What are these “Bubbles”? Bubbles in Economics are “trade in high volumes at prices that are considerably at variance with intrinsic values” (trade in products or assets with inflated values) Post-Bubble economies are hard to manage: Poor response to falling interest rates The greater the debt buildingthe more difficult the recovery
Why do they occur? Still being debated: Some economists deny that bubbles occur Some economists believe it might be caused by price coordinationor emerging social norms. Because it is often difficult to observe intrinsic values in real-life markets, bubbles are often conclusively identified only in retrospect, when a sudden drop in prices appears (crash or bubble burst)
The Issue Individual banks and financial institutions can act prudently. However, collectively they can contribute considerable risks and negatively shock the aggregate economy.
The Schools of Thought Implement the use of macroprudential tools with new capital rules (REGULATE) To leave it alone (DEREGULATE)
Advantages Regulation of financial markets would allow policymakers to limit risky behavior of individual banks to prevent the collapse of bubbles Deregulation would allow for economic freedom
Problems with Regulation “To embed the rules, regulators will need models capable of identifying risks across the financial system, not just in banks. And those models would need to be sophisticated enough to map the linkages between different asset classes and counterparties, while also calculating the likelihood of a boom turning to bust.” –WSJ 9/5/10
“Punch Bowls” Pool of Liquidity that has kept US economy out of depression Easy money via low Federal Funds Rate Idea of “Quantitative Easing” FED buys up assets, mainly Treasury Bonds
Need for Exit Strategy Trillions of dollars in stimulus, what next? Historically: Drain the Punch Bowl Problem of hyper-inflation If FED raises interest rates too quickly When should FED sell off assets? Concern that party will spin out of control
Bernanke on Timing Critical to tighten monetary policies and restrain credit once economy begins to “heat up” ”…we have been working to ensure that we have the tools to reverse, at the appropriate time, the currently very high degree of monetary stimulus. We have full confidence that, when the time comes, we will be ready to do so."
Alternative Solutions Reverse Repurchase Agreements FED sheds off assets, central bank takes them out of circulation FED promises to repurchase assets at later date Assets on FED balance sheet remains unchanged, liabilities shift from providing resources today to providing in future
Bubbles and Fed’s reactions 1973 Oil crises: OPEC stopped the shipment of Oil to the U.S Started Oct. 1973, ended Mar. 1974 Dow lost more than 45% of its value. Fed’s reaction: More focus on controlling inflations Increased the fed funds rate up to 12.91% in Jul. 1974. Was not affective, it may also longer the recession
Bubbles and Fed’s reactions 2000 Dot-Com bubble: Internet stocks was growing rapidly in the 90s But the growth stopped in Mar. 200 NASDAQ was more affected than Dow. Fed’s reaction Wanted to keep the growth Lower the funds rate as low as 0.98 in Dec. 2003 (Jul. 2000: 6.54) Helped the growth, but it might also caused the next bubble
Bubbles and Fed’s reactions Subprime Mortgage Crisis: Started 2007 Housing price dropped People could not pay mortgages. Banks start write-off their mortgage loans Fed’s Reaction: Helped the banks with emergency funds Lower the fed funds rate to almost 0.00% (5.25 in Jan. 2007) Expect to stay at 0.00% for long time
Monetary Policy 1913- Serve as a lender of last resort in times of crisis. Provide elastic currency. 1950s- Assume a proactive macroeconomic role… “Take away the punch bowl just as the party gets going.” 1977- Promote maximum employment and stable prices
Regulation 1913 Establish effective supervision of banks 1956 Federal Reserve is responsible for holding companies 1968-77 Protect consumer rights and promote fair lending 2008 Expand regulation to protect against complex risky assets and improve containment of systemic risk
Is the Federal Reserve Overextended? Is it realistic to ask for a chairman versed in macroeconomics as well as a dynamic banking system? Is it possible to separate the interests of the FED, the Government, and Corporate America? Should the FED be responsible for preventing asset bubbles?
Thank You! TEAM UK Anthony Liang David King Andy Irish JoonJeon Ted Gagner