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320.326: Monetary Economics and the
European Union
Lecture 6
Instructor: Prof Robert Hill
Lessons from the Global Financial Crisis
1
2
The sources used to prepare this lecture include the following:
Malkiel B. G. (2010), Bubbles in Asset Prices, CEPS Working Paper No.
200.
Malkiel B. G. (2011), The Efficient Market Hypothesis and the Financial
Crisis, Mimeo.
Mishkin F. S. (2010), Monetary Policy Strategy: Lessons from the Crisis
downloadable at:
http://www0.gsb.columbia.edu/faculty/fmishkin/papers/10ecb.pdf
Case K. E. and J. M. Quigley (2008), “How Housing Booms Unwind:
Income Effects, Wealth Effects, and Feedbacks through Financial
Markets,” European Journal of Housing Policy 8(2), 161–180.
Cecchetti S. G. (2008), Monetary Policy and the Financial Crisis of
2007-2008
3
1. Asset Market Bubbles
A bubble is a situation where the price of an asset rises to a level
that can only be justified by expectations of future capital gains,
and not by the underlying stream of returns the asset is able to
provide.
A bubble does not necessarily imply a departure from the
efficient markets hypothesis (EMH) – usually defined as a
situation where it is not possible to obtain profits by
instantaneously trading assets of equal risk.
If you think everyone else expects the price to keep rising, then
maybe you should too. If everyone expects the price to rise it
probably will. This is a self-fulfilling prophecy.
4
In Jan 2013 Eugene Fama (a true believer in EMH) was asked
the following question:
Many people would argue that … the inefficiency [in the GFC]
was primarily in the credit markets, not the stock market—that
there was a credit bubble that inflated and ultimately burst.
Fama’s reply is illuminating.
“I don’t even know what that means. People who get credit have
to get it from somewhere. Does a credit bubble mean that people
save too much during that period? I don’t know what a credit
bubble means. I don’t even know what a bubble means. These
words have become popular. I don’t think they have any
meaning.”
The rise and fall of NASDAQ stocks
Source: Burda and Wyplosz, Macroeconomics: A European Text, 5th Edition 6
7
I find this statement remarkable.
Admittedly measuring the fundamental value of an asset is
highly problematic. In a boom, expectations of the
fundamantal value are likely to rise with asset prices. Hence
during a boom it may be difficult to tell whether the price is
above its equilibrium level.
Robert Shiller on the other hand has described EMH as “the
most remarkable error in the history of economic thought.”
Fama and Shiller shared the 2013 Nobel prize in economics for
their work on asset pricing.
8
Another Nobel prize winner (Paul Krugman) said the
following:
“the belief in efficient financial markets blinded many if not
most economists to the emergence of the biggest financial
bubble in history. And efficient-market theory also played a role
in inflating that bubble in the first place.”
Malkiel (another believer in EMH) denies that the housing
bubble in the US was a violation of EMH.
According to him the EMH implies that there are no
unexploited riskless arbitrage opportunities in the market.
9
Malkiel then acknowledges that:
“Markets can make mistakes, sometimes egregious ones,
and those mistakes can have extremely unfortunate
macroeconomic consequences. But there were no ex ante
arbitrage opportunities.”
If you think there is a bubble, you can bet against it by
shorting the market. But the problem is you do not know
when the bubble will burst.
Markets can remain irrational much longer than you can
remain solvent betting against the market.
10
In other words, betting against a bubble is risky (even if you
are certain it is a bubble).
But arbitrage opportunities are hardly ever completely
riskless. Even George Soro’s arbitrage on the British pound in
1992 was not 100 percent riskless.
Soros saw that the British pound was overvalued in the
European Exchange Rate Mechanism (ERM).
Soros borrowed in pounds and converted them into DM. After
the pound was forced out of the ERM and the subsequent
depreciation, he converted DM back into pounds, paid off the
loan and had more than $1 billion left over.
11
Malkiel’s definition of EMH makes it very hard to ever
observe a clear violation of EMH. In this sense it ceases to be
a testable hypothesis.
Also, irrespective of what Malkiel thinks, many market
participants believed in EMH and also believed that EMH
implies that markets do not make mistakes.
2. Hyman Minsky‘s Instability Hypothesis
Minsky (1982) described a scenario that fits well with what
happened in the GFC. He argued that stability sows the seeds
of instability in a capitalist system.
12
Periods of economic expansion and relative stability lead
market participants to reduce the premiums they demand to
hold risky assets and to tolerate greater amounts of debt than
they had previously accepted.
The increased willingness of borrowers to borrow and
lenders to lend leads to a growth in the availability and flow
of credit, which in turn drives up asset prices to levels that
may be inconsistent with their fundamental values.
The process ends with what has been called a “Minsky
Moment.”
Sadly, Minsky died in 1996 and so did not live to see the
vindication of his ideas.
3. The Subprime Crisis of 2007
Housing mortgages in the US were collected together into large
pools, sliced up into standardized strips and sold to investors.
This process is referred to as securitization.
Pooled and sliced mortgages of this type are also known as
mortgage backed securities (MBS).
Problems:
(i) The mortgage initiator sold the mortgage on to a financial
intermediary, who then packaged them into MBS and sold them
to investors.
This created a principle-agent problem.
13
14
The purchaser of an MBS is the principle.
The mortgage initiator is the agent.
In the event of default it is the principle not the agent who bares
the cost. The agent therefore does not care about default risk.
The extreme case was NINJA mortgages (NINJA=no income, no
job or assets).
Buyers of MBS did not realize until too late the extent of the
principle-agent problem.
(ii) Default risk was highly correlated across subprime mortgages,
and foreclosed houses sell for far less than expected once the
housing bubble burst.
(iii) MBS were often packaged together with other debt products
like credit card debt and student loans to form collateralized debt
obligations (CDOs).
The securities were so complicated that nonone was then sure how
much overpriced they were once the crisis started.
The rating agencies – Moody´s, Standard and Poor´s, and Fitch –
gave the CDOs and MBS good credit ratings until 2007.
15
16
Not knowing the value of their own balance sheets, banks did
not know how much they could lend, or how solvent their
counterparties were. Increased volatility in the markets also
increased the perceived level for risk, causing banks to further
cut back lending.
The result was a severe credit crunch that threatened to drive
not only insolvent firms, but also even slightly illiquid but
solvent firms into bankruptcy.
After the collapse of Lehman brothers in 2008 even the
payment system wobbled.
The whole financial system came close to collapse in late 2008.
17
4. MBS and the US Housing Bubble
There was until 2007 high demand for MBS securities.
Investors (including banks) saw MBS and CDOs as a new low
risk asset class that would allow them to further diversify their
portfolios.
The high demand for MBS (stimulated partly by the inflow of
funds from China and oil rich countries) encouraged an increase
in supply of MBS, thus eroding lending standards.
The stable macroeconomic environment also encouraged
market participants to underestimate the level of systemic risk.
18
This effectively provided house buyers with a huge amount of
additional funding to buy houses, which helped trigger a
housing boom. The Figure on the next slide shows real house
prices in the US from 1890 to 2010.
5. The Psychology of Bubbles
Kahneman and Tversky in a series of papers argue that people
often follow simple heuristic rules when making decisions.
In asset markets (especially the housing market) they observe
the recent trend and may then expect this trend to continue.
This mentality of extrapolating recent trends leads naturally to
booms and busts.
20
Shiller (2000) makes a similar argument. He emphasizes the
role of feedback loops in the way people form their
expectations.
Rising asset prices generate enthusiasm, which leads to
increased demand for the asset and further price rises, etc.
Both perspectives share the theme that investors are more
influenced by recent price trends than considerations of where
the current price stands relative to the asset‘s underlying
fundamental value.
Bottom line: Asset markets are prone to booms and busts.
This is something central banks should pay attention to.
21
6. The Impact of a Bust in the Housing Market on the
Economy
(i) Wealth effects
According to Syz (2008), about one third of total wealth is tied
up in residential housing.
Consumption depends on both wealth and income. When house
prices rise, households feel wealthier and increase consumption,
either by withdrawing equity from their house or by saving less.
Conversely, households cut consumption when house prices fall.
22
Case, Quigley and Shiller (2005) find that changes in house
prices have a larger impact than changes in stock market prices
on household consumption. They find that a 1 percent rise in
housing wealth increases consumption by 0.11-0.17 percent.
(ii) Income effects
When home sales and housing starts rise this increases the
income of mortgage brokers, building inspectors, appraisers,
mortgage lenders, home appliance firms, and real estate agents.
The housing construction industry depends on the number of
housing starts (i.e., new builds). In 2006 new investment in
residential structures accounted for 5.5 percent of US GDP.
Housing starts in the US more than halved from 2006 to 2008.
23
(iii) Financial market effects
During a boom more money is deposited in banks. Banks are
keen to lend out this money. Hence their lending standards
become more lax. Also, during a boom, banks and other market
participants tend to stop paying enough attention to risk.
This leads to overinvestment in the whole economy (not just in
the housing sector).
During a bust (and recession) the reverse happens. Less money
is deposited in banks. Hence banks are less keen to lend and
start applying stricter lending rules. Also, having just lost
money they are acutely aware of risk. Hence the fall in
investment is even bigger than it otherwise would be.
This pattern of lax lending during booms and tight lending in
busts tends to accentuate the boom bust cycle.
24
(iv) Fiscal effects
Recapitalizing banks in a crisis increases the level of
Government debt. In Ireland and Spain this process beginning
in 2009 caused huge increases in Government debt.
In 2007 Ireland’s debt to GDP ratio was 29 percent. By 2011 it
had risen to 110 percent.
The large increase in government debt in Ireland and Spain
increased the perceived risk of default, and hence the risk
premium went up (i.e., governments started having to pay
more interest on new bond issues).
25
In most countries the buyer of a house pays a percentage tax on
the purchase price of the house.
These taxes are an important source of tax revenue for
governments during booms. When boom turns to bust, tax
revenue hence falls.
More generally, housing busts tend to cause recessions. In a
recession, less people are employed and paying taxes, while
more are unemployed receiving unemployment benefits. This
also hurts the government budget.
26
7. Possible Responses of Central Banks to Housing Booms
(i) Distinguishing between types of bubbles
Mishkin argues that it is important to distinguish between credit
driven bubbles and other bubbles, and that credit driven bubbles
are much more dangerous. A bursting credit driven bubble can
endanger the financial system.
Housing bubbles are almost inevitably credit driven and hence
warrant serious attention.
The next slides shows a decomposition of housing wealth into
equity and borrowing (i.e., credit). The share of total housing
wealth that is mortgaged in the US rose steadily during the
housing boom.
28
(ii) Distinguishing between booms and bubbles
Some ways to check for bubbles in the housing market are to
look at the following statistics.
(a) The rate of credit growth in the economy
(b) The ratio of house prices to income
(c) The ratio of house prices to rents
Central banks should monitor closely these statistics.
29
(iii) Using interest rates to lean on bubbles
One way for a central bank to lean on a housing boom is to
raise interest rates.
Many monetary economists and central bankers do not like
doing this. They argue that interest rates should be used to
control inflation and that if we use them to manage asset
prices as well, then we have a two goal-one instrument
problem.
Also, it takes away the clarity of inflation targeting making it
harder for a central bank to manage expectations in the
market.
30
(iv) Prudential Regulation
Those monetary economists and central bankers who have since
the GFC become more willing to lean against bubbles tend to
prefer using prudential regulation of the banking sector.
Prudential regulation of banks includes the following:
- Caps on loan-to-value ratios for mortgages
- Caps on debt-to-income ratios for mortgages
- Caps on leverage relative to assets
- Liquidity requirements
These types of regulations are focused on individual firms.
31
Macroprudential regulation
It is possible that the problem lies more with the whole system.
Interactions between firms could be generating externalities that
act to destabilize the system.
Example: the rise in asset values in a boom encourages banks to
increase lending in the face of an unchanging benchmark for
loan-to-value ratios In a bust, bank lending can drop
precipitously, causing a credit crunch.
Macroprudential regulation focuses on trying to reduce the level
of risk in the whole system by for example allowing the
maximum loan-to-value ratio to vary over the business cycle.
32
Mishkin notes that prudential and macroprudential regulation
may not be enough to manage the financial sector.
This is because the regulated firms (mostly banks) will lobby
the regulator to relax regulatory rules (particularly when the
economy is booming and regulation is most needed).
Mishkin therefore reluctantly accepts that central banks may
need to use interest rates as well to restrain financial markets
during booms.
33
8. Beyond Inflation Targeting?
There is a feeling amongst some market participants that
inflation targeting encouraged central banks to ignore asset
prices in the build up to the GFC, and since the crisis they have
not done enough to encourage growth.
For this reason, some alternatives to inflation targeting have
recently been discussed that it has been argued may work
better in recession hit economies (e.g., in the aftermath of a
burst bubble).
We consider some of these here.
34
(i) Unemployment targeting
Bernanke announced on 12 Dec 2012 that the US Federal
Reserve is adopting an unemployment target of 6.5 percent.
“That is the level the Federal Reserve now says it wants the US
unemployment rate to fall to, before it will consider raising
interest rates.
There are caveats to this promise, and it is not independent of
what happens to inflation. In its statement yesterday, the Fed
said that its forecast for inflation would also need to be below
2.5% for them to think about raising rates.” (Source: Stephanie Flanders, BBC website, 13 Dec 2012)
Bernanke’s successor as Fed chair (Janet Yellen) abandoned this
unemployment target in mid March 2014.
35
(ii) Nominal GDP targeting
In a speech on 11 December 2012, Mark Carney – then the
Governor of the Bank of Canada and now the Governor of the
Bank of England – said that
“it might make more sense in today's circumstances to target not
the growth of prices (inflation) but the growth in the cash value
of economic output: nominal GDP.”
A nominal GDP target (say of 4.5 percent) merges concerns
over inflation and growth into a single target.
A nominal GDP target is like a flexible inflation target that
varies over the business cycle (i.e., the target is lower in a boom
and higher in a recession).
36
Example:
growth rate of nom GDP = growth rate of real GDP + inflation
Suppose:
target growth rate of real GDP = 2 percent
target for inflation = 2.5 percent
This yields a nominal GDP target of 4.5 percent.
But when real GDP falls by 1 percent (i.e., a recession), this
means the inflation target rises to 5.5 percent.
If real GDP grows by 5 percent (i.e., the economy is booming), the
inflation target falls to -0.5 percent.
37
Two problems with nominal GDP targeting are:
(a) It is not clear what the right nominal GDP target is. For
example it should be a lot higher for a fast growing
country like China than for the USA.
If set at too low a level (say 5 percent in China) then this
will push the Chinese central bank to try and create strong
deflation, which will hurt the Chinese economy.
If set at too high a level, it can lead to higher than desired
inflation.
(b) Central banks do not really have any experience with
nominal GDP targeting.
38
(iii) Price level targeting
Consider a rise in the price of oil. This shifts the AS curve to the
left. An inflation targeting central bank will respond with an
expansionary monetary policy (see Figure on next slide) while a
price level targeting central bank will not.
The shock moves the economy from A to B. A price level targeter
will wait for the economy to return to point A. An inflation
targeter does not care that the price level is now higher, and only
wants to stabilize the price level at its new higher level. The
inflation targeter therefore aims for point C.
40
Conversely, in response to a negative demand shock, a price level
targeting central bank will respond with a more expansionary
monetary policy than an inflation targeting central bank (again see
Figure).
The shock takes the economy from A to B. An inflation targeter
will again aim for point C (to stabilize the price level at its new
lower level). A price level targeter will aim to return the economy
to point A.
The second case is more relevant in a financial crisis, where there
is a big fall in aggregate demand. A price level target implies that
the central bank will be willing to tolerate higher inflation during
the period of recovery from the crisis so as to get the price level
back to its target level.
41
9. Monetary Policy After the GFC
The GFC has hopefully persuaded most economists that central
banks should not ignore asset prices. Cecchetti (2005) lists the
options for managing asset market booms as follows:
(i) Take them into account only insofar as they influence
forecasts of future inflation.
(ii) Act only after the bubble bursts, reacting to the fallout of the
bubble.
(iii) Lean against the bubble, raising interest rates in an attempt
to keep it from enlarging.
(iv) Include housing prices directly in the price index that the
central bank targets.
(v) Look for regulatory solutions both to keep the bubble from
developing and to reduce the impact of a crash should one occur.
42
We conclude by assessing each of these in turn.
(i) Take them into account only insofar as they influence
forecasts of future inflation
Bean (2003) argues that in an inflation targeting framework,
when the entire future path of expected inflation and growth is
considered there is no independent role for asset prices.
In practice though inflation targeting is typically based on 1-3
year ahead forecasts. Hence asset prices get insufficient weight.
Forecasting over longer horizons is anyway probably not a
serious option since the realibilty of the forecasts declines
rapidly.
43
(ii) Act only after the bubble bursts, reacting to the fallout of
the bubble
This position is completely discredited since the GFC.
It rested on three incorrect assumptions.
(a) The central bank cannot tell that there is a bubble until it
bursts.
Focusing on housing, very high price-rent ratios and price-
income ratios, and rapid growth in credit are clear indicators
of a bubble.
44
(b) If the central bank can tell there is a bubble so can market
participants. As soon as the market thinks there is a bubble, it
will immediately stop.
Not necessarily. Markets can remain irrational longer than
you can remain solvent betting against it.
No-one knows when a bubble will burst.
Most fund managers want to run with the herd. If you lose
money at the same time as everyone else loses money, then
you probably keep your job.
If you lose money by betting against a bubble while everyone
else continues riding the bubble, you may well lose your job.
45
(c) The central bank can clean up the mess after a bubble
bursts.
Until the GFC, the damage that a credit dsriven burst bubble
(e.g., a housing bubble) can cause was hugely unestimated.
The bubble almost brought down the whole financial system.
A central bank cannot afford to wait until a credit driven
bubble bursts by itself.
46
(iii) Lean against the bubble, raising interest rates in an
attempt to keep it from enlarging.
The post GFC consensus is moving in this direction,
although probably in combination with (v). The Australian
and Swedish central banks have successfully leant against the
housing market.
There is great reluctance among central bankers to actually
include an asset price index explicitly in the Taylor rule.
The Taylor rule is derived from a loss function, and it is not
clear how asset prices could be included in the loss function.
47
Most supporters of leaning using interest rates say that it
should be done in an informal way.
The central bank simply says that it is raising interest rates this
month because of concerns over the housing market.
Critics object that this makes monetary policy less transparent.
It should be noted though that nominal GDP targeting
provides a natural way of leaning against the wind. This is
because, while inflation may be stable during a housing boom,
the economy itself is likely to boom along with the housing
market. The rise in real GDP will trigger a rise in interest rates
(even if inflation is stable).
48
(iv) Include housing prices directly in the price index that the
central bank targets
There is strong opposition to targeting a broader measure of
inflation that includes asset prices, since this approach lacks
firm theoretical foundations.
However, the CPI could be made more responsive to changes in
house prices by changing the way the cost of housing services
of owner-occupied housing (OOH) are included in the CPI.
The problem with the current approach (rental equivalence) is
that during a housing boom rents often remain stable. Hence the
CPI is not really affected by a housing boom.
49
If OOH was treated differently, then leaning against a housing
bubble could happen naturally in an inflation target.
See the example the graph on the next slide which shows a
CPI for the UK where the cost of housing services of OOH
has been made more responsive to movements in house prices.
51
(v) Look for regulatory solutions both to keep the bubble
from developing and to reduce the impact of a crash should
one occur
More use should be made of macroprudential regulation,
such as maximum loan-to-value ratios that are lowered
during booms and raised in recessions.
Such regulatory rules should probably be used in
combination with either (iii) or (iv).