
contracts 3 quarters in a row.
If Inventories fall then production must increases in order to meet
demand, also consumer spending is rising a little. Ultimate demand fell
by 3.4% annual rate, economy is forecast to fall from 2%- 3.5% rate.

Why the ‘green shoots’ of recovery could yet whiter:

Barack Obama, Lawrence Summers, and Ben Bernanke all have been
saying the economy is improving when in reality it is still contracting
but at a decelerating rate.

“Consider obvious perils: given huge excess capacity, a risk of deflation

remains, with potentially dire results for overindebted borrowers; given
the rising unemployment and huge losses in wealth, indebted
households in low-saving countries may raise their savings rates to
exceptional levels; given the collapse in demand and profits, cutbacks in
investment may be exceptionally prolonged and severe; given massive
and persistent fiscal deficits and soaring debt, risk aversion may lead to
higher interest rates on government borrowing; and given the flight
from riskier borrowers, a number of emerging economies may find
themselves in a vicious downward spiral of weakening capital inflow,
falling output and reductions in the quality of assets.”

“This raises the big question: how and when might the world return to
normality, with sustainable fiscal positions, strongly positive short-term
official interest rates and solvent financial systems? That Japan has
failed to achieve this over 20 years is surely frightening.”
“Thus, neither short-term macroeconomic stimulus nor restructuring of
balance sheets of financial institutions will generate sustained and
healthy global growth.”

“he danger is that a turnround, however shallow, will convince the

world things are soon going to be the way they were before. They will
not be. It will merely show that collapse does not last for ever once
substantial stimulus is applied. The brutal truth is that the financial
system is still far from healthy, the deleveraging of the private sectors of
highly indebted countries has not begun, the needed rebalancing of
global demand has barely even started and, for all these reasons, a
return to sustained, private-sector-led growth probably remains a long
way in the future.”

“The world economy cannot go back to where it was before the crisis,
because that was demonstrably unsustainable.”

A Tale of two Depressions:

Baseline Scenario:

Recessions:

Causes of Current Recession:

a. Housing Bubble
b. Lax Monetary Policy
a. Fast and loose, Oct 18, 2007.
i. 2003: Greenspan cuts interest rates in fear of
deflation with prices falling to 1%, lowest
since 1958.
ii. Was Monetary Policy to loose?
iii. Taylor rule, what interest rates should be as
a function of economic slack and the inflation
rate.
iv. For example if economy is slacked and
inflation dips monetary policy should be
 eased. If GDP out strips long-run capacity or
inflation rises above target then you increase
interest rates above the neutral level.
v. Money and credit will given an earlier sign
of Inflation if measured with the inclusion of
asset-price inflation.
vi. By the time of the rate cuts, economy as a
whole weakened, but Housing was booming
by 10% annually. In 2005 Housing
construction accounted for 6.2% of GDP
highest since 1950.
vii. Oddly, mortgage rates started to stay low
after the central bank had officially started to
increase rates. Fed rate increased but not
the long term rate which mortgages are
dependent upon.
viii. People were confident in the Fed’s ability to
control interest rates.
ix. Savings Glut, China’s increasing savings rate,
asian economies in general. Savings must
equal investment that means advanced
countries save less relative to invesment,
and lower real interest rates.
x. As Housing prices soared, interest rates
stayed low, delinquency rates stayed low.
xi. Taylor says Fed, feed the housing bubble by
taking its eye off inflation.
xii. The article also argues for a refinement in
policy, that central banks need to pay more
attention to financial imbalances and the risk
of asset-price bubbles.
xiii. Even if inflation is low an economy can build
up financial imbalances.
xiv. The orthodox policy for central banks is to
watch out for inflationary pressures. They
should the article says lead against credit
and asset price booms that appear
unsustainable.
 b. Central Banks must target more than just
inflation, May 5, 2009:
i. Fed lost its way by keeping interest rates to
low in the early 2000s and so ignoring
Taylors rule. This caused the housing boom.
ii. The lower the interest rate gap the more
money was cheap, it induced lowered
lending standards.
iii. Central banks also argues Martin Wolf must
target credit and asset-price market
instabilities because the aftermath of a bust
is severe to the economy. But since they
didn’t pay attention to them the worries of
inflation and deflation have increased.
iv. Monetary policy was to loose, and now we
face two consequences, clearing the mess
and designing a new approach to monetary
policy.
v. Three choices: liquidation, inflation, or
growth.
1. Liquidation would proceed via mass
bankruptcy further injurying the
collapse of the credit markets.
2. Inflation would re-awaken inflation
expectations and would lead to
antoher rescession in order to re-
establish monetary stability.
3. Growth, sustain demand and return to
growth without stoking up another
credit bubble.
4. Is gold still absurd? What will future
generations decide.

c. Global Savings glut

a. Revenge of the Glut, March 2, 2009:
i. Causes of the rapid rise in the U.S trade
deficit, caused by Asia.
ii. In mid-1990’s emerging economies of Asia
had been borrowers abroad in order to
 finance their development that is until the
asian crisis of 1997-1998 and ever since then
they have been amassing a large chest of
foreign assets, in effect exporting capital to
the world.
iii. So, you have a lot of money coming in, that
means cheap money. Most of the money
went to the United States. Why? Depth of the
Financial system.
iv. Global Paradox of thrift around the world,
desired savings exceeds the amound
businesses are willing to invest, result a
global slump.
d. Failure of regulation
a. Lack of Authority
b. Failure to use authority
i.

Solutions:
c. Monetary
i. Credit and Liquidity Programs and the
Balance sheet:
1. Feds goals, stable prices, moderate
long term interest rates, and maximum
employment.
2. This website discusses conventional
fed policies and the actions they are
taking now for this current crisis. Read
over a few.

ii. Falling wage syndrome

1. Wages in America are falling. Why is
this bad. Paradox of thrift. When
everyone is selling assets and cleaning
balance sheets in order to reduce debt,
the result is a financial crisis.
 2. When you decrease wages,
unemployment increases. Why? It
may save jobs for an indivdual
employer but if everybody is doing it
then whats the point? No one has a
competitive advantage.
3. Rising burden of debt will put
downward pressure on consumer
spending.
4. Stabilizing the economy isn’t enough
we need a real recovery.
5. There is a weakening in the labor
market and unemployment will
continue to rise. The Job market will be
terrible for months or even years to
come.
6. Krugmans solution: more stimulus,
more decisive action on the banks, and
more job creation.
7. Worries of deflation, is still rising
iii. Inflation Nation: May 4, 2009
1. The feds interest rates are nearly zero,
and their increase in reservers are
surely to lead to inflation.
2. Central banks are not suppose to be
bailing out banks the treasury is
suppose to be doing this not the fed.
3. In Volckers fed, it was independent so
it could refuse to finance deficits.
4. The main engine of economic growth
is productivity.
5. If economic growth declines then it
increases the inflation rate. Prices will
inrease because of a lack of innovative
productivity.
6. Deflation or Inflation refers to the
sustained rate of change of prices, not
the price level.
 7. Meltzer argues then for independence
of the fed and the need to tackle
inflation rather than deflation.
8. The fed should look beyond the near
term and also focus on the medium
and long term consequences of their
actions. The index Meltzer uses for
inflation is the Gross Domestic
Deflator.
iv. A History Lesson for Alan Meltzer.
1. Japan had an enourmous budget
deficit, and an increase in the money
supply and it did experience deflation
rather than inflation.
Fiscal
Stimulus Plan
Financial Industry Bailouts