1. ASSET BUBBLES AND THE FINANCIAL CRISIS TASSOS G. MALLIARIS University of Piraeus EMBA, July 11-14, 2009 What are Asset Bubbles? Variety of Bubbles Selected facts Financial Crisis of 2007-2009

2. Origins of the Crisis Housing Bubble in the US and elsewhere Was the Housing Bubble related to other Bubbles? Can Markets Alone Develop Bubbles? Role of Central Banks in Bubble Formation

3. Approach Discuss the Concept of an Asset Bubble Relate the Global Financial Crisis to a Sequence of Asset Bubbles Conclude with Lessons Learned

4. What Are Asset Bubbles? Price of an Asset = Fundamentals + Bubble

5. THINK What are the Fundamentals? Supply and Demand The Role of Information Reality of Uncertainty Animal Spirits

6. Fundamentals Market Efficiency works well when information and arbitrage are costless Market Efficiency as a Unique Equilibrium Multiple Equilibria

7. George Soros Theory of Reflexivity: From Fundamentals to Price or Price to Fundamentals? What happens when attention shifts from Fundamentals to Price? Expectations

8. Three Views Charles Kindleberger: Feedback or Momentum Robert Shiller: Reversals Minsky: Three stages of Financing or Leveraging

9. Financial Instabilities Financial stability means the efficient allocation of funds to investment opportunities F. Mishkin: adverse selection and moral hazard G. Kaufman: bank soundness Slow return to the pre-shock state Keynes: capitalism is unstable Challenging to define

10. Financial Instabilities Financial instabilities increase uncertainty and generate risks Valuation risks: valuing securities during a financial distress Macroeconomic risks: deterioration of the real economy

11. Preconditions for Bubbles Low Inflation Low Interest Rates Above average productivity Above average GDP growth Deregulation Animal Spirits: Keynes and Shiller NEW ECONOMY OUTLOOK

12. Variety of Bubbles Exchange Rates Bubbles Stock Market Bubbles Real Estate Bubbles Art Bubbles Commodities Bubbles Credit Bubbles Other

13. Who says we cannot recognize a bubble?

14. Evolution of Bubbles Some Deflate Some Crash Some Do not Affect the Real Economy Some Cause Serious Economic Damage

15. What are the basic questions? Do all booms/bubbles end in crashes? How are equity and real estate bubbles and crashes related? What are the economic consequences of bubble bursts

16. IMF Data Sample includes 14 Industrialized Countries Equity data from 1959 to 2002 Housing data from 1970 to 2002

17. Methodological Issues Consider only top quartile of recorded peak to peak price increases as bubbles Consider only bottom quartile of recorded peak to trough price declines as bubble crashes

19. Findings about Stock Market 52 equity crashes found during sample On average, there was one crash per country every 13 years Sample average of crash was 45% Only one fourth of bubbles end up crashing Crashes unfold over 2.5 years

20. Findings about Housing Bubbles A Housing crash is defined as a 14% decline in prices Housing crashes occur less often than stock market crashes In the sub sample there were 20 housing vs. 25 stock market crashes Housing crashes are clustered while equity crashes are evenly distributed Housing crashes lasted 4 years

21. Equity and Housing Crashes Stock market crashes may cause GDP declines of up to 4% Housing market crashes may cause GDP declines of up to 8%

22. Crashes and Consumption For every 100 dollars of wealth lost in a stock market crash consumers decrease their consumption by 4 dollars For every 100 dollars of wealth lost in housing, consumers decrease their consumption by 10 dollars Thus, housing crashes are more difficult than stock market crashes

23. Crashes and Banks Stock Market crashes do not always affect banks Housing crashes influence the banking sector more severely Housing crashes are most often the result of monetary tightening

24. Crashes and Corporations Stock Market bubbles accelerate business investments Stock Market bubbles increase equity financing and reduce debt financing

25. The Role of Monetary Policy Price Stability and Economic Growth The Monetary Policy Paradox: achieving low inflation may lead to bubbles Should Monetary Policy “target” bubbles? Does Monetary Policy “target” bubbles? Role of Financial Stability

26. Are Bubbles Isolated? The Crash of the Internet Bubble in 2000- 2001 9/11 Terrorist Attack Was Monetary Policy Easy for Too Long?

27. The Normative Question Bernanke and Gertler: The Fed Should Not Target Asset Prices Cecchetti and Others: React Cautiously Filardo: Deflate Bubbles Roubini: Burst Bubbles

28. Positive Question Hayford and Malliaris: Difficult to Assess Fed’s Policy Greenspan: Appears to Have Tried Using an Axe to Do Brain Surgery

29. 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)

30. 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

31. The Nasdaq Bubble and its Bursting

32. Fed Funds During the Past Decade

33. The Emergence of the Housing Bubble

34. Possible Causes of the Recent Financial Crisis Easy Monetary Policy Very Low Interest Rates Large Global Savings Housing Bubble Subprime Mortgages Role of Credit Agencies Credit and Leverage Bubbles Other

35. Monetary and Fiscal Policies Economic Stability: Definition? Financial Stability: Definition? Lender of Last Resort Fiscal Initiatives

36. Moving Forward From the Financial Sector To the Real Economy What are the Links?

37. The Financial Dimension What has happened to the U.S. stock market? Recent History The Very Long Run

39. December 2009 value for S&P is the June 30 close.

40. Ratio of value of S&P 500 to the average earnings of those companies over the previous 10 years, adapted and updated from Shiller. Blue line: ratio of monthly average S&P 500 index (deflated by current CPI) to 10-year average of most recent monthly earnings (each deflated by CPI for that month). April-June 2008 earnings from straight-line monthly interpolation of 12-month as reported quarterly earnings from Standard & Poor's. November 2008 value for S&P is the November 12 close. Red line: historical average (16.34).ShillerStandard & Poor's

42. The Impact on GDP Shorter Perspective Longer Perspective

45. Global Perspectives Past Crises Were in Developing Economies Major U.S. Crisis How to Establish Global Financial and Economic Stability

46. Sequence of Bubbles? Are the Internet Bubble Bursting and the Housing Bubble Connected? How About the Commodities Bubbles? Global Dimensions: Savings Glut

47. Conclusions U.S. Driven Global Financial Crisis Multiple Causes Double Feedback between Financial and Real Sectors Multiple Global Feedback Balance Between Bail-outs and Bankruptcies What Role for Regulation? Global Stability?

51. 12 Lessons and Future Research Agenda Monetary Policy and the Great Moderation The Great Moderation and Asset Bubbles What Causes Asset Bubbles? Endogenous or Exogenous? Multiple Bubbles Globally Theories of Financial Instabilities a la Minsky: Banks and Shadow “Banks”

52. 12 Lessons and Future Research Agenda Private Sector Risk Management: Showers vs. Storms Debt Deflation (I. Fisher) vs. Reflation Systemic Risk and Financial Stability Policy Goals and Instruments Macro Prudential Regulation Addressing Global Instabilities Principles of Crisis Management: Reducing Knightian Uncertainty

53. Tentative Future Scenarios Anemic growth and possible deflation a la Japan Slow growth with reflation Rapid Inflation as in 1970s, 3% to 6% Both of these scenarios imply modest equity increases, difficulties for the dollar and changes in global financial intermediation Potential formation of an Asian Currency Union Eventual re-emergence of animal spirits