Alexander Bleck of the University of British Columbia explores the unconventional responses of China, Europe, Japan, and the United States to the 2007–09 financial crisis.


Larry Wall: One of the things you notice when you pay much attention to financial instability around the world is how frequently it's correlated with problems in the real estate sector. That has long puzzled me. There was also the comment that the U.S. problems in real estate originated from loose monetary policy in the early 2000s, and that also kind of puzzled me because by the end of the boom, monetary policy had pretty much normalized.

So I found it very interesting—this paper by Alexander Bleck—that's going to talk some about how financing can influence real estate prices. He is on the faculty at the University of British Columbia. It will be discussed by Julia Coronado, who is president and founder of MacroPolicy Perspectives. There is additional information on both speakers in your packet. And with that, I'll turn it over to Alexander.

Alexander Bleck: Well, thank you so much for putting the paper on the program—to Larry. He's seen the paper once before, and so I'm kind of grateful that he's willing to sit through this one more time. [laughter] And I have to say, it's a little bit intimidating to speak to such a diverse audience—some of which are policymakers—and the paper has a bit of the flavor of highlighting an unintended consequence of policy—so I guess I'm on very thin ground here. And as the speaker tomorrow pointed out, it's hardly as bad following lunch—it's not quite as bad as following Larry Summers. So I think I have the easier task today, and I should stop complaining.

This is joint work with somebody who used to be my PhD classmate a while ago, Xuewen Liu, who is in Hong Kong at HKUST [Hong Kong University of Science and Technology]. In the paper, basically we try to think about why monetary policy—especially the very aggressive kind that we have observed following the financial crisis—apparently wasn't all that effective all the time, everywhere, and what might explain that. Part of the answer is that there are some unintended consequences, naturally, and I'll try to maybe see if I could open your mind to that a little bit.

I have to say the talk is quite high level, so I hope I got that pitch right. But let me try to motivate that first with some observations—probably in this room I don't have to motivate that very much—that following the financial crisis there was enormous stimulus, especially of the monetary kind, in various forms and shades around the world. And it's fairly obvious that this stimulus was motivated by the fact that we were trying to save all these economies from dipping into a recession following the financial crisis. But what's turned out is that apparently these policies were not always that effective—and I'm going to free ride on Raghu's argument on what "effective" is here—on stimulating the real economy. Apparently, some places in the economy were very much stimulated, but apparently not always the ones that we thought ought to have been stimulated.

I think if you look around in the data that that's particularly true, I think, in emerging markets. A very illustrative case in point of that is actually China—and China for, I think, two reasons: one, the stimulus package was extremely large there. It was about—depending on a little bit how you counted—about twice that of the United States, by some measures (13 percent of GDP at the time). Not all of which was monetary stimulus, but that's included. I think it's about or around a third.

But also, that's not the only reason. The second reason is because China is a very much heavily bank-based system. And so, both of these things, when you think about how the stimulus should have transmitted through the banking system, and the money should have ended up at the right places: this is of course the place to look when you want to think about why the money didn't end up in the right places.

So when you when you look at the data, the stimulus was extremely large. You can see the—it's not a very sophisticated graph here, but if you look at that graph it probably sticks out to you that the money supply jumped up substantially, and in response funding to various places in the economy increased—in particular, bank lending just about doubled. You can see this also when you look at the composition of funding in the economy, and I want you to focus on the big blue chart, which is bank lending. And so you can see that the biggest increase was in the form of bank loans. That about doubled in one year, so I would call that a massive stimulus.

And so the question is, well, what happened to that money? And let's maybe check some outcomes—and I'm not trying to be too provocative here, given the introduction that Larry just gave. Apparently, one thing you can see is that some markets, especially housing markets, apparently responded quite strongly—this is of course cherry-picked a little bit. Beijing, where house prices—much like in, where I currently live: Vancouver—about doubled in about two years. You can also pick Shanghai, and it looks not too different.

But those aren't the only markets that apparently had a boom. I could also go on down the list. Commodity markets seem to have experienced a similar thing, that when you strip out things like agriculture—so food and fue, so things that are probably commodities that were used more for production. They also just about doubled in price, a lot of which was attributed to China.

I ran out of graphs here, but if you looked at the stock market in China, that pretty much followed a very similar pattern. And yet, if you look at the real sector—so I kind of abused this here. At the top here, I call this the financial sector— it's what I call I guess the non-real economy sectors: real estate, commodities, and the stock market.

But if you look at the real sector that apparently we were trying to stimulate with this these massive packages, there's a different picture that emerges. In particular, if you look at small to medium enterprises that still make up the chunk of the economy—even in China—in fact, things look actually worse than they looked before the stimulus. That is, there were lots of places where actually their borrowing rates increased after the stimulus—not decreased, which is what you would expect from traditional explanations of monetary policy. To some extent, that became so problematic that some of these firms actually were totally left out of the credit market altogether after the stimulus.

I'm trying to suggest to you that, yes, some sectors were very much stimulated. But the places that we might have thought should have been stimulated apparently weren't, or even had a harder time getting financing than before the stimulus. Even though China, for those reasons that I mentioned—the fact that they are bank-based and had a large stimulus package—even though that's, I feel, a good illustrative case in point, there are similar phenomena if you look in other economies. The alphabet soup takes off here, so in the U.S.—we called it credit easing—and there were a number of rounds. So the fact that we had QE [quantitative easing] one, two, three, four—or, as Raghu said, to infinity—probably suggests that any one of these rounds could not have done the job. It was also massive. And you looked in other places—Europe, Japan, or other emerging economies—the picture is somewhat similar.

And since we're on the U.S., there is now some evidence that of that type of stimulus in the U.S., Andy highlights also that, following the stimulus, apparently credit to the real economy in fact was also reduced by bank and that the stimulus package actually had very different effects on credit to different places. Mortgage credit apparently went up, but commercial credit didn't. So these are sort of similar phenomena there.

So the question is, what explains this? And one way to think about this is what, for example, do these three examples here, or sectors—the top—what do they have in common? Why are they so fundamentally different from what we would call some chunks of the real economy?

And so naturally, we were wondering what is therefore the best response by policy? What is the optimal policy here? And apparently since we're trying to explain this somewhat unexpected picture, what is the limitation of it? What is the downside of having such expansive policy? Specifically, I guess we want to ask two questions that I've made somewhat shorter here. One is, what is the effect on lending? How well does this strong policy transmit through the banking system? And what does it do to asset prices in these different sectors?

The answers that we want to give are that there is a crowding out of credit to some places if monetary policy becomes too expansive, and that certain asset markets, you should expect to boom. Now probably, when you look at this, the first argument I think is new. The second argument, I'm sure you've heard before. Our argument is a little more intricate. We would say that, in fact, those two are not unrelated phenomena. In fact, they're sort of two sides of the same coin. It is because there are asset booms in some places that causes credit not to go to certain places. And so the punchline then would be that monetary policy itself, in trying to address one market failure—that in the credit market—actually causes a market failure. That is the unintended consequence, the downside, of it—when it becomes excessive.

Let me back up and become a little more high level—which I guess as an academic, you're always tempted to do. When I first thought of might have noticed in the program, my job is actually that of a bean counter. I'm a professor of accounting, but my research interests, I guess as you can see, are fairly eclectic. When I first looked at this with my co-author, I tried to figure out—since this is somewhat new to me—what is so special about this? One thing I noticed is—when you look at how monetary policy is implemented—it in fact is implemented in a particular way. The central bank, through its various tools and mechanisms, doesn't give money directly to the real economy—which, if you looked at this picture and you said, "Well, the money doesn't end up there—why don't they just give the money to the real economy?"

We don't typically pick winners and losers as the central bank, so there's no direct lending to the real economy. But instead we give it to the credit market, in the hope that the credit market will put it in the right hands in the real economy. And you could see probably why that might make good sense. The banks, of course, by their existence are the ones that probably have better information about where that money is most effectively invested, who the deserving borrowers are. So, since it didn't work, there must be some downside, and our exploration is that there is an imperfect alignment between how the central bank—if it had the information about the deserving borrowers—would lend, and what the individual private commercial bank would do.

Broadly speaking, the central bank has a much broader thing in mind: the economy as a whole. It has the social value in mind. The individual commercial bank is much more narrowly interested, self-interested, in its profit, its risk-adjusted profit, from a lending transaction. Therefore, you don't expect those two to do the same thing, even if they shared the same information. And so that downside, that misalignment, leads us to think that when you take money as a central bank and you give it to these commercial banks that don't necessarily have the same incentives, relying on and implementing the policy through the credit market could actually distort this credit market, and as a result therefore actually produce another market failure in the attempt to correct another, which has of course helped the credit market on its feet in the first place.

And so, another way to put this—which seems somewhat curious to me, who admittedly had not thought about this very much before this came along—is that typically policy is motivated on some market failure, and clearly in this case you would think it's a failure in the credit market to efficiently allocate credit in the economy. But now that we observe that there is this failure, what we do in response with a policy is we give more money to the failed market to do the allocation that it wasn't happy to do effectively beforehand, and so that to me seems like a little bit logically not fully consistent.

And so that, to an economist, of course—that sounds like what they would call the theory of the second best—if you've got one problem in the economy and you try to address it with policy, then you better make sure that that policy does not worsen another problem in the economy to the overall detriment of the economy. And I guess that is what we're trying to potentially use here to explain why this excessive policy might have backfired.

Okay, so the basic idea is that if you think back to the basics of monetary policy, or macroeconomics. By the way, what I'm going to say now is—I'm going to be a little bit loose with some terminology and use words like "liquidity," "money," and "credit" as if they were the same thing—I hope I don't have to explain to you that they're not the same thing, but just for the sake of the talk, I'll pretend as though they are. So as a nonnative speaker, it makes it a little bit easier for me.

So what you would expect is: as the monetary policy expands, as the supply of money goes up, the price of money—money is not as scarce anymore—the price of money should go down. The interest rate should fall. Therefore, all else equal, firms would have an added incentive to perceive value-attractive investments. And that's, I guess, the traditional channel.

Now, we want to argue that you should not expect that to be true in a context where you take the problem that motivates monetary policy in the first place seriously. In academic-speak, in a general equilibrium, the demand for credit, the demand for liquidity and the supply of liquidity are not independent. In fact, we would argue that the supply of liquidity affects and causes the liquidity demand to change. And therefore, since both of course determine the price of money—the interest rate—you now have to be careful about just exactly how this multiplier, if you will—the extra effect on liquidity demand—works to make sure that the policy indeed has the desired effect.

Now most of time, I will say this actually goes in the right direction. The argument is as follows: what happens here, and the reason the liquidity [supply] can affect the liquidity demand is because of the reason why firms find it difficult to borrow in the first place: the financing friction. And so the optimal way to finance, often, is therefore to resort to secured lending, in which the very investment project has a dual role. It's no longer just the source of production but also the thing that makes the borrowing easier. It serves as collateral. And therefore, a bank that sits there and says to itself, "Well, if I were to lend to this firm and this deal is going to go belly up, well, how could I reduce my risk in the transaction?" Well, if there is fundamental or strategic default the guy can't pay back, I'm just going to seize the collateral and sell it.

And therefore, what mitigates the risk to the bank is, of course, a higher future market price of this investment. The higher the rationally anticipated market price, the more the bank is willing to lend against this higher value of the collateral today. And therefore if it is true that more money spent, essentially, in a sector does have the effect—as I'll try to convince you in a bit—of appreciating, potentially, the asset price. That now means that everyone in the sector could borrow more. The collateral value is higher, and therefore that, you would think, is a good thing for everyone in the sector. So therefore, the fact that the supply does affect the demand is actually a good thing, even though it does muck with the interest rate.

So, the same thing put a little bit differently, in graph terms [shows graph]. What's here on the left is essentially the traditional view of monetary policy. And that is—these graphs essentially plot the interest rates against the quantity of money—and in blue...and I don't know how to. ..does that do anything?

In blue here, that is the supply curve, and in the other blue—strikingly similar, unfortunately—is the demand curve. The traditional view of monetary policy therefore is as the central bank acts and injects money into the economy, the supply curve would shift out. Since demand is traditionally unaffected, we are at a low interest rate and it has all these stimulating effects. Now that, we would argue, is not always true. It depends very much on the extent to which borrowing is difficult in the first place—on the severity of this financing friction.

So, take a second sector—there—which illustrates now how supply does, or could, affect demand. As the supply curve shifts out, demand is affected, and so the demand curve also shifts out. And depending on how strongly demand responds to this extra supply, we could end up in a situation where the interest rate is actually higher than it was before we instituted the policy.

What I'm trying to highlight here is, Sector 1 and Sector 2—I guess I have stand-in names for them. Sector 1 is a sector that is harder to lend to. The demand does not respond as easily to the policy. And Sector 2 is a sector in which, when you pour in money, people will actually use this money in some way. And that might lead to an increase in the asset price and therefore in an increase in the effective demand for money, okay?

And so you would think that, even though the interest rate may go up it may not always be a bad thing, since the collateral value has gone up. That is an opposing force in how people can now go about borrowing. You can probably guess what I'm about to do—I'm about to argue that Sector 1, for some reason, will look like the real economy, and Sector 2, like commodities, the stock market, and all the other ones I had up there earlier. The main idea is that what differentiates these two places is the degree, the severity, of the financing friction, okay? All right.

That's true, I guess, for any one sector on its own, but of course they don't exist in a vacuum. In the economy, they compete for money, so if you put them together—that is our attempt at the explanation of why credit might not have ended up in the right place. That is what we call this crowding-out effect—the fact that if you inject money, some sectors actually receive—or are able to borrow—less money. They end up with less money, less credit, than they would have ended up with before you put money into the economy, just the opposite of what you might have expected.

And so, to see this—and I'm still struggling with these two buttons, I'm not sure why. So I think that initially in the economy we had a total amount of money in the economy of QI, which ended up sitting in Sector 1—that's this little bit—plus a quantity QII. That's the total amount of money in the economy that ended up sitting in these two sectors. Now the central bank starts injecting a further amount. And the further amount, given what I just showed you on the other slide, apparently could shift out the demand curve—stimulate Sector 2 more—to the extent that the interest rate actually decreases. And at that higher interest rate the only way this credit market could clear is now, such that there is actually less money that flows into Sector I. In fact, it gets taken out, and pumped back into Sector 2.

In fact, it's worse than that—it kind of feeds on itself. The reason is that in Sector 1, once you put money in, because the collateral value in Sector 1 does not respond as much—but it did respond in Sector 2. In Sector 2, all these firms that are now stimulated, where the money is flowing into, they see the value of their investments, that are being productively pursued, appreciate. That increases the collateral value, which means that more people, more firms in this sector, now qualify to borrow. They can borrow, which increases the demand, the competition, for money. Therefore, when the competition for money goes up, clearly the interest rate that banks can get away with charging goes up. But since, of course, any firm in the marketplace competes for this money, so do firms from Sector 1 that did not see the appreciation in the collateral value but are now faced with a higher interest rate.

So at those terms, the bank says, "Well, if my risk is higher, the collateral value is not as high, and I have to live with a higher interest rate. Well, I'm not going to lend as much to Sector 1." So they might have received $100 million before the stimulus. After this excessive stimulus, they may only receive $80 million—the extra $20 [million] goes into Sector 2. And that may then therefore further appreciate, lead to further investments, further appreciate the collateral value, lead to further relaxation of these borrowing constraints, further competition for money. Interest rate goes up, and that crowds out more money out of the initial sector.

And so I realize I'm probably jumping a little bit ahead of myself. But you can see now—I guess I'm happy to say this now—that one thing, you can of course see why that in itself, of course, is a market failure. There is an externality from Sector 2 to Sector 1. Sector 2 attracting the money hurts Sector 1, because they get—as a result of the first one getting the money—less money. So now, if you imagine what if Sector 1 were actually the more productive sector—the real economy—but they're just harder to finance? Think of maybe a pharmaceutical company, that if they want to come up with a new blockbuster drug, but when they go to the banker and say, "Hey, can I please have a loan?" He says, "Well, what can you secure the loan with?" And they say, "Well, at this moment, nothing but a good idea."

Of course, I'm exaggerating here. But that is one way to think about this, and therefore you could see that it might be not a good thing for the economy as a whole if the productive sectors end up being the ones that are hardest to lend to.

I feel like I've already said what's on this slide, but let me—since this was fairly high-level here—let me try to therefore get to the concrete point that makes these two sectors that I've described, with the real economy and commodity markets and so forth, generally speaking. What really is the difference between them? And to us, the difference is, as I said, the severity of the financing friction. In our argument, this comes from the fundamental nature of these assets. In the sector over here, that is apparently easier to lend to, we would call these assets less specific, another way of saying there are probably many more potential users of these assets that would be, if they were put up for sale, be willing to use these more, and therefore be willing to pay more for these assets than in Sector 1.

So take maybe an egregious case—that of a house. You don't probably have to be an expert to know how to live in a house, or buy one. But in order to operate the machinery of a specialized carmaker that only can make cars by that car maker, you probably won't find as many people, as many firms, interested in buying the machinery off that car maker if that car maker were to go belly up, the bank were to seize the collateral, and then try to find a buyer. In that market, probably the future market price won't be able to find as many buyers, won't be able to fetch as high a price. And that is to us what, in our argument, what differentiates these two sectors: what commodities—stocks, financial securities, and commodities (by their very name, they commoditize)—have in common. They are a lot less specific in their usage, an interpretation is that it might require a lot less expertise, perhaps, than how to operate and derive value from specific machinery, for instance.

And so what that, in some sense, highlights is that, as you can see—as I'm trying to indicate with these graphs here—is that money by itself is hurtful. But before we even get there, money by itself cannot solve the problem, right? Even if there were only one sector, QI, if you poured nothing but money, flooded the sector with money, apparently—according to our argument—that collateral value might not respond all that much, and you might not get the favorable multiplier effect.

Therefore, there is something more fundamental that anchors, and therefore potentially also limits, the effectiveness of policy. That is the fundamental value of these assets, which in our story here depend on how specific they are. It is the specificity that really makes people later on be able to use them to a higher and more effective extent. That will keep the future asset price either higher, or not. Therefore the bank internalizes and says, "Well, if the loan were to go belly up and I can't sell this asset for a high price, I'm not willing to lend as much to this sector today."

I feel like I've already said this, but what does optimal policy therefore look like? Our argument is that—we're not trying to suggest that monetary policy would not probably be a good place to do this. In this crowd that would be a bad thing. What we're trying to suggest is that excessive monetary policy might come at a cost, and so one way to see this is in this graphic—just put these graphs together to show this maybe a little more succinctly. So imagine again that we're in a case where the amount of money in the economy is QI—this bit—plus QII, which is that bit. And they're somehow initially allocated across these two sectors. Now the central bank wants to inject money again, and that money initially will flow to both sectors.

But at some point—in fact, I picked that point judiciously—at QI plus QII, that is the optimum, because as you start to inject further money, that money will flow to Sector 2, which will see its collateral value appreciate, end up clearing the credit market at high interest rate, crowd out Sector 1. Well, that money, that market, has to clear. Where is that money going to go? It's going to go to Sector 2 and so forth. So there is a benefit, clearly. Both sectors will be helped by the policy, to an extent. When you haven't exhausted the optimum amount, everybody will get money, and that will be a good thing. It's just when you push beyond this bliss point—which of course, in practice...don't ask me for a number or anything here—but in practice, of course, is a difficult thing to figure out. But we are arguing that the excessive monetary policy—QE three, four, five, six, seven—in fact might actually be more ineffective than helpful.

And so, let me end with maybe putting that into words: we want to argue that in some sense, temperate monetary policy that does get implemented through the market, where you give money to the banks in the hope that they put in the right places, is effective, that it can stimulate the economy. But it's the excessive kind that actually distorts the credit market. In fact, the credit market will give you the wrong signal, in some sense. It will tell you that one sector is more worthwhile of investment, but that is in fact what is hurtful to other sectors. And clearly the individual market participant doesn't care about that, and therefore that is the market failure that undermines this type of policy.

And therefore that suggests there is perhaps a limit to thinking about this very blunt policy. Just giving money bluntly, and hoping it's going to end up in the right places, since it's not as fine-tuned, might have these distorting effects. And therefore, to understand this, it seems we may have to go back and try to understand the nuances of what really explained the market failing that justified the policy in the first place, to really try to understand what the optimal policy design should be. And specifically in our case, I guess that meant, what really makes sectors respond differently to the policy? That is, I guess, the culprit here.

So I don't know how I'm doing with time—I forgot to time myself—but I'll stop here. Thank you very much.


Julia Coronado: So this was a real pleasure to read this paper. This was, I think, a paper that is part of a growing academic literature that's trying to put a more rigorous framework around the financial sector and its interaction with the real economy and the interaction with policy. And that is indeed a worthy goal because it's obviously something that we're living with, we've been living with for a long time, and we're probably going to live with it for a lot longer, so the more we can understand the essence of what that interaction is, then the better policy decisions we'll be able to make. And we've been sort of making things up as we go along, and it's good to kind of have these more theoretical explorations.

The model creates a very useful structure, I think, for formalizing a relationship between credit availability and asset valuations,  solvency—Alex didn't go into detail about some of the mechanisms for why the central bank gets involved, but that is in the paper. And that that differs across sectors, and that the idea of asset specificity or financing frictions. And I think it's, to me, very productive to have that kind of mechanism in an economic model of a feedback loop between the credit creation and the asset valuations. Clearly, I think, that is something that is a reality that we live with, and that the Fed has been interacting with, and so certainly, having that in the model is I think quite productive and useful.

As Alex noted, he does equate a lot of things: he equates liquidity and credit, and he specifically equates central bank liquidity with private bank credit. And I think that can potentially lead us astray in drawing policy inferences. Not "astray." I think I'm pretty sympathetic to the policy conclusions that Alex draws, but I want to broaden the discussion to really kind of look for what is the broader framework. What was the motivating force that led the Fed—or the ECB [European Central Bank] or the Bank of Japan—to engage in these unconventional policies?

So I'm going to discuss this through a concept—the concept of financialization. Financialization is a term that gets used like "asset bubbles." It can mean a lot of different things. So to me, in spirit, it's a lot of what Alex is trying to get at with his asset specificity. So I'm going to define "financialization" as when the exchange of goods and services is increasingly facilitated through financial instruments. We've seen that financialization allows you to exchange goods and services across different currencies, across time, across different states of the world. There's a lot of contingencies you can build into financial contracts that allow you to exchange goods and services, and it also allows you to borrow. It allows you to take assets and turn them into credit and liquidity and grow and make decisions. And this has been something that has been a trend. I am going to divide time between the postwar period and 1980 and 1980 and now. And since 1980, we've seen a rapid increase in financialization, as I define it, and a rapid increase in debt, debt-to-GDP ratios.

And that financialization can—in Alex's framework, or similar to the framework he's modeling—it can amplify a natural speculative process. I quote Keynes here because still, to me, Keynes's Chapter 12 is one of the best descriptions of how markets really work, and I often return to it.

When you have, in a financialized world—he wrote this, he's writing in the aftermath of the Great Depression, obviously the boom and bust of the equity markets—he says, "When investing, the American is not attaching his hopes to the investment's long-term expected return, but rather to a favorable change in its short-term valuation—i.e., he is a speculator. Now, speculators may do little or no harm when they're only bubbles on a steady stream of long-term investors, but they can be seriously harmful when long-term investors become the bubble on a whirlpool of speculators. When the capital development of a country becomes a byproduct of the activities of a casino, the job is not likely to be well done."

Okay, so what is Keynes talking about? Keynes really struggles with the speculative, with liquidity. Keynes is talking about market liquidity, and he laments market liquidity and the short-term thinking that it can give rise to. But at the same time, he understands that that very market liquidity is bringing more capital into the market than would otherwise enter the market, so it's a trade-off. I think this is really the spirit—so this is not new. Financialization and the angst about the efficient allocation of capital through liquid markets—this is something we've been living with for a very long time.

So this is debt-to-GDP [shows charts] in the United States since World War II, and this is all debt, so this is financial [plus] private sector and public sector nonfinancial debt as a percent of GDP. So you can see that between the late '40s and 1980, we're kind of on this gentle upward trend, from about 145 percent to 160 percent. And then after 1980—mid-1980s—we saw a big jump up, and then another sort of upward drift, and then a sort of exponential spike up to 380 percent, so that's a pretty phenomenal degree of financialization.

And what are the drivers? Well, there are multiple drivers. Floating currency regimes after the collapse of Bretton Woods no doubt facilitate easier money rather than tighter money. Technology and globalization—I remember when I was at the Federal Reserve Board, and we were looking at that sort of level shift up in the mid '80s. We talked a lot about things like credit scoring and the ability to extend credit to borrowers who previously were constrained, to access credit cheaply and easily. So that's technology, globalization, and the rise of China—so creating a large and growing nonmarket economy, that's the savings glut sort of channeling its reserves back into markets. And then the deregulation of the financial system. And then I would say, when we're talking about monetary policy, the complacency of regulators, the faith they put in the efficiency of markets and the efficiency of risk takers to take risk well, and the supremacy of the efficient markets hypothesis over the kind of imperfections that Keynes was thinking of and grappling with.

So obviously that was an unsustainable degree of financialization that led us to the financial crisis. And I think what's really striking for the United States, we actually did delever somewhat—a little bit—and we've been stable. So it's kind of remarkable that we've actually achieved a recovery through some deregulation, some pretty meaningful deregulation. This [set of charts] takes the same debt-to-GDP ratio across different sectors, so the nonfinancial business sector—the household sector on the top charts, and then the public sector and then the financial sector. So I think a couple of interesting things there that the business borrowing really didn't account for much of the leverage overall—about 20 percentage points of 220 percentage points—but what's interesting is that business borrowing has become quite a bit more cyclical since 1980. We actually borrow and deleverage, and borrow and deleverage in the nonfinancial business sector, and that's a new dimension of activity of business cycles.

The household sector was more sort of an upward trend, and then a housing bubble. And then the federal sector really wasn't part of it—the leverage cycle—for a long, long time until the crisis. And really, you can see the financial sector is phenomenal—more than half of the total increase in overall leverage in the economy was the financial sector itself, and I think that's kind of what Alex has in mind when he's thinking of that asset specificity. And maybe—I mean, he says it—that that may be not the most productive use of credit is allocating it to the financial sector.

But what wasn't part of it is the Fed, and this is the Fed's balance sheet. And it is not included in the debt-to-GDP ratio because it's not debt. It is the central bank's balance sheet. It was pretty much doing nothing through this whole period, until the financial crisis. So a lot of the inefficiencies that I think that Alex is focused on—and models well, and I think some of the structures of the model are very useful—have nothing to do with the central bank. They have more to do with financialization and the forces that have led us here.

So why is that important? Well, I think getting to the heart of these credit dynamics—and to the degree they're excessive, to the degree they're inefficient—understanding why that is, and how is the central bank involved in this whole process, is important to drawing the right policy conclusions. And especially now we are at a crossroads, and we've got some really big decisions that the Fed is about to make that could affect all of us in this room in significant ways. So I think the paper very usefully creates a structure whereby access to credit varies according to differing degrees of asset specificity. But the mechanism that the paper relies on for perpetuating the inefficiencies doesn't seem plausible, at least in the U.S. context. I think that there are some very important distinctions between the U.S. Fed stimulus and China's stimulus. In particular that the Fed is going to stimulate so much borrowing in one sector that it crowds out another. In fact, we've been deleveraging. This isn't about the credit channel. Actually, the credit channel's been very, very meager in this cycle. The real channel of monetary policy—and Trish, I think, stated this earlier in her discussion—is the asset price channel. That's really been operative. By supporting balance sheets—be they corporate balance sheets through equity valuations, be they household balance sheets—we're facilitating a deleveraging. This is not a credit cycle.

And there's an important distinction between liquidity and credit. When the Fed did extend credit in the crisis, they did. They lent money against collateral, and then it got paid back. That was Bagehot-style emergency lending in a crisis. QE [quantitative easing] is very different. QE is not the creation of credit—it is the creation of assets out of thin air, which the central bank can uniquely do, and the only repayment is through its effect on the value of the currency, the valuation of assets.

One of the conclusions of the paper that Alex didn't get into in detail was that some of the advantages—he concludes that maybe we don't want to rely too much on monetary policy, but more on fiscal. Of course, we want to get that balance right, and I think he does point out, usefully, some of the shortcomings. But there are some advantages. There is a sort of a siren song of fiscal policy right now: the fiscal policy, if we could just get it, would solve a lot of problems. It's also going to create a lot more debt, and that has to be repaid by future generations. And if we look at our own electoral politics, it's not exactly like that leads to always happy, efficient, peaceful outcomes. It can lead to a lot of upheaval and difficulties and clashes between sectors and inefficiencies...are you giving me the sign? Okay, okay—I'll finish up here.

So I'm going to just wrap up with a couple of things. I think that the reality is we're in a financialized world. We're also in a heavily indebted world. Monetary policy works through different channels, through different mechanisms, because of that. That wasn't caused by the Fed, that was the Fed reacting. I think that's really important to understand, because all those forces that led us to this world are still out there. The chart I showed you with the U.S. deleveraging a bit—if you put this on the global scale, we haven't deleveraged at all, because China's been leveraging. And so we're still in this financialized, indebted world. We're going to be with these tools for a long time, and so I think there is a reaction among some observers—and certainly even among some monetary policymakers—to say, "Ew, this yucky balance sheet—let's just get rid of it, let's just put it to the side, put it on autopilot, we don't ever want to have to deal with it again." You're going to have to deal with it again, I nearly guarantee it. It's going to be there. It's going to be part of policy.

And I'm just going to leave with one last thing—the right-hand chart, I want the left-hand side shows that we're not unique in this, of course. The right-hand chart shows you two measures—one is stock market capitalization-to-GDP, as a percent of GDP (good old flow of funds measure). It doesn't have QI because we don't have QI flow of funds yet. But once we do, that baby's going to a new all-time high. And so that would say, "Holy smokes—that's pretty bubblicious!"

The green line, though, is the Shiller Cyclically Adjusted P/E Ratio, okay? So this takes into account inflation, it takes into account the discount rate—a-ha! That is very key—that is the difference between these two measures—that is the discount rate you're using to discount future earnings streams. So with low interest rates, low 10-year—it uses the 10-year Treasury yield—low 10-year interest rates, the stock market doesn't look quite so overvalued.

This is what I want to end with. The question confronting the Fed now, with its balance sheet, is all about that differential. The Fed shows nice charts about how much term premia subsidy they've given through their balance sheet. Well, it's not just affecting Treasury yields—it's affecting all types of yields. Change it, and it's going to affect all types of valuations. And you need to think about that, and not just model the term premia but its ripple effect through all assets.

And the Fed has this concept of r*, the neutral equilibrium funds rate. What is "balance sheet*"? If there's an r*, there's a balance sheet*. You're getting a certain amount of accommodation from the balance sheet—it's a tool of policy. What's neutral? Do you know what it is? So that's something that I think we need to incorporate into thinking and calibrating and looking at the future, and not just saying, "Ugh, let's just get rid of this as soon as possible," because the world that led to this is still the world we live in.


Wall: Awfully nice. Okay, so we have much more in the way of questions than we have time, so I'm going to combine several of them. And the first one that I want to deal with—there was a variety of questions here kind of arguing with, "Well, does this really describe what's happened in the U.S., especially postcrisis?" But I'm going to back it up to the more general question of, when does liquidity become excessive? And I realize the graphs aren't going to tell you, but you're now in a policy position, and you have to judge. What do you look at, how do you know or have any sense?

Bleck: Can I take a mulligan, or...? [laughter] Well, I guess if you take the theory seriously...the nice thing about being at a conference like this, I think, was also dinner yesterday. I sat in between two people that knew each other quite intimately well, but came from different places. And I just realized just how difficult the job of a policymaker really is. So I guess what the theory would say is that not only do you need to check one market—in our case not just the credit market—you also should check the asset market. But not just the asset and the credit market, you need to do this potentially for several asset markets.

And so to get the full brunt of the picture—to conclude whether there is excess liquidity—it takes quite a broad picture of things. But if you take the model quite literally, it would say some indications might be if you see a rise in asset price in some place of the economy, but not in others where there are signs that people do want to borrow, but there is no response to the asset price, that might be one. And of course, the interest rate by itself.

One thing, of course, that comes out of this is that if there is too much money put in, in fact the interest rate just goes the wrong way. So in other words, the credit market and the multiple asset markets, you might have to bear in mind to be able to draw a conclusion about whether there is excess liquidity in the system.

Wall: So, you've got a pretty stylized model, and there are a couple of questions that get at essentially the same issue in slightly different ways. And this question was, would the results change if you have a heterogeneous bank, and some of them are more specialized and less collateralized, in a less collateral-available sector? And there's also one that said: couldn't maybe the firm solve this? Are there ways that the private sector could have, and arguably should have, solved the problem?

Bleck: Yes, I already forgot the first one, but very good questions. One thing that may benefit from question number two is that I guess one thing that I like to think about is what the limits of using the market are for various purposes. So the second question I guess relates to this, which is you typically think—I guess our response is—most things, somewhat intuitively, you want to delegate to the market. And then only if the market has a problem, we have fixes like regulation. But the other solution to the market failure is the firm itself. And so I think it's a very much open question to what extent a market failure is often better solved by a firm expanding, let's say, and internalizing the problem versus the policymaker necessarily being burdened with this.

And of course, like I learned at dinner yesterday: if you have multiple policies, you have to think about how they interact—much like here, if you have two solutions and how they interact. I mean, I don't think in academia...I don't want to speak that broadly, but I haven't seen that much work on exactly that question. But if you just look at the, let's say, the data, it might paint a very different picture. So of course, coming out of the crisis we've seen that there's been much more of a concentration in the banking sector. And most people would have said that's a bad thing, right? That now we're even bigger. "Too big, and even bigger, too"—whatever that is in English—"bigger to fail."

But maybe that was the natural, rational response—that the bigger bank in fact subsumed some of the problems that could not have been as efficiently addressed, or weren't addressed, by the policy. But let me just try to address this specifically—and just to clarify: so if you're saying, why can't we essentially in some sense have information about firms in both markets? Is that how you would read that question?

Wall: It seems to be: you have a single bank in your model, and it's specialized: it operates in both sectors. If you had specialist banks, maybe this is less of a problem?

Bleck: I see, yes. Good question. Now of course, the model—as people have already noted—is somewhat stylized. What makes this...I guess, the fundamental thing that makes the mechanism work is that there is some link between different sectors borrowing in a common credit market. No doubt, of course, is there differentiation in the real world among firms in any given sector, and across sectors. So our mechanism is at work, and you would expect that if there's of course a common component, like a common price of money that nobody can escape from, the price of intermediation of credit across the economy, across sectors. So some sectors might of course slightly have different spreads. They might respond somewhat differently. But to the extent that there's a common component, that is what could create the link. So clearly, we're simplifying here.

So that would be my response there. That therefore tells you, and back to the first question: what would give you the indication of an excess? Well, if you do find a commonality in the response in credit across the sectors—even though they may respond somewhat differently—but there is an upward shift. Some may move upward more than others, and so forth. It's the commonality.

I don't know if I answered the first question. I have to admit I did forget it.

Wall: Yes, well—I think the first question was, firms could have the collateral and borrow based on the general-purpose collateral?

Bleck: Yes, that's right. So the underlying assumption, of course, is in some sense what makes a sector? And so you would think the initial stage here is that whoever is the most efficient user of a particular source of real capital—the machines versus land or commodities—is the one that is willing to pay the most for it, and therefore you would expect that if things are not too bad those are the guys that end up using and having that capital, and therefore that is what defines the sector.

So in other words, even if you had something that is used by multiple sectors, there's got to be some core type of investment that some sectors can use more productively than others. And you would expect therefore that these sectors therefore specialize, and that would be my answer to that.

Wall: I would add my recollection is that in Japan, before their blow-up, that a lot of the lending was land-based. So that might buy you a little bit. One last question, because we are pretty much out of time—is the solution then doing some sort of central banks targeting their lending facilities?

Bleck: "Targeting" as in...targeting a sector? Versus...

Wall: "Targeting" as in you could say, we'll lend you money on...

Coronado: [Referring to a slide with text] Is that supposed to be "TLTRO" [targeted long-term refinancing operations]?

Bleck: Yes—I'm not...

Coronado: I think that's TLTRO, right? It was just auto-correct. [laughter] TLTRO, right? TLTRO. Now we know what TLTRO auto-corrects to. [laughter]

Bleck: So, can I interpret that as the sectoral policy?

Wall: Yes, that's the central bank somehow targeting its credit loosening to a particular sector.

Bleck: Yes, right—I would think so. I don't think there's an easy, general answer to this, but I guess viewed through the model, you would think, if you could do something...let's say if you have an indication that one sector tends to get out of whack, maybe there is a point in reducing the credit to this sector and maybe giving it to the other. But it is a double-edged sword. I mean, that's what I was trying to highlight with the slide about the limit to market-based policy, which is I suppose the extreme case in which the first sector that doesn't get the money—in fact, is the one that shouldn't get the money—it does not look like the worthwhile sector. Does the central bank have the better information about that, or the individual, highly specialized, commercial bank? And therefore you, by trying to undermine the problem that we highlight, you invite another, which is maybe a misallocation of a different sort.

Coronado: Or even more practically—do they have the legal ability to do so? [laughter] And most of the time the answer is "no."

Wall: And even if they have it, do they have the political ability?

Coronado: Or the political ability.

Wall: So they are not going to provide funding to housing...

Coronado: Or the ECB, for example—lending most to the countries that need it most. Well, that's proved to have constitutional issues, and there are all kinds of practical, legal constraints.

Wall: Okay, with that, I'd like to say thanks, Alex—thank you, Julia.


Bleck: Thank you very much.

Coronado: Thank you.