ASSET BUBBLES AND THE FINANCIAL CRISIS OF 2008?A. G. MALLIARIS

Presented to the Xavier EMBA, November 26, 2008

• What are Asset Bubbles?

• Variety of Bubbles• Selected facts• Financial Crisis of

2007-8

What Are Asset Bubbles?

• Price of an Asset =

Fundamentals + Bubble

THINK

• What are the Fundamentals?

• Supply and Demand

• The Role of Information

• Reality of Uncertainty

Fundamentals

• Market Efficiency works well when information and arbitrage are costless

George Soros

• Theory of Reflexivity: From Fundamentals to Price or Price to Fundamentals?

• What happens when attention shifts from Fundamentals to Price?

• Expectations

Two Views

• Charles Kindleberger: Feedback

• Robert Shiller: Reversals

Preconditions for Bubbles

• Low Inflation

• Low Interest Rates

• Above average productivity

• Above average GDP growth

• NEW ECONOMY OUTLOOK

Variety of Bubbles

• Exchange Rates Bubbles

• Stock Market Bubbles

• Real Estate Bubbles

• Art Bubbles

• Commodities Bubbles

• Credit Bubbles

• Other

Who says we cannot recognize a bubble?

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

IMF Data

• Sample includes 14 Industrialized Countries

• Equity data from 1959 to 2002

• Housing data from 1970 to 2002

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

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

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

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%

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

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

Crashes and Corporations

• Stock Market bubbles accelerate business investments

• Stock Market bubbles increase equity financing and reduce debt financing

The Role of Monetary Policy

• The Monetary Policy Paradox: achieving low inflation may lead to bubbles

• Should Monetary Policy “target” bubbles?

• Does Monetary Policy “target” bubbles?

Are Bubbles Isolated?

• The Crash of the Internet Bubble in 2000-2001

• 9/11 Terrorist Attack

• Was Monetary Policy Easy for Too Long?

The Nasdaq Bubble and its Bursting

Fed Funds During the Past Decade

The Emergence of the Housing Bubble

Composite-10 CSXR

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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 Bubble• Other

Monetary and Fiscal Policies

• Economic Stability: Definition?

• Financial Stability: Definition?

• Lender of Last Resort

• Fiscal Initiatives

Moving Forward

• From the Financial Sector

• To the Real Economy

• What are the Links?

The Financial Dimension

• What has happened to the U.S, stock market?

• Recent History

• The Very Long Run

S&P Yearly Returns

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December 2008 value for S&P is the November 24 close.

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).

The Impact on GDP

• Shorter Perspective

• Longer Perspective

Global Perspectives

• Past Crises Were in Developing Economies

• Major US Crisis

• How to Establish Global Financial and Economic Stability

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?