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Understanding Financial Crisis Theories & Policies

Explore theories explaining the global financial crisis & appropriate policies. Learn about asset bubbles, monetary policy, market regulation, and risk management. Delve into the origins of the crisis, productivity, and real Fed rates. Discover diverse viewpoints on bubbles and monetary policy, along with proposed regulatory strategies to mitigate systemic risks and protect consumers. Gain insights into economic stability, instability, and the challenges of formulating optimal policies amidst varying theories.

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Understanding Financial Crisis Theories & Policies

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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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