U.S. ECONOMIC POLICIES THAT CONTRIBUTED TO THE GLOBAL FINANCIAL CRISIS OF 2007-09

A.G. MalliarisLoyola University Chicago

Fourth European Conference on the Welfare State and the Global Financial CrisisThe Catholic University of Leuven,

19-20 April 2010

Focus of the Presentation

• Global Financial Crisis of 2007-09• Financial Instabilities of Market Economies• U.S. Asset Bubbles• U.S. Monetary Policy• All Are Interrelated Issues

Financial Instabilities• Keynes: capitalism is unstable• U.S. choice between freedom and

regulation• Financial stability means the efficient

allocation of funds to investment opportunities

• F. Mishkin: adverse selection and moral hazard: bank soundness

• Slow return to the pre-shock state

Financial Instabilities

• Financial instabilities increase uncertainty and generate risks

• Valuation risks: valuing securities during a financial distress

• Macroeconomic risks: deterioration of the real economy

Asset Price Bubbles

• Asset Bubbles and Instabilities• Controversial Topic; Market Efficiency• 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

• Some Deflate• Some Crash• Some Do not Affect the Real Economy• Some Cause Serious Economic Damage

Monetary Policy

• Price Stability

• Economic Growth

• Risk Management Approach to Financial Instabilities

• Reservations of Anna Schwartz

Major Asset Bubbles and Crashes

• 1929 US: Stock Market Crash

• 1989 Japan: Real Estate and Equities

• 2000 US: NASDAQ

• 2007-9 US: Housing and Credit Bubbles

Bubbles and Monetary Policy

• Two Questions

• Normative: Should Monetary Policy Target Asset Prices?

• Positive: Does Monetary Policy Target Asset Prices?

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

Origins of the Financial Crisis

• Among various causes, consider the role of monetary policy in the U.S.

• Did the Fed contribute to the housing bubble?

• Yes (Taylor); No (Greenspan)

Productivity and Real Fed Rates

2003 Nominal Treasury Yield Curves

0.801.051.301.551.802.052.302.552.803.053.303.553.804.054.30

0 1 2 3 4 5 6 7 8 9 10

Maturity (Years)

Annu

al R

ate

(%)

2003_q1

2003_q2

2003_q3

2003_q4

2004 Nominal Treasury Yield Curves

0.801.051.301.551.802.052.302.552.803.053.303.553.804.054.304.55

0 1 2 3 4 5 6 7 8 9 10

Maturity (Years)

Annu

al R

ate

(%)

2004_q1

2004_q2

2004_q3

2004_q4

Sequence of Bubbles?

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

• How About the Commodities Bubbles?

• Global Dimensions: Savings Glut

• Huge Demand for Long-term AAA’s

The Bursting of the Housing Bubble

• Late 2006 Housing Prices Peaked

• Early 2007 Funds Investing in Home Mortgages experienced problems

• The De-Leveraging Process Started

• The U.S. Crisis was globalized

The De-Leverage Cycle

U.S. Policies and the Global Financial Crisis: Lessons

• From the Great Moderation to Asset Bubble Accommodation

• Deregulation of Financial Markets• Multiple Bubbles Globally• Risk Management Difficulties and

Insufficient Corporate Governance

U.S. Policies and the Global Financial Crisis: Further Lessons• Substantial Leveraging• Private Sector Risk Management: Showers

vs. Storms• Systemic Risk and Financial Stability• The Role of the U.S. Treasury and the Fed• Principles of Crisis Management: Act Rapidly,

Decisively and Forcefully

U.S. Policies and the Global Financial Crisis: Further Lessons

• Crises in Emerging Nations vs. Developed Nations such as the U.S.

• U.S. Policies to Address Future Crises Remain Uncertain

• Global Imbalances Persist