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FINANCIAL INSTABILITIES AND RISK MANAGEMENT BY CENTRAL BANKS

FINANCIAL INSTABILITIES AND RISK MANAGEMENT BY CENTRAL BANKS. Marc Hayford and A.G. Malliaris Loyola University Chicago WEAI 83 rd Annual Conference The Sheraton Waikiki, Honolulu, Hawaii June 29- July 3, 2008. Focus of the Paper. Financial Instabilities Emphasis on Asset Bubbles

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FINANCIAL INSTABILITIES AND RISK MANAGEMENT BY CENTRAL BANKS

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  1. FINANCIAL INSTABILITIES AND RISK MANAGEMENT BY CENTRAL BANKS Marc Hayford and A.G. Malliaris Loyola University Chicago WEAI 83rd Annual Conference The Sheraton Waikiki, Honolulu, Hawaii June 29- July 3, 2008

  2. Focus of the Paper • Financial Instabilities • Emphasis on Asset Bubbles • The Risk Management Approach to Monetary Policy

  3. Financial Instabilities • Challenging to define “Instability” • Financial stability means the efficient allocation of funds to investment opportunities that is robust to shocks • F. Mishkin: adverse selection and moral hazard • G. Kaufman: bank soundness

  4. Financial Instabilities • Financial instabilities increase uncertainty and generate risks • Valuation risks: valuing securities during a financial distress • Liquidity Pressures • Macroeconomic risks: deterioration of the real economy

  5. Why Do Instabilities Matter? • Ineffective Transmission of Monetary Policy • From Financial Instability to Economic Instability • From Local to Global Instabilities

  6. Key Episodes of Financial Instability • The October 1929 Stock Market Crash • The Savings and Loans Crisis of 1989-91 • The Asian Financial Crisis • The Japanese Burst of Real Estate and Stock Market twin Bubbles • The Collapse of Long Term Capital Hedge Fund • The NASDAQ and Housing Twin Bubbles • The 2007-8 Securitization Crisis

  7. Theories of Financial Instability • Not well developed field • Consensus (Greenspan, Mishkin): Stabilizing inflation contributes to financial stability • Hyman Minsky’s hypothesis that “stability causes instability” • Income-debt relationships: Hedging, Speculation and Ponzi Finance

  8. Asset Price Bubbles • Controversial topic: less now than a decade ago • Kindleberger: “an upward price movement over an extended range that then implodes” • Significant deviations from fundamentals • NASDAQ -100 Index in 2000 • U.S. Housing Bubble of 2004-7

  9. NASDAQ-100 Index

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

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

  12. The Normative Question • Bernanke and Gertler: The Fed should not target asset prices • Cecchetti and others: React cautiously • Filardo: Deflate bubbles; Double bubbles • Roubini: Burst bubbles

  13. The Positive Question • Hayford and Malliaris: Difficult to assess Fed’s policy • Greenspan: appears to have tried • Using an axe to do brain surgery

  14. Risk Management Choices • 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

  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. Risk Management Challenges • Between the duality of symmetric and asymmetric responses the consensus is on the asymmetric • Did the easy monetary policy that followed the bursting of the NASDAQ bubble contribute to the housing Bubble? • Two goals and one instrument • Risk Management: Fed funds and counter-cyclical regulation

  17. Conclusions • Monetary Policy and the Great Moderation • The Great Moderation and Asset Bubbles • What causes Asset Bubbles? Endogenous or exogenous? • Formalize the Theories of Financial Instabilities a la Minsky • Add new Instruments

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