ASSET BUBBLES, MONETARY POLICY AND RISKS TO THE

ECONOMY

A. G. (Tassos) MalliarisProfessor of Economics and

FinanceLoyola University Chicago

EURO WORKING GROUP FOR

FINANCIAL MODELINGRome, Italy, May 3-5, 2012

My Plan

• Offer Critical Comments on Monetary Policy.• Relate Monetary Policy and Asset Bubbles.• Discuss Financial Instability.• Propose a New Hypothesis: Price Stability

Leads to Financial Instability Using the

Asset Price Bubble Channel.

Critical Event

• The Global Financial Crisis of 2007-09.• It Is A Major Regime Shift.• It Is the Main Reason to Reconsider Asset

Bubbles, Macroeconomic Risk and Monetary Policy.

• Why Was it Missed By Academics, Policy Makers, Practitioners and Regulators?

A Selective List of Causes of the Global Financial Crisis

• The Bursting of the Housing Bubble.• Easy Monetary Policy During 2002-2005.• Global Exuberance and Imbalances.• Government Housing Policies, Fannie Mae,

Freddie Mac.• Opaque Financial Instruments.• Shadow Financial System.• Interconnectedness and Too Big to Fail.

Why Was It A Surprise To All?

• Academics: Neoclassical Theories.• Practitioners: Short-term Trading Horizons.• Regulators: Market Discipline.• Policy Makers: Inflation Targeting and the

Great Moderation.

Pre-Crisis Main 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.

Corollaries

• Sufficiency of Price Stability Rather Than Financial Stability.

• Inflation Targeting Promotes Economic and Financial Stability.

• Diversification and Risk Management. • Ignore Financial Crises Because They Are

Unavoidable; Little in Common; Hard to Predict.

Thus: Neoclassical Theories Do Not Fully Explain

• Financial Crises and Asset Bubbles

• Large Macroeconomic Risks

• Inflation Targeting and Financial Instabilities

“The dogmas of the quiet past

are inadequate to the stormy present”

Abraham Lincoln

Search for New Theories to Explain:

• Asset Bubbles

• Role of Monetary Policy

• Financial Instabilities

• Financial Crises

From Criticism to Construction

• Review Asset Price Bubbles• State Facts about Macroeconomic Risks• Discuss Financial Instability• Evaluate the Role of Monetary Policy• Propose and Argue a New Hypothesis

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?

Evolution of Bubbles

• Some Deflate• Some Crash• Some Do not Affect the Real Economy• Some Cause Serious Economic Damage

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

More On 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

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

How Important Is Monetary Policy?

• 1929 – 1960: Not Very Effective, Keynes• 1970s: Burns and Inflation• 1979-87: Volcker and the Dramatic Reduction

of Inflation• 1987- 2007: Greenspan and Bernanke: The

Risk Management Approach

CPI Less Food and Energy

Fed funds

The Paradox of Asset Bubbles and Monetary Policy

• Price Stability or Inflation Targeting

• Risk Management Approach to Financial Instabilities

• Fact of a Sequence of Booms and Busts

Bubbles and Monetary Policy• Two Questions

• Normative: Should Monetary Policy Target Asset Prices?

• Positive: Does Monetary Policy Target Asset Prices?

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

Positive Question• Hayford and Malliaris: Fed Policy may have Encouraged Bubbles

• 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)

Legislative Response

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 the Causes Listed Focus Now on the Role of Easy Monetary Policy

• Did the Fed Contribute to the Housing Bubble?

• Yes (Taylor); No (Greenspan)

Lessons Learned from the Crisis

• Price Stability Does Not Imply Financial Stability

• Asset Price Bubbles Are Very Risky

• The Cost of Cleaning up After a Bubble Bursts is Very High

• Financial Instability Seriously Impacts

the Real Macroeconomy

Where Are We Now?

• 15 million Unemployed in the U.S.• 13 trillion of wealth lost in the U.S.• Slow Growth in the U.S. and Europe• Significant Increases in U.S. Deficits• Sovereign Debt Crisis in the EU• Unbalanced Growth in China• Financial Instability

How Can We Get Out?

Examine Inflation Targeting Causes Financial

New Hypothesis

• Inflation Targeting Causes Financial Instability

• Present 7 scenarios

• Conclude With Policy Implications

1. Insufficient Tools

• Suppose the Central Bank Targets Both Price Stability and Financial Stability.

• These Are Two Goals.• It Currently Has Only One Tool: Interest Rates• Financial Stability Is Ignored

2. Minsky’s Stability Causes Instability

• Also Discussed By Greenspan.• Suppose the Central Bank Succeeds With

Inflation Targeting.• Low Inflation, Low Fed Funds, Low Long

Term Interest Rates, Low Risk, High Valuations, Asset Bubbles, More Collateral, More Credit, Bubble Grows.

• Eventually Bubble Crashes.

3. Moral Hazard Argument

• The Asymmetric Approach of the Central Bank (Also Called the Jackson Hole Consensus) Encourages Moral Hazard.

• Asset Prices Grow Slowly But Crash Quickly.• Central Banks Ignore the Slow Growth But

Respond Quickly to a Crash to Avoid Real Risks.

• Lean vs Clean as Before.

4. Capital Misallocation

• Price Stability Achieves Low Inflation.• Low Inflation Brings Down Interest Rates and

Risks.• Asset Bubbles Attract Capital.• Is Such Capital Allocated Correctly? No !

5. Price Stability and Banks

• Suppose the Central Bank Wishes to Supplement Price Stability with Financial Stability.

• Introduce Micro-prudential Regulation.• It Only Considers Individual Banks.• It Ignores Systemic Risk.

6. Neo-Austrian Financial Crisis Ideas

• Nominal vs Natural Interest Rates.• Nominal is What Banks Charge.• Natural is What the Real Sector Supports With

Stable Prices.• If Nominal and Natural Differ, Asset Prices

Are Affected.• Keeping Inflation Low Generates Bubbles

7. Globalism and a Sequence of Asset Bubbles

• Savings and Loan Crisis of 1989-91• Asian Crisis• Internet Bubbles• Housing Bubble• The Current Bond Bubble

“It is better to act and repent

than not to act and regret it” Machiavelli

Conclusions: Focus on Financial Stability

• Long History Described by Reinhart and Rogoff• Monitor Credit Expansion• Lean Against Asset Price Bubbles• A Bubble Is Bursting in the EU: Sovereign Debt• With U.S. Interests Near Zero, Do We Have a

Government Bond Bubble? What Impact On The Dollar?

Longer Term: The Fed and Financial Stability

• The Fed and Monetary Policy

• The Financial Stability Oversight Council Established by the Dodd Frank Act

• IMF and Global Financial Stability

Moving Forward: What Policies?

• Revise Inflation Targeting: Go Beyond CPI.• Lean Against Asset Bubbles; Particularly

Housing Bubbles.• Implement Macro-Prudential Regulation: To

Avoid Systemic Risks Monitor Credit Growth And Collateral.

• Accept Limitations of Monetary Policy.