FINANCIAL INSTABILITIES, ASSET PRICES AND CRISES:

THEORIES AND POLICIES

Marc Hayford and A.G. MalliarisLoyola University Chicago

Association for Social Economics ProgramAtlanta, Georgia,

January 2 – 5, 2010

Focus of the Paper• Financial Instabilities

• Asset Bubbles

• Financial Crisis

• Monetary Policy

• What Theories? What Policies?

Financial Instabilities• Challenging to define• Financial stability means the efficient

allocation of funds to investment opportunities

• F. Mishkin: adverse selection and moral hazard

• G. Kaufman: bank soundness• Slow return to the pre-shock state• Keynes: capitalism is unstable

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.

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

Monetary Policy

• Price Stability

• Economic Growth

• Risk Management Approach to Financial Instabilities

• Reservations of Anna Schwartz

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 Encouraged the Bubble

• 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)

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 Credit Crisis

• Among various causes, consider the role of monetary policy

• Did the Fed contribute to the housing bubble?

• Yes (Taylor); No (Greenspan)

Productivity and Real Fed Rates

What Theories?• Schumpeter, Fisher, Keynes, Kindleberger

and Minsky tradition• Classical, Friedman, Lucas, Great

Moderation, Greenspan, Bernanke tradition

• Reformulation in current debate on bubbles and monetary policy

• Micro theories: Kane, Mishkin, Allen, Gale• Social and Psychological theories

What Policies?

• Lender of Last Resort• Macro-Prudential Regulation: Systemic

risks• Do Not Act Until We Understand• Yellen: Linkages Between Regulation and

Monetary Policy• Micro Financial Regulation• Shiller: Humanize and Democratize

Conclusion

• Difficult Task to Integrate Theories

• Even Greater Challenge to Introduce Optimal Economic Policies and Regulation