ASSET BUBBLES AND THE FINANCIAL CRISISTASSOS G. MALLIARIS

University of Piraeus EMBA, July 11-14, 2009

• What are Asset Bubbles?

• Variety of Bubbles• Selected facts• Financial Crisis of

2007-2009

Origins of the Crisis

• Housing Bubble in the US and elsewhere

• Was the Housing Bubble related to other Bubbles?

• Can Markets Alone Develop Bubbles?

• Role of Central Banks in Bubble Formation

Approach

• Discuss the Concept of an Asset Bubble

• Relate the Global Financial Crisis to a Sequence of Asset Bubbles

• Conclude with Lessons Learned

What Are Asset Bubbles?

• Price of an Asset =

Fundamentals + Bubble

THINK

• What are the Fundamentals?

• Supply and Demand

• The Role of Information

• Reality of Uncertainty

• Animal Spirits

Fundamentals

• Market Efficiency works well when information and arbitrage are costless

• Market Efficiency as a Unique Equilibrium

• Multiple Equilibria

George Soros

• Theory of Reflexivity: From Fundamentals to Price or Price to Fundamentals?

• What happens when attention shifts from Fundamentals to Price?

• Expectations

Three Views

• Charles Kindleberger: Feedback or Momentum

• Robert Shiller: Reversals

• Minsky: Three stages of Financing or Leveraging

Financial Instabilities

• 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• Challenging to define

Financial Instabilities

• Financial instabilities increase uncertainty and generate risks

• Valuation risks: valuing securities during a financial distress

• Macroeconomic risks: deterioration of the real economy

Preconditions for Bubbles

• Low Inflation

• Low Interest Rates

• Above average productivity

• Above average GDP growth

• Deregulation

• Animal Spirits: Keynes and Shiller

• NEW ECONOMY OUTLOOK

Variety of Bubbles

• Exchange Rates Bubbles

• Stock Market Bubbles

• Real Estate Bubbles

• Art Bubbles

• Commodities Bubbles

• Credit Bubbles

• Other

Who says we cannot recognize a bubble?

Evolution of Bubbles

• Some Deflate

• Some Crash

• Some Do not Affect the Real Economy

• Some Cause Serious Economic Damage

What are the basic questions?

• Do all booms/bubbles end in crashes?

• How are equity and real estate bubbles and crashes related?

• What are the economic consequences of bubble bursts

IMF Data

• Sample includes 14 Industrialized Countries

• Equity data from 1959 to 2002

• Housing data from 1970 to 2002

Methodological Issues

• Consider only top quartile of recorded peak to peak price increases as bubbles

• Consider only bottom quartile of recorded peak to trough price declines as bubble crashes

Findings about Stock Market

• 52 equity crashes found during sample

• On average, there was one crash per country every 13 years

• Sample average of crash was 45%

• Only one fourth of bubbles end up crashing

• Crashes unfold over 2.5 years

Findings about Housing Bubbles

• A Housing crash is defined as a 14% decline in prices

• Housing crashes occur less often than stock market crashes

• In the sub sample there were 20 housing vs. 25 stock market crashes

• Housing crashes are clustered while equity crashes are evenly distributed

• Housing crashes lasted 4 years

Equity and Housing Crashes

• Stock market crashes may cause GDP declines of up to 4%

• Housing market crashes may cause GDP declines of up to 8%

Crashes and Consumption

• For every 100 dollars of wealth lost in a stock market crash consumers decrease their consumption by 4 dollars

• For every 100 dollars of wealth lost in housing, consumers decrease their consumption by 10 dollars

• Thus, housing crashes are more difficult than stock market crashes

Crashes and Banks

• Stock Market crashes do not always affect banks

• Housing crashes influence the banking sector more severely

• Housing crashes are most often the result of monetary tightening

Crashes and Corporations

• Stock Market bubbles accelerate business investments

• Stock Market bubbles increase equity financing and reduce debt financing

The Role of Monetary Policy

• Price Stability and Economic Growth

• The Monetary Policy Paradox: achieving low inflation may lead to bubbles

• Should Monetary Policy “target” bubbles?

• Does Monetary Policy “target” bubbles?

• Role of Financial Stability

Are Bubbles Isolated?

• The Crash of the Internet Bubble in 2000-2001

• 9/11 Terrorist Attack

• Was Monetary Policy Easy for Too Long?

The Normative Question

• Bernanke and Gertler: The Fed Should Not Target Asset Prices

• Cecchetti and Others: React Cautiously

• Filardo: Deflate Bubbles

• Roubini: Burst Bubbles

Positive Question

• Hayford and Malliaris: Difficult to Assess Fed’s Policy

• Greenspan: Appears to Have Tried

• Using an Axe to Do Brain Surgery

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)

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

The Nasdaq Bubble and its Bursting

Fed Funds During the Past Decade

The Emergence of the Housing BubbleComposite-10 CSXR

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Possible Causes of the Recent Financial Crisis

• Easy Monetary Policy• Very Low Interest Rates• Large Global Savings• Housing Bubble• Subprime Mortgages• Role of Credit Agencies• Credit and Leverage Bubbles• Other

Monetary and Fiscal Policies

• Economic Stability: Definition?

• Financial Stability: Definition?

• Lender of Last Resort

• Fiscal Initiatives

Moving Forward

• From the Financial Sector

• To the Real Economy

• What are the Links?

The Financial Dimension

• What has happened to the U.S. stock market?

• Recent History

• The Very Long Run

December 2009 value for S&P is the June 30 close.

S&P Yearly Returns

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Ratio of value of S&P 500 to the average earnings of those companies over the previous 10 years, adapted and updated from Shiller. Blue line: ratio of monthly average S&P 500 index (deflated by current CPI) to 10-year average of most recent monthly earnings (each deflated by CPI for that month). April-June 2008 earnings from straight-line monthly interpolation of 12-month as reported quarterly earnings from Standard & Poor's. November 2008 value for S&P is the November 12 close. Red line: historical average (16.34).

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The Impact on GDP

• Shorter Perspective

• Longer Perspective

Global Perspectives

• Past Crises Were in Developing Economies

• Major U.S. Crisis

• How to Establish Global Financial and Economic Stability

Sequence of Bubbles?

• Are the Internet Bubble Bursting and the Housing Bubble Connected?

• How About the Commodities Bubbles?

• Global Dimensions: Savings Glut

Conclusions

• U.S. Driven Global Financial Crisis• Multiple Causes• Double Feedback between Financial and Real

Sectors• Multiple Global Feedback• Balance Between Bail-outs and Bankruptcies• What Role for Regulation?• Global Stability?

12 Lessons and Future Research Agenda

• Monetary Policy and the Great Moderation

• The Great Moderation and Asset Bubbles

• What Causes Asset Bubbles? Endogenous or Exogenous?

• Multiple Bubbles Globally

• Theories of Financial Instabilities a la Minsky: Banks and Shadow “Banks”

12 Lessons and Future Research Agenda

• Private Sector Risk Management: Showers vs. Storms

• Debt Deflation (I. Fisher) vs. Reflation• Systemic Risk and Financial Stability• Policy Goals and Instruments• Macro Prudential Regulation• Addressing Global Instabilities• Principles of Crisis Management: Reducing

Knightian Uncertainty

Tentative Future Scenarios

• Anemic growth and possible deflation a la Japan• Slow growth with reflation• Rapid Inflation as in 1970s, 3% to 6%• Both of these scenarios imply modest equity

increases, difficulties for the dollar and changes in global financial intermediation

• Potential formation of an Asian Currency Union• Eventual re-emergence of animal spirits