1. 1 How Macroeconomics has evolved Before and After the Global Crisis by Professor Assaf Razin Tel Aviv University and Cornell University EBA Special Lecture July 11, 2011

2. Current Global Crisis: 4 Acts Act I: Credit-fed Asset Bubble Act II: Financial Collapse after the Burst of the bubble Act III: spillovers to the real economy Act IV: Sovereign Debt Crises 2

3. Proximate Causes Financial innovation, globalization, and reduced transparency in the financial intermediation Global imbalances: China excess lending flown into USA to finance excess borrowing Panicky in the free fall of asset prices Under capitalized banking system and credit crunch 3

4. Historical Precedents? The great depression? Japan in the 1990s? Sweden in the 1980s? The saving and loan crisis in the US in the 1980? 4

5. Percentage decline in employment in recessions since 1970 5

6. History Carmen Reinhart of Maryland and Ken Rogoff identify previous 18 banking crises in industrial countries since the second world war. They find what they call "stunning qualitative and quantitative parallels across a number of standard financial crisis indicators" - the common themes that translate these individual dramas into the big-picture story of financial boom and bust. Their study is focused on the US, 6

7. Banking Crises BANKING CRISES ARE PROTRACTED, THEY NOTE, WITH OUTPUT DECLINING, ON AVERAGE, FOR TWO YEARS. ASSET MARKET COLLAPSES ARE DEEP, WITH REAL HOUSE PRICES FALLING, AGAIN ON AVERAGE, BY 35 PER CENT OVER SIX YEARS AND EQUITY PRICES DECLINING BY 55 PER CENT OVER 3½ YEARS. THE RATE OF UNEMPLOYMENT RISES, ON AVERAGE, BY 7 PERCENTAGE POINTS OVER FOUR YEARS, WHILE OUTPUT FALLS BY 9 PER CENT. 7

8. Remarkable prediction to the Global Crisis The current unemployment situation in the USA, 9.2 percent, bears a remarkable similarity to Reinhart-Roggof account of the prolonged bust that came after previous banking crises. 8

9. Monetary Policy and Asset Prices: Pre-crisis Prevailng View During the past quarter century, monetary authorities in developed countries have remarkably successful in reducing and stabilizing inflation. This phenomenon is coined” the great moderation” 9

10. Irrational exuberance A common view was that asset prices are driven by exogenous shocks to investor beliefs or preferences that have little to do with underlying macro fundamentals. Greenspan, famously used the phrase irrational exuberance 10

11. Asset prices reflect expectations about economic growth An alternative view is that asset markets They reflect evolving beliefs about the long term prospects for the economy, particularly trends about growth, rather than Irrational exuberance, which describe an exogenous shock to investor beliefs 11

12. Fluctuations in asset markets The same period, however, has seen major fluctuations in asset markets. The equity bull markets during the 1980s and the 1990s, the boom and bust in technology stocks during the late 1990s and early 2000s, And the dramatic rise in hose prices that busted into the “great recession “ 12

13. Early Warning In 2006 there were warning predictions: from a few studies : Ceccheti, in an empirical study, finds strong linkages between housing markets and the macroeconomy. Housing booms predict strong economic growth in the near term, weak economic growth in the longer term, and relatively high inflation. 13

14. Financial accelerator and inflation targeting Gilchrist and Saito, use in the model the financial accelerator model : high asset prices increase the collateral of entrepreneurs and lower the external cost of funds for investment. They find, using standard loss function, that a policy of aggressive inflation targeting is less than ideal because, while stabilizing inflation, it allows the financial accelerator to destabilize output. 14

15. 15 Pre-crisis monetary policy thinking Schools of thought had a remarkable convergence before the 2008 crisis. Backed by the New Keynesian paradigm Macroeconomists thought that: Monetary policy should have one target, inflation, and one instrument, the policy rate. As long as inflation was stable, the output gap was expected to be small and stable; and 1 target, 1 tool monetary policy did its job.

16. 16 Fiscal policy as playing a secondary role, with political constraints limiting its usefulness. Financial regulation was mostly outside the macroeconomic policy framework.

17. 17 The “Great Moderation” which supported a convergence in macroeconomics The decline in the variability of output and inflation led to greater confidence that a coherent macro framework had been achieved. In addition, the successful responses to the 1987 stock market crash, the LTCM collapse, and the bursting of the tech (dotcom) bubble reinforced the view that monetary policy was also well equipped to deal with asset price busts. Thus, by the mid-2000s, it was not unreasonable to think that better macroeconomic policy could deliver, and had delivered, higher economic stability.

18. But, then a global crisis erupts! 18

19. 19 Business cycles theory before the 2008 crisis Business cycle based on price rigidity, Lucas suggested, last only as long as price- and wage- setters can’t disentangle nominal from real shocks - and monetary or fiscal policy can’t stabilize the economy, at most they add noise. Real business cycles are driven by productivity shocks. The welfare cost of business cycles emanates essentially from breaks in the smoothed path of consumption of a representative consumer in normal times. The cCosts of such productivity shock related business cycle fluctuations are small.

20. Credit frictions were ignored in this welfare calculus of business cycles 20

21. 21 Monetary policy--One target The one target: Inflation Stable and low inflation was presented as the primary, if not exclusive, mandate of central banks. This justified by the reputational need of central bankers to focus on inflation no such reputation issues are associated with economic activity An intellectual support for inflation targeting provided by the New Keynesian model.

22. benchmark version of the New Keynesian model In the benchmark version of that model, constant inflation is indeed the optimal policy, delivering a zero output gap, which turns out to be the best possible outcome for activity given the imperfections present in the economy. Even if policymakers cared about activity, the best they could do was to maintain stable inflation. There was also consensus that inflation should be very low (most central banks targeted 2% inflation). 22

23. Stable inflation maintains stable activity Even if policymakers cared about activity, the best they could do was to maintain stable inflation. There was also consensus that inflation should be very low (most central banks targeted 2% inflation). 23

24. 24 Monetary policy: One instrument The policy rate Monetary policy focused on one instrument, the policy interest rate. Under the prevailing assumptions, one only needed to affect current and future expected short rates, and all other rates and prices would follow through arbitrage relations in a perfectly functioning capital market.

25. 25 Arbitrage across time and assets Arbitrage across time and assets means that the long term rate is a compounded sequence of expected policy rates -central bank control both short and long rates. Arbitrage across assets means that fed rate can influence other assets rates.

26. 26 A limited role assigned for fiscal policy Following its glory days of the Keynesian 1950s and 1960s, and the high inflation of the 1970s, fiscal policy took a backseat in the past two-three decades. The reasons included skepticism about the effects of fiscal policy, itself largely based on Ricardian equivalence arguments; concerns about lags and political influences in the design and implementation of fiscal policy; and the need to stabilize and reduce typically high debt levels. Automatic stabilizers could be left to play when they did not conflict with fiscal sustainability.

27. 27 The details of financial intermediation seen as irrelevant for monetary policy An exception was made for commercial banks, with an emphasis on the “credit channel.” The possibility of runs justified ofcourse deposit insurance and the traditional role of central banks as lenders of last resort. The resulting distortions were the main justification for bank regulation and supervision. Little attention was paid, however, to the rest of the financial system from a macro standpoint

28. 28 The global crisis vs. the Great Depression: Similarly sized shocks but strikingly different policy reactions The Great D and the Great R Have one thing in common: A big financial shock; But the policy reaction was different: Balanced budget and tight liquidity vs. deficits, bank bailouts and credit easing

29. 29 Central Bank is using new tools: Credit easing and quantitative easing Quantitative easing: open market transactions in T bills to influence long rates Credit easing: open market operations in non government securities to lend to illiquid sectors

30. 30 And, the effectiveness of the expansionary fiscal policy is strengthened when monetary policy is constrained by the zero lower bound

31. 31 Macroeconomics: The Post-Crisis Division Take government budget deficits, which now exceed 10 per cent of gross domestic product in countries such as the US and the UK. One camp of macroeconomists (The “Ricardians”), CAMP I, claims that, if not quickly reversed, such deficits will lead to rising interest rates and a crowding out of private investment..

32. 32 Instead of stimulating the economy, the deficits will lead to a new recession coupled with a surge in inflation

33. 33 Budget Deficits Wrong, says the other camp, CAMP II. There is no danger of inflation. These large deficits are necessary to avoid deflation. A clampdown on deficits would intensify the deflationary forces in the economy and would lead to a new and more intense recession.

34. 34 Second camp on fiscal policy Camp II, the “Keynesians”, predict that the same 1 per cent of extra government spending multiplies into significantly more than 1 per cent of extra GDP each year until the end of 2012. This is the stuff of dreams for governments, because such multiplier effects are likely to generate additional tax income so that budget deficits decline.

35. 35 Monetary Policy: Camp I One camp warns that the build-up of massive amounts of liquidity is the surest road to hyperinflation and advises central banks to prepare an “exit strategy”.

36. 36 Monetary Policy: Camp II Camp II: The build-up of liquidity just reflects the fact that banks are hoarding funds to improve their balance sheets. They sit on this pile of cash but do not use it to increase credit. Once the economy picks up, central banks can withdraw the liquidity as fast as they injected it. The risk of inflation is zero; indeed, there is a risk of deflation.

37. 37 Does the controversy between Camp I and Camp II matter? Take the issue of government deficits. If you want to forecast the long-term interest rate, it matters a great deal which of the two camps you believe. If you believe the first one, you will fear future inflation and you will sell long-term government bonds. As a result, bond prices will drop and rates will rise, prolonging the recession. You will have made a reality of the fears of the first camp.

38. 38 An alternative self-fulfilling equilibrium But if you believe the story told by the camp II, you will buy long-term government bonds, allowing the government to spend without a surge in rates, thereby contributing to a recovery.

39. Positions Camp II declared that we were in a liquidity trap, which meant that some of the usual rules no longer applied: the expansion of the Fed’s balance sheet wouldn’t be inflationary — in fact the danger was a slide toward deflation; the government’s borrowing would not lead to a spike in interest rates. Camp I declared that we were in imminent danger of runaway inflation, and that federal borrowing would lead to very high interest rates. imminent danger of runaway inflation very high interest rates 39

40. 40 What actually happened?

41. 41 Policy making under uncertainty The two camps have also wildly different estimates of the effect of a 1 per cent permanent increase in government spending on real US GDP over the next four years. According to the first camp, the “Ricardians”, the multiplier is closer to zero than to one, i.e., 1 per cent extra spending generates much less than 1 per cent of extra GDP, producing little extra tax revenue. Thus budget deficits surge with fiscal stimulus and become unsustainable.The two camps have also wildly different estimates of the effect of a 1 per cent permanent increase in government spending on real US GDP over the next four years. According to the first camp, the “Ricardians”, the multiplier is closer to zero than to one, i.e., 1 per cent extra spending generates much less than 1 per cent of extra GDP, producing little extra tax revenue. Thus budget deficits surge with fiscal stimulus and become unsustainable.

42. Fiscal multiplier when the policy rate is at the lowest bound But, according to the camp II, the “Keynesians”, the multiplier is above one when the monetary policy rate is at its lower bound,, i.e., 1 per cent extra spending generates much more than 1 per cent of extra GDP, producing more extra tax revenue. Thus budget deficits become more sustainable.But, according to the camp II, the “Keynesians”, the multiplier is above one when the monetary policy rate is at its lower bound,, i.e., 1 per cent extra spending generates much more than 1 per cent of extra GDP, producing more extra tax revenue. Thus budget deficits become more sustainable. 42

43. 43 Banking panic– missing from the conventional macro In a banking panic, depositors run en masse to their banks and demand their money back. The bank system cannot honor these demands because they lent the money out or they hold long term bonds. To honor the demands of depositors, banks must sell assets, but only the central bank is large enough to be a significant buyer of these assets.

44. 44 The Panic of 2007-2008 The panic in 2007 was not like the previous panics in US history because they involved firms and institutional investors, not households. The bank liabilities of interest were not deposits but repurchase agreement, called “repo”. The collateral for “repo” is securitized bonds. These liabilities are not insured by the FDIC.

45. 45 Some general lessons? Beyond the division into the two camps, what are the more general lessons?

46. 46 Macroeconomic fragilities may arise even when inflation is stable Core inflation was stable in most advanced economies until the crisis started. Some have argued in retrospect that core inflation was not the right measure of inflation, and that the increase in oil or housing prices should have been taken into account. But no single index will do the trick. Moreover, core inflation may be stable and the output gap may nevertheless vary, leading to a trade-off between the two. Or, as in the case of the pre-crisis 2000s, both inflation and the output gap may be stable, but the behaviour of some asset prices and credit aggregates, or the composition of output, may be undesirable.

47. 47 Low inflation limits the scope of monetary policy in deflationary recessions When the crisis started in earnest in 2008, and aggregate demand collapsed, most central banks quickly decreased their policy rate to close to zero. Had they been able to, they would have decreased the rate further. But the zero nominal interest rate bound prevented them from doing so. Had pre- crisis inflation (and consequently policy rates) been somewhat higher, the scope for reducing real interest rates would have been greater.

48. 48 Financial intermediation matters Markets are segmented, with specialized investors operating in specific markets. Most of the time, they are well linked through arbitrage. However, when some investors withdraw (because of losses in other activities, cuts in access to funds, or internal agency issues) the effect on prices can be very large. When this happens, rates are no longer linked through arbitrage, and the policy rate is no longer a sufficient instrument. Interventions, either through the acceptance of assets as collateral, or through their straight purchase by the central bank, can affect the rates on different classes of assets, for a given policy rate. In this sense, wholesale funding is not fundamentally different from demand deposits, and the demand for liquidity extends far beyond banks.

49. 49 Countercyclical fiscal policy The crisis has returned fiscal policy to centre stage for two main reasons. First, monetary policy had reached its limits. Second, from its early stages, the recession was expected to be long lasting, so that it was clear that fiscal stimulus would have ample time to yield a beneficial impact despite implementation lags. The aggressive fiscal response has been warranted given the exceptional circumstances, but it has further exposed some drawbacks of discretionary fiscal policy for more “normal” fluctuations – in particular lags in formulating, enacting, and implementing appropriate fiscal measures. The crisis has also shown the importance of having “fiscal space,” as some economies that entered the crisis with high levels of government debt had limited ability to use fiscal policy.

50. 50 A Set of Monetary policy tools Policy interest rate—the central policy tool Foreign Reserve accumulation- to affect the exchange rate Cyclical banks’ capital ratios-raise capital during bubbles; lower capital in normal times Housing market loans to value ratios- maximum mortgage as a ratio of the acquisition cost Capital Controls

51. 51 Fiscal Policy Tools Discretionary policy despite lags Strengthening Automatic stabilizers - Cyclical investment tax credit Cyclical rates of unemployment benefits Stabilize debt to GDP ratios as a precaution to avoid debt crises triggered by financial collapse

52. 52 Interactions between monetary and fiscal policies The fiscal-multiplier debate

53. 53 Multiplier smaller than one under flexible prices

54. 54 Size of the Multiplier: Mitigating Factors Multiplier depends on pre existing public debt, on currency regimes, and the degree of openness Higher level of public debt provides a reason for permanently lower government purchases than would otherwise have been affordable. Hence, the current rise in spending is less persistent with high debt. Spending multipliers are higher under fixed exchange rate than under flexible exchange rate (The Mundell-Fleming model). Spending multipliers are smaller the more open is the economy ( due to the leakage of spending into imports)

55. 55 is the real policy rate required to maintain a constant path for private expenditure (at the steady-state level). If the spread becomes large enough, for a period of time, as a result of a disturbance to the financial sector, then the value of rnet t may temporarily be negative. In such a case the zero lower bound on it will make (4.1) incompatible, for example, with achievement of the steady state with zero in°ation and government purchases equal to ¹G in all periods.

56. 56 is the real policy rate required to maintain a constant path for private expenditure (at the steady-state level). If the spread becomes large enough, for a period of time, as a result of a disturbance to the financial sector, then the value of rnet t may temporarily be negative. In such a case the zero lower bound on it will make (4.1) incompatible, for example, with achievement of the steady state with zero in°ation and government purchases equal to ¹G in all periods.

57. 57 Output gap and deflation

58. 58 Output gap and G

59. 59 II. Global imbalances and financial crises Bernanke hypothesized that the global saving glut was causing large trade balances. However, if there were to be a global savings glut (and low interest rates) there should have been a large investment boom in countries that imported capital. Instead, those countries experienced consumption boom. National asset bubbles seem to explain better the international imbalances.

60. 60 Saving Glut Ben Barnanke (2005), “The Global Saving Glut and the U.S. Current Account Deficit,” offered a novel explanation for the rapid rise of the U.S. trade deficit in the early 21st century. The causes, argued Bernanke, lay not in America but in Asia.

61. 61 Global Picture (Continued) In the mid-1990s, Bernanke pointed out, the emerging economies of Asia had been major importers of capital, borrowing abroad to finance their development. But after the Asian financial crisis of 1997-98, these countries began protecting themselves by amassing huge war chests of foreign assets, in effect exporting capital to the rest of the world.

62. 62 Global Picture (Continued) Most of the Asia cheap money went to the United States - hence our giant trade deficit, because a trade deficit is the flip side of capital inflows. But as Mr. Bernanke correctly pointed out, money surged into other nations as well. In particular, a number of smaller European economies experienced capital inflows that, while much smaller in dollar terms than the flows into the United States, were much larger compared with the size of their economies.

63. 63 Global Picture (Continued) wide-open, loosely regulated financial systems characterized the US shadow banking system and mortgage institutions, as well as many of the other recipients of large capital inflows. This may explain the almost eerie correlation between conservative praise two or three years ago and economic disaster today. “Reforms have made Iceland a Nordic tiger,” declared a paper from the Cato Institute. “How Ireland Became the Celtic Tiger” was the title of one Heritage Foundation article; “The Estonian Economic Miracle” was the title of another. All three nations are in deep crisis now.

64. 64 Global Picture (Continued) For a while, the inrush of capital created the illusion of wealth in these countries, just as it did for American homeowners: asset prices were rising, currencies were strong, and everything looked fine. But bubbles always burst sooner or later, and yesterday’s miracle economies have become today’s basket cases, nations whose assets have evaporated but whose debts remain all too real. And these debts are an especially heavy burden because most of the loans were denominated in other countries’ currencies.

65. 65 Global Picture (end) Nor is the damage confined to the original borrowers. In America, the housing bubble mainly took place along the coasts, but when the bubble burst, demand for manufactured goods, especially cars, collapsed - and that has taken a terrible toll on the industrial heartland. Similarly, Europe’s bubbles were mainly around the continent’s periphery, yet industrial production in Germany - which never had a financial bubble but is Europe’s manufacturing core - is falling rapidly, thanks to a plunge in exports.

66. 66 Mechanisms which played a role in the liquidity and credit crunch 1.The effects of large quantities bad loan write- downs on borrowers' balance sheets caused two "liquidity spirals“: 1a. As asset prices dropped, financial institutions not only had less capital; 1b. financial institutions also had harder time borrowing, because of tightened lending standards. The two spirals forced financial institutions to shed assets and reduce their leverage. This led to fire sales, lower prices, and even tighter funding, amplifying the crisis beyond the mortgage market.

67. 67 And credit market frictions 1.Lending channels dried up when banks, concerned about their future access to capital markets, hoarded funds from borrowers regardless of credit-worthiness. 2. Runs on financial institutions, as occurred at Bear Stearns, Lehman Brothers, and others following the mortgage crisis, can and did suddenly erode bank capital. 3. The mortgage crisis was amplified and became systemic through network effects, which can arise when financial institutions are lenders and borrowers at the same time. Because each party has to hold additional funds out of concern about counterparties' credit, liquidity gridlock can result.

68. 68 Leverage cycles Perhaps the most important lesson from Geanakopolis (and the current crisis) is that the macro economy is strongly influenced by financial variables beyond prices and interest rates. This was the theme of much of the work of Minsky (1986), who called attention to the dangers of leverage, and of James Tobin (who in Tobin-Golub (1998) explicitly defined leverage and stated that it should be determined in equilibrium, alongside interest rates), and also of Bernanke, Gertler, and Gilchrist. Model is based on the dynamics of a mix of optimists and pessimists in the market. With the optimists fueling the leverage cycle, asset prices collapse at a crucial stage where optimists are burned by high leverage, and financial markets plunge as well.

69. 69 Deflationary spirals The recent crisis can be analyzed in terms of three deflationary spirals: (1)Keynesian saving paradox: Individuals save as a result of a collective lack of confidence, leading to fall in aggregate demand and self-fulfilling fall in output. (2)Fisher’s debt deflation: Individuals try to reduce their debt, driven by a collective movement of distrust. They all sell assets at the same time, thereby reducing the value of assets. This leads to a deterioration of the solvency of everybody else. (3)Bank credit deflation: Banks are gripped by extreme risk aversion simultaneously reduce lending, thereby increasing the risk of their loan portfolio.

70. 70 The aftermath of financial crises People who study the aftermath of financial crises conclude that recovery typically tends to be slow; the general consensus is that this recovery is likely to be slower than most. One of the reasons is that the Federal Reserve is running out of ammunition as it reaches the interest rate lower bound.

71. 71 Forecasting Issues The way things typically work is that there are leading and lagging indicators. Financial markets tend to lead and we have already seen a huge run-up in the stock market since last March. Then there is usually an improvement in GDP, which we are starting to see. The last to come are the labor markets.

72. 72 Lack of a structural model Economists are notoriously bad at forecasting. To some extent that is because unexpected things happen. Economic forecasting is most useful for contingency planning: what should we do if this happens? But we do not have a structural model - which puts together the dynamics of finacial sector, the goods sector, and the labor sector.

73. 73 Banking Regulation? Bank regulation issue is in terms of Diamond -Dybvig, which views banks as institutions that allow individuals ready access to their money, while at the same time allowing most money to be invested in illiquid, productive, assets.

74. 74 Narrow Banking regulation The recent crisis was centered on repo - overnight loans in which many businesses park their funds. They are money (liquidity) just as much bank deposits are. That is why regulation be different than narrow banking regulation.

75. 75 General Equilibrium theory:Leverage cycles Agents are divided between natural buyers of assets (optimists) and those who potentially hold these assets but normally end up as lenders (pessimists) The collateral requirement and interest rates arise from the need to satisfy the less optimistic agents that the loan is safe. Following bad news for the asset, there is a redistribution of wealth away from the optimists.

76. 76 Interest rate and collateral There is the whole schedule of pairs (interest rate and collateral). If a borrower cannot repay then he should hand over the collateral. Less secured loans with more risky collateral have higher interest rate. With only one dimension of disagreement, only one contract out of the whole possible schedule is actually traded. Dynamics happens with new information.

77. 77 Role of news Geanekoplos defines a “scary news” as one which leads to lower expectation and more disagreement. It leads to dramatic changes in prices and collateral. Good news give rise to booms; bad news lead to a bust that bankrupts the optimists. Price movements are amplified relative to to the news.