30057-2015-Second-Week-200215

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International Economics:

Before the Crisis: The Great Deviation

International Economics Second Week

2014/2015

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Summing Up • Understanding the Great Crisis, analyzing the Great

Moderation (GM) • The GM Economics: The Efficient Markets View • Crucial Policies: Financial Deregulation and Monetary

Policy • Financial Deregulation = Changing Face of Finance

(Leverage) • Micro: Finance = Dimension, Complexity,

Interconnections • Macro: output growth ok, inflation ok • Any imbalances? 1) AU (House prices)? NO • 2) RU (Trade)? NO … • 3) Monetary Policy

3 3 Fonte: Ferrero,

FED New York 2012

The Great Moderation: Any Con? 3) Lax Monetary Policy?

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Deregulation and MP

• In order to design and implement deregulation you have to finance it =

• In order to increase the overall leverage the interest rates have to be low and stable

• Deregulation and Monetary Policy = Two Faces of the same Coin

• How to evaluate the US MP?

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Evaluating the US MP

• US MP and • Greenspan, • the Wizard

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Evaluating the US MP

• Which Wizard?

Evaluating the MP: Which is our benchmark?

• To evaluate the MP action, we need a benchmark :

• In general we can discuss two different MP strategies, given the existent demand for money L …

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MP: Quantitative Policy

• The central bank sets the money supply, and the market determines the interest rate level

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i

m M

i*

L

MP: Interest Rate Policy

• The central bank sets the interest rate level, and the market determines the money supply

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i

m M

i*

L

MP Strategies

• Is there any difference? Yes, with uncertainty on L:

• Interest rate policies smooth interest rate volatility

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??? ???

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Evaluating the US MP: the Taylor Rule

• We will work with the more common (usual, normal) RBMP – Rule Based MP - strategy:

• Flexible Rule Based MP = the Taylor Rule:

• It’s a Rule, but it is also Flexible (state contingent)

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Building up the Taylor Rule: Assumptions

• Assumptions: • 1) In the long run

equilibrium the Fisher Equation holds:

• 2) But in short/medium run supply shocks and demand shocks can occur

• 3) Causing deviations from the optimal (potential) output growth y* and inflation growth π*

π+= ri

)();( ** yy −−ππ

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The Taylor Rule and the CB

• In each country: • 1) The Central Bank knows the values of: • The optimal output growth y* and inflation growth π* ;

• 2) The parameters α and β,representing their relative importance (=weights)

• 3) He/she can use the interest rate policy to implement the optimal monetary policy. Therefore the rule will be:

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The Taylor Rule

• Note: the simplest specification, with r=π*=y* =2 and α=β=0.5, is:

)()( ** yyriT −+−++= βππαπ

yiT 5.05.1 += π

First Remark: The Taylor Rule and the Central Bank Governance

• The Taylor Rule can be implemented in different central bank settings

• Central Bank Governance = rules defining central bank goals and tools

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• We can link the MP actions with the CB settings

• Ex: the CBs Mandates are different

• Most Important Cases : • A) Single Mandate (Monetary

Stability) (ECB) • B) Dual Mandate (Monetary

Stability and Employment) (FED)

Examples: Taylor Rules and CBs

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ECB Mandate

• Single Mandate: Monetary Stability Goal • The EU Treaty establishes that the primary

objective of the ECB is the price stability • Today Goal: Price stability is a yearly increase

in the Consumer Price for the Euro Area below but closed to 2%

• Therefore in a TL: • and π*=2%

)()( ** yyri −+−++= βππαπ

•α>β

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FED Mandate • Dual Mandate: Monetary Stability and Employment • The FED Act establishes that the objectives of the FED

are maximum employment, stable prices and moderate interest rate

• Recent Goal: Low Interest rates until unemployment falls below 6.5 % or inflation rises above 2.5%

• Therefore in a TL: • • and π*=2.5%

)()( ** yyri −+−++= βππαπ

•α=β

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Second Remark: The Taylor Rule in Open Economy

• Is it possible to use the Taylor Rule as the Monetary Policy Rule in a open economy?

• Yes, with: a) perfect capital mobility; b) flexible exchange rates;

)()( ** yyri −+−++= βππαπ

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The Taylor Rule in Open Economy

• In fact if the two above assumptions hold: • Each external shock can hit the output growth

and/or the inflation, triggering changes in the monetary policy stance:

)()( ** yyri −+−++= βππαπ

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The Taylor Rule in Open Economy

• One Important Effect follows: • Financial Interconnections - a) + b) –

produce the Harmonization (Convergence) of the Monetary Policy Rules

• Which substitutes the “old” Monetary Policy Coordination

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Third Remark: The Taylor Rule and the ZLB

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ZLB Missing (FT, 13,2015)

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Extraordinary Times: negative interest rates and CB losses

ASSETS

LIABILITIES

• PUBLIC ASSETS

• FOREIGN ASSETS

• MONETARY BASE:

• A)CASH • B) BANK

RESERVE

* CAPITAL:

• In ET it is possible that:

• CB interest rates are negative

• CB losses occur

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)()( ** yyri −+−++= βππαπ

US MP: The Taylor Critique

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EU MP: The Taylor Critique

i Taylor = bold line; source: Ahrend, 2010

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UK MP: The Taylor Critique


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J MP: The Taylor Critique


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D MP: The Taylor Critique


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IT MP: The Taylor Critique


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FR MP: The Taylor Critique


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ES MP: The Taylor Critique


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IR MP: The Taylor Critique


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PR MP: The Taylor Critique


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GR MP: The Taylor Critique


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The Taylor Critique: MP & Housing Bubble

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The Taylor Critique: MP & HB

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The Taylor Critique: MP & AB

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The Taylor Critique: MP & Financial Crisis

• On top of that: • If we assume that: • Financial Crisis = F(lax

monetary policy) • and we use as FC proxy the

fiscal costs of bank rescue • We can see that…

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The Taylor Critique: MP & Financial Crisis

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The US MP as a Great Deviation

• The Taylor Critique: The US MP was a Great Deviation (respect to the standard rules = Taylor Rules ),

• Triggering the Great Crisis

• Disagreement: Criticizing the Taylor Critique…

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Lax Monetary Policy? No, low inflation π

0,00

1,00

2,00

3,00

4,00

5,00

6,00

7,00

1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 61 64 67 70 73 76 79 82

Tito

lo a

sse

FED rates and inflation rates (bold) (2000-2006, monthly data)

Serie1

Serie2

)()( ** yyri −+−++= βππαπ

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Lax Monetary Policy? No, Noises

)()( ** yyeeri −+−++= βππαπ

Lax Monetary Policy? No, Low Real Rate

• Assuming that the real rate r is the clearing price in the saving market:

• Where Investment I= Demand for Saving = I(r) Saving S = Supply for Saving = S(r)

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r

I,S

I

S

Lax Monetary Policy? No, Low Real Rate = Saving Glut

• If a saving glut occurs:

• A downward shift of the S curve triggers

• Higher I,S • Lower r

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r

I,S

I

S

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Lax Monetary Policy? No, Saving Glut (World Data, 2002-

2004)

saving

investment

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Saving Glut? Be Sure? (World Data, 1970-2004)

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Summing Up: The US MP as a Great Deviation

• The US MP was a Great Deviation (respect to the standard rules = Taylor Rules ),

• Effect: Overlook financial instability signal • More generally….

The Great Deviation in FR and MP

• The years before the GC = The Great Deviation

• Financial Regulation = Deviation from the Standard Regulation = De – Regulation

• Monetary Policy = Deviation from the Standard Monetary Rules = Lax Monetary Policies

• Effect: To overlook instability signals …

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Summing up: Overlooked Instability Signals

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Summing Up: Overlooked Instability Signals

• In general: • Housing Price Bubble = Asset Price

Movements = Financial Phenomenon = Negligible

• Current Account Deficit = Aggregate Demand Phenomenon = Negligible

• Monetary Policy Laxity = Aggregate Demand Phenomenon = Negligible

• Why? It depends on the GM economics …

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The Economics of the Great Moderation: The Efficient Markets View

• The Economics of the GM: The Efficient Markets View (EMV)

• EMV: If the micro market structure is efficient in producing and distributing goods and services :

• The macro performances are automatically good

•

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The Efficient Markets View and the Supply Side Economics

• In the Efficient Markets View which are the optimal economic policies?

• Aggregate Demand Policies? NO • Supply Side Policies? YES • Why? Any change in AD can be permanent or

temporary

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The Efficient Markets View and the Supply Side Economics

• Why? Any change in AD can be permanent or temporary

• If an AD change is permanent: the efficient producers anticipate it, changing his/her choices

• If an AD change is temporary: the efficient producers doesn’t change his/her choices

• Therefore just the producers’ choices (Supply Side) matter

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Supply Side Economics and Economic Policies

• Therefore economic policy is effective if and only if trigger efficiency

• Efficiency = productivity • Which policies can increase productivity?

Supply Side Policies, as : • - antitrust policy = changes in the markets for

goods and services • - flexibility policy = changes in the labour

markets • Macro Effects …

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Supply Side Economics, Growth and Inflation

• In the Supply Side Economics: • 1) Growth depends on Productivity • 2) It is possible to have more Growth without

Inflation = The Phillips Curve disappears • 3) It is possible to have Growth and Stability • In fact…

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GC: Just Productivity matters …

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GM: … The end of the Phillips curve

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GM: … growth stability and …

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GM: … inflation stability

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Summing Up: the GM and its Policies

• If you assume that the EMV – Efficient Markets View = Supply Side Economics - holds:

• In general, just the Supply Policies matter. • Regarding the financial markets: • Deregulation + Lax Monetary Policy is an Effective

Policy Mix • In general, instability phenomena – if any – are

negligible • Therefore …

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GM: The Quiet before the Storm (GC)

FINANCIAL IMBALANCES CA

IMBALANCES

MONETARY IMBALANCES

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… The Storm (GC)

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Explaining the GC

• The FC as a domino effect, with monetary policy and regulation as triggers/catalysts

• The domino effect: from a single market default to a systemic crisis …..

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Explaining the GC

WORLD FINANCIAL MARKETS

WORLD BANKING

MARKETS

US

FINANCIAL MARKETS

US

BANKING

MARKETS

US SUBPRIME

MARKETS

US MORTGAGE

MARKETS

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Market default: the US sub-prime market

• DEREGULATION EFFECT: • US sub-prime (SP) market: a huge and rapid growth • Micro: number of SP contracts: from 624000 (2001)

to 2.646.000 (2006). Value on Average: from $ 151.000 (2001) to $ 259.000 (2006).

• Macro: SP Market Absolute Value: from $ 94 billion (2001) to $ 685 billion (2006); stock (2001-2006): $ 2.601 trillion

• Market Relative Value: SP market/ overall mortgage market: from 8% (2001) to 20% (2006).

• SP Market Evolution: Boom and Bust …

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the US sub-prime market: boom and bust

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Default Drivers

• Leverage = f (interest rate, collateral value) • MONETARY POLICY EFFECT: LOW INTEREST

RATES (LEVERAGE DEMAND TRIGGER) • DEREGULATION EFFECTS : LOW COLLATERAL

REQUIREMENT (LEVERAGE SUPPLY TRIGGER) • DEREGULATION EFFECT: HIGH COMPETITION

(LEVERAGE SUPPLY TRIGGER)

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• Bad loans in the SP market: about 10% • Credit boom and bad allocation: nothing more, nothing

less, nothing new

• But…

the US sub-prime market: just a bubble …

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• From single market default (snow ball) to system financial instability (avalanche)

• THE Uncertainty CHAIN: THE FINANCIAL SYSTEM FEATURES …

the US sub-prime market: … no, let’s start the Armageddon!

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UNCERTAINTY CHAIN = FINANCE FEATURES

=

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Externality: US systemic uncertainty

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Externality: overall systemic uncertainty

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the GC final effect

WORLD FINANCIAL MARKETS

WORLD BANKING

MARKETS

US

FINANCIAL MARKETS

US

BANKING

MARKETS

US SUBPRIME

MARKETS

US MORTGAGE

MARKETS

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