1. ASSET BUBBLES, MONETARY POLICY AND RISKS TO THE ECONOMY A. G. (Tassos) Malliaris Professor of Economics and Finance Loyola University Chicago EURO WORKING GROUP FOR FINANCIAL MODELING Rome, Italy, May 3-5, 2012

2. My Plan Offer Critical Comments on Monetary Policy. Relate Monetary Policy and Asset Bubbles. Discuss Financial Instability. Propose a New Hypothesis: Price Stability Leads to Financial Instability Using the Asset Price Bubble Channel.

3. Critical Event The Global Financial Crisis of 2007-09. It Is A Major Regime Shift. It Is the Main Reason to Reconsider Asset Bubbles, Macroeconomic Risk and Monetary Policy. Why Was it Missed By Academics, Policy Makers, Practitioners and Regulators?

4. A Selective List of Causes of the Global Financial Crisis The Bursting of the Housing Bubble. Easy Monetary Policy During 2002-2005. Global Exuberance and Imbalances. Government Housing Policies, Fannie Mae, Freddie Mac. Opaque Financial Instruments. Shadow Financial System. Interconnectedness and Too Big to Fail.

5. Why Was It A Surprise To All? Academics: Neoclassical Theories. Practitioners: Short-term Trading Horizons. Regulators: Market Discipline. Policy Makers: Inflation Targeting and the Great Moderation.

6. Pre-Crisis Main Theories Rational Consumers, Firms and Investors. Markets are Efficient; Allow for Behavioral Deviations. Reality of Business Cycles: Great Moderation. Monetary Policy and Taylor Rules. Financial Innovation Contributes to Growth. Market Discipline vs. Market Regulation.

7. Corollaries Sufficiency of Price Stability Rather Than Financial Stability. Inflation Targeting Promotes Economic and Financial Stability. Diversification and Risk Management. Ignore Financial Crises Because They Are Unavoidable; Little in Common; Hard to Predict.

8. Thus: Neoclassical Theories Do Not Fully Explain Financial Crises and Asset Bubbles Large Macroeconomic Risks Inflation Targeting and Financial Instabilities

9. “The dogmas of the quiet past are inadequate to the stormy present” Abraham Lincoln

10. Search for New Theories to Explain: Asset Bubbles Role of Monetary Policy Financial Instabilities Financial Crises

11. From Criticism to Construction Review Asset Price Bubbles State Facts about Macroeconomic Risks Discuss Financial Instability Evaluate the Role of Monetary Policy Propose and Argue a New Hypothesis

12. Asset Price Bubbles Controversial Topic Kindleberger: “An Upward Price Movement Over an Extended Range that then Implodes” Soros on Reflexivity Keynes, Minsky, Shiller on Animal Spirits Preconditions for Bubbles?

13. Evolution of Bubbles Some Deflate Some Crash Some Do not Affect the Real Economy Some Cause Serious Economic Damage

15. Financial Instabilities Challenging to Define Financial Stability Means the Efficient Allocation of Funds to Investment Opportunities F. Mishkin: Adverse Selection and Moral Hazard Slow Return to the Pre-shock State Keynes: Capitalism is Unstable

16. More On Financial Instabilities Financial Instabilities Increase Uncertainty and Generate Risks Valuation Risks: valuing securities during a financial distress Macroeconomic Risks: deterioration of the real economy with high social costs

17. Proposed Definition Let X = R + F denote a vector of real and financial variables that are endogenous Let I and U denote exogenous and random variables An economy f(X, I, U) is stable if shocks to any of the variables do not translate to significant deviations from trend GDP. Role of Leverage

18. How Important Is Monetary Policy? 1929 – 1960: Not Very Effective, Keynes 1970s: Burns and Inflation 1979-87: Volcker and the Dramatic Reduction of Inflation 1987- 2007: Greenspan and Bernanke: The Risk Management Approach

19. CPI Less Food and Energy

20. Fed funds

21. The Paradox of Asset Bubbles and Monetary Policy Price Stability or Inflation Targeting Risk Management Approach to Financial Instabilities Fact of a Sequence of Booms and Busts

22. Bubbles and Monetary Policy Two Questions Normative: Should Monetary Policy Target Asset Prices? Positive: Does Monetary Policy Target Asset Prices?

23. The Normative Question Greenspan, Bernanke and Gertler: The Fed Should Not Target Asset Prices Cecchetti and Others: React Cautiously Filardo: Deflate Bubbles Roubini: Burst Bubbles

24. Positive Question Hayford and Malliaris: Fed Policy may have Encouraged Bubbles Greenspan: Appears to Have Tried Using an Axe to Do Brain Surgery

25. Conceptualizing the Debate 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 (Greenspan’s put)

26. Legislative Response

27. The Asymmetric Approach Greenspan’s 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

28. Origins of the Financial Crisis Among the Causes Listed Focus Now on the Role of Easy Monetary Policy Did the Fed Contribute to the Housing Bubble? Yes (Taylor); No (Greenspan)

32. Lessons Learned from the Crisis Price Stability Does Not Imply Financial Stability Asset Price Bubbles Are Very Risky The Cost of Cleaning up After a Bubble Bursts is Very High Financial Instability Seriously Impacts the Real Macroeconomy

33. Where Are We Now? 15 million Unemployed in the U.S. 13 trillion of wealth lost in the U.S. Slow Growth in the U.S. and Europe Significant Increases in U.S. Deficits Sovereign Debt Crisis in the EU Unbalanced Growth in China Financial Instability

34. How Can We Get Out? Examine Inflation Targeting Causes Financial

35. New Hypothesis Inflation Targeting Causes Financial Instability Present 7 scenarios Conclude With Policy Implications

36. 1. Insufficient Tools Suppose the Central Bank Targets Both Price Stability and Financial Stability. These Are Two Goals. It Currently Has Only One Tool: Interest Rates Financial Stability Is Ignored

37. 2. Minsky’s Stability Causes Instability Also Discussed By Greenspan. Suppose the Central Bank Succeeds With Inflation Targeting. Low Inflation, Low Fed Funds, Low Long Term Interest Rates, Low Risk, High Valuations, Asset Bubbles, More Collateral, More Credit, Bubble Grows. Eventually Bubble Crashes.

38. 3. Moral Hazard Argument The Asymmetric Approach of the Central Bank (Also Called the Jackson Hole Consensus) Encourages Moral Hazard. Asset Prices Grow Slowly But Crash Quickly. Central Banks Ignore the Slow Growth But Respond Quickly to a Crash to Avoid Real Risks. Lean vs Clean as Before.

39. 4. Capital Misallocation Price Stability Achieves Low Inflation. Low Inflation Brings Down Interest Rates and Risks. Asset Bubbles Attract Capital. Is Such Capital Allocated Correctly? No !

40. 5. Price Stability and Banks Suppose the Central Bank Wishes to Supplement Price Stability with Financial Stability. Introduce Micro-prudential Regulation. It Only Considers Individual Banks. It Ignores Systemic Risk.

41. 6. Neo-Austrian Financial Crisis Ideas Nominal vs Natural Interest Rates. Nominal is What Banks Charge. Natural is What the Real Sector Supports With Stable Prices. If Nominal and Natural Differ, Asset Prices Are Affected. Keeping Inflation Low Generates Bubbles

42. 7. Globalism and a Sequence of Asset Bubbles Savings and Loan Crisis of 1989-91 Asian Crisis Internet Bubbles Housing Bubble The Current Bond Bubble

43. “It is better to act and repent than not to act and regret it” Machiavelli

44. Conclusions: Focus on Financial Stability Long History Described by Reinhart and Rogoff Monitor Credit Expansion Lean Against Asset Price Bubbles A Bubble Is Bursting in the EU: Sovereign Debt With U.S. Interests Near Zero, Do We Have a Government Bond Bubble? What Impact On The Dollar?

45. Longer Term: The Fed and Financial Stability The Fed and Monetary Policy The Financial Stability Oversight Council Established by the Dodd Frank Act IMF and Global Financial Stability

46. Moving Forward: What Policies? Revise Inflation Targeting: Go Beyond CPI. Lean Against Asset Bubbles; Particularly Housing Bubbles. Implement Macro-Prudential Regulation: To Avoid Systemic Risks Monitor Credit Growth And Collateral. Accept Limitations of Monetary Policy.