1.

1he CreaL 8ecesslon 1

!"#$%&'(#!%" )"& %*+$*!+,
Coals of Lhe course:
Lxpand your knowledge of macroeconomlcs, bulldlng on
maLerlal covered ln Lhe flrsL year course
Lnable you Lo undersLand and analyze recenL economlc evenLs

We wlll lllusLraLe Lhe Loplcs of Lhe course wlLh a sLory of Lhe CreaL
8ecesslon

MosL lmporLanL macroeconomlc developmenL ln Lhe lasL 70
years
1. 1he CreaL 8ecesslon 2

Llkely Lo have consequences for a long Llme, ln parLlcular,
when you graduaLe and hlL Lhe [ob markeL.

We wlll spend a loL of Llme dlscusslng Lhe CreaL 8ecesslon and lLs
afLermaLh. 1he goal ls Lwofold:
lL wlll allow us Lo use very recenL or currenL evenLs Lo lllusLraLe
macroeconomlc concepLs, reasonlng, and pollcles,
lL wlll provlde you wlLh Lhe knowledge and undersLandlng of,
and Lhe ablllLy Lo lnLelllgenLly dlscuss, macroeconomlcs. 1hls
may prove lnvaluable ln your fuLure careers.



1. 1he CreaL 8ecesslon 3

-. #/+ 0$+)# $+(+11!%".
SLarLed around 1am Sep 13, 2008 Lehman 8roLhers flled for
ChapLer 11 bankrupLcy proLecLlon
AL LhaL Llme fourLh largesL lnvesLmenL bank ln Lhe uS.
1.1. LLPMAn 88C1PL8S 8Ank8u1C?.
Lehman 8roLhers ln Lrouble for some Llme.
8ad lnvesLmenLs ln real esLaLe, rapldly deLerloraLlng asseLs
SepLember 1314: a hlghlevel meeLlng ln new ?ork.
Penry oulson, Lhen Lhe 1reasury SecreLary,
8en 8ernanke, Lhe chalrman of Lhe lederal 8eserve (led)
1lmoLhy CelLhner, Lhen Lhe presldenL of Lhe lederal 8eserve
8ank of new ?ork and Lhe currenL 1reasury SecreLary.
1. 1he CreaL 8ecesslon 4

1he general expecLaLlon was LhaL Lhe governmenL and Lhe led
wlll sLep ln and flnd a buyer who wlll save Lhe flrm from
bankrupLcy
March 2008 led arranged a purchase of 8ear SLerns by !
Morgan
SepLember 8, 2008 - rescue of lannle Mae and lreddle Mac
prlvaLe companles creaLed by Lhe uS governmenL Lo
lmprove Lhe llquldlLy ln Lhe houslng markeL and avallablllLy
of morLgages.
WP? WAS LLPMAn 88C1PL8S ALLCWLu 1C lAlL?
Concern abouL moral hazard.
Moral hazard arlses when a company (or an lndlvldual) does
noL have Lo bear all consequences of lLs acLlons.
1. 1he CreaL 8ecesslon 3

1reasury and led offlclals concerned LhaL, lf Lhey save
anoLher falllng lnvesLmenL bank, Lhe paLLern of governmenL
lnLervenLlon wlll be esLabllshed and moral hazard wlll be a
blg problem

LargesL bankrupLcy: $700 bln ln asseLs.
1he largesL prevlous bankrupLcy was Worldcom, 2002,
$100bln ln asseLs
lnvesLmenL banks borrow large amounLs, llLLle caplLal, owed
lenders $630bln.

MarkeLs caughL unprepared.

1. 1he CreaL 8ecesslon 6

1.2. C8Lul1 AnlC
Langled web of flnanclal obllgaLlons beLween flnanclal
lnsLlLuLlons
derlvaLlves, credlL defaulL swaps
obllgaLlons noL Lraded on organlzed exchanges

credlLworLhlness of poLenal borrowers dlculL Lo assess

banklng sysLem froze - very dlfflculL Lo obLaln credlL

Ceorge Soros: 2345 567879: ;5<< 7;; 345 6<=;;>.
8ecesslon usually deflned as Lwo consecuLlve quarLers of falllng
ouLpuL.
1. 1he CreaL 8ecesslon 7

!" #"$%&'(" )*+ *,-.,- '$ /"0$,&"# '1 %)0.-"& 23 4506%,60-'17
8,-.,-9:
LxLra, exLra! 1hls [usL lnl 8ernanke ls quoLed as saylng ln Lhe
documenL flled wlLh Lhe courL. SepLember and CcLober of
2008 was Lhe worsL flnanclal crlsls ln global hlsLory, lncludlng Lhe
CreaL uepresslon," Cf Lhe 13 mosL lmporLanL flnanclal
lnsLlLuLlons ln Lhe unlLed SLaLes, 12 were aL rlsk of fallure wlLhln
a perlod of a week or Lwo."
8rad ueLong: CreaL 8ecesslon has become Lhe CreaLer
uepresslon
Larry Summers: Secular SLagnaLlon
n8L8 (naLlonal 8ureau of Lconomlc 8esearch): Lhe recesslon
sLarLed ln uecember 2007.
1. 1he CreaL 8ecesslon 8

ln SepLember 2008 lL goL much worse
MosL economlc acLlvlLles requlre credlL. WlLhouL credlL:
decllne ln lnvesLmenL
decllne ln ouLpuL
rapld rlse of unemploymenL
consumer pesslmlsm - decllne ln consumpLlon

Pow bad dld lL look: 8ernanke: Lhe worsL flnanclal crlsls ln
global hlsLory, lncludlng Lhe CreaL uepresslon" All buL one of Lhe
largesL uS flnanclal lnsLlLuLlons were a week or Lwo from
collapse.
Why call lL Lhe CreaL 8ecesslon? 1o dlsLlngulsh from lesser
(ordlnary) recesslons and from Lhe CreaL uepresslon
1. 1he CreaL 8ecesslon 9

1.3. 1PL CLlC? 8LSCnSL
ln Lhe end - noL as bad as feared.
unemploymenL peaked aL 8.8 ln Canada, 10.6 ln Lhe uS (ln
Lhe CreaL uepresslon lL was over 20).
!" +'66 -06; 0(*,- <0%-*&$ 0<<"%-'17 ,1"/.6*=/"1- '1 %)0.-"& >3
4?1"/.6*=/"1-9:
AcLlve macroeconomlc pollcles Lo counLeracL Lhe CreaL
8ecesslon: expanslonary moneLary and flscal pollcles.
used lessons from Lhe CreaL uepresslon.
Maln 97853?@: pollcy: reduce shorLLerm nomlnal lnLeresL raLes.
CenLral bank has dlrecL conLrol of Lhose raLes.

1. 1he CreaL 8ecesslon 10

8uL nomlnal lnLeresL raLe cannoL be lower Lhan zero.
CuesLlon: +)=@
!" -06; 0(*,- -)" &"60-'*1$)'. ("-+""1 1*/'106 01# &"06
'1-"&"$- &0-"$ '1 %)0.-"& A3 4B*1"=C D1<60-'*1 01# E"06 01#
F*/'106 G0&'0(6"$9
So: employed alLernaLlve pollcles called quanLlLaLlve easlng.
purchases of asseLs of longer maLurlLy,
affecLlng expecLaLlons by promlslng Lo keep lnLeresL raLes
low for exLended perlods

!" #"$%&'(" (*-) -)" -&0#'-'*106 01# 1"+ 0..&*0%)"$ -*
/*1"-0&= .*6'%= '1 %)0.-"& HI 4B*1"-0&= J*6'%= 01# -)" K01; *<
5010#09
1. 1he CreaL 8ecesslon 11

A=B6?< pollcles: dlscreLlonary and auLomaLlc
ulscreLlonary: ralse governmenL purchases and Lransfers, cuL
Laxes
AuLomaLlc: changes ln spendlng and LaxaLlon LhaL Lake place
wlLhouL governmenL acLlon: hlgher unemploymenL and
welfare paymenLs, lower lncome Laxes as lncome falls.

!" +'66 -06; 0(*,- -)" -)"*&= (")'1# -)"$" $-'/,60-'L" .*6'%'"$ '1
5)0.-"& M3 4N)" DOD5 B*#"63 -)" K0$'% P&0/"+*&; -* ?1#"&$-01#
B0%&*"%*1*/'% J*6'%=:9

1. 1he CreaL 8ecesslon 12

8oLh acLlve and auLomaLlc flscal pollcles ralse deflclL and debL
concerns abouL debL level and drlve Lo reduce spendlng ln
several counLrles.

!" #'$%,$$ -)" <'$%06 .*6'%= '$$,"$ '1 5)0.-"& HH3 4P'$%06 J*6'%=9
01# '1 5)0.-"& HA 4Q"<'%'-$ 01# Q"(-9

1. 1he CreaL 8ecesslon 13

1.4 PCW 1PL MC81CACL C8lSlS uLvLLCLu
2001 recesslon - low lnLeresL raLes
Low lnLeresL raLes - encourage house buylng
Low lnflaLlon subsequenLly - Lhe led kepL lnLeresL raLes low
led goal: Lo promoLe effecLlvely Lhe goals of maxlmum
employmenL, sLable prlces, and moderaLe longLerm lnLeresL
raLes
8ank of Canada - LargeLs lnflaLlon beLween 1 and 3

!" +'66 -06; 0(*,- .&*(6"/$ (&*,7)- 0(*,- (= '1<60-'*1C 01# +)=
%"1-&06 (01;$ 0&" %*1%"&1"# 0(*,- '-C '1 %)0.-"& HI3 4B*1"-0&=
J*6'%= 01# -)" K01; *< 5010#09:
1. 1he CreaL 8ecesslon 14

1.4.1 uLvLLCMLn1S ln 1PL llnAnClAL SLC1C8
LCAn SLCu8l1lZA1lCn.
MorLgages from many properLles are puL LogeLher (pooled) lnLo
a securlLy (called a MorLgage8acked SecurlLy) whlch ls Lhen sold
Lo lnvesLors
removes Lhe rlsk of nonperformlng loans from Lhe bank LhaL
gave Lhe morLgage moral hazard
provldes Lhe bank wlLh funds Lo glve more morLgages
roflLable process:
lndlvldual morLgages pay hlgh lnLeresL raLes
rlsk appears dlverslfled - lL ls unllkely LhaL many morLgages
ln a pool defaulL aL Lhe same Llme
1. 1he CreaL 8ecesslon 13

pools of morLgages appear less rlsky, so a morLgage backed
securlLy has hlgh yleld and percelved low rlsk
uecllne ln lendlng sLandards due Lo moral hazard


1. 1he CreaL 8ecesslon 16

Su88lML LCAnS.
uemand exceeded supply - banks lncreased loans Lo rlsklesL
borrowers
Subprlme: loan Lo borrower who does noL quallfy for a regular
(prlme) loan
hlgher defaulL rlsk and pay hlgher lnLeresL raLes
oollng subprlme loans wlLh prlme loans creaLed securlLles wlLh
hlgh yleld and relaLlvely low rlsk
Ad[usLable raLe morLgages (A8M).
Lhe lnlLlal lnLeresL raLe ls low
lL lncreases slgnlflcanLly afLer 2 or 3 years
borrower expecLs Lo Lake advanLage of house appreclaLlon
and reflnance
1. 1he CreaL 8ecesslon 17

LLvL8ACL.
Leverage based on uslng borrowed money Lo acqulre asseLs.
&5;=8=3=78: Leverage ls equal Lo Lhe raLlo of asseLs Lo Lhe
dlfference beLween asseLs and llablllLles (excludlng caplLal).
MulLlplles galns and losses.
llnanclal lnsLlLuLlons around Lhe world were very heavlly
leveraged. Leverage of 33 was noL uncommon, some
lnsLlLuLlons had leverage of 30.
LxLenL of leverage - hldden by accounLlng Lrlcks.


1. 1he CreaL 8ecesslon 18

LLvL8ACL LxAMLL.
1. CaplLal = 100, buy securlLles whlch pay 6
lncrease or fall ln value by 6
Leverage =1

2. CaplLal=100, borrow 1900, lnLeresL raLe 3. 8uy securlLles
whlch pay 6
lncrease or fall ln value by 6
Leverage = 20

1. 1he CreaL 8ecesslon 19

Leverage change ln
asseL prlce
lnLeresL
on loan
lnLeresL
recelved
CaplLal
galn/loss
1oLal
reLurn
reLurn
Cood beL
1 +6 $0 $6 $6 $12 12
20 +6 $93 $120 $120 $143 143
8ad beL
1 6 $0 $6 $6 $0 0
20 6$ $93 $120 $120 $93 93









1. 1he CreaL 8ecesslon 20

1.4.2. 8lSlnC PCuSL 8lCLS
Subprlme and A8M morLgages ok ln a rlslng markeL:
when Lhe value of Lhe house lncreases, Lhe borrower can
reflnance
Lhe proceeds from reflnanclng can be used Lo make
morLgage paymenLs.
So even borrowers wlLh weak credlL hlsLory are expecLed Lo be
able Lo servlce Lhelr morLgage

1oo much subprlme loans:
Loan securlLlzaLlon moral hazard subprlme loans
proflLable easy Lo obLaln
1. 1he CreaL 8ecesslon 21


Selfrelnforclng process:
hlgher house prlces lower rlsk of defaulL hlgher demand
and supply of morLgages more house purchases hlgher
house prlces
uS house prlces

1. 1he CreaL 8ecesslon 22

WLAL1P LllLC1 Cl PlCPL8 PCuSL 8lCLS
1he lncrease ln house prlces makes homeowners feel wealLhler.
!" #'$%,$$ -)" "<<"%- *< +"06-) *1 %*1$,/.-'*1 '1 %)0.-"& R3
45*1$,/.-'*19
When households feel wealLhler, Lhey lncrease spendlng.
So, Plgher house prlces hlgher consumpon, lower savlngs
lavourable buslness condlLlons:
ConsumpLlon - 2/3 of Cu ln Lhe uS . When consumpLlon rlses,
so does lnvesLmenL and ouLpuL. Plgher ouLpuL leads Lo hlgher
demand for houslng, hlgher house prlces and hlgher
consumpLlon.

1. 1he CreaL 8ecesslon 23

WAS l1 A 8u88LL?
A bubble ls a slLuaLlon when Lhe asseL ls overvalued (relaLlve Lo
fundamenLals) buL people conLlnue Lo buy lL ln Lhe expecLaLlon
LhaL lLs prlce wlll lncrease even more.
ln reLrospecL, yes.
8ubbles easy Lo ldenLlfy afLer Lhe facL: a rapld lncrease ln
prlces ls followed by a rapld decrease. ulfflculL Lo ldenLlfy
conLemporaneously
lundamenLals may have changed:
flnanclal deregulaLlon reduced Lhe cosL of flnanclng.
SecurlLlzaLlon reduced Lhe rlsk of subprlme lendlng.
So Lhe lncrease ln house prlces could be vlewed aL Lhe Llme as
[usLlfled by changed fundamenLals
1. 1he CreaL 8ecesslon 24

1.3 1PL llnAnClAL C8ASP
1.3.1. 1PL uLCLlnL ln PCuSL 8lCLS.
large, speculaLlve supply of houslng (overbulldlng)
led ralses lnLeresL raLes demand falls
Plgh supply, low demand prlces sLarL falllng (ln Lhe second
half of 2006).

1.3.2. MC81CACL uLlAuL1S
no longer posslble Lo reflnance - homeowners under
waLer"
nonrecourse loans llmlLed penalLy for defaulLlng
1. 1he CreaL 8ecesslon 23

lC8LCLCSu8LS Anu lu81PL8 uLC8LASL ln PCuSL 8lCLS.
lf Lhe house owner does noL pay lnLeresL on Lhe loan, Lhe
morLgage owner can foreclose
vlclous clrcle:
Pouse prlces fall owners are unable Lo re!nance and defaulL
on loans bank forecloses bank sells Lhe properLy wlLh Lhe
exLra supply prlces fell furLher

1. 1he CreaL 8ecesslon 26

llnAnClAL lnS1l1u1lCn LCSSLS.
uefaulLs and foreclosures Lhe value of morLgagebased
securlLles falls.
llnanclal lnsLlLuLlons lncur losses.
Many lnsLlLuLlons ln dlfflculL poslLlon - had Lo sell securlLles,
reduclng prlces furLher
As menLloned aL beglnnlng: complex web of lnLerrelaLlonshlps -
uncerLalnLy abouL solvency of Lhe poLenLlal borrower credlL
markeL freezes
So Lhe credlL markeL drled up - much harder Lhan before Lo
obLaln a loan.

1. 1he CreaL 8ecesslon 27

1.6. LllLC1 Cn 1PL 8LAL LCCnCM?.
llnanclal crlsls
reduced Lhe avallablllLy of credlL
lower consumer confldence
uecllne ln house prlces
lower household wealLh
So:
lower consumpLlon
blg drop ln demand for Lhlngs boughL on credlL (cars, large
LlckeL lLems)

1. 1he CreaL 8ecesslon 28

8lg decllne ln lnvesLmenL, Lyplcal ln recesslons.
Maln reasons: lower demand, uncerLalnLy abouL Lhe fuLure
buslness flxed lnvesLmenL - falls as flrms posLpone pro[ecLs
lnvenLory lnvesLmenL falls slnce demand ls lower and flrms
reduce operaLlonal cosLs
resldenLlal consLrucLlon falls as people sLop buylng new
homes
!" #'$%,$$ <0%-*&$ 0<<"%-'17 '1L"$-/"1- '1 %)0.-"& S3
4D1L"$-/"1-9:

1. 1he CreaL 8ecesslon 29

1.7. 1PL C8lSlS S8LAuS A88CAu.
uS - abouL 20 of Lhe world economy, world's blggesL lmporLer.
1yplcal effecL of a recesslon ln Lhe uS Lhrough lnLernaLlonal
Lrade.
uS ouLpuL falls uS lmporLs fall.
8ecesslon ln Lhe uS need noL cause a recesslon ln oLher
counLrles (for example 2001 - dld noL even cause a recesslon
ln Canada).
CLher counLrles - less affecLed as have weaker Lrade llnks


1. 1he CreaL 8ecesslon 30

CPAnnLLS Cl 18AnSMlSSlCn ln 1PL C8LA1 8LCLSSlCn.
-. #4@7CD4 ;=8?86=?< 9?@E53B
1he mosL lmporLanL channel
MorLgagebased securlLles sold around Lhe world (Lo
Cerman banks, Spanlsh penslon funds, ArgenLlnean
lnsurance companles eLc).
uerlvaLlve exposure - unknown and so credlLworLhlness of
flnanclal lnsLlLuLlons - suspecL.
Plgh leverage ln Luropean lnsLlLuLlons.



1. 1he CreaL 8ecesslon 31

F. !835@8?3=78?< 3@?G5 ?8G =835@67885635G BCHH<: 64?=8B
unprecedenLed Lrade decllne: world Lrade fell by over 20, ln
1alwan, Lhey fell over 40.
1he decllne, lnlLlally, much more rapld Lhan durlng Lhe CreaL
uepresslon
8ed llne: CreaL 8ecesslon, blue llne: CreaL uepresslon

1. 1he CreaL 8ecesslon 32

Complex goods rarely produced ln a slngle counLry.
roducLlon organlzed Lhrough lnLernaLlonal, lnLerconnecLed
supply chalns: componenLs are made ln many dlfferenL
counLrles, flnal assembly somewhere else.

1. 1he CreaL 8ecesslon 33


1. 1he CreaL 8ecesslon 34

ulfferenL recordlng of ouLpuL and lnLernaLlonal Lrade:
ouLpuL - compuLed as value added (value of flnal producL
mlnus lnLermedlaLe lnpuLs)
Lrade - compuLed as value of sale - lnvolves double counLlng
1hls - lmporLanL Lo accounL for decllne ln Canadlan exporLs.

I. #45 5;;563 7; 345 6@?B4 =8 345 '1 78 JCB=85BB ?8G 678BC95@
?33=3CG5B =8 7345@ 67C83@=5B.

1. 1he CreaL 8ecesslon 33

1.8 1PL C8lSlS ln CAnAuA
8efore Lhe CreaL 8ecesslon, Lhe Canadlan economy was ln good
shape.
low unemploymenL
fasL growLh
governmenL budgeL surpluses, boLh federal and provlnclal
hlgh resource prlces.
K=9=35G 5;;563 78 ;=8?86=?< 9?@E53B
Solld banklng sysLem
Lower leverage
Plgh caplLal raLlos
Less securlLlzaLlon of morLgages
lew hlgh - raLlo morLgages, need Lo be lnsured
1. 1he CreaL 8ecesslon 36

World Lconomlc lorum - called Canadlan banks Lhe besL ln Lhe
world


+LH7@3 64?885< H?@3=6C<?@<: B3@78D =8 (?8?G?.

1he uS economy ls our largesL Lradlng parLner, by far.
uS: 73 of Canadlan exporLs
8rlLaln: 3 of exporLs
Lspeclally hard hlL: Lhe car lndusLry Canadlan auLomoblle
exporLs fell 40.


1. 1he CreaL 8ecesslon 37

+;;563 78 JCB=85BB ?8G 678BC95@ ?33=3CG5BM =9H7@3?83.
Canadlan households became concerned abouL Lhe severe
recesslon ln Lhe uS and reduced spendlng.
lnvesLmenL fell as flrms Look a walL and see" approach and
delayed pro[ecLs.

1. 1he CreaL 8ecesslon 38

92
94
96
98
100
102
104
C1
2003
C1
2006
C1
2007
C1
2008
C1
2009
C1
2010
C1
2011
C1
2012
Canada uS
1.8.1. Cu1u1
llgure 1.3.
8eal Cu
ln Canada
and Lhe
uS, C4
2007=100

1. 1he CreaL 8ecesslon 39

94
96
98
100
102
104
8 4 0 4 8 12
Canada uS
CuLpuL decllne ln Canada
sLarLed a quarLer laLer
abouL as deep
Lhe economy rebounded fasLer








1. 1he CreaL 8ecesslon 40

4.0
3.0
6.0
7.0
8.0
9.0
10.0
C12003 C12007 C12009 C12011
Canada uS
unLMLC?MLn1
PlsLorlcally - uS unemploymenL lower (around 2 lower)
[usL prlor Lo Lhe CreaL 8ecesslon - slmllar raLes (around 6)
lncrease ln Canada - smaller (Lo 8.8, ln Lhe uS Lo 10.6)
decllnes Lo 7 ln Canada, Lo 9 ln Lhe uS

llgure 1.3.





1. 1he CreaL 8ecesslon 41

!" $-,#= -)" 60(*,& /0&;"- 01# ,1"/.6*=/"1- '1 5)0.-"&$ T
4N)" U0(*,& B0&;"-9 01# 5)0.-"& >3 4?1"/.6*=/"1-9:
LxCPAnCL 8A1L
reached parlLy ln CcLober 2007
sLayed close Lo parlLy Llll Lhe beglnnlng of Lhe CreaL
8ecesslon
depreclaLed 20 durlng Lhe recesslon as Lhere was fllghL Lo
uS bonds - blggesL and mosL llquld markeL
has appreclaLed back Lo parlLy

1. 1he CreaL 8ecesslon 42

0.73
0.80
0.83
0.90
0.93
1.00
1.03
200701 200801 200901 201001 201101 201201


llgure 1.6.
$uS/$CAn
Lxchange
raLe


!" #'$%,$$ "V%)017" &0-"$ '1 5)0.-"& W3 4XV%)017" E0-"$9:


1. 1he CreaL 8ecesslon 43

1.9. SuMMA8?
!" +'66 (" #'$%,$$'17 %,&&"1- "L"1-$ 0$ -)"= )0.."1 01#C -'/"
."&/'--'17C 0- -)" "1# *< -)" %*,&$" +" +'66 #'$%,$$ 4N)"
O*L"&"'71 Q"(- 5&'$'$9 01# 4N)" E'$" *< 5)'10 01# D1#'09: