NBER Reporter NATIONAL BUREAU OF ECONOMIC RESEARCH A quarterly summary of NBER research No. 3, September 2018 The 2018 Martin Feldstein Lecture The Two Faces of Liquidity Raghuram Rajan* It has been about 10 years since the global financial crisis. What have we learnt about it? The behavior of financial-sector participants was clearly aberrant, and needed to be rectified. We have had a tre- mendous amount of regulation since then, especially focused on banks. Whether this will solve the underlying problems is an issue that is much debated. Yet we have at least attempted to tackle the problems of poor incentives and distorted financial firm capital structures, includ- ing mismatched asset-liability structures. We have paid far less attention to the shadow financial sector — the Raghuram Rajan financial institutions other than the banks — or to the role of macro- economic conditions in precipitating the crisis. We do acknowledge ALSO IN THIS ISSUE the need to bring the shadow sector under the regulatory net, for we Environment, Energy, and did learn that institutions can infect one another through common Unintended Consequences 10 markets. We are less clear about what ought to be done. On macroeco- nomic conditions, even when we do acknowledge a role, when it comes Taxation and Innovation 14 to altering policy, we shrug and move on. Somehow, it seems that we The Economics of Drug Development 19 have agreed that macroeconomic conditions are outside the remit of Mortgage Lending and anyone tasked with addressing financial stability. I will argue in my Housing Markets 25 talk today that this is a mistake. NBER News 29 Conferences 31 Program and Working Group Meetings 38 * Raghuram Rajan is the Katherine Dusak Miller Distinguished Service Professor of Finance at the University of Chicago’s Booth School of Business. He served as the 23rd Governor of the Reserve Bank of India between September 2013 and September 2016, and was chief economist and director of research at the International Monetary Fund 2003–06. He delivered the 2018 Martin Feldstein Lecture, based on this article, at the NBER Summer Institute on July 10, 2018. The lecture is named in honor of the NBER’s president emeritus. Reporter Online at: www.nber.org/reporter the United States, with major components The IMF Financial Conditions Index, 1991–2017 of financial conditions tightening with a lag, especially after Taylor rule residuals Median cross-country measure of financial conditions become positive. Put differently, part of the 2.0 Easing Easing reason there is so much of a gap between 1.5 when the Fed started raising interest rates and when financial conditions started tight- 1.0 ening may well be because monetary condi- 0.5 tions remained very accommodative until 2006. 0.0 These figures are obviously not proof -0.5 that credit conditions remained easy before the crisis because monetary policy was easy. -1.0 All I want to establish is that it is not Tightening entirely ridiculous to argue that monetary -1.5 policy’s influence needs to be investigated Q1 1992 Q1 1997 Q1 2002 Q1 2007 Q1 2012 Q1 2017 in any post-mortem of the crisis. However, for the rest of the talk, it is sufficient for my The Financial Conditions Index is an internationally representative composite of various economic indicators purposes if you grant me that financial con- Source: The International Monetary Fund ditions were easy for a long period before the crisis. Figure 1 Financial Conditions Taylor rule, an empirical description of how The Consequences of Easy and Monetary Policy policy is ordinarily set). It also indicates Financing Conditions that lending standards for corporate loans Figure 1, computed by the IMF, is the and mortgage loans did not start tighten- What are the consequences of easy median at every point in time of the distri- ing until after Taylor rule residuals became financing conditions? The seminal work of bution of financial conditions across coun- positive. In other words, there seems to be a Claudio Borio and Philip Lowe suggests sus- tries, with higher being easier.1 lag between a tightening of monetary policy tained rapid credit growth combined with What we see is that leading up to the and a tightening of representative elements large increases in asset prices increases the financial crisis, we have a tremendous easing of financial conditions. probability of an episode of financial insta- of financial conditions, even though the Fed In Figure 3, we see a similar picture for bility.3 More recently, in a study of crises, started raising the federal Arvind Krishnamurthy funds rate in June 2004. As and Tyler Muir show the crisis spread in 2007, Euro Area Taylor Rule Residuals and Lending Standards that credit growth and we had an extremely sharp credit spreads are nega- tightening of financial con- Taylor Rule residuals (percentage points) Banks reporting a tightening of their lending standards (%) tively correlated before a ditions. By the middle of 1.5 80 crisis begins, with spreads Corporate loans 2009, you see financial con- 1.0 widening a little only just ditions easing once again, 60 before the onset of the and they have continued to 0.5 crisis.4 The change in become much easier. 40 credit spreads as the cri- Now consider two 0.0 sis occurs seems to pre- 20 figures from the work -0.5 dict the extent of the sub- of Angela Maddaloni sequent output decline. 2 0 and José-Luis Peydró. -1.0 Mortgage loans It seems the credit mar- Figure 2 suggests that kets do not really price monetary policy in the -1.5 -20 in the crisis until it is Eurozone was very accom- Q4 2002 Q4 2003 Q4 2004 Q4 2005 Q4 2006 Q4 2007 almost upon them; the modative before the cri- greater their compla- Taylor Rule residuals are a measure of expansionary or contractionary monetary policy. Each residual is the dierence sis, as measured by Taylor between the policy rate and the rate suggested by the Taylor Rule – an empirical description of how policy is ordinarily set cency, the greater seems rule residuals (the differ- Source: Maddaloni and Peydró, European Central Bank Working Paper Series, No. 1248 the gravity of the cri- ence between policy rates sis. David López-Salido, and rates suggested by the Figure 2 Jeremy Stein, and Egon 2 NBER Reporter • No. 3, September 2018 Zakrajšek5 and Atif Mian, Amir Sufi, and since everybody was doing it, Citi could tors get lulled by a series of good signals to Emil Verner6 find similar effects. What the- not be the only one to stop. Herd behavior overweight the probability that the state of ories might account for this? models of banking such as one I have ana- the world is good.8 A few bad signals do not Three come immediately to mind. One lyzed have this flavor; being the lone lender cause investors to worry that the bad state is herd behavior in banking markets. Perhaps to stop lending has costs.7 For instance, in a may be imminent, because they still think the most famous statement made before the credit boom, loan officers may believe they the good state is likely. Eventually, though, crisis was by Chuck Prince, the chairman of have to maintain the pretense that they have enough bad news leads to a radical change Citigroup, who responded thus to a ques- really good lending prospects, and credit in beliefs, and investor pessimism causes the financial crisis. So there is a neglect of the “tail” bad state initially and excessive credit U.S. Taylor Rule Residuals and Lending Standards extension, an initial underreaction to bad news, and eventually, overreaction. Taylor Rule residuals (percentage points) Banks reporting a tightening of their lending standards (%) A different behavioral model, in which 3 100 there is a distribution of optimists and pes- 2 80 simists in the economy, is advanced by John Geanakoplos.9 Relative to pessimists, opti- 1 60 mists think there is a higher probability of 0 40 the good state, where the price of the asset Corporate loans being traded will be higher still. They are -1 20 willing to buy the asset, and even borrow to -2 0 buy yet more. The pessimists sell at the price available in the market, and lend money -3 Mortgage loans -20 to the optimists. The arrival of good news -4 -40 therefore enhances the wealth of optimists, Q4 1992 Q4 1995 Q4 1998 Q4 2001 Q4 2004 Q4 2007 and their positive views have greater impact on the asset price. In contrast, bad news ren- Taylor Rule residuals are a measure of expansionary or contractionary monetary policy. Each residual is the dierence ders a few optimists bankrupt, and allows between the policy rate and the rate suggested by the Taylor Rule – an empirical description of how policy is ordinarily set the consequent preponderance of pessimists Source: Maddaloni and Peydró, European Central Bank Working Paper Series, No. 1248 to push down the asset price. Therefore there is overreaction to news in either direc- Figure 3 tion because it changes the wealth of players, tion from the Financial Times: “When the quality has not deteriorated, since no one and therefore effectively changes the mone- music stops, in terms of liquidity, things will else seems to be worried or shows signs of tary weight placed on beliefs. So behavioral be complicated. But as long as the music problems. Rather than be singled out as the explanations of various kinds could be use- is playing, you’ve got to get up and dance. incompetent lender who cannot find good ful in explaining the abrupt shift that we We’re still dancing.” prospects, the loan officer ensures credit saw from the complacency before the crisis I met Mr.