Macroeconomics of Finance

Transcription

1 Macroeconomics of Finance Joanna Mackiewicz-Łyziak Lecture 12

2 Literature Borio C., 2012, The financial cycle and macroeconomics: What have we learnt?, BIS Working Papers No. 395.

3 Business cycles Business cycles are fluctuations in economic activity, defined in terms of expansion or recession. A recession is a period between a peak and a through, and an expansion is a period between a through and a peak. (NBER) During a recession, a significant decline in economic activity spreads across the economy and can last from a few months to more than a year. During an expansion, economic activity rises substantially, spreads across the economy, and usually lasts for several years. Measuring business cycles NBER examines and compares the behavior of various measures of broad activity: real GDP (the product and income sides), employment, and real income. NBER may consider real sales and industrial production.

4 Financial cycles key issues Macroeconomics without the financial cycle is like Hamlet without the Prince it is not possible to understand business fluctuations without understanding the financial cycle. The financial cycle is much longer than the traditional business cycle (medium term). To model the financial cycle correctly one has to take into account that the financial system does not just allocate, but also generates purchasing power (monetary view). Global economy is highly integrated and to understand its developments we need holistic perspective. This includes analysis of financial cycles which may proceed in sync or at different speed and in different phases across the world (global view).

5 Financial cycles core stylised features There is no consensus on the definition of the financial cycle. Borio: self-reinforcing interactions between perceptions of value and risk, attitudes towards risk and financing constraints, which translate into booms followed by busts. These interactions can amplify economic fluctuations and possibly lead to serious financial distress and economic dislocations. How best to approximate empirically the financial cycle? Feature 1: Most parsimonious description of FC: credit and property prices Closely related to each other, especially at low frequencies, The smallest set of variables needed to capture the interaction between financing constraint (credit) and perceptions of value and risks (property prices).

6 Financial cycles core stylised features Feature 2: The FC has a lower frequency than the traditional business cycle Business cycle: from 1 to 8 years, Financial cycle: around 16 years (in a sample of 7 industrialised countries since the 1960s). Feature 3: Peaks in the FC are closely associated with financial crises All the financial crises with domestic origin occur at, or close to, the peak of FC (in the sample examined). The financial crises that do not occur at peaks reflect losses on exposures to foreign such cycles. Recessions that coincide with the contraction phase of the financial cycle are especially severe.

7 Source: Borio (2014)

8 Source: Runstler G., Vlekke M. (2016), Business, housing and credit cycles, ECB Working Paper No.1915/June 2016

9 Financial cycles core stylised features Feature 4: FC helps detect financial distress risks with a good lead in real time Leading indicators of financial crises: simultaneous positive deviations (or gaps) of the ratio of (private sector) credit-to-gdp and asset prices (especially property prices) from historical norms. The cross-border credit tends to outgrow the domestic credit during financial booms.

10 Source: Borio (2014)

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12 Financial cycles core stylised features Feature 5: Length and amplitude of the FC depend on policy regimes Financial regime Financial liberalization weakens financing constraint Monetary policy regime Focused on near-term inflation => less resistance to financial booms Real-economy regime Positive supply side developments (eg. globalisation of the real side of the economy) raise growth potential (scope for credit and asset price booms) and lower inflation (less room for monetary policy tightening). Empirical evidence: the length and amplitude of the FC have increased since the mid-1980s.

13 Modelling of the financial cycle What features require modelling: The financial boom should not just precede the bust but cause it. The bust is a result of vulnerabilities that build up during the boom phase. Presence of debt and capital stock overhangs Current models usually do not include the presence of such disequilibrium stocks or assume them exogenous. Distinction between potential output as non-inflationary output and as sustainable output.

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15 Modelling of the financial cycle How? Expectations are not rational and knowledge is not complete Attitudes towards risk vary with the state of the economy Monetary nature of economies Financial contracts are set in nominal, not in real, terms. The banking sector generates (nominal) purchasing power. Deposits are not endowments that precede loan formation, it is loans that create deposits.

16 The importance of a monetary economy: an example Excess saving view: global current account imbalances were at the origin of the financial crisis. How? CA surpluses (especially in Asia) and net capital outflows financed the credit boom in the deficit countries (especially USA). Excess of savings over investment put downward pressure on world real interest rates, which fuelled the credit boom and risk-taking. Objections to this view: financing vs. saving Financing is gross cash-flow concept Saving is income (output) not consumed Expenditures require financing, not saving Link between credit and saving is loose

17 The importance of a monetary economy: an example US credit boom was mostly finances domestically Foreign funding came largely from countries with a CA deficit (UK) or in balance (the euro area). Criticism concerning behavioral relationships: balance between savings and investment affects the natural, not market, interest rate. Market interest rates are determined by monetary factors: policy rates set by central banks, market expectations about future policy rates and risk premia. Natural rates are unobservable, equilibrium concepts determined by real factors. Empirically, little link between global saving and current accounts, and both short and long real interest rates. Application of real analysis to monetary economies is questionable

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19 Policy challenges dealing with the boom Addressing financial booms may include several policies: Macroprudential policy appropriate design of tools (capital and liquidity standards, provisioning, collateral and margining practices) Monetary policy adopt strategies that allow central banks to tighten monetary conditions even if near-term inflation remains subdued (the lean option ) Extending policy horizon beyond 2-year one Fiscal policy extra prudence during economic expansions associated with financial booms. Unfinished recession phenomenon: policy responses that fail to take mediumterm financial cycles into account (too much focus on equity prices and standard business cycle measures) can contain recessions in the short run but at the cost of larger recessions later (continued build-up of the financial cycle).

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21 Policy challenges dealing with the bust Not all recessions are born equal: the typical recession triggered by tightening of monetary policy (until the mid-1980s) vs. balance sheet recession (the most recent recession). Two phases: crisis management and crisis resolution Crisis management the priority is to prevent the implosion of the financial system (central banks lender of last resort function, sharp cuts in policy rates) Crisis resolution the priority is balance sheet repair. Essential is addressing the debt overhang. Fiscal policy may be less effective in balance sheet recessions than in normal ones. The possible solution would be to use the public sector balance sheet to repair and strengthen the private sector s balance sheet.

22 Policy challenges dealing with the bust Monetary policy is also likely to be less effective in stimulating aggregate demand in a balance sheet recession. Possible side-effects of extraordinarily accommodative monetary easing: It can mask balance sheet weakness and delay the recognition of losses. It can undermine the earnings capacity of financial intermediaries (very low interest rates). It can atrophy markets and mask market signals (central banks take over larger part of financial intermediation). It can make central banks vulnerable to losses (balance sheet policies), which can undermine their financial independence. The main problem: monetary policy typically operates by encouraging borrowing, boosting asset prices and risk-taking => but initial conditions already include to much debt, too high asset prices and too much risk-taking.

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