the global financial crisis of 2007-09: scope of regulatory responses
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The Global Financial Crisis of 2007-09: Scope of Regulatory Responses . Marc Hayford A.G. Malliaris Loyola University Chicago The 10 th Biennial Athenian Policy Forum Conference at the Duetsche Bundesbank , Frankfurt, July 28-31, 2010. Focus of the Paper. - PowerPoint PPT PresentationTRANSCRIPT
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The Global Financial Crisis of 2007-09: Scope of Regulatory
Responses
Marc HayfordA.G. Malliaris
Loyola University Chicago
The 10th Biennial Athenian Policy Forum Conference at the Duetsche Bundesbank,
Frankfurt, July 28-31, 2010
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Focus of the Paper
• The Global Financial Crisis of 2007-09
• Theoretical Perspectives: How Do We Understand It?
• Scope of Financial Regulation: How Do We Fix It?
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The Global Financial Crisis
• Causes of the Crisis Have Been Debated
• Present a Selective List of Causes
• Why Was It Missed By Academics, Policy Makers, Practitioners and Regulators?
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A Selective List of Causes
• The Bursting of the Housing Bubble• Easy Monetary Policy during 2002-2005• Global Imbalances• Government Housing Policies, Fannie
Mae, Freddie Mac• Opaque Financial Instruments• Shadow Financial System• Interconnectedness and Too Big to Fail
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Why Was It A Surprise?
• Academics: Neoclassical Theories
• Practitioners: Short-term Trading Horizons
• Regulators: Market Discipline
• Policy Makers: Inflation Targeting
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Current Theories
• Rational Consumers, Firms and Investors• Markets are Efficient; Allow for Behavioral
Deviations• Reality of Business Cycles: Great
Moderation• Monetary Policy and Taylor Rules• Financial Innovation Contributes to Growth• Market Discipline vs. Market Regulation
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Corollaries
• Priority for Monetary Rather than Financial Stability
• Inflation Targeting Promotes Economic and Financial Stability
• Diversification and Risk Management • Financial Crises Are Unavoidable; Little in
Common; Hard to Predict
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Current Theories Do Not Explain
• Financial Instabilities
• Asset Bubbles
• Financial Crises
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Financial Instabilities• Challenging to Define• Financial Stability Means the Efficient
Allocation of Funds to Investment Opportunities
• F. Mishkin: Adverse Selection and Moral Hazard
• Slow Return to the Pre-shock State• Keynes: Capitalism is Unstable
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Financial Instabilities
• Financial Instabilities Increase Uncertainty and Generate Risks
• Valuation Risks: valuing securities during a financial distress
• Macroeconomic Risks: deterioration of the real economy with high social costs
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Proposed Definition
• Let X = R + F denote a vector of real and financial variables that are endogenous
• Let I and U denote exogenous and random variables
• An economy f(X, I, U) is stable if shocks to any of the variables do not translate to significant deviations from trend GDP.
• Role of Leverage
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Asset Price Bubbles
• Controversial Topic• Kindleberger: “An Upward Price
Movement Over an Extended Range that then Implodes”
• Soros on Reflexivity• Keynes, Minsky, Shiller on Animal Spirits• Preconditions for Bubbles?
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Evolution of Bubbles
• Some Deflate• Some Crash• Some Do not Affect the Real Economy• Some Cause Serious Economic Damage
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Asset Bubbles and Monetary Policy
• Price Stability
• Economic Growth
• Risk Management Approach to Financial Instabilities
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Bubbles and Monetary Policy
• Two Questions
• Normative: Should Monetary Policy Target Asset Prices?
• Positive: Does Monetary Policy Target Asset Prices?
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The Normative Question• Greenspan, Bernanke and Gertler: The
Fed Should Not Target Asset Prices
• Cecchetti and Others: React Cautiously
• Filardo: Deflate Bubbles
• Roubini: Burst Bubbles
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Positive Question
• Hayford and Malliaris: Fed Policy Encouraged the Bubble
• Greenspan: Appears to Have Tried
• Using an Axe to Do Brain Surgery
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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)
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Legislative Response
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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
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Origins of the Financial Crisis
• Among Various Causes, Consider the Role of Easy Monetary Policy
• Did the Fed Contribute to the Housing Bubble?
• Yes (Taylor); No (Greenspan)
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Productivity and Real Fed Rates
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Moving Forward: Theories• Revise Neo-classical, Friedman, Lucas,
Fama, Greenspan, Bernanke tradition: Economy is Stable
• Formalize Schumpeter, Fisher, Keynes, and Minsky Tradition: Endogenous Instability
• Reformulation of Current Debate on Bubbles and Monetary Policy
• Social and Psychological theories
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Moving Forward: What Policies?
• Do Not Act Until We Understand• Incremental Regulation During Normal
Times: Micro-prudential• Substantial Steps During Major Crises• From Micro Financial Regulation to Macro-
Prudential Regulation: Systemic Risks• Yellen: Linkages Between Regulation and
Monetary Policy (excessive credit growth)
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Objectives of Financial Regulation
• Constraint Oligopoly Power and Promote Competition
• Protect Market Participants When Information is Hard to Obtain
• Prevent Negative Externalities from Market Failure
• Stabilize and Unstable Economy
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Scope of Dodd-Frank Reform
• 2300 pages
• 243 New Federal Rule-makings, primarily by the SEC (95), the CFTC (61), the Financial Stability Oversight Council (56), the Federal Reserve (54),the FDIC (31) and others
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Regulatory Developments
• Curb Excessive Risk-Taking• Reduce Leverage• Reform Compensation• Protect Consumers• Regulate Derivatives Markets• Address “Too Big to Fail”• Ensure Taxpayers Do Not Bear Costs of
Failed Institutions
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Conclusion
• Difficult Task to Integrate Theories
• Even Greater Challenge to Formulate Optimal Economic Policies and Regulation