June 30, 2011
17th Dubrovnik Economic
Conference
Paul Wachtel
Stern School of Business. New York University
1
Discussion of:
Sustainable Financial Obligations
and Crisis Cycles
Mikael Juselius and Moshe Kim
2
Overview
The first – to my knowledge – serious
stab at an important problem.
 Provides explicit thresholds for the
danger level for aggregate credit
 But, fails to address the next question


What is a central banker to do when a
threshold is crossed?
3
Background
A sentence on the first page struck me
(italics mine)
“Close association between high
aggregate leverage and
subsequent credit and output losses
has been empirically established.”
I probably wrote something similar years
ago 
4
My sentence
“Close association between
deepening of financial markets
and subsequent real growth has
been empirically established.”
5
Words matter
What is the difference between
aggregate leverage
and
deep financial markets?
They are the same thing except one
generates crisis and the other growth.
6
Tales of the Croatian economy


Early on there was a banking crisis (98-99)
And then a period of financial deepening



All of a sudden, the message changed



Domestic credit to private sector to GDP ratio doubled –
reached 70% in 2006
Financial deepening [leverage] was creating growth
I was told that there was a dangerous credit boom
Although the credit to GDP ration was not unusually high for a
middle income country
The central bankers realized that some dangerous
threshold had been crossed


How did they know?
Policy changed and crisis was averted.
7
Juselius-Kim tell us how…..

With US data they estimate the threshold that
distinguishes episodes of financial deepening
from credit booms.
 Debt to income ratios are not always the best
thing to look at so they use a related concept –


Financial obligations ratio (i.e. debt servicing +
ammortization to income)
Which is effected by stock of debt, loan maturities
and interest rates.
8
What is the issue in the US?
Ratio increased by about one-third in the 80s
and again in the 00s.
Figure 2b US Nonfinancial domesticdebt to GDP
1960Q1-2010Q1
300.00
250.00
200.00
Total nonfiancial domestic
debt
150.00
Private only
100.00
50.00
Jan-08
Jan-04
Jan-00
Jan-96
Jan-92
Jan-88
Jan-84
Jan-80
Jan-76
Jan-72
Jan-68
Jan-64
Jan-60
0.00
Digitalization
9
Finance does matter, even if crisis
may follow
Industrialization
Modernization
Figure 2a US financial Intermeidary assets to
GDP, 1870-1929
120.00
100.00
%
80.00
60.00
40.00
20.00
0.00
1860
1870
1880
1890
1900
1910
1920
1930
1940
10
Financing growth or crisis?
Credit Booms
Digitalization
Modernization
Industrialization
11
My warning
History is complex – interaction between
leverage-deepening and crisis-growth – has
been around for a while
 Need to look at more than the last 25 years
used by J-K



25 years with 3 cycle episodes
And, you can


Synthetic financial obligations ratio can be
constructed.
Loss rates – for bank loans to business – can be
extended back.
12
Too little data….
Much is made of the difference between 90-91,
08-09 recessions and the milder (non-real
estate) recession of 01.

Each is a special case.




S&Ls and subprime mortgages
Are these two failures of regulation or consequence
of credit excesses?
Are we making inferences from 100 quarterly
observations or from 2 recessions?
Moreover, there is only one really different
observation – the crisis.
13
What if we identify the threshold?
It’s a financial obligations ratio of about
10% for both household and business.
 What should the central bank do when it
is crossed?
 What should the central bank do if very
gradual de-leveraging keeps us about
the threshold for years?

14
We know what central bankers
thought pre crisis
How would central bankers have responded if they had
been informed by J&K that the critical threshold had
been reached.
Greenspan (1999) told Congress that policy should
‘mitigate the fallout when it occurs’  role of the
central bank is to mop up after the bubble bursts.
Bernanke (2002) said ‘“leaning against the bubble” is
unlikely to be productive in practice’ The danger of
false positives – tightening when there really was not a
bubble – was viewed as too great to warrant any
concern ex ante about bubbles.
15
Central bankers

This impressive paper would not have made it
on to a Fed research seminar in those days.
 But, it would now in a world where fear of
systemic risk is everywhere:



Risk from aggregate macro conditions
Risk from financial sector stability
And, as Janet Yellin argued ‘Monetary policy
cannot be a primary instrument for systemic
risk management.’
16
World of central banking is in turmoil

Even if central bank wanted to respond to a
move over the J-K threshold, it might not know
what tools to use.
 The new US FSOC needs to develop
indicators of financial fragility and instability
 Let’s hope that they include the tools
developed here in their arsenal –

Sometimes important ideas can be based on two
just two observations
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The Evolution of the Finance