Jeffrey FrankelJeffrey FrankelHarpel Professor of Capital Formation & GrowthHarpel Professor of Capital Formation & Growth

Economic Crisis & Economic Crisis & RecoveryRecovery

Senior Executive FellowsSenior Executive FellowsMay 3, 2010May 3, 2010

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• The US recession• Forecasts

• Origins of the financial crisis

• Policy response: • How did we avoid a Great Depression?

• Intellectual implications of the crisis

• for the field of economics

• Appendices• The global economy• The problem of global imbalances• The G-20 in 2010

Topics

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The US RecessionThe US Recession

The US recession started in Dec. 2007 The US recession started in Dec. 2007 according according to the NBER Business Cycle Dating to the NBER Business Cycle Dating Committee.Committee.

In May 2009, the recession’s length passed In May 2009, the recession’s length passed thethe postwar records postwar records -- 1973-75 & 1981-82-- 1973-75 & 1981-82 = 16 months= 16 months One has to go back to 1929-33 for a longer One has to go back to 1929-33 for a longer

downturn.downturn.

Also the most severe, by most measures: Also the most severe, by most measures: rise in unemployment rate, job loss, output loss….rise in unemployment rate, job loss, output loss….

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BUSINESS CYCLE REFERENCE DATESBUSINESS CYCLE REFERENCE DATES   Source: NBERSource: NBER

PeakPeak TroughTrough ContractioContractionn

Quarterly dates are in parenthesesQuarterly dates are in parentheses Peak to TroughPeak to Trough

August 1929 (III)August 1929 (III)May 1937 (II)May 1937 (II)February 1945 (I)February 1945 (I)November 1948 (IV)November 1948 (IV)July 1953 (II)July 1953 (II)August 1957 (III)August 1957 (III)April 1960 (II)April 1960 (II)December 1969 (IV)December 1969 (IV)November 1973 (IV)November 1973 (IV)January 1980 (I)January 1980 (I)July 1981 (III)July 1981 (III)July 1990 (III)July 1990 (III)March 2001 (I)March 2001 (I)December 2007 (IV) December 2007 (IV)

March 1933 (I)March 1933 (I)June 1938 (II)June 1938 (II)October 1945 (IV)October 1945 (IV)October 1949 (IV)October 1949 (IV)May 1954 (II)May 1954 (II)April 1958 (II)April 1958 (II)February 1961 (I)February 1961 (I)November 1970 (IV)November 1970 (IV)March 1975 (I)March 1975 (I)July 1980 (III)July 1980 (III)November 1982 (IV)November 1982 (IV)March 1991 (I)March 1991 (I)November 20011 (IV)November 20011 (IV)

43 months43 months13138811111010881010111116166616168888

Average, all cycles:Average, all cycles: 1854-2001 (32 cycles) 1854-2001 (32 cycles)

1945-2001 (10 cycles)1945-2001 (10 cycles)

  

1717

1010

June 2009 (II) or later > 18 months[not yet declared]

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US employment peaked in Dec. 2007,which is one reason why

the NBER BCDC dated the peak from that month.

8 million jobs were lost over the next two years.

Payroll employment series Source: Bureau of Labor Statistics

Payroll employment series Source: Bureau of Labor Statistics, April 2010

Jobs peak

Jobstrough

US employment fell fully in proportion to GDP,unlike the “labor hoarding” pattern of the past.

In Germany, by contrast, the recession has shown up only in GDP,

not at all in employment.

Until the end of

2009, the US

recoverydepended

on inventori

es and did not show up

in employm

ent.

Source: IMF WEO, April 2010

The 2007-09, recession

was unusualin the size of

job loss, and in

financial markets’ liquidity crisis.

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Most indicators began to Most indicators began to improve improve

in mid or late 2009in mid or late 2009 Interbank spreads Interbank spreads

Output Output

Stock marketStock market

Consumer confidence & spendingConsumer confidence & spending

Even housing measures have bottomed out.Even housing measures have bottomed out.

The labor market has been terrible.The labor market has been terrible. But even it has responded with lags no worse than usual.But even it has responded with lags no worse than usual.

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OECD Econ.Outlook, April 2010 Evidence that the banking sector

returned to normal by late 2009.

Start of US sub-prime mortgage

crisis

Lehmanfailure

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OECD Economic Outlook, April 2010 Evidence that the banking sector

returned to normal in late 2009.

%%

Corporate bond rates have come back down too.

OECD Economic Outlook, April 2010

Now < interest rates in the (mild) 2001 recession.

Source:Jeff Frankel’s blog,

Nov. 2009

But the usual cyclical pattern of recoverybegan in 2009, Q II:

1. Leading indicators come first.

2. Output indicators come next.

3. Labor market indicators come last.

The economic roller coaster went into free-fallin the 3rd quarter of 2008.

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Employment Lags Behind GDPEmployment Lags Behind GDPAlthough U.S. job loss has been especially Although U.S. job loss has been especially

badbadin this recession,in this recession, the recovery lag behind GDP has the recovery lag behind GDP has

not been unusual.not been unusual.

Recession ofMar. 2001 – Nov.

2001

Recession of

Dec. 2007 – ?

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Total hours worked in the US Total hours worked in the US economyeconomy

(an indicator that does not lag as far behind as (an indicator that does not lag as far behind as unemployment)unemployment)

began to turn upward in began to turn upward in October 2009October 2009

Source: New series from BLS covering the entire private economy. 4/8/2010

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Danger of a W-shaped Danger of a W-shaped recession?recession?

Demand growth in the 2Demand growth in the 2ndnd half of 2009 half of 2009came in large part from:came in large part from: fiscal stimulus, &fiscal stimulus, & ending of firms’ inventory disinvestment.ending of firms’ inventory disinvestment.

Both sources of stimulus are running down in 2010.Both sources of stimulus are running down in 2010. Fortunately it looks like consumption & investment may be Fortunately it looks like consumption & investment may be

catching fire:catching fire: Friday’s GDP report from BEA Friday’s GDP report from BEA (4/30/10).(4/30/10).

QIII-QI: 2.2% 5.6% 3.2QIII-QI: 2.2% 5.6% 3.2 .% , now led by consumption. .% , now led by consumption.

There could always be new shocks:There could always be new shocks: An Iceland or Dubai or GreeceAn Iceland or Dubai or Greece Hard landing for the $Hard landing for the $ Geopolitical/oil shock…Geopolitical/oil shock…

I now put the I now put the odds of a double dip recessionodds of a double dip recession as as rather small,rather small, but but big enoughbig enough to have persuaded the NBER BCDC in our April 8 to have persuaded the NBER BCDC in our April 8

meeting meeting to wait longer before declaring the 2009 trough.to wait longer before declaring the 2009 trough.

Four leading private forecasts of growth in 2010

Mussa, PIIE, April

Economist

average,

March

Consensus

average,

March

Blue Chip average,

March

U.S.

4.0 3.1 3.1 3.1

Japan 2.7 1.7 1.5 1.8Euro area

2.0 1.2 1.1 1.3

UK 2.0 1.3 1.4 1.2

Source: Michael Mussa, Global Economic Prospects for 2010 and 2011, PIIE, April 8, 2010.

International Monetary Fund | April 14, 2010Table 1.1. World Economic Outlook (%)

Year over Year Q4 over Q4 (2010-2011 are projections)

2008 2009 2010 2011 2009 2010 2011

World Output 3.0 –0.6 4.2 4.3 1.7 3.9 4.5

Advanced Economies 0.5 –3.2 2.3 2.4 –0.5 2.2 2.5

Japan –1.2 –5.2 1.9 2.0 –1.4 1.6 2.3United States 0.4 –2.4 3.1 2.6 0.1 2.8 2.4Euro Area 0.6 –4.1 1.0 1.5 –2.2 1.2 1.8Newly Industrialized Asian Economies 1.8 –0.9 5.2 4.9 6.1 3.4 5.9

Emerging & Devel- 6.1 2.4 6.3 6.5 5.2 6.3 7.3oping Economies

Central & E.Europe 3.0 –3.7 2.8 3.4 1.9 1.3 4.1Russia 5.6 –7.9 4.0 3.3 –3.8 1.7 4.2

Developing Asia 7.9 6.6 8.7 8.7 8.6 8.9 9.1China 9.6 8.7 10.0 9.9 10.7 9.4 10.1India 7.3 5.7 8.8 8.4 6.0 10.9 8.2ASEAN-5 4.7 1.7 5.4 5.6 5.0 4.2 6.2

Middle East & N.Africa 5.1 2.4 4.5 4.8 . . . . . . . . .Sub-Saharan Africa 5.5 2.1 4.7 5.9 . . . . . . . . .

Western Hemisphere 4.3 –1.8 4.0 4.0 . . . . . . . . .Brazil 5.1 –0.2 5.5 4.1 4.3 4.2 4.2Mexico 1.5 –6.5 4.2 4.5 –2.4 2.3 5.5

Year over Year Q4 over Q4 (2010-2011 are projections)

2008 2009 2010 2011 2009 2010 2011

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Soon we must return toward fiscal Soon we must return toward fiscal discipline.discipline.

The only way to do this is The only way to do this is both both reduce spending reduce spending & raise tax revenue, as we did in the 1990s.& raise tax revenue, as we did in the 1990s.

Tax revenueTax revenue Let President Bush’s tax cuts for the rich expire in 2011.Let President Bush’s tax cuts for the rich expire in 2011. Phase in carbon tax or auctioning tradable emission permitsPhase in carbon tax or auctioning tradable emission permits Or introduce a Value Added TaxOr introduce a Value Added Tax Curtail expensive and distorting tax expendituresCurtail expensive and distorting tax expenditures

E.g., Tax-deductibility of mortgage interestE.g., Tax-deductibility of mortgage interest

All politically All politically veryvery difficult, needless to say. difficult, needless to say.

Any solution requires:Any solution requires: Honest budgeting Honest budgeting (i.e., war in Iraq goes on-budget)(i.e., war in Iraq goes on-budget) PAYGOPAYGO Wise up to politicians who claim they want to do it Wise up to politicians who claim they want to do it

entirely on the spending side & but who raise spending entirely on the spending side & but who raise spending when they get the chance.when they get the chance.

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SpendingSpending Cuts in farm subsidies for agribusiness & farmers Cuts in farm subsidies for agribusiness & farmers Cut unwanted weapons systems Cut unwanted weapons systems (a rare success: the F22 (a rare success: the F22

fighter)fighter) Cut manned space program…Cut manned space program…

Social securitySocial security Raise retirement age – just a littleRaise retirement age – just a little Progressively index future benefit growth to inflationProgressively index future benefit growth to inflation If necessary, raise the cap on social security taxes.If necessary, raise the cap on social security taxes.

Health careHealth care Encourage hospitals to standardize around best-practice Encourage hospitals to standardize around best-practice

medicine medicine to pursue the checklist that minimizes patient infections and to pursue the checklist that minimizes patient infections and to avoid unnecessary medical tests & procedures.to avoid unnecessary medical tests & procedures. Lever: making Medicare payments conditional on these best Lever: making Medicare payments conditional on these best

practices .practices . Curtail corporate tax-deductibility of health insurance, Curtail corporate tax-deductibility of health insurance,

especially gold-plated.especially gold-plated.

When will US adopt the tough measures to get back to fiscal

sustainability?

Ideally, we would now adopt measures that would begin to go into effect in 2011-12 and over the coming decades – repeating the 1990s success.

That is unlikely politically, partisan gridlock.

Hopefully, then, after the 2012 presidential elections.

Otherwise, in response to future crises, when it will be much more painful !

More on the crisis of 2007-2009

1. Six root causes of the financial crisis

2. Policy response: How did we avoid a Great Depression?

3. Implications for the field of economics

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Six root causes of the Six root causes of the financial crisisfinancial crisis

1. US1. US corporate governance falls shortcorporate governance falls short E.g., rating agencies; E.g., rating agencies; executive compensationexecutive compensation … …

options; options; golden parachutes…golden parachutes…

2. US households save too little,2. US households save too little, borrow too much.borrow too much.

3.3. Politicians slant excessively Politicians slant excessively toward toward homeowner debt:homeowner debt:

Tax-deductible mortgage interest; Tax-deductible mortgage interest; FFannieannieMMae & Freddie Macae & Freddie Mac; ; Allowing teasers, no-equity, Allowing teasers, no-equity, NINJANINJA loans, liar loans, liar

loans… loans…

MSN Money & Forbes

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Six root causes of financial crisis,Six root causes of financial crisis, cont.cont.

4. The 4. The federal budgetfederal budget has been on a reckless path since 2001,has been on a reckless path since 2001,

reminiscent of 1981-1990reminiscent of 1981-1990

5. Monetary policy 5. Monetary policy was too loose during was too loose during 2004-05,2004-05,

accommodating fiscal expansion,accommodating fiscal expansion, reminiscent of the Vietnam era.reminiscent of the Vietnam era.

6. Financial market participants 6. Financial market participants grossly grossly underpriced risk underpriced risk 2005-07.2005-07. Ignoring possible shocks such as: Ignoring possible shocks such as:

housing crash, housing crash, $ crash, $ crash, oil prices, oil prices, geopolitics….geopolitics….

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US real interest rate < 0, US real interest rate < 0, 2003-04 2003-04

Real interest Real interest rates <0 rates <0

Source: Benn Steil, CFR, March 2009

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In 2003-07, market-perceived volatility, as measured by options (VIX), plummeted.So did spreads on US junk & emerging market bonds.In 2008, it all reversed.

Source: “The EMBI in the Global Village,” Javier Gomez May 18, 2008 juanpablofernandez.wordpress.com/2008/05/

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Monetary policy easy

2004-05

Federal budget deficits

Underestimated

risk in financial mkts

Failures of corporate

governance

Households saving too little, borrowing too

much

Excessive leverage in financial institutions

Stockmarketbubble

Housing

bubble

Stock marketcrash

HousingcrashFinancial

crisis2007-08

China’s growth

Low national saving

Lower long-term

econ.growth

Eventual loss of US hegemony

Recession2008-09

Oil price spike2007-08

Gulfinsta-bility

Foreign debt

Origins of the financial/economic Origins of the financial/economic crisescrises

Excessive complexity

CDSsMBSs

CDOs

Predatory lending

Homeownership bias

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They did. Indices peaked in late 2006, They did. Indices peaked in late 2006, and fell 1/3.and fell 1/3.

The “black swan”: The “black swan”: investors thought housing prices could investors thought housing prices could

never go down. never go down.

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Financial meltdown:Financial meltdown: bank spreads bank spreads rose sharplyrose sharply

when sub-prime mortgage crisis hit (Aug. 2007) when sub-prime mortgage crisis hit (Aug. 2007) and up again when Lehman crisis hit (Sept. 2008).and up again when Lehman crisis hit (Sept. 2008).

Source: OECD Economic Outlook

(Nov. 2008).

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My favorite monthly indicator:My favorite monthly indicator:total hours worked in the total hours worked in the

economyeconomy

It confirms: US recession began Dec. 07, turned severe in Sept. 08, when the worst of the financial crisis hit (Lehman bankruptcy…)

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National income has been more National income has been more reliable than GDP, reliable than GDP,

even though they are supposed to measure even though they are supposed to measure the same thingthe same thing..

Recession of July 1990 –

March 91

Recession ofMar. 2001 – Nov.

2001

Recession of

Dec. 2007 – ?

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2: Policy Response -- How did we avoid

another Great Depression?

We learned We learned important lessons important lessons from the 1930s from the 1930s and, for the most and, for the most part, didn’t repeat part, didn’t repeat the mistakes we the mistakes we made then.made then.

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We learnt from the mistakes of the We learnt from the mistakes of the 1930s.1930s.

Monetary response:Monetary response: good this time good this time

Fiscal response:Fiscal response: relatively good, relatively good, but but : : constrained by inherited debtconstrained by inherited debt and congressional politics. and congressional politics.

Trade policy:Trade policy: Some slippage, e.g., Chinese tires.Some slippage, e.g., Chinese tires. But we did not repeat 1981 auto quotas or 2001 steel But we did not repeat 1981 auto quotas or 2001 steel

tariffstariffs let alone Smoot-Hawley !let alone Smoot-Hawley !

Financial regulation?Financial regulation?

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U.S. Policy U.S. Policy ResponsesResponses

MonetaryMonetary easingeasing was was unprecedented, unprecedented, appropriately avoiding the mistake of appropriately avoiding the mistake of 1930s. 1930s. (graph)(graph)

Policy interest rates ≈ 0.Policy interest rates ≈ 0.

The famous liquidity trip is not mythical after all.The famous liquidity trip is not mythical after all. Lending, even inter-bank, built in big spreads. Lending, even inter-bank, built in big spreads.

Then we had aggressive quantitative easing: Then we had aggressive quantitative easing: the Fed purchased assets not previously dreamt the Fed purchased assets not previously dreamt

of.of.

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The Fed certainly did The Fed certainly did not not repeated repeated the mistake of 1930s: letting the the mistake of 1930s: letting the

money supply fall.money supply fall.

SourcSource: e:

IMF, IMF, WEOWEO, , April April 20092009Box Box 3.13.1

1930s

2008-09

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Federal Reserve AssetsFederal Reserve Assets ($ billions)($ billions)

have more-than-doubledhave more-than-doubled, , through new facilities, rather than through new facilities, rather than

conventional T bill purchasesconventional T bill purchases

Source: Federal Reserve H.4.1 report

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Policy Responses,Policy Responses, continuedcontinued

succeeded in getting the financial system succeeded in getting the financial system going again,going again, thereby precluding a new Great Depression,thereby precluding a new Great Depression, yet without “nationalization” of the banks.yet without “nationalization” of the banks.

Contrary to almost all commentary at the Contrary to almost all commentary at the time of TARP:time of TARP: The conditions imposed on banks The conditions imposed on banks

were enough to make them balk at keeping the were enough to make them balk at keeping the funds.funds.

The banks have now paid back the taxpayer at a The banks have now paid back the taxpayer at a profit.profit.

Geithner’s stress tests fulfilled their function of Geithner’s stress tests fulfilled their function of telling strong banks from weak.telling strong banks from weak.

The policy of The policy of “financial repair”“financial repair”

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Next up in US: Financial reform. Next up in US: Financial reform. What is needed? What is needed?

LendingLending MortgagesMortgages

Consumer protection, including standards for mortgage brokersConsumer protection, including standards for mortgage brokers Fix “originate Fix “originate to to distribute” model, so lenders stay on distribute” model, so lenders stay on the the hook.hook. Remove pro-housing bias in policy. Remove pro-housing bias in policy. (But politicians remain (But politicians remain

unanimously pro.)unanimously pro.)

Banks: Banks: Regulators shouldn’t let banks use their own risk modelsRegulators shouldn’t let banks use their own risk models;; should make capital requirements higher & less pro-cyclical .should make capital requirements higher & less pro-cyclical . Is “too big to fail” inevitable? Is “too big to fail” inevitable? (The worst is to say “no” and (The worst is to say “no” and

then do “yes.”)then do “yes.”)

Extend bank-like regulation to “Extend bank-like regulation to “near banksnear banks.”.” Regulators need resolution authority.Regulators need resolution authority. Segmentation of function: Segmentation of function:

Volcker rule ?Volcker rule ? or all the way back to Glass-Steagall or breaking up large banks?or all the way back to Glass-Steagall or breaking up large banks? (I (I

don’t think so.)don’t think so.)

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Financial reformsFinancial reforms continuedcontinued

Executive compensationExecutive compensation Compensation committee not under CEO. Compensation committee not under CEO.

Maybe need Chairman of Board.Maybe need Chairman of Board. Discourage golden parachutes & options, Discourage golden parachutes & options,

unless truly tied to performance.unless truly tied to performance.

SecuritiesSecurities Regulatory agencies:Regulatory agencies: less decentalization of less decentalization of

authorityauthority?? Regulate Regulate derivativesderivatives: :

Create a central clearing house for Create a central clearing house for CDSsCDSs . . Credit ratings: Credit ratings:

Reduce reliance on ratings: AAA does not mean no Reduce reliance on ratings: AAA does not mean no risk.risk.

Reduce ratings agencies’ conflicts of interest.Reduce ratings agencies’ conflicts of interest.

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Policy Responses,Policy Responses, continuedcontinued

$787 b $787 b fiscal stimulus fiscal stimulus passed passed Feb. 2009.Feb. 2009. Good old-fashioned Keynesian stimulusGood old-fashioned Keynesian stimulus

Even the principle that spending provides more Even the principle that spending provides more stimulus than tax cuts has returned;stimulus than tax cuts has returned;

not just from Larry Summers, e.g., not just from Larry Summers, e.g., but also from Martin Feldstein.but also from Martin Feldstein.

Is $800 billion too small? Too large?Is $800 billion too small? Too large? Yes: Too small to knock out recession ;Yes: Too small to knock out recession ; too large to reassure global investors re US too large to reassure global investors re US

debt.debt. Also Congress was not willing to vote for more, Also Congress was not willing to vote for more,

especially on the spending side.especially on the spending side.

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Bottom line of Bottom line of macroeconomic policy macroeconomic policy

response:response: The monetary and fiscal response wasThe monetary and fiscal response was

sufficient to halt the economic free-fall.sufficient to halt the economic free-fall. It won’t be enough to return us rapidly It won’t be enough to return us rapidly

to full employment and potential output.to full employment and potential output. Given the path of debt that was Given the path of debt that was

inherited in 2009, it is unlikely that inherited in 2009, it is unlikely that more could be done.more could be done. Chinese officials already questioning our Chinese officials already questioning our

creditworthinesscreditworthiness Questions asked about US AAA ratingQuestions asked about US AAA rating Risk of hard landing for the $Risk of hard landing for the $

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3: Intellectual 3: Intellectual implications of the implications of the crisis for economicscrisis for economics

The return of KeynesThe return of Keynes And 4 others who mainstream theory had forgotten.And 4 others who mainstream theory had forgotten.

The implications for Inflation TargetingThe implications for Inflation Targeting

8 economists who got parts right8 economists who got parts right

In what direction should macro theory now In what direction should macro theory now move?move? The phyloxera analogy: The phyloxera analogy:

reimporting models from emerging markets.reimporting models from emerging markets.

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The return of KeynesThe return of Keynes

Keynesian truths abound todayKeynesian truths abound today:: Origins of the crisisOrigins of the crisis The Liquidity TrapThe Liquidity Trap Fiscal response; spending vs. tax cutsFiscal response; spending vs. tax cuts Motivation for macroeconomic Motivation for macroeconomic

intervention:intervention:to save market microeconomicsto save market microeconomics

International transmissionInternational transmission Need for coordinated expansion (now the Need for coordinated expansion (now the

G20)G20)

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Motivation for macroeconomic Motivation for macroeconomic interventionintervention

The view that Keynes stood for The view that Keynes stood for big government is not really right.big government is not really right. He wanted to save market microeconomics from He wanted to save market microeconomics from

central planning, which had allure in the 30s & central planning, which had allure in the 30s & 40s,40s,

by using macroeconomic demand to return to by using macroeconomic demand to return to equilibrium.equilibrium.

Some on the Left reacted to the 2008 crisis Some on the Left reacted to the 2008 crisis & election by hoping for fundamental & election by hoping for fundamental overhaul of the economic system.overhaul of the economic system. But the policy that prevails today is the same.But the policy that prevails today is the same.

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The origin of the crisis was an asset bubble The origin of the crisis was an asset bubble collapse, loss of confidence, credit crunch….collapse, loss of confidence, credit crunch….

like Keynes’ animal spirits or beauty contestlike Keynes’ animal spirits or beauty contest . . Add in von Hayek’s credit cycle, Add in von Hayek’s credit cycle, KindlebergerKindleberger78 78 ’s “manias & panics”’s “manias & panics” the “Minsky moment,” the “Minsky moment,” & Fisher’s “debt deflation.”& Fisher’s “debt deflation.”

The origin this time was The origin this time was notnot a monetary a monetary contraction contraction in response to inflationin response to inflation as were 1980-82 or 1991.as were 1980-82 or 1991.

But, rather, a credit cycle: But, rather, a credit cycle: 2003-04 monetary expansion showed up only in 2003-04 monetary expansion showed up only in asset prices. asset prices.

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Who got pieces of it right, Who got pieces of it right, beforehand?beforehand?

Krugman: If a Depression can happen in Japan, Krugman: If a Depression can happen in Japan, it can happen in any modern economy. it can happen in any modern economy.

Rajan: Failures of corporate governance.Rajan: Failures of corporate governance. BIS (Borio & White): Too-easy credit, via asset BIS (Borio & White): Too-easy credit, via asset

prices, prices, leads to crises -- with no inflation in between.leads to crises -- with no inflation in between.

Shiller: US housing price bubble.Shiller: US housing price bubble. Gramlich: Homeowners are being Gramlich: Homeowners are being

sold mortgages that they can’t repay.sold mortgages that they can’t repay. Rogoff: “This Time Is Rogoff: “This Time Is NotNot Different.” Different.” Roubini: The recession will be severe.Roubini: The recession will be severe.

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Appendix:Appendix:“Where should mainstream “Where should mainstream

macro go,macro go, inin lightlight ofof thethe 2007-09 2007-09

globalglobal financialfinancial crisiscrisis?”?” Some models that had been thriving in an emerging Some models that had been thriving in an emerging

markets context may now help answer this question.markets context may now help answer this question.

Some were applications of models originally Some were applications of models originally designed for advanced-country financial markets, designed for advanced-country financial markets, but never fully incorporated into the mainstream but never fully incorporated into the mainstream macro core.macro core.

A possible explanation why they had been A possible explanation why they had been transplanted to emerging markets: transplanted to emerging markets: assumptions of imperfections in financial markets assumptions of imperfections in financial markets were considered more acceptable there, were considered more acceptable there, than in the context of advanced economies.than in the context of advanced economies.

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Financial crises: Financial crises: Not just for emerging markets Not just for emerging markets

anymore.anymore.

An analogyAn analogy In the latter part of the 19th century most of the In the latter part of the 19th century most of the

vineyards of France were destroyed by vineyards of France were destroyed by Phylloxera.Phylloxera.

Eventually a desperate last resort was tried: Eventually a desperate last resort was tried: grafting susceptible European vines grafting susceptible European vines onto resistant American root stock. onto resistant American root stock.

Purist French vintners initially disdained Purist French vintners initially disdained what the considered compromising what the considered compromising the refined tastes of their grape varieties.the refined tastes of their grape varieties.

But it saved the European vineyards, But it saved the European vineyards, and did not impair the quality of the wine. and did not impair the quality of the wine.

The New World had come to the rescue of the The New World had come to the rescue of the Old.Old.

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Implications of the 2008 Implications of the 2008 financial crisis for financial crisis for macroeconomics?macroeconomics?

In 2007-08, the global financial system was In 2007-08, the global financial system was grievously infected by “toxic assets” originating in grievously infected by “toxic assets” originating in the United States.the United States.

Many ask what fundamental rethinking is necessary Many ask what fundamental rethinking is necessary to save orthodox macroeconomic theory. to save orthodox macroeconomic theory.

Some answers may lie with models that have been Some answers may lie with models that have been applied to the realities of emerging markets. applied to the realities of emerging markets.

Purists may be reluctant to seek help from this Purists may be reluctant to seek help from this direction.direction.

But they should not fear that the hardy root stock of But they should not fear that the hardy root stock of emerging market models is incompatible with fine emerging market models is incompatible with fine taste.taste.

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What are some of these What are some of these models?models?

Asymmetric information Asymmetric information (Akerlof…)(Akerlof…) Credit rationing (Stiglitz…)Credit rationing (Stiglitz…) Need for collateral (Kiyotaki & Moore, Caballero…)Need for collateral (Kiyotaki & Moore, Caballero…) Leverage cycle (Geanakoplos)Leverage cycle (Geanakoplos)

The credit channel The credit channel (Bernanke & Gertler… )(Bernanke & Gertler… )

Speculative attacks Speculative attacks (Krugman) (Krugman) Bank runs Bank runs (Diamond & Dybvyg)(Diamond & Dybvyg) Multiple equilibria (Multiple equilibria (Obstfeld; Morris & Shin; …)Obstfeld; Morris & Shin; …) Balance sheet effects & sudden stops Balance sheet effects & sudden stops (Calvo, Velasco…)(Calvo, Velasco…) Moral hazard & incentive incompatibility Moral hazard & incentive incompatibility (Dooley…)(Dooley…)

Behavioural economicsBehavioural economics (Thaler..) (Thaler..)