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DOES PRICE STABILITY LEAD
TO FINANCIAL INSTABILITY?
A. G. (Tassos) Malliaris
Quinlan School of Business
Loyola University Chicago
20th Annual Conference of the
Multinational Finance Society
Izmir, Turkey, June 30-July 3, 2013
My Plan
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Offer Critical Comments on Monetary Policy.
Relate Monetary Policy and Asset Bubbles.
Discuss Financial Instability.
Propose a New Hypothesis: Price Stability
Leads to Financial Instability Using the
Asset Price Bubble Channel.
Critical Event
• The Global Financial Crisis of 2007-09.
• It Is A Major Regime Shift.
• It Is the Main Reason to Reconsider Asset
Bubbles, Macroeconomic Risk and Monetary
Policy.
• Why Was it Missed By Academics, Policy
Makers, Practitioners and Regulators?
A Selective List of Causes of the
Global Financial Crisis
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The Bursting of the Housing Bubble.
Easy Monetary Policy During 2002-2005.
Global Exuberance and Imbalances.
Government Housing Policies, Fannie Mae,
Freddie Mac.
• Opaque Financial Instruments.
• Shadow Financial System.
• Interconnectedness and Too Big to Fail.
Why Was It A Surprise To All?
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Academics: Neoclassical Theories.
Practitioners: Short-term Trading Horizons.
Regulators: Market Discipline.
Policy Makers: Inflation Targeting and the
Great Moderation.
Pre-Crisis Main 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.
Corollaries
• Sufficiency of Price Stability Rather Than
Financial Stability.
• Inflation Targeting Promotes Economic and
Financial Stability.
• Diversification and Risk Management.
• Ignore Financial Crises Because They Are
Unavoidable; Little in Common; Hard to
Predict.
“The dogmas of the quiet past
are inadequate to the stormy
present”
Abraham Lincoln
“Perhaps the greatest irony of the past decade is that
the gradually unfolding success against inflation may
well have contributed to the stock price bubble of the
latter part of the 1990s. Looking back on those years,
it is evident that technology-driven increases in
productivity growth imparted significant upward
momentum to expectations of earnings growth and,
accordingly, to stock prices. At the same time,
an environment of increasing macroeconomic
stability reduced perceptions of risk.
Greenspan (2004, 35)
Search for New Theories to
Explain:
• Asset Bubbles
• Role of Monetary Policy
• Financial Instabilities
• Financial Crises
From Criticism to Construction
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Review Asset Price Bubbles
State Facts about Macroeconomic Risks
Discuss Financial Instability
Evaluate the Role of Monetary Policy
Propose and Argue a New Hypothesis
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?
Evolution of Bubbles
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Some Deflate
Some Crash
Some Do not Affect the Real Economy
Some Cause Serious Economic Damage
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
More On 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
Legislative Response
Lessons Learned from the Crisis
• Price Stability Does Not Imply Financial
Stability
• Asset Price Bubbles Are Very Risky
• The Cost of Cleaning up After a Bubble Bursts
is Very High
• Financial Instability Seriously Impacts
the Real Macroeconomy
How Can We Get Out?
Examine Inflation Targeting
Causes Financial
New Hypothesis
• Inflation Targeting Causes Financial Instability
• Present 7 scenarios
• Conclude With Policy Implications
1. Insufficient Tools
• Suppose the Central Bank Targets Both Price
Stability and Financial Stability.
• These Are Two Goals.
• It Currently Has Only One Tool: Interest Rates
• Financial Stability Is Ignored
2. Minsky’s Stability Causes
Instability
• Also Discussed By Greenspan.
• Suppose the Central Bank Succeeds With
Inflation Targeting.
• Low Inflation, Low Fed Funds, Low Long
Term Interest Rates, Low Risk, High
Valuations, Asset Bubbles, More Collateral,
More Credit, Bubble Grows.
• Eventually Bubble Crashes.
3. Moral Hazard Argument
• The Asymmetric Approach of the Central
Bank (Also Called the Jackson Hole
Consensus) Encourages Moral Hazard.
• Asset Prices Grow Slowly But Crash Quickly.
• Central Banks Ignore the Slow Growth But
Respond Quickly to a Crash to Avoid Real
Risks.
• Lean vs. Clean as Before.
4. Capital Misallocation
• Price Stability Achieves Low Inflation.
• Low Inflation Brings Down Interest Rates and
Risks.
• Asset Bubbles Attract Capital.
• Is Such Capital Allocated Correctly? No !
5. Price Stability and Banks
• Suppose the Central Bank Wishes to
Supplement Price Stability with Financial
Stability.
• Introduce Micro-prudential Regulation.
• It Only Considers Individual Banks.
• It Ignores Systemic Risk.
6. Neo-Austrian Financial
Crisis Ideas
• Nominal vs. Natural Interest Rates.
• Nominal is What Banks Charge.
• Natural is What the Real Sector Supports With
Stable Prices.
• If Nominal and Natural Differ, Asset Prices
Are Affected.
• Keeping Inflation Low Generates Bubbles
7. Globalism and a Sequence of
Asset Bubbles
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Savings and Loan Crisis of 1989-91
Asian Crisis
Internet Bubbles
Housing Bubble
The Current Bond Bubble
“It is better to act and repent
than not to act and regret it”
Machiavelli
Conclusions: Focus on Financial
Stability
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Long History Described by Reinhart and Rogoff
Monitor Credit Expansion
Lean Against Asset Price Bubbles
With U.S. Interests Near Zero, Do We Have a
Government Bond Bubble? What Impact On The
Dollar?
Longer Term: The Fed
and Financial Stability
• The Fed and Monetary Policy
• The Financial Stability Oversight Council
Established by the Dodd Frank Act
• IMF and Global Financial Stability
Moving Forward: What Policies?
• Revise Inflation Targeting: Go Beyond CPI.
• Lean Against Asset Bubbles; Particularly
Housing Bubbles.
• Implement Macro-Prudential Regulation: To
Avoid Systemic Risks Monitor Credit Growth
And Collateral.
• Accept Limitations of Monetary Policy.