Class Notes 10

Here is a summary of what we discussed in class today.

Hi class,

Thanks for all your good participation today. I've got a summary of our summary of the global financial crisis below.

First, readings: I've added a few pages for you to read from the Amartya Sen book on Google books, Development as Freedom. Please read pp. 13-17 and 38-41. The other readings are uploaded on Blackboard and on my site,

Wednesday we are doing a class on what we think "development" is. I think I'll have you think up short skits and act them out in class. Should be fun. So when you are reading the various texts on what development is, try to think of situations that illustrate the different ideas.

On the global financial crisis, we basically saw that a tremendous amount of cash from surplus countries (China, Japan, and oil producers) flowed in to countries such as the US and UK. In the US, this combined with very low interest rates to produce a credit boom. There was also a good deal of financial innovation on how to use all this easy credit to make money, leading to some funny instruments such as collateralized debt obligations (CDOs) and credit default swaps (CDSs). These were working fine as long as credit was available. Also, people started obtaining mortgages even when they probably couldn't afford them. This was ok as long as there was credit AND the price of houses was always going up. Well, as all bubbles do, the housing market bubble eventually popped, and housing prices started to go down (by a lot -- 20-30%?). So some people started to default on their mortgage payments -- mostly those who had taken out big big loans to pay for houses whose prices were now significantly below what they had paid.

The proximate cause -- what set off the real panic -- was the failure of Lehman Brothers, an investment bank, in September of 2008, and the government's decision to allow it to fail without a bailout. (It had earlier bailed out Bear Stearns, to some extent, and AIG, a big insurance company.) Already skittish, the big investment companies and banks decided that they did not know what risks they faced -- they couldn't figure out who owed what to whom, because their derivative financial instruments were too complicated -- and they didn't know what the government would do if they got into trouble, so they just froze and would not give any credit to anyone, basically. The short-term commercial paper market froze up, businesses' credit lines were retracted, municipalities could not sell their bonds... The "real economy" was becoming seriously affected.

With credit markets dried up, nobody knew what assets were worth anymore because no one was buying any (the price was effectively zero). With asset prices unknown or very low, wealth was evaporating. Those institutions with a lot of money, such as sovereign wealth funds, weren't sure where to put their money anymore. The safest place still seemed to be US Treasury bonds. So the dollar didn't lose value nearly as much as it would have otherwise.

The government's three classes of response are basically fiscal, monetary, and financial (dealing with the financial sector). Fiscally, the US and many other countries are passing big stimulus packages (government spending and tax cuts) to try to make up for everyone else's rational desire to save or not take on new debt right now. A lot of economists agree that the fiscal spending is needed, but mostly so that things won't be much worse -- it is not going to turn things around on its own. The money is coming from other (saving) countries, the future (we will all have to pay taxes), and future inflation (money getting printed). So while the US government can just about handle this, it wouldn't be able to handle many more crises or responses of this kind. Some governments are in more precarious positions, having already been in big deficits for some time (Spain, Italy, Greece...).

As far as monetary policy goes, there is not much further that the Fed can cut interest rates. Maybe the European bank can cut a little further. But this too can only keep things from getting worse, it can't make people borrow who don't want to borrow.

The government's attempts to fix the financial markets have been a little all over the place. There has been some talk of nationalization, some stock injected into banks -- mostly of the "preferred" variety as opposed to "common" stock, so it gets a higher dividend and is wiped out after the common stock, but it doesn't get a vote. But there hasn't been a consistent policy, so banks and other financial institutions are still waiting around to see what's going to happen next. Some "bad assets" have been taken off the books through the "Troubled Asset Relief Program" (TARP I & II).

Long-term, economists are counseling that the government try to get the country's economy refocused away from finance and back toward manufacturing, services, and high technology. There needs to be more investment in infrastructure and education, and more openness to immigrants (who start a lot of companies and work very hard). This crisis could in fact present an opportunity, as thousands of smart people are being shed from jobs in the finance sector and are being snapped up by other industries.

Take-home point: The crisis was a long time in the making (at least a decade), and the conditions that led to it have not all been undone. Some have been exacerbated (like developing countries wanting to build up massive reserves). The financial crisis has had a big impact on the "real" economy, worldwide. Nobody knows yet how or when we are going to pull ourselves out of this one.