La dramatización como estrategia didáctica

Bearing in mind that a generally accepted definition of financial stability has not emerged in the literature, and besides the tendency to define financial instability instead, there exists a clear distinction between definitions that refer to the volatility of directly observable financial variables and those that are based on a system approach. The latter tend to broadly follow Mishkin (1991), which can be adapted

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See BIS (1999), chapter IV. Since the late 1800s, periods of deflation have also generally been periods of positive (if moderated) real growth. The principal exception to this was the first few years of the Great Depression of the 1930s.

according to Issing (2003) to a broad, but intellectually convincing definition of financial stability as “the prevalence of a financial system which is able to ensure in a lasting way, and without major disruptions, an efficient allocation of savings to investment opportunities” (Issing (2003), p. 16). The degree of financial fragility can then be viewed as the proximity of the economy to the break point, exceeding that which would impair the efficient allocation of savings (Issing (2003), p. 16).

Asset prices tend to exhibit considerable volatility, being a sign of the wide range of variation in expected future income prospects. Movements in asset make cyclical volatility more intense as they reduce the external finance premium during the boom phase and increase it during the bust. Nevertheless, asset price volatility seems to be a symptom rather than a cause of the boom-bust cycle, and, therefore, monetary policymakers need principally to address any monetary policy problems that may potentially create economic instability.

Finally, this chapter explored the relationship between monetary policy, deflation and financial stability. After reviewing financial stability (or its negative counterpart), we discussed price stability and financial stability and provided a brief analysis of the relationship between asset prices, monetary policy, and the consequences of financial distress for banking crises or simply movements in asset prices. It is argued that equity prices, in fact, constitute a misleading guide for interest-rate monetary policy, in addition to the fact that monetary policy actions exercise significant protection to market liquidity and maximise a central bank’s leverage over longer-term interest rates and aggregate demand. Monetary policy is also argued to be a fundamental source of deflation and stagnation risk in a regime of

fully credible price level stability. Two main issues of concern for monetary policy remain, though, namely that a central bank can be insufficiently pre-emptive in a business expansion, while being misled by its own credibility for low inflation. Monetary policy may face the constraint of the zero bound on nominal rates in its attempts to reduce real interest rates enough in order to forestall deflation and stagnation in the subsequent contraction (as discussed in Goodfriend (2001), (2003)).

As White (2001) suggests it is crucial to answer the question of how a country enters into a deflationary situation. He suggests that “the answer can be succinctly expressed in two words, ‘boom’ and ‘bust’…” (White (2001), p. 167). Goodfriend (2001) stresses a simple but fundamental point referring to the problem arising in the ‘boom’ phase of an economic cycle. It is concluded that “justified optimism can turn into excessive optimism; rational enthusiasm can turn into irrational exuberance. The “good news” of low inflation can blind both policymakers and market participants to emerging problems” (White (2001), p. 167).

C H A P T E R 5

A S S E T P R I C E B U B B L E S : A N O V E R V I E W

5.1 Introduction

Monetary policymakers are confronted with no other alternative but to encounter the risks caused by asset price bubbles. Bubbles in asset prices create distortions to nearly all economic decisions. Wealth effects create rapid expansions in consumption followed by vast collapses. Increases in equity prices enable firms to finance new projects, causing a boom in investment, followed by a bust. The overvaluation in collateral used to back loans leads to balance-sheet deteriorations for the financial intermediaries that issued the loans, after the prices collapse. In addition, fiscal revenue rises in a booming economy, and encourages, thus, cuts in taxation and increases in expenditure. After the consequent, inevitable, slump in asset prices such fiscal policy actions are politically difficult to reverse. Therefore asset price bubbles can create volatility in consumption, investment, financial intermediaries’ solvency, and fiscal policy. They, usually, have an impact on aggregate demand, since they cause inflation and output to increase during the boom and decrease during the bust. Therefore, monetary policymakers are faced with no other alternative but to address the issue of asset price misalignments – even when their primary objective is price stability.

In the effort to evaluate the ways in which monetary policy (as well as public policy in general) should address bubbles in asset prices, one must first identify the ways in

which asset prices influence inflation and aggregate economic activity. As those influences span through various channels, asset prices send signals with respect to profitable investments, influence household wealth, and affect the cost of capital for firms and households. Increases in equity prices, for example, irrespective of the source – be it bubble-behaviour like “irrational exuberance” or a shift in fundamentals like lower real interest rates or faster productivity growth, tend to lower the cost of capital, boosting investment, and to generate increased wealth, raising, thus, household demand. The resulting fluctuations in resource utilization lead to changes in inflation.

Of course, asset price bubbles have additional implications for economic efficiency. Departures of asset prices from levels implied by economic fundamentals can lead to inappropriate investments that decrease the efficiency of the economy by diverting resources toward economic activities that are supported by the bubble (for example, see Dupor, 2005). For example, during the bubble in technology-stocks in the late 1990s, there was overinvestment in some types of high-tech infrastructure. Similarly, the bubble in housing prices led to too many houses being built. Mishkin (2008), in particular, views these distortions to activity across sectors of the economy as a ‘drag on efficiency’ and hence a matter of concern above and beyond fluctuations in overall economic activity and inflation (Mishkin (2008), p. 8). In addition, he remarks that monetary policy is directly concerned with the effects changes in asset prices impose on inflation and demand through wealth and cost-of-capital channels. Bearing, though, in mind that asset price bubbles may vary (sometimes to a great extent), it is important to note that some types of asset price bubbles may fall beyond the direct responsibility (or circle of influence) of monetary policy but be more

appropriately countered by the broader regulatory framework safe-guarding the financial system. He, finally, contends that some asset price bubbles may also stir financial instability, and as such raise further substantial concerns for the policymakers (Mishkin (2008), p. 1).

The main function of the financial system is to channel efficiently funds from savers to individuals or corporations that present worthy investment opportunities. In the presence of shocks obstructing the flow of information that is vital for the smooth operation of the system, the latter may be disrupted giving rise to financial instability. The subsequent disruption in the credit flow may eventually threaten overall economic performance101. The efficiency in the operation of the financial system is based on the flow of information that is yet asymmetric in its nature. This asymmetry refers to one part in an investment project, which is typically the provider of the funds – the lender, being less accurately informed about the project than the other that will carry out the investment – the borrower. This type of asymmetry in information can give rise to ‘adverse selection’ and ‘moral hazard’ that hamper the efficient operation of the financial system102 (Mishkin (2007a), p. 1-2).

Financial intermediaries, and especially banking institutions, manage to reduce the above informational asymmetry by efficiently collecting information from borrowers and building a strong network with their clientele. The growth of financial innovation,

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See, for example, Mishkin (1997) for a detailed account of the causes of financial instability and its effect on economic activity.

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Adverse selection describes the problem of financial intermediaries issuing loans to investors who are willing to assume excessive risk because they are unlikely to pay back their loans. Moral hazard describes the problem a borrower having incentives to undertake excessively risky investments in which the lender bears most of the cost in case of failure but the borrower gets a high benefit in case of success. See Milgrom and Roberts (1992) for a detailed discussion.

either as new financial products and new types of institutions active in the markets, enabled the more efficient flow of information. The latter minimises the problems of ‘adverse selection’ and ‘moral hazard’ and is principal in the ability of the participants in the financial markets to collect relevant information and properly evaluate the value of assets traded in the financial markets (termed as ‘price discovery’).

However, the flow of information may be disrupted, and price discovery may be impaired during periods of financial distress. The increased uncertainty that characterizes the disruption in the information flows results in high risk spreads and a reluctance to purchase assets103.

Moreover, during a recession, the deterioration of balance-sheets renders ineffectual the use of collateral as a remedy to the adverse selection and moral hazard problems. If a loan is backed by collateral, in the case of default, namely after the lender has in effect made an adverse selection, the lender obtains the collateral as compensation. Considering moral hazard, the collateral works as a penalty for the borrower in case extra risks are assumed that may jeopardise the project, reducing thus the problem of moral hazard. Yet as the overall economic outlook deteriorates, collateral values tend

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In an effort to understand financial instability, it is vital to address two kinds of risk, valuation and macroeconomic risk. The first one reflects the difficulty that the market faces in assessing the value of a security, due to the inherent complexity of the security or the opaqueness of its underlying creditworthiness. According to Mishkin (2007b), “valuation risk has been central to the repricing of many structured-credit products during the [recent] turmoil … when investors have struggled to understand how potential losses in subprime mortgages might filter through the layers of complexity that such products entail” (Mishkin (2007b), p.2). In turn, macroeconomic risk refers to the increase in the probability that a disruption in the financial system will deteriorate the real economy to a great extent. Such episodes tend to give rise to a vicious circle as real economy deteriorations increase the ‘opaqueness in the creditworthiness’ of the securities traded in the financial markets, financial disruptions lead to a decline in investment and consumer spending leading, thus, to a contraction in overall economic activity. This contraction leads to an increase in the uncertainty referring to the value of assets making the financial disruption more acute (Mishkin (2007b), p.2).

to deteriorate as well, making the above two problems more acute. As lenders, in turn, show a relative reluctance to issue loans, a vicious circle may be in effect reinforcing, thus, the macroeconomic downturn.

Shocks interfering with the flow of information in various parts of the financial system precipitating financial instability span from higher interest rates (that may give rise to credit rationing) to problems in the banking sector (as a weakening in the financial positions of several financial intermediaries), and increases in uncertainty to asset-market effects on balance-sheets. Financial instability, in the absence of any remedial action, can produce a severely adverse impact not only for the functioning of financial markets but also for the overall prospects of a country’s economy. This strong link between financial stability and the real side of an economy renders the former a principal concern for central banks. Monetary policy authorities face the central concern of finding and evaluating ways to prevent financial instability. In this endeavour one needs, first, to understand the nature of financial instability and the effect it may impose to the macroeconomy.

As Mishkin (2008) points out, financial history shows a sequence of events that typically proceed in the following manner. Stemming from either excessive optimism about economic prospects or fundamental changes in the structure of the financial system, a boom in credit provision takes place, which leads to higher demand for certain assets and, in turn, to higher prices for those assets104. The latter raises the values of those assets, consequently, promoting further issuing of credit backed by those assets, which further raises demand and, thus, the prices of those assets. Such a

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reinforcing mechanism can create a bubble. The latter can encourage lax credit standards since lenders rely more on the further appreciation of the pertinent assets (in order to shield themselves from potential loss) than on the borrowers’ ability to repay the debt issued to them. When the bubble (inevitably) bursts the mechanism described above works backwards. The drop in asset prices causes a decrease in supply of credit, and as the demand for assets continues to fall their prices drop further. Loan defaults and the slump in asset prices deteriorate the balance-sheet positions of financial institutions leading to a further decrease in credit supply and investment. Business and household spending shrinks as a result of the decline in lending. In turn overall economic activity deteriorates and macroeconomic risk in credit markets increases. Finally, “in the extreme, the interaction between asset prices and the health of financial institutions following the collapse of an asset price bubble can endanger the operation of the financial system as a whole” (Mishkin (2008), p. 2).