How Macroeconomics has
evolved Before and After the
Global Crisis
by
Professor Assaf Razin
Tel Aviv University and Cornell University
EBA Special Lecture
July 11, 2011
1
Current Global Crisis: 4 Acts
• Act I: Credit-fed Asset Bubble
• Act II: Financial Collapse after the Burst of
the bubble
• Act III: spillovers to the real economy
• Act IV: Sovereign Debt Crises
2
Proximate Causes
• Financial innovation, globalization, and
reduced transparency in the financial
intermediation
• Global imbalances: China excess lending
flown into USA to finance excess
borrowing
• Panicky in the free fall of asset prices
• Under capitalized banking system and
credit crunch
3
Historical Precedents?
•
•
•
•
The great depression?
Japan in the 1990s?
Sweden in the 1980s?
The saving and loan crisis in the US in the
1980?
4
Percentage decline in employment
in recessions since 1970
5
History
• Carmen Reinhart of Maryland and Ken Rogoff
identify previous 18 banking crises in industrial
countries since the second world war. They
find what they call "stunning qualitative and
quantitative parallels across a number of
standard financial crisis indicators" - the
common themes that translate these individual
dramas into the big-picture story of financial
boom and bust. Their study is focused on the
US,
6
Banking Crises
• BANKING CRISES ARE PROTRACTED, THEY
NOTE, WITH OUTPUT DECLINING, ON
AVERAGE, FOR TWO YEARS.
• ASSET MARKET COLLAPSES ARE DEEP,
WITH REAL HOUSE PRICES FALLING,
AGAIN ON AVERAGE, BY 35 PER CENT
OVER SIX YEARS AND EQUITY PRICES
DECLINING BY 55 PER CENT OVER 3½
YEARS.
• THE RATE OF UNEMPLOYMENT RISES, ON
AVERAGE, BY 7 PERCENTAGE POINTS
OVER FOUR YEARS, WHILE OUTPUT FALLS
BY 9 PER CENT.
7
Remarkable prediction to the
Global Crisis
• The current unemployment situation in the
USA, 9.2 percent, bears a remarkable
similarity to Reinhart-Roggof account of
the prolonged bust that came after
previous banking crises.
8
Monetary Policy and Asset
Prices: Pre-crisis Prevailng View
• During the past quarter century, monetary
authorities in developed countries have
remarkably successful in reducing and
stabilizing inflation.
• This phenomenon is coined” the great
moderation”
9
Irrational exuberance
• A common view was that asset prices are
driven by exogenous shocks to investor
beliefs or preferences that have little to do
with underlying macro fundamentals.
• Greenspan, famously used the phrase
irrational exuberance
10
Asset prices reflect expectations
about economic growth
• An alternative view is that asset markets
• They reflect evolving beliefs about the long
term prospects for the economy,
particularly trends about growth, rather
than Irrational exuberance, which
describe an exogenous shock to investor
beliefs
11
Fluctuations in asset markets
• The same period, however, has seen
major fluctuations in asset markets.
• The equity bull markets during the 1980s
and the 1990s,
• the boom and bust in technology stocks
during the late 1990s and early 2000s,
• And the dramatic rise in hose prices that
busted into the “great recession “
12
Early Warning
• In 2006 there were warning predictions:
from a few studies :
• Ceccheti, in an empirical study, finds
strong linkages between housing markets
and the macroeconomy. Housing booms
predict strong economic growth in the near
term, weak economic growth in the longer
term, and relatively high inflation.
13
Financial accelerator and
inflation targeting
• Gilchrist and Saito , use in the model the
financial accelerator model : high asset
prices increase the collateral of
entrepreneurs and lower the external cost
of funds for investment.
• They find, using standard loss function,
that a policy of aggressive inflation
targeting is less than ideal because, while
stabilizing inflation, it allows the financial
14
accelerator to destabilize output.
Pre-crisis monetary policy
thinking
Schools of thought had a remarkable
convergence before the 2008 crisis.
Backed by the New Keynesian paradigm
Macroeconomists thought that:
Monetary policy should have one target,
inflation, and one instrument, the policy rate.
As long as inflation was stable, the output gap
was expected to be small and stable; and 1
target , 1 tool monetary policy did its job.
15
Fiscal policy as playing a secondary
role, with political constraints limiting
its usefulness.
Financial regulation was mostly
outside the macroeconomic policy
framework.
16
The “Great Moderation” which
supported a convergence in
macroeconomics
• 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 (dotcom) 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.
17
But, then a global crisis
erupts!
18
Business cycles theory before
the 2008 crisis
• Business cycle based on price rigidity, Lucas
suggested, last only as long as price- and wagesetters can’t disentangle nominal from real
shocks - and monetary or fiscal policy can’t
stabilize the economy, at most they add noise.
• Real business cycles are driven by productivity
shocks.
• The welfare cost of business cycles emanates
essentially from breaks in the smoothed path of
consumption of a representative consumer in
normal times. The cCosts of such productivity
shock related business cycle fluctuations are
small.
19
Credit frictions were ignored
in this welfare calculus of
business cycles
20
Monetary policy--One target
The one target: Inflation
• Stable and low inflation was presented as the primary,
if not exclusive, mandate of central banks.
• This justified by the reputational need of central
bankers to focus on inflation
• no such reputation issues are associated with
economic activity
• An intellectual support for inflation targeting provided
by the New Keynesian model.
21
benchmark version of 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. 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).
22
Stable inflation maintains stable
activity
• 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).
23
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 through arbitrage
relations in a perfectly functioning capital
market.
24
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.
25
A limited role assigned 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 two-three decades.
• The reasons included skepticism 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 fiscal
sustainability.
26
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.”
• The possibility of runs justified ofcourse
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 was paid,
however, to the rest of the financial system
27
from a macro standpoint
The global crisis vs. the Great
Depression: Similarly sized shocks but
strikingly different policy reactions
The Great D and the Great R
Have one thing in common:
A big financial shock;
But the policy reaction was
different:
Balanced budget and tight
liquidity vs. deficits, bank
bailouts and credit easing
28
Central Bank is using new tools:
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
29
And, the effectiveness of the
expansionary fiscal policy is
strengthened when monetary policy is
constrained by the zero lower bound
30
Macroeconomics:
The Post-Crisis 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 (The
“Ricardians”), CAMP I, claims that, if not
quickly reversed, such deficits will lead to
rising interest rates and a crowding out of
private investment..
31
Instead of stimulating the economy, the
deficits will lead to a new recession
coupled with a surge in inflation
32
Budget Deficits
• Wrong, says the other camp, CAMP II.
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.
33
Second camp on fiscal policy
• Camp II, 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.
34
Monetary Policy: Camp I
• 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”.
35
Monetary Policy: Camp II
• Camp II: 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; indeed, there is a
risk of deflation.
36
Does the controversy between
Camp I and Camp II 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, prolonging the recession. You will have
made a reality of the fears of the first camp.
37
An alternative self-fulfilling
equilibrium
• But if you believe the story told by the camp
II, you will buy long-term government bonds,
allowing the government to spend without a
surge in rates, thereby contributing to a
recovery.
38
Positions
• Camp II declared that we were in a liquidity trap, which
meant that some of the usual rules no longer applied: the
expansion of the Fed’s balance sheet wouldn’t be
inflationary — in fact the danger was a slide toward
deflation; the government’s borrowing would not lead to
a spike in interest rates. Camp I declared that we were in
imminent danger of runaway inflation, and that federal
borrowing would lead to very high interest rates.
39
What actually happened?
40
Policy making under uncertainty
• The two camps have also 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 with fiscal stimulus
and become unsustainable.
41
Fiscal multiplier when the policy
rate is at the lowest bound
• But, according to the camp II, the
“Keynesians”, the multiplier is above one
when the monetary policy rate is at its
lower bound, , i.e., 1 per cent extra
spending generates much more than 1 per
cent of extra GDP, producing more extra
tax revenue. Thus budget deficits become
more sustainable.
42
Banking panic– missing from the
conventional macro
• 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.
43
The 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 FDIC.
44
Some general lessons?
• Beyond the division into the two camps,
what are the more general lessons?
45
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.
46
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 precrisis inflation (and consequently policy
rates) been somewhat higher, the scope for
reducing real interest rates would have
been greater.
47
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.
48
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.
49
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
• Capital Controls
50
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
51
Interactions between monetary
and fiscal policies
The fiscal-multiplier debate
52
Multiplier smaller than one
under flexible prices
53
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)
54
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.
55
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.
56
Output gap and deflation
57
Output gap and G
58
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.
59
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.
60
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.
61
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.
62
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.
63
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.
64
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.
65
Mechanisms which played a role
in the liquidity and credit crunch
1.The effects of large quantities bad loan writedowns 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.
66
And credit market frictions
1.
2.
3.
Lending channels dried up when banks,
concerned about their future access to capital
markets, hoarded funds from borrowers
regardless of credit-worthiness.
Runs on financial institutions, as occurred at Bear
Stearns, Lehman Brothers, and others following
the mortgage crisis, can and did suddenly erode
bank capital.
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.
67
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.
68
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.
69
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.
70
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.
71
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.
72
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.
73
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.
74
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
optimists.
75
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.
76
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.
77