FROM ASSET BUBBLES TO A LIQUIDITY TRAP Presented by A.G. Malliaris
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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
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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
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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
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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)
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-40
-20
020
40
1870 1890 1910 1930 1950 1970 1990 2010Year
growthrate zerotenpercent minustenpercent
Real S&P Growth Rates
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“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
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CHALLENGE
• Decompose an economic cycle into 4 phases instead of just 2
• Introduce Upper Turning Period and Lower Turning Period
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ExpansionRecession
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Upper Turning Period
ExpansionRecession
Lower Turning Period
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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
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The Expansion Phase: December 2001 to November 2007
• The expansion was weaker than average
• One major event: the formation of the Housing Bubble
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“The dogmas of the quiet past are inadequate to the stormy
present”
Abraham Lincoln
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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
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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
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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)
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Job Losses Were Unprecedented
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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
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GDP Fell Far Below What the Economy Was Capable of Producing
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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
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Legislative Response
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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
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“It is better to act and repent than not to act and regret it”
Machiavelli
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THANK YOU
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