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

Current Theories Do Not Fully Explain

• Financial Instabilities

• Asset Bubbles

• Financial Crises

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)

Legislative Response

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)

Productivity and Real Fed Rates

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

Conclusion

• Difficult Task to Integrate Theories

• Even Greater Challenge to Formulate Optimal Economic Policies and Regulation