- Time and Date: 10:00-16:55, Friday December 19, 2008 (Open: 9:45 a.m.)
- Venue: RIETI's seminar room (1121,11th Floor, METI ANNEX)
1-3-1 Kasumigaseki, Chiyoda-ku, Tokyo
- Language: English (no interpretation available)
Working Lunch: "Financial Crisis"
Morten RAVN (Professor of Economics, University of Southampton / Professor of Economics, European University Institute / Research Fellow, CEPR)
In relation to the current financial crisis, a great moderation was previously seen in macro-volatility. In the early 1980s, the volatility of U.S. GDP at the cyclical frequencies declined very significantly. The standard deviation during the 1970s and up to the early 1980s was around 2% per quarter, but that figure dropped to below 1% in the mid-1980s onwards. What this means is that an enormous macro-moderation had taken place in the United States and the amount of aggregate risk in the economy had declined. This observation can be referenced against the idiosyncratic risk present in the U.S. economy. There was a micro-exaggeration of risk at the same time that there was a macro-moderation of risk. This scenario can take the form of securitization and an increase in the supply of risky loans.
This situation may also be related to the U.S. current account deficit. With an increase in the amount of idiosyncratic risk, borrowers have more resources that they can commit to paying back loans. This may be why the U.S. was able to increase foreign borrowing. In terms of consumer borrowing, there was a steady increase in the loan-to-price ratio of home mortgages from the 1970s onward. This same pattern is seen in the loan-to-value ratio for new car loans. At the same time, a large decline in the price of loans took place in terms of the Fed-mandated three-month lending rate. While household debt and idiosyncratic risk increased, there was a drop in foreclosure rates.
These factors led to certain conditions that caused the financial crisis. There was an illusion of little or no aggregate risk. Households were willing to borrow more due to low rates, capital gains, and a positive outlook for the future. Financial institutions were willing to lend more due to securitization and to households' increased ability to commit to no-default loans. Finally, investment banks and others were profiting heavily by insuring contracts with no-default provisions.
At this point, a macro shock took place. It is yet unclear what that shock was, but growth in real consumption dropped precipitously and foreclosure rates increased from zero to 40% in a very short time. It can be seen now that insurance contracts could not deal with such aggregate risk. Those who had sold insurance contracts nominally had very large liabilities, including insurer default, which forced those who had bought insurance to bear a risk they were not aware of.
Mistakes were made in the U.S. economy. There was a systematic underestimation of the risk of loans. Rating agencies and regulators were backward-looking and had become too reliant on backward-looking estimates of risk. In closing, Europe needs to think about coordinated supervision and the issue of who would be a lender of last resort.
Fabio CANOVA (ICREA Research Professor, Universitat Pompeu Fabra; Research Associate, CREI, Research Fellow, CEPR)
Most of the patterns mentioned previously for the American economy also occurred in Europe. The creation of the European Central Bank (ECB) was a key difference between the two economies. Many credit-constrained consumers could access the market at a much lower rate with less collateral, which created greater credit demand.
There were large flows of credit within Europe due to slow growth in Germany. Many banks, especially in Southern Europe, had balance sheets that were not in balance. Mortgages and long-term investments made up assets, and one-day or one-week loans made up liabilities. As housing demand and prices increased, mortgages became larger since consumers' income could not keep up with the increasing prices. Mortgages of 40-50 years were not unusual.
The main difference between European and U.S. banks is that there was slightly more supervision in Europe over the banking system. It seems as though greater supervision has kept the problem from exploding, though it will continue to be a problem.
As for the role of the central banks, the low interest rates in the U.S. pressured the ECB to keep interest rates low. Historically, the Federal Reserve has gone through waves of increasing and decreasing activism, with the 2000s being very active. The Fed engaged in very large interest rate movements to prevent the recession after 9/11. The interest rate being held so low for so long may have helped the problem balloon disproportionately.
Over the last few days, there has been a high level of activism by the Fed, but this activism should be considered with caution. There is yet no telling where this activism coupled with the evolving crisis will lead. The tripling in size of the Fed's balance sheet will have real consequences in the next six months. Central banks should concentrate on managing inflation, which is their main goal. They should facilitate growth, but leave other matters to fiscal policy, which is the responsibility of the government. It seems that this is what the ECB is doing. It is not hyperactive, and although it is getting bad press at the moment, the ECB does not seem to be doing badly in historical perspective..
Jordi GALI (Director and Senior Researcher, Centre de Recerca en Economia Internacional; Professor, Department of Economics, Universitat Pompeu Fabra; Research Fellow, CEPR)
In recent years there has been a growing consensus regarding the framework that should be used to undertake policy analysis. Many central banks have been developing in-house versions of a new Keynesian model.
It is clear, however, that this model has some important shortcomings. The standard versions of this framework do not incorporate financial intermediary sectors. In the coming months and years, some version of the Bernanke, Gertler and Gilchrist model, a new Keynesian model that does take financial intermediaries into account, will be incorporated into the standard medium-scale model that is being used for policy simulations.
The transmission mechanism of monetary policy in the standard model is very simple. Central banks have made dramatic policy rate adjustments that have had very little impact on market rates. Furthermore, the current model does not allow for liquidity risk or solvency risk.
Theorists are used to working with log-linearized versions of models, so that by construction, the degree of uncertainty has no effect on the levels of any variables. The degree of uncertainty is playing a role in determining factors like consumption and investment. This may necessitate relinquishing the simplicity of linearized models in order to allow for higher-order terms to play a role.
The standard model assumes rational expectations. However, the current crisis has shown that there may be important deviations from rational expectations, which could be quite persistent. While it may not be important under normal conditions, when it is triggered by an event there is a huge reassessment of that risk and the standard macroeconomic model has no way of dealing with the increased risk level following reassessment.
The models currently in use are "too stationary". What has been seen in the previous year is closer to what emerging market economies have experienced in exchange rate and banking crises. There is a gradual buildup of imbalances that cannot be sustained forever, and at some point those imbalances lead to a sudden crisis. This is an outcome that cannot be easily explained by a model with such a simple process.
The standard model does not take into consideration the lower bound of zero in the nominal interest rate. In Europe and in the U.S., this was not thought to be a major problem. Introducing the zero lower bound and the constraints it imposes on monetary policy creates some technical challenges. It also implies relinquishing the linearity of the models currently in use.
Bubbles need to be accounted for in models. They pose an interesting challenge because they are a manifestation of the multiplicity of equilibria. Regulatory policies also must be accounted for. Cyclical regulatory policies will play a central role in macroeconomic policy in the coming year.
Question and Answer Session
Q. This crisis seems to be a great failure of the Anglo-Saxon model of capitalism. The U.S. is to blame for this crisis. The U.S. economy recorded the highest economic growth among industrial economies despite the fact that the Fed recorded a negative real interest rate for many years. This shows that the Fed not only caused a housing bubble, but also that the U.S. economy as a whole was a bubble that has just burst. This is not a downturn of the U.S. economy, but the beginning of a long-term trend of economic decline for the U.S. As a committee, we should criticize the U.S.
Q. Can the shortcomings of the new Keynesian model be explained by the way money was introduced into this model? Nominal rigidities are the only way to introduce the effect of money into the real economy.
Many people criticize the standard new Keynesian model because money plays no role. In the simplest version of the model, monetary assets are not found. This is not a shortcoming to understanding the current crisis because there are ways of introducing money. However, it is not clear how the introduction of money explicitly in the model would improve understanding of the crisis. It requires the introduction of financial intermediation, and the introduction of credit markets with imperfections and misperceptions of risk. This goes above and beyond the introduction of money.
Q. The concept of a key currency among many different currencies needs to be introduced into future theory.
In regards to previous comments made regarding the U.S.'s role in the financial crisis, the U.S. holds some responsibility for the problem, but the growth of Asia must also be taken into account. With the rise of the U.S. as the world's financial center along with the growth of Asia as the manufacturing center, this created a fundamental source of the bubble.
Q. Given the limitations of low-interest monetary policies, the discussion has turned to whether fiscal or monetary policy will be more effective in combating the financial crisis. In the new Keynesian model, is the policy of government job creation through borrowing effective in this situation?
It is effective inasmuch as it can increase output and employment. The question is how will it be financed? Typically, it would be financed through lump-sum taxes. There will have to be either current or future distortionary taxes, which will lead to inefficiencies. From the point of view of welfare, it is hard to tell which would prevail. In a model in which one starts from a steady state with no inefficiencies, there is no reason why government spending should be increased. There does not seem to be any analysis that would give an answer to that question in terms of desirability.
Fiscal policy has a large role to play here, and not only in terms of output and employment. In fact, fiscal policy can affect prices. Under some configuration of the monetary-fiscal policy interaction, fiscal policy can determine the price level. Since fiscal policy can do a lot in crisis situations, it is worth exploring at the theoretical level the implications of deficit policies. However, before putting such policies into practice, much more work needs to be done in the framework of standard models that clearly reflect these interactions.
When looking at the history of financial and banking crises in the U.S., it becomes clear that the current crisis is not unusual. This is not a sign that capitalism is dying or that it has been on the verge of dying for a long time. Crises of this type are consistently driven by the same factors; misperception of risk, poor regulations, lack of understanding of the fundamentals behind booms and busts, etc. This experience is not very different from others. New developments in the markets were seen as a reason to relinquish regulatory activity. It is now clear that this decision was wrong..
Q. The pound sterling has a problem in terms of its value and future possibilities surrounding the euro economy. The situation has changed regarding the British and European economies. The pound and euro have recently been moving together. There has been a movement to integrate the two economies. Which option would be more advantageous; integration, or remaining separate?
Since the Thatcher days, the Bank of England has refused to admit that it is worried about the pound sterling. One of the reasons why the pound sterling is losing value is the outlook for the economy of the city of London as well as the UK. The pound sterling has also been overvalued for some time. The slide in the pound sterling may actually be bringing it into equilibrium. The speed of the drop could create some worry, but from a long-term perspective, the decrease may be needed to recreate competitiveness in the UK economy.
Also, some macroeconomists have said that now is the time for the UK to accept the euro. This probably will not happen as it is not politically viable. This prescription is correct for Iceland and Denmark, but it may not be the right decision for the UK, and it will not happen either way.
Q. Regarding China's investments in the U.S. holding down interest rates, it seems like China is in a very bad position. It had an undervalued exchange rate to keep down export prices, misallocated resources, and other issues. Should reinvesting in Asia be part of the solution for China? Would the renminbi appreciate if China invested in pollution control, education or other factors? The yen could appreciate in a similar fashion. If Asia were to be growing with stronger exchange rates, it could also help the U.S.
Q. Many part-time employees are losing their jobs in Japan and unemployment is around 3.6%. Also, the number of autos being manufactured is decreasing dramatically. What is the situation like for industry and the labor market in Europe?
As for the euro area on a whole, there is no evidence yet of an absolute decline in employment. The latest data available indicates the third and fourth quarter will most likely see a significant decline. There is much heterogeneity when comparing the experiences of different countries. Germany, for example, had been experiencing until recently a continuing decline in the rate of unemployment, which may explain the German government's reluctance to enact a large fiscal stimulus plan. In Spain, on the other hand, the unemployment rate has increased by more than 3% in six months. All the short-term indicators, however, show that the European economy has entered into a recession in the last quarter of the year..
Ireland, Denmark and the UK were the earliest affected European economies in this crisis. All three have very flexible labor markets. It seems that the more inflexible labor markets are in for a longer but more gradual decline, while the more flexible economies should rise out of the crisis faster.
There seems to be many sectoral differences. For example, the auto industry has been hit very hard. This crisis will cause a sectoral readjustment.
Q. As for international coordination, while the G20 met last month, the World Trade Organization has not made any moves in response to the crisis. What is your assessment of the possibility of the G20 or other competent countries coming together in the near future to help resolve this situation?
It is possible that the key policies and decisions will remain in the hands of national governments. There are many structural differences in terms of financial sectors and other areas. This may be the most desirable option for many countries. While there may be cooperation, that cooperation will take the form of setting minimum standards when it comes to fiscal policy, and regulation to prevent free-riding by any country. In a situation like this it is tempting not to do much in terms of fiscal policies; let other countries expand, and take advantage of their fiscal stimulus by increasing exports without creating the distortions present in a domestic fiscal stimulus.
Europe needs to sort out its central bank policy. The lender of last resort needs to be specified among the ECB and the national central banks. There has been a high degree of coordination between U.S. and UK policies. The UK has had mixed success with imposing its policies on the euro area.