Week 3 - Financial crises: causes

Question 1

What causes asset price bubbles?

A speculative asset price bubble occurs when asset prices depart from their fundamental values, which is measured by the stream of future cashflows generated by the asset.

Answer 1

1. Occurs through misperception that RISING PRICES are driven by fundamentals; in reality driven by SPECULATION
   - credit supply increases
2. Sustained asset price inflation generates EXCESSIVE OPTIMISM that there has been an improvement in fundamentals
   - which fuels speculative investment & cycle continues

Question 2

Leverage

Answer 2

The use of borrowed funds for the purpose of investment in financial assets
- banks require borrowers to post COLLATERAL to ensure that they repay their loans
- leveraging MULTIPLIES returns if prices are expected to increase (but also multiplies losses)

Question 3

Passive credit view vs Active credit view

IDENTIFICATION PROBLEM: is the expansion in credit in the market driven by supply or demand?

Answer 3

Passive credit view
1. HOUSE PRICE BOOM caused credit boom
- leveraging by speculative investors
2. SPECULATORS bought houses & drove up prices; they borrowed money from bank to buy houses -> surge in credit boom
- RISING PRICES induced new investors to engage in the practice of leverage (define), in order to make CAPITAL GAINS: leveraging multiplies returns if prices are expected to increase.
3. Therefore, credit growth was DEMAND-DRIVEN
- banks were not to blame for the crisis

Active credit view
1. CREDIT BOOM caused house price boom
- expansion of credit availability by banks
- not based on improvements in income but driven by fall in BANKS’ FUNDING COSTS due to cheap money flowing in from China/India.
- The excess supply of funds pushed down deposit rates, increasing bank profit margins and thus incentivising them to increase lending
2. Banks EXPANDED the availability of credit & lowered their LENDING STANDARDS
- after lent to good borrowers, started lending to low income, subprime borrowers
3. Therefore, credit growth was SUPPLY-DRIVEN

Question 4

Interest rate-credit graphs: what happens if demand of credit increases? If supply of credit increases?

Answer 4

Increase in demand of credit
- Rightward shift in demand curve
- (eqm) Interest rate & quantity of credit increase

Increase in supply of credit
- Rightward shift in supply curve
- (eqm) Interest rate decreases, quantity of credit increases

Question 5

2 pieces of evidence that support the active credit view (ie. banks caused the CREDIT BOOM, which caused the house price boom)

**SPECULATIVE INVESTMENT also played a significant part in fuelling the housing bubble

+ LTV formula

Answer 5

1. Expansion of SUBPRIME MORTGAGES from 10% to 40% of market share during 2000-06 (Levitin and Wachter),
   ie. expansion in quantity of CREDIT
   - driven by FALL in bank FUNDING COSTS (fall in cost of production), not based on improvements in income
   - Increased lending to borrowers w/ POOR CREDIT HISTORIES & HIGH LOAN-TO-VALUE RATIOS

LTV ratio = maximum loan amount/collateral value

2. Justiniano et al. (2016) found a sharp decline in MORTGAGE INTEREST RATES from 2002-05

1+2 -> classic signal of an outward shift in the credit supply curve

Question 6

Information cascade aka Herding

^a theory about how house prices propagate. Why the housing bubble kept growing when investors know that the houses were significantly OVER-VALUED.

Answer 6

1. Occurs when ppl DISREGARD their own individually collected information b/c feel that everyone else simply couldn’t be wrong
   ie. they FOLLOW THE CROWD & ABANDON own superior information in favour of INFERENCES based on other ppl’s actions.
2. Hence, herding behaviour generates an EXCESSIVE OPTIMISM that house price inflation will persist
   - encourages further LEVERAGING, further boosts credit growth
   - which fuels further price inflation
   - which perpetuates excessive optimism, and so on…until turned into pessimism and bubble pops

Question 7

Why would the central bank increase interest rates if credit growth > target?

Answer 7

Higher interest rates mean higher borrowing costs, should decrease leveraging & reduce demand for credit

Question 8

2 schools of thought if central bank uses MONETARY POLICY to prick asset price bubbles
*central bank will have a dual mandate - credit growth target & inflation target

Answer 8

1. Lean against the wind (LATW)
   - Increase interest rates higher than required to meet the INFLATION TARGET during the boom phase
   - Involves huge risks, might require monetary tightening during recession {money supply too high}
2. Mop up the mess (cleaning)
   - Do nothing during the boom phase (let the bubble run its course), then cut interest rates aggressively should the asset price bubble burst to limit damage to economy

Question 9

3 arguments against Lean against the wind (LATW) - the problem of “2 targets and 1 instrument”

Answer 9

1. Difficulty of curbing speculators’ incentives
   - empirical evidence suggests a large tightening {large increase in int rates} would be required to restrain asset price bubbles, because investors expect such high rates of return from holding bubble-driven assets, which may drive the economy into recession.
2. CREDIT CYCLE has a lower frequency (16-20 years) than the BUSINESS CYCLE (5-8 years), typically NOT SYNCHRONISED
   - Hence, LATW might require TIGHTENING MONETARY POLICY during a RECESSION {increasing interest rates}, ie. the central bank faces the problem of 2 TARGETS & 1 INSTRUMENT.
   > (Should CB raise interest rates to curb credit growth? OR Cut interest rates to mitigate recession?)
3. LACK OF TRANSPARENCY of the central bank’s objectives on monetary policy
   - If the central bank has DUAL OBJECTIVES of controlling inflation and asset prices, then it similar to the Fed’s dual mandate
   - creating financial and economic uncertainty, undermining ACCOUNTABILITY and compromising ANCHORING of INFLATION EXPECTATIONS.

Question 10

Use of monetary policy & macroprudential policy + why not the other way round?

Answer 10

1. Monetary policy can focus on TARGETTING INFLATION using interest rates
   - blunt & ineffective tool for constraining credit growth,
   ie. a few p.p. increase in interest rates will have little impact in curbing speculative investment; need very large increase in interest rates (eg. 20%) to prevent SPECULATORS from borrowing
2. Macroprudential policy can focus on CONTROLLING CREDIT GROWTH using LTV ratios
   - a more targeted weapon, cuts off credit supply at the source by directly stopping banks from lending too much

There will be some impact on REAL ECONOMY from constraining credit growth b/c FIRMS need to BORROW FOR INVESTMENT but effects will be fairly minimal. Main effect is to reduce borrowing by speculators, which is driving the credit boom and house price boom. During these booms, most credit lending is to the speculators.

Question 11

Price stability-Financial stability (PS-FS) model

Answer 11

• Developed by the BoE to illustrate the interactions between monetary policy & macroprudential policy
  x-axis is R = interest rates (to control inflation); go along right as monetary policy tightens
  y-axis is K = macroprudential tool, eg. LTV ratio (to control credit growth); move up axis as macroprudential policy tightens - K is the RECIPROCAL of LTV

Question 12

Price stability (PS) curve represents inflation target. Why is it downward sloping?

Answer 12

1. Price stability curve traces out all combinations of R & K for which the economy satisfies the inflation target.
2. Start at point A {at inflation target}. If R rises, AD decreases, hence inflation falls BELOW target (point B).
3. To return to target/PS curve, we require an offsetting DECREASE in K (i.e. easing in LTV ratio),
   - which increases the AVAILABILITY of CREDIT to firms for investment, hence AD increases and inflation rises back to target at point C.

Question 13

Financial stability (FS) curve represents credit target. Why is it downward sloping?

Rmb that it is harder for ppl to borrow as we move up K axis.
*increasing interest rates increases cost of borrowing -> demand for credit falls

Answer 13

A decrease in R means credit growth increases above target, which requires an offsetting TIGHTENING in K to return to the FS curve

1. Financial stability curve traces out all combinations of R & K for which the economy satisfies the credit target.
2. Start at point A {at credit target}. A decrease in K increases the SUPPLY of credit, hence credit growth increases ABOVE target (point B).
3. To return to target/FS curve, we need an increase in R,
   - which increases the COST of borrowing and decreases demand for credit, hence credit growth falls back to target at point C.

Question 14

Why is the FS curve flatter than the PS curve?

Answer 14

B/c credit growth is more sensitive to changes in LTV than inflation.
1. 1 p.p. increase in K / tightening in the LTV ratio {both are opposites here, don’t confuse them} has a larger impact on credit growth than AGGREGATE DEMAND and hence inflation.
2. Intuitively, tightening of LTV is a more TARGETED weapon which hits credit growth hardest (especially speculative investment in housing)…
3. …whilst it only has a small impact on AD
- Only a small proportion of (corporate) investments are constrained, as small firms often put up their houses as collateral for bank loans
- Consumer spending {consumption} and exports are relatively unaffected.

4. Hence credit growth requires a LARGER offsetting reduction in INTEREST RATES to return to the CREDIT TARGET

Question 15

What is the point of intersection between PS & FS curves, when the economy is at both inflation & credit growth targets, called?

Answer 15

Macro-financial equilibrium

Question 16

The former US Federal Reserve Chair Alan Greenspan has famously argued that central banks should not use monetary policy to prick an asset price bubble because they are almost impossible to identify. What did he mean by that? (from PS3 reading)

Answer 16

1. Difficult to distinguish whether asset price inflation is driven by a SPECULATIVE BUBBLE or an IMPROVEMENT in FUNDAMENTALS
   - Thus, a central bank might prevent a genuine economic expansion which it erroneously believed to be bubble-driven.
2. Greenspan also argued that if central bank knew a bubble was in progress, then INVESTORS buying these assets SHOULD ALSO KNOW this and therefore stop buying them, hence the bubble would fizzle out of its own accord.
   - This relies on the argument that the sum total of information gleaned by millions of market participants should SURELY be BETTER than a single central bank Governor’s judgments.

Question 17

Greenspan’s conclusion was that central banks should instead concentrate on containing the damage after bubbles burst, i.e. “mop up the mess”. What problems do you foresee with this strategy, in part in light of the recent US asset price bubble and financial crisis which followed? (from PS3 reading)

Answer 17

The deflationary impacts of a bursting bubble are often so severe that interest rates are driven down to zero and can go no lower,
i.e. monetary policy reaches the ZERO LOWER BOUND and loses effectiveness.

Question 18

Another objection levelled against the “leaning against the wind” policy is that monetary policy operates with long lags on the real economy, but it affects financial assets almost immediately. What problems do you think this might cause? (from PS3 reading)

Answer 18

1. The end of a bubble usually causes OUTPUT to FALL due to negative wealth effects, so interest rates should decrease & NOT increase {which is the optimal policy to control inflation}.
   - the economy could be exposed to the twin deflationary forces of an asset price bust and the effects of the policy tightening
   ^damaging, might worsen problem!
2. Hence, the optimal timing for central bank intervention would be to act AHEAD of the asset-price peak, but this is hardly possible to guess.
   - As a result, central banks that embark on ASSET-PRICE TARGETTING run the RISK of throwing the economy into a RECESSION
   eg. what the Bank of Japan did in the early 1990s.

Question 19

Some commentators have argued that if the central bank starts targeting asset price inflation, this may perversely induce investors to take even more risk. Why might that be? (from PS3 reading)

Answer 19

MORAL HAZARD PROBLEM
1. If investors are re-assured that the central bank is carefully monitoring and controlling asset price inflation, investors are FALSELY REASSURED that that bubbles will never develop and hence eliminates their exposure to a price collapse.
2. This provides implicit insurance against risk and induces them to TAKE EXCESSIVE RISK.

Question 20

In what sense is an asset price bubble SELF-FULFILLING? (from mid-term assignment)

Answer 20

1. An asset price bubble occurs through a misperception that rising prices are driven by fundamentals, whereas in reality they are driven by speculation.
2. Investors buy assets expecting prices to go up for spurious reasons, but through their actions they drive up prices and it becomes self-fulfilling.

Question 21

Why is it important for policy to determine the identification issue of which of the 2 factors predominantly caused the financial crisis? (from mid-term assignment)

Answer 21

1. Policy has a role to play if credit growth is driven by BANKS lowering their lending standards through application of macroprudential tools, e.g. caps on LTV and DTI ratios.
2. But policy is relatively INEFFECTIVE in curbing SPECULATIVE INVESTMENT:
   (i) macroprudential tools are less effective if banks are not taking excessive risks – if banks are lending to borrowers with good credit histories and sound collateral at the market interest rate, there is little scope to prevent them;
   (ii) monetary policy is also ineffective as HIGHER INTEREST RATES would impose collateral damage on the real economy. {speculators expect higher returns from leveraging}