Faculty of Economics

1
Macroeconomic and Financial LinkagesSome
observations and some questionsTony
CockerillTuesday 16 December 2008tc317_at_cam.ac.u
k
Faculty of Economics

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Precursors of Global Financial TurmoilThe
butterfly flaps its wings..

• Sustained world economic growth - driven by
  US, China and other emerging markets
• Global financial capital flows
• Low nominal interest rates
• Global competition
• Low price and cost inflation
• Low and undifferentiated pricing of risk
• Credit growth
• Diversification of risk - securitisation -
  off-balance sheet liabilities - collateral debt
  obligations (CDOs) - structured investment
  vehicles (SIVs)

Faculty of Economics

3
Drivers of Global Financial Turmoil. and the
hurricane rages

• US Federal Reserve tightens (loose) monetary
  stance and interest rates rise
• US residential housing market weakens
• Mortgages re-price, and sub-prime mortgage
  holders default
• Value of mortgage-backed securities falls
• Banks do not know the extent of their debt
  obligation exposure
• Flight to liquidity and drop in value of other
  asset-backed securities, including short-term
  commercial paper
• Sharp rise in short-term market interest rates
• Inter-bank short-term finance becomes expensive
  and scarce
• Liquidity dries up
• Effects spill over into equities and other
  financial markets
• Cost of insuring against debt default increases
• Banks announce major asset write-downs and
  escalating trading losses
• The Fed and the European Central Bank pump
  liquidity into the market
• The Bank of England delays taking action

Faculty of Economics

4
The Banking CrisisRoots of the Crisis
Time to jump?

• Banks inflated aggregate balance sheets
• Expansion into assets whose underlying value,
  credit quality and liquidity are uncertain -
  Higher-risk households and companies - complex
  securities
• Over-reliance on short-term wholesale funding
• Inadequate capital levels relative to risk
• Interconnections and systemic weaknesses in
  global financial markets

Faculty of Economics

5
The Crisis Deepens

• US bank failures, forced mergers and rescues-
  Merrill Lynch, American Insurance Group (AIG),
  Washington Mutual, Wachovia
• Rescue of Fannie Mae and Freddie Mac-
  Independent Federal mortgage agencies,
  supplying US Treasury underwritten funds to
  support mortgage lending with an implicit
  government guarantee
• Moral hazard- Too big to fail?
• Collapse of Lehman Brothers- Failure of US
  Treasury planned sale- Not big enough not to
  fail- Was 15 September 2008 the tipping point?
• Global loss of confidence in the banking
  sector- Interbank lending and money markets
  freeze- Financial liquidity dries up

Faculty of Economics

6
The Banking CrisisBail-outs

• US Treasury/Federal Reserve Troubled
  Assets Relief Program (TARP) - 700
  billion - Purchase of toxic assets -
  Derivatives based on Residential Mortgage
  Backed Securities (RMBS) - Unquantified risk
  - Initiative failed, 12 November 2008 -
  Shift to recapitalisation
• Global action - Recapitalisation of
  banks balance sheets - Restore/improve
  Basel II Tier 1 capital ratios - But what
  are the appropriate ratios? - Revive
  interbank lending - But LIBOR is still well
  above base rates and Treasuries

Faculty of Economics

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And short-term market rates remain stubbornly high
Faculty of Economics

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The shape of things to come?
Faculty of Economics

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Financial Cycles and Bubbles

• Efficient Market Hypothesis - Rapidly
  changing market conditions and information
  can lead markets to be volatile
• Herd instinct - Follow the majority.
  Can be rational if uncertainty is high
  and information is scare
• Kindleberger Manias Panics and Crashes -
  Frenzied buying causes prices to rise
  sharply - Investors (irrationally) assume
  prices will continue to rise and go on
  buying in expectation of speculative
  gains, ignoring the possibility of
  losses - Higher prices increase risk, so
  buying goes on to increase prospect of
  profit and to offset higher risk -
  The bubble bursts. Change in market
  sentiment and rush to sell

Faculty of Economics

10
Financial Cycles and Bubbles

• Minsky - Financial and investment
  decisions made under uncertainty
  (un-insurable), not risk - Prices of
  capital assets and of output goods and
  services made in different markets -
  Shocks occur in financial markets, are
  transmitted to investment and ultimately
  to output and employment - In the upswing,
  confidence increases, safety margins
  decline, and investment increases -
  Speculative boom - High and rising interest
  rates lead to payments on debt being met
  by further borrowing (Ponzi finance)
  - Information reveals the weakness of
  (some) contracts - Banks reduce/stop lending
  (The Minsky moment 9 August 2007?)
  

• Noise traders - The market has much
  information, large amounts of which are
  irrelevant (noise) - Smart
  money agents act rationally on
  fundamentals - Noise traders act
  irrationally - Market participants are
  o fundamentalists (market
  fundamentals) o chartists (recent
  behaviour) o portfolio managers (balance
  assets to maximise risk-adjusted
  return - In upswing, portfolio managers move
  funds into growth stocks, driving
  prices higher - In downswing, the reverse

Faculty of Economics

11
The Transmission Mechanism of Monetary Policy
Faculty of Economics

12
UK Money Supply and Inflation, 1880 - 2004

• Money supply growth and price inflation are
  positively and closely correlated
• But this does not confirm the direction of
  causality

Source Bank of England, Inflation Report,
February 2004
Faculty of Economics

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The Taylor Rule How official interest rates are
set

• The Taylor Rule indicates an optimal short-term
  interest rate depending on how far inflation and
  economic output diverge from their normal
  levels.
• It needs five inputs - The natural real
  rate of interest, which is where rates would be
  if inflation and output were at their
  normal levels - The normal, or taget, rate
  of inflation - Current inflation -
  Expected inflation - The output gap
• Specifically, it subtracts half the divergence
  of both inflation and output from a long-run real
  interest rate. It then adds expected inflation to
  get the result.

• The Taylor Rule equation isShort-term
  interest rates Natural real rate expected
  inflation 0.5(current inflation target
  inflation) 0.5(output gap)

Financial Times 5 November 2008
Faculty of Economics

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How serious are the effects of global shocks?

• Only the US has been pushed into a real
  recession by a global shock since 1986
• Since the 1990s, economies have recovered
  quite quickly from shocks
• But subsequent growth has been below trend
  for some time

Faculty of Economics

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Questions

• How much influence does monetary policy really
  have?
• How to unfreeze the money and credit markets?
• When does an upswing become an unsustainable
  speculative boom?
• Will the trend increase in US productivity be
  maintained through the recession?
• How can regulation improve risk assessment
  without damaging innovation?
• Was Greenspan right? - Central Banks should
  not worry about asset prices - Central Banks
  should mop up after the bubble has burst
• How much output is permanently lost in a
  downswing?
• Will the shape of the UKs 2008/2010 recession
  be like 1991/1993? - If not, why not?
• How do Central Banks really set interest rates?
• Is the European Central Bank right to monitor
  broad money growth?
• Can Basel II, as revised, be effective?
• Does the Taylor Rule work in a recession?

Faculty of Economics

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Does the Taylor Rule work?
Faculty of Economics