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THE GLOBALFINANCIAL CRISIS : WHAT THEORIES EXPLAIN IT AND WHAT POLICIES ARE APPROPRIATE?

THE GLOBALFINANCIAL CRISIS : WHAT THEORIES EXPLAIN IT AND WHAT POLICIES ARE APPROPRIATE?. A.G. Malliaris Loyola University Chicago 17 th Annual Conference of the Multinational Finance Society June 27 -30, 2010 Barcelona, Spain. Current Theories. Rational Consumers, Firms and Investors

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THE GLOBALFINANCIAL CRISIS : WHAT THEORIES EXPLAIN IT AND WHAT POLICIES ARE APPROPRIATE?

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  1. THE GLOBALFINANCIAL CRISIS : WHAT THEORIES EXPLAIN IT AND WHAT POLICIES ARE APPROPRIATE? A.G. Malliaris Loyola University Chicago 17th Annual Conference of the Multinational Finance Society June 27 -30, 2010 Barcelona, Spain

  2. 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

  3. 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

  4. Focus of the Paper • Asset Bubbles • Financial Instabilities • Financial Crises • Monetary Policy • What Theories? What Policies?

  5. Financial Instabilities • Challenging to define • Financial stability means the efficient allocation of funds to investment opportunities • F. Mishkin: adverse selection and moral hazard • G. Kaufman: bank soundness • Slow return to the pre-shock state • Keynes: capitalism is unstable

  6. 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

  7. 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.

  8. 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?

  9. Evolution of Bubbles • Some Deflate • Some Crash • Some Do not Affect the Real Economy • Some Cause Serious Economic Damage

  10. Monetary Policy • Price Stability • Economic Growth • Risk Management Approach to Financial Instabilities

  11. Bubbles and Monetary Policy • Two Questions • Normative: Should Monetary Policy Target Asset Prices? • Positive: Does Monetary Policy Target Asset Prices?

  12. 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

  13. Positive Question • Hayford and Malliaris: Fed Policy Encouraged the Bubble • Greenspan: Appears to Have Tried • Using an Axe to Do Brain Surgery

  14. 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)

  15. 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

  16. 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)

  17. Productivity and Real Fed Rates

  18. The Global Financial Crisis • Easy Monetary Policies • Global Financial Instabilities • The Bursting of the Real Estate Bubble • The Subprime Mortgage Crisis • Overleveraged Firms and Households • Systemic Risk and Uncertainty • Long Economic Recession 6-8 Quarters

  19. What Theories? • Neo-classical, Friedman, Lucas, Miller, Fama, Great Moderation, Greenspan, Bernanke tradition: Economy is Stable • Schumpeter, Fisher, Keynes, Kindleberger and Minsky Tradition: Instability • Reformulation of Current Debate on Bubbles and Monetary Policy • Micro theories: Kane, Mishkin, Allen, Gale • Social and Psychological theories

  20. What Policies? • Do Not Act Until We Understand • From Micro Financial Regulation to Macro-Prudential Regulation: Systemic Risks • Yellen: Linkages Between Regulation and Monetary Policy (excessive credit growth) • Lender of Last Resort • Shiller: Humanize and Democratize

  21. 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

  22. Conclusion • Difficult Task to Integrate Theories • Even Greater Challenge to Formulate Optimal Economic Policies and Regulation

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