Financial Crisis Macroeconomics for Beginners

(For a complete list of Beginners posts, see Financial Crisis for Beginners.)

If you want to get caught up on the financial and economic crisis in a hurry (and get a quick refresher on first-year macroeconomics), Charles Jones has a drafted a new chapter on the crisis for his macroeconomics textbook. (If you’ve already read all of our Beginners posts, though, hopefully you won’t need to get caught up.) It’s 43 pages long (not very many words per page, though) and includes a relatively standard account of how the crisis came about (with a focus on the U.S. housing bubble), the impact on the real economy, and the thinking behind monetary policy, the fiscal stimulus, and the main proposals to fix the banking system. (Perhaps wisely, he doesn’t say which proposal – buying toxic assets, recapitalization, or reorganization – he recommends.) There is a discussion of what the crisis looks like in IS-LM terms – the main change from the standard version being the jump in the risk premium, which undermines the Fed’s ability to reduce effective interest rates. He also discusses the “zero bound” on nominal interest rates, in case you were wondering what that meant.

I think there should be a lot more on the crisis outside the U.S., for two reasons: first, it’s hitting harder in most other countries; and second, with so many countries being affected in so many different ways (Eastern Europe bubbles collapsing, China and Japan losing demand for exports, Russia hit by falling commodity prices, Iceland crashing under a hypertrophied banking sector), there would be lots to write about.

Jones even closes with a note of optimism:

Whatever happens in the coming years, it is worth remembering a key fact about the Great Depression, in evidence on the cover of the macroeconomics textbook . . . Even something as earth-shaking as the Great Depression essentially left the long-run GDP of the United States largely unaffected.

Update: I meant, but forgot, to add that Jones does not attempt to address the question of whether macroeconomics as a field needs to be revised in the light of the crisis. Mark Thoma has several posts on this question: a few are here, here, and here.

21 responses to “Financial Crisis Macroeconomics for Beginners

  1. Page 7, bottom paragraph, currently reads “the end of Wall Street investment banking was nye.”

    Don’t know much about investment banking, but shouldn’t that be the end was “nigh”?

  2. This is a massively bogus claim to knowledge of an unknowable counterfactual, I’d say.

    “Even something as earth-shaking as the Great Depression essentially left the long-run GDP of the United States largely unaffected.”

  3. Andrew Foland

    Even something as earthshaking as the Second World War essentially left the long-run population of the planet largely unaffected.

  4. One of the few things that I ever remembered about J.M. Keynes was that he once said: “In the long-run, we are all dead…”

  5. Take a look at the cover of his book. Look at the trend line of GDP.

  6. Danny L. McDaniel

    John Maynard Keynes did say “in the long-run, we are all dead.” But Lord Keynes was wrong, because in economics in the short-run we’re dead, in the long-run we live and will thrive. As far as Charles Jones book goes, he should name the chapter on financial crisis, “The Good, the Bad, and the Ugly.”

    Danny L. McDaniel
    Lafayette, Indiana

  7. jajajajajajaajaj excellent comment

  8. Ces mystères nous dépassent, feignons d’en être les instigateurs!

  9. re: “how the crisis came about”

    “…you totally miss the failure by the bureaucrats/regulators that caused all this (“The consequence of bad economics”, editorial, March 10)…you seem not to understand that the problem is that the central banks and governments refused to let the market work for 15-20 years or so. Had they done so, we would not have these problems today…. Had [Greenspan] let Long-Term Capital Management collapse in 1998, Lehman, Bear et al would still be in business…” http://www.ft.com/cms/s/0/a1c18156-0ddc-11de-8ea3-0000779fd2ac.html

    long-run GDP is of little (and ultimately negative) worth when it is achieved by generating negative externalities. for the roots of today’s problems, perhaps it would be more instructive to start as far back as the first and second world wars.

  10. Respectfully:

    This counterfactual has an N-size of exactly 1.

    Let’s ask this question: What would the GDP have looked like if WWII (and the massive technological and industrial investments to drive it) had not followed immediately after? If the US had lost WWII (which very nearly happened)? If the US had not rebuilt Europe with the Martial Plan? If the US had not invested in domestic infrastructure in order to build a manufacturing base capable of opposing the Soviet Union?

    Nor can we look across countries and say the N-size = the number of countries in the world. If CDO traunching has taught the quants anything, it’s not to underrate the impact of cross-unit correlation.

    I’m not sure about the motivation behind the statement, but in reading the chapter I too immediately thought it very odd and out of place. Certainly it does not add to the credibility of the author.

  11. The most interest piece of the chapter (to me anyway – probably not to most people) is the IS-LM treatment and the translation to AS-AD.

    The author introduces a new variable (risk premium) as an exogenous entity. Likewise, the _wealth_ loss caused by the housing price plummet (and stock market collapse) is treated as an _exogenous_ shock to the system, specifically to demand.

    I have two critiques about introducing these as _exogenous_ variables:

    1) The Wealth Shock. The LM curve is supposed to embody the equillibrium between the willingness to hold cash and to hold assets – specifically transaction demand as well as speculative demand. It is quite clear that LM has a direct impact on (perceived) household wealth, since the dramatic loss in household wealth is a largely _result_ of the flight from assets to cash.

    Let me rephrase this: Many people agree that the loss in household wealth (fall in home/401k values) is a _direct_ result of a change in liquidity preference (which is supposed to be represented by the LM curve), but in this model it’s represented as an independent and external shock to the system.

    Makes no sense. Moreover, by asserting this, the model essentially says “it’s exogenous, there’s nothing we can do about it… it’s an act of nature”.

    2) The risk premium, likewise, is seen as an exogenous parameter.

    Aversion to risk “just happened”. There’s no internal explanation for it within the model.

    It has nothing to do with legal rules (like the cap asset ratio) that enforce extreme reductions in outstanding assets whenever capital base shrinks due to a modest loss on a highly leveraged balance sheet.

    It has nothing to do with imposing a mark-to-market rule at the height of the bubble, which front-loads implied losses before those losses actually happen, and thereby creates an immediate credit crunch as forward-looking markets translate future losses into the present (and thereby create immediate massive constraints on lending).

    Seriously, isn’t LM supposed to be the “Liquidity/Money Equillibrium”? Modeling risk premium as an external shock is a slight-of-hand to get the model to fit the data by adding a “free parameter”.

    However, that new parameter explains nothing. It doesn’t tell us how we got into this mess, or how to get out of it. It’s basically saying “bad stuff happened – it was an act of nature”.

    It also has no predictive value, since we don’t know whether that risk premium will stay the same or change. And if the risk premium can change, then the LM curve is no longer a line – it’s more like a wide band that is now contingent of “risk premium”.

    It reminds me of Keynes’ “animal spirits”.

    Reading this chapter vaguely reminded me of Ptolemaic Astronomy – full of cycles and epicycles and other contortions trying to explain observed facts while still keeping the sun at the center of the universe.

    Perhaps economics needs to confront the fact that the sun is not at the center of the universe.

  12. Preemptively, I apologize for impugning the credibility of the author – that was not called for on this blog. In all likelihood, he’s probably just making a simple observation.

  13. Perhsps he meant Mr. Nye, the Republican shill for big business that sat on any progressive legislation that did not continue to feed the cavier eating hoy-paloy that paid his campaign bills.

  14. Thanks for the timely and concise information contained in this blog post. As an Economics major in college, I believe that some common-sense, layman terms economics is needed to explain the roots of this crisis to everyday Americans. As the saying goes, if we forget our past, we are doomed to repeat our mistakes. The same goes if we don’t understand the mistakes we made in the first place.
    -Chef, your friendly blogger at twobigboobs.wordpress.com

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  17. You have a gift, StatsGuy. Please write a comprehensive book-like piece on economics for [folks one step–but not much more–ahead of] dummies.

  18. I sent Jones’ thing to a friend who replied that it “repeated the old bullshit about banks making their money on the spread between deposit interest and loan interest. this has been the official story hammered into our heads for way too long. People still believe it because everywhere they look the lie is repeated. The ‘FED’ has people making careers out of spreading this nonsense, with the purpose of keeping us poor saps duped.”

    Anyone care to respond?

  19. What your friend means is that when banks borrow at 3% and loan at 5%, they are making far more than 2%.

    For each dollar they have in deposits/capital, they are making 10+ different loans on your initial deposit. (It’s a bit more complicated than that.) Banks make their money by… well… creating money. Literally.

    The challenge is we are now dependent on banks to create the money we have in circulation. This crisis has forced enough interest from the public that a few are pulling back the curtain. And they don’t like what they see.

  20. Walt Wriston

    Corps and Banks has been dubbed as a new collective aka an oligarchy class itself: Transnational Capitalist Class like any corporate structure there’s a distinct hierarchy, and just to note this is a bunch of Marxists drivel. Right Mr. IMF? You should start contacting your old partner of the IMF Hernam Daly.

  21. Walt Wriston

    Simple edit to say Herman Daly worked for the World Bank. And, is IMHO the best ecological economists alive. You should read his book: for the common good. Esp. the Afterword on Money.