Arestis karakitsos financial stability in the aftermath of the great recession (2013)

Financial Stability in the Aftermath of the ‘Great Recession’ Financial Stability in the Aftermath of the ‘Great Recession’ Philip Arestis University of Cambridge, UK Elias Karakitsos Global Economic Research LLC © Philip Arestis and Elias Karakitsos 2013 Softcover reprint of the hardcover 1st edition 2013 978-1-137-33395-7 All rights reserved No reproduction, copy or transmission of this publication may be made without written permission No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6–10 Kirby Street, London EC1N 8TS Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988 First published 2013 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS Palgrave Macmillan in the US is a division of St Martin’s Press LLC, 175 Fifth Avenue, New York, NY 10010 Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries ISBN 978-1-349-46247-6 DOI 10.1057/9781137333964 ISBN 978-1-137-33396-4 (eBook) This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin A catalogue record for this book is available from the British Library A catalog record for this book is available from the Library of Congress Contents List of Figures and Tables vi Introduction Origins of the ‘Great Recession’ 13 The Theoretical Framework That Underpins the Origins of the ‘Great Recession’ 41 Too Much Liquidity: The Source of the Trouble 64 Anaemic Recovery: The US Housing Market and the Consumer 88 Anaemic Recovery: The Vicious Circle of Consumption and Investment 111 The Sovereign Debt Crisis 140 Lessons From the ‘Great Recession’ for Both Theory and Economic Policy 164 Financial Stability and Proposals to Restore It 193 Notes 227 References 240 Index 253 v List of Figures and Tables Figures 2.1 UK wages as a percentage of GDP 2.2 UK wages relative to productivity 2.3 Percentage deviation of real wage rate from productivity (January 1968 = 100) and unemployment 2.4 Compensation of employees and its components 2.5 Corporate profits as percentage of nominal GDP 3.1 Steady state 4.1 US GDP 4.2 Japan – money supply M2 + CD % YoY 4.3 China, monetary financial institutions, uses of funds, loans, growth rate, Chg Y/Y 4.4 Liabilities of shadow and traditional banking 4.5 Growth of assets of four sectors in the USA (in logs 1954 = 1) 4.6 Asset leverage of investment banks 4.7 Corporate credit risk 4.8 Banking credit risk (libor OIS vs libor repo) 4.9 Output gap and potential output 4.10 Interest rate, inflation and real profit rate 4.11 Response to a highly leveraged economy 4.12 CRB index 4.13 China – real GDP and construction 4.14 Equity market value 4.15 Composite risk premium 4.16 Long-term valuation of equities 4.17 Real S&P 500 (2008 prices) 5.1 Real residential investment as a percentage of real GDP 5.2 Relative median price – existing homes 5.3 New homes sales 5.4 Sales of existing homes 5.5 Home mortgages % YoY 5.6 Debt service burden 5.7 Median price of existing homes relative to nominal per capita disposable income 5.8 Gross, net real estate of households and mortgage debt 5.9 Months’ supply of homes on market 5.10 Consumption, income, savings and wealth 6.1 Gross private domestic investment vi 15 16 16 17 17 61 66 68 68 71 71 72 73 74 77 78 80 81 81 85 85 86 86 96 96 97 98 99 102 102 103 107 108 113 List of Figures and Tables 6.2 6.3 6.4 6.5 6.6 6.7 6.8a 6.8b 6.9 6.10 6.11 6.12 6.13 6.14 6.15 6.16 6.17 6.18 7.1 7.2 7.3 7.4 7.5 7.6 7.7 8.1 8.2 8.3 8.4 8.5 8.6 8.7 Real investment YoY Investment as a percentage of GDP Inventory-to-sales ratio in manufacturing Total industrial production percentage YoY Consumption percentage YoY Capacity utilisation in manufacturing Total profits NFC percentage YoY Corporate sector pre-tax profits as a percentage of GDP Unit labour cost percentage YoY Corporate sector net worth as percentage of GDP Corporate sector debt as percentage of GDP Corporate debt percentage YoY Degree of debt leverage: Corporate sector debt as a percentage of internal funds Long-term debt (securities & mortgages) to total debt Spread between AAA yield and prime lending rate Spread between Baa yield and prime lending rate Interest payments as a percentage of net cash flow Gross, net real estate of households and mortgage debt US and EU OIS spread Spread between 3M Libor and 3M CD Banking credit risk (Libor OIS vs Libor repo) EU carry-to-risk ratio Corporate credit risk Budget deficit as a percentage of GDP Current account surplus/deficit as a percentage of GDP Fed portfolio (SOMA) and components Liquidity lending facilities Fed assets – credit and SOMA Monetary base and bank deposits at the fed Monetary aggregates Financial markets liquidity (fed credit less deposits at the fed) Non-bank private sector liquidity vii 114 117 118 119 119 120 122 122 123 125 126 126 128 129 130 131 132 135 153 155 155 156 157 158 160 177 178 178 179 180 181 181 Tables 5.1 Existing home sales 6.1 Percentage change over three quarters leading up to trough 106 116 Introduction 1.1 The purpose of the book The 1990s was seen as probably the best decade since the 1960s; it was heralded as the beginning of a new era based on the success of the capitalist system The success of the 1990s was attributed to free markets, which, it is claimed, produced an optimal allocation of resources The neoliberal, model along with the Efficient Markets Hypothesis and the new consensus macroeconomics models, were credited with the success The US economy expanded for a period of ten years, the longest ever recorded by an industrialised country The macroeconomic performance was stunning: both inflation and unemployment fell to new lows and short- and longterm interest rates fell to levels that had not been observed since the 1960s The stock market produced enormous gains, particularly in the areas of technology, media and telecommunications There was widespread acceptance of the idea that this time was different The enthusiasts dubbed it the ‘new economy’ where seemingly large productivity gains increased the rate of growth of potential output, thereby making possible the reduction in inflation and unemployment.1 Yet the optimism did not last With the beginning of the new millennium and, more precisely, in March 2001, the stock market crashed with the Nasdaq suffering unprecedented losses, comparable to those experienced in the 1930s Astute observers remarked that the internet bubble had imploded, but the consensus view was that everything was normal The consensus view gained widespread support as the recession that followed was shallow and short-lived Pundits asserted that had the internet been a bubble, it would have had devastating effects on the economy The small impact of the stock market on the economy was taken as prima facie evidence in support of the view that the internet was not a bubble The fact that the recovery that followed the 2001 recession was anaemic did not cause any concern to the consensus, which continued to hold the view that internet was not a bubble After all, the previous recession in the early 1990s was also anaemic Policy Financial Stability after the ‘Great Recession’ makers and central banks did not react any different than in previous recessions Alan Greenspan, the then Chairman of the Federal Reserve System (Fed), was adamant that there was no reason to change policies Targeting the growth in asset prices would have required the central bank to outsmart investors, a task that was regarded as impossible This led to the emergence of the doctrine that it is better for central banks to deal with the consequences of a bubble than to try to prevent it, which was immediately accepted by almost all of the major central banks But Alan Greenspan fearing the worst reacted with an unprecedented monetary stimulus; the fed funds rate was cut no less than 13 times to per cent from 6.5 per cent With a prodigious fiscal and monetary stimulus, the anaemic recovery finally became sustainable The nightmare of an asset and debt deflation had been averted! However, the new cycle was again short-lived After the boom in 2004, growth slowed to below potential and the USA finally succumbed to recession at the end of 2007 Astute observers again pointed out that what the Fed had achieved was to transform the internet into a housing bubble that would soon burst, dragging the economy to the dreaded asset and debt deflation process that had plagued the US economy in the 1930s and Japan in the 1990s However, such views were brushed aside and policy makers continued with the policy of ‘business as usual’ Alan Greenspan kept interest rates at the per cent level until mid-2004 and then removed the accommodation bias too slowly, thereby fuelling the housing bubble For astute observers the role of the housing market was telling The housing market ameliorated the early 2001 recession thanks to the prodigious monetary stimulus The prognosis was that the bursting of the housing bubble would have a disastrous effect on the stock market Ben Bernanke, Alan Greenspan’s successor at the helm of the Fed, carried on with the same speed in removing the accommodation bias But he was too late in lowering rates by at least eight months High interest rates had already inflicted a terrible blow to the housing market, which had peaked at the end of 2005 Yet up to 2007 the fall in house prices was orderly and the Fed saw no reason to alter the course of its monetary policy The summer of 2007 saw the eruption of the credit crisis and the Fed began a policy of aggressive easing, but it was too late The financial system became insolvent and it had to be bailed out to prevent a complete meltdown The economy fell into a deep decline that was dubbed the ‘great recession’ In March 2009 the Obama Administration made a U-turn in term of its attitude and policies in relation to financial institutions It rejected a House bill that had aimed to tax the bonuses of Wall Street; it adopted a ‘business-as-usual’ model for banks; and it allowed them to price their distressed assets at their own discretion by purging the standard mark-to-market method This boosted confidence, triggering a period of restocking by companies on a worldwide basis With the adoption of substantial fiscal and monetary stimuli by all important governments a recovery emerged But after a year the recovery once again ran out Introduction of steam This led to the development of a sovereign debt crisis in Europe and policy makers adopted austerity measures to deal with the new crisis, thus further undermining the recovery At the time of writing Europe has fallen back into recession and the question now is whether it will drag the rest of the world back into recession Housing was not the only asset bubble Commodities were another bubble that went unchecked in the first half of 2008 when the USA was already in a mild recession This bubble burst when the USA fell off the cliff in the second half of 2008, dragging the global economy into recession With the recovery in 2009 the commodities bubble re-emerged as it was widely believed that China and the other rapidly developing nations, the so-called BRICs,2 could sustain growth even as the western world experienced little or no growth The renewed commodities bubble dealt a terrible blow to BRIC countries as inflation, which had been reignited because of overheating, accelerated to dangerous levels, thereby triggering an aggressively tight monetary policy As a result, the BRIC countries are now slowing rapidly at a time when Europe is falling into recession and the US economy is experiencing only a weak recovery Policy makers have opted for a stricter regulatory environment as a means of preventing another systemic crisis For example, and in the US case, the Dodd–Frank Act, and at the international level the Basel III have emerged, along with similar measures in other countries that will be discussed at length in chapter The purpose of this book is to throw light on the causes of the credit crisis and the ensuing ‘great recession’ It traces the origins of the ‘great recession’ in the USA and outlines the distributional effects, deregulation and financial liberalisation that laid the foundations for the financial engineering, which assumed gigantic dimensions following the repeal of the Glass–Steagall Act in 1999 The book examines the emergence of the excessive liquidity that has financed a series of bubbles over the past ten years But it also investigates the role played by the growing redistribution of income in encouraging excessive leverage in the banking sector which enabled the personal sector to become over-indebted and therefore vulnerable to shocks At a deeper and more theoretical level the book examines the role played by the Efficient Market Hypothesis (EMH) and the New Consensus Macroeconomics in providing the intellectual basis for the neo-liberal model and the policies pursued by central banks and the fiscal authorities It deals with the issue of whether such conduct of monetary policy leads to instability and how future monetary policy should be formulated to avoid the mistakes of the past Furthermore the book examines the reasons for the anaemic recovery and compares and contrasts it with the anaemic recovery of the two previous cycles It also investigates the sovereign debt crisis that has plagued Europe and why it has developed there rather than in the USA It also considers the contagion channels from the euro area debt crisis 246 References Goodhart, C.A.E (2009b) ‘The Continuing Muddles of Monetary Theory: A Steadfast Refusal to Face Facts’, in E Hein, T Niechoj and E Stockhammer (eds), Macroeconomic Policies on Shaky Foundations – Whither Mainstream Economics?, Marburg: Metropolis-Verlag Goodhart, C.A.E (2010) ‘Banks Survival Rates Should Improve with Living Wills’, Financial Times, 10 August Gorton, G (2010) ‘Questions and Answers about the Financial Crisis’, prepared for the US Financial Crisis Inquiry Commission, February Available at: http://www ssrn.com/abstract=1557279 Grebler, L., Blank, D.M and Winnick, L (1956) Capital Formation in Residential Real Estate, Princeton, NJ: NBER and Princeton University Press Greenlaw, D., Hatzius, J., Kashyap, A.K and Song Shin, H (2008) ‘Leveraged Losses: Lessons from the Mortgage market Meltdown’, in Proceedings of the U.S Monetary Policy Forum, Chicago: US Monetary Policy Forum, pp 7–59 Greenspan, A (1999) ‘Mortgage Markets and Economic Activity’ Remarks Before a Conference on Mortgage Markets and Economic Activity, Sponsored by America’s Community Bankers, Washington DC, November Greenspan, A (2002) ‘Issues for Monetary Policy’ Remarks Before the Economic Club of New York, New York City, 19 December Available at: http://www.federalreserve gov/boarddocs/speeches/2002/20021219/ (pages in the text refer to the website document) Greenspan, A (2004) ‘Government-Sponsored Enterprises’, Testimony of Chairman Alan Greenspan, Before the Committee on Banking, Housing, and Urban Affairs, US Senate, February Greenspan, A (2005) ‘Reflections on Central Banking’ Paper presented at ‘The Greenspan Era: Lessons for the Future’, a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 25–7 August Greenspan, A (2009) ‘Greenspan’s Libor Barometer Shows Markets Stay Frozen (Update3)’, Bloomberg, 23 February Greenspan, A (2010) ‘The Crisis’ Available at: http://www.brookings.edu/∼/media/ Files/Programs/ES/BPEA/2010_spring_bpea_papers/spring2010_greenspan.pdf Greenspan, A and Kennedy, J (2005) ‘Estimates of Home Mortgages Originations, Repayments and Debt on One-to-Four Family Residences’, Finance and Economics Discussion Series, 2005-41, Board of Governors of the Federal Reserve System, September Haldane, A.G (2010) ‘The $100 Billion Question’ Speech at the Institute of Regulation & Risk, North Asia (IRRNA), Hong Kong, 30 March 2010 Available at: http:// www.bankofengland.co.uk/publications/speeches/2010/speech433.pdf Haldane, A.G (2011) ‘Capital Discipline’ Presented at the American Economic Association, Denver, USA, January 2011 Available at: http://www.bankofengland.co uk/publications/speeches/2011/speech484.pdf Hansen, S.G., Kashyap, A.K and Stein, J.C (2011) ‘A Macroprudential Approach to Financial Regulation’, Journal of Economic Perspectives, 25(1), 3–28 Hatzius, J (2005) ‘Housing Holds the Key to Fed Policy’, Goldman Sachs Global Economics, Paper No 137 He, J., Qian, J and Strahan, P.E (2011) ‘Credit Ratings and the Evolution of the Mortgage-Backed Securities Market’, American Economic Review: Papers & Proceedings, 101(3), 131–5 Himmelberg, C., Mayer, C and Sinai, T (2005) ‘Assessing High House Prices: Bubbles, Fundamentals, and Misperceptions’, Journal of Economic Perspectives, 19(4), 67–92 References 247 HM Treasury (2010) ‘A New Approach to Financial Regulation: Judgement, Focus and Stability’ Available at: http://www.hm-treasury.gov.uk/d/consult_financial_ regulation_condoc.pdf Hubbard, R.G (1998) ‘Capital-Market Imperfections and Investment’, Journal of Economic Literature, 36(1), 193–225 IIF (2010) Systemic Risk and Systemically Important Firms: An Integrated Approach, May, Institute of International Finance Inc.: The Global Association of Financial Institutions Independent Evaluation Office (IEO) (2011) ‘IMF Performance in the Run-Up to the Financial and Economic Crisis: IMF Surveillance in 2004–07’ Available at http:// www.ieo-imf.org/eval/complete/eval_01102011.html IMF (2007) World Economic Outlook, April 2007, Washington, DC: International Monetary Fund Available at http://www.imf.org/external/pubs/ft/weo/2007/01/ index.htm IMF (2009) World Economic Outlook, October 2009, Washington, DC: International Monetary Fund Available at: http://www.imf.org/external/pubs/ft/weo/2009/02/ index.htm IMF (2010a) World Economic Outlook, April 2010, Washington, DC: International Monetary Fund Available at: http://www.imf.org/external/pubs/ft/weo/2010/01/ index.htm IMF (2010b), ‘A Fair and Substantial Contribution by the Financial Sector’, Interim Report for the Meeting of the G20 Ministers, 16 April 2010, Washington, DC: International Monetary Fund IMF (2010c) ‘Central Banking Lessons from the Crisis’, Monetary and Capital Markets Department, 27 May 2010, Washington, DC: International Monetary Fund IMF (2010d) ‘Resolution of Cross Border Banks – A Proposed Framework for Enhanced Coordination’ Available at http://www.imf.org/external/np/pp/eng/ 2010/061110.pdf IMF (2010e) World Economic Outlook, October 2010, Washington, DC: International Monetary Fund Available at http://www.imf.org/external/pubs/ft/weo/2010/02/ index.htm IMF (2010f) ‘Shaping the New Financial System’, IMF Staff Position Note, SPN/10/15, Monetary and Capital Markets Department, October, Washington, DC: International Monetary Fund Available at http://www.imf.org/external/pubs/ft/spn/2010/ spn1015.pdf IMF (2010g), Global Financial Stability Report: Sovereigns, Funding, and Systemic Liquidity, October 2010, Washington, DC: International Monetary Fund Available at http:// www.imf.org/external/pubs/ft/gfsr/2010/02/index.htm Independent Commission on Banking (ICB) (2010) ‘Issues Paper’, 24 September Available at: http://bankingcommission.independent.gov.uk/ Independent Commission on Banking (ICB) (2011a) Independent Interim Report: Consultation on Reform Options, Independent Commission on Banking: London Available at http://bankingcommission.independent.gov.uk/ Independent Commission on Banking (ICB) (2011b) ‘Final Report Recommendations’, September Available at http://bankingcommission.independent gov.uk/ Independent Commission on Banking (ICB) (2011c) Final Report Publication 12 September 2011 Opening Remarks, Independent Commission on Banking: London Available at http://bankingcommission.independent.gov.uk/ Inside Mortgage Finance Publications (2009) The 2009 Mortgage Market Statistical Annual, Bethesda, Maryland: Inside Mortgage Finance Publications, Inc 248 References International Swaps and Derivatives Association (ISDA) (1999) “Credit Derivative Definitions” Available at https://encrypted.google.com/search?hl=es& source=hp&biw=1660&bih=804&q=International+Swaps+and+Derivatives+ Association+%28ISDA%29+%281999%29%2C+%E2%80%9CCredit+Derivative+ Definitions%E2%80%9D+&oq=International+Swaps+and+Derivatives+ Association+%28ISDA%29+%281999%29%2C+%E2%80%9CCredit+Derivative+ Definitions%E2%80%9D+&aq=f&aqi=&aql=undefined&gs_sm=e&gs_upl= 3391l3391l0l1l1l0l0l0l0l219l219l2-1l1 Jorgenson, D (1963) ‘Capital Theory and Investment Behaviour’, American Economic Review, 53(May), 247–59 Jorgenson, D (1971) ‘Econometric Studies of Investment Behaviour: A Survey’, Journal of Economic Literature, 53, 1111–47 Karakitsos, E (2008) ‘The “New Consensus Macroeconomics” in the Light of the Current Crisis’, Ekonomia, 11(2), 89–111 Karakitsos, E (2009) ‘Bubbles Lead to Long-term Instability’, in Giuseppe Fontana, John McCombie and Malcolm Sawyer (eds), Macroeconomics, Finance and Money: Essays in Honour of Philip Arestis, Basingstoke: Palgrave Macmillan, pp 179–95 Karakitsos, E (2011) ‘Monetary Policy in Asset and Deflation Cycles’, Global Economic Research, Issue No 338 London Karakitsos, E (2012) ‘The EU Debt Crisis: Is There a Solution?’, Keynote Address, Financial Markets Law Committee, Sovereign Debt Seminar, Bank of England, February Karakitsos, E and Rustem, B (1984) ‘Optimally Derived Fixed Rules and Indicators’, Journal of Economic Dynamics and Control, 8(1), 33–64 Karakitsos, E and Rustem, B (1985) ‘Optimal Fixed Rules and Simple Feedback Laws in the Design of Economic Policy’, Automatica, 21(2), 169–80 Karakitsos, E and Scheunpflug, I (1998) ‘An Intertemporal Model of Asset Demand Functions with Leverage in the Business Cycle’, Global Economic Research, Issue No 223, 1–12 Kaufman, M and Mühleison, M (2003) ‘Are U.S House Prices Overvalued?’, IMF Staff Country Report No 03/245, United States, 2003, Washington, DC: International Monetary Fund Keynes, J.M (1936) The General Theory of Employment, Interest, and Money, London: Macmillan Keynes, J.M (1980) ‘Activities, 1940–1946: Shaping the Post-War World: The Clearing Union’, Collected Writings Vol 25, London: Macmillan Khan, M.S and Senhadji, A.S (2001) ‘Threshold Effects in the Relationship between Inflation and Growth’, IMF Staff Papers, 48(1), 1–21 Kiff, J (2010) ‘Reducing Role of Credit Ratings Would Aid Markets’, IMF Survey Magazine: IMF Research, 29 September, Washington DC: International Monetary Fund Available at http://www.imf.org/external/pubs/ft/survey/so/2010/res092910.htm King, M (2005) ‘Monetary Policy: Practice Ahead of Theory’, Mais Lecture, Cass Business School, City University, London King, M (2009) Speech at the Lord Mayor’s Banquet for Bankers and Merchants of the City of London at the Mansion House, 17 June Available at http://www bankofengland.co.uk/publications/speeches/2009/speech394.pdf King, M (2010a) Speech at the University of Exeter, 19 January 2010 Available at http://www.telegraph.co.uk/finance/economics/7033318/Bank-of-EnglandGovernor-Mervyn-Kings-speech-key-points.html References 249 King, M (2010b) ‘Banking: From Bagehot to Basel, and Back Again’, The Second Bagehot Lecture, Buttonwood Gathering, New York City, 25 October Available at http://www.bankofengland.co.uk/publications/speeches/2010/speech455.pdf King, M (2012) Speech at the 2012 BBC Today Programme Lecture, May Available at http://www.bankofengland.co.uk/publications/Documents/speeches/2012/ speech567.pdf Klein, R and Juhle, D (2010) ‘Majority Rules: Non-Cash Bids and the Reorganization Sale’, American Bankruptcy Law Journal, 84, 297–326 Krugman, P (2009) ‘How Did Economists Get It So Wrong?’, New York Times, September Available at http://www.nytimes.com/2009/09/06/magazine/ 06Economic-t.html?pagewanted=8 Lacker, J.M (2010) ‘Reflections on Economics, Policy and the Financial Crisis’ Speech to the Kentucky Economic Association, Frankfort, KY, 24 September Available at http://www.richmondfed.org/press_room/speeches/president_jeff_lacker/2010/ lacker_speech_20100924.cfm Lacker, J.M (2011) ‘Innovation in the New Financial Regulatory Environment’, Speech to the Ferrum College Forum on Critical Thought, Innovation and Leadership, April Available at http://www.richmondfed.org/press_room/speeches/president_ jeff_lacker/2011/lacker_speech_20110407.cfm Lawrence, M., Bernstein, J and Shierholz, H (2009) The State of Working America 2008/2009, Economic Policy Institute, Ithaca, NY: Cornell University Press Leamer, E (2007) ‘Housing Is the Business Cycle’ Paper presented at symposium on The Housing Market, sponsored by the Federal Reserve Bank of Kansas City, 30 August–1 September, Jackson Hole, Wyoming, pp 1–74 Levine, R and Renelt, D (1992) ‘A Sensitivity Analysis of Cross-Country Growth Regressions’, American Economic Review, 82(3), 942–63 Llaudes, R., Salman, F and Chivakul, M (2010) ‘The Impact of the Great Recession on Emerging Markets’, IMF Working Paper WP/10/237, Washington, DC: International Monetary Fund Lusardi, A (1996) ‘Current Income, Permanent Income and Consumption: Evidence From Two Panel Data Sets’, Journal of Business and Economic Statistics, 14(1), 81–90 Martel, R (1996) ‘Heterogeneity, Aggregation, and a Meaningful Macroeconomics’, in D Colander (ed.), Beyond Microfoundations: Post Walrasian Macroeconomics, Cambridge: Cambridge University Press Mayer, C (1994) ‘The Assessment: Money and Banking: Theory and Evidence’, Oxford Economic Review, 10, 1–13 McCarthy, J and Peach, R.W (2002) ‘Monetary Policy Transmission to Residential Investment’, Economic Policy Review, 8(1), 139–58 McCarthy, J and Peach, R.W (2004) ‘Are Home Prices the Next “Bubble”?’, Federal Reserve Bank of New York Economic Policy Review, 10(3), 1–17 McCarthy, J and Peach, R.W (2005) ‘Is There a “Bubble” in the Housing Market Now?’, mimeo, Federal Reserve Bank of New York Available on http://www newyorkfed.org/research/economists/mccarthy/pub.html Merton, R.C (1969) ‘Lifetime Portfolio Selection Under Uncertainty: The Continuoustime Case’, Review of Economics and Statistics, 51, 247–57 Merton, R.C (1971) ‘Optimum Consumption and Portfolio Rules in a Continuoustime Model’, Journal of Economic Theory, 3, 373–413 Meyer, L.H (2001) ‘Does Money Matter?’, Federal Reserve Bank of St Louis Review Quarterly Review, 83(5), 1–15 250 References Miles, D (2010) ‘Monetary Policy and Financial Stability’ Speech at the Bristol Business Forum, 14 July 2010 Available at: http://www.bankofengland.co.uk/ publications/speeches/2010/speech443.pdf Miles, D., Yang, J and Marcheggiano, G (2011) ‘Optimal Bank Capital’, Bank of England Discussion Paper No 31: Revised and Expanded Version, London: Bank of England, External MPC Unit Minsky, H.P (1982) Can ‘It’ Happen Again?: Essays on Instability and Finance, Armonk, NY: M.E Sharpe Minsky, H.P (1986) Stabilizing an Unstable Economy, New Haven, CT: Yale University Press Mishkin, F.S (2007a) The Economics of Money, Banking and Financial Markets, 8th edition, Kansas City: Addison-Wesley Mishkin, F.S (2007b) ‘Housing and the Monetary Transmission Mechanism’, Federal Reserve Bank of Kansas City Annual Conference, Wyoming, 31 August–1 September Mishkin, F.S (2011) ‘Over the Cliff: From the Subprime to the Global Financial Crisis’, Journal of Economic Perspectives, 25(1), 49–70 Modigliani, F and Miller, M (1958) ‘The Cost of Capital, Corporation Finance and the Theory of Investment’, American Economic Review, 48(3), 261–97 Modigliani, F and Miller, M (1963) ‘Corporate Income Taxes and the Cost of Capital: A Correction’, American Economic Review, 53(3), 433–43 Monea, E and Sawhill, I (2010) ‘An Update to “Simulating the Effect of the “Great Recession on Poverty” ’, Brookings, Washington, DC: The Brookings Institution Available at: http://www.brookings.edu/papers/2010/0916_poverty_monea_ sawhill Mundell, R (1961) ‘A Theory of Optimum Currency Areas’, American Economic Review, 51(4), 657–65 Organisation for Economic Co-operation and Development (OECD) (2008) ‘Growing Unequal? Income Distribution and Poverty in OECD Countries’, Country Note: Germany Available at www.oecd.org/els/social/inequality Philippon, T and Reshef, A (2009) ‘Wages and Human Capital in the U.S Financial Industry: 1909–2006’, NBER Working Paper No 14644, Washington, DC: National Bureau of Economics Research Poterba, J (1984) ‘Tax Subsidies to Owner-Occupied Housing: An Asset Market Approach’, Quarterly Journal of Economics, 99 (November), 729–75 Pozsar, Z., Adrian, T Ashcraft, A and Boesky, H (2010) ‘Shadow Banking’, Federal Reserve Bank of New York Staff Report No 458, New York: Federal Reserve Bank of New York, July Reich, R (2010) ‘The Senate Finance Bill Merits Two Cheers’, Financial Times, 24 May Reifschneider, D., Tetlow, R and Williams, J (1999) ‘Aggregate Disturbances, Monetary Policy and the Macroeconomy: The FRB/US Perspective’, Federal Reserve Bulletin, 85 (January), 1–19 Reinhart, C and Rogoff, K.S (2009) This Time is Different: Eight Centuries of Financial Folly, Princeton: Princeton University Press Rotemberg, J.J and Woodford, M (1995) ‘Dynamic General Equilibrium Models with Imperfectly Competitive Product Markets’, in T.J Cooley (ed.) Frontiers of Business Cycle Research, Princeton, NJ: Princeton University Press, pp 243–93 Rotemberg, J.J and Woodford, M (1997) ‘An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy’, NBER Macroeconomics Annual 1997, Cambridge, MA: National Bureau of Economic Research, pp 297–346 References 251 Securities and Exchange Commission (SEC) (2010) ‘Complaint’, 16 April Available at http://www.sec.gov/litigation/complaints/2010/comp21489.pdf Sengupta, R and Tam, U (2008) ‘The LIBOR–OIS Spread as a Summary Indicator’, Federal Reserve Bank of St Louis Economic Synopses, no 25, 1–2 Shiller, R.J (2007) ‘Understanding Recent Trends in House Prices and Home Ownership’, Federal Reserve Bank of Kansas City Annual Conference, Wyoming, 31 August– September Singh, M and Aitken, J (2010) ‘The (Sizeable) Role of Rehypothecation in the Shadow Banking System’, IMF Working Paper WP/10/172, Washington, DC: International Monetary Fund Solow, R.M (2008) ‘The State of Macroeconomics’, Journal of Economic Perspectives, 22(1), 243–6 Soulenes, N (1999) ‘The Response of Household Consumption to Income Tax Refunds’, American Economic Review, 89(4), 947–58 Stiglitz, J (2003) ‘Symposium on Bubbles’, Journal of Economic Perspectives, 4(2), 13–18 Stiglitz, J.E (2011) ‘A Balanced Debate about Reforming Macroeconomics’, iIMFdirect, The International Monetary Fund’s Global Economic Forum, 22 March, Washington, DC: International Monetary Fund Stiglitz, J and Weiss, A (1981) ‘Credit Rationing in Markets with Imperfect Information’, American Economic Review, 71(3), 393–410 Strauss-Khan, D (2011) ‘Global Challenges, Global Solutions’, An Address at George Washington University, Washington: International Monetary Fund, April Available at http://www.imf.org/external/np/speeches/2011/040411.htm Svensson, L.E.O (1997) ‘Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets’, European Economic Review, 41(6), 1111–46 Svensson, L.E.O (1999) ‘Inflation Targeting as Monetary Policy Rule’, Journal of Monetary Economics, 43(4), 607–54 Svensson, L.E.O (2003) ‘What is Wrong with Taylor Rules? Using Judgement in Monetary Policy through Targeting Rules’, Journal of Economic Literature, 41(2), 426–77 Taylor, J.B (1993) ‘Discretion versus Policy Rules in Practice’, Carnegie-Rochester Conference Series on Public Policy, December, 195–214 Taylor, J.B (1999) ‘A Historical Analysis of Monetary Policy Rules’, in J.B Taylor (ed.), Monetary Policy Rules, Chicago: Chicago University Press Taylor, J.B (2001) ‘The Role of the Exchange Rate in Monetary-Policy Rules’, American Economic Review, 91(2), 263-267 Tett, G (2009) Fool’s Gold: How Unrestrained Greed Corrupted a Dream, Shattered Global Markets and Unleashed a Catastrophe, London: Simon & Schuster Thadden von, E.L (1999) ‘Liquidity Creation Through Banks and Markets: Multiple Insurance and Limited Market Access’, European Economic Review, 43(4–6), 991–1006 Thornton, D.L (2009) ‘What the Libor–OIS Spread Says’, Federal Reserve Bank of St Louis Economic Synopses, no 24, 1–2 Tobin, J (1969) ‘A General Equilibrium Approach to Monetary Theory’, Journal of Money, Credit, and Banking, 1(1), 15–29 Tobin, J (1978) ‘Monetary Policies and the Economy: The Transmission Mechanism’, Southern Economic Journal, 44(3), 421–31 Tucker, P (2010) ‘Resolution of Large and Complex Financial Institutions: the Big Issues’, European Commission’s Conference on Crisis Management, Brussels, Belgium, 19 March Available at http://www.bankofengland.co.uk/publications/ speeches/2010/speech431.pdf 252 References Turner, A (2010) ‘What Do Banks Do? What Should They Do and What Public Policies are Needed to Ensure Best Results for the Real Economy?’, Speech given at the CASS Business School, 17 March Available at: http://www.fsa.gov.uk/pubs/speeches/at_ 17mar10.pdf Utzig, S (2010) ‘The Financial Crisis and the Regulation of Credit Rating Agencies: A European Banking Perspective’, ADBI Working Paper Series, No 188, January, Tokyo: Asian Development Bank Institute Available at: http://papers.ssrn.com/sol3/ papers.cfm?abstract_id=1592834 Valukas, A.R (2010) Examiner’s Report for the United States Bankruptcy Court, Southern District of New York, 11 March Available at: http://lehmanreport.jenner.com/ VOLUME%203.pdf Vickers, J (2011) ‘How to Regulate the Capital and Corporate Structures of Banks?’ Paper delivered at the London Business School and University of Chicago Conference on Regulating Financial Intermediaries – Challenges and Constraint, London, 22 January Available at http://bankingcommission.independent.gov.uk/ bankingcommission/wp-content/uploads/2011/01/John-Vickers-2201111.pdf Volcker, P (2010) ‘Testimony to the Senate Banking Committee’, Written Testimony, February Volcker, P (2011) ‘Three Years later: Unfinishing Business in Financial Reform’, BlackSummit Financial Group, Inc., 27 September Available at http:// blacksummitfg.com/1046?print=true Weber, A.A., Wolfgang, L., and Worms, A (2008) ‘How Useful is the Concept of the Natural Real Rate of Interest for Monetary Policy?’, Cambridge Journal of Economics, 32(1), 49–64 Wicksell, K (1898) Geldzins und Güterpreise, Frankfurt: Verlag Gustav Fischer English translation in R.F Kahn (1965) Interest and Prices, New York: Kelley Woodford, M (1997) ‘Doing Without Money: Controlling Inflation in a Postmonetary World’, mimeo, Princeton University Woodford, M (1999) ‘Optimal Monetary Policy Inertia’, NBER Working Paper Series, No 7261, Cambridge, MA: National Bureau of Economic Research Woodford, M (2003) Interest and Prices, Princeton, NJ: Princeton University Press Woodford, M (2007) ‘The Case for Forecast Targeting as a Monetary Policy Strategy’, Journal of Economic Perspectives, 21(4), 3–24 Woodford, M (2009) ‘Convergence in Macroeconomics: Elements of the New Synthesis’, American Journal of Economics – Macro, 1(1), 267–79 Index Note: Page numbers in italics indicate a reference in the endnotes AAA credit rating 33–4, 52, 73, 161, 175 AAA yield, and prime lending rate 130 accidental risk 150–2 account surplus/deficit, and GDP 160 adjustment 25, 30, 36, 43, 46, 47, 57, 77, 79, 80, 117, 118, 123, 127, 136, 141, 169, 171, 185, 186 aggregate demand 12, 28, 44, 46, 48, 55, 76, 90, 91, 111, 134, 164, 168, 169, 185, 191, 232 AIG 22, 27 American International Group see AIG anaemic recovery 9, 10, 111–39, 233 cyclical factors 115–24, 137–8 housing market 88–110 long-run factors 124–34 personal sector and banking imbalances 134–7 Asian–Russian crisis 5, 51, 67, 72, 165, 181–2 asset bubbles 3, 6, 32, 74, 151, 166, 173, 188–90 asset and debt deflation 6, asset leverage 72–3, 79–80, 150, 163 asset price targeting 189 asset-backed commercial paper, money market, mutual fund liquidity facility (AMLF) 177 asset-backed securities 21, 70, 79, 176, 178, 190, 191, 200 asset-led business cycles 65–74, 171 central bank response 74–5 monetary policy in 75–80 Association for Financial Markets 197 Baa yield 156–7 and prime lending rate 131 bail-in bonds 212–13 bailouts 53, 142, 159, 199, 200–2, 204, 222, 231, 234, 237 bancor 30 Bank of England 27, 37, 189, 200, 206, 219, 220, 237 bank resolution funds 201 banking credit risk 74, 155 banking imbalances 134–7 banking pollution 205 Barclays Bank 209 Basel Committee on Bank Supervision 201, 215–17, 237, 238 Basel III 3, 12, 154, 210, 212, 214–21, 239 Bear Stearns 53, 155 Belgium 154 Bernanke, Ben 2, 51, 53, 92, 165, 173 BNP Paribas 26 Brazil 182 Bretton Woods 30 BRICs 3, 10, 64, 82, 105, 227 Broad Index Secured Trust Offering (BISTRO) 21 bubbles 6, 32, 80–6, 170, 227 asset 3, 6, 32, 74, 151, 166, 173, 188–90 commodities 3, 6, 9, 51, 64, 67, 75, 82 housing 2, 5, 6, 9, 51, 64, 67, 74, 99, 100–3, 137 internet 1, 9, 23, 64, 67, 74, 181–2, 189 shipping 67 budget deficit, and GDP 158 business-as-usual 2, 83, 153, 156 Canada 15 capacity utilisation 115, 120–1, 124 capital asset pricing model (CAPM) 93 capital mobility 149, 160 carry-to-risk ratio 152, 156, 235 casino banks 205 central banks 171, 191 liquidity swap arrangements 177, 178 response to asset-led business cycles 74–5 253 254 Index central banks – continued response to housing market 99–100 see also Federal Reserve Bank; and individual banks certificates of deposit 11, 150, 162 character 23, 51 China 3, 5, 7, 14, 19, 28, 64, 67, 147–8, 182 credit expansion 67 economic growth 82 financial institutions 68 GDP 81 Citigroup 52 cliff effect 230 CoCos 213, 220–1 collateral 23, 51, 154, 175 collateralised bond obligations (CBOs) 24 collateralised debt obligations (CDOs) 21, 23, 24, 26, 33–4, 39, 52, 70, 174, 228 collateralised loan obligations (CLOs) 24 collateralised mortgage obligations (CMOs) 21, 23, 24, 26, 33–4, 70 collective action clauses (CACs) 11, 145, 161, 162 commercial paper funding facility (CPFF) 177 commercial paper market 175–6 Committee of European Banking Supervisors (CEBS) 204 commodities bubble 3, 6, 9, 51, 64, 67, 75, 82 Commodities Research Bureau (CRB) index 80, 81 Commodities Research Bureau index see CRB index Commodity Futures Modernisation Act (2000) 20, 21, 69 composite risk premium 85 constant relative risk aversion (CRRA) 93 consumer debt 91, 101, 135, 184 Consumer Financial Protection Agency (CFPA) 199 Consumer Price Index (CPI) 95, 151, 189 see also CPI-inflation consumer saving see savings consumer spending 9, 90, 92, 105, 189 consumption 91–2, 108, 111–39 year-on-year 119 contagion 11, 26, 52, 53, 58, 62, 147, 149–50, 159, 161–3, 175, 183, 227 channels of 3, 152–7, 209 core banking 11, 141, 226 core capital 198, 204, 214–17 corporate credit risk 73, 156, 157 corporate debt market 156–7 corporate profits, and GDP 17, 19 corporate sector debt 126 imbalances 124–34 net worth 125 counter-cyclicity 89, 93, 109, 117, 124, 214 CPI-inflation 51, 63, 151, 166, 189 credit channels 90, 92 credit crisis 4, 7, 8, 62, 77, 191 see also great recession credit default swaps (CDSs) 21, 24, 156, 162, 229 credit history 23, 51 credit rating agencies 15, 33–40, 231 home-grown 37 problems with 39–40 credit risk banking 74, 155 corporate 73, 156, 157 cyclical factors 115–24, 137–8 debt consumer 91, 101, 135, 184 corporate sector 126 household 135, 165, 184 long-term 126–7, 129 mortgage 23, 31, 103, 135–6, 165, 184, 189, 230 refinancing 7, 127, 129, 152, 153 debt contagion 149–50 debt deleveraging 51, 53, 70, 134 debt leverage 128, 133, 165 debt service burden 101, 102, 124, 133, 138 deflation 6, 7, 51, 112 deleveraging 51, 53, 70, 172–3 deregulation 3, 4, 9, 14, 19, 20, 68–71, 95–9, 109, 181 discount window facility 38, 175, 177 Index 255 Dodd, Chris 198 Dodd–Frank Act (2010) 3, 8, 12, 37, 39–40, 151, 154, 194, 198–9, 200, 213, 218, 236 Draghi, Mario 148 dynamic stochastic general equilibrium (DSGE) 232 efficient markets hypothesis (EMH) 1, 3, 4–5, 13, 50 emerging countries 83, 182, 187, 236 employees, compensation 17, 18–19 EONIA rate 152–3, 235 equity markets 26, 55, 59, 83, 85, 86 Euribor 152, 235 Euribor–OIS spread 152, 153, 154, 163 Euro Interbank Offer Rate see Euribor Euro overnight index average see EONIA rate ‘euro-plus pact’ 203 Europe 19, 36, 140 Association for Financial Markets 197 financial crisis see sovereign debt crisis financial stability package 201–5 Fiscal Compact 148, 202, 234 monetary union 36, 149 recession Stability and Growth Pact (SGP) 202, 203 European Banking Authority (EBA) 202, 204 European Central Bank 27, 37, 53, 144, 166, 182, 189 European Commission 201 European Economic and Monetary Union (EMU) 36, 149 European Finance Committee 145 European Financial Stability Facility (EFSF) 140, 161, 201, 237 European Insurance and Occupational Pensions Authority (EIOPA) 202 European Securities and Markets Authority (ESMA) 36, 38, 202, 204, 231 European Stability Mechanism (ESM) 140, 201 European Systemic Risk Board (ESRB) 202 exchange rate mechanism (ERM) 149 exchange rates 45–6, 47–8, 147, 149, 169, 186 export-led recovery 67 Fannie Mae 172, 235 Federal Deposit Insurance Corporation (FDIC) 196–7 Federal Home Loan banks 235 Federal Reserve Bank (Fed) 2, 6, 21, 34, 47, 53, 75, 104, 165, 172, 189 funds rate 2, 174 monetary aggregates 180 monetary base and bank deposits 179 policy response 173–83 SOMA 176, 177, 178, 235 Federal Reserve Bank of New York 176 financial activity tax (FAT) 222 Financial Conduct Authority 211 financial engineering 3–5, 13, 14, 19–28, 33, 40, 67–70, 73, 87, 98, 99, 109, 124, 170, 188, 190 financial innovation 8, 14–15, 20, 23, 25, 30, 33, 41, 51, 53, 62, 63, 68, 165, 170, 171, 229 financial institutions 2, 19, 22–4, 26, 28, 29, 33, 39, 51, 52, 62, 68–9, 82, 142, 144, 150, 151, 155, 156, 162, 163, 166, 167, 170, 172–6, 180, 183, 186, 195–200, 206, 214, 215, 218, 221, 222 non-bank see non-bank institutions financial liberalisation 4, 9, 13, 14, 68, 69, 165 USA 20–8, 69 financial markets liquidity 181 financial obligations ratio (FOR) 101 Financial Policy Committee (FPC) 206 financial repression 13, 50 Financial Services Authority (FSA) 19, 32, 205, 206–7 Financial Services Forum (FSF) 197 financial stability 60–2, 167–8, 169, 186, 193–226 international dimension 214–24 Basel III 3, 12, 154, 210, 212, 214–21 IMF 221–4 256 Index financial stability – continued packages Europe 201–5 UK 205–13 USA 194–201 Financial Stability Board (FSB) 39, 217, 223 Financial Stability Contribution tax 222 Financial Stability Council (FSC) 205 Financial Stability Oversight Council (FSOC) 199 financial wealth 108, 136, 184–5, 189–90, 230 net wealth targeting 33, 188–92 Fiscal Compact 148, 202, 234 fiscal policy 49, 55, 168, 186 see also monetary policy fiscal stimulus 7, 82, 83, 121–4, 133, 137–8, 159, 185 France 154 Frank, Barney 198 see also Dodd–Frank Act (2010) Freddie Mac 235 free riding 11, 144, 146, 162, 234 funding liquidity 218 G20 countries 30, 187, 200, 214, 223 see also Basel III GDP 66, 203, 220 and account surplus/deficit 160 and budget deficit 158 and corporate profits 17, 19 and investment 117 and residential investment 96 and wages 15, 18 see also individual countries general method of moments (GMM) 239 Germany 15, 66, 147, 218, 239 export-led recovery 67 GDP and account surplus/deficit 160 and budget deficit 158 income inequality 227 gimmick accounting 159 Ginny Mae 235 Glass, Carter 227 Glass–Steagall Act (1933) 3, 6, 18, 19, 20, 21–2, 24, 51, 69, 196, 199, 205, 227 Goldman Sachs 159, 198, 228 government-sponsored enterprises (GSEs) 70, 176 Grand Neoclassical Synthesis 5, 42 Great Depression 4, 104 great moderation 23, 26 great recession 2, 3, 4, 6, 8, 13–40, 53, 70, 82, 104, 149, 195, 212, 227–31 anaemic recovery 9, 10, 88–110, 111–39 characteristics of 14–28 contributory features 28–40 Federal Reserve Bank response 173–83 lessons from 164–92 theoretical framework 41–63 US government economic policy response 183–5 see also specific elements great stability 23, 26 Greece debt crisis 11, 36, 38, 140, 141, 152, 156 GDP and account surplus/deficit 160 and budget deficit 158 Government Bonds 143, 159, 161, 162, 231 public deficit 157–9 state bubble 157–8 green fiscal policy 186, 235 Greenspan, Alan 2, 51, 62, 72, 88, 104, 154, 165, 173, 189, 230 gross domestic product see GDP gross private domestic investment 111, 113 haircuts 25, 143–4, 154, 206, 235 hedge funds 22, 151, 195, 196 house prices 29, 53, 58, 77, 88, 90–2, 95, 97, 98, 101–6, 107, 110, 136, 159, 172–4, 184, 188, 191 see also housing bubble household debt 135, 165, 184 real estate 103, 135 Index 257 housing bubble 2, 5, 6, 9, 51, 64, 67, 74, 99, 100–3, 137 housing market 88–110 central bank response 99–100 consumer impact 103–9 existing homes sales 98, 106, 107 future prospects 103–9 new homes sales 97, 107 overview 95–9 relative median price 96 see also house prices; mortgages IMF 35, 36, 168, 221–4, 228, 239 income 6, 48, 55, 56, 70, 83–4, 95, 108, 112, 174 real/disposable 23, 33, 42, 101–5, 107–9, 135–7, 171, 184 redistribution 3, 4, 8, 9, 14, 15–20 Independent Commission on Banking (ICB) 207–8, 209–12 industry capacity utilisation 120–1, 124 inventories-to-sales ratio 117, 118 production 119 profits 122 unit labour cost 123 unsold goods 117 inflation 44, 57, 78, 169, 171 and asset leveraging 80 expected 50 inflation gap 47 inflation targeting 164, 166 Institute of International Finance (IIF) 214 interbank interest rate see Libor interest payments, and net cash flow 132 interest rates 2, 53, 78, 125, 169–70, 191 and asset leveraging 80 Libor see Libor International Clearing Bank 30 international contagion see contagion International Currency Union 30 international imbalances 28–30 International Monetary Fund see IMF International Swaps and Derivatives Association (ISDA) 235 internet bubble 1, 9, 23, 64, 67, 74, 181–2, 189 inventories-to-sales ratio 117, 118 investment 113–15, 116 cyclical factors 115–24, 137–8 gross private domestic 113 long-run factors 124–34, 138–9 as percentage of GDP 117 year-on-year 114 investment banks 6, 20–2, 24, 53, 69–70, 151, 159, 163, 193, 196, 197, 205, 207–13, 216, 224 asset leverage 72, 79 Ireland 140, 153 debt crisis 159 irrational exuberance 86, 189 Italy 154 debt crisis 159–60 GDP and account surplus/deficit 160 and budget deficit 158 Japan 5, 15, 19, 64, 66, 147 export-led recovery 67 money supply 68 JP Morgan 53 junk bonds 21, 151, 228 Keynes, John Maynard 14, 30, 137 keynesianism 168 King, Mervyn 200, 219, 225, 237, 238 labour mobility 160 Lehman Brothers 18, 27, 73, 74, 79, 150, 154, 155, 162, 175, 177, 229–30 leveraging 19, 27, 79, 92, 124, 190–1 assets 72–3, 79–80, 150, 163 debts 128, 133, 165 Libor 23, 52, 153, 174 Libor–CD spread 154, 155 Libor–OIS spread 152, 153 Libor–repo spread 154–5 lifecycle hypothesis 10, 89 liquidity 31, 68–9, 150–1, 170, 232 ample 175 asset-led business cycles 65–74 excessive 9, 51–4, 64–87, 99, 150–1, 165 financial markets 181 funding 218 lending facilities 177, 178 non-bank private sector 181 258 Index liquidity coverage ratio (LCR) 217 liquidity trap 137, 172 long-run equilibrium 60–3 long-run factors 124–34, 138–9 low participation incentive 144 macroprudential policy 8, 166–7, 186, 205–6 218, 222, 224 mark-to-market 2, 83, 183 menu-costs 57 Merkel, Angela 142 Merton model 93–5 microeconomics 44 microprudential policy 7–8, 167, 186, 206 minimum wage monetary policy 30–3, 44, 47, 58, 165–6 in asset-led business cycles 75–80 and house prices 90 see also fiscal policy Monetary Policy Committee (MPC) 206, 237 monetary stimulus 2, 82, 120 see also fiscal stimulus Moody credit rating agency 36 moral hazard 142–3, 166, 193, 206, 227 Morgan Stanley 198 mortgage debt 23, 31, 103, 135–6, 165, 184, 189, 230 mortgage-backed securities (MBS) 75, 100, 176 mortgages 13, 19, 21–4, 26, 35, 51, 69, 70, 91, 97–9, 103, 129, 135, 172, 196, 206, 207, 213, 228, 229, 233 subprime 19, 21, 23–4, 26, 34–5, 70, 228 multi-factor productivity 44 NAIRU 44, 55, 56, 57, 61 Nationally Recognised Statistical Rating Organisations (NRSROs) 199 negative demand shock 61–2 neo-Wicksellian models 41, 43–5, 54–60, 75 see also New Consensus Macroeconomics net cash flow, and interest payments 132 net stable funding ratio (NSFR) 217–18 net wealth targeting 33, 188–92 New Consensus Macroeconomics 5, 8–9, 31, 40, 41, 75, 164, 168, 193, 231 economic policy implications 49–51 model 45–9 structure of 42–51 New Deal 172 new keynesian economics 42 nominal wage growth 137, 185 non-accelerating inflation rate of unemployment see NAIRU non-bank institutions 46, 166, 195, 196, 197, 222 liquidity 181 Obama administration 8, 82–3, 153, 156, 194 Office of Credit Ratings 199 oil shocks 66–7, 73–4, 147 OIS see overnight indexed swaps Okun’s Law 56 open market operations (OMO) 152, 176 orderly liquidation 199 originate-and-distribute models 21, 22, 29, 227 originate-and-hold models 21 output 55, 56 potential 77 output gap 56–7, 60, 77, 171 over-the-counter (OTC) agreements 152, 235 overnight indexed swaps (OIS) 152 Euribor–OIS spread 152, 153, 154, 163 Libor–OIS spread 152, 153 ‘pact for the euro’ 203 paradox of credibility 166, 189 pension funds 25, 69, 79, 151, 180 permanent income hypothesis 10, 89, 92–3 personal consumption expenditure 190 personal sector imbalances 134–7 Phillips curve 42, 44, 46, 61 Portugal 140, 153 debt crisis 159–60 pretax profits 122 price stability 12, 32, 43, 49, 164, 168 Index 259 price–earnings ratio 84 primary dealer credit facility (PDCF) 175, 177 prime lending rate and AAA yield 130 and Baa yield 131 private equity funds 194, 195, 196, 197, 198 private sector involvement (PSI) 11, 142–3, 162 PSI1 143 PSI2 143–4 pro-cyclicity 92, 124, 206 productivity, and wages 16 profitability, lack of 121, 122 profits 60, 122 pretax 122 proprietary trading 195, 196, 197, 198, 201 Prudential Regulatory Authority (PRA) 207 quantitative easing 148, 176 QE1 70, 75, 100, 105 QE2 70, 75, 83, 84, 100, 105 QE3 83 Ramsey model 49 real profit rate 44, 78 and asset leveraging 80 real wage rate 15, 16, 18, 45 refinancing 7, 127, 129, 152, 153 regulation 170–1 Regulation Q 20, 69 Rehn, Olli 141 rehypothecation 25, 229 repo market 25, 27, 151, 229, 234 Libor–repo spread 154–5 Reserve Primary Fund 229 retail operations, ring-fencing of 208–13 retrenchment 100, 129, 171 Ricardian Equivalence hypothesis 49 ring-fencing 208–13 risk accidental 150–2 banking credit 74, 155 corporate credit 73, 156, 157 underpricing of 26 risk assessment 157–62 risk aversion 72, 73, 152, 155 constant relative (CRRA) 93 risk–reward ratio 93–4 risk-weighted assets (RWA) 212–13, 217, 219 risky assets 152, 173, 180–2 S&P 500 86 Sarkozy, Nicolas 142 savings 29, 55–8, 83, 84, 91, 92, 108, 136, 143, 151, 211 and consumption patterns 92–3 savings ratio 10, 89, 92–3, 105, 107–9, 185 Say’s Law 43 Securities and Exchange Commission 199 Securities Industry and Financial Markets Association 197 securitisation 24, 69–70, 170–1, 190 separability 208–9 separation theorem 110 Shad–Johnson jurisdictional accord 20, 69 shadow banking 6, 24–5, 26–7, 70, 71, 151, 170, 191, 193, 218 shipping bubble 67 smoothing 46, 47, 58, 93 SOMA see system open market account sovereign debt crisis 3, 7, 11, 35–6, 88, 140–63, 230, 233–5 background 141 international contagion 149–50, 152–7 remedial treatment 142–5 risk assessment 157–62 solutions to 146–8 systemic vs accidental risk 150–2 Spain 154 debt crisis 159 GDP and account surplus/deficit 160 and budget deficit 158 stability see financial stability Stability and Growth Pact (SGP) 160, 202, 203 steady state 60–2 stock market crash 1, 28 structured investment vehicles (SIVs) 23, 33, 52, 171, 173–4, 191 260 Index subprime mortgages 19, 21, 23–4, 26, 34–5, 70, 228 supply shocks 66–7 system open market account (SOMA) 176, 177, 178, 235 systemic risk 150–2 TARP 27 Taylor Rule 43, 47 term auction credit (TAC) 177 term auction facility (TAF) 175 term securities lending facility (TSLF) 175, 177 too big to fail 22, 186, 194, 195, 197, 199, 205, 206, 212, 213, 219, 222, 237 too important to fail 166 toxic assets 26, 32, 33 trade unions traditional banking 71 Trichet, Jean-Claude 143, 148 triple A status see AAA credit rating Troika 146 Troubled Asset Relief Program see TARP UK 15, 66 financial regulation 205 Financial Services Authority (FSA) 19, 32, 205, 206–7 financial stability package 205–13 GDP and debt 31 and wages 15 OIS spread 153 wages and GDP 15 and productivity 16 unemployment 16, 18, 28, 41, 44, 55, 57, 61, 63, 85–6, 88, 109, 111, 137, 165, 185, 187, 225, 236 unit labour cost 11, 54, 57, 76, 115, 123, 141, 159, 173, 190 unsold goods 117 USA 66 asset growth 71 dollar privilege 29 economic policy response 183–5 financial liberalisation 20–8, 69 financial stability package 194–201 GDP 66 housing market 88–110, 170 OIS spread 153 as optimum currency area 149 Vickers, John 208 Volcker, Paul 73, 98, 195, 196, 236 Volcker Rule 8, 12, 194, 196–8, 199–200 see also Dodd–Frank Act (2010) wages and GDP 15, 18 minimum nominal growth 137, 185 and productivity 16 real wage rate 15, 16, 18, 45 Wall Street bonuses, taxation of .. .Financial Stability in the Aftermath of the Great Recession Financial Stability in the Aftermath of the Great Recession Philip Arestis University of Cambridge, UK Elias Karakitsos. .. themselves in view of the narrowing of the margins of lending and borrowing rates Investment banks moved into the origination and distribution of complex Origins of the Great Recession 21 derivative... risk-taking in financial institutions In the words of the chairman of the UK Financial Services Authority, There has thus been an increasingly ‘financialisation’ of the economy, an increasing role for the