Question 1

The debate discusses, in the wake of the Global Financial Crisis and reflecting on similar economic crises from the past including the dot com bubble and the economic crisis in Asia the issues associated with former and current policy regulating financial markets. The debate focuses on the policies that have and could have been implemented and the mechanisms that should be introduced in order to rectify what appears to be market failure in the financial markets that allowed these crises to happen. In particular, the GFC is the central focus as both the latest and largest crisis in recent history, exploring how and why it occurred and what can be done to try and prevent it from occurring again.

Question 2

The relationship between nominal and real interest rate is a difference of inflation, more formally defined by the Fischer equation: \(n = (1+r) \times (1+i)\).

The relationship between expected inflation and actual inflation is the difference between economic expectations and reality. As long as most assumptions about inflation expectations hold, \(E(i) \approx i\).

The relationship between interest rates and expected inflation is that interest rates will use expectations when calculating nominal and real interest rates. Therefore the nominal interest given will be defined as \(n^* = (1+r) \times (1+E(i))\), where \(n^*\) represents expected nominal interest. If there is a large discrepancy between \(n^*\) and \(n\), it can cause severe issues as the economy must revise the value of investments, which could cause major issues including the possibility of recession due to the sudden ‘disappearance’ of value from the market.

Question 3

An asset bubble refers to an inflation of asset prices in a particular market above the normal expectations, usually induced by some external factor such as low interest rates. In the case of the asset bubble of the American housing market, the inflation arose due to an increase in demand as a direct result of the historically low interest rates allowing for cheap borrowing, a lack of desirable yields in safer alternate investments such as treasury bonds and the quest for investors to find greater and greater yields.

The effect before an asset bubble bursts is an inflation in prices, whilst after the burst prices in the market drop significantly and suddenly due to both a natural downward revision to more stable prices and a further reduction in price due to reduced demand resulting from the sudden losses in the market due to large investment in assets valued using time-value of money. Specifically, the change in expected yield causes a change in the calculated price of the asset, effectively wiping value from the market in an instant.

Question 4

The example that Professor McKibbin gives is the Australian mining tax, stating that the policy is badly designed as it made assumptions about the continuation of the mining boom; the legislation was otherwise effectively useless but would still have allocated projects that would be funded by the revenue from the legislation, even if that revenue were to hit 0. In relation to the GFC, the increase in the quota of low-income individuals that GSE’s (Government sponsored Enterprises) had to provide services to may have been a contributing factor, as these individuals were likely in the category of ‘sub-prime mortgages’ which has been suggested as being one of the key triggers of the GFC.

Question 5

The Basel III Accord are measures in which to regulate banks to encourage stronger banking liquidity and reduce leverage in banks. The strength of this accord is that it encourages banks to hold more liquid assets and be better prepared for economic shocks than previous regulations required. The major weakness is that it is built on the foundation of the current system, particularly credit ratings which the GFC proved are likely flawed due to market pressures forcing credit rating agencies to give higher credit ratings than an asset may be normally rated (an issue of ‘if we don’t get the credit rating we want, we’ll go to your competitor’; not the best way to get an accurate credit rating). It is unlikely that the Basel III Accord would be effective in preventing another large shock as it does not produce a disincentive for risk-taking behavior. A way to prevent excess leverage would be to forcibly divide up the banks into smaller institutions, removing the ‘too-big-to-fail’ issue that encourages excessive risk-taking out of the equation. This would allow the market to more accurately measure risk and prevent its own demise as the possibility of government intervention would no longer be factored into the risk profiling of investments.

Question 6

‘Too-big-to-fail’ is a termed coined to describe the issue of firms being far too influential to be allowed to fail. The big banks in America, if they were to fail could wreak havoc on the American economy even further than the damage that had already been done, and thus to prevent further damage to the economy the government was effectively coerced into bailing them out. It is likely the banks considered this within their risk strategies, allowing them to take larger risks than smaller firms could take as they were effectively unable to suffer from a catastrophic loss due to their integral role in the economy. Dividing up the larger banks into smaller institutions and regulating the maximum size of banks could be an effective measure to prevent the kind of risk-taking behavior the larger banks took prior to the GFC.

Question 7

The difference between the shocks is the impact they have on the economy and the appropriate responses. The Asian financial crisis caused a large surge of investment movement out of Asia as the relative price shock caused investors to panic. This caused a large flow of capital into the American financial markets that increased overall investment in the American economy. The dot com bubble crisis caused stock prices to crash as investors panicked fearing that the effects could spread. This caused a shift in investment towards other assets. In each case the reaction to the shock has caused as much damage to the economy as the shock itself. The shocks to the economy over time funneled investors in the American market into the housing markets and the infamous “CDO’s” that eventually became one of the major contributing factors to the GFC.

Question 8

Professor McKibben discusses that the global fiscal policy response was somewhat effective in reducing the impact of the GFC on the global economy due to the simultaneous fiscal policy shifts that occurred in response to the GFC. He effectively states that monetary policy was ineffective during the GFC and seems to hold strong views that monetary policy is an inappropriate tool for combating economic downturns and should be isolated to smaller scale issues such as smoothing business cycles.

Initially if we assume the economy is at point \(AD_1\) that experiences a shock that shifts to \(AD_2\), we would like to see fiscal policy restore back to \(AD_1\). In reality, we’re more likely to observe a shift to \(AD_2\), which is closer to what has occurred as limitations on fiscal policy in America due to low interest rates has created an effective limit as the interest rate can only drop so far. This cap has created a shift towards \(AD_3\), which is more desirable than \(AD_2\) but does not restore the long-run equilibrium at \(AD_1\) as would normally be desired. This is one of the key concerns that Professor McKibbin raised; that fiscal policy was ineffective at restoring equilibrium. I am inclined to agree; the low interest rates in America created a dangerous situation where fiscal policy had minimal room to move in the event of an economic downturn. Monetary policy could be used to offset the difference theoretically, but it would be quickly drowned out due to the open nature of the economy. What is not modeled in this AS-AD model is the significant impact the GFC had on risk assessment; this diminishes any effect that fiscal and monetary policy might have compared to expected outcomes as the market completely re-evaluates assets and credit is restricted or freezed entirely. Fiscal policy is effectively powerless to change these views as they are linked to behavioral issues rather than monetary issues.

Question 9

Professor McKibbin criticizes the American Federal Reserve Bank for not announcing an inflation target to encourage the economy to spend. An inflation target would discourage consumers from holding onto highly liquid assets and invest in order to gain returns on their currency rather than see it devalue from inflation. Many investors held onto cash and other liquid assets in the fear that another crash may occur and thus were preparing themselves for the worst. This restricts the amount of investment in the economy as less liquid assets are not invested in giving less security to go ahead with projects that could generate far more returns than the highly liquid assets currently being held.

Question 10

Professor McKibbin argues that, in the face of globalization individual government fiscal policy is ineffective as the global market will quickly adjust and will severely diminish if not entirely nullify the effects of the fiscal policy. Under a fixed exchange rate, the central bank is required to buy and sell currency according to global demand; this interferes with independent monetary policy and thus renders it difficult to use monetary policy as a means of economic intervention. Fiscal policy under fixed exchange rate is effective, but the inability for capital to flow freely is detrimental to the long-term forecasts of the economy. A floating exchange rate allows for free capital flow and independent monetary policy, but is weak to external forces. Both monetary and fiscal policy have minimal effect in a floating exchange, as the demand for currency can quickly adjust.

Question 11

Professor McKibbin responds that the problems of the US economy is “pretty sound” with a rationale that the US economy is inventive and flexible; given the right incentives the markets can correct itself as the American economy is both strong and at the forefront of the technological frontier. This can be illustrated with the use of a Solow-Swan model:

Although simplistic (the real economy has many more factors and is much more complicated) it does illustrate the basic concept. The original trajectory of the economy, \(y\) shows overall GDP growth without the GFC. The second projection, \(y_1\) illustrates a shock to the economy such as the GFC. As the model illustrates, the economy eventually converges back to similar growth levels, which is approximately what Professor McKibbin is arguing when he speaks about the US economy. The final projection, \(y_u\) shows a technology shock, which is unrelated to the GFC and is simply shown for the purpose of illustrating what kind of shock would be required to have a permanent effect on long-term GDP growth.

Question 12

A major contributing factor to the GFC and other economic crises seems to be overvaluation in financial markets and lack of regulation to prevent such overvaluations. Particular in reference to the GFC, one of the key issues that allowed such large overvaluations was economic pressure on credit rating agencies to issue AAA ratings to CDO’s (Collateral Debt Obligations) that otherwise should not have been issued AAA ratings. One policy that could rectify this is to require an independent, government-run organization to randomly evaluate assets and determine if they’ve been correctly rated. If the credit rating is found to be outside of a margin of error, then action would be taken to revise the credit rating of the asset and some form of disciplinary action be taken against the credit rating agency in question. Additionally, introducing a mechanism that disincentivises the risk-taking habits of the large banks that was prominent prior to the GFC, either through some form of monetary payment such as taxation or regulation would assist in preventing another economic crisis of a similar nature from repeating itself.