Download Pre crisis monetary policy thinking

The Financial Crisis and its
consequences: The Re-emergence
of Two School of Thought
by Assaf Razin (June 2010)
Lessons to be learnt about:
• The effectiveness of monetary and fiscal policy when monetary
policy is constrained by the zero lower bound ( see Balnchard, Dell
Aricia and Mauro, Woodford, De Grauwe).
• The mechanisms of credit and liquidity
• Mechanics of financial crises
• Global imbalances in the wake of financial crises (Krugman);
• Risk sharing and global integration in the in the presence of
bankruptcies (Stiglitz).
• Leverage cycles (Geanakoplos)
• Forecasting in the aftermath of financial crises
• The welfare cost of business cycles (Is the Lucas benchmark
calibration from the early 1990s relevant?)
1
Pre crisis monetary policy
thinking
Schools of though had a remarkable
convergence before the 2008 crisis. Backed by
the New Keynesian paradigm Macroeconomists
thought that:
Monetary policy as having one target, inflation,
and one instrument, the policy rate. So long as
inflation was stable, the output gap was likely to
be small and stable and monetary policy did its
job.
Fiscal policy as playing a secondary role, with
political constraints limiting its usefulness.
Financial regulation as mostly outside the
macroeconomic policy framework.
2
The “Great Moderation” that
created the convergence in
macro
• The decline in the variability of output and
inflation led to greater confidence that a
coherent macro framework had been achieved.
In addition, the successful responses to the
1987 stock market crash, the LTCM collapse,
and the bursting of the tech bubble reinforced
the view that monetary policy was also well
equipped to deal with asset price busts. Thus, by
the mid-2000s, it was not unreasonable to think
that better macroeconomic policy could deliver,
and had delivered, higher economic stability.
Then the crisis came.
3
Business cycles theory before the
2008 crisis
• Business cycle price rigidity, Lucas suggested,
last only as long as price- and wage-setters can’t
disentangle nominal from real shocks — and
monetary or fiscal policy can’t stabilize the
economy, at most they add noise.
• Business cycles are driven by productivity
shocks.
• The welfare cost emanates essentially from
breaks in the smoothed consumption path of a
representative consumer in normal times. Costs
of such productivity shock related business
cycle fluctuations are small.
4
Monetary policy--One target
One target: Inflation
• Stable and low inflation was presented as the primary, if not
exclusive, mandate of central banks. This resulted from the
reputational need of central bankers to focus on inflation rather than
activity and the intellectual support for inflation targeting provided by
the New Keynesian model. In the benchmark version of that model,
constant inflation is indeed the optimal policy, delivering a zero
output gap, which turns out to be the best possible outcome for
activity given the imperfections present in the economy. This “divine
coincidence” implied that, even if policymakers cared about activity,
the best they could do was to maintain stable inflation. There was
also consensus that inflation should be very low (most central banks
targeted 2% inflation).
5
Monetary policy: One instrument
The policy rate
• Monetary policy focused on one instrument, the policy
interest rate. Under the prevailing assumptions, one only
needed to affect current and future expected short rates,
and all other rates and prices would follow.
6
Arbitrage across time and
assets
• Arbitrage across time and assets means
that the long term rate is a compounded
sequence of expected policy rates—
central bank control both short and long
rates.
• Arbitrage across assets means that fed
rate can influence other assets rates.
7
A limited role for fiscal policy
• Following its glory days of the Keynesian 1950s
and 1960s, and the high inflation of the 1970s,
fiscal policy took a backseat in the past twothree decades. The reasons included scepticism
about the effects of fiscal policy, itself largely
based on Ricardian equivalence arguments;
concerns about lags and political influences in
the design and implementation of fiscal policy;
and the need to stabilize and reduce typically
high debt levels. Automatic stabilizers could be
left to play when they did not conflict with
sustainability.
8
The details of financial
intermediation seen as
irrelevant for monetary policy
• An exception was made for commercial
banks, with an emphasis on the “credit
channel.” Moreover, the possibility of runs
justified deposit insurance and the
traditional role of central banks as lenders
of last resort. The resulting distortions
were the main justification for bank
regulation and supervision. Little attention
9
was paid, however, to the rest of the
The global crisis vs. the Great
depression: A Similar shock but
strikingly different policy
reaction
In view of the success of the
2008-9 recovery efforts:
The relearned analysis
about:
limitations of monetary
policy
and the role of
fiscal policy!
10
Credit easing and quantitative
easing
• Quantitative easing: open market
transactions in T bills to influence long
rates
• Credit easing: open market operations in
non government securities to lend to
illiquid sectors
11
Effectiveness of fiscal policy is
strengthened when monetary
policy is constrained by the zero
lower bound (Balnchard, Dell
Aricia and Mauro, Woodford, De
Grauwe).
12
Macroeconomics: The current
Division
• Take government budget deficits, which
now exceed 10 per cent of gross domestic
product in countries such as the US and
the UK. One camp of macroeconomists
claims that, if not quickly reversed, such
deficits will lead to rising interest rates and
a crowding out of private investment.
Instead of stimulating the economy, the
deficits will lead to a new recession
coupled with a surge in inflation.
13
13
Budget Deficits
• Wrong, says the other camp. There is no
danger of inflation. These large deficits are
necessary to avoid deflation. A clampdown
on deficits would intensify the deflationary
forces in the economy and would lead to a
new and more intense recession.
14
14
Monetary Policy I
• take monetary policy. One camp warns
that the build-up of massive amounts of
liquidity is the surest road to hyperinflation
and advises central banks to prepare an
“exit strategy”.
15
15
Monetary Policy II
• Nonsense, the other camp retorts. The
build-up of liquidity just reflects the fact
that banks are hoarding funds to improve
their balance sheets. They sit on this pile
of cash but do not use it to increase credit.
Once the economy picks up, central banks
can withdraw the liquidity as fast as they
injected it. The risk of inflation is zero
16
16
Does it Matter?
• Take the issue of government deficits. If
you want to forecast the long-term interest
rate, it matters a great deal which of the
two camps you believe. If you believe the
first one, you will fear future inflation and
you will sell long-term government bonds.
As a result, bond prices will drop and rates
will rise. You will have made a reality of
the fears of the first camp.
17
17
An alternative self-fulfilling
equilbrium
…
• But if you believe the story told by the
second camp, you will happily buy longterm government bonds, allowing the
government to spend without a surge in
rates, thereby contributing to a recovery
that the second camp predicts will follow
from high budget deficits.
18
18
Second camp on fiscal policy
• By contrast, the second camp, the
Keynesians, predict that the same 1 per
cent of extra government spending
multiplies into significantly more than 1 per
cent of extra GDP each year until the end
of 2012. This is the stuff of dreams for
governments, because such multiplier
effects are likely to generate additional tax
income so that budget deficits decline.
19
19
Policy making under uncertainty
• The two camps of economists have wildly
different estimates of the effect of a 1 per
cent permanent increase in government
spending on real US GDP over the next
four years. According to the first camp, the
Ricardians, the multiplier is closer to zero
than to one, i.e., 1 per cent extra spending
generates much less than 1 per cent of
extra GDP, producing little extra tax
revenue. Thus budget deficits surge and
20
become unsustainable.
20
Forecasts are ambiguous
Ultimately, all our forecasts use a
particular economic model to interpret data
and to forecast their future course. The
existence of wildly different models takes
away this intellectual anchor and this
translates into more market volatility.
21
21
Banking panic
• In a banking panic, depositors run en
masse to their banks and demand their
money back. The bank system cannot
honor these demands because they lent
the money out or they hold long term
bonds. To honor the demands of
depositors, banks must sell assets, but
only the central bank is large enough to
be a significant buyer of these assets.
22
Panic of 2007-2008
• The panic in 2007 was not like the
previous panics in US history because
they involved firms and institutional
investors, not households.
• The bank liabilities of interest were not
deposits but repurchase agreement, called
“repo”. The collateral for “repo” is
securitized bonds.
• These liabilities are not insured by the
23
FDIC.
More general lessons?
• Beyond the division into the two camps,
what are the more general lessons?
24
Macroeconomic fragilities may
arise even when inflation is
stable
• Core inflation was stable in most advanced economies
until the crisis started. Some have argued in retrospect
that core inflation was not the right measure of inflation,
and that the increase in oil or housing prices should have
been taken into account. But no single index will do the
trick. Moreover, core inflation may be stable and the
output gap may nevertheless vary, leading to a trade-off
between the two. Or, as in the case of the pre-crisis
2000s, both inflation and the output gap may be stable,
but the behaviour of some asset prices and credit
aggregates, or the composition of output, may be
undesirable.
25
Low inflation limits the scope of
monetary policy in deflationary
recessions
When the crisis started in earnest in 2008, and
aggregate demand collapsed, most central
banks quickly decreased their policy rate to
close to zero. Had they been able to, they would
have decreased the rate further. But the zero
nominal interest rate bound prevented them
from doing so. Had pre-crisis inflation (and
consequently policy rates) been somewhat
higher, the scope for reducing real interest rates
would have been greater.
26
Financial intermediation matters
Markets are segmented, with specialized investors
operating in specific markets. Most of the time, they are
well linked through arbitrage. However, when some
investors withdraw (because of losses in other activities,
cuts in access to funds, or internal agency issues) the
effect on prices can be very large. When this happens,
rates are no longer linked through arbitrage, and the
policy rate is no longer a sufficient instrument.
Interventions, either through the acceptance of assets as
collateral, or through their straight purchase by the
central bank, can affect the rates on different classes of
assets, for a given policy rate. In this sense, wholesale
funding is not fundamentally different from demand
deposits, and the demand for liquidity extends far
beyond banks.
27
Countercyclical fiscal policy
The crisis has returned fiscal policy to centre stage for
two main reasons. First, monetary policy had reached its
limits. Second, from its early stages, the recession was
expected to be long lasting, so that it was clear that fiscal
stimulus would have ample time to yield a beneficial
impact despite implementation lags. The aggressive
fiscal response has been warranted given the
exceptional circumstances, but it has further exposed
some drawbacks of discretionary fiscal policy for more
“normal” fluctuations – in particular lags in formulating,
enacting, and implementing appropriate fiscal measures.
The crisis has also shown the importance of having
“fiscal space,” as some economies that entered the crisis
with high levels of government debt had limited ability to
use fiscal policy.
28
A Set of Monetary policy tools
• Policy interest rate—the central policy tool
• Foreign Reserve accumulation- to affect
the exchange rate
• Cyclical banks’ capital ratios-raise capital
during bubbles; lower capital in normal
times
• Housing market loans to value ratiosmaximum mortgage as a ratio of the
acquisition cost
29
• Capital Controls
Fiscal Policy Tools
•
•
•
•
•
Discretionary policy despite lags
Strengthening Automatic stabilizers-Cyclical investment tax credit
Cyclical rates of unemployment benefits
Stabilize debt to gdp ratios as a precaution
to avoid debt crises triggered by financial
collapse
30
Interactions between monetary and
fiscal policies
The fiscal-multiplier debate
31
Multiplier smaller than one under
flexible prices
32
Size of the Multiplier: Mitigating
Factors
• Multiplier depends on pre existing public debt, on
currency regimes, and the degree of openness
• Higher level of public debt provides a reason for
permanently lower government purchases than
would otherwise have been affordable.
• Hence, the current rise in spending is less
persistent with high debt.
• Spending multipliers are higher under fixed
exchange rate than under flexible exchange rate
(The Mundell-Fleming model).
• Spending multipliers are smaller the more open is
the economy ( due to the leakage of spending into
imports)
33
is the real policy rate required to maintain a constant path
for private expenditure (at the steady-state level). If the spread
becomes large
enough, for a period of time, as a result of a disturbance to the financial sector, then
the value of rnet t may temporarily be negative. In such a case the zero lower bound
on it will make (4.1) incompatible, for example, with achievement of the steady state
with zero in°ation and government purchases equal to ¹G in all periods.
34
is the real policy rate required to maintain a constant path
for private expenditure (at the steady-state level). If the spread
becomes large
enough, for a period of time, as a result of a disturbance to the financial sector, then
the value of rnet t may temporarily be negative. In such a case the zero lower bound
on it will make (4.1) incompatible, for example, with achievement of the steady state
with zero in°ation and government purchases equal to ¹G in all periods.
35
Output gap and deflation
36
Output gap and G
Real interest
Rate
Investment
Flex price saving

G
Savings, investment
37
II. Global imbalances and financial
crises
• Bernanke hypothesized that the global
saving glut was causing large trade
balances. However, if there were to be a
global savings glut (and low interest rates)
there should have been a large investment
boom in countries that imported capital.
Instead, those countries experienced
consumption boom. National asset
bubbles seem to explain better the
international imbalances.
38
Saving Glut
• Ben Barnanke (2005), “The Global Saving
Glut and the U.S. Current Account Deficit,”
offered a novel explanation for the rapid
rise of the U.S. trade deficit in the early
21st century. The causes, argued
Bernanke, lay not in America but in Asia.
39
39
Global Picture (Continued)
• In the mid-1990s, Bernanke pointed out,
the emerging economies of Asia had been
major importers of capital, borrowing
abroad to finance their development. But
after the Asian financial crisis of 1997-98,
these countries began protecting
themselves by amassing huge war chests
of foreign assets, in effect exporting capital
to the rest of the world.
40
40
Global Picture (Continued)
• Most of the Asia cheap money went to the
United States — hence our giant trade deficit,
because a trade deficit is the flip side of capital
inflows. But as Mr. Bernanke correctly pointed
out, money surged into other nations as well. In
particular, a number of smaller European
economies experienced capital inflows that,
while much smaller in dollar terms than the flows
into the United States, were much larger
compared with the size of their economies.
41
41
Global Picture (Continued)
• wide-open, loosely regulated financial systems
characterized the US shadow banking system
and mortgage institutions, as well as many of
the other recipients of large capital inflows. This
may explain the almost eerie correlation
between conservative praise two or three years
ago and economic disaster today. “Reforms
have made Iceland a Nordic tiger,” declared a
paper from the Cato Institute. “How Ireland
Became the Celtic Tiger” was the title of one
Heritage Foundation article; “The Estonian
Economic Miracle” was the title of another. All
three nations are in deep crisis now.
42
42
Global Picture (Continued)
• For a while, the inrush of capital created the
illusion of wealth in these countries, just as it did
for American homeowners: asset prices were
rising, currencies were strong, and everything
looked fine. But bubbles always burst sooner or
later, and yesterday’s miracle economies have
become today’s basket cases, nations whose
assets have evaporated but whose debts remain
all too real. And these debts are an especially
heavy burden because most of the loans were
denominated in other countries’ currencies.
43
43
Global Picture (end)
• Nor is the damage confined to the original
borrowers. In America, the housing bubble
mainly took place along the coasts, but when the
bubble burst, demand for manufactured goods,
especially cars, collapsed — and that has taken
a terrible toll on the industrial heartland.
Similarly, Europe’s bubbles were mainly around
the continent’s periphery, yet industrial
production in Germany — which never had a
financial bubble but is Europe’s manufacturing
core — is falling rapidly, thanks to a plunge in
exports.
44
44
Mechanisms which played a role in
the liquidity and credit crunch
• 1. The effects of large quantities bad loan write-downs
on borrowers' balance sheets caused two "liquidity
spirals“:
• 1a. As asset prices dropped, financial institutions not
only had less capital;
• 1b. financial institutions also had harder time borrowing,
because of tightened lending standards.
• The two spirals forced financial institutions to shed
assets and reduce their leverage. This led to fire sales,
lower prices, and even tighter funding, amplifying the
crisis beyond the mortgage market.
45
45
And credit market frictions
• 1. Lending channels dried up when banks, concerned
about their future access to capital markets, hoarded
funds from borrowers regardless of credit-worthiness.
• 2. Runs on financial institutions, as occurred at Bear
Stearns, Lehman Brothers, and others following the
mortgage crisis, can and did suddenly erode bank
capital.
• 3. The mortgage crisis was amplified and became
systemic through network effects, which can arise when
financial institutions are lenders and borrowers at the
same time. Because each party has to hold additional
funds out of concern about counterparties' credit,
liquidity gridlock can result.
46
46
Leverage cycles
• Perhaps the most important lesson from Geanakopolis (and the
current crisis) is that the macro economy is strongly influenced by
financial variables beyond prices and interest rates.
• This was the theme of much of the work of Minsky (1986), who
called attention to the dangers of leverage, and of James Tobin
(who in Tobin-Golub (1998) explicitly defined leverage and stated
that it should be determined in equilibrium, alongside interest rates),
and also of Bernanke, Gertler, and Gilchrist.
• Model is based on the dynamics of a mix of optimists and pessimists
in the market. With the optimists fueling the leverage cycle, asset
prices collapse at a crucial stage where optimists are burned by high
leverage, and financial markets plunge as well.
47
Deflationary spirals
The recent crisis can be analyzed in terms
of three deflationary spirals:
(1) Keynesian saving paradox: Individuals
save as a result of a collective lack of
confidence, leading to fall in aggregate
demand and self-fulfilling fall in output.
(2) Fisher’s debt deflation: Individuals try to
reduce their debt, driven by a collective
movement of distrust. They all sell
assets at the same time, thereby
reducing the value of assets. This leads
to a deterioration of the solvency of
everybody else.
(3) Bank credit deflation: Banks are
gripped by extreme risk aversion
simultaneously reduce lending, thereby
increasing the risk of their loan portfolio.
48
The aftermath of financial crises
• People who study the aftermath of
financial crises conclude that recovery
typically tends to be slow; the general
consensus is that this recovery is likely to
be slower than most. One of the reasons
is that the Federal Reserve is running out
of ammunition as it reaches the interest
rate lower bound.
49
Forecasting Issues
• The way things typically work is that there
are leading and lagging indicators.
Financial markets tend to lead and we
have already seen a huge run-up in the
stock market since last March. Then there
is usually an improvement in GDP, which
we are starting to see. The last to come
are the labor markets.
50
Lack of a structural model
• Economists are notoriously bad at
forecasting. To some extent that is
because unexpected things happen.
Economic forecasting is most useful for
contingency planning: what should we do
if this happens? But we do not have a
structural model—which puts together the
dynamics of finacial sector, the goods
sector, and the labor sector.
51
Banking Regulation?
• Bank regulation issue is in terms of
Diamond -Dybvig, which views banks as
institutions that allow individuals ready
access to their money, while at the same
time allowing most money to be invested
in illiquid, productive, assets.
52
Narrow Banking regulation
The recent crisis was centered on
repo—overnight loans in which
many businesses park their funds.
They are money (liquidity) just as
much bank deposits are. That is
why regulation be different than
narrow banking regulation.
53
General Equilibrium
theory:Leverage cycles
• Agents are divided between natural buyers
of assets (optimists) and those who
potentially hold these assets but normally
end up as lenders (pessimists)
• The collateral requirement and interest
rates arise from the need to satisfy the
less optimistic agents that the loan is safe.
• Following bad news for the asset, there is
a redistribution of wealth away from the
54
optimists.
Interest rate and collateral
• There is the whole schedule of pairs
(interest rate and collateral). If a borrower
cannot repay then he should hand over
the collateral. Less secured loans with
more risky collateral have higher interest
rate.
• With only one dimension of disagreement,
only one contract out of the whole possible
schedule is actually traded.
• Dynamics happens with new information. 55
Role of news
• Geanekoplos defines a “scary news” as
one which leads to lower expectation and
more disagreement. It leads to dramatic
changes in prices and collateral.
• Good news give rise to booms; bad news
lead to a bust that bankrupts the optimists.
Price movements are amplified relative to
to the news.
56