from asset bubbles to a liquidity trap presented by a.g. malliaris

LOYOLA UNIVERSITY CHICAGO QUINLAN SCHOOL OF BUSINESS

FROM ASSET BUBBLES TO A LIQUIDITY TRAP

Presented by A.G. Malliaris

A Conference on the Global Financial Crisis of 2007-09

April 11, 2013

LOYOLA UNIVERSITY CHICAGO QUINLAN SCHOOL OF BUSINESSLOYOLA UNIVERSITY CHICAGO QUINLAN SCHOOL OF BUSINESS

PURPOSE OF PRESENTATION

• Consider the Cyclical Behavior of the U.S. Economy

• Distinguish 4 Phases: Expansion, Upper Turning, Recession and Lower Turning

• Focus on the Global Financial Crisis of 2007-09

• Introduce Behavioral Hypotheses


1860 1885 1910 1935 1960 1985 2010Year

95% CI for Predictionloggdp

99.9% CI for Mean Trend

Fitted values

Confidence Intervals for Real GDP Trend


1870 1890 1910 1930 1950 1970 1990 2010

95% CI for Predicted Values95% CI for Mean Growth RateLog (Real S&P)

Real S&P: Confidence Interval for Trend (Log Scale)


-40

-20

020

40

1870 1890 1910 1930 1950 1970 1990 2010Year

growthrate zerotenpercent minustenpercent

Real S&P Growth Rates


“We can model the euphoria and the fear stages of the business cycle. Their parameters are quite different. We have never successfully modeled the transition from euphoria to fear”

Alan Greenspan


CHALLENGE

• Decompose an economic cycle into 4 phases instead of just 2

• Introduce Upper Turning Period and Lower Turning Period


ExpansionRecession


Upper Turning Period

ExpansionRecession

Lower Turning Period


METHODOLOGY• Use Current Economic Reasoning

• Introduce Ideas from Behavioral Finance

• Reconsider Keynes’s “Animal Spirits”

• Employ Minsky’s Financial Instability Hypothesis

• Apply This Methodology to the Latest Global Financial Crisis


The Expansion Phase: December 2001 to November 2007

• The expansion was weaker than average

• One major event: the formation of the Housing Bubble


“The dogmas of the quiet past are inadequate to the stormy

present”

Abraham Lincoln


Asset Price Bubbles• Interplay Between Economic and Behavioral

Factors

• Economic Factors: Easy Monetary Policy; Global Imbalances; Financial Innovations; Poor Incentives and Regulation

• Behavioral Factors: Representative Heuristic, Feedback Mechanism, Overconfidence, Short Selling Constraints


Upper Turning Period:January 2007 to September 2008

• Concave, Fragile and Ambivalent• Housing Prices Peak by Mid-2006 and then

Begin to Decline• Behavioral Finance: Prospect Theory• From a Subprime Crisis to a Full Credit Crisis• Lehman’ s Bankruptcy• Financial and Psychological Amplification• Minsky’s Instability Hypothesis


The Great Recession Table 1: 2007-09 Recession versus Postwar Recessions, United States

Output Consumption Investment Employment

Hours worked

2007-09 recession -7.2 -5.4 -33.5 -6.7 -8.7

Average of other postwar recessions

-4.4 -2.1 -17.8 -3.8 -3.2

(Ohanian (2011) Percent Change in per Capita Values)


Job Losses Were Unprecedented


The Lower Turning Period: The Liquidity Trap

• When Interest Rates Are Close to Zero While the Economy is Below Its Potential and Has High Unemployment

• Period of Economic and Psychological Uncertainty

• Aggressive Monetary Policy: Q1, Q2, Q3

• Indecisive Fiscal Policy


GDP Fell Far Below What the Economy Was Capable of Producing


Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die.

Keynes 1936


Legislative Response


Financial Stability Oversight Council

• Established by under the Dodd-Frank Wall Street Reform and Consumer Protection Act

• Restore Optimism in Long-run Economic Expectations

• Reconsider Price Stability, Financial Stability and Global Economic Stability

• Reassess Debt-Financed Government Spending

• Support Growth that Generates Employment


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

Machiavelli


THANK YOU

from asset bubbles to a liquidity trap presented by a.g. malliaris

Documents

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feedback mechanism

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