Literature on the financial system discusses two ways that crises come about: price inflation of assets followed by deflation; or a bank run causing a cascade of bank failures, destabilizing the entire banking system.
Speculative bubbles in the financial market nucleate and grow when a difference is created between the intrinsic value of an asset and the price at which it is traded.
In efficient, complete markets, the value of assets is strictly linked to the discounted cash flow of future payoffs. Prices respond immediately to new information from the market and are unaffected by the quantities bought and sold. The liquidity of the market ensures coherence among valuations that depend on intrinsic value and market price via the principle of arbitrage (Conant 1905; Fama 1970).
In a speculative bubble, the asset is purchased regardless of the value determined by the discounted cash flow of future payoffs because the buyer hopes to sell it at a higher price in the future. Variations in the degree of rationality of the players and uneven distribution of information produce different patterns and equilibria (Brunnermeier and Oehmke 2013). In any case, the probability distribution that influences the valuation appears to be extrinsic both to the market and to the larger economy. The divergence from an appropriate assessment appears to be triggered by a variable of dubious economic significance. Critics of the concept of rationality and efficiency of financial markets underscore the importance of psychological elements that they explain as the irrational exuberance of investors (Shiller 2005; Akerlof and Shiller 2009).
An element extrinsic to the dynamics of the economy is also found in models that seek to explain bank runs (Diamond and Dybvig 1983). The banks respond to the publicās need for liquidity by issuing deposits that can be converted into cash while investing in illiquid assets that cannot easily be rendered liquid on the market. The transformation of mature assets and the deadlines implicit in the bankās assets and liabilities balance expose the bank to the risk of a run.
The public is composed of agents with different preferences. Some are patient, others are impatient. No one knows ahead of time what his or her preferences will be in the future. It is thus in the interest of all agents to have an insurance mechanism that guarantees the necessary liquidity to the impatient consumer manifesting a preference. The banking system achieves a positive equilibrium when the demand for liquidity derives only from impatient consumers. If, on the other hand, the patient consumers find themselves forced to hasten their conversion decisions, fearing a similar behavior on the part of other patient consumers, the banking system would be forced to liquidate its long-term assets and eventually fail, because it would not be able to satisfy a widespread demand for liquidity.
The patient consumer feels obliged to demand liquidity sooner because the banks act on a first-come, first-served basis. The sequential nature of conversion drives impatient consumers to demand liquidity once their preferences have been revealed; the patient consumers imitate them, fearing that other consumers sharing their preferences will beat them to it. In these models, no information is available regarding the position of the consumer in the line to obtain liquidity and no rationing mechanisms are provided to regulate the request for conversion in proportion to the amount of funds on deposit.
A similar model can be constructed, mutatis mutandis, regardless of preferences, if we introduce the distinction between informed and non-informed consumers (He and Xiong 2012; He and Asaf 2014). If the stock of information does not increase, the convictions vis-Ć -vis the solvency of a bank remain stable within normal time limits and there is no possibility of a bank run. When new information is acquired by investors, the reaction will differ depending on how this information is classified and transformed into a new valuation. The information may increase fears of some investors regarding the solvency of a bank while others may assess the situation differently. However, fearing a bank run by the former, the latter choose to withdraw their investment to make sure others donāt beat them to the punch. The fear of a negative assessment by a group of investors may expose a solvent but illiquid bank to the risk of a bank run.
The extrinsic element in this case is the information on the status of the bank and the banking system, the way it is assessed, and the time it takes different groups of investors to assimilate it.
Interpretive models of financial crises are thus based on extrinsic elements, sunspot equilibria, self-fulfilling prophecies, and second-guessing the expectations of others. There is a grain of truth in all this, but it precludes the possibility of analyzing how instability is generated within financial markets and the incentives motivating the various players.
An analysis of the crises in the US financial market appears to offer a more complex interpretive key regarding the instability of the financial system, which allows us to circumscribe the random variables that do not have a meaningful relation to macroeconomic and financial variables and thus give more space to explanations of the intrinsic dynamics of the financial system. This may also bring improvement in how regulation can be brought to bear, in an appropriate, targeted way, on the fragility of the financial system, on its functions rather than its institutions.
This objective can be achieved by accounting for three elements that are usually ignored in current analyses:
- a.monetary policy plays a relevant role in both expanding and contracting financial cycles;
- b.non-bank financial brokers (broker-dealers, investment banks ) play a key role in transmitting the positive and negative effects of monetary policy . These brokers use means of financing that are different from those used by commercial banks , they deal with the wholesale liquidity of the financial system and display high sensitivity to variations in the interest rate;
- c.banks, financial markets , and non-bank financial brokers are not mutually independent. The dynamics of their relations are important in understanding the development of financial crises.
These three factors are a permanent characteristic of the US financial system, as well will see in our analysis of the crises of 1907, 1929, and 2007ā2008.
The idea that monetary policy shaped by the Taylor rule can create financial instability by keeping interest rates too low for too long has been developed recently by Borio and Zhu (2013), Adrian and Shin (2010), and Stein (2014) and has proven useful in explaining previous crises. The effects of monetary policy on non-bank financial brokers are either ignored or marginalized in the analyses of economists, even though an awareness of the connection was elucidated well over a century ago (Bagehot 1873). Non-bank financial brokers stand at the center of the money market and handle surplus liquidity that is systematically created by the financial system, absorbing this liquidity by issuing short-term liabilities that are used to finance the acquisition of long-term assets.
The banking system āproducesā new credit and corresponding deposits. The expansion of a commercial bankās assets generates deposits. The non-bank financial brokers offer credit at a certain interest rate, seeking to finance this credit on the money market at a lower interest rate.
Expansionary monetary policy at low interest rates stimulates the expansion of credit, expands non-bank brokerage, and tends to increase the cost of financial assets. Restrictive monetary policy , on the other hand, compresses the balance sheets of broker-dealers (Adrian and Shin 2008). Restrictive monetary policy and credit shrinkage reduce the value of financial assets; the bursting of a speculative bubble is not the unexpected outcome of a process driven by irrational exuberance, it is the outcome of a systematic, progressive increase in interest rates , which the central banks have often used to interrupt a boom cycle on the financial markets (denying the need and the possibility of intervention).
Such restriction causes prices of financial assets to fall and interest rates to rise, reducing the profitability of the brokerage process and the amount of liquidity on the market, forcing players to sell financial assets, triggering a downward spiral.
The effects of the dynamic relationship between interest rate and monetary policy are reflected in the risk premium. The risk premium is not a stable variable (Adrian and Shin 2010); its oscillation and the effects of this oscillation on the value of financial assets are closely related to monetary policy. The risk premium tends to shrink under expansionary monetary policy and expand when it becomes restrictive. The volatility of the interest rate amplifies the instability of the financial system.
Exploring the dynamics of financial markets by analyzing the role that they play within the overall economic system and getting beyond the idea that these markets can be explained exclusively in terms of speculative intent is important to understanding the behavior of real markets and explaining how levels of production and employment are determined. Macroeconomic theory struggles to grasp this connection because current models view financial markets as mechanisms capable of redistributing consumption over time. They are seen as not affecting production levels or equilibrium conditions in the labor market. They are viewed as being neutral, in a certain sense, with respect to the real economy by virtue of their structure and regardless of the Modigliani-Miller theorem.
Efforts are needed to get beyond this separation. The work below is intended as a contribution in this direction.
Bibliography
- Adrian, T., & Shin, S. (2008). Financial intermediaries, financial stability, and monetary policy (Staff Reports 346). Federal Reserv...