Loyola University Chicago The Catholic University of Leuven, U.S. ECONOMIC POLICIES THAT CONTRIBUTED TO THE GLOBAL FINANCIAL CRISIS OF 2007-09 A.G. Malliaris Loyola University Chicago Fourth European Conference on the Welfare State and the Global Financial Crisis The 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?

http://www.ritholtz.com/blog/2009/06/market-capitalization-as-a-percentage-of-gdp/

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

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