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FINANCIAL INSTABILITIES, ASSET PRICES AND CRISES: THEORIES AND POLICIES

FINANCIAL INSTABILITIES, ASSET PRICES AND CRISES: THEORIES AND POLICIES. Marc Hayford and A.G. Malliaris Loyola University Chicago Association for Social Economics Program Atlanta, Georgia, January 2 – 5, 2010. Focus of the Paper. Financial Instabilities Asset Bubbles Financial Crisis

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FINANCIAL INSTABILITIES, ASSET PRICES AND CRISES: THEORIES AND POLICIES

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  1. FINANCIAL INSTABILITIES, ASSET PRICES AND CRISES:THEORIES AND POLICIES Marc Hayford and A.G. Malliaris Loyola University Chicago Association for Social Economics Program Atlanta, Georgia, January 2 – 5, 2010

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

  3. 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

  4. 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

  5. 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.

  6. 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?

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

  8. Monetary Policy • Price Stability • Economic Growth • Risk Management Approach to Financial Instabilities • Reservations of Anna Schwartz

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

  10. 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

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

  12. 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)

  13. 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

  14. Origins of the Credit Crisis • Among various causes, consider the role of monetary policy • Did the Fed contribute to the housing bubble? • Yes (Taylor); No (Greenspan)

  15. Productivity and Real Fed Rates

  16. What Theories? • Schumpeter, Fisher, Keynes, Kindleberger and Minsky tradition • Classical, Friedman, Lucas, Great Moderation, Greenspan, Bernanke tradition • Reformulation in current debate on bubbles and monetary policy • Micro theories: Kane, Mishkin, Allen, Gale • Social and Psychological theories

  17. What Policies? • Lender of Last Resort • Macro-Prudential Regulation: Systemic risks • Do Not Act Until We Understand • Yellen: Linkages Between Regulation and Monetary Policy • Micro Financial Regulation • Shiller: Humanize and Democratize

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

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