The perfect storm: the global financial crisis - Policy errors

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Meeting Investors' Goals

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University of Geneva

Meeting Investors' Goals

907 ratings

Course 2 of 5 in the Specialization Investment Management

In this course, you will dive into the concepts of rationality and irrationality and understand how they impact our investment decisions and what the consequences can be at the market level. You will first explore the different biases that we, as humans, are subjected to when facing investment decisions and how they may impact the outcomes of these decisions. Moreover, you will see how emotions and ethical concerns such as honesty and trust influence market participants. When they are considered as a group rather than individually, you will discover how rationality and irrationality can drive asset prices to and away from their fair value. Finally, you will be presented with different portfolio construction methodologies and investment styles that make up the landscape of today's portfolio management industry. At key points throughout the course, you will benefit from the practical knowledge of experts from our corporate partner, UBS, in how to build and manage clients' portfolios.

From the lesson

Market Efficiency, Bubbles & Crises

In this third week, we will have a look at investors’ behavior as a group. How does it impact asset prices? How do these prices reflect available information? What does it imply for the profitability of some trading strategies? What can go wrong in this price formation process and how can (and did) it cause financial bubbles and crises? This week also features as special guest: Prof. Jean-Pierre Danthine, former vice-chairman of the Swiss National Bank, who will offer insights into some of these issues.

Overview of different origins of financial crises3:44

A first example for the development and fallout of a real crisis: the VW scandal4:51

A second example for the development and fallout of a real crisis: oil shocks - 1970s8:23

A first example of an anticipation crisis: 1987 - The "Fed Model"9:23

A first example of an anticipation crisis: 1987 - The crash8:52

A second example of an anticipation crisis: 200010:14

The perfect storm: the global financial crisis - Global imbalances9:40

The perfect storm: the global financial crisis - Policy errors9:24

The perfect storm: the global financial crisis - Lax regulation7:09

Meet the Instructors

University of Geneva- Tony Berrada
SFI Associate Professor of Finance
Geneva Finance Research Institute
University of Geneva- Jonas Demaurex
Teaching Assistant
Geneva Finance Research Institute
University of Geneva- Rajna Gibson Brandon
SFI Senior Chaired Professor of Finance and Managing Director of the GFRI
Geneva Finance Research Institute
University of Geneva- Michel Girardin
Lecturer in Macro-Finance - Project Leader for the "Investment Management" specialization
Geneva Finance Research Institute
University of Geneva- Kerstin Preuschoff
Associate Professor of Neurofinance and Neuroeconomics
Geneva Finance Research Institute
University of Geneva- Olivier Scaillet
SFI Senior Chaired Professor of Finance and Vice-dean (research) at GSEM
Geneva Finance Research Institute
University of Geneva- Philip Valta
SFI Assistant Professor of Finance
Geneva Finance Research Institute

[MUSIC]

So we're going to see now how the fact that emerging markets did have better

fundamentals than developed markets, created the problem within these

developed markets in general and in the US in particular.

We're going to illustrate that with the following two charts.

Just look at this chart here which depicts in green, the evolution

of the US ten-year bond yield in real term.

So, the nominal yield less the inflation rate and that's on the left hand scale.

And in red, that's the federal funds rate.

So, that's the key interest rates which is used by the federal reserve,

the central bank in the U.S to conduct monetary policy.

Well, we can see here that when the bubble, the dot com bubble,

burst in 2000, the Feds slashed interest rates.

Just look at this.

They went from 6.5% percent to 1% in just two years.

A little bit more.

Then probably in 2004 Alan Greenspan, which was at the helm of

the Federal Reserve, decided that this easing had been a bit excessive and

he reversed the easing and he started increasing rates.

And look at what happened here.

2004 interests rates were at one percent and

they rose back to close to six percent, in a very short time.

You see the sharp increase.

Now what should have happened then, is an increase at the long end of the u curve.

The bond market reacting.

But the bond market took no notice.

As we put here in this chart.

Basically you see it keeps falling.

So this is what Alan Greenspan referred to as the conundrum.

Enigma.

We don't know why.

You raise interest rates.

You remember when we talk about yield curve, shifts of flattening.

When normally, when the short end of the yield curve rises typically the long end

also moves, maybe by less, the magnitude is less, but normally it also moves up.

Here we have the short end of the yield curve going up, and

the long end still going down.

Conundrum, problem.

So the explanation of this conundrum is actually, and

that's referring to the global micro economic imbalance, we just discussed.

Basically, to much savings in China.

The, we've heard many stories about

the Central Bank in China accumulating all these reserves.

So what was the central bank doing with all this reserves?

It was buying foreign assets and in particular US treasuries, so

that's why although the federal reserve tighten interest rates,

bond yield kept falling because someone else was buying those treasuries.

They buy, depressing the bond yield.

So here, you see the evolution of the bond yield in real terms.

It's on an inverted left hand scale.

So the rise in the green line indicates a fall in the yield.

And you see in red, that's the evolution of the savings rate in China,

and look, it goes.

In 2000 from 37% on the right hand scale, to close to

50% in this decade now, 2013.

So we see here that there's a lot of savings,

the pool of excessive savings, so, a lot of savings.

And that's what we refer to as the savings glut.

You know, emerging markets, too much savings, buying

assets in the developed markets, and that's maybe what is fueling,

there, an asset price bubble in this developed markets.

Okay.

So now, we started talking about the Federal Reserve and

we've moved to the second factor, or the second explanation of why we

had a problem that lead to the global financial crisis.

And the problem is referred to as.

Did the federal reserve conduct a too lax, to expansionary monetary policy?

How do we know?

Okay, so how do we know, how do we measure this fact that

federal funds rate are not where they should be.

Well, there's a rule which we refer to, and is indicated in this abstract,

it's known as the Taylor Rule.

The Taylor Rule was devised by this economist called John Taylor.

In a paper he was published in 1993.

And the paper gives this formula.

You see it here.

R = p + 0.5y + 0.5 (p- 2) + 2.

Now you see what that means.

R is the federal funds rate p is the rate of inflation,

and y is the percent deviation of real GDP from a target.

So if y is positive, it means that we have some kind of overheating economy,

an economy which is growing above its potential.

A growth, with is defined here very simply in terms of trend GDP.

You see here are the formulas.

So what is the Taylor rule suggesting?

That basically, if we have inflation rising above its target of 2%,

for that is the target which is set by the Federal Reserve.

Or we have excessive growth.

GDP growing above its trend line or above its potential.

Then, or a combination of both.

Typical of an overheating economy, then the federal funds rates should be higher,

that should increase the federal funds rates.

So the Taylor rule is very interesting because it tells us where interest

rates should be, and then when you confront it to where they are actually,

from what the conduct of monetary policy.

We can derive some conclusion as to whether the Federal Reserve

is being too expansionary, or it's being too restrictive.

Now, quiz to you, if we assume that inflation is on target at

2% and GDP is growing at its trend line or full potential.

What is the federal funds rate according to the Taylor rule?

So the answer to the quiz is a basically just

a using the Taylor rule You put p=2, y=0 so

p minus two is also zero, so from the formula you find that r equals four.

So the funds rate should be four or 2% in real terms so r minus p is two.

So interestingly now, let's have a look at this chart,

it compares the Taylor Rule where the federal rules rates should be.

And that's the red line.

And the blue line is the actual federal funds rate and

here you see very clearly, a gap in the year 2003,

2004 up to 2006 that the red line is above the blue line,

meaning the federal reserve was conducting two lax a monetary policy.

It was raising rates, but not enough, as suggested by the Taylor Rule.

So there was some inflationary pressure.

There was some overheating in the economy due to the housing bubble.

And so the federal reserve should have dampen that, it should've been much more

aggressive in it's restrictive monetary policy than it actually was.

And this too lax monetary policy accounts for the housing bubble.

And you can see with this following chart here,

basically the red line is the difference between the rule based,

the Taylor Rule based federal funds rate and the actual rate.

So, a positive number for this variable shows that the federal reserve is too lax.

The rule based is above the actual rate.

Conversely, when that difference is negative and

here we have the other excess.

We have excessive restriction in monetary policy.

Actual rates are above what they should be according to the Taylor Rule.

And you see here that there's a pretty good fit

between the fact that in the years prior to the global financial

crisis the Federal Funds rate was not high enough.

So that probably helped fuel the housing bubble,

which was the main culprit of the global financial crisis.

In the next video, we're going to be looking at the third and

last factor which caused the global financial crisis.

[MUSIC]

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