FINANCIAL INSTABILITIES AND RISK MANAGEMENT BY CENTRAL BANKS

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FINANCIAL INSTABILITIES AND RISK MANAGEMENT BY
CENTRAL BANKS

• Marc Hayford and A.G. Malliaris
• Loyola University Chicago
• WEAI 83rd Annual Conference
• The Sheraton Waikiki, Honolulu, Hawaii
• June 29- July 3, 2008

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Focus of the Paper

• Financial Instabilities
• Emphasis on Asset Bubbles
• The Risk Management Approach to Monetary Policy

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Financial Instabilities

• Challenging to define Instability
• Financial stability means the efficient
  allocation of funds to investment opportunities
  that is robust to shocks
• F. Mishkin adverse selection and moral hazard
• G. Kaufman bank soundness

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Financial Instabilities

• Financial instabilities increase uncertainty and
  generate risks
• Valuation risks valuing securities during a
  financial distress
• Liquidity Pressures
• Macroeconomic risks deterioration of the real
  economy

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Why Do Instabilities Matter?

• Ineffective Transmission of Monetary Policy
• From Financial Instability to Economic
  Instability
• From Local to Global Instabilities

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Key Episodes of Financial Instability

• The October 1929 Stock Market Crash
• The Savings and Loans Crisis of 1989-91
• The Asian Financial Crisis
• The Japanese Burst of Real Estate and Stock
  Market twin Bubbles
• The Collapse of Long Term Capital Hedge Fund
• The NASDAQ and Housing Twin Bubbles
• The 2007-8 Securitization Crisis

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Theories of Financial Instability

• Not well developed field
• Consensus (Greenspan, Mishkin) Stabilizing
  inflation contributes to financial stability
• Hyman Minskys hypothesis that stability causes
  instability
• Income-debt relationships Hedging, Speculation
  and Ponzi Finance

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Asset Price Bubbles

• Controversial topic less now than a decade ago
• Kindleberger an upward price movement over an
  extended range that then implodes
• Significant deviations from fundamentals
• NASDAQ -100 Index in 2000
• U.S. Housing Bubble of 2004-7

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NASDAQ-100 Index
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Monetary Policy

• Price Stability
• Economic Growth
• Risk Management Approach to Financial
  Instabilities

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Bubbles and Monetary Policy Risk Management

• Two Questions
• Normative Should Monetary Policy Target Asset
  Prices?
• Positive Does Monetary Policy Target Asset
  Prices?

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The Normative Question

• Bernanke and Gertler The Fed should not target
  asset prices
• Cecchetti and others React cautiously
• Filardo Deflate bubbles Double bubbles
• Roubini Burst bubbles

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The Positive Question

• Hayford and Malliaris Difficult to assess Feds
  policy
• Greenspan appears to have tried
• Using an axe to do brain surgery

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Risk Management Choices

• 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

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The Asymmetric Approach

• Greenspans 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

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Risk Management Challenges

• Between the duality of symmetric and asymmetric
  responses the consensus is on the asymmetric
• Did the easy monetary policy that followed the
  bursting of the NASDAQ bubble contribute to the
  housing Bubble?
• Two goals and one instrument
• Risk Management Fed funds and counter-cyclical
  regulation

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Conclusions

• Monetary Policy and the Great Moderation
• The Great Moderation and Asset Bubbles
• What causes Asset Bubbles? Endogenous or
  exogenous?
• Formalize the Theories of Financial Instabilities
  a la Minsky
• Add new Instruments