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ASSET BUBBLES AND THE FINANCIAL CRISIS
TASSOS 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
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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
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Low Inflation
Low Interest Rates
Above average productivity
Above average GDP growth
Deregulation
Animal Spirits: Keynes and Shiller
NEW ECONOMY OUTLOOK
Variety of Bubbles
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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
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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 20002001
• 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
Mar-09
Aug-07
Jan-06
Jun-04
Nov-02
Apr-01
Sep-99
Feb-98
Jul-96
Dec-94
May-93
Oct-91
Mar-90
Aug-88
Jan-87
The Emergence of the Housing
Bubble
Composite-10 CSXR
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50
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Possible Causes of the Recent
Financial Crisis
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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
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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
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December 2009 value for S&P is the June 30 close.
2007
2002
1997
1992
1987
1982
1977
1972
1967
1962
1957
1952
1947
1942
1937
1932
1927
1922
1917
1912
1907
1902
1897
1892
1887
1882
1877
1872
S&P Yearly Returns
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45
40
30
25
20
15
10
5
2009
2003
1998
1993
1987
1982
1977
1971
1966
1961
1955
1950
1945
1939
1934
1929
1923
1918
1913
1907
1902
1897
1891
1886
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1881
Price-Earnings Ratio
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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).
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
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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