Asset Prices and the Global Financial Crisis of 2007-09
Marc HayfordA.G. Malliaris
Loyola University Chicago
International Banking, Economics & FinanceAssociation at the ASSA Annual Meetings
Denver, Colorado, January 7-9, 2011
Focus of the Paper
• Asset Prices and the Global Financial Crisis of 2007-09
• Theoretical Perspectives: How Do We Understand Financial Crises?
• Scope of Financial Regulation: How Do We Fix Financial Crises?
The Global Financial Crisis
• Causes of the Crisis Have Been Debated
• Present a Selective List of Causes
• Why Was It Missed By Academics, Policy Makers, Practitioners and Regulators?
A Selective List of Causes
• The Bursting of the Housing Bubble• Easy Monetary Policy during 2002-2005• Global Imbalances• Government Housing Policies, Fannie
Mae, Freddie Mac• Opaque Financial Instruments• Shadow Financial System• Interconnectedness and Too Big to Fail
Why Was It A Surprise?
• Academics: Neoclassical Theories
• Practitioners: Short-term Trading Horizons
• Regulators: Market Discipline
• Policy Makers: Inflation Targeting
Current Theories
• Rational Consumers, Firms and Investors• Markets are Efficient; Allow for Behavioral
Deviations• Reality of Business Cycles: Great
Moderation• Monetary Policy and Taylor Rules• Financial Innovation Contributes to Growth• Market Discipline vs. Market Regulation
Corollaries
• Priority for Monetary Rather than Financial Stability
• Inflation Targeting Promotes Economic and Financial Stability
• Diversification and Risk Management • Financial Crises Are Unavoidable; Little in
Common; Hard to Predict
Financial Instabilities
• Challenging to Define• Financial Stability Means the Efficient
Allocation of Funds to Investment Opportunities
• F. Mishkin: Adverse Selection and Moral Hazard
• Slow Return to the Pre-shock State• Keynes: Capitalism is Unstable
Financial Instabilities
• Financial Instabilities Increase Uncertainty and Generate Risks
• Valuation Risks: valuing securities during a financial distress
• Macroeconomic Risks: deterioration of the real economy with high social costs
Proposed Definition
• Let X = R + F denote a vector of real and financial variables that are endogenous
• Let I and U denote exogenous and random variables
• An economy f(X, I, U) is stable if shocks to any of the variables do not translate to significant deviations from trend GDP.
• Role of Leverage
Asset Price Bubbles
• Controversial Topic• Kindleberger: “An Upward Price
Movement Over an Extended Range that then Implodes”
• Soros on Reflexivity• Keynes, Minsky, Shiller on Animal Spirits• Preconditions for Bubbles?
Evolution of Bubbles
• Some Deflate• Some Crash• Some Do not Affect the Real Economy• Some Cause Serious Economic Damage
Asset Bubbles and Monetary Policy
• Price Stability
• Economic Growth
• Risk Management Approach to Financial Instabilities
Bubbles and Monetary Policy
• Two Questions
• Normative: Should Monetary Policy Target Asset Prices?
• Positive: Does Monetary Policy Target Asset Prices?
The Normative Question
• Greenspan, Bernanke and Gertler: The Fed Should Not Target Asset Prices
• Cecchetti and Others: React Cautiously
• Filardo: Deflate Bubbles
• Roubini: Burst Bubbles
Positive Question
• Hayford and Malliaris: Fed Policy may have Encouraged Bubbles
• Greenspan: Appears to Have Tried
• Using an Axe to Do Brain Surgery
Conceptualizing the Debate
• Monetary Policy is Symmetric: increase Fed funds as bubbles grow and decrease them when they crash
• Monetary Policy is Asymmetric: ignore bubbles until they burst, then lower Fed funds to minimize problems to the real economy (Greenspan’s put)
The Asymmetric Approach
• Greenspan’s Clarification• Some support from the Historical Record• Central Bankers Appear Skeptical About
the Theoretical Simulations• Targeting Bubbles may Destabilize the
Real Economy• There is No Political Consensus for
Targeting Bubbles
Origins of the Financial Crisis
• Among Various Causes, Consider the Role of Easy Monetary Policy
• Did the Fed Contribute to the Housing Bubble?
• Yes (Taylor); No (Greenspan)
Moving Forward: Theories• Revise Neo-classical, Friedman, Lucas,
Fama, Greenspan, Bernanke tradition: Economy is Stable
• Formalize Schumpeter, Fisher, Keynes, and Minsky Tradition: Endogenous Instability
• Reformulation of Current Debate on Bubbles and Monetary Policy
• Social and Psychological theories
Moving Forward: What Policies?
• Do Not Act Until We Understand• Incremental Regulation During Normal
Times: Micro-prudential• Substantial Steps During Major Crises• From Micro Financial Regulation to Macro-
Prudential Regulation: Systemic Risks• Yellen: Linkages Between Regulation and
Monetary Policy (excessive credit growth)
Regulatory Developments
• Curb Excessive Risk-Taking• Reduce Leverage• Reform Compensation• Protect Consumers• Regulate Derivatives Markets• Address “Too Big to Fail”• Ensure Taxpayers Do Not Bear Costs of
Failed Institutions
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