Who is responsible for the ‘Great Financial Crisis’ ? Endogenous or exogenous phenomenon ? Dr. Nicolas BARBAROUX Associate Professor in Economics Thusday, 20 th Karelia University- Wärtsilä Campus Centre for Business and Engineering
Did economists become blind ? Nobody saw the crisis even in the macro data « Why did nobody notice this ? » (Queen Elizabeth II at the LSE) Should we blame economists ? Three mistakes: They did see the crisis coming They did not, even, consider the possibility of a crisis They were not able to propose a common policy to remove from the crisis Why ? Macroeconomics viewed the world from their models instead of having models to see the world (Mary Morgan, LSE, 2012) The solution ? To remeber what « our due fathers taugh us » (Krugman, 2011) To change the way we speak and we think about monetary policy
OULINES I. The Financial crisis roots Microeconomics roots Macroeconomics roots Exogenous shocks Long-term perspective analysis II. The challenges to economists and policymakers The Financial stability issue The academics’ issues
I. Who is responsible for the crisis ? Great Financial Crisis Macroeconomics roots Easy money policy Saving. Investment imbalance Microeconomics roots Excessive risk taking Lack of regulation Exogenous schock Structural roots « Black Swan » phenomenon 1980’s Financial Globalization
Macroeconomics’ roots (1) Easy money policy prior 2007 Low federal funds rate by the Fed (US cenral bank) Interest rates maladjustments: « great deviation thesis » (Taylor) Which feed excessive investment and risk-taking, real-estate bubbles… under a free system with no regulation (2) Saving-Investment unbalance Disequilibrium in international trade A lot of excess saving on the money and capital markets
Easy money policy
Taylor’s eponymous rule In 1993 John B. Taylor proposed a descriptive (or prescriptive) rule of conduct on the way Fed managed monetary policy The US central bank acts as if it follows: Thus, the federal rate (r) should be increased when output gap (y) decreased or/and when the inflation rate (p) overpassed its target (here 2%) Thus, monetary policy deliberations (FOMC) should consider GDP and inflation With no regard to financial markets disturbances
Was the Fed off the Taylor Rule over 2001 ? Source: Yash P. Mehra and Bansi Sawhney, Economic Quaterly, 96: 2, 2010)
Saving-Investment imbalance (Source: Barbaroux 2013: 164)
Microeconomics roots (1) Financial innovations Risky credit instrument Subprime credit With risk transfert system embodied in it: securization process Asset Backed securities (ABS), Mortgage backed securities (MBS), Collateral Default Obligations (CDO)… and so on…. (2) Lack of banking regulation prevent people (economic advisors) to see that: All those practices were off-balance sheet SPV: risk transfert system Rating agencies (Moody’s, Fitsch and S&P) Conflict of interests and blindness (concerning risk evaluation)
1 st Step Real-estate market bubble (subprime market)
2 nd step: reversal trend
From macroeconomics to microeconomics roots Low interest rate context created unbalanced system which pushed economics agents (investors) to excessive risk taking More risk taking (deregulated financial assets linked with subprime ones) so as to earn more profits Knut Wicksell’s legacy: Higher investment when the rate is too low regarding the (expected) profitabilty perspectives In a universe where there is no regulation at large Emerging shadow banking system (hedge funds and future markets) Due to low long-term interest rates
Exogenous shock Under-estimation of risk (for investors) feed excess risk taking on financial markets which implied a speculative bubble Market failure: when market set bad prices disconnected from risk As a consequence: « black swan » (Nassim Nicholas Taleb; Taylor 2008) phenomenon appeared Low probability occurring for an unforeseen event When the bubble explosed everybody realized the right level of risk they took End of bubble= huge selling of assets at the same time Asymetrical information context = self-referential behaviours outweigh over rational decision making process Keynes 1936 « Beauty Contest »
The begining of the crisis: an exogenous shocks August 9, 2007: BNP Paribas announces they cannot price three of their funds invested in subprime MBS Interbank market seizes up: Hoarding of cash, sudden cessation of interbank lending Interbank rates explosed: confidence crisis Severe liquidity constraints in financial institutions Surge of risk premia in money markets
The ‘Black Swan’ phenomenon on money market
« The Beauty contest » by Keynes
The turning point 15 sept. 2008: Bankruptcy of Lehman Brothers triggers an unprecedented disruption of global financial markets The end of the ‘Too big to fail’ myth ? Emerging stress within the interbank money market
Another ‘Black Swan’ phenomenon on money market
Structural roots Long-term perspective Structural analysis = endogenous process Financial globalization (1980’s) created a new capitalistic system that transformed the way we create wealth and the way we share economic incomes as well. Under the influence of macroeconomic policies
The disequilibrium schedule Step 1= downward trend of labour share of total factor incomes To the benefits of shareholders Results in increasing domestic debt while increasing the ability to buy financial assets Step 2= decreasing productive investment over financial ones better returns on financial assets investments (due to financial globalization) Step 3= increasing discrepancy between the richest and poorest encouraged by irrelevant fiscal policy Outcome = global instability context
Step 1
French case Labour share in factor income (OCDE data, in Askenazy, 2003)
Labour share in factor income for Australia from the September-quarter 1959 to the June-quarter 2013
Overall donward pressure on labour share of total income: Why ? « An increased role of financial activity and rising prominence of financial institutions is a hallmark of the transformations of economy and society since the mid-1970 s » We have found that globalisation, i. e. increased international trade, has negative effects on the wage share in advanced as well as in developing economies. (…) Overall, the results are similar for advanced and developing economies. Financialisation has had the largest negative effect on wage shares. Technological progress (including structural change) has had substantial (positive) effects on the wage share, Globalisation and welfare state retrenchment have had moderate negative effects on the wage share In Global Wage Report 2012/13: ‘Wages and Equitable Growth’
Higher productivity does not mean higher wages
US Case
What causes the share of labour to decrease ? (ILO, Wage Report 2012 -13)
Step 2: Gross fixed investment (per cent, GDP) (OECD)
The I=S paradox ? Why investment decreased ? Intuition ? Decreasing investment means decreasing profit returns Investment used to be a good barometer for profit, the two used to be closely correlated. Correlation coefficient close to 1 Reality ? Since 1987, this is no longer the case. Reverse situation ouweights= it’s almost like less investment is leading to more profit Why such a paradox?
Capitalists are now investing less in productive assets because returns from such investment are too low as compared to the ones from financial assets or in realestate markets.
Returns on real-estate investment(INSEE)
Step 3: Trickle down effects (IMF)
US widening income inequality (The Economist)
A disequilibrium system Step 1= results in underconsumption Step 2= underinvestment context while inflating financial assets Facing decreasing income implied Increasing debt/income ratio Domestic debt are financed by financial assest issues which are bought by (richest) household, firms, banks and so on… Trickle down effect: wealth move from poorest to richest people increasing discrepancy between poorest and richest people Structural changes under a double sided globalization: Financial globalization (political policies) Running after profits (the 5%-15% rule) Which speed up the labour globalization Financial goals > productive ones
II. The challenges to monetary policymakers 1. The financial stability issue Why financial stability should matter ? Treaty (Art. 127 -2): « prudential supervision of credit institutions and the stability of the financial system » From one side, credit = determinant in the process of economic development Schumpeterian views= entrepreneurs need credit to innovate From the other side, finance development = answer to the economic development Economic growth: people are more likely to demand financial services In both cases, finance grwoth is detrmined by structural parameters (level of debt, legal constraints…and so on…) Major argument= financial (innovative) markets are a major source of (external) instability Systematic impact on real economy by way of contractual, informational or psychological (powerful) links
Bankruptcy = stimulus to banking run, self-referential behaviour, financial panics… Informational link Psychological link Financial instability Bankruptcy = severe negative signal of mistrust on financial markets at large Contractual link Creditors were the first to be hit by financial losses (bankruptucy)
II. The challenges to monetary policymakers 2. The academics’ issues (1) Bad model better than no model ? Economic blindness: use of New Keynesian models or New Neoclassical Synthesis models in which representative economic agents are perfectly rational in those models They optimze their econimic decisions in an intertemporal kind of way money and credit play no direct role. Nor does a financial market. How money can be considered ? . . . . by central banking only (End of Keynesianism) (2) Updating stilized facts: Saving-Investment unbalances matter for economic instablity Shadow banking sector emerged +Increasing role of financial intermediaries Endogenous variations in credit and credit spread (instability) Resulting in increasing money supply BUT off balance sheet (Woodford 2010) (3) Return to « Core vs Periphery » models ? Non €uro countries outdo €uro ones: is €uro a burden ? Finland vs Sweden performance
Finland vs Sweden
Conclusion In the aftermath of the ‘Great Financial Crisis’, monetary policy is questioned In theory: what monetary policy should we design ? conventional vs unconventional practices (how long does it last) In practice: a decreasing confidence towards €uro Thus, economists should changed the way they think and speak about monetary policymaking To consider both internal and external (in)stability (My 2013 book thesis) To give greater weight on (unconvenional) open-market interventions in the money market Asset purchase program (on public assets), swaps practices, long-term refinancing operations (link between short-terma nd long term rate)
Thanks for attention Nicolas. Barbaroux@univ-st-etienne. fr
II. The challenges to monetary policymakers 3. Towards a new monetary policy startegy ? (1) From interest rate setting policy to forward guidance policy In case of zero lower bound, unconventional policy measures matter QE, Credit Easing, Covered bond purchase Program…and so on… To influence the future path of short term rates: How ? By increasing transparency (explaining the major indicators used in monetary policy deliberations) (2) Dual mandate ? Implied new policy tools (Tinbergen paradox) Open-markets practices= discretionary policy Macroprudential policy measures= Basel III and others regulations from BIS (3) New Taylor rule ? Taylor rule with unemployment rate and financial markets’ Pric Index
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