Top national economists, gathered recently at the University of Virginia to discuss the impact of national and international economic policy, focused on two key themes as possibilities for preventing another recession: redirecting federal attention toward margin rates, instead of just interest rates; and regulating shadow banking.
Coming as the nation anticipates December interest rate increases from the Federal Reserve, participants in this year’s Conference on Mathematical Economics, held Nov. 6-7, examined other policy avenues that might be more effective in preventing another crash.
The Importance of Leverage
Much media attention has been devoted to if and when the Federal Reserve will raise interest rates. However, during his keynote presentation, John Geanakoplos, the James Tobin Professor of Economics at Yale University, suggested that the media – and the Fed – should be paying more attention to a less-heralded metric: margin requirements.
“We should make it easier for people to borrow during bad times and put restrictions on how much people borrow during good times.” -- Ana Fostel, UVA economist
Margin requirements refer to how much money consumers must put down to purchase an asset, such as a home. Fluctuations in margin requirements create what Geanakoplos calls a “leverage cycle.” In very good times, leverage – the difference between the down payment required and the actual value of the asset – is too high and consumers can more easily secure assets they cannot actually afford. In very bad times, leverage is too low and consumers have too few options for building up their assets.
The last recession fits this pattern well. Leverage soared during the boom period from 1999 to 2006 and then collapsed from 2007 to 2009. To prevent this from happening again, the Federal Reserve Bank must monitor margin rates as closely as it does interest rates, argued Geanakoplos, whose research on the relationship between leverage and asset prices is widely acknowledged as one of the best theories explaining the 2008 housing bubble and related recession.
“John was one of the economists who actually developed mathematical tools to help us understand the crisis as early as 1997,” said UVA associate economics professor Ana Fostel, who co-organized the conference with Mateo Maggiori, an assistant professor of economics at Harvard University.
“The Fed is always targeting interest rates, but if they had intervened on margin requirements before the crisis, we might not have had so much leverage and the crash might not have been so bad,” Fostel said.
“We should make it easier for people to borrow during bad times and put restrictions on how much people borrow during good times,” she said, noting that this could help curtail the drastic boom-to-bust cycle that proved so devastating in 2008.
Regulating Shadow Banking
Shadow banking refers to a system of financial institutions, such as hedge funds, that carry out banking functions outside of the traditional system of regulated deposits and are not subject to traditional banking regulations. Shadow banks extend credit to riskier borrowers, providing more liquidity to investors in good times. In bad times, however, those riskier assets become illiquid, creating a more fragile system.
One paper, presented by Yale professor Alan Moreira and NYU professor Alexi Savov, sparked extensive discussion about how to regulate shadow banking as part of a holistic approach to minimizing economic crises.
Shadow banking thrives during good times, but those boom periods build up more and more fragile assets that eventually prime the market for a crash. Consequently, as Moreira and Savov wrote in their paper, shadow banking “propels the economy in good times at the expense of bad times.”
The Conference on Mathematical Economics has been the premiere gathering in the field since its inception in 1970, when five of the 10 original presenters went on to win the Nobel Prize in Economics. This year’s event focused heavily on the Great Recession of 2008.
As the recession wore on, many economists, politicians and journalists wondered if economists had focused too much on math and lost touch with reality. Geanakoplos’ models – not part of the mainstream models used in macroeconomics – did not receive enough attention until after the crisis, Fostel said. Now, Geanakoplos and the almost 40 economists attending the recent conference are using complex mathematical models to try to explain what caused the recession and how the country might move forward.
“The richness and diversity of this conference proved that we have made a lot of progress and that there are still many questions to be explored,” -- Ana Fostel, UVA economist
“This conference is an example of how we can use mathematical models – in the right way – to explain a lot of things,” said Fostel, who has worked with Geanakoplos for a decade building such models. “We addressed a lot of questions about the impact of monetary policy, how global markets were effected by 2008 and of course, what caused the crisis and how we can use new mathematical models to prevent it from happening in the future.”
The conference drew participants from UVA’s Department of Economics and the Darden School of Business, as well as representatives from other leading institutions, including Yale University, Harvard University, the University of Chicago and several others. There were 10 presentations on national economics topics, such as the housing bubble and the functioning of over-the-counter stock markets, and international topics, such as volatile exchange rates and the special status of U.S. Treasury bonds.
In addition to discussions of leverage and shadow banking regulation, presentations at the conference explored the impact of monetary policy, especially on income inequality; the safety of U.S. treasury bonds; the behavior of exchange rates and global imbalances. All used mathematical models to identify and explain key implications for monetary policy and global financial stability.
“The richness and diversity of this conference proved that we have made a lot of progress and that there are still many questions to be explored,” Fostel said. “That is what makes this an extremely exciting time to study economics.”