Transcript The Great Moderation

THE GREAT MODERATION
AND THE GLOBAL FINANCIAL CRISIS
1. The Great Moderation
2. Doctrines: towards consensus?
3. The Global Financial Crisis: Causes and consequences
4. The Global Financial Crisis: Policies and Lessons
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1. The Great Moderation
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A reduction in the volatility of the business cycle started to be visible starting in
the mid-1980s
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The reasons, it was thought, might include structural changes: like better inventory
management made possible by ITC , the shift from manufacturing to services, the
increased sophistication of financial markets …
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But avobe all: the great moderation was seen as a triumph of independent central
banking geared to inflation targetting
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Robert Lucas in 2003 declared that ”the central problem of depression-prevention
has been solved, for all practical purposes”
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Question: Has the great moderation come to its end because of the Global
Financial Crisis or are we on our way back to the great moderation?
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The Great Moderation
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The policy consensus (associated with the great moderation)
as it used to be before the global financial crisis

Monetary policy is focussed on price stability or low inflation in the medium term, the overriding or
only objective of the monetary policy run by politically independent central banks, using the shortterm interest rate as the main instrument (the short-term market rate of interest being strongly
influenced by the policy rates and open market operations of the central bank);

price stability was expected to further output stability as well, as can be expected at least if
demand shocks dominate

Fiscal policy and particularly discretionary policy would play a more limited role, but the automatic
stabilizers should be allowed to operate fully, and it would therefore be important to keep public
debt at a reasonable level and aim at a balanced budget over the cycle

Discretionary fiscal policy action risked being ’too late’, overly politicised and less effective than
monetary policy (partly becuase of ’Ricardian equivalence’)

Structural reform should aim at improving the functioning of the market economy (incentives,
competition, no heavy regulation), thereby enhancing allocative efficiency

Also, financial regulation was not seen as part of the macroeconomic policy framework, it was
concerned with regulation and supervision of individual financial institutions without any focus on
’systemic risks’ to the financial system or the economy as a whole
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Schools of thought/policy doctrines

from Keynes and the Classics to the Neoclassical synthesis (Paul Samulson) → some
role for both supply and demand or macroeconomic policy, both fiscal and monetary

the rise and decline of monetarism → supply side policy ok, no role for fiscal policy, no
useful role for active or discretionary monetary policy

New classical macroeconomics and rational expectations and the real business cycle
school: ”Walrasian macroeconomics” (efficient markets plus rational expectations) →
no role for macroeconomic policy whatsoever

Post-Keynesian economics: fundamental uncertainty (”animal spirits”), key role of
effective demand, no (unique) long-run equilibrium, money: public institution but
privately provided, financial instability inherent… → key role for demand management

New Keynesian economics: wage and/or price rigidities plus rational expectations →
role for demand management policy in the short run
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2. The Global Financial Crisis: Causes and Consequences
Question: who is to blame for the global financial crisis?
Answer: Deng Xiao Ping!
Or perhaps:
1) the ’savings glut’ (global financial imbalances)
2) financial innovations like subprime mortgages
3) lax monetary policies (Alan Greenspan)
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The ’savings glut’
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China and other ’emerging market’ countries were running large current account surpluses (from
the late 1990s onwards), reflecting very high national saving rates
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NB that the current account surplus = national saving – national investment
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Many western countries, notably the US, were at the same time running large current account
deficits, reflecting budget deficits and low household saving
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As a consequence of the current account surpluses, the central bank of China invested heavily in
foreign assets, notably in US treasury bills and bonds, which made it easy for the US to finance its
current account deficit
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The high savings rate in Asia and the associated large-scale asset buying of the central bank of
China contributed to keep the level of global interest rates low
•
In all, due to the savings glut there was a lot of money going around and searching for safe and
liquid financial assets (+ with a good return) to be invested in
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US is the world’s deepest and most sophisticated financial market, a lot of the excess saving of
China and oher BRICs ended up in the US
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China had a huge national investment and particularly savings rate,
the difference constituting its external surplus (surplus of current account)
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One counterpart to the Chinese surpluses was
the current account deficit of the United States
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The current account surplus of one country is the deficit of some other
country (the global current account is in balance by definition)
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Personal saving declined in the US from the 1990s until 2008
and household debt increased rapidly
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Subprime lending and the subprime mortgage crisis
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Subprime lending = mortgage loans to people with potential difficulties to manage repayment
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Subprime loans had high interest rates but often ’teasers’ in the form of low rates in the early
phase; they often had poor quality collatera (if any)
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The borrowers were often young, members of discriminated minorities, people with weak and
uncertain incomes. Politicians were pleased that such groups would have access to mortgages for
buying homes and gave legislative support for this
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Earlier banks used to hold mortgage loans on their books, but not so any more: New loans were
increasingly sold to financial institutions that would package them together into mortgage-backed
securities (MBS) to be placed on the market and therefore reducing the need of capital of banks (or
giving additional scope for financial intermediation)
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the packaging was often done by investment banks and then sold to government-sponsord
insitutions such as Fanny Mae of Freddie Mac (originally set up to sponsor home buying by giving
quarantees for mortgage loans)
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All of this was asso ciated with rapid growth of ’shadow banking’ or non-traditional banks or
financial institutions: investment banks, hedge funds, money market funds etc.
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Cont.
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Some of the MBS-instruments were collateralized debt obligations CDO, which would consist of
tranches with different rights to repayment in case of trouble: the most senior tranches were best
protected and would therefore be rated AAA by rating agencies, while junior tranches would be
risky and receive lower rating
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It was assumed that repayments of the underlying loans would be uncorrelated, which, if true,
would substantially reduce the risk of the asset
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However, when the crisis started with declines in home prices, these occured widely in the US, and
lack of confidence quickly caused dramatic declines in the market value of these securities, the
underlying value of which was difficult to evaluate
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The outcome was a ’bank run’ on the shadow banking system, giving rise to acute liquidity
shortages and ’fire-price sales’ of assets at great loss for the shadow banks
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While the US authorities allowed the failure of Lehman Brothers 15.9.2008, they did not dare allow
more failures, given the dramatic consequences in the form of a generalized panic that the fall of
Lehman Brothers gave rise to
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Some of the shaky institutions had issued large amounts of credit default swaps (CDS), a kind of
insurance against losses of holding financial assets. Such institutions risked bankruptcy as a
consequence of the financial crisis, forcing authorities to act to stop the crisis, because these
institutions could not possibly have honoured all the CDS-contracts in a situation with wide-spread
default
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Lax monetary policy (Greenspan)
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Central banks were in the first decade of this millenium pursuing monetary policies with
quite low interest rates without running into inflationary problems, partly because
China and other BRICs were incrreasingly supplying world markets with cheap
manufacturing goods
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Also, the US Fed reacted to occasional declines in the stock market by aggressive easing
of monetary policy. Alan Greenspan thought central banks should not worry about the
build-up of bubbles (in housing or in the stock exchange) but should instead
concentrate on softening the conseuences if the bubble burst. This, however, created
an expansionary bias in monetary policy, which supported borrowing and lending and
highly leveraged investments (providing incentives for high leverage)
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Central bankers, including Greenspan, more or less neglected the role of financial
regulation and supervision and did not consider the possibility that financial fragility
and disturbances could give rise to problems for the financial system and the economy
as a whole: no consideration was given to the possible need for ’macroprudential
supervision’.
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The global financial crisis: consequences

In the end the housing bubble burst, first in the USA, later elsewhere

The stock market turned down
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Risk premia in money markets and financial markets more generally rose

Investment and consumption declined abruptly, GDP fell dramatically

Unemployment increased fast

The whole world economy was hit by pessimism: gloom and doom
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The global financial crisis: policies
The collapse of the world economy starting gradually in 2007, escalating in 2008 (15.9.2008
Lehman Brothers bankruptcy!) was dramatic and did trigger large-scale macroeconomic
action widely in the world, with key discussion taking place within the IMF and notably G20
Monetary policy was eased fast in all major countries, notably in the US and in the euro
area; later many central bansk would also resort to quantitative easing as well as to
negative interest rates on central bank deposits (+ ’policy guidance’, talking interest rates
down)
Fiscal expansion was strong notably in 2009, thereafter fiscal polices became cautious and
in many cases at least mildly contractionary, but public debt was allowed to increase
Forcecul policy action prevented the repeat of the great depression of the 1930s, but
economic growth after the global financial crisis has nevertheless been very weak for a long
sequence of years
As emphasized by Reinhart and Rogoff (’This time is different’), it is a typical historical
experience that a financial crisis, associated with excessive debt, will have long-lasting
negative consequences for economic growth; unemployment and public debt will be at a
high level for a long time to come
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Central banks took down policy rates to the zero level
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Both the US Fed and the ECB did the same, later first the US Fed and recently
the ECB have also embarked upon ’quantitative easing’ , buying bonds in large
amounts in the market
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Fiscal policy
2007 2008 2009 2010 2011 2012 2013
Gen.gov.financial deficit
OECD
USA
Euro area
1,5
3,7
0,6
3,5
7,2
2,1
8,3 7,9 6,5
12,8 12,2 10,7
6,2 6,1 4,1
5,7
9,0
3,6
4,3
5,7
2,9
Gen.gov.cyclically adj.deficit
OECD
USA
Euro area
2,9
4,7
2,2
4,5
7,3
3,5
7,5 7,2 6,0
11,0 10,3 8,9
5,3 5,2 3,6
5,0
7,4
2,7
3,5
4,4
1,3
Public debt in the US (% of GDP): 2007 = 64,3, 2014 = 109,7
Public debt in the euro area (%): 2007 = 72,8, 2014 = 108,2
In sum, fiscal policy was more expansionary in the US (as seen when looking at the
change in the cyclically adjusted balance from, SAY, 2007 to 20109, also monetary
policy was more forceful (as was action to put the banking system on a sound footing)
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The Global Financial Crisis: Lessons

Monetary policy cannot just focus on price stability; it needs to be concerned about the risk of
financial instability, it must consider the risk of a very deep slump with deflation etc

Monetary policy may run into the zero lower bound, which then calls for negative interest rates
(possible within some limits) or large-scale quantitative easing to push down the risk-free interest
rate and push investors into more risky assets (like equity)

Fiscal policy made a (temporary?) comeback: there may be a need for fiscal expansion if monetary
policy is ineffective because of a liquidity trap or the zero lower bound of interest rates

There is a need not only for supervision of individual banks or financial institutions but for
macroprudential supervision of the system as a whole; the authorities should also have some
instruments to enhance financial stability when excessive leverage is feared
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Financial regulation and supervision needs strenthening and action is called for to deal with the ’too
big to fail’ syndrome of large, systemically important financial institutions

However, the lessons to be drawn are still a matter of discussion and dispute
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