How do central banks deal with the issue of financial (in)stability? - Course 1 recap

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En provenance du cours de University of Geneva

Meeting Investors' Goals

908 notes

University of Geneva

Meeting Investors' Goals

908 notes

Cours 2 sur 5 dans 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.

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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.

How do central banks deal with the issue of financial (in)stability? - Course 1 recap10:30

How do central banks deal with the issue of financial (in)stability? - Asset prices8:37

An interview with Prof. Jean-Pierre Danthine16:12

Rencontrer les enseignants

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]

Hi there!

In this set of three videos we are going to talk about central banks and

we are going to see how they deal with the major issue of financial instability.

In the second video, just after this one,

we're going to have a debate with Professor Jean Pierre Valteen,

who was actually my professor of economics and he gave me really,

the passion for economics, and he was also my PhD Director.

And he was Vice Chairman of the Swiss National Bank.

So we're going to talk about central bank policy and

how they should deal with the crucial issue of financial stability.

So by the end of these three videos.

You will know that central banks may have conflicting goals.

And you will know how they deal with the issue of financial instability.

And last but not least we will also address the fundamental question

of whether central banks should include asset prices in their inflation targeting.

But first, before we go into this, let's have a look at the various mandates of

the central banks and see what their aims are, starting with the Federal Reserve.

What we see is that we always talk about the Federal Reserve,

the Fed as having a duel mandate, IE two objectives.

Actually there are more three than two as you can see from this excerpt

which was the Federal Reserve Act in 1977.

It states basically that first and

foremost the Federal Reserve wants to achieve full employment.

It says it shall maintain long run growth of monetary and credit

aggregate commensurate with the long run economic potential, blah blah blah.

So it's to ensure maximum employment, then stable prices and

also and this is less known, moderate long-term interest rates.

So it's actually really two objectives and possibly even three.

Okay, moving to the Swiss National Bank, here we have the typical, I would say

monetary stance which states that you should focus on price stability and in so

doing you will ensure that economic activity is alive and well.

So you see here when since the SNB, the Swiss National Bank, is to ensure price

stability and in so doing to take due account of economic developments.

So this is the typical Milton Friedman theory saying focus on price stability and

you will take care of everything, basically, of economic growth.

Now, moving to the ECB, the European Central Bank, there too we have

the monetarist tilt in their mandate of saying that the primary

objective of the ECB is to maintain price stability within the Eurozone.

There's no specific reference here to the fact of financial stability.

When there's market turmoil like there is currently, in the beginning of this year,

2016, how should central banks react to this turmoil, to this price instability.

We see that the BOJ, the Bank of Japan and the Bank of England, they are the first

to actually say that they want to maintain monetary and financial stability.

So here we have two central banks that do include financial stability

in their mandate.

The Bank of Canada, and the Reserve Bank of Australia have a different focus.

And we can see why because Canada and Australia for

them these two countries the currency is of primary importance.

So their goal there is to maintain the integrity and value of the currency.

And finally, last but not least, we have the People's Bank of China, so the central

bank of China which is a combination of Bank of Japan and Bank of Canada.

It says here that the People's Bank of China, shall guard against and

eliminate financial risks, and maintain financial stability.

So financial stability here is part and

parcel of the objective of the mandate of the Central Bank.

And also the aim of monetary policy should be to maintain the stability of

the value of the currency and thereby promote economic growth.

This makes me smile a little bit because, well,

when I say maintain currency stability and thereby promote economic growth,

I immediately think, yes, well possibly, but maybe not.

[LAUGH] Just think of this.

Let's assume, this is clearly not the case now,

that the one would be at a very high level, indeed,

an overvalued level vis a vis the Euro and vis a vis the dollar.

Remember when we saw the Big Mac parity?

This was more the case for the Swiss Franc than for the Chinese currency, but

let's assume that we swap here,

and that the most expensive Bic Mac is that of China.

And so China becomes the most expensive currency in place of the Swiss Franc.

So a really overvalued currency.

Would a central bank aiming at maintaining the value

of a currency at an overvalued level achieve economic growth?

I am not sure about that so.

Probably here we have to take these mandates with a pinch of salt,

and assume that here we're talking about maintaining stability in

the currency market, but not when the currency is at an overvalued

level because that's not going to ensure economic growth.

Okay, so we here that central banks may have different goals but

they all are more or less converging,

price stability, focus on currency, but

not all of them include financial stability in their mandates.

But we're going to be talking about this with debate with Jean Pierre Dante in

the next video.

Before we move into the key issue of whether financial stability

should be part in puzzle of the mandate of the central bank I want to

illustrate with you this principle of this mister Jan Tinbergen,

he was actually the first economist who won the Nobel Prize

when it was first instituted in 1969.

And Jan Tinbergen made a very famous contribution for

economist when dealing with Central Banks, and it became the key principle.

And the key principle is actually a simple one, but very powerful idea.

That basically central banks have instruments and they have goals.

Instruments can be the interest rates,

can be currencies, and the currency, money supply, and

goals can be priced ability, can be financial stability.

Can be full employment.

Sometimes the instrument could be a goal and say, typically the currency, right?

As we just saw.

Some central banks do say that their aim is actually to maintain a stable currency.

Okay so an instrument can also be a goal but the rule of Mr.

Jan Tinbergen is to say, you should have as many instruments as there are goals.

Ie you know the famous saying which says,

you try sometimes to kill two birds with one stone.

But here Mr. Tinbergen says you cannot kill two birds with one stone,

you need two stones, okay?

So this is principle.

Now let me illustrate you how sometimes central banks may have conflicting goals.

And the example of the following we already talked about

Brazil which is currently going through so-called stackflation.

You see here on this chart in red the evolution of growth.

You see that the GDP is falling, indeed quite sharply so.

It's on the minus 5% and on the left hand scale.

But you see simultaneously inflation is growing.

And it's rising and it's a double digit.

It's at 12%.

So what should the central banks here do?

Should it raise interest rates to address rising inflation?

Or should it lower interest rates to promote growths.

Here two conflicting goals.

Okay, and the other conflicting goals and

this is indeed a major issue and a major debate for central banks.

Is sometimes you want to lower interest rates, because you want to promote growth.

Or you think that growth is too weak,

which is currently the case in Switzerland, in the Eurozone.

But simultaneously, you see that these low interest rates.

They're actually even negative in Switzerland, and

in other countries, as well.

These lower interest rates fuel an asset price bubble.

Basically, everyone buys real estate and prices go through the roof.

And so the central banks here may have conflicting goals if it wants to achieve

financial stability.

It has a problem because at the same time it wants to keep interest rates very low

so as to keep the Swiss franc low.

For instance in the case of the Swiss National Bank or to promote growth for

the European Central Banks.

But these low interest rates may fuel an asset price bubble.

[MUSIC]

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