Charles Bean: The Great Moderation, the Great Panic and the Great
Contraction
Text of the Schumpeter Lecture by Mr Charles Bean, Deputy Governor for Monetary Policy
and Member of the Monetary Policy Committee, Bank of England, at the Annual Congress of
the European Economic Association, Barcelona, 25 August 2009.
I am grateful for the assistance of Adrian Penalver. The views expressed are those of the author and do not
necessarily reflect those of either the Bank of England or the Monetary Policy Committee.
* * *
Summary
Charles Bean, the Bank of England's Deputy Governor, Monetary Policy, was invited to
deliver the Schumpeter lecture at the Annual Congress of the European Economic
The Great Moderation, the Great Panic and the Great
Association. Contraction, looks back at
the causes of the financial crisis and subsequent recession. He argues that much of what
went wrong can be analysed using standard economic tools.
The Great Moderation was a period of unusually stable macroeconomic activity in advanced
economies. This was partly thanks to good luck, including the integration of emerging market
countries into the global economy, and partly a dividend from structural economic changes
and better policy frameworks. The longer this stability persisted, the more markets became
convinced of its permanence and risk premia became extremely low. Real short and long
term interest rates were also low due to a combination of loose monetary policy, particularly
in the US, and strong savings rates in a number of surplus countries.
Low interest rates and low apparent risk created strong incentives for financial institutions to
become highly geared. Unfortunately much of this leverage occurred off-balance sheet in
order to avoid on-balance sheet capital charges. The innovative financial instruments
developed to achieve this were highly complex. This complexity did not seem to matter when
markets were steady and defaults low but was fatal once conditions deteriorated, as it
became impossible to understand and price these instruments objectively. Leveraged
institutions were trapped; as their assets sank in value and funding dried up, buyers became
wary - a classic lemons problem. As losses moved inexorably towards institutions at the
heart of the financial system, the complexity of the inter-bank network created enormous
uncertainty about the extent of counterparty risk.
Uncertainties in the financial system were transmitted to the real economy after the collapse
of Lehman Brothers as expectations of future credit tightening, higher precautionary savings
and the postponement of investment took a sudden and widespread toll on global demand.
This made the task of deleveraging in the financial system even more difficult and the
tightening of credit more severe. Central banks responded aggressively with sharp cuts in
policy rates. To affect the yield curve over the medium run, central banks have made explicit
commitments to keep rates low for a significant period of time or engaged in purchases of
financial assets. Policy makers are also considering the benefits of developing additional
macroprudential instruments which can be used to respond to rapid credit growth and rising
asset prices. These new instruments should directly target the incentives to extend excessive
credit. But there are a number of practical questions to answer before they can be
implemented.
Charles Bean concludes that it is a mistake to look for a single culprit. Just as in Agatha
Christie's Murder on the Orient Express, those with different motives but similar objectives
can all contribute to the same outcome. The economics profession was one of those culprits
and there are lessons for the discipline. It could incorporate psychology or behavioural
economics into the study of financial markets but this may be unnecessary since much of the
story can be explained using standard microeconomics. Economists should take more notice
of history and not treat crises as pathologies that happen in other times or in other places but
as a central feature of free-market economies that models should aspire to explain. Finally,
macroeconomists have to learn how to put credit markets into their models in a meaningful
way and which enable us to model shocks originating in the financial sector rather than just
as an amplification mechanism.
The Great Moderation, the Great Panic and the Great Contraction
The past twenty-four months have been tumultuous for the global economy, for economic
policy makers and, indeed, for the discipline of economics. Following a long period of
unusually good economic performance, characterised by relatively steady growth and low
and stable inflation in the advanced economies and rapid growth and development in key
emerging market economies, we have seen the eruption of a systemic financial crisis of quite
unusual intensity and international reach. The nearest precedent is probably the widespread
closing of international capital markets on the eve of the First World War. And associated
with that, we have seen the sharpest internationally synchronised slowdown in growth in the
post-war period, together with an unprecedented contraction in world trade.
To the public at large our present troubles are the fault of: whiz-kid financiers, who created
financial instruments that even they didn't properly understand; greedy bankers, who
pursued profit and personal reward without regard to risk or common sense; somnolent
supervisors, who failed to adequately regulate and restrain those bankers; and negligent
central bankers, who allowed an explosion in liquidity, credit and asset prices that supported
the whole rotten edifice. And all the while, the culprits were cheered on by an economics
profession that was over-enamoured of theoretical models, blind to the lessons of history and
subject to a severe case of "group think". Wasn't it blindingly obvious that the whole house of
cards would come crashing down at some point?
As one of those involved in responding to the crisis - and some might charge also a bit part
in creating the conditions for it - I want to look this evening at how we got here. But rather
than giving a blow-by-blow account of events, I want instead to focus on what I see as the
key underlying economic forces. How could what appeared initially to be little more than an
over-extension of loans to a high-risk subset of US households end up generating total
financial sector losses in the advanced economies currently estimated by the IMF to be in the
region of $4.1 trillion and an output gap that is expected to reach nearly 6% of GDP in 2010?
And while there were a few Wise Owls1 who saw trouble coming, why did most of the
profession fail to spot the dangers? Is that because we were locked into an inappropriate
paradigm? If so, is the time ripe for a Schumpeterian "gale of creative destruction" in the
subject?
The credit boom
Let me start by recalling a few facts regarding the credit boom that preceded the crisis.
During the decade preceding the crisis there was a substantial increase in the ratio of
household and business debt to GDP in a number of advanced economies, particularly the
United States, the United Kingdom and Spain; see the left-hand panel of Fig. 1. A striking
feature of this period was also the increased use of the credit markets by the financial sector
to fund its activities, rather than relying on the traditional medium of deposits; that is
illustrated in the right-hand panel for the United States.
This build up in debt accompanied a wave of financial innovation. There was a marked
expansion in the issuance of asset-backed securities: bundles of residential and commercial
mortgages, other consumer credit, and of loans to businesses that were sold on by the loan
originator, thus shifting the associated risks. And a new class of asset in the shape of
Collateralised Debt Obligations (CDOs) was created, which facilitated a further layer of
restructuring and redistribution of the risks in an asset-backed security. The extent to which
loans were moved off balance sheet through these means is shown in Fig. 2 (left-hand
panel). Finally, we saw a veritable explosion in the issuance of Credit Default Swaps (CDSs),
which allowed investors to hedge themselves against a wider range of default risks
(righthand panel).
The picture that emerges from this is one of a more complex process of financial
intermediation, but one in which the innovation in contracts apparently allowed specific types
of risks to be split out, traded and redistributed towards those in a better position to bear
them. We thus seemed to be moving ever closer to an idealised Arrow-Debreu world of a full
set of state-contingent securities. Moreover, it seemed natural to think that the increased
dispersion of risk would make the financial system more, rather than less, stable, a view that
was certainly held by the former Chairman of the US Federal Reserve, Alan Greenspan:
"These increasingly complex financial instruments have been especial
contributors, particularly over the past couple of stressful years, to the
development of a far more flexible, efficient, and resilient financial system than
existed just a quarter-century ago." (Greenspan, 2002).
Accompanying this expansion in credit, there was also a rise in certain asset prices,
particularly that of housing, in those countries where credit rose most sharply (see Fig. 3).
But significantly, that explosion in credit was not associated with a marked expansion either
in the demand for goods and services, or in consumer price inflation. It is also notable that
the run-up in house prices in the United States was less marked than in the other
Anglophone countries and Spain. In part, that may reflect a more elastic response in the
construction of new houses in the United States.
The point to stress is that there was nothing self-evidently wrong with this expansion in
balance sheets and the associated rise in asset prices. There is some evidence from
developing economies that suggests that increased development in financial markets helps
to foster growth and catch-up. And if financial innovation allows households to gain access to
mortgage finance where they were previously unable to, one should expect that to lead to a
rise in the real price of houses. But just as there is evidence that increased financial
intermediation is often a Good Thing, so there is also evidence from numerous past
credit/asset price boom-bust episodes that a juxtaposition of rapid credit expansion and
sharp asset price increases is often a harbinger of a painful bust to come. So everything
hinges on whether the underlying developments are sustainable or not. The mistake of (most
of) the economics profession, along with many others, was a failure to see what was really
going on beneath the surface and to understand how disruptively things could unwind. But,
as I shall explain, I believe that the standard tools of economic analysis, far from being
proved redundant, can shed useful light on what went wrong.
Macroeconomic antecedents
The proximate causes of the present crisis undoubtedly lie within the financial markets. But it
is worth dwelling briefly on the macroeconomic environment in the years preceding the crisis,
which was conducive to the formation of what proved to be an unsustainable credit bubble.
The Great Moderation
To begin with, this period was characterised by an unusually high degree of macroeconomic
stability, with steady growth and low and stable inflation in most of the advanced economies;
see for instance Fig. 4, which shows performance in the G5 countries before and after 19922.
There are three broad explanations for this "Great Moderation".
First, it could just have been a happy accident, if this was a period characterised by
unusually small, or a benign sequence of, shocks. In particular, access to a cheap source of
manufactured goods as result of the rapid development of China and other emerging market
economies created a terms of trade gain for the advanced countries and a beneficial
"tailwind", which only mutated into a "headwind" towards the end of the period as rapid global
growth put upward pressure on oil and other commodity prices.
Second, changes in the structure of the economy could have meant that similar sized shocks
had smaller macroeconomic effects. Candidate structural changes included the shift from
manufacturing to services, tighter control of inventories leading to an attenuation of the
inventory cycle, increased competition in product and labour markets, and innovation in
financial markets that facilitated the greater spreading of risk and an enhanced ability to
smooth spending in the face of shocks to income or wealth.
A final possibility is that better macroeconomic policies, including improved policy
frameworks, had moved economies closer to the eponymous Taylor frontier which traces out
the lowest achievable inflation volatility for a given volatility of the output gap. In particular,
earlier periods were bedevilled by monetary policies that had failed to anchor inflation
expectations. But the pursuit of inflation targets and similar stability-oriented monetary
policies by independent central banks seemed to have been more successful in anchoring
inflation expectations.
Now if the Great Moderation was down to "good luck", then improved macroeconomic
performance was more likely to be ephemeral. But if it was down to structural changes or
better policy, there was more chance of it proving permanent. Moreover, if it was permanent,
then part of the "dividend" from this reduced macroeconomic volatility should be a greater
willingness to take on risk.
As it happens, the academic literature has so far failed to provide a conclusive answer on the
relative contributions of the various explanations3. But what matters is how market
participants responded to these benign conditions. They are faced with what is, in essence, a
complex signal-extraction problem. But whereas many such problems in economics involve
learning about first moments of a distribution, this involves making inferences about higher
moments. The longer such a period of low volatility lasts, the more reasonable it is to assume
that it is permanent. But as tail events are necessarily rarely observed, there is always going
to be a danger of underestimating tail risks.
Certainly it appears from measures of volatility implied from options prices for US equities
(VIX) and treasuries (MOVE) that the perceived risks in financial markets had shrunk to
extremely low levels by 2006; see Fig. 5. There are two ways of rationalising this. One
possibility is straightforward extrapolation into the future of the benign experience of the
preceding few years. An alternative and complementary explanation is excessive faith in the
ability of policy makers to maintain steady growth in the real economy. The Fed's reluctance
to use interest rates to lean against asset price booms coupled with a willingness to relax
monetary policy aggressively in the wake of sharp asset price falls (Greenspan, 2002) may
also have helped place a floor under expected asset prices (the "Greenspan Put"; see Miller,
Weller and Zhang, 2002).
A tendency of people to underestimate future risks during periods of good economic
performance seems to be a recurring theme in the history of financial markets. In part this
seems to be a mixture of a willingness or desire to believe that the world has changed for the
better, and moreover to find ways to rationalise that belief - in other words, "this time it's
different". To that must be coupled a limited imagination - shared in this instance with
regulators and central bankers - to see quite how badly things could go wrong. But when
market participants can claim, as David Viniar, the Chief Financial Officer of Goldman Sachs,
did in August 2007 that they "were seeing things that were 25-standard deviation moves,
several days in a row" it is a sign that something must be badly wrong4. Wrong, that is, not
with the world, but rather with market participants' estimation of risk.
A particular feature of this underestimation of risk lay in the prevalent assumption that bad
shocks were likely to be uncorrelated with each other. Thus the management of Northern
Rock probably believed that if they were unable to roll over their short-term wholesale
funding in the Asset-Backed Commercial Paper market, then they would always be able to
find an alternative source of funds in the inter-bank market. But as it transpired, the same
forces that led to a shutting down of the former in August 2007 also led to the closure of the
latter at all but very short maturities. By the same token, many investors thought they had
purchased relatively safe securities because there were insured against default by the
monolines or through the purchase of CDS contracts. But that insurance proved worthless
when large correlated losses occurred and the insurers proved to have insufficiently deep
pockets. A systemic financial crisis is apt to generate dysfunctions in multiple markets
simultaneously, making bad tail outcomes much more likely to occur than they appear when
risks are treated as largely independent. And joint distributions with independence in the
central mass but high correlation in the tails are likely to be extremely hard to model and
calibrate.
Monetary policy
Other macroeconomic features also probably contributed to the growth in credit leading up to
the crisis. In particular, according to some monetary policy was too loose over this period,
especially in the United States (see Taylor, 2007). Fig. 6 shows the difference between the
policy rate and benchmark estimates of an "appropriate" policy rate derived from a Taylor
rule. Notwithstanding the usual caveats about the construction of such benchmarks, the very
low level of the Federal Funds rate relative to the Taylor rule during 2001-5 is striking. Of
course, the FOMC held rates this low for a reason - they were concerned about entering a
Japanese-style deflation and in order to mitigate that risk committed to holding the policy rate
at a low level for a sustained period so as to pull down longer-term market interest rates.
There is, though, little to suggest that policy rates were noticeably out of line in the euro area
and the United Kingdom. Credit was nevertheless growing rapidly, as documented earlier in
Fig. 1. Despite generally low and stable inflation, that led some - most notably Bill White and
colleagues at the Bank for International Settlements (Borio and White, 2003; White 2006) -
to argue that the credit/asset-price boom was storing up trouble for the future. Accordingly,
they argued that central banks should actively "lean against the wind" to mitigate these risks,
even though inflation objectives did not appear to be under threat. Others, including the
present and former Chairmen of the Federal Reserve, took the view that diagnosing a
misaligned asset price was only possible in retrospect and that only a large increase in policy
rates could stop such a boom, which risked creating exactly the shock to the real economy
that one wanted to avoid (see Bean, 2003, and the references therein). I shall return to this
issue at the end of this lecture.
Global imbalances
Another feature of potential importance is the counterintuitive pattern of international capital
flows. The rapid development and integration into the global market economy of China, India,
Brazil and other emerging market economies could have been expected to lead to capital
flows from the advanced countries into these economies in order to provide the investment to
equip the extra workers being brought on to the global labour market. But instead we saw
China exporting capital and the United States and the United Kingdom importing it; see Fig.
7. In 2007, for instance, the US current account deficit stood at $730 billion, while China's
surplus stood at no less than $372 billion. Moreover, the deficits are also large in historical
terms.
A number of competing explanations have been advanced for this pattern of flows. First, it
could simply reflect the juxtaposition of strong demand in the United States, coupled with
China's adoption of an undervalued exchange rate in order to accelerate the development of
the traded goods sector and to soak up labour from the rural areas (Dooley, Folkerts-Landau
and Garber, 2004). Second, it could reflect a "savings glut" in the surplus countries
(Bernanke, 2005), resulting from a lack of an adequate household safety net in China, the
accumulation of precautionary holdings of international reserves by several emerging market
countries after the Asia crisis, and rational savings of the windfall gains from higher oil prices
on the part of oil producers. Finally, it has been suggested that the United States holds a
comparative advantage in the creation of "high quality" financial assets from real
investments, leading to a direction of savings into the US financial markets (Caballero, Farhi
and Gourinchas, 2008).
Now while these flows are certainly likely to have added to the growth in credit, on the face of
it they could only be a part of the explanation. For instance, the cumulative US current
account deficit over the 2000-7 period was $4.7 trillion. Over the same period, the stock of
household, corporate and government debt outstanding rose by $14.4 trillion, more than
three times as much. But it is possible that the global imbalances may have played into the
credit boom through another route. Bernanke's "savings glut" hypothesis was advanced
primarily as an explanation for the decline in long-term real interest rates seen during this
decade; see Fig. 8. And that low level of real returns on government bonds may in turn have
encouraged financial institutions to shift into other, riskier, assets that offered a higher return,
such as the burgeoning class of asset-backed securities - what came to be known as the
"search for yield".
There is not a lot of research yet that sheds light one way or the other on the role of the
global imbalances in the credit/asset-price boom. There is quite a strong correlation across
countries between house price inflation and current account deficits (Fig. 9), but this says
nothing about causality, which plausibly could also run from house prices, via demand, to the
current account. In fact, Granger-causality tests point to bi-directional causality, running from
both current accounts to house prices and vice versa5. That is consistent with an influence of
the imbalances on asset prices. But equally the results could just indicate that both variables
are affected by the state of the business cycle.
What went wrong?
While the macroeconomic environment may have provided fertile ground for the credit/asset
price boom to develop, to explain both the extent of the growth in credit and the magnitude of
the subsequent crisis one needs to dig down into what was happening inside financial
markets. And when one does that, one finds a variety of incentive distortions and information
problems that appear to have played a central role.
Distorted incentives
Banks are vulnerable institutions because they make long-term loans with uncertain returns
that are financed predominantly by short-term debt instruments and callable deposits. If
creditors think that the borrowers will be unable to repay the loans, then there is every
incentive for them to run. That is why banks are required to hold a buffer of capital and
reserves large enough to absorb losses in most feasible states of nature.
Consider for a moment a very simple financial intermediary (a "bank") that can finance risky
lending with either debt, which here encompasses both deposits and credit market
instruments, or equity. Assume that the bank pays RD on its debt and earns (a stochastic) RL
on its loans, net of intermediation and monitoring costs. Then the return on its capital, is
RK,
given by:
RK = (1+λ)RL - λRD,
λ
where is the leverage (debt-to-equity) ratio. In the normal course of events, one would
expect the return on debt to be an increasing function of leverage, as the greater the
leverage, the greater the chance that the bank's capital will be wiped out in the event of low
returns on the loans and they will be forced to default on part or all of the debt. Indeed, with
symmetric information between bank and creditor, there should be no gain from raising
leverage at all by virtue of the Modigliani-Miller theorem.
For a number of reasons, however, this may not work in practice. Creditors - especially if
they are households rather than sophisticated financial market participants - may not even
factor in the implications of higher leverage for the possibility of default. And even if they do,
the debt may be partially or wholly underwritten by the state, with the cost of the insurance
only imperfectly passed back to the bank. Similarly, the bank may be thought to be too
important to be allowed to fail, in which case people might expect an injection of capital by
the state to make good abnormal losses. In any of these cases, there is an incentive for the
bank to raise leverage. Moreover, the lower is the perceived uncertainty associated with the
loans, the more the bank can afford to leverage up, while maintaining the same uncertainty
over the return on its capital. So the environment of the Great Moderation would have been
particularly conducive to intermediaries increasing the leverage of their positions.
The incentive distortions here are intrinsic to the process of financial intermediation. The next
set of distortions is more specific to the present conjuncture and relates to securitisation.
Securitisation is attractive because selling on the loans and the attendant risks enables a
bank to leverage more loans off its capital. And, as noted earlier, such distribution of risks
should in principle be beneficial for the economy.
Unfortunately, it transpired that this model, or at least its application in the past few years,
suffered from a number of incentive problems. First, there is the obvious one that if a loan
originator can sell a loan on at par, then he has less incentive to take care who he lends to.
The much higher default rates on cohorts of US sub-prime loans originated in 2006 and 2007
compared with earlier years is indicative of the consequences of this lack of incentive (see
Fig. 10). The originator needs to have enough "skin in the game" if he is going to exercise
due diligence in loan origination - and having a reputation at stake may not always suffice.
Second, the crisis revealed that many of the risks that securitisation was supposed to
distribute more widely had in fact remained either within the banking system, or else could be
re-intermediated back into it. Thus, the debt securities issued by one bank were not sold on
to investors outside the banking system, but were instead bought by the proprietary trading
desks of other banks, leading to a network of cross-holdings of the underlying loans. That
may make sense when the main risks are idiosyncratic to the loans originated by particular
banks, but looks rather foolish when the risks are macroeconomic in nature and the returns
on all such securities are correlated.
Moreover, a considerable amount of the remaining risk was contained in institutions which,
while not formally recognised as banks, engaged in exactly the same sort of maturity
transformation, financing long-term assets by short-term debt instruments. These included
entities such as conduits, which housed the securitised loans and then financed them by
selling short-term paper. But in many cases these entities had back-up credit lines to the
supporting bank, so that when funding difficulties arose, the securitised loans in effect came
back onto the bank's balance sheet. And even where there was no formal obligation to act as
a lender of last resort, originators often chose to provide back-up finance in order to protect
their name in funding markets.
The motive for setting up these off-balance-sheet entities was entirely one of regulatory
arbitrage. Off-balance-sheet vehicles were not required to hold capital in the same way as a
bank would if the loans were on their balance sheet. So it appeared to be a neat way to
boost profits without having to raise more capital. The Banco d'España, the Spanish banking
supervisor, insisted that Spanish banks would have to treat conduits and the like as on
balance sheet for capital purposes. As a result, Spain did not see the mushrooming of these
off-balance-sheet vehicles.
A third distortion lies in the nature of remuneration contracts. Incentive contracts that offer
potentially unlimited upside rewards, but cap the downside losses, encourage traders to take
on excessive risk. One unintended consequence of financial innovation was that it enabled
clever traders to create positions with considerable embedded leverage - that is, portfolios
requiring little payment up front, but whose returns amplified changes in the value of the
underlying assets. Traders then had a natural incentive to gravitate towards these types of
highly risky instruments.
A related problem is that it is extremely difficult for management to observe the risk being
taken on by their traders, particularly when innovative financial instruments have unusual
return distributions. Take, for example, a deeply out of the money option. This pays a steady
income premium and has little variation in value when the underlying instrument is a long
way from the strike price, but generates rapidly escalating losses in bad states of the world.
In good times this looks like a high return, low risk instrument. Only in very bad states of the
world do the true risks taken on become apparent.
Information problems
Information problems have also been central to the crisis. Most of the asset-backed
securities that have proved toxic are far from simple. A plain vanilla Residential Mortgage
Backed Security (RMBS) typically contains tens or hundreds of thousands of underlying
mortgages and even the documentation on them can run to a couple of hundred pages.
These instruments provide diversification, but unless the mortgages are fairly homogenous in
nature, it will be difficult for an individual investor to monitor the evolution of the underlying
risk exposures at all precisely. The problem is compounded when the pool of mortgages is
continually topped up to replace maturing mortgages, as is the case with Master Trusts, as
the characteristics of newer cohorts may differ from those of older cohorts.
In addition, US RMBS contain embedded options that further complicates the evaluation of
their worth. Ordinary US mortgage loans are usually non-recourse and offer the borrower the
option of both early repayment and of default if the price of the house falls below the value of
the loan, leaving the lender to recover what they can from re-sale of the house at what will be
an uncertain price. US sub-prime mortgages also embed an option for the lender. Essentially
sub-prime mortgages are structured as a rolling sequence of short-term loans, with the
lender sharing in some of the increase in housing equity when house prices rise and having
discretion over whether to offer a new and affordable loan depending on whether house
prices have risen or not (see Gorton, 2008, for further details). As a consequence of these
embedded options, RMBS, particularly of sub-prime mortgages, have a rather complex
payoff structure that is tricky to price and difficult to monitor.
CDOs are yet more complex. These re-package the payoffs in bundles of asset-backed
securities into an ordered hierarchy of other securities, with each tranche only bearing losses
once tranches above it have been wiped out. A bundle of risky assets could thus be
repackaged into other assets, some of which offered bond-like returns suitable for investors
such as pension funds seeking low-risk assets, while the tranches bearing more risk would
be sold to those willing to carry more risk6. But the pay-offs to these assets are highly
nonlinear in the underlying risks (see Fig. 11). As a consequence the prices are apt to drop
sharply with changing perceptions of the underlying default rates, a feature that has been
apparent during the crisis.
A typical CDO comprises a large number and variety of RMBS, including a mix of prime and
sub-prime mortgages from a variety of originators. On the face of it, this might seem like a
good thing as it creates diversification. However, even more than with plain vanilla RMBS, it
becomes impossible to monitor the evolution of the underlying risks - it is akin to trying to
unpick the ingredients of