id30213687 pdfMachine by Broadgun Software - a great PDF writer! - a great PDF creator! - http://www.pdfmachine.com http://www.broadgun.com ANALYSIS AND INTERPRETATION OF THE U.S. MONETARY POLICY DURING THE DOT.COM BUBBLE AND THE SUBPRIME CRISIS Master Thesis Master of Science in Economics and Business Administration Finance and Strategic Management Candidates: Advisor: Marco Govetto Finn Østrup Thomas Walcher Copenhagen Business School August 2009 1 1. PREFACE ..................................................................................................................... 4 1.1 Introduction ................................................................................................................ 4 1.2 Problem statement ...................................................................................................... 5 1.3 Methodology ............................................................................................................... 6 1.3.1 Method of work ................................................................................................... 6 1.3.3 Definition of key concepts ................................................................................. 10 2. MONETARY POLICY AROUND THE DOT-COM BUBBLE ............................... 13 2.1 The dot-com bubble .................................................................................................. 14 2.2 Actions taken by the Fed .......................................................................................... 15 2.3 Reasons behind the actions taken ............................................................................. 16 2.4 Critics to the monetary policy adopted ..................................................................... 20 2.5 Data analysis ............................................................................................................. 30 2.5.1 GDP ................................................................................................................... 30 2.5.2 Unemployment .................................................................................................. 32 2.5.3 Equity Markets .................................................................................................. 33 2.5.4 The debt securities ............................................................................................. 35 2.5.5 Chase Shiller House Price Index ....................................................................... 36 2.5.6 Summarizing the Data ....................................................................................... 37 3. MONETARY POLICY AROUND THE SUBPRIME CRISIS ................................. 39 3.1 The subprime crisis ................................................................................................... 39 3.2 Actions taken by the Fed .......................................................................................... 41 3.3 Reasons behind the actions taken ............................................................................. 42 3.4 Critics to the monetary policy adopted ..................................................................... 45 3.5 Data Analysis ............................................................................................................ 52 3.5.1 GDP ................................................................................................................... 52 3.5.2 Unemployment .................................................................................................. 52 3.5.3 Equity Market .................................................................................................... 53 3.5.4 Debt market ....................................................................................................... 54 3.5.5 Chase Shiller House Price Index ....................................................................... 55 3.5.6 Summarizing ...................................................................................................... 55 4. CRITICISMS AND PREDICTIONS ......................................................................... 57 4.1 Has the Fed monetary policy been successful? ........................................................ 57 2 4.2 Problems arose during the dot-com .......................................................................... 65 4.2.1 Use of a framework ........................................................................................... 66 4.2.2 Proaction vs Reaction ........................................................................................ 68 4.2.3 Independence of the Fed .................................................................................... 71 4.2.4 “Technical” mistakes ......................................................................................... 72 4.3 Has the Fed been able to improve? ........................................................................... 74 4.4 Is the Fed monetary policy going in the right direction now? .................................. 78 4.5 Economic predictions for the near future ................................................................. 80 4.5.1 Commercial real estate ...................................................................................... 80 4.5.2 Consumer spending: private vs. public debt ...................................................... 82 4.5.3 Leveraged Buy Outs .......................................................................................... 84 4.5.4 China .................................................................................................................. 85 4.5.5 Eastern Europe ................................................................................................... 87 4.6 What to pursue .......................................................................................................... 88 4.6.1 New supervisory authorities .............................................................................. 88 4.6.2 The end of “Too Big To Fail” institutions ......................................................... 90 4.6.3 New regulations for off balance sheet vehicles and Hedge Funds .................... 93 4.6.4 Reform the rating agencies ................................................................................ 93 4.6.5 Confidence ......................................................................................................... 94 4.7 A Final Word ............................................................................................................ 95 Bibliography ................................................................................................................... 98 Appendix ...................................................................................................................... 101 3 4 1. PREFACE 1.1 Introduction Monetary policy is certainly one of the most important tools that a central bank can use in order to achieve its goals. The goal of the Federal Reserve (the American central bank) is to foster sustainable economic growth in the economy of the United States of America. It is natural therefore that in times like the one we are currently in, defined by tragic developments of the global economy, the monetary operations and policies adopted by the central banks are questioned. Recently there has been a lot of discussion about the operations of the Federal Reserve in the years before the bust of the housing bubble (approximately from the beginning of 2001 to the end of 2006). Everybody recognizes the cyclical trends of the economy. Periods of economic expansion are followed by period of contraction and this has always been the case in the history of every economic system. What is then the role of a central bank, if the economy cannot avoid contractions in its cyclical development? What does it mean to foster economic growth, given this cyclical development? Does a central bank really have the possibility to influence the economic cycle? If so, what frameworks does it use? These questions are open to discussion, now more than ever before. We believe that these issues have to be clarified before entering into the technicalities of the specific policies implemented by the Fed. Our opinion is that it is responsibility of a central bank to try to intervene if it recognizes a negative trend in the economy. We are sure everybody would agree on this issue, but we would like to go a bit further in the analysis of the problem. We believe that a central bank has the duty to intervene not only after it observes the negative trend of the economy but also in the very moment it recognizes the beginning of a trend that can create imbalances in the system and eventually lead to a crisis. In other words we think that the role of the central bank has to be proactive and not reactive with respect to the economic situation. This is the case if it wants to obey to its mandate. We believe 5 that for a central bank to be proactive implies the use of a clear framework of intervention. If there is not such a thing than the independency and accountability of the policies adopted by the central bank can be questioned. We think that these are interesting and important issues that cannot be underestimated anymore. In our work we will study what the Fed has done in the last thirteen years and we will try to understand the mistakes it did and if these mistakes were caused by a lack of knowledge or by a misrepresentation of the role of the central bank. We think