-"an account of the collision of two forces: aspiration and authoritarianism"

Having explored Egypt in The Buried, we now turn our focus to China, which has an extremely different economic and political institutional environment. We do this again by focusing on lived experiences.

Winner of the National Book Award and part of a Pulitzer Prize-winning team for investigative reporting, Evans Osnos spent eight years living in Beijing, witnessing the changes occurring from 2005-2013. The selected excerpts from Age of Ambition – Chasing Fortune, Truth, and Faith inthe New China capture the ways in which state institutions in China have fueled economic growth while also imposing limits on broader opportunity.

Main Themes:

1. Paradox of Chinese Reforms: Despite official suspicion of individualism, China enacted core free-market ideas.
2. Embracing Market Principles (Under New Labels): Early reformers like Wu Jinglian, despite a background in orthodox socialism, became leading experts on the free market, necessitated by economic realities.
3. Mass Migration and Labor: China's growth relied on "abundant cheap labor and a surge of investment in factories and infrastructure." The relaxation of the hukou system in 1985 permitted temporary rural-to-urban migration, fueling this labor supply.
4. Rise of Individualism and Self-Reliance: Companies actively promoted individualistic messages. Even in rural areas, teachers prepared students for a world requiring "self-reliance, self-promotion, and the self-made individual."
5. The "Got Rich First Crowd" (xianfu qunti): The emergence of a wealthy class led to new societal dynamics.
6. New Class Distinctions and Identities: The return of class led to a society actively defining new archetypes
7. Changing Aspirations: The shift from traditional village views to independence and personal choice.
8. Co-opting the Wealthy: The Party saw the return of class as an "opportunity" to buttress itself against democracy.
9. Ideological Contortions: To reconcile its Marxist-Leninist roots with the new reality, Jiang Zemin in 2002 avoided "middle class" but declared dedication to the "New Middle-Income Stratum."
10. Shift from "Revolutionary Party" to "Party in Power": A constitutional change in 2002 saw the Party stop calling itself a "revolutionary party," becoming "ardent defenders of the status quo."
11. Technocratic Rule and Lack of Personality: Leaders embodied the belief that "development is the only hard truth." The Party deliberately suppressed cults of personality, presenting a "tableau of conformity".
12. Party vs. Society: Despite the Party becoming "more homogenous, buttoned-down, and conservative," Chinese society was simultaneously "becoming more diverse, raucous, and freewheeling."
13. The "Grand Bargain": The Wenzhou train crash symbolized the fragility of "the grand bargain of modern Chinese politics in the era after socialism: allow the Party to reign unchallenged as long as it was reasonably competent." The crash "violated the deal".
14. Corruption: The crash's underlying problems were tied to "graft, fraud, embezzlement, and patronage." The signal system that failed was rushed through development and had "grave flaws and major hidden dangers."
15. Broader Infrastructure Failures: The crash was not isolated; parts of "the new China had been built too fast for their own good," leading to other collapses.
16. Pervasiveness of Corruption: Corruption functions through "unwritten rules" and personal connections.
17. "Protective Umbrellas" and "Mafiazation": Officials and businessmen formed networks, creating "protective umbrellas," described by scholars as the "Mafiazation" of the state.
18. Impact on Public Services: Corruption directly impacted public safety and services.
19. Economic Impact Debated: Optimists argue corruption is a transition phase enabling growth, citing infrastructure achievements. Others are less optimistic, pointing to low prosecution rates (3-6% of wrongdoers) and comparing China's corruption to "anarchy".

-"There's no nizam"

We've relied heavily on real-time economic data to understand short-term economic trends & policy decisions. When exploring long-term economic growth, perspectives focused on lived experiences can show how institutions shape what feel possible, what talents are used, & what futures seem worth pursuing.

MacArthur fellow and finalist for the National Book Award, Peter Hessler, spent a decade living in China, chronicling the country’s growth through the lives of ordinary citizens. In 2011, he and his family moved to Cairo during the Arab Spring. The selected excerpts from The Buried, An Archeology of the Egyptian Revolution, focuses on the experiences of ordinary Egyptian citizens to provide insights into how institutions, culture, & history intertwine in Egypt to shape individual lives, choices, & opportunities.

Main Themes:

1. The Role of Institutions: How formal & informal institutions (government, social etiquette, family) shape opportunities, talent utilization, and future aspirations.
2. Cultural and Historical Context: The deep influence of historical legacies (e.g., pharaonic history, colonialism, past revolutions) and cultural norms (e.g., politeness, "evil eye," lack of nizam) on contemporary Egyptian society.
3. Informal Systems and Adaptability: The emergence and function of informal economic & social systems (e.g., ashwa'iyat, zabaleen, wasta, family-based politics) in the absence of effective formal governance.
4. The Arab Spring's Impact: The revolution's initial promise of change versus the realities of institutional inertia and the unexpected consequences of political participation without strong institutional frameworks.
5. Contrasting Egypt with China: A recurring comparison that highlights differences in national priorities, economic development strategies, social norms, approaches to modernization, and rural-to-urban migration patterns.
6. Family Structures: The pervasive influence of family in Egypt, often superseding formal government institutions &political parties.

Excerpt Sections:

1. Introduction: Introduces the Abydos archaeological dig as a microcosm and highlights the initial disconnect between the Arab Spring in Cairo and more remote areas.
2. There's No Nizam: Explores the concept of nizam (system/order) and its perceived absence in Egypt, contrasting Egyptian and Chinese structure. Introduces wasta and its static nature compared to Chinese guanxi.
3. The Abydos Rayis: Details the local impact of the Arab Spring in Abydos, focusing on the practical, localized nature of governance in the absence of systematic administration.
4. Ashwa'iyat: Describes Cairo's informal settlements, highlighting how they grew without formal planning but provided functional, if illegal, housing. Highlights how informal local initiatives can fill governance gaps.
5. Tamarrod: Focuses on the Tamarrod petition campaign against Morsi & the widespread disillusionment with formal politics. Introduces the concept of a "praetorian state" where participation outruns institutionalization.
6. This Tiny Place called Connections: Explores how geographic factors &cultural traditions (family ties, ancestral villages) shape migration patterns & urban integration differently in Egypt vs China.
7. 100k Miles in a Renault Sedan: Uses the example of a Chinese entrepreneur in Egypt to illustrate practical challenges of business in an unsystematic environment.
8. Dawar Politics: Describes the informal, family- and clan-based nature of local elections in Abydos, where the family is the primary political structure vs formal parties or issues.
9. The "Deep State": Reinforces the importance of family structures in Egypt, directing votes and shaping social interactions.
10. The Abydos Rayis Revisited: Reinforces the ongoing nature of informal governance & police presence, emphasizing the unpredictability and contributing to a sense of political stagnation and a return to familiar patterns after the initial revolutionary fervor.

Our focus in Module 5 turns towards factors that affect the long-term growth rates, which are central to understanding industry transformation, poverty rates, and, in many cases, why nations fail.

To prepare for Module 5, we recap Chapter 3 from Why Nations Fail by Nobel Prize winners Daron Acemoglu & James Robinson, establishing that long-term economic growth depends on a country's institutions: the formal and informal structures that constrain individual behavior in a society.

Main Themes:

1. Economic Institutions are structures that specifically shape incentives to pursue education, invest, innovate, trade, and accumulate capital. These include Infrastructure, Access to Economic Gains, Education, Centralized Power, Rule of Law, Corruption (for Economic Gain), and Property Rights.
2. Inclusive Economic Institutions are structures that allow and encourage participation by the great mass of people in economic activities that make the best use of their talents and enable them to engage in economic pursuits. Key characteristics include broad distribution of power and opportunity, secure property rights for the everyone, a level playing field for economic activity, freedom to choose careers, and a capable state that provides public services and enforces order.
3. Extractive Economic Institutions are structures (or lack thereof) that prevent participation by the great mass of people in economic activities that make the best use of their talents and prevent them from engaging in economic pursuits, giving benefits to a select few at the expense of the masses. Key characteristics include the concentration of power and opportunity to an elite, extraction of incomes and wealth from one part of society to benefit another, lack of widespread property rights, limited economic choices for the general populace, and state power often used to benefit the elite rather than providing public services for general prosperity.
4. Political Institutions are the structures that determine how power is distributed and exercised, determining who holds political power, what decisions can be made and by whom, and how power is constrained.
5. Inclusive Political Institutions are structures that disperse power across a great mass of people and place constraints on the exercise of power. Key characteristics include a broad distribution of political power, limits on the exercise of power, citizen participation in political decision-making, and the rule of law applied equally.
6. Extractive Political Institutions are structures (or lack thereof) that concentrate power in the hands of a narrow elite and place few constraints on the exercise of this power. Key characteristics include the concentration of power in a narrow elite, few limits on the exercise of this power, limited or manipulated political participation, selectively enforced laws, and state power often maintained through force.
7. Extractive Elites are individuals or groups with some political power who support policies detrimental to widespread economic growth because reforming existing institutions would negatively affect their personal well-being. Extractive elites do not need to be wealthy. Anyone whose well-being would be negatively impacted by a change from the status quo who possesses some ability to obstruct progress (e.g., through bloc voting), can be considered an extractive elite.
8. Economic and Political Institutions interact and evolve to become self-reinforcing. In a Virtuous Cycle, inclusive economic institutions ensure wealth is dispersed, preventing a wealthy elite from dominating politics. And the inclusive political institutions that then form ensure extractive economic institutions are dismantled. In a Vicious Circle, extractive economic institutions enrich the elite, who use their wealth to ensure political dominance. And these individuals with political power then ensure extractive economic institutions are maintained to benefit themselves.

This Bonus Session expands on our in-class GMI discussion on NAFTA and explores the long-term decline in U.S. manufacturing jobs, drawing from research by Acemoglu and Restrepo's 2022 paper, Tasks, Automation, and the Rise in U.S. Wage Inequality. While trade and globalization played a role, the research shows that automation is the primary force behind both the drop in manufacturing employment and the rise in wage inequality since 1980. Its effects have been broad, sustained, and nationwide, particularly displacing routine-intensive blue-collar jobs, even as total manufacturing output continued to grow.

1. Manufacturing Employment Decline

• In 1950, ~1 in 3 U.S. workers had a manufacturing job.
• By 1980: ~20%; by 2016: under 10%; today: closer to 8%.
• The decline occurred despite steady or rising output—indicating productivity gains through automation, not offshoring, were the main factor.

2. Automation’s Impact on Jobs and Wages

• Automation accounts for an estimated 50–70% of changes in the U.S. wage structure from 1980–2016.
• Workers without a high school diploma saw wages fall ~8.8%, with industrial robots alone displacing between 400,000–700,000 jobs from 1990–2015.
• Job loss was concentrated among those performing routine, repetitive tasks, traditionally the foundation of middle-class, blue-collar employment.

3. Trade vs. Automation

• NAFTA and China’s WTO accession caused localized disruptions, but the national employment impact was smaller.
• NAFTA job losses estimated at 200k–800k.
• Increased import competition from China linked to ~2 million lost jobs, but regionally concentrated.
• Automation alone accounts for 3.3–5 million lost jobs, across the entire country.

4. Echoes in the Age of AI
The same task-displacing patterns seen in manufacturing may now emerge in white-collar sectors:

• Generative AI poses risks to routine cognitive tasks (e.g., summarizing reports, drafting standard communications).
• Like factory automation, GenAI may reshape job roles rather than eliminate whole professions.
• The potential outcome: wage polarization, where high-skill workers benefit while middle-tier roles are eroded.

5. Key Differences with GenAI
Despite parallels, AI adoption is moving faster and may be more flexible:

• Potential for task complementarity rather than substitution.
• White-collar workers may adapt more quickly due to higher education levels and geographic mobility.
• Still, the risk of “technological hollowing”—a shrinking middle class—remains.

6. Institutions Matter
Following the arguments in Acemoglu and Robinson's book, Why Nations Fail (which we will discuss in Module 5), a shrinking middle class has repercussions for the long-term economic growth rate in the US, as innovation requires wide-scale participation in economic activities. If "inclusive" institutions do not exist that both allow (via access to education, capital markets, etc.) and encourage (via ensuring new businesses can compete, supporting both small- and large- scale innovation, etc.) widespread economic innovation, long-term growth will decline.

While technological hollowing is possible in white collar sectors with the growth of genAI, it is not inevitable. Recognizing that there are always tradeoffs, there are historical policy precedents in the US that could guide this technological change towards more broad-based growth than what was experienced as automation transformed the US manufacturing sector:

• Workforce investment (e.g., GI Bill)
• Wage subsidies and expanded Earned Income Tax Credit
• Public R&D support (e.g., DARPA)
• Place-based development (e.g., Empowerment Zones)
• Balanced labor standards (e.g., Fair Labor Standards Act)

This Bonus Session summarizes Dr. J's live discussion on tariffs and the US economy held on March 15, 2025.

Main Points - Tariffs

• Theoretical Irrelevance Post-Great Depression: Economists widely agree tariffs generally harm economies based on insights gained since the Great Depression.

• Presidential Power and Constitutional Authority: Presidents have limited short-term influence on economic strength but can negatively impact it, especially through tariffs. While Congress constitutionally controls tariffs, it has delegated substantial authority to the executive branch.

• Political Statements vs. Economic Principles: Economic claims by politicians should be viewed skeptically regardless of affiliation.

False Claims About Tariffs

1. Tariffs Pay National Bills: Tariffs do not cover significant government expenses; they're paid by domestic consumers, not foreign countries.

2. Tariffs Improve Trade Deficits: Increasing tariffs does not sustainably reduce trade deficits. Initially, imports may decline, but currency appreciation makes exports pricier and imports cheaper, nullifying effects. Reagan-era tariffs did not meaningfully reduce deficits. True deficit reduction requires fiscal responsibility—higher domestic savings, lower investments, or reduced government spending.

3. Tariffs Boost the Economy: They do the opposite. Tariffs, as taxes, create inflation and decrease economic output, potentially causing stagflation.

Valid Reasons for Tariffs

1. Protect Domestic Industries: Common rationale; US sugar tariffs benefit domestic producers at consumers' expense.

2. Political Influence/Lobbying: Industries lobby for tariffs to shield their interests.

3. Support New Industries: Temporary tariffs can help emerging sectors develop efficiencies & compete globally, for instance in fields like clean energy and semiconductors.

4. National Security: Protecting vital domestic production (weapons, semiconductors) is a legitimate security concern.

5. Counter Unfair Practices: Tariffs counteract foreign policies (subsidies, weak regulations) granting unfair advantages.

6. Game-Theoretic Responses: Retaliatory tariffs can incentivize negotiation but risk damaging trade wars.

7. Weaponization of Policy: Tariffs might serve broader political strategies, effectively a weapon to obtain unrelated concessions.

8. Smooth Economic Transitions: More gradual adjustments to economic shifts (e.g., post-NAFTA manufacturing decline) reduce instability.

Current State of the US Economy

• Government Spending Cuts: Sharp cuts negatively impact economic growth, particularly affecting regions dependent on government-funded sectors.

• Increased Uncertainty: Economic uncertainty is dampening consumer spending &business investments.

• Stagflation Risk: Persistent tariffs amidst economic slowdown elevate stagflation risks, complicating Fed policy.

• Lagging Indicators: Effects may not be immediately apparent in economic data due to reporting delays.

• Financial System Stability (Currently): Positively, no widespread financial system distress or bank failures exist presently, critical to avoiding depressions. Banks have sufficient reserves, though concerns linger about potential deregulation and reduced capital requirements.

Advice for Individuals/Companies During Uncertainty

Overview of Module 4, Section 8: Central Bank Operations in the New Norm, which discusses the evolution of the Fed's monetary policy operations, particularly the transition from a "corridor policy" to a "floor policy" following the 2008 financial crisis.

Main Themes

1. Shift from Corridor Policy to Floor Policy

• Corridor Policy (Pre-2008): This regime operated when reserves in the banking system were scarce. The Federal Reserve used Open Market Operations (OMO) (buying and selling government securities) to adjust the money supply and steer the Federal Funds Rate (FFR) towards its target.
• Floor Policy (Post-2008): The period of significantly accommodative monetary policy, including Quantitative Easing (QE), led to an abundance of Reserves in the banking system. In this environment, changes in the money supply no longer significantly impact the FFR, as banks already hold all the Reserves they desire. The Fed now primarily influences the FFR by adjusting the interest rate paid on overnight Reserve Balances (IORB) held at the Central Bank and the interest rate offered on Overnight Reverse Repos.

2. Key Policy Rates Used in the Floor Policy

• Interest on Reserve Balances (IORB): Only available to banks, this is the interest rate the Central Bank pays to banks on their Reserve balances (similar to the interest rate your bank pays you for your deposits). IORB determines the lowest interest rate a bank would be willing to lend their Reserves because banks have no incentive to lend Reserves at a rate lower than what they can earn by keeping them risk-free at the Central Bank.
• Central Bank Overnight Reverse Repurchase Rate (ON RRP): Available to a broader range of financial institutions such as money market funds (in the US, these institutions must be approved by the Federal Reserve Bank of New York), this is the rate the Central Bank pays for reverse repos. It is conceptually equivalent to the IORB (an entity gives the Central Bank money for a short amount of time and the Central Bank pays them interest), but for a larger group of financial institutions and set slightly lower than the IORB. Analogous to the IORB for banks, the Overnight Reverse Repo rate is the lowest rate at which these non-bank financial institutions would be willing to lend their excess cash.
• Discount Rate: As in the corridor range, the discount rate is the rate at which banks can borrow directly from the Central Bank and is intentionally set above the Federal Funds target rate so that it is only used as a last resort.

3. Mechanism in which the Federal Funds Rate is Managed

• As non-bank financial institutions (such as money market funds) market do not have access to the IORB rate, they lend to banks at rates below the IORB, because doing so still offers a better return than lending through the Fed’s Overnight Reverse Repurchase facility, which offers a slightly lower rate.
• Banks remain the primary borrowers in the federal funds market. But rather than borrowing to meet liquidity needs, they do so to profit from arbitrage. Specifically, banks borrow cash from nonbanks at rates below IORB (for example, from a money market fund at 5.30%), and then immediately redeposit those funds at the Fed to earn IORB (e.g. 5.40%), capturing the spread as risk-free profit.
• The federal funds rate is then pinned down between these two rates and reflects the price nonbank institutions are willing to accept for lending cash, and banks are willing to pay, to facilitate this arbitrage.

4. The New Norm

• The floor policy is expected to remain in place until the excess reserves created by QE are reduced. This unwinding is occurring through the Fed ceasing to reinvest maturing assets and through outright sales of Treasury securities and agency mortgage-backed securities.
• As reserve levels decline and the demand for reserves increases, the Fed could eventually transition back to a corridor policy and potentially lower the IORB back to zero. However, this is expected to be a gradual process.

Overview of Module 4, Section 7: Central Bank Operations in "Normal" Times, which discusses mechanisms through which Central Banks manage the overnight bank-to-bank lending rate during “normal” economic periods. i.e. in periods prior to significant events like the 2008 Financial Crisis.

Main Themes

1. The Overnight Bank-to-Bank Lending Rate as a Key Monetary Policy Tool

• The overnight bank-to-bank lending rate (in the US, the federal funds rate), the interest rate at which banks lend reserves to each other overnight, is the central lever for monetary policy. Central banks aim to influence this rate to achieve broader economic objectives.

2. Supply and Demand of Reserves

• The federal funds rate is determined by the equilibrium between the supply and demand for bank reserves.
• Demand for Reserves: Banks demand reserves for various reasons, including meeting reserve requirements, hedging against liquidity risk, and potential speculative opportunities. The demand curve for reserves is downward sloping because as the federal funds rate decreases, banks have less incentive to lend out excess reserves and are more willing to hold onto them. Expectations of future interest rate increases can also shift the demand curve outward.
• Supply of Reserves: The Central Bank is the sole entity capable of creating reserves. The supply of Reserves is a policy decision and is represented by a vertical line at the quantity set by the central bank.

3. Central Bank Tools to Influence the Federal Funds Rate

• Open Market Operations: Buying and selling government securities (primarily Treasuries) is the primary tool to shift the supply of Reserves. Purchasing securities injects reserves into the banking system (shifting the supply curve outward and typically lowering the federal funds rate), while selling securities withdraws Reserves (shifting the supply curve inward and typically raising the federal funds rate).
• Discount Rate: This is the interest rate at which commercial banks can borrow money directly from the Central Bank. The discount rate acts as a ceiling for the federal funds rate because banks would be unlikely to borrow from other banks at a rate higher than what they could obtain from the Central Bank.
• Required Reserve Ratio: This is the fraction of a bank's deposits that they are legally required to hold in reserve at the Central Bank. Increasing the Reserve Ratio forces banks to hold more Reserves, shifting the demand curve for Reserves outward and typically increasing interest rates. Decreasing the ratio has the opposite effect.
• Interest on Reserve Balances (IORB): This is the interest rate that the central bank pays to commercial banks on the Reserves they hold at the central bank. The IORB acts as a floor for the federal funds rate because banks would be unwilling to lend Reserves to other banks at a rate lower than what they can earn by simply holding those reserves at the Central Bank. Prior to the financial crisis in the US, this rate was generally 0%.

Overview of Module 4, Section 6: Quantitative Easing, regarding Quantitative Easing (QE) as implemented by the Federal Reserve, particularly during &after the 2008 Financial Crisis and during the COVID-19 pandemic.

Main Themes

1. Definition and Purpose of Quantitative Easing (QE)

• QE is described as credit easing without sterilization focused on a much larger range of assets, specifically those having long maturities.
• The primary goal during the Financial Crisis was to address the risk stemming from Asset-Backed Securities by purchasing them from banks &financial institutions.
• QE aimed to remove almost worthless assets off the banks’ balance sheets, significantly improving their risk profile and increasing bank Reserves to encourage lending.
• The underlying issue during the Financial Crisis wasn't a lack of Reserves but instead the extreme amount of risk on banks’ balance sheets due to the loss of almost all market value of their asset backed securities. Banks were hesitant to lend or borrow until these risky assets were off their books.

2. Implementation During the 2008 Financial Crisis

• The Fed initially implemented credit easing measures, acting as a wholesale lender to banks, sometimes with sterilization (keeping the money supply constant) and sometimes without (increasing the money supply).
• These initial measures provided temporary relief, as seen in the rise of S&P financials and the decrease in credit default swap spreads.
• However, the failures of institutions like Bear Stearns led to a rapid escalation of the crisis, and these initial tools proved insufficient.
• The Fed then moved to large-scale asset purchases (QE Round 1), primarily focusing on ABS.
• This took $1.1 trillion off the books of banks & other financial institutions around the world and significantly increased Reserves.
• As with most Fed policies, the strategy involved a gradual approach based on macroeconomic conditions. Subsequent rounds of QE (Rounds 2 and 3) continued to purchase assets to further ease financial conditions .

3. Quantitative Easing During the COVID-19 Pandemic

• Most of the COVID Quantitative Easing was in the form of Treasuries, Central Banks’ preferred monetary tool. More than $1 trillion dollars in Treasuries were purchased to inject massive liquidity into the system, along with some $200 billion in ABS.

4. Unwinding Quantitative Easing (Quantitative Tightening - QT)

• The Fed has started unwinding Quantitative Easing (i.e. Quantitative Tightening) by letting some of the assets mature (and not purchasing new debt with it) and selling some of the assets. This is equivalent to decreasing the money supply.
• Fed statements indicate QT is occurring by phrasing such as “the Fed continues to reduce holdings of Treasury Securities and agency debt and agency mortgage-backed securities.”
• The primary method of QT has been through the Fed selling its Treasuries. The Fed is proceeding more cautiously with selling ABS to avoid triggering a fire sale and causing prices to plummet again.

5. Transparency and Monitoring of the Fed's Balance Sheet

• The Fed publishes its balance sheet every week on Wednesdays. It can be accessed on the Fed website and through FRED.
• The balance sheet details Assets (like Treasury securities and Mortgage-backed securities) and Liabilities (like Currency and Reserves).
• Changes in these holdings, particularly in Treasury and ABS, reflect the implementation and unwinding of QE.

6. Risk and Considerations

• There is a moral hazard tradeoff when Central Banks intervene in markets in which investors accepted excessive risk without due diligence in order to obtain short-term gains.
• During the 2008 crisis, the systemic nature of the problem justified the intervention to prevent a global financial meltdown.
• There is significant political sensitivity towards a Central Bank purchasing industry-specific assets, particularly before a crisis is fully evident.

Overview of Module 4, Section 5: The Financial Crisis, which introduces the Federal Reserve's balance sheet and the tools it employs to manage the money supply & influence interest rates.

Main Themes

1. Short-Term Collateralized Financial Products: Repurchase Agreements (Repos) and Reverse Repurchase Agreements (Reverse Repos)

Repo (RP) A financial product involving the purchase of securities (generally Treasury securities) coupled with an agreement to sell them back at a future date for a slightly higher price. It's a short-term lending agreement used to earn a small return on excess cash with low risk.

• Central Banks use repos to inject liquidity into the financial system (increase money supply) and lower interest rates by providing short-term loans to banks (collateralized by securities), increasing the Reserves in the banking system.
• Repos allow financial institutions to borrow for very short time-periods against assets they own.

Reverse Repo (RRP) A financial product that involves the sale of securities coupled with an agreement to purchase them back at a future date for a slightly higher price. It's a short-term borrowing agreement used to manage short-term liquidity needs.

• Central Banks use Reverse Repos to remove liquidity from the financial system (decrease money supply) & raise interest rates by acting as a borrower, taking in money from financial institutions in exchange for securities, thus decreasing the Reserves in the banking system.

2. The Fed’s Balance Sheet

• The Fed's balance sheet has assets (things the Fed owns or that pay it interest) and liabilities (things the Fed owes to others or pays interest on).
• Assets: Primarily include U.S. Treasury securities, Repos, and Other Assets including foreign reserves and gold. During crises, the Fed’s balance sheet can expand to include other assets including asset-backed securities and longer-term loans.
• Liabilities: Primarily include Currency in circulation (a liability as it technically belongs to the government), Reserves held by banks at the Fed (on which interest may be paid), Reverse Repos (the Fed owing money), the Treasury General Account (the U.S. govt's checking account), and other smaller Liabilities including the Capital used to originally fund the Fed.
• The size of the Fed's balance sheet is a key indicator of the money supply. An increasing balance sheet generally indicates an increase in the money supply.

3. Open Market Operations (OMOs)

Under "normal" economic conditions, OMOs are the primary tool the Fed uses to maintain the federal funds rate.

• OMOs involve the sale and purchase (or temporary trade via Repos & Reverse Repos) of primarily Treasury securities to eligible banks in exchange for Reserves.
• To increase the money supply, the Fed purchases Treasuries from banks and increases the Reserves in the system, which banks will likely use for loans.
• To decrease the money supply, the Fed sells Treasuries to banks, which decreases the Reserves in the system as banks pay for the securities.

4. Credit Easing

• Credit easing is employed during periods of heightened risk or a "credit crunch" when lowering the federal funds rate does not significantly increase borrowing & lending. This occurs as lenders become cautious and prefer low-risk assets (like Treasuries) or increased Reserves.
• The Fed acts as the short-term lender of last resort through mechanisms such as purchasing or accepting as collateral a broader range of riskier assets. The goal is to reduce the risk exposure of banks, making them more willing to lend their Reserves.

• Credit Easing with Sterilization: The Fed can implement credit easing without increasing the money supply by selling an equivalent amount of Treasuries, pulling the newly created Reserves back out of the system. The effect is to shift risk from banks to the Fed while providing liquidity without inflationary pressure.

• During the 2007-2008 credit crunch, the Fed initially used normal credit easing measures with sterilization.

Overview of Module 4, Section 4: The Financial Crisis, which summarizes the four phases of the 2008 Financial Crisis, which ultimately resulted in a near collapse of the global financial system.

Four Phases of The Financial Crisis:

Phase 1: The Bursting of the Housing Bubble

• The crisis originated with a significant housing bubble. Home prices peaked nationally in July 2006 and subsequently dropped by 9% in less than two years, with some major cities experiencing declines of over 20%.

Phase 2: ARM Credit Crunch

1. The increase in mortgage debt, particularly in the subprime market since 2000, was fueled by Adjustable Rate Mortgages (ARMs) and Interest-Only Mortgages. These were manageable during the bubble due to the ability to refinance with low rates as debt-to-equity ratios decreased with rising home prices.
2. However, when the housing bubble burst, debt-to-equity ratios sharply increased, preventing borrowers from refinancing. As ARM terms ended, borrowers faced higher monthly payments they couldn't afford, leading to a surge in delinquencies and foreclosures. As borrowers faced higher monthly payments as ARM terms ended and were unable to refinance, delinquencies and foreclosures more than doubled.

Phase 3: The Collapse of the Asset-Backed Securities (ABS) Market

1. The mortgages that underpinned Asset-Backed Securities (ABS) lost value due to rising non-payment and foreclosure rates. Consequently, the prices of these ABS sharply declined. Any ABS rated below AAA became almost worthless. And even AAA ABS financial products experienced a 60% reduction in value.
2. Banks held significant amounts of these ABS on their balance sheets, often financed with short-term funding. As the value of these assets plummeted, it created a severe credit crunch. Given the prevalence of these products on balance sheets financed with short-term funding, all major bank risks coalesced in rapid sequence.
3. The rush to sell ABS securities (i.e. a fire sale) was exacerbated due to the lack of due diligence in underwriting standards, by credit agencies, and by those purchasing the Asset Backed Securities. There was not a clear understanding of what risk exposure existed within ABS products, even those rated AAA.
4. Even ABS with low-risk profiles became worthless on the secondary market, hindering banks' liquidity despite the underlying mortgages still generating reasonable returns.

Phase 4: The Spread of Contagion and Bank Failure

1. Freddie Mac's warning and New Century Financial's failure (2007) Freddie Mac indicated the higher-than-perceived risk of subprime ABS, and New Century Financial, a leading subprime lender, filed for bankruptcy. This caused a panic in the ABS market.
2. Northern Rock's failure (February 2008):The failure of a major UK bank highlighted the global nature of the crisis and continued stress in the financial sector.
3. Bear Stearns' acquisition (March 2008) JPMorgan Chase acquired Bear Stearns, indicating escalating stress and the potential for further contagion, though this intervention provided some control.
4. IndyMac's failure (July 2008) The failure of IndyMac, a $30 billion thrift, due in part to a bank run, illustrated the accelerating speed at which contagion was occurring.
5. Fannie Mae and Freddie Mac conservatorship (September 2008) The government placed these organizations into conservatorship, further devaluing mortgage-backed assets due to the strong negative signal this represented.
6. Lehman Brothers' bankruptcy (September 2008) Lehman's sudden failure, heavily exposed to ABS risk and deeply interconnected with other financial institutions, brought the global financial system to the brink of collapse.
7. AIG's near failure (September 2008) As AIG had insured many of Lehman's losses, its inability to pay back claims threatened to trigger a complete meltdown of the financial system. Had they failed, every bank with risk hedged by AIG would suddenly have significantly larger amounts of risk on their books.