FINANCIAL INSTABILITIES, ASSET PRICES AND CRISES: THEORIES AND POLICIES

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?

8. 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 • Reservations of Anna Schwartz

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

17. Productivity and Real Fed Rates

19. 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

20. 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

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