2012.04.02 - Lessons from the Financial Crisis for Teaching Economics

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L f h Fi i l C i i fLessons from the Financial Crisis for 
Teaching Economicsg
John B TaylorJohn B. Taylor
Stanford University
June 2, 2011
National Conference on Teaching Economics 
and Research in Economic Education 
OutlineOutline
• Narrative of the Financial Crisis
– Informs one’s views about lessons for teaching
• Alternative Narratives
N t i i l i t di– Not surprisingly, economists disagree
• Implications for Teaching
– Examples will be presented throughout talk based on– Examples will be presented throughout talk based on 
experience
– Graduate (1st year Ph.D. course at Stanford)
– Undergraduate (Economics 1 at Stanford)
– Textbook (Principles Book with Weerapana)
Narrative
E i li d i t d f b i i• Economic policy deviated from basic economic 
principles which had worked well
• Result? A great recession a financial panic and a• Result?  A great recession, a financial panic, and a 
very weak, nearly nonexistent, recovery.
• The deviations began with policies such asThe deviations began with policies such as 
– a monetary policy with interest rates too low for too long
– a regulatory policy which failed to enforce existing rulesg y p y g
• The deviations from sound principles continued 
when government responded with an ad hoc bailout 
process and temporary stimulus programs 
• The good news: economic growth and stability can 
be restored by adopting policies consistent with 
basic economic principles. 
An illustration that basic principles work well, when followed
15
20
Percent
Great Moderation
period
10
15 period 
0
5
-5
0
G t R i
-15
-10
Great Recession
(End of Great Moderation?)
50 55 60 65 70 75 80 85 90 95 00 05 10
Growth Rate of Real GDP
Illustrative monetary policy chart from San 
Francisco Fed,  March 1995, Judd and Trehan
1965‐79
1987‐92
1993‐94
Illustrative monetary policy chart from St Louis Fed
February 2007, Bill Poole  y
Policy Deviations Leading up to the 
d h llCrisis and the Panic in Fall 2008 
• Interest rates too low for too longg
• Discretionary fiscal stimulus of Feb ‘08 ($152B)
• On‐again off‐again bailouts financed by centralOn‐again, off‐again bailouts financed by central 
bank’s balance sheet
– on for BSC creditors’ bailout off for Lehman creditors’on for BSC creditors  bailout, off for Lehman creditors  
bailout, on for AIG creditors’ bailout, off for TARP role out
• Government regulators and supervisors deviatedGovernment regulators and supervisors deviated 
from sound regulatory rules, especially at large 
banks
Illustrative monetary policy chart from St Louis Fed
February 2007, Bill Poole  y
Illustrative monetary policy chart from St Louis Fed
February 2007, Bill Poole  y
Chart from Kansas City Fed, 2009, Tom Hoenig
(2000‐2009)
The Boom‐Bust in Housing Starts 
Compared with the CounterfactualCompared with the Counterfactual
Illustrative Chart from the OECD, March 2008  
Illustrative Chart from the OECD, March 2008  
Temporary stimulus meets 
permanent income hypothesisp yp
The Panic of Fall ‘08
Policy makers then doubled‐downPolicy makers then doubled down
• Discretionary fiscal stimulus of 2009 ($862 billion)sc et o a y sca st u us o 009 ($86 b o )
– One‐time payments again 
– More government spending too
• Cash for clunkers program 
• Quantitative easing in 2009, now called QE1
– Purchases of $1.25 trillion of mortgage backed 
securities, $300 billion of longer term Treasury bonds
QE2 i 2010 d 2011• QE2 in 2010 and 2011
– purchases of $600 billion of longer term Treasury 
bondsbonds.  
Temporary  stimulus meets
permanent income hypothesis againp yp g
Cash for clunkers: incentives really matter
400
Billions of dollars, annual rates
300
350
200
250 --- Temporary transfer
 payments and credits
t
150
200
G t t t t d
 to persons
50
100
F d l t ti
--- Grants to state and
 local governments
0
09Q1 09Q2 09Q3 09Q4 10Q1 10Q2 10Q3 10Q4
--- Federal government investment
--- Federal government consumption
Two-Year Effect of ARRA on Major Federal Budget Categories
 (Source: Bureau of Economic Analysis)
2,300
Billions of dollars, annual rates
2 100
2,200
,
Total receipts of state
and local governments
2,000
2,100
Recepits less
1,800
1,900
p
ARRA grants
1 600
1,700 Purchases by state
 and local governments
1,500
1,600
1,400
2005 2006 2007 2008 2009 2010
State and local governments also consider permanent income
Compare with textbook discussion: 
Sharp drop in I causes expenditure lineSharp drop in I causes expenditure line 
to shift down 
45-degree line
SPENDING
25_10
New E line
Original E lineOriginal point 
of spending 
balance
I falls by this 
amount 
Income or real GDP falls by this amount 
(more than by amount I falls ).
New point of spending balance
Original 
income 
level
New 
income 
level
INCOME OR REAL GDP
(more than by amount I falls ).
Offset by Countercyclical fiscal policy
Increase in G raises GDP depending on size of the p g
multiplier and amount of crowding out 
45-degree line
SPENDING
25_10
G rises 
INCOME OR REAL GDP
But look what happened
6
Percent, annual rate
Growth rate of real GDP
2
4
0
Contribution of
-4
-2 government purchases
-6
-8
07Q1 07Q3 08Q1 08Q3 09Q1 09Q3 10Q1 10Q3
Quantitative Easing Financed by Monetary Base
2,800
Billions of dollars
2,400
Monetary base
(currency plus reserves)
2,000
1,600
1,200
800
Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11
A Wonderful Teaching Moment:
The Money Multiplier and the Monetary BaseThe Money Multiplier and the Monetary Base
Percent
800
1,000
CBO Outlook
 in 2010
600
800
Federal Debt as a
CBO Outlook
 in 2009
400
600 Federal Debt as a
Percent of GDP
200
400
0
200
CBO Outlook
 in 2011??0
1800 1850 1900 1950 2000 2050
Teaching About Regulatory Capture:
E l i f il t f l t lExplains failure to enforce regulatory rules
C ti b t• Cozy connections between 
government and the 
fi i l i d tfinancial industry. 
• Book shows government 
helping well‐connected 
individuals, who in turn 
helped the government 
officials. 
• Result: Reckless policy
Implication of Narrative for Basic Economics
• Needs a reformulation?
– Paul Samuelson (January 2009) Paul Samuelson (January 2009) 
• “today we see how utterly mistaken was the Milton Friedman 
notion that a market system can regulate itself… This 
prevailing ideology of the last few decades has now beenprevailing ideology of the last few decades has now been 
reversed…I wish Friedman were still alive so he could witness 
how his extremism led to the defeat of his own ideas”. 
– Paul Krugman blames modern economics (especially 
macro) for the crisis. 
B t ti h i li b i i k• But narrative here implies basic economics works
– The crisis was caused by a deviation from principles
f h h h d• But of course there is much research to do
Another NarrativeAnother Narrative
• US policy was not an issue leading up to theUS policy was not an issue leading up to the 
crisis and is not an issue now
• Global capital flows were and are the problem• Global capital flows were and are the problem
– Caused emerging market crises in 1990s
C d 2007 09 i i S i Gl– Caused 2007‐09 crisis: Saving Glut
– Cause of future crises: focus on global rebalancing 
• Much different policy implication
But chart from the IMF in 2005 
Shows No Global Saving Glut 
So Why Do Economists Disagree?So Why Do Economists Disagree?
• Students and everyone else really want toStudents and everyone else really want to 
know the answer
• One reason is that the details of their models• One reason is that the details of their models 
are different, even though there is agreement 
about the basic principlesabout the basic principles
• The next three charts from the New York 
Ti d h ill hi llTimes and two others illustrate this well.
6
6
New Keynesian
Smets ‐ ECB
Robert Barro
Harvard
3
4
5
With stimulus
3
4
5
With stimulus
0
1
2
If no
stimulus
0
1
2
Ifno
stimulus
-1
2009 2010
-1
2009 2010
“The accumulation of hard data and real-lifeThe accumulation of hard data and real life 
experience has allowed more dispassionate analysts to 
reach a consensus that the stimulus package, messy p g y
as it is, is working”
New York Times November 12, 2009
Implications for Teaching
M ill t ti f b i i• Many new illustrations of basic economics 
• Interesting debates between economists 
R l di ti– Rules versus discretion
– But raise more questions about discretionary policy
• More integration of micro and macro• More integration of micro and macro 
– interest rates too low for too long (macro)
– housing markets including bubbles (micro)housing markets including bubbles (micro)
– stimulus package (macro) 
– regulatory capture and moral hazard (micro)
– new instruments of monetary policy (macro)
– risk premia in interest rates(micro) 
– debate over size of multipliers (macro)
– cash for clunkers, first time home‐buyer (micro)
Many New YouTube Videos
Quantitative Easing Explained. 5 million downloads. Doesn't 
get it all right and brutal in places, but good for discussion
The Wrong Financial Adviser Created by Nobel prize winner 
Bill Sharpe
Fed Chairman  on the Daily Show with Jon Stewart. From two 
different episodes of 60 Minutes, focus on whether 
quantitative easing is printing money.
Unmasking Interest Rates, Honky Tonk Style
Merle Hazard sings "Inflation or Deflation“
Inside Job Trailer 
Christine Lagarde in clip from Inside JobChristine Lagarde in clip from Inside Job
Hayek‐Keynes rap videos "Fear the Boom and Bust“ and “Fight 
of the Century”
Lines from “Fight of the Century”Lines from  Fight of the Century
Keynes: “Even you must admit that the lessonKeynes:  Even you must admit that the lesson 
we’ve learned is that more oversight’s needed 
or else we’ll get burned”or else we ll get burned
Hayek: “Oversight? The government ‘s long been 
in bed with those Wall Street execs and thein bed with those Wall Street execs and the 
firms that they’ve led.”