-
International Monetary EconomicsLecture 5
Stephen Kinsella
Dept. Economics,University of [email protected]
February 23, 2010
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 1 / 30
-
Agenda
Last Time
1 Price changes: inflation, disinflation, hyperinflation, deflation
2 Link from money supply/demand to domestic price levels to nominaland real exchange rates
3 Central Bank behaviour in all of this (inflation targeting at ECB)
Today
1 Crises
2 Currency Crises
3 Asset/Debt Crises
Admin: Tutorial Times
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 2 / 30
-
In the News
TDs dropping like flies
Greek bonds v.close to Junk status
Consumer confidence falling in US and EU
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 3 / 30
-
Ireland’s GDP/GNPSee http://www.cso.ie/releasespublications/documents/economy/current/qna.pdf
-14.0
-12.0
-10.0
-8.0
-6.0
-4.0
-2.0
0.0
2.0
4.0
2009Q3
2009Q2
2009Q1
2008Q4
2008Q3
2008Q2
2008Q1
% Change
Year on year growth rates
GNP
GDP
Q3 2009
Jan-Sept
2009 Q3 2009
Jan-Sept
2009
GDP 42,506 128,247 -7.4 -8.1
GNP 33,941 104,192 -11.3 -12.1
GDP and GNP at constant prices
Annual % changeAmount €m
17 December 2009
Quarterly National AccountsQuarter 3 2009
GNP down 1.4 per cent but GDP shows small increase,seasonally adjusted, in Q3
Initial estimates of Gross Domestic Product (GDP) and Gross National Product(GNP), on a seasonally adjusted basis, for the third quarter of 2009 show a declineof 1.4 per cent in GNP and a small increase of 0.3 per cent in GDP compared withthe previous quarter. In comparison with the corresponding quarter of 2008, GDPat constant prices was 7.4 per cent lower while GNP was 11.3 per cent lower.
Some of the main features of the results are:
! Consumer spending (personal consumption of goods and services) involume terms was 7.3 per cent lower in Q3 2009 compared with thesame period of the previous year.
! Capital investment, in constant prices, declined by 35 per cent in Q32009 compared with Q3 2008.
! Net Exports (exports minus imports) in constant prices were €2,813million higher in Q3 2009 compared with Q3 2008.
! The volume of output of Industry (incl. Construction) decreased by 9.6per cent in Q3 2009 compared with Q3 2008. Within this the output ofthe Construction sector fell by 34.4 per cent over the same period.Output of Distribution, Transport and Communications was down 9.0per cent, while Output of Other Services was 3.4 per cent lower in thethird quarter of 2009 compared with the same period of last year.
GNPThe estimate of GNP is derived by adjusting GDP for income flows betweenresidents and non-residents. The timing of these flows can be variable. Theyinclude, in particular, the profits of foreign owned enterprises which increased by€1,054m between Q3 2008 and Q3 2009. The increase, in this quarter, in the netfactor income flows is also affected by (a) reduced credits (inward flows),compared to Q3 2008, to Irish outward direct investment enterprises and (b)increased interest payments on government debt. As a result, the decline in GNPwas more severe than that in GDP.
The calculation methods for quarterly accounts are similar to those used in the annual National
Income and Expenditure. As some of the available sources are of lesser reliability than those used
for the annual national accounts, the quarterly estimates are subject to a greater margin of error
than the annual figures. These preliminary estimates will therefore be revised when the next
detailed annual results are published.
For more information contact Gordon Cavanagh at 01 498 4307 or AndrewMcManus at 01 498 4368.
Published by the Central Statistics Office, Ireland.
Ardee Road Skehard RoadDublin 6 CorkIreland Ireland
LoCall: 1890 313 414 (ROI)0870 8760256 (UK/N
Tel: +353 1 498 4000 Tel: +353 21 453 5000Fax: +353 1 498 4229 Fax: +353 21 453 5555
Both offices may be contacted through any of thesetelephone numbers.
CSO on the Web: www.cso.ie
and go to
Economy: National Accounts
Director General: Gerard O'Hanlon
Enquiries:
National Accounts National Accounts, ext [email protected]
Queries and Sales Information Section, ext [email protected]
" Central Statistics OfficeThe contents of this release may be quoted provided thesource is given clearly and accurately. Reproduction for ownor internal use is permitted.
Ref 222/2009 ISSN 1393-9017
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 4 / 30
-
Recap
Causal story
Causality: Money Supply and Demand interact, → Price Level → Inflationrate → Nominal Interest rate → Money Demand.
Macroeconomic Pathologies
“our credit system [is] much more delicate at some times than at others ...panics come according to a fixed rule ... every ten years or so we musthave one of them” Walter Bagehot
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 5 / 30
-
Part I
Crisis
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 6 / 30
-
1st Gen Models of Currency Crises
1 Simple monetary flexible price model, fixed exchange rates, outputassumed constant, token real side
2 Policy maker wants to run budget deficit each period, ∆D > 0
3 Fixed exchange rates plus money financing of budget totallyunsustainable, crisis in currency inevitable.
4 Model asks: when and where does the crisis happen?
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 7 / 30
-
Model
m − p = α× i (money marketeqm)
m = d + r (CB balance sheet)
p = e + P∗ (PPP)
i = i∗ + ė (UIP)
ḋ = µ (govt chooses this)
m money supply
p flexible price level
i interest rate
d domestic assets held by CB
r CB foreign reserves
e exchange rate
µ budget deficit
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 8 / 30
-
Implications of 1st Gen models
Policy Trilemma
Fixed exchange rates, Monetary Policy oriented toward domestic goals, orInternational capital mobility (capital account convertibility). Pick two.Three is impossible.
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 9 / 30
-
2nd Gen Currency Crises Models
Big Idea
Expectations and policymaker’s incentives play key role in shaping policiesthat lead to crises
1 If policymaker finds upholding the peg costly in the first place
2 and if a devaluation is suddenly expected, adding to cost of peggedexchange rate
3 Devaluation! Self-fulfilling expectations
Policy wonk must minimise this loss function:
L = (a× ( e∗︸︷︷︸optimal ex.rate
−peg︷︸︸︷ē ) + b × ( �︸︷︷︸
exp.deval
))2 + C (∆e) (1)
C (∆e) = 0 if no devaluation, C (∆e) = C if a devaluation
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 10 / 30
-
Implications of 2nd Gen Models
1 Multiple equilibria (sunspots) possible, see Woodford (2003)
2 Self-fulfilling expectations / prophecies
3 Open Issue: Coordination of market expectations
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 11 / 30
-
3rd Gen models
1 Take account of huge increase in financial globalisation since 1960s.
2 Show crises as balance sheet mismatches (Krugman (1989))
Assume Owners of firms are the only investors, and their investmentdepends on their net wealth, and firms are leveraged partly in foreigncurrency: balance sheet effects of exchange rate changes.
1 Goods: y = D(Y , i ,EP/P∗) + NX (EP/P∗,Y )
2 Money:M/P = L(Y , i)
3 Interest parity: i = i∗
4 Static expectations and risk neutrality, fixed prices
5 The real exchange rate effects demand through currency mismatcheson investors’ balance sheets for any given P. (Can you see the linkwith the last lecture?)
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 12 / 30
-
Countries
Archive
ECB Watch
Briefing Notes
Press Reviews
SyndicatedColumn
EMU Monitor
Munchau's EuroBlog
PublicationReviews
NewspaperColumns
Your Commentsand Suggestions
Links
About us
LATEST UPDATES
The euro group getsconcrete – on whatGreece has to do,but not on thebailout
16.02.10
The Euro Area'spolitical constraints
By: Wolfgang Münchau
16.02.10
Greece undermassive pressure tostep up austeritypackage
15.02.10
A historic politicalagreement
12.02.10
Greek Crisis: Ending(at last) the TrojanWar
By: Jacques Delpla
11.02.10
Towards a Bailout
11.02.10
Now we help, nowwe don’t –
10.02.10
Markets attackseuro, Portugal andSpain
09.02.10
Europeans want totough it out
08.02.10
Markets are startingto bet on Euro areadisintegration
05.02.10
EMU MONITOREMU Monitor providesinformed debate onmacroeconomics in theeuro area by a group ofacademic experts. EMUMonitor started in 1998 asone of the first ECB watchgroups. Its backgroundpapers and pressconferences contributed tothe debate onmacroeconomic policy inEMU throughout the years.
Alan AhearneBruegel andNUI Galway
BarryEichengreen
University ofCalifornia,Berkeley
Stefan GerlachUniversity ofFrankfurt
Paul deGrauweK. U. Leuven
Jürgen vonHagenUniversity ofBonn
PatrickMinfordCardiffBusinessSchool
ManfredNeumannUniversity ofBonn
RobertoPerotti
IGIER,BocconiUniversity
Jean Pisani-FerryBruegel
Georg RichRichInternationalConsulting
06.01.2009
IRELAND'S PAINFUL ADJUSTMENT
By: Alan Ahearne, NUI Galway and Bruegel
For small European countries such as Ireland, the experience of the past decade demonstrates thatmembership of EMU can bring significant benefits. At no time have these benefits been more evident thanover the last 18 months. Notwithstanding domestic banking problems, membership of a large currencyunion has provided considerable insulation to euro area economies against the turmoil on global financialmarkets. The joke currently doing the rounds that the only difference between Iceland and Ireland is oneletter and about 6 months fails to recognise that small countries with their own domestic currencies aremuch more vulnerable to changes in investor confidence.
These benefits, however, come at a price. Ireland has an export-dependent economy -- and not having aseparate exchange rate as a tool for coping with the economic shocks clobbering the country raisesenormous challenges for policymakers. The past year or so has seen the bursting of Ireland’s housingbubble, the collapse of housing-related tax revenues and an accompanying rapid deterioration in the publicfinances, turmoil on international financial markets, deepening recessions in many of Ireland’s largesttrading partners including the United Kingdom and the United States, and a sharp rise in the value of theeuro against sterling and the dollar. The agility of the Irish economy and its capacity to adjust to suchshocks through internal flexibility will be severely tested over the next few years.
Chart 1: Nominal and real effective exchange rates - Ireland
Flexibility will be required to reverse the loss of international competitiveness that the country experiencedduring the boom (see Chart 1). Given the projected paths for monetary policy in Britain and the US overthe near term, it is difficult to foresee a strong rebound in sterling and the dollar. Along with Ireland’smembership of the single currency, this means that the necessary real exchange rate adjustment can onlybe brought about through changes in domestic prices and wages. In other words, the so-called“competitiveness channel” will be the key economic adjustment mechanism. For this mechanism to workproperly, two things must happen. First, wage and price inflation have to ease to rates below those inIreland’s largest trading partners. Since low (or even negative) inflation is projected in Europe and theUnited States, this implies deflation is required in Ireland. Second, the improvement in competitivenessmust affect trade performance.
How likely is it that both these conditions will be met? Honohan and Lane (2005) find that the nominaleffective exchange rate and output gap are important determinants of inflation differentials in the euro
Figure: Real Exchange Rate for Ireland.
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 13 / 30
-
Crisis Literature
1 Corporate finance and macroeconomics – Bernanke and Gertler(1989)/ Kiyotaki and Moore (1997, 2000)/SuarezSussman (1997,2007)
2 Role of liquidity for corporations
3 Complete contracts: Holmstrom/Tirole (1998, 2008)
4 Spot markets: Caballero/Krishnamurty (2001, 2003, 2004), Lorenzoni(2008)
5 Equilibrium supply of liquidity – Gorton/Huang (2004), Fostel/Geanakoplos (2008), Acharya, Shin/Yorulmazer (2009)
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 13 / 30
-
How did balance sheets get so out of whack?
1 Poor corporate governance/Regulation
2 Crony capitalism
3 Moral Hazard
4 Herding behaviour
Contagion through
Trade flows
Capital flows and financial institutions balance sheets
Financial market participants minds and “herding behavior”
Becomes a systemic risk through interconnectedness
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 14 / 30
-
Credit Crunch?
The largest financial Meltdown since the Great Depression US$6trillion lost on US Stock Exchange The Collapse of major financialfirms: Merrill Lynch, Bear Stearns, Lehman Brothers
International Contagion- Europe and Asia
Impact on Commodity prices
Worldwide recession
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 15 / 30
-
Part II
Minsky
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 16 / 30
-
Minsky’s Big Idea
Idea
Credit markets create their own reversal.
How?
1 Cheap interest rates lead to increased lending.
2 This leads to increases in leverage (L/D ratio).
3 Perverse incentives breed dodgy lending via financial innovations(Junk bonds/CDOS) ensues.
4 Something changes, dodgy loans default, banks fail, unless they getbailed out by Big Bank/Big Govt.
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 17 / 30
-
The Financial Instability HypothesisSee debtdeflation.com
Economy in historical time
Debt-induced recession in recent past
Firms and banks conservative re debt/equity ratios, asset valuation
Only conservative projects are funded
Recovery means conservative projects succeed
Firms and banks revise risk premiums
Accepted debt/equity ratio rises
Assets revalued upwards
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 18 / 30
-
Economy gets Euphoric
Self-fulfilling expectations
Decline in risk aversion causes increase in investment
Investment causes economy to grow faster
Asset prices rise
Speculation on assets becomes profitable
Increased willingness to lend increases money supply
Credit money endogenous
Riskier investments enabled, more asset speculation
Emergence of “Ponzi” financiers
Cash flow always less than debt servicing costs
Profits made by selling assets on a rising market
Interest-rate insensitive demand for finance
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 19 / 30
-
Asset Boom/Bust
Initial profitability of asset speculation:
reduces debt and interest rate sensitivity
drives up supply of and demand for finance
market interest rates rise
But eventually:
rising interest rates make many once conservative projects speculative
forces non-Ponzi investors to attempt to sell assets to service debts
entry of new sellers floods asset markets
rising trend of asset prices falters or reverses
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 20 / 30
-
Crisis/Aftermath
1 Ponzi financiers go bankrupt:
2 can no longer sell assets for a profit
3 debt servicing on assets far exceeds cash flows
4 Asset prices collapse, drastically increasing debt/equity ratios
5 Endogenous expansion of money supply reverses
6 Investment evaporates; economic growth slows or reverses
7 Economy enters a debt-induced recession ...
8 High Inflation?
9 Debts repaid by rising price level
10 Economic growth remains low: Stagflation
11 Renewal of cycle once debt levels reduced
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 21 / 30
-
The Big Bank again
1 Low Inflation?
2 Debts cannot be repaid
3 Chain of bankruptcy affects even non-speculative businesses
4 Economic activity remains suppressed: a Depression
5 Big Government?
6 Anti-cyclical spending and taxation of government enables debts tobe repaid
7 Renewal of cycle once debt levels reduced
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 22 / 30
-
Simple Model
1 Lit : index of liquidity measurement for one economic unit i at time t.
2 Liquidity at any t is the difference between unit i ’s inflows, Init , andoutflows, OUTit .
3 L∗it be the expected solvency of unit i between point t and a laterpoint t + m.
4 The funding ratio at any moment is given by Lit = INit/OUTit .
5 Long term financial sustainability requires that L∗it < 1.
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 23 / 30
-
Simple Model, contd.
1 Liquidity threshold, µ, which each unit holds.
2 If a unit perceives itself as beyond safety margin 1− µi , it reacts byreducing its current illiquidity margin 1− Lit with a resulting decreaseof L∗it .
3 Whenever a unit is within the safe zone L∗it < 1− µi , the unit ispushed by competition to increase the financial outflows more than itsinflows, and thus its Lit , in order to increase utility or returns.
4 An increase of Lit beyond the liquidity line (where Lit > 1), inprinciple, deteriorates L∗it , by increasing debt while worseningexpectations, and vice versa.
L̇it/Lit = −αi [L∗it − (1− µi )], (2)
andL̇∗it/L
∗it = βi (kit − 1). (3)
Here α and β are simple speeds of adjustment of each economic unit overtime.
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 24 / 30
-
Cyclical behaviour
Figure: We can think about financial fragility as the smallest shock to INit and/orOUTit that produces insolvency.
-
Leverage Ratios
0
5
10
15
20
25
30
35
2005 2006 2007 2008
Bank of Ireland AIB IL&P Anglo Irish
Figure: Leverage ratios (shareholder capital/equity)
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 26 / 30
-
Central Bank Behaviour in a Minsky WorldSee http://www.frbsf.org/news/speeches/2009/0416.html
1 CBs must bail out system to keep liquidity flowing. Why?
2 Banks too big/too Interconnected To Fail
3 Lack of regulation of new/esoteric products: Credit default swaps(CDS) ( 98% of credit derivatives) had a large role in creating currentcrisis.
4 Question for the class: Should central banks attempt to deflate assetprice bubbles before they get big enough to cause big problems?
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 27 / 30
-
Bank Behaviour, again
Monetary PolicyRate
Inflation Expectations
Market i. ratesterm structures
Money/CreditAggregates
Asset Prices (Wealth)
Nominal ExchangeRate
Output Gap, Employment
Absorbtion/Income Gap (current account)
Real Exchange Rate
Monetary Policy Rate
Project of Core target inflation gap
Core Inflation
Target Inflation
Figure: Central Bank Behaviour.
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 28 / 30
-
In Class exercise
Classification
Classify the Years 1998-2010 into the Minsky schema above.
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 29 / 30
-
Summary
Please write down 2 things you remember from today.
My Summary1 Crises can be self fulfilling
2 they are little understood, but much new and good work is going ontrying to explain why they occur (and reoccur).
Stephen Kinsella (University of Limerick) EC6012 February 23, 2010 30 / 30
CrisisMinsky