Why Recession?

interaction of financial market innovation, lax internal governance and external oversight, and easy
global monetary conditions.

financial market innovation:-

 Opaque
 Originate to distribute model- Loans of questionable quality had been made and then sold
 Implication- Lehman Brothers (founded in 1850) and others being allowed to go bankrupt.
 But how does a government decide whom to bail out and whom to cut loose? Geithner and
Bernanke knew they would never know the true answer. The debris from the crisis was so
widely scattered that Geithner and Bernanke could not possibly know with certainty who
was “too interconnected to fail” (i.e., whose failure would put the entire country at risk).

lax internal governance and external oversight,

 colossal lapses in firms’ internal governance mechanisms

 Regulators- how an entire shadow banking sector—the off-balance-sheet special vehicles
that were set up by traditional banks and investment banks, the enormous markets in selling
“credit protection” that ostensibly insured against your counterparties’ default, but only
until the insurer itself went bankrupt—could blossom without prompting substantial
regulatory activity.

Easy global monetary conditions

 Low interest rates- why?-

o an improved credibility of central banks and a focus on inflation targeting
o beneficial supply shocks (technological progress, globalization), which helped to shift
out long-run aggregate supply curves and made the jobs of central bankers seem
deceptively easy.

Global imbalances also kept rates low. When, for example, U.S. monetary policy was finally
tightened—recall that the Fed continually raised the policy rate from mid-2004 through 2006
(Exhibit 2)—emerging markets’ policy of managing their exchange rates by purchasing long-term
U.S. bonds kept long-term borrowing costs low (and stoked inflation locally and globally)

2008

 Slumping demand was tearing the U.S. auto industry apart.(sales down 30-45%).
Consumption spending, not just on cars, but on just about everything, had been falling
sharply. GM received a $13.4 billion emergency bridge loan from the U.S. Treasury in
December and was fighting to avoid bankruptcy protection. Chrysler, which received $4
billion in federal funding, was considering an equity carve-up that would help avoid
bankruptcy but leave the existing equity owners (Cerberus and Daimler) with less than 10%
of the company.
 home prices were falling sharply. Permits for new home construction—a leading indicator of
economic activity, in part because new homes typically generate much additional
spending—were always cyclical, but these days, they were plummeting
 The federal budget was under strain (Exhibit 1). budget deficit for 2008 was a record $455
billion. Expected to Increase to 750-1000 Bn in 2009.
 Credit markets essentially seized up. TED spread, (gap between three-month LIBOR and the
threemonth U.S. Treasury bill rate), was thought to reflect a risk or liquidity premium. As
Exhibit 5 shows, it had reached extremely high levels. Another measure, the Baa–Aaa
spread, represented the difficulty most firms would have in getting loans compared with
those firms who had the best credit quality (i.e., who had Aaa credit ratings). It had reached
levels not seen since the Great Depression. With credits markets not functioning,
investment was falling sharply, as firms could not borrow to fund new projects
 The risk aversion that pushed the TED and Baa–Aaa spreads to high levels also played out
internationally, with money from all over the world flowing into short-term U.S. debt
instruments, such as money markets and Treasury bills
 The Fed’s attempts to offset the massive increase in money demand associated with the
flight from risky assets by increasing the size of its balance sheet had been thwarted by a
plummeting of the money multiplier.( The money multiplier is the amount of money that
banks generate with each dollar of reserves. )

What to do

Geithner and Bernanke did not know the best way forward. No one did. Each potential path was
fraught with pitfalls, moral hazard, and the potential wasting of the public’s money. But neither
considered doing nothing to be a viable option, and new policies were almost continuously being
proposed and implemented.

Fiscal Policy

Substantial fiscal stimulus- what form

 Tax cuts vs new spending debate- The Economist reported various estimates of
spending multipliers . Direct federal spending and federal funding of state and local
infrastructure had the highest (estimated) multiplier effects at anywhere from 1.0 to 2.5.
Individual tax cuts had lower estimated effects (0.5 to 1.7).
 Eventually, on February 17, 2009, Obama signed a stimulus package that totaled $787
billion:
o about one-third tax cuts and one-third aid (for states, the unemployed, and for
access to health care).
o Of the rest, labor, health, and education got 8%,
o infrastructure about 7%, and some was earmarked for energy and water.
o $3.2 billion tax credit for GM, $1.3 billion to “invest in air transportation,” and
$2.3 billion to improve Department of Defense facilities related to the quality of
life
 As per Harvard economist Obama admin hoped multiplier associated with this package
would be greater than one (a multiplier of one would imply that when increasing
spending, the government was not crowding out private investment but was only using
slack resources—unemployed labor and capital), he anticipated the multiplier was more
likely to be far less than one and that any increase in government spending would be at
least partially offset by some reduction in private spending.
 Treasury policy: TARP
 700 billion “bazooka” to bail out the U.S. financial sector
 Original idea dropped - use public money to troubled assets - to free banks and
other financial firms of the most toxic loans and securities on their books by
purchasing them in auctions
 Rather used TARP funds to recapitalize banks and nonbank financial institutions. By
the end of 2008, the government had committed $244 billion of public money not
to troubled assets, but to troubled financial institutions. This included $40 billion to
buy shares in AIG, the single largest injection of capital ever by a government, and
$125 billion to banks such as Citigroup, Wells Fargo, and JPMorgan Chase.
 On February 10, 2009, Geithner announced the revamped TARP- Nagative
o Rejected idea of govt run bad bank
 put off by the high upfront cost and the problems it would have
valuing the debt
 drawing in investors, such as private-equity groups, whose inclusion
would stretch the government’s money further and bring more
discipline to pricing.. targeting $1 trillion
 but huge gap to bridge between banks, which do not want to sell at
depressed prices because of losses they would have to recognize,
and potential buyers, who need to be sure of healthy returns
 Barclays Capital counts $2 trillion–3 trillion of troubled assets in America, excluding
prime mortgages, which are souring fast--. Goldman reportedly estimated that the
United States had troubled assets that amounted to about 40% of GDP—problem
was who would invest so much money.
 Fiscal cost of bail outs- HUGE

FED

nonstandard, uncommon, aggressive, scary—

that there were other nonstandard tools that were permissible by the Federal Reserve Act’s
Section 13(3).1 In addition to the traditional tools, the Fed had employed three other types of tools
to improve the functioning of credit markets.

 Short-term liquidity facilities for U.S. banks and currency swap facilities for foreign central
banks.

 Facilities for commercial paper market, money market mutual funds, and ABS market.
 purchase of longer-term securities for the Fed’s portfolio.

1
Section 13(3) of the Federal Reserve Act permits the board, in unusual and exigent circumstances, to
authorize Federal Reserve banks to extend credit to individuals, partnerships, and corporations that are unable to
obtain adequate credit accommodations.