Financial Bubbles: What is next?

Transcription

1 Financial Bubbles: What is next? Professor El Thalassinos University of Piraeus, Greece Chair Jean Monnet General Editor ERSJ 1

2 Abstract The main aim of this paper is: to analyse the recent financial bubbles and to make recommendations how to handle them in the best possible way. 2

3 Introduction Due to internationalization the world economy behaves like a domino and any disturbance in any place in the world has a chain effect to almost all other economies. The recent financial bubble in the sub-prime mortgage market creates new problems in the world market with unforeseen continuances. 3

4 There are 4 famous financial bubbles: The US stock market crisis in late 1920s (Big Depression). The Japanese stock market in the late 1980s (Asian Crisis). The US stock market during (New economy, High Tech crisis). The US Sub-prime mortgage market 2008 (Investment and Mortgage Banks, Real estate crisis). 4

5 Deflation after financial bubbles? When financial bubbles collapse, often but not always deflation follows. Deflation often result in financial and economic crises. Financial and economic crises affect the architecture of the monetary system. A change in the system may affect the role of the dollar, the euro and the yen. 5

6 Terminology Deflation versus inflation: (deflation is when prices go down however you have no money to buy goods and inflation is when prices go up however you have not enough money to buy goods). Depression versus recession: (recession is when your neighbor loses his job and depression is when you lose yours). 6

7 Big Depression 1920s- Lessons From US real output fall by nearly a third (33%). Unemployment from 3% to 25%. Stock market declined by more than 90%. Stock prices took a quarter century to regain their peak. New monetary measures adapted to protect the system. 7

8 Asian Crisis-Lessons Export oriented growth. Fixed exchange rates. Heavy indebtedness to foreign banks. Over investment / moral hazard. Stock markets decline by more than 50%. 8

9 Theories to explain the Asian Crisis Theory on economic fundamentals: (Weak domestic macroeconomic factors precipitate a balance of payments crisis because of the fixed exchange rate regime). Theory on financial panic: (This theory attribute the crisis to an exogenous change in investor confidence, leading to liquidity problems. The loss of confidence leads to sudden withdrawal of short term capital from the troubled economies). Which one explains better? We don t know yet. 9

10 The New Economy Crisis-Lessons Lack of effective Corporate Governance. Inefficient markets. Informal regulation. Ineffective auditing. High investments in IT. Risky business. 10

11 The Real Estate Market Crisis-Lessons Lack of effective regulation in Investment Banking. Market makers. Risky innovative products (toxic products). Economy decline. Globalization. 11

12 The Unpredictability of the Crises Currency crises. Banking crises. Financial crises. Economic crises. 12

13 Global Instability How to stabilize the global economy: Strengthen Global Financial Architecture. Reconsider the role of the IMF. Lessons from EMU. Will NAFTA move towards a Monetary Union? Coordination of global policies among EU, US and Japan. 13

14 Desirable conditions for the new Monetary System stable in crises? Fixed exchange rates. Capital Mobility. Autonomous monetary policy. 14

15 The Trilemma of the Global Monetary System James Tobin, (Nobel) Paul Krugman, (MIT) Joseph Stiglitz, (Nobel) have agreed on: Fixed Exchange Rates and Autonomous Monetary Policy. Milton Friednam, (Nobel) supports: Autonomous Monetary Policy and Capital Mobility. EMU, Robert Mundell, (Nobel) Paul Volcker, (Fed) in favor of: Fixed Exchange Rates and Capital Mobility. 15

16 EU and NAFTA Mundell+ proposes the same system (EMU) for NAFTA (USA, Mexico, Canada, Latin America). Japan has lost the opportunity to unify South East Asia in a YEN zone. His proposal was the creation of a new global currency named D.E.Y. (Dollar, Euro, Yen). The Byzantine currency lasted for 500 years in the period 900 AC to 1400 AC was the most stable in history. 16

17 Global Market associated with Risk (I) Risk Mgt answers the following questions: Do I have an asset whose value may decline? Do I have future obligations that become more expensive? Do I speculate for future returns? If your answer is yes in any of these questions then you need risk mgt. John Campbell (NWC): Period of instability in stocks, real estate, incomes. Even the human capital has risk. Risk Mgt is necessary. 17

18 Global Market associated with Risk (II) Solution: The creation of future markets. Since all obligations are taken today to be paid in the future we have to define a formula for the future value of our obligations. 18

19 Global Market associated with Risk (III) To connect present and future values you have to determined a formula New markets have been created, known as futures markets Futures markets are very risky There is no effective regulation in futures markets Future markets have high volatility 19

20 Global Market associated with Risk (IV) Cash, values are known: Actual / Physical market Multiple places Good or service Accept risk Buyer and seller No daily resettlement 20

21 Global Market associated with Risk (V) Futures, value to be determined: Derivatives Exchanges Contracts Protect risk for high volatility Clearing house for buyer and seller Daily resettlement 21

22 Efficient Market Hypothesis Is the theory of the EMH sufficient? Markets utilize and incorporate all public available information. Assumptions: Rational Traders Infinitely lived All equally informed 22

23 The Theorem of EMH Rational Risk Averse fully informed long lived traders do not cause bubbles. It can be proved using two equations one for money supply and one for inflation. 23

24 Informed-not informed traders Market is a jungle (Lions, foxes, wolfs, rabbits, etc.). Traders are divided into informed traders and not informed traders they both try to create a trend. 24

25 Volatility If volatility is high the trend changes (Sorros). Informed traders step out. New generations getting in creating new bubbles. 25

26 Uncertainty Determine a upper and lower level. Determine the cost of capital. What is the acceptable return? Clear up your position in seconds. Trade according to volatility. Attention every time FED (ECB) intervenes. 26

27 Long Term Traders Personal Characteristics Yield Risk averse Low return 27

28 The Current Crisis: Three different views: First view (I) The first view argues the current financial crisis has already outstripped available social resources, so that there is no market or state solution. This view asserts that the imbalances created in the financial markets are so vast that the market solution must consist of an extended period of depression. 28

29 The Current Crisis: Three different views: First view (II) Any attempt by the state to appropriate social resources to solve the financial imbalance not only will be ineffective, it will prolong the crisis even further, although perhaps buying some minor alleviation up front. 29

30 The Current Crisis: Three different views: Second view (I) A second view argues that the financial crisis has not outstripped the ability of society-organized by the state-to manage but that it has outstripped the market s ability to manage it. 30

31 The Current Crisis: Three different views: Second view (II) The financial markets have been the problem, according to this view, and have created a massive liquidity crisis. The economy-as distinct from the financial markets-is relatively sound, but if the liquidity crisis is left unsolved, it will begin to affect the economy as a whole. 31

32 The Current Crisis: Three different views: Third view (I) The third view argues that the state mobilization of resources to save the financial system is in fact an attempt to save financial institutions including many of those whose imprudence and avarice caused the current crisis. This view divides in two sub views. 32

33 The Current Crisis: Three different views: Third view (II) The first sub view agrees the current financial crisis could have profound economic consequences, but believes a solution exists that would bring liquidity to the financial markets without rescuing the culpable. 33

34 The Current Crisis: Three different views: Third view (III) The second sub view argues that the thread to the economic system is overblown, and that the financial crisis will correct itself without major state intervention but with some limited implementation of new regulations. 34

35 Three views of the Financial Crisis: First view summary (I) The first view believes that the situation is beyond salvation, and certainly rejects any political solution as incapable of addressing the issues from the standpoint of magnitude or competence. 35

36 Three views of the Financial Crisis: First view summary (II) This view is out of the political game by its own rules, since for it the situation is beyond the ability of politics to make a difference-except perhaps to make the situation worse. 36

37 Three views of the Financial Crisis: Second view summary (I) The second view represents the establishment consensus, which is that the markets cannot solve the problem but the federal government canprovided it acts quickly and decisively enough. 37

38 Three views of the Financial Crisis: Third view summary (I) The third view defeats the establishment proposal. For a myriad of reasons, some contradictory, this view opposed the bailout. The reasons ranged from moral outrage at protecting the interests of the perpetrators of this crisis to distrust of a plan implemented by the government. 38

39 Three views of the Financial Crisis: Third view summary (II) The delay would not lead to economic catastrophe according to this view. 39

40 Critiques (I) Professor Martin Feldstein (Harvard University) former President of the National Bureau of Economic Research in Cambridge MA, former economic adviser to Republican President Ronald Reagan. Market participants and the FED and the administration were slow at first to recognize just how serious the problem was. I think there s an understanding now that it is a much deeper, much more serious problem for financial markets. 40

41 Critiques (II) Professor Robert Mundell, (Columbia University, Nobel Prize 1999). European policy makers have few options. Hampered by inflation and budget deficits, they can do very little to stimulate the economy with interest rate cuts and tax rebates as their US counterparts have done. Europe hasn t hit bottom yet, and its eventual rebound won t be rapid. 41

42 Critiques (III) Professor El Thalassinos (University of Piraeus). Are the resources of the US sufficient to redefine financial markets in such a way as to manage the outcome of this crisis? Has the crisis become so large that even the resources of a $14 trillion economy mobilized by the state can t do the job? 42

43 Critiques (III) cont. If the latter is true, then all other discussions are irrelevant. Events will take their course, and nothing can be done. We are going in a deep depression, cross your fingers and wait. God bless us. 43

44 Critiques (III) cont. If it is not true, that means that politics defines the crisis as it has other crisis. In that case, the federal government can marshall the resources needed to redefine the markets. The federal government must act in due course, and an institutional resolution taking power from the Treasury will emerge as soon as possible. 44

45 Critiques (III) cont. The question is how much time remains before massive damage is done to the economy. If there is no time events will take their course, and nothing can be done. We are going in a deep depression, cross your fingers and wait. God bless us. If there is still time events will take their course, and something can be done. We are going in a deep recession, so again cross your fingers and wait. God bless us. 45

46 Conclusion Be prepared for either: A deep recession (when your neighbor loses his job) or A deep depression (when you lose yours). I wish neither of you to be in either position but who knows Thank you for your attention! 46