The ‘fear factor’: Personal experience and risk aversion in times of crisis
Peter Koudijs, Hans-Joachim Voth12 April 2014
Human behaviour in times of financial crises is difficult to understand, but critical to policymaking. This column discusses new evidence showing that personal experience in financial markets can dramatically change risk tolerance. A cleanly identified historical episode demonstrates that even without losses, negative shocks not only modify risk appetite, but can also create ‘leverage cycles’. These, in turn, have the potential to make markets extremely fragile. Remarkably, those who witnessed this episode but were not directly threatened by it, did not change their own behaviour. Thus, personal experience can be a powerful determinant of investors’ actions and can eventually affect aggregate instability.
To paraphrase Larry Summers, some people are scared – just look around. The crisis of 2007–08 took a toll on a lot of people, investors included. What seemed to be a new age of steady, moderately high growth and stable equity returns suddenly turned into the biggest economic crisis since the 1930s:
Rational learning about rare-disaster frequencies: A persistent source of asset-price overreaction
Volker Wieland, Christos Koulovatianos01 November 2011
A stock-market collapse such as the one after the 2008 Lehman Brothers default is followed by more pessimistic assessments of the likelihood of future collapses in surveys and by lower price-dividend ratios. This column argues this reaction of expectations and asset prices can be explained by Bayesian decision theory. The key is to appreciate that market participants know little about the drivers of such crashes. They revise their beliefs and learn over time.
Investors want to understand how asset markets work. Their perceptions of the mechanism determining asset prices are essentially forecasting models with unknown parameters. If they could have full confidence in the model’s parameters such as in a casino where unknowns have known probabilities, investment strategies and asset prices would reflect rational expectations.
To what extent has financial nationalism changed banks' lending behaviour in the aftermath of the global crisis? The authors of CEPR DP8404 find much evidence that financial protectionism has morphed the lending practices of foreign banks in Britain since 2008. But--unexpectedly--they also find that British banks nationalised during the crisis changed their lending practices in no substantive way.
With public debt in the US higher than it's been since 1945 and private debt burgeoning, governments are panicking about the impact of debt overhang on growth. In CEPR DP8310, Reinhart and Rogoff argue that governments have increasingly resorted to undercover restructuring by using the tools of "financial repression" that characterized the Bretton Woods era. If states continue to ignore or distort their debt problems, the authors predict, their bond markets could become ever more repressed.
Greece’s public debt is in turmoil. This column says that the country is nowhere near defaulting, but the Greek government should heed the financial markets’ warning and end three decades of fiscal profligacy. It suggests that Greece adopt immediate deep spending cuts and reform its budgetary process to credibly enforce discipline.
The near-run on the Greek public debt is wholly unjustified. The Greek government has no incentive to default, and no need to do so as long as financial markets do not panic. On the other hand, governments have indulged in blatant fiscal indiscipline for more than three decades. The renewed financial market pressure should be taken as a signal that the party is over. It is time for Greece to adopt two simultaneous measures:
Jean-Pierre Chauffour, Thomas Farole05 September 2009
In April, G20 leaders agreed to massively support trade finance. Should international trade finance be a significant concern in current circumstances? This column cautions against overestimating the trade finance “gap”, yet highlights the possible rationales and conditions for an effective intervention in support of trade finance.
By providing liquidity and security to facilitate the movement of goods and services, trade finance lies at the heart of the global trading system. Indeed, as Auboin (2009) notes, trade finance – upon which some 80-90% of world trade relies – has become ever more critical as global supply chains have increasingly integrated in recent years:
Dumping Russia in 1998 and Lehman ten years later: Triple time-inconsistency episodes
Guillermo Calvo31 August 2009
This column introduces "triple time-inconsistent" episodes. First, a public institution is expected to cave in and offer a bailout to prevent a crisis. Then, in an attempt to regain credibility, it pulls back. Finally, it resumes bailing out the survivors of the wreckage caused by the policy surprise. This column characterises the 1998 Russian crisis and the current crisis as triple time-inconsistency episodes and says that a financial crisis may simply be a bad time to try to build credibility.
In the last decade we have witnessed two major systemic financial crises, namely, the 1998 Russian crisis and the current crisis, the latter initially associated with the subprime mortgage market (henceforth, subprime crisis). A critical event in the subprime crisis was the Lehman Brothers’ episode in September 2008. Lehman’s collapse, coming on the heels of the sell-off of Bear Stearns, took the market by surprise. The ensuing about-face regarding AIG was perhaps less surprising but still added a heavy dose of policy uncertainty.
Should we rush to further regulate financial institutions?
Guillermo Calvo, Rudy Loo-Kung29 June 2009
The financial sector is prone to crises, which are typically associated with serious effects on output and employment. This column weighs the costs and benefits of financial deregulation that spurs temporarily high growth that then collapse and suggests that bubbles may be socially efficient.
The global financial crisis: A wake-up call for trade finance capacity building in emerging Asia
Wei Liu, Yann Duval19 June 2009
The current crisis has drawn attention to the important role of trade finance in supporting international trade. This column argues that emerging market economies in Asia need to significantly develop and strengthen national trade finance institutions.
The current financial crisis has provided a useful reminder of how essential trade finance is to international trade. The capacity to trade is significantly affected by the availability and cost of financing and the availability of instruments to mitigate the risks associated with international trade transactions (Auboin and Meier-Ewert 2003; Thomas, 2009).1