The Global Financial Crisis of 2007-09: Scope of Regulatory Responses

1. The Global Financial Crisis of 2007-09: Scope of Regulatory Responses Marc Hayford A.G. Malliaris Loyola University Chicago The 10th Biennial Athenian Policy Forum Conference at the DuetscheBundesbank, Frankfurt, July 28-31, 2010

2. Focus of the Paper • The Global Financial Crisis of 2007-09 • Theoretical Perspectives: How Do We Understand It? • Scope of Financial Regulation: How Do We Fix It?

3. The Global Financial Crisis • Causes of the Crisis Have Been Debated • Present a Selective List of Causes • Why Was It Missed By Academics, Policy Makers, Practitioners and Regulators?

4. A Selective List of Causes • The Bursting of the Housing Bubble • Easy Monetary Policy during 2002-2005 • Global Imbalances • Government Housing Policies, Fannie Mae, Freddie Mac • Opaque Financial Instruments • Shadow Financial System • Interconnectedness and Too Big to Fail

5. Why Was It A Surprise? • Academics: Neoclassical Theories • Practitioners: Short-term Trading Horizons • Regulators: Market Discipline • Policy Makers: Inflation Targeting

6. 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

7. 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

8. Current Theories Do Not Explain • Financial Instabilities • Asset Bubbles • Financial Crises

9. Financial Instabilities • Challenging to Define • Financial Stability Means the Efficient Allocation of Funds to Investment Opportunities • F. Mishkin: Adverse Selection and Moral Hazard • Slow Return to the Pre-shock State • Keynes: Capitalism is Unstable

10. 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

11. 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. • Role of Leverage

12. 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?

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

16. Asset Bubbles and Monetary Policy • Price Stability • Economic Growth • Risk Management Approach to Financial Instabilities

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

18. 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

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

20. 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)

21. Legislative Response

22. 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

23. 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)

24. Productivity and Real Fed Rates

26. Moving Forward: Theories • Revise Neo-classical, Friedman, Lucas, Fama, Greenspan, Bernanke tradition: Economy is Stable • Formalize Schumpeter, Fisher, Keynes, and Minsky Tradition: Endogenous Instability • Reformulation of Current Debate on Bubbles and Monetary Policy • Social and Psychological theories

27. Moving Forward: What Policies? • Do Not Act Until We Understand • Incremental Regulation During Normal Times: Micro-prudential • Substantial Steps During Major Crises • From Micro Financial Regulation to Macro-Prudential Regulation: Systemic Risks • Yellen: Linkages Between Regulation and Monetary Policy (excessive credit growth)

28. Objectives of Financial Regulation • Constraint Oligopoly Power and Promote Competition • Protect Market Participants When Information is Hard to Obtain • Prevent Negative Externalities from Market Failure • Stabilize and Unstable Economy

29. Scope of Dodd-Frank Reform • 2300 pages • 243 New Federal Rule-makings, primarily by the SEC (95), the CFTC (61), the Financial Stability Oversight Council (56), the Federal Reserve (54),the FDIC (31) and others

30. 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

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