Bubbles and Systemic Risk

There is a wide-spread concern that the current monetary easing plants the seeds for the next bubble and therefore for the next financial meltdown. The logic is clear – between 2001 and 2004 Greenspan lowered interest rates to clean up the dot.com bust and as a result of the low interest rates a bubble in the housing market materialized. Over the past few months, Bernanke went well beyond Greenspan’s expansionary policy by lowering rates to 0%, by starting credit “defrosting“ programs as well as by implementing the so-called “quantitative easing”. The ultimate side effect of these efforts to resuscitate the economy must be again a bubble.

Whether a bubble will develop or not in the immediate future is not entirely clear. In this entry, however, I want to use these concerns in order to put up two topics for discussion: (1) Not all bubbles are the same; (2) The big issue is systemic risk – with or without bubbles.

1. Not all bubbles are born equal. The fact that a bubble may develop does not necessarily mean that we will get to the same catastrophic dynamics as in the past two years. Suppose that a bubble develops in the market for gold and the price goes to $3000 per ounce. At some point investors may realize that demand is faltering, they will start selling their holdings of gold and the bubble will deflate. Although for some investors the collapse of this bubble will generate uncomfortable redistribution of wealth, it is not going to lead necessarily to a financial meltdown. Even the dot.com bubble did not generate the same kind of dynamics as the ones we saw after 2007. The gold bubble and the dot.com bubble are very different from the house price bubble. In my view, the key distinction is whether the bursting of the bubble generates systemic risk for the banking sector. One of the fundamental reasons for the severity of the current recession is that credit markets froze because banks had too much uncertainty about their survival probability and they stopped lending. In plain words, the collapse of the bubble had implications for the entire economic and financial system. Not all bubbles have such effects.

Inevitably, there will be more bubbles in the future. There is little doubt that euphoria in some markets at some point will lead to a disconnect between fundamental values and current prices. Whether policy makers should address a bubble and by what means depends to a large degree on the risk of having an economy-wide meltdown once the bubble starts deflating.

2. From regulation to systemic risk policy? The dynamics of the vicious circle between the contraction of the real economy and the disintegration of the financial sector is reminiscent of the dynamics that led to the severity of the Great Depression. Roosevelt arrested these dynamics by implementing four policy changes: (1) financial restructuring (after the banking holiday); (2) expansionary monetary policy (allowed by the suspension of the gold standard); (3) fiscal expansion (i.e. the New Deal; I know that it had a small contribution to the recovery, but at least fiscal policy was not in the way of other policies); (4) regulatory changes (the Glass-Steagall act, etc.). Since the start of the toxic interaction between the financial collapse and the real economy contraction after the collapse of Lehman brothers, I have argued that policy makers have to act in the same four dimensions in order to stabilize the economic activity. This is hardly an original thought, but it is useful to remember that these were also the actions of the Roosevelt government.

At an event organized by INSEAD on April 3, 2009, I made the same argument and in a panel discussion after my presentation, Sir Andrew Large – a former Deputy Governor of the Bank of England – suggested that there is a fifth item that should be added to this list: policy related to systemic risk.

So far systemic risk has been in the realm of regulation. We can think of various restrictions on lending, leverage, capital adequacy ratios, etc., which are designed to minimize the risk of a system-wide collapse. The point of Sir Andrew Large was that these are static measures, but given the sharp increase in financial innovation and the rapid changes in financial markets, shouldn’t we think of a policy body that continuously reviews and changes some of these ratios on a dynamic basis? In the way that monetary policy changes interest rates, the new policy authority will have a set of instruments to deal with developments that raise systemic risk in the economy. Naturally, this body will be in charge of addressing bubbles that have systemic implications. However, it will not be just a bubble-buster, since systemic risk can arise even in periods without bubbles.

There are certainly pros and cons in implementing such a dramatic institutional change and I am sure that I do not do justice here to the ideas of Sir Andrew Large. But I think that this is a very original idea and it deserves further consideration.

Ilian Mihov

The Euro area is (was) officially in a recession (in case you did not know)

Today, the CEPR (Center for Economic and Policy Research) has announced that the Euro area entered a recession in the first quarter of 2008 (and they identify January as the month when the recession started). This follows the earlier announcement (December 1, 2008) by the NBER (National Bureau of Economic Research) that the US economy had entered a recession in December 2007. This means that both economic areas entered a recession almost around the same time.

In case of the Euro area, this recession signals the end of an expansion that has lasted 57 quarters (or more than 14 years). The previous recession was in 1993. The CEPR does not recognize the 2002/2003 period as a recession although they admit that it was  period of particularly slow growth. In the case of the US, the last expansion lasted 73 months given that there was a recession in 2001 (March to November). 

Both the CEPR and the NBER follow similar methodologies to define a recession, they look for periods of "significant decline of activity" and "activity" is measured by a set of economic indicators (not just GDP). This definition differs from what many refer to as a technical definition of recession, two consecutive quarters of negative growth. As an example, in 2001, the US did not have two consecutive quarters of negative growth as it alternated from positive to negative but the NBER recognizes this period as a recession. 

The reason why their announcement take place months after a recession has started is that they wait for very strong evidence of the change in the phase of the cycle before they make their call. They are not in the business of forecasting business cycles.

More information on the CEPR dating can be found here. The NBER methodology and announcements are on their web site.

Antonio Fatás

The stock market and the value of the US dollar

I already wrote a note on this topic earlier in the blog but I thought it was useful to refresh the discussion with a picture. See below a picture of the evolution of the US stock market and the USD/EUR exchange rate since January 1st, 2009. The correlation between these two series is close to 0.9 (you get a similar correlation if you look at a longer series that starts in the summer of 2008). Whenever the US stock market goes up, the dollar goes down (relative to the Euro).

This correlation is not easy to explain with traditional macroeconomic models (to some this might not be a surprise given how bad some of our traditional macroeconomic models have helped us navigate through the current financial crisis,...). 

To explain exchange rates we normally look for changes in the economic fundamentals of one economy relative to another (the exchange rate is by definition a bilateral variable). If this was just news about the US economy, what is normally assumed (and, under certain assumptions backed by economic theory) is that good news about the US economy get reflected in an appreciation of the currency. But here we have the reverse, the dollar depreciates when the US stock market does well. 

Of course, if we truly want to make a relative statement about the US versus Euro economies we are missing information on the Euro countries in the chart. We know that during these months the behavior of these stock markets has been almost identical, influenced by news about the global economy. So, in some sense, it is not clear whether this is a correlation between the US stock market and the exchange rate or between global equity markets and the exchange rate. Should there be a correlation between global equity markets and a currency? It cannot be that all currencies appreciate when equity markets are doing poorly (some currencies need to depreciate!).  But the US dollar is not just a regular currency. We are constantly reminded these days that the US dollar is still perceived as the currency of the world and that the only true "safe assets" are assets denominated in US dollars (treasury bills). If that's the case, bad news about the global economy trigger a "flight to quality" and this means moving away from equity but also away from currencies other than the dollar.  This is consistent with the picture above although it is unclear how to make this consistent with other mode fundamental theories of the exchange rate (or the stock market) that are relevant at longer horizons -- but in times of panic, who cares about longer horizons? 

If this the explanation for the correlation above, then we should expect that as signs of the economic recovery become strong, there will be a corresponding move away from the US dollar, which could lead to a significant depreciation (and more so if the US dollar starts losing its status as the safest currency in the world).

Antonio Fatás

A stronger role for the IMF in times of crisis

During the current crisis the IMF (International Monetary Fund) has been lending to countries in need of funds. Despite this increase in activity there is a sense that the IMF could play a much stronger role in times of crisis. One of the constraints was the limited pool of funds available but this is about to change as there has been an agreement to increase substantially these funds. But, in addition, some countries where not willing to go to the IMF because of the conditions that it imposed on the borrowers. The IMF has just approved new lending facilities that address some of these concerns. Some of the changes include

• increase in the amount of lending that countries can obtain from the IMF
• additional flexibility in the terms of the loan as well as the lending processes
• loans are conditional on pre-qualification criteria rather than ex-post outcomes (this is probably one of the most significant changes as these conditions were many times seen as unnecessary impositions on domestic economic policy

If you want to know more, the IMF provides details on all these changes in their web site. 

It will be interesting to see how the new lending facilities change the attitude of some of the countries that today do not consider the IMF as the first place to go for funding in times of crisis. These changes are also happening at the time when we hear additional demands for the need of an international authority in matters such as exchange rate or the creation of a world currency which is independent of national governments (as expressed by Zhoe Xiaochuan, the Chinese central bank governor).

Antonio Fatás

Yet another paradox of thrift

The most recent IMF projections for the world economy indicate that in 2009 we will see world output contracting for the first time in the last thirty years. The global nature of the crisis has come as a surprise to some. A few years ago as we witnessed an increasing divergence of growth rates between advanced and emerging economies (see chart below) there was much talk about the “decoupling theory”. While for many decades advanced economies and emerging markets had displayed very similar growth rates, after the mid-90s, partly driven by the fast growth rates of the largest emerging countries, there was an increasing gap between the two.  It was this increasing gap that led to the "decoupling theory" and the assumption that a slowdown in advanced economies would not affect emerging markets.

Why is this recession global? Why is it that problems originating in some (not even all) of the advanced economies that were on a path of unsustainable spending, current account deficits and asset price bubbles has spread everywhere? How can it be that countries that prior to the crisis had a current account surplus, limited appreciation in asset prices, no subprime mortgages are also being dragged into a recession?

The global nature of the current recession is clearly a consequence of the increases in trade and capital flows that we had witnessed in previous decades. But, more importantly, it is also a reminder that imbalances (such as current account imbalances) always have two sides. When adjustments are needed they require changes not only in countries with deficits but also in those with surpluses. In fact, under some circumstances, the changes can be as dramatic for those who were seen as the cause of the problem (the countries with a deficit) than for those who seemed to be doing everything right.

Here is the intuition: Let’s split the world into countries with current account deficits (the ”spenders” (US)) and countries with current account surpluses (the “producers” (Germany, Japan, China)). The countries with deficits were, of course, financing their excess spending by borrowing from those who had a surplus. At some point, the countries with a deficit realize that they are not as rich as they thought and they are forced to cut their spending. They were the ones with a problem, with an imbalance to solve but what happens to the “producers”?Clearly they will see the demand falling for their products (their exports). What is interesting is that, under some circumstances, they might see a drop in GDP which is as large as the countries that “were in trouble”. In fact, and what might look like a contradiction, it is likely that the larger the initial imbalance, the more the countries with a surplus will suffer, in terms of GDP (think about an extreme case where the spending countries do not produce anything, all the fall in GDP will happen in the producing countries). So for the countries with large current account surpluses, their apparent position of strength before the crisis has turned against them when the crisis takes place and they might see larger drops in GDP than the countries that started with a deficit.  In addition, if their exports were in goods that are highly cyclical (durable goods, cars, equipment, IT), the effect can be even more dramatic, and this is an important factor for Japan, Germany or some of the Asian exporters. Finally, how much of the necessary adjustment of spending in the US will fall on imports versus domestic goods will be a function of the exchange rate.

Let me be clear that this does not mean that the countries that started with a deficit are not suffering the consequences of the crisis, what I am looking at here is the evolution of GDP, a measure of production. What we have is a very different pattern of adjustment when it comes to spending or consumption. In a country like the US we have consumption falling at a rate similar to GDP while in countries like Germany or Japan, consumption is not falling that much. So if we take the perspective of consumers we can say that consumers in Germany or Japan are not feeling the pain of the recession as much as the Americans. But when we look at GPD and because of the collapse of their exports, German of Japanese GDP are expected to contract at a similar or even faster pace than in the US (the most recent IMF forecasts for 2009 are -5.8% for Japan, -3.2 for the Euro area and -2.6% for the US).

In summary, generating current account surpluses and accumulating reserves as protection against the possibility of a future crisis cannot be seen as a a guarantee against a global recession, especially if it is caused by the need to adjust global imbalances. The accumulated savings will serve as a buffer to avoid a fall in domestic spending but we might still see a significant slowdown in GDP growth or even a recession. 

Antonio Fatás

CNBC Interview on monetary policy

Ilian on monetary policy in the US and Japan (aired on Tuesday March 17th, CNBC)

Euro countries: missing their old currencies? Maybe not.

The current financial crisis is the first real test that the Euro area has faced since its launch in January 1999. While the idea of sharing one currency sounds very good from the perspective of lowering transaction costs and uncertainty, it comes with a cost. There is always the fear that individual members will not be able to cope with recessions as they have lost their ability to decide on their monetary policy (and the exchange rate).

For some, the current crisis is already showing the large costs of sharing a single currency. In a recent column, Paul Krugman argues that for a country like Spain, the fact that they do not have their currency and they cannot simply devalue it to get out of the current recession means that they will endure a bigger pain over the coming years. Some go further and forecast that several countries will soon leave the Euro area.

The economic logic behind these arguments is standard and one can find it in any macroeconomic textbook: facing a recession, monetary policy needs to be aggressive (lower the interest rate) which is likely to lead to an exchange rate depreciation. Both the lower interest rate and the depreciated currency increase the demand for domestic goods and allow the economy to escape the recession faster.

 Let me question this logic and argue that a country like Spain would be in a much more difficult situation if it still had its own currency (the Peseta). Just to be clear, this is a difficult debate (whether sharing a common currency is good or bad) and there is a very large academic literature out there that I will ignore in this note (apologies). My goal is simply to share a few facts and arguments supporting the common currency arrangement.

 Let’s first think about what the Spanish Central Bank would be doing if they still had power over their interest rate. It is unclear that they would be choosing a lower interest rate than the ECB has chosen. In fact, according to the IMF GDP growth forecasts, the Spanish economy is expected to grow at rates which are almost identical to those of the Euro area as a whole, it is therefore unclear that the Spanish economy needs an interest rate which is different from that of the Euro area (of course, we can argue that the ECB is not choosing the right interest rate and the Bank of Spain would be better at it, but that’s a very different argument).

GDP Growth Rates

	Spain	Euro
2008	1.2	1.0
2009	-1.7	-2.0
2010	-0.1	0.2

Source: IMF World Economic Outlook

But what about the exchange rate? Wouldn’t it be nice if Spain could devalue its currency to boost their exports? Maybe, but it is unclear that this would translate into a stronger GDP growth and it could have damaging long-term consequences. Some anecdotal evidence: a country like the UK is “lucky” enough to have the Pound. In fact the Pound has depreciated very strongly relative to the Euro and the US dollar. This means that the UK economy should benefit from this and be able to escape the recession faster, right? Well, the IMF forecasts for the UK economy are marginally worse than for the Euro area (or Spain). I am aware that there are many other factors to consider and that this is not a (scientific) proof that exchange rates are not powerful, but I think that the numbers make clear that the assumption that a depreciating currency is powerful macroeconomic stabilization tool should be, at least, questioned. Another interesting case is the US where despite the fact that they have their own currency, the currency has appreciated in recent months and following the logic above this should be hurting the US economy rather than helping it (i.e. even if you have your own currency, it might move in the “wrong” direction).

GDP Growth Rates

	UK
2008	0.7
2009	-2.8
2010	0.2

Source: IMF World Economic Outlook

Finally, if Spain still had their own currency and the currency had depreciated, we would have likely observed two very damaging outcomes in financial markets. First, the Spanish government as well as some of the Spanish multinational companies and banks would have seen their foreign-denominated liabilities explode because of the depreciation of the Peseta (as it is likely that they would have been borrowing in foreign currencies in previous years). In addition, when issuing new debt Spain would have faces a much higher interest rate. The Spanish government is already facing today an interest rate that is about one percentage point above the one, faced by the German government. This is all because of the fear of default; there is no uncertainty with respect to the value of the currency (both of them are denominated in Euros). If the bonds were denominated in the Spanish currency, it is very plausible that this differential would be even higher.

So having the King of Spain (or the Queen of England) printed on your bank notes is, for some, a strong sign of independence and of your ability to decide on your own destiny. But how much can a depreciation of these pictures of the King or the Queen help us getting out of a recession is much less obvious when one looks at the data.

Antonio Fatás