Financial Crisis American Style

There is a near consensus among financial journalists, economists, and policymakers that the US housing boom—which started just after the turn of the millennium and ended by mid-20071—and the financial crisis that followed were caused by loose monetary policy and negligent financial regulation, aided and abetted by avarice and dishonesty among bankers and their borrowers.2 Many people believe that these errant practices enabled reckless financial leverage, easy credit, and fraud to proliferate, which generated an unsustainable boom that, because of its unstable foundation, was destined to end in a calamitous crisis. That was the core conclusion of the Financial Inquiry Commission appointed by the US Congress to investigate the causes of the crisis.3 “We conclude a combination of excessive borrowing, risky investments and lack of transparency put the financial system on a collision course with crisis.”4

International capital flows have been on an unprecedented roller-coaster ride in recent years. Capital flows to emerging market economies have been strongly correlated with changes in global financing conditions, rising sharply during periods with relatively low global interest rates and low VIX (called risk-on) and shrinking afterward. In open emerging market economies, interest rate increases can attract excessive capital inflows appreciating the exchange rate, and leading to excessive borrowing in foreign currency, and encouraging leverage. A well-designed macro prudential policy prevents credit –driven bubble and mitigating pro-cyclicality of capital flows.

Housing markets have played a prominent role in macroeconomic developments over recent years. For a great part of the 2000s, buoyant housing markets have contributed to sustained economic activity in most OECD countries. But many markets overheated and the collapse of the US subprime mortgage market has been at the epicentre of a deep financial and economic crisis. Against this background, this paper: i) documents housing market developments in 18 OECD countries since the 1970s, putting recent evolutions into historical perspective; ii) examines the drivers of supply and demand for housing; iii) investigates the interactions between housing markets and the wider economy; iv) assesses the responsibilities of housing taxation, monetary policy and financial supervision and regulation in fuelling or amplifying housing booms; v) explores the link between global imbalances and housing booms.

Securitization of subprime credit and the propagation of housing shocks

Die durch die grose Finanzkrise induzierten hohen Schuldenquoten zwingen die Staaten zu Masnahmen des Schuldenabbaus. Financial Repression bietet dafur Moglichkeiten. Sie entsteht, wenn staatliche Instanzen den Finanzmarkten Masnahmen oktroyieren und manifestiert sich in erster Linie in niedrigen Realzinsen. Financial Repression wird als weiteres Charakteristikum einer „neuen Normalitat“ der Weltwirtschaft mit niedrigen Potenzialwachstumsraten und Zinssatzen sowie hohen staatlichen Schuldenstanden angesehen. Der Beitrag stellt dieses Charakteristikum vor und beurteilt seine empirische Relevanz.

This paper outlines an operational approach for incorporating the impact of asset price cycles in the calculation of structural fiscal balances (SFBs). The global financial crisis demonstrated that movements in asset prices can have an important fiscal impact. Failing to account for the fiscal impact of asset price cycles can encourage a pro-cyclical policy stance if temporarily high revenues are passed through into expenditures. In addition, over-estimating the SFB may lead to inadequate fiscal buffers when cyclical revenues eventually dissipate. The paper proposes an empirical approach to correct for asset prices and provides illustrative country results for selected OECD countries. We find that asset price cycles are imperfectly synchronized with the business cycle and are quantitatively significant with an average pre-crisis fiscal impact ranging from about ½ to 2 percent of GDP in the sample. For a number of countries, the pre-crisis fiscal impact of high asset prices was larger at about 4 percent of GDP.

The worldwide financial turbulences of 2008 and the following European debt crisis have put the Swiss franc under persistent upward pressure, prompting the Swiss National Bank to lower short-term interest rates as far as possible. Under this policy, the export-oriented sectors of the Swiss economy performed rather sluggishly while housing investment and house prices were driven up markedly by low interest rates. This has raised fears about the buildup of a housing bubble. Meanwhile, however, the housing boom has calmed down gradually without turning into a crash. This paper seeks to provide a theoretical and empirical basis for these developments. It analyzes the relationship between exchange rate shocks, the reaction of monetary policy and the resulting repercussions on the housing market in the framework of an econometric macro model. The stock-flow dynamics in the housing market allow for the possibility of a boom-bust cycle: An excess of housing demand over the existing housing stock and increasing house prices interact in a self-enforcing process, until an excessive level of house prices initiates a turnaround. The econometric analysis supports this view but also shows that the turnaround takes place rather smoothly as long as the strength of the Swiss franc and low interest rates persist. More prone to produce a pronounced downturn in the housing market is a scenario in which the upward pressure on the Swiss franc weakens so that interest rates increase after the initial decline.

A financial crisis arises when the value of financial assets or markets rapidly declines, often leading to panic, liquidity shortages, and the collapse of the banking systems. In modern financial systems, financial innovations such as mortgage-backed securities (MBS), credit default swaps (CDS), and high-frequency trading have emerged as key drivers of both market efficiency and systemic instability. These innovations can amplify financial crises by increasing leverage, introducing complexity, and precipitating abrupt market shocks. This paper examines how specific financial innovations, particularly derivatives like MBS and CDS, contributed to the amplification of the 2007-2008 financial crisis. The study uses a case study approach to analyze the crisis and evaluate both the advantages and disadvantages associated with these financial innovations. The conclusion underscores the necessity for stronger regulation and oversight of financial innovations since unchecked complexity, excessive leverage, and inadequate risk management can precipitate to systemic collapse. Transparent markets, robust risk management practices, and prudent regulation are indispensable in averting and preventing future crises. This research highlights the critical role that financial innovations play in both driving and mitigating financial crises. By analyzing the 2007-2008 American Financial Crisis, the paper provides insights into how these innovations, while offering potential benefits, can also introduce significant risks when improperly regulated. The findings emphasize the necessity of balanced oversight to ensure innovation does not compromise systemic stability.

Book Review

PurposeThe purpose of this paper is to measure how frequently innovative financial products appeared or became widely adopted in the municipal securities markets over the last two decades; and also investigate what types of issuers adopted the innovations, the relationship between yields and innovation and the patterns of diffusion within states.Design/methodology/approachUsing comprehensive data on municipal securities issued from 1992 to 2015, the author searches for financial innovations as defined in the literature. The author uses issuer fixed effects models to characterize the relationship between yields and use of innovative products. Other models provide estimates of the conditional correlations between issuer characteristics and innovation usage. Finally, the author fits trend models to identify significant differences in the pace of adoption between different types of issuers.FindingsIn total, 35 security features fit one or more definitions of innovation. Extensive analysis is presented for four innovations that represent significant transfers of risk: variable rates, put options, corporate backers and derivatives. Small issuers used these innovative products, but the largest issuers adopted them to a greater extent. Usage appears to diffuse within states. Issuance of innovative securities fell during the financial crisis and has not recovered. Novel securities since the financial crisis have been created by legislation rather than by market participants.Research limitations/implicationsThe data appear to cover all or nearly all municipal securities, but they do not cover loans or other types of municipal borrowing.Practical implicationsThis analysis reveals that financial innovations in municipal securities markets usually take the form of a rare practice becoming widespread rather than a never-before-seen feature appearing in the market. Changes in response to legislation are an exception.Social implicationsRegulators concerned about financial stability can monitor the expansion of formerly rare securities features. This will be informative about new risks or transfers of risk in the market. They can also anticipate that expanded use of an innovation by states and high-volume issuers will be followed by adoption of the innovations by smaller, less sophisticated issuers in subsequent years.Originality/valueThis paper is the first attempt to empirically analyze the extent of financial innovation in municipal securities. Existing public finance literature has proposed definitions of financial innovation, qualitatively documented some specific innovations and empirically analyzed others. However, no previous study has empirically analyzed the entire municipal securities market for all possible innovations.

Borio and Disyatat (2010) is at the heart of the ongoing debate on the cause(s) of the recent financial crisis. Many agree on the role played by the inability of the prudential authorities to contain the excessive speculation by US and European financial institutions in the credit market. Some of the existing regulations seem to have encouraged it. People disagree on the role played by monetary policy.Low interest rates are normally a precondition for serious imprudent behavior by financial institutions.During the 2004‐ 2007 period, however, the Fed raised its policy rate by more than 400 basis points. Yet, long-term Treasury bond rates responded little to the rise in short-term rates ‐ the so-called conundrum.Thus,Bernanke (2010) asserts that monetary policy played a minor role in the formation of the credit bubble. According to Bernanke, it was financial innovations that encouraged risky investment in securitized assets and capital inflows from current account surplus countries that contributed significantly to the bubble. Capital inflows must have contained the rise in long-term interest rates and added to the binge. Borio and Disyatat start by criticizing the theory of interest inherent in the view that emphasizes the role played by capital inflows.This view,the excess saving (ES) view,holds that saving and investment determine the rate of interest. Borio and Disyatat are skeptical of this approach, and are in favor of a perspective that looks at the role of gross capital flows. Now, there is a long debate on the theory of interest rate determination, for example, the loanable funds theory versus the liquidity preference theory. I do not think it would be useful for me to go into that debate. I would just like to point out that, although it is entirely possible to write down a model where saving and investment determine the rate of interest, in modern developed financial markets it is usually the supply of, and the demand for, the stock of assets that determine asset prices. Flow variables affect asset prices as they slowly change the levels of asset supplies. Such a perspective is, of course, close to looking at gross international capital flows. Borio and Disyatat then turn to the analysis of the pattern of international gross capital movements in the 2000s, and find that banks in the Euro area and the UK dominated in terms of gross capital inflows into, and outflows from, the USA. That is, in addition to US financial institutions, they were the ones most active in the credit market binge, not Asian investors. I must say that very few object to this view of the world.

Globally, economies are preparing for a future where innovations accelerate. Governments are vying to harness new technologies and developing financial innovations to drive progress. Against such a backdrop, this thesis comprises of three independent essays on institutions incorporating innovation and the resulting impact on macroeconomic and financial stability. The first two essays pertains to financial innovation by a central bank who replaces the cash in circulation with a central bank issued digital currency. Several countries like China, France, Sweden etc. have already taken concrete steps or announced their intentions to launch a CBDC in the future (Desouza and Ye, 2019). In this context, the first two essays studies the welfare and macroeconomic implications of the central banks using a financial innovation like CBDC as a secondary monetary policy instrument. The third and final essay deviates from financial innovation to a framework of technological innovation where firms create new patents through Research and Development (R&D). Chapter 1 examines the economic consequences of an interest-bearing design of CBDC, and extend the discussion to an open-economy context with trade and capital flows. Through the lens of a dynamic stochastic general equilibrium (DSGE) model, the study simulate a baseline scenario which resembles a cash economy, and two counter-factual scenarios associated with interest-bearing CBDC — the price rule and the quantity rule regimes. The simulations show that 1) the price rule regime is welfare-improving; 2) the adjustable interest rate on CBDC causes uneven distributional effects between households and financial investors; and 3) macroeconomic stability is enhanced with the adjustable interest rate. Chapter 2 investigates the macroeconomic consequences of implementing an interest-bearing CBDC in the monetary policy framework of an emerging market economy. The model setup in chapter 2 deviates from chapter 1 in terms of; a) households buy both domestic and imported consumption goods using CBDC b) firms use labour alone as the factor of production c) central bank use CBDC interest rate (price rule) to target CPI inflation instead of domestic price inflation d) central bank engages in sterilised foreign exchange (FX) intervention to target exchange rate. The study simulate a baseline cash economy, a cash economy with FX intervention and a CBDC economy with FX intervention. The simulations show that 1) interest-bearing CBDC is welfare improving for an emerging market economy; 2) the adjustable interest rate on CBDC causes uneven distributional effects between households and financial investors; and 3) exchange rate management becomes even more effective when interest-bearing CBDC interacts with sterilised FX intervention. Chapter 3 deviates from the framework of CBDC to a production based asset pricing model where innovation is driven by firms through R&D. Chapter 3 examines the implications of wage inertia on macroeconomic aggregates and asset prices in a production economy where growth is endogenously determined by innovation as developed by Kung and Schmid (2015). Wage inertia such as wage stickiness with endogenous labour supply (Uhlig, 2007; Donadelli and Gruning, 2016) and search and matching models with Nash and with alternative offer bargaining (AOB) (Christiano et al., 2016) are incorporated in the Kung and Schmid (KS) model. Following a positive productivity shock, the AOB model shows a) labour market and asset pricing moments are closer to the data compared to other types of wage inertia models and the benchmark KS model b) the impulse response of dividends is larger – and closer to the data - under AOB compared to the other models since wages rise the least, as labour, vacancies and unemployment are more responsive following a positive productivity shock.

The Dangers of an Extended Period of Low Interest Rates: Why the Bank of Canada Should Start Raising Them Now

This study investigates the causal relationship between financial innovation (FI) as proxied by the bank credits to private sector, as percentage of GDP and economic growth in case of Azerbaijan using annual data covering the period from 1992 to 2018. For this purpose, the Toda–Yamamoto causality test with the framework of vector autoregressive (VAR) model is utilized to test causal relationship between the variables. The estimation results reveal that there is bidirectional causal relationship between FI and economic growth. The findings of the study suggest the researchers and policy makers to understand the role of FI in economic growth for macroeconomic stability and sustainable development purposes in Azerbaijan and other developing oil-rich countries.

Asset Price movements indicate financial health of an economy because of the serious affects these have on financial indicators. This study is carried out to see the behaviour of asset price movements in different time horizons in the presence of leading economic indicators. The objective of this study is to track asset price movements and the impact of economic indicators on asset prices in different time horizons. This study intends to find out the appropriate time horizon for predicting asset price buildup that can lead to a potential financial crisis. Uni-variate and Multi-variate Logit Regression Analysis is performed in this study to be applied in four different time horizons. Results show that Real Gross Domestic Product, Credit to private sector, Interest rates of Long and Short term, Gross Domestic Product-deflator, the Consumer Price Index, Real effective exchange rates and nominal effective exchange rates are the significant early warning indicators for predicting the future financial crisis in the economy of Pakistan in longer time horizon as they affect asset price buildup in the long time periods. This study shows that asset prices contain more information in long run and can be effectively used as a tool to predict financial crises due to asset price misalignments