Transcript After the banking crisis: what now? Monetary, fiscal and

After the banking crisis: what now?
Monetary, fiscal and regulatory
policy
There are three problems:
1. The liquidity crisis and QE
2. QE and monetary policy when interest rates
are close to zero
3. Banking regulation
The liquidity crisis and QE
• The liquidity crisis was really a risk crisis. It was
caused by a failure of risk management: either a
failure to measure risk correctly, or a moral
hazard problem due to asymmetric incentives to
take on risk.
• And due to bad risk assessment of one bank by
another the inter-bank market dried up.
• QE was designed to inject liquidity back into the
system and restore the money supply.
QE and monetary policy when
interest rates are close to zero
• The current recession is entirely due to the
financial crisis
• Near zero interest rates are due to in large part to
central banks trying to achieve their inflation
targets by stimulating their economies.
• The failure to get banks to lend – they preferred
to rebuild their balance sheets – implied the need
for monetary stimulation. Hence QE.
• Eggertsson and Woodford argued that with
perfect foresight the optimal interest rate policy
under commitment involves keeping interest
rates lower for longer.
• QE in the UK was implemented by increasing the
proportion of govt long bonds in BoE’s balance
sheet in order to increase bank reserves.
QE works through 3 channels:
• Buying assets increases their price. As bond prices rise,
yields and borrowing costs fall.
• Central bank purchases increase bank reserves and,
unless sterilised, the money supply. This is expected to
result in more loans to the private sector.
• Asset purchases – particularly of long bonds – affects
the term structure and hence inflation expectations:
lower long yields indicates a commitment to keep
inflation down in the long run.
Some issues and problems
• Is this is a low risk solution or has the risk been transferred
to the public sector? Even higher risk to the tax payer is to
buy corporate bonds like the Fed.
• The theory is weak. The policy works only if assets are
imperfect substitutes and this allows quantities to affect
prices. Tobin’s portfolio balance model comes to mind.
Harrison (BoE) solves this by putting a quadratic cost due to
deviations in the maturity structure of household debt in
their utility function.
• An alternative argument is that QE can alter the risk
characteristics of private (and CB) portfolios.
Has QE worked?
• The banks have not increased lending to the private sector much.
Instead they have rebuilt their balance sheets. QE has solved the
liquidity crisis but not the underlying problem of risk.
• It has been argued that bank reserve and interest rate policy may
be decoupled especially if reserves receive the same interest as the
policy rate.
• As the CB balance sheet should be consolidated with that of the
government it is the total effect that counts.
• The burgeoning UK fiscal deficit has resulted in offsetting increases
in the supply of long-dated bonds. QE = £200bn=14% GDP. Increase
in govt debt = 45% GDP.
Fiscal stance of the UK and ailing
eurozone countries
• The UK had a structural fiscal problem since 2001
but the fiscal position deteriorated sharply due to
the recession in 2008.
• Greece has had an unsustainable fiscal position
even longer - since before joining the euro. And it
too deteriorated from 2008.
• Ireland had no fiscal problem until 2008 and
neither did Spain.
UK: government expenditures and revenues as a percentage of GDP
60
50
40
exp-gdp
30
rev-gdp
20
10
0
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Greece: government expenditures and revenues as a percentage of
GDP
60
50
40
exp-gdp
30
rev-gdp
20
10
0
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Spain: government expenditures and revenues as a percentage of
GDP
50
45
40
35
30
exp-gdp
25
rev-gdp
20
15
10
5
0
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
The liquidity crisis and QE
• The liquidity crisis was really a risk crisis. It was caused
by a failure of risk management: either a failure to
measure risk correctly, or a moral hazard problem due
to asymmetric incentives to take on risk.
• And due to bad risk assessment of one bank by
another the inter-bank market dried up.
• QE was designed to inject liquidity back into the
system, restore bank balance sheets and reduce the
risk of lending
Banking regulation
• The problem was excessive risk taking with the
public ultimately paying the price and taking
on the risk.
• The solution must be a re-alignment of risk,
reward and liability .
Finally a graph especially for Harris
EU average rate of growth against average govt expenditures as a %
of GDP
1998-2011
6
5
4
ave rate of growth 3
correlation = -0.74
2
1
0
0
10
20
30
ave govt exp as % GDP
40
50
60