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The Financial Crisis and its consequences: The Re-emergence of Two School of Thought by Assaf Razin (June 2010)


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Title: The Financial Crisis and its consequences: The Re-emergence of Two School of Thought by Assaf Razin (June 2010)

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

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.

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.

Business cycles theory before the 2008 crisis
  • Business cycle price rigidity, Lucas suggested,
    last only as long as price- and wage-setters
    cant disentangle nominal from real shocks and
    monetary or fiscal policy cant stabilize the
    economy, at most they add noise.
  • Business cycles are driven by productivity
  • 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.

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).

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.

Arbitrage across time and assets
  • Arbitrage across time and assets means that the
    long term rate is a compounded sequence of
    expected policy ratescentral bank control both
    short and long rates.
  • Arbitrage across assets means that fed rate can
    influence other assets rates.

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
    two-three 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.

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 was
    paid, however, to the rest of the financial
    system from a macro standpoint

The global crisis vs. the Great depression A
Similar shock but strikingly different policy
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!
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

Effectiveness of fiscal policy is strengthened
when monetary policy is constrained by the zero
lower bound (Balnchard, Dell Aricia and Mauro,
Woodford, De Grauwe).
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.

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

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.

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

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.

An alternative self-fulfilling equilbrium
  • But if you believe the story told by the second
    camp, you will happily buy long-term 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.

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.

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 become unsustainable.

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.

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

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.

More general lessons?
  • Beyond the division into the two camps, what are
    the more general lessons?

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

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.

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.

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.

A Set of Monetary policy tools
  • Policy interest ratethe 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 ratios-maximum
    mortgage as a ratio of the acquisition cost
  • 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

Interactions between monetary and fiscal policies
  • The fiscal-multiplier debate

Multiplier smaller than one under flexible prices
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

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
ination and government purchases equal to ¹G in
all periods.
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
ination and government purchases equal to ¹G in
all periods.
Output gap and deflation
Output gap and G
Real interest Rate
Flex price saving
Savings, investment
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.

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.

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.

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.

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.

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 yesterdays miracle economies have
    become todays 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.

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,
    Europes bubbles were mainly around the
    continents periphery, yet industrial production
    in Germany which never had a financial bubble
    but is Europes manufacturing core is falling
    rapidly, thanks to a plunge in exports.

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
  • 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.

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

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.

Deflationary spirals
  • The recent crisis can be analyzed in terms of
    three deflationary spirals
  • 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.
  • Fishers 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.
  • Bank credit deflation Banks are gripped by
    extreme risk aversion simultaneously reduce
    lending, thereby increasing the risk of their
    loan portfolio.

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.

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.

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
    modelwhich puts together the dynamics of
    finacial sector, the goods sector, and the labor

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.

Narrow Banking regulation
  • The recent crisis was centered on repoovernight
    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.

General Equilibrium theoryLeverage cycles
  • Agents are divided between natural buyers of
    assets (optimists) and those who potentially hold
    these assets but normally end up as lenders
  • 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.

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.

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
  • 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.