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Theory and History of Financial Crises Programme : M1, FE ACADEMIC YEAR 2012/2013

Theory and History of Financial Crises Programme : M1, FE ACADEMIC YEAR 2012/2013. Theory and History of Financial crises. Pr Nikolay NENOVSKY University of Picardie Jules Verne Former Member of Bulgarian Central Bank Governing Council. EDHEC, Nice, May 2013.

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Theory and History of Financial Crises Programme : M1, FE ACADEMIC YEAR 2012/2013

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  1. Theory and History of Financial Crises Programme: M1, FE ACADEMIC YEAR 2012/2013 EDHEC May 2013

  2. Theory and History of Financial crises Pr Nikolay NENOVSKY University of Picardie Jules Verne Former Member of Bulgarian Central Bank Governing Council EDHEC, Nice, May 2013 EDHEC May 2013

  3. Lecture 2Crises and cycles: basic theoretical concepts EDHEC May 2012

  4. Monetary policy (ex: ECB) Open Market Operations (OMO) Main refinancing operations (one week maturity, weekly ) Long term refinancing operations (three month, monthly) Fine tuning operations (non regular, non standardized) Type of transactions Liquidity providing Liquidity absorbing

  5. ECB Monetary Policy Operations EDHEC, Nice, April 2011

  6. Transmission mechanism of monetary policy (ECB) EDHEC, Nice, April 2011

  7. Monetary policy (ex: ECB) In exceptional times Quantitative easing (QE1/QE2/QE3) Enhanced credit support (ECS) Securities market program (SMP) Emergency liquidity assistance (ELA)

  8. Non standard: liquidity provision (Standard: Price level) Separation principle (?) Quantitative easing (QE): Unlimited liquidity provisions, on fixed rate full allotment, ECB offers unlimited 1 week//1 month and 3 months full allotment at 0.75% (before 1%/1.25%) …even 3 years/LTRO The quality of collateral was lowered, low rated assets… SMP ELA Monetary policy during the crisis

  9. EDHEC, Nice, April 2011

  10. EDHEC, Nice, April 2011

  11. China interest rates EDHEC, Nice, April 2011

  12. Risk and term structure of interest rates • Risk structure – relationship among interest rates on bonds with the same maturity (default risk, liquidity risks, tax considerations…) • Term structure (Yield Curve) – a plot of the yield on bonds (costs of borrowing) with different terms to maturity but the same risk, liquidity and tax characteristics, the same borrower and the same currency …

  13. EDHEC May 2012

  14. Yield curve (term structure) EDHEC, Nice, April 2011

  15. Portugaise yield curve (Roubini) EDHEC, Nice, April 2011

  16. Greek yield curve (Roubini)

  17. German yield curve (Roubini) igure 3: German Yield Curve Evolution EDHEC, Nice, April 2011

  18. EU Convergence Issues/ Heterogeneity …. EDHEC May 2012

  19. Convergence Issues Maastricht criteria Short term: inflation, public deficit, exchange rate; Long term: public debt, long term interest rate… Since 2008 total violation…. Stability and growth pact Fiscal compact/penalty?

  20. Econometric measuring  convergence (the variable of the poorer country advance faster that of richer country and catch-up with them)  convergence (means dispersion between the variables in the rich and the poor countries decreases with time) Conditional convergence: local (versus absolute)

  21. IIIEconomic cycle and crises

  22. Crises classification Economic crisis and business cycle Monetary crisis Balance of payment crisis Exchange rate crisis Debt crisis Financial crisis Banking crisis Stock market crisis Twin crisis (banking and exchange rate) Systemic crisis Global crisis

  23. Cycles and crises Economic cycles Types (seasonal, business, sectoral, Kondratieff, secular, etc.) Cycles accumulation (Great Depression) Economic crises Radical/prolonged deviation from the natural level (y*) Assessments (natural, positive, negative…) Cyclical and structural (…trend)

  24. Boom-bust cycle and crisis

  25. Definitions Crisis Moment when the conjuncture is going to turn down (the descendant part of the cycle) Recession When growth becomes slow and when production starts falling, and unemployment raises at least temporary Depression Deep fall of the production and high level of unemployment, cumulative mechanisms exist that make the exit difficult Deflation Prolonged decline of nominal variables as money, price, etc. Debt deflation When prices fall faster that nominal interest rate, and consecutively real rate raise, raising real debt burden

  26. EDHEC, Nice, April 2011

  27. Measurements issues: duration and depth

  28. Measurement issues: potential output y* (?)

  29. More definitions Banking crisis Financial distress that is severe enough to result in the erosion of most or all of the capital in the banking system Banking failures, banking panics, liquidity and solvency issues Exchange rate crisis Forced change in parity, abandonment of pegged or semi pegged exchange rate and international rescue Twin crisis Banking and exchange rate crisis Systemic crisis (form one segment to whole system)

  30. Basic questions Impulse/ driving forces/ causal links/transmission..… According to the impulse Exogenous//endogenous Economic//extra economic (sociological, political, ideological technological//entrepreneur) Monetary //real Market failure//state failure Over-consumption//over (bad) investment Under-consumption//under-investment According to the solution Back to free market State intervention

  31. Two theoretical interpretations Monetary instability (F. Hayek) Exogenous (Central bank) Money supply disturbances Credit or foreign reserve Interest rate below natural rate (i < i*) Preference and relative prices distortions Over/bad Investments Growth not goal in itself Sustainable growth (preferences stability) Crisis is good, healthy Real instability (J. Keynes) Endogenous Preferences instability Especially Investments (heard behavior/animal spirits) – over Investments Under consumption (income distribution) Growth is a main goal Preferences are not stable and could be manipulated in order to obtain growth Crisis is bad, state intervention is needed

  32. Money is not capital, only medium of exchange The only natural and save basis for capital, Investment (I), and growth is the real genuine, voluntary saving (S) Money and lending cannot generate long term growth Long term growth depend of productivity/economic structure Monetary approach: basic postulates

  33. Discretionary monetary policy is disturbing and dangerous Monetary injection (OMO) → (i < i*) the market interest rate below its natural level → this raises liquidity and deforms patterns of C, S, I Over-investment and mal-investments are observed (modification of capital structure) but sooner or later restoration of preferences The crisis technically start when Monetary policy stance changes: i< i* to i > i* (ex: 2005/2006/FED…) Monetary approach

  34. Market for loanable funds and production possibilities frontier

  35. Fisher’s debt deflation model Irving Fisher (1933) Econometrica,”The debt deflation theory of the great depressions” “The more debtors pay, the more they owe…”

  36. Fisher’s debt deflation model • Basic ideas: two diseases • debt disease (over-indebtedness) • + price level disease (deflation) • From borrowed money (debt, debt leverage) to over-I, over – speculation, over-confidence, over - adjustment

  37. Fisher’s debt deflation model • Causal chain • Debt liquidation to distress selling… • Contraction of deposits (as loans are paid off); velocity of circulation decline… • Fall in the Price level • Fall in the net worth (wealth) of business, precipitated bankruptcies… • Fall in profit … • Reduction of output, trade and employment… • Pessimism and loss of confidence, hoarding • Finally: nominal (monetary) i↓, and real r ↑ “The more debtors pay, the more they owe”.

  38. Debt starters New inventions, opportunities and perspectives for profits “Fueling the flames”: easy money is the great cause of over-borrowing Reconstruction loans after war debts (ex: EU funds) Public psychology of going into debt//role of scandals and frauds… Fisher’s debt deflation model

  39. Two opposite solutions according to Fisher Laissez-faire, market solution (bankruptcy) Scientific policy (inflation (reflation), P↑) Fisher’s debt deflation model

  40. Others theoretical interpretations All theories are in fact similar/stress different aspects Minsky’s Financial system instability model Friedman and Schwartz monetary instability model Marxist interpretations (Profit instability) Lenin and Rosa Luxembourg (limited markets, colonies) Schumpeter’s entrepreneur “instability” Books Kindleberger (1977), JK Galbraith (1954) Lionel Robbins (1935), Rothbard (1963)

  41. Modern interpretations Micro-economic explications Informational issues (moral hazard, adverse selection …) Coordination failure; multiple equilibriums Financial system failures Risk management failures (VAR failure )

  42. Modern interpretations Global and geopolitical explanations: Change of world leadership Global imbalances (USA-Europe-Asia…) Struggle for limited resources Exchange rates misalignments (China ….)

  43. Conclusions All theories give parts of a general picture Basically: monetary disturbances and S-I disequilibria//distortions of preferences Technically: informational issues/multiple equilibrium/panics (animal spirits) Need to look deeply into the nature and functioning of money and financial intermediaries

  44. Conclusions Need to reconsider our basic economic knowledge Back to the sound principles of economics Managing the complexity with a simple devices, rules

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