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The Global Financial Crisis: Facts and Lessons for Economists


The Global Financial Crisis: Facts and Lessons for Economists by Professor Assaf Razin Tel Aviv University and Cornell University EBA Special Lecture – PowerPoint PPT presentation

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Title: The Global Financial Crisis: Facts and Lessons for Economists

The Global Financial Crisis Facts and Lessons
for Economists
  • by
  • Professor Assaf Razin
  • Tel Aviv University and Cornell University

EBA Special Lecture July 6, 2010
Pre-crisis monetary policy thinking
  • Schools of thought had a remarkable convergence
    before the 2008 crisis.
  • Backed by the New Keynesian paradigm
    Macroeconomists thought that
  • Monetary policy should have one target,
    inflation, and one instrument, the policy rate.
  • As long as inflation was stable, the output gap
    was expected to be small and stable and 1 target
    , 1 tool monetary policy did its job.

  • Fiscal policy as playing a secondary role, with
    political constraints limiting its usefulness.
  • Financial regulation was mostly outside the
    macroeconomic policy framework.

The Great Moderation which supported a
convergence in macroeconomics
  • The decline in the variability of output and
    inflation led to greater confidence that a
    coherent macro framework had been achieved.
  • In addition, the successful responses to the 1987
    stock market crash, the LTCM collapse, and the
    bursting of the tech (dotcom) bubble reinforced
    the view that monetary policy was also well
    equipped to deal with asset price busts.
  • Thus, by the mid-2000s, it was not unreasonable
    to think that better macroeconomic policy could
    deliver, and had delivered, higher economic

But, then the crisis came.
Business cycles theory before the 2008 crisis
  • Business cycle based on price rigidity, Lucas
    suggested, last only as long as price- and
    wage-setters cant disentangle nominal from real
    shocks - and monetary or fiscal policy cant
    stabilize the economy, at most they add noise.
  • Real business cycles are driven by productivity
  • The welfare cost of business cycles emanates
    essentially from breaks in the smoothed path of
    consumption of a representative consumer in
    normal times. The cCosts of such productivity
    shock related business cycle fluctuations are

Credit frictions were ignored in this welfare
calculus of business cycles
Monetary policy--One target
  • The one target Inflation
  • Stable and low inflation was presented as the
    primary, if not exclusive, mandate of central
  • This justified by the reputational need of
    central bankers to focus on inflation
  • no such reputation issues are associated with
    economic activity
  • An intellectual support for inflation targeting
    provided by the New Keynesian model.

benchmark version of the New Keynesian model
  • In the benchmark version of that model, constant
    inflation is indeed the optimal policy,
    delivering a zero output gap, which turns out to
    be the best possible outcome for activity given
    the imperfections present in the economy. Even if
    policymakers cared about activity, the best they
    could do was to maintain stable inflation. There
    was also consensus that inflation should be very
    low (most central banks targeted 2 inflation).

Stable inflation maintains stable activity
  • Even if policymakers cared about activity, the
    best they could do was to maintain stable
    inflation. There was also consensus that
    inflation should be very low (most central banks
    targeted 2 inflation).

Monetary policy One instrument
  • The policy rate
  • Monetary policy focused on one instrument, the
    policy interest rate.
  • Under the prevailing assumptions, one only
    needed to affect current and future expected
    short rates, and all other rates and prices would
    follow through arbitrage relations in a perfectly
    functioning capital market.

Arbitrage across time and assets
  • Arbitrage across time and assets means that the
    long term rate is a compounded sequence of
    expected policy rates -central bank control both
    short and long rates.
  • Arbitrage across assets means that fed rate can
    influence other assets rates.

A limited role assigned for fiscal policy
  • Following its glory days of the Keynesian 1950s
    and 1960s, and the high inflation of the 1970s,
    fiscal policy took a backseat in the past
    two-three decades.
  • The reasons included skepticism about the
    effects of fiscal policy, itself largely based on
    Ricardian equivalence arguments concerns about
    lags and political influences in the design and
    implementation of fiscal policy and the need to
    stabilize and reduce typically high debt levels.
  • Automatic stabilizers could be left to play when
    they did not conflict with fiscal sustainability.

The details of financial intermediation seen as
irrelevant for monetary policy
  • An exception was made for commercial banks, with
    an emphasis on the credit channel.
  • The possibility of runs justified ofcourse
    deposit insurance and the traditional role of
    central banks as lenders of last resort. The
    resulting distortions were the main justification
    for bank regulation and supervision. Little
    attention was paid, however, to the rest of the
    financial system from a macro standpoint

The global crisis vs. the Great Depression
Similarly sized shocks but strikingly different
policy reactions
  • The Great D and the Great R
  • Have one thing in common
  • A big financial shock
  • But the policy reaction was different
  • Balanced budget and tight liquidity vs. deficits,
    bank bailouts and credit easing

Central Bank is using new tools Credit easing
and quantitative easing
  • Quantitative easing open market transactions in
    T bills to influence long rates
  • Credit easing open market operations in non
    government securities to lend to illiquid sectors

  • And, the effectiveness of the expansionary
    fiscal policy is strengthened when monetary
    policy is constrained by the zero lower bound

Macroeconomics The Post-Crisis Division
  • Take government budget deficits, which now exceed
    10 per cent of gross domestic product in
    countries such as the US and the UK.
  • One camp of macroeconomists (The Ricardians),
    CAMP I, claims that, if not quickly reversed,
    such deficits will lead to rising interest rates
    and a crowding out of private investment..

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  • Instead of stimulating the economy, the deficits
    will lead to a new recession coupled with a surge
    in inflation

Budget Deficits
  • Wrong, says the other camp, CAMP II.
  • There is no danger of inflation. These large
    deficits are necessary to avoid deflation.
  • A clampdown on deficits would intensify the
    deflationary forces in the economy and would lead
    to a new and more intense recession.

Second camp on fiscal policy
  • Camp II, the Keynesians, predict that the same
    1 per cent of extra government spending
    multiplies into significantly more than 1 per
    cent of extra GDP each year until the end of
    2012. This is the stuff of dreams for
    governments, because such multiplier effects are
    likely to generate additional tax income so that
    budget deficits decline.

Monetary Policy Camp I
  • One camp warns that the build-up of massive
    amounts of liquidity is the surest road to
    hyperinflation and advises central banks to
    prepare an exit strategy.

Monetary Policy Camp II
  • Camp II The build-up of liquidity just reflects
    the fact that banks are hoarding funds to improve
    their balance sheets.
  • They sit on this pile of cash but do not use
    it to increase credit. Once the economy picks up,
    central banks can withdraw the liquidity as fast
    as they injected it.
  • The risk of inflation is zero indeed, there
    is a risk of deflation.

Does the controversy between Camp I and Camp II
  • Take the issue of government deficits.
  • If you want to forecast the long-term interest
    rate, it matters a great deal which of the two
    camps you believe. If you believe the first one,
    you will fear future inflation and you will sell
    long-term government bonds. As a result, bond
    prices will drop and rates will rise, prolonging
    the recession. You will have made a reality of
    the fears of the first camp.

An alternative self-fulfilling equilbrium
  • But if you believe the story told by the camp II,
    you will buy long-term government bonds, allowing
    the government to spend without a surge in rates,
    thereby contributing to a recovery.

  • Camp II declared that we were in a liquidity
    trap, which meant that some of the usual rules no
    longer applied the expansion of the Feds
    balance sheet wouldnt be inflationary in fact
    the danger was a slide toward deflation the
    governments borrowing would not lead to a spike
    in interest rates. Camp I declared that we were
    in imminent danger of runaway inflation, and that
    federal borrowing would lead to very high
    interest rates.

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What actually happened?
Policy making under uncertainty
  • The two camps have also wildly different
    estimates of the effect of a 1 per cent permanent
    increase in government spending on real US GDP
    over the next four years. According to the first
    camp, the Ricardians, the multiplier is closer
    to zero than to one, i.e., 1 per cent extra
    spending generates much less than 1 per cent of
    extra GDP, producing little extra tax revenue.
    Thus budget deficits surge with fiscal stimulus
    and become unsustainable.

Fiscal multiplier when the policy rate is at the
lowest bound
  • But, according to the camp II, the Keynesians,
    the multiplier is above one when the monetary
    policy rate is at its lower bound, , i.e., 1 per
    cent extra spending generates much more than 1
    per cent of extra GDP, producing more extra tax
    revenue. Thus budget deficits become more

Banking panic missing from conventional macro
  • In a banking panic, depositors run en masse to
    their banks and demand their money back. The bank
    system cannot honor these demands because they
    lent the money out or they hold long term bonds.
    To honor the demands of depositors, banks must
    sell assets, but only the central bank is large
    enough to be a significant buyer of these assets.

The Panic of 2007-2008
  • The panic in 2007 was not like the previous
    panics in US history because they involved firms
    and institutional investors, not households.
  • The bank liabilities of interest were not
    deposits but repurchase agreement, called repo.
    The collateral for repo is securitized bonds.
  • These liabilities are not insured by the FDIC.

Some general lessons?
  • Beyond the division into the two camps, what are
    the more general lessons?

Macroeconomic fragilities may arise even when
inflation is stable
  • Core inflation was stable in most advanced
    economies until the crisis started. Some have
    argued in retrospect that core inflation was not
    the right measure of inflation, and that the
    increase in oil or housing prices should have
    been taken into account. But no single index will
    do the trick. Moreover, core inflation may be
    stable and the output gap may nevertheless vary,
    leading to a trade-off between the two. Or, as in
    the case of the pre-crisis 2000s, both inflation
    and the output gap may be stable, but the
    behaviour of some asset prices and credit
    aggregates, or the composition of output, may be

Low inflation limits the scope of monetary policy
in deflationary recessions
  • When the crisis started in earnest in 2008, and
    aggregate demand collapsed, most central banks
    quickly decreased their policy rate to close to
    zero. Had they been able to, they would have
    decreased the rate further. But the zero nominal
    interest rate bound prevented them from doing so.
    Had pre-crisis inflation (and consequently policy
    rates) been somewhat higher, the scope for
    reducing real interest rates would have been

Financial intermediation matters
  • Markets are segmented, with specialized
    investors operating in specific markets. Most of
    the time, they are well linked through arbitrage.
    However, when some investors withdraw (because of
    losses in other activities, cuts in access to
    funds, or internal agency issues) the effect on
    prices can be very large. When this happens,
    rates are no longer linked through arbitrage, and
    the policy rate is no longer a sufficient
    instrument. Interventions, either through the
    acceptance of assets as collateral, or through
    their straight purchase by the central bank, can
    affect the rates on different classes of assets,
    for a given policy rate. In this sense, wholesale
    funding is not fundamentally different from
    demand deposits, and the demand for liquidity
    extends far beyond banks.

Countercyclical fiscal policy
  • The crisis has returned fiscal policy to centre
    stage for two main reasons. First, monetary
    policy had reached its limits. Second, from its
    early stages, the recession was expected to be
    long lasting, so that it was clear that fiscal
    stimulus would have ample time to yield a
    beneficial impact despite implementation lags.
    The aggressive fiscal response has been warranted
    given the exceptional circumstances, but it has
    further exposed some drawbacks of discretionary
    fiscal policy for more normal fluctuations in
    particular lags in formulating, enacting, and
    implementing appropriate fiscal measures. The
    crisis has also shown the importance of having
    fiscal space, as some economies that entered
    the crisis with high levels of government debt
    had limited ability to use fiscal policy.

A Set of Monetary policy tools
  • Policy interest ratethe central policy tool
  • Foreign Reserve accumulation- to affect the
    exchange rate
  • Cyclical banks capital ratios-raise capital
    during bubbles lower capital in normal times
  • Housing market loans to value ratios-maximum
    mortgage as a ratio of the acquisition cost
  • Capital Controls

Fiscal Policy Tools
  • Discretionary policy despite lags
  • Strengthening Automatic stabilizers -
  • Cyclical investment tax credit
  • Cyclical rates of unemployment benefits
  • Stabilize debt to GDP ratios as a precaution to
    avoid debt crises triggered by financial collapse

Interactions between monetary and fiscal policies
  • The fiscal-multiplier debate

Multiplier smaller than one under flexible prices
Size of the Multiplier Mitigating Factors
  • Multiplier depends on pre existing public debt,
    on currency regimes, and the degree of openness
  • Higher level of public debt provides a reason for
    permanently lower government purchases than would
    otherwise have been affordable.
  • Hence, the current rise in spending is less
    persistent with high debt.
  • Spending multipliers are higher under fixed
    exchange rate than under flexible exchange rate
    (The Mundell-Fleming model).
  • Spending multipliers are smaller the more open is
    the economy ( due to the leakage of spending into

is the real policy rate required to maintain a
constant path for private expenditure (at the
steady-state level). If the spread becomes
large enough, for a period of time, as a result
of a disturbance to the financial sector,
then the value of rnet t may temporarily be
negative. In such a case the zero lower bound on
it will make (4.1) incompatible, for example,
with achievement of the steady state with zero
ination and government purchases equal to ¹G in
all periods.
is the real policy rate required to maintain a
constant path for private expenditure (at the
steady-state level). If the spread becomes
large enough, for a period of time, as a result
of a disturbance to the financial sector,
then the value of rnet t may temporarily be
negative. In such a case the zero lower bound on
it will make (4.1) incompatible, for example,
with achievement of the steady state with zero
ination and government purchases equal to ¹G in
all periods.
Output gap and deflation
Output gap and G
II. Global imbalances and financial crises
  • Bernanke hypothesized that the global saving glut
    was causing large trade balances. However, if
    there were to be a global savings glut (and low
    interest rates) there should have been a large
    investment boom in countries that imported
    capital. Instead, those countries experienced
    consumption boom. National asset bubbles seem to
    explain better the international imbalances.

Saving Glut
  • Ben Barnanke (2005), The Global Saving Glut and
    the U.S. Current Account Deficit, offered a
    novel explanation for the rapid rise of the U.S.
    trade deficit in the early 21st century. The
    causes, argued Bernanke, lay not in America but
    in Asia.

Global Picture (Continued)
  • In the mid-1990s, Bernanke pointed out, the
    emerging economies of Asia had been major
    importers of capital, borrowing abroad to finance
    their development. But after the Asian financial
    crisis of 1997-98, these countries began
    protecting themselves by amassing huge war chests
    of foreign assets, in effect exporting capital to
    the rest of the world.

Global Picture (Continued)
  • Most of the Asia cheap money went to the United
    States - hence our giant trade deficit, because a
    trade deficit is the flip side of capital
    inflows. But as Mr. Bernanke correctly pointed
    out, money surged into other nations as well. In
    particular, a number of smaller European
    economies experienced capital inflows that, while
    much smaller in dollar terms than the flows into
    the United States, were much larger compared with
    the size of their economies.

Global Picture (Continued)
  • wide-open, loosely regulated financial systems
    characterized the US shadow banking system and
    mortgage institutions, as well as many of the
    other recipients of large capital inflows. This
    may explain the almost eerie correlation between
    conservative praise two or three years ago and
    economic disaster today. Reforms have made
    Iceland a Nordic tiger, declared a paper from
    the Cato Institute. How Ireland Became the
    Celtic Tiger was the title of one Heritage
    Foundation article The Estonian Economic
    Miracle was the title of another. All three
    nations are in deep crisis now.

Global Picture (Continued)
  • For a while, the inrush of capital created the
    illusion of wealth in these countries, just as it
    did for American homeowners asset prices were
    rising, currencies were strong, and everything
    looked fine. But bubbles always burst sooner or
    later, and yesterdays miracle economies have
    become todays basket cases, nations whose assets
    have evaporated but whose debts remain all too
    real. And these debts are an especially heavy
    burden because most of the loans were denominated
    in other countries currencies.

Global Picture (end)
  • Nor is the damage confined to the original
    borrowers. In America, the housing bubble mainly
    took place along the coasts, but when the bubble
    burst, demand for manufactured goods, especially
    cars, collapsed - and that has taken a terrible
    toll on the industrial heartland. Similarly,
    Europes bubbles were mainly around the
    continents periphery, yet industrial production
    in Germany - which never had a financial bubble
    but is Europes manufacturing core - is falling
    rapidly, thanks to a plunge in exports.

Mechanisms which played a role in the liquidity
and credit crunch
  • 1.The effects of large quantities bad loan
    write-downs on borrowers' balance sheets caused
    two "liquidity spirals
  • 1a. As asset prices dropped, financial
    institutions not only had less capital
  • 1b. financial institutions also had harder time
    borrowing, because of tightened lending
  • The two spirals forced financial institutions to
    shed assets and reduce their leverage. This led
    to fire sales, lower prices, and even tighter
    funding, amplifying the crisis beyond the
    mortgage market.

And credit market frictions
  • Lending channels dried up when banks, concerned
    about their future access to capital markets,
    hoarded funds from borrowers regardless of
  • 2. Runs on financial institutions, as occurred
    at Bear Stearns, Lehman Brothers, and others
    following the mortgage crisis, can and did
    suddenly erode bank capital.
  • 3. The mortgage crisis was amplified and became
    systemic through network effects, which can arise
    when financial institutions are lenders and
    borrowers at the same time. Because each party
    has to hold additional funds out of concern about
    counterparties' credit, liquidity gridlock can

Leverage cycles
  • Perhaps the most important lesson from
    Geanakopolis (and the current crisis) is that the
    macro economy is strongly influenced by financial
    variables beyond prices and interest rates.
  • This was the theme of much of the work of Minsky
    (1986), who called attention to the dangers of
    leverage, and of James Tobin (who in Tobin-Golub
    (1998) explicitly defined leverage and stated
    that it should be determined in equilibrium,
    alongside interest rates), and also of Bernanke,
    Gertler, and Gilchrist.
  • Model is based on the dynamics of a mix of
    optimists and pessimists in the market. With the
    optimists fueling the leverage cycle, asset
    prices collapse at a crucial stage where
    optimists are burned by high leverage, and
    financial markets plunge as well.

Deflationary spirals
  • The recent crisis can be analyzed in terms of
    three deflationary spirals
  • (1)Keynesian saving paradox Individuals save as
    a result of a collective lack of confidence,
    leading to fall in aggregate demand and
    self-fulfilling fall in output.
  • (2)Fishers debt deflation Individuals try to
    reduce their debt, driven by a collective
    movement of distrust. They all sell assets at the
    same time, thereby reducing the value of assets.
    This leads to a deterioration of the solvency of
    everybody else.
  • (3)Bank credit deflation Banks are gripped by
    extreme risk aversion simultaneously reduce
    lending, thereby increasing the risk of their
    loan portfolio.

The aftermath of financial crises
  • People who study the aftermath of financial
    crises conclude that recovery typically tends to
    be slow the general consensus is that this
    recovery is likely to be slower than most. One of
    the reasons is that the Federal Reserve is
    running out of ammunition as it reaches the
    interest rate lower bound.

Forecasting Issues
  • The way things typically work is that there are
    leading and lagging indicators. Financial markets
    tend to lead and we have already seen a huge
    run-up in the stock market since last March. Then
    there is usually an improvement in GDP, which we
    are starting to see. The last to come are the
    labor markets.

Lack of a structural model
  • Economists are notoriously bad at forecasting.
    To some extent that is because unexpected things
    happen. Economic forecasting is most useful for
    contingency planning what should we do if this
    happens? But we do not have a structural model -
    which puts together the dynamics of finacial
    sector, the goods sector, and the labor sector.

Banking Regulation?
  • Bank regulation issue is in terms of Diamond
    -Dybvig, which views banks as institutions that
    allow individuals ready access to their money,
    while at the same time allowing most money to be
    invested in illiquid, productive, assets.

Narrow Banking regulation
  • The recent crisis was centered on repo -
    overnight loans in which many businesses park
    their funds.
  • They are money (liquidity) just as much bank
    deposits are. That is why regulation be different
    than narrow banking regulation.

General Equilibrium theoryLeverage cycles
  • Agents are divided between natural buyers of
    assets (optimists) and those who potentially hold
    these assets but normally end up as lenders
  • The collateral requirement and interest rates
    arise from the need to satisfy the less
    optimistic agents that the loan is safe.
  • Following bad news for the asset, there is a
    redistribution of wealth away from the optimists.

Interest rate and collateral
  • There is the whole schedule of pairs (interest
    rate and collateral). If a borrower cannot repay
    then he should hand over the collateral. Less
    secured loans with more risky collateral have
    higher interest rate.
  • With only one dimension of disagreement, only one
    contract out of the whole possible schedule is
    actually traded.
  • Dynamics happens with new information.

Role of news
  • Geanekoplos defines a scary news as one which
    leads to lower expectation and more disagreement.
    It leads to dramatic changes in prices and
  • Good news give rise to booms bad news lead to a
    bust that bankrupts the optimists. Price
    movements are amplified relative to to the news.
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