The Global Financial Crisis: Lessons for Monetary Economics ...
The Global Financial Crisis: Lessons for Economic and Financial Theory and Policy Swiss Finance Institute Zrich September 20, 2010 Joseph E. Stiglitz General Consensus Federal Reserve fell down on the job in Anticipating the downturn Taking actions to prevent the crisis
Given kudos for bringing the economy back from the brink But measures have failed to restart lending Shadow banking system remains in shambles Potential fiscal costs (with pass through of profits/losses to Treasury) are huge Policies engendered large redistributions that have called into question institutional frameworks (independence) Not Yet a General Consensus On why the Fed failed so badly Flawed models
Flawed judgments Too low interest rate (Taylor) Flawed regulatory policies On what the Fed should have done In the run up to the crisis In response to the crisis On changes in policy framework On changes in governance Though there is a political consensus against the Fed Reflected in recent votes in Congress
Some Broad Lessons Some new, some old that need to be relearned Old lesson: Markets, by themselves, may not be either efficient or stable Theory had already explained that with imperfect information and incomplete risk markets, market equilibrium is not in general (constrained Pareto) efficient Self-regulation doesnt work Old lesson: Hard to reconcile observed behavior with hypothesis of rationality, rational expectations Ideas that have played central role in economic theory
Some Broad Lessons Some new, some old that need to be relearned New lesson: Macroeconomic models need to do a better job of modeling financial sector Banking sector, shadow banking sector Understanding better the limits to monetary policy Flawed Policy Framework 1. Maintaining price stability is necessary and almost sufficient for growth and stability It is not the role of the Fed to ensure stability of asset prices
2. Markets, by themselves, are efficient, selfcorrecting Can therefore rely on self-regulation 3. In particular, there cannot be bubbles Just a little froth in the housing market Flawed policy framework 4. Even if there might be a bubble, we couldnt be sure until after it bursts 5. And in any case, the interest rate is a blunt instrument
Using it to break bubble will distort economy and have other adverse side effects 6. Less expensive to clean up a problem after bubble breaks Flawed policy framework Implication of this framework: DO NOTHING Expected Benefit is small Expected Cost is large EACH of the propositions was FLAWED
1. Inflation targeting Distortions from relative commodity prices being out of equilibrium as a result of inflation second order relative to losses from financial sector distortions Both before the crisis andeven moreafter the bubble broke Clear that ensuring low inflation does not suffice to ensure high and stable growth
Bubbles themselves give rise to relative price distortion, given that different prices adjust in different ways Inflation targeting risks shifting attention away from first order concerns 2. Markets are efficient and self-correcting Flawed General theorem: whenever information is imperfect or risk markets incomplete (that is, always) markets are not constrained Pareto efficient
Pervasive externalities Pervasive agency problems Manifest in financial sector (e.g. in their incentive structure) 2. Markets are efficient and selfcorrecting Greenspan should not have been surprised at risks financial sector had incentives to undertake excessive risk Systemic consequences (externalities, which market participants will not take into account when making decisions) are the reason we have regulations Especially significant when government provides (implicit or
explicit) insurance Problems of too-big-to-fail banks had grown markedly worse in the previous decade as a result of the repeal of Glass-Steagall 3. There cannot be bubbles False Bubbles have marked capitalism since the beginning Bubbles are even consistent with models of rational expectations Collateral-based credit systems are especially prone to bubbles
4. Cant be sure All policies are made in the context of uncertainty As housing prices continued to increaseeven though real incomes of most Americans were decliningit was increasingly likely that there was a bubble 5. We had no instruments False they had instruments Congress had given them additional authority in 1994 Could have gone to Congress to ask for more authority if needed
Could have used regulations (loan to value ratios) to dampen bubble Had been briefly mentioned during tech bubble Ideological commitment not to intervene in the market But setting interest rates is an intervention in the market General consensus on the need for such intervention Ramsey theorem: single intervention in general not optimal 6. Less expensive to clean up the mess Few would agree with that today
Loss before the bubble burst in hundreds of billions Loss after the bubble in trillions Flawed Models Key channel through monetary policy affects the availability of credit (Greenwald-Stiglitz, 2003, Towards a New Paradigm of Monetary Policy) And the terms at which it is available (spread between T-bill rate and lending rate is an endogenous variable, which can be affected by conventional policies and regulatory policies)
Insufficient Attention to Microeconomics of Banks Banks are critical to the provision of credit to small and medium sized enterprises (source of job creation) Especially important in understanding how to recapitalize banks, in order to Restart flow of credit Determination of spread between T-bill rate and lending rate Need to understand both role of incentives and constraints At organizational level (too big to fail banks) At individual level
And relations (corporate governance) What role did change in organizational form (from partnerships to joint stock companies) play? The Limits of Monetary Policy Monetary policy may have stopped systemic collapse, but it has not been able to restore economic growth Keynes argument: pushing on a string But situation is markedly different from Keynesian liquidity trap Relates to behavior of banks Clearly real interest rate as measured by T-bill is not the
driving force Considerable uncertainty about the conduct of monetary policy Fiscal Policy Whole world were Keynesiansfor a moment Worked in stimulating the economy US stimulus was too small, not well-designed But impacts were reasonably accurately anticipated Highlights importance of the design of the stimulus Worries about crowding out were misplaced Record low levels of interest rates
For the U.S. a second stimulus is needed The U.S. can finance A well-designed stimulus (focusing on investment) would lower long term national debt Other Failures of Prevalent Models Insufficient attention to architecture of risk Including analysis of how systemic stability can be affected by policy frameworks Insufficient attention to architecture of
information Including an analysis of how moving from banks to markets predictably led to deterioration in quality of information Insufficient Attention to Architecture of Risk Theory was that diversification would lead to lower risk, more stable economy Didnt happen: where did theory go wrong? Mathematics: Assumed concavity; world marked by convexities In former, spreading risk increases expected utility In latter, it can lead to lower economic performance
Two sides reflected in standard debate Before crisisadvantages of globalization After crisesrisks of contagion Standard models only reflect former, not latter Should reflect both Optimal electric grids
Circuit breakers Stiglitz, AER 2010, Journal of Globalization and Development, 2010 Insufficient Attention to Architecture of Risk Market incentives both on risk taking and risk sharing distorted Can show that there is systematically too much exposure to risk Can give risk to bankruptcy cascades Giving rise to systemic risk Can Be Affected by Policy Frameworks
Bankruptcy law (indentured servitude) Lenders may take less care in giving loans More competitive banking system lowers franchise value May lead to excessive risk taking Capital market liberalization Flows into and out of country can give risk to instability Financial market liberalization May have played a role in spreading crisis In many LDCs, financial market liberalization has been associated with less lending to SMEs
Can Be Affected by Policy Frameworks Central banks need to pay attention to systemic stability which is affected by Exposure to risk The extent to which shocks are amplified and persist The extent to which there are automatic stabilizers and destabilizers Changes in the structure of the economy can lead to an increase or decrease in systemic stability Movement from defined benefit to defined contribution old age pension system
Key Controversy in Regulatory Reform Senate Committee: FDIC-insured institutions should not be engaged in swaps trading Fire insurance important for mortgages But banks should not be in business of writing fire insurance And if they are, make sure that they have adequate capital not underwritten by US taxpayer Banks, Bernanke, Administration wanted to continue exposure to risk, implicit subsidy But several regional Presidents supported Senate Committee
Insufficient Attention to Architecture of Information Moving from banks to markets predictably led to deterioration in quality of information Shadow banking system not a substitute for banking system Leading to deterioration in quality of lending Inherent problems in rating agencies But also increased problems associated with renegotiation of contracts Increasing litigation risk Improving markets may lead to lower information content in markets
Extension of Grossman-Stiglitz (1980) Problems posed by flash-trading (In zero sum game, more information rents appropriated by those looking at behavior of those who gather and process information) Market Equilibrium Is Not Generally Efficient Derivatives marketan example Large fraction of market over the counter, non-transparent Huge exposuresin billions Undermining ability to have market discipline Market couldnt assess risks to which firm was exposed
Impeded basic notions of decentralizability Needed to know risk position of counterparties, in an infinite web Explaining lack of transparency: Ensuring that those who gathered information got information rents? Exploitation of market ignorance? Corruption (as in IPO scandals in US earlier in decade)? Some Implications Cannot rely on self-regulation And even less so on rating agencies Distorted incentives Competition among rating agencies made matters worse
Need to focus on shadow banking system as well as on banking system New role for Fed, over $1.2 trillion in mortgages Two are related in complex ways Going back to Glass-Steagall is not enougha failure of investment banks can put economy in jeopardy Some Implications Need to use full gamut of instrumentsconventional instruments as well as regulatory instruments to affect lending There are supply side and demand side effects of monetary policy
Bank behavior may not depend just on amount of capital Bank managers interest may differ from that of bondholders and shareholders: have to look at their incentives Private bank owners interests may differ from that of other suppliers of capital (including government) Increasing capital adequacy requirements may not lead to less risk taking (reduced franchise value) Some Implications More attention needs to be focused on dealing with failed financial institutions Especially in the presence of systemic failure Miller/Stiglitz argued for a super-chapter 11 for
corporations in event of systemic crisis Need to think about how to handle mortgages Need to think about how to handle banks Failure to restructure mortgages will contribute to slow recovery of America Way banks were bailed out led to less competitive banking system and exacerbated problems of moral hazard Regulatory reform bill did not fix the problemkey issue was not resolution authority Conclusion Models and policy frameworks many Central Banks used contributed to their failures before and after the crisis
Fortunately, many Central Banks are now developing new models and better policy frameworks Focus not just on price stability but also in financial stability Credit availability/banking behavior Credit interlinkages Gallegati et al, Greenwald-Stiglitz, Haldane, Haldane-May Conclusion Less likely that a single model, a simple (but wrong) paradigm will dominate as it did in the past Trade-offs in modeling
Greater realism in modeling banking/shadow banking may necessitate simplifying in other, less important directions
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