The Global Financial Crisis: Facts and Lessons for Economists

1
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
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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.

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

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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
  stability.

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But, then the crisis came.
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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
  shocks.
• 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
  small.

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Credit frictions were ignored in this welfare
calculus of business cycles
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Monetary policy--One target

• The one target Inflation
• Stable and low inflation was presented as the
  primary, if not exclusive, mandate of central
  banks.
• 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.

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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).

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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).

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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.

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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.

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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.

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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

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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

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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

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

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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

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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.

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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.

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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.

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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.

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Does the controversy between Camp I and Camp II
matter?

• 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.

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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.

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Positions

• 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?
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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.

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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
  sustainable.

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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.

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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.

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Some general lessons?

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

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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
  undesirable.

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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
  greater.

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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.

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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.

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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

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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

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Interactions between monetary and fiscal policies

• The fiscal-multiplier debate

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Multiplier smaller than one under flexible prices
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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
  imports)

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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.
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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.
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Output gap and deflation
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Output gap and G
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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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
  standards.
• 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.

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And credit market frictions

• Lending channels dried up when banks, concerned
  about their future access to capital markets,
  hoarded funds from borrowers regardless of
  credit-worthiness.
• 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
  result.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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
  (pessimists)
• 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.

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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.

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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
  collateral.
• 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.