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Global financial crisis as a phenomenon of stock market overshooting

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Abstract

Inspired by Dornbusch’s model of exchange rate overshooting we develop a theory of stock market behaviour and its impact on the real economy. The idea is that stock market prices overshoot and undershoot their long-run equilibrium values which are determined by the development in the real economy. The overshooting is triggered primarily by a loose monetary policy. With our model we explain the genesis of the global financial crisis (GFC) 2008/2009 primarily as the result of a loose monetary policy in the USA. Following the overshooting and crash in the stock market the real economy dropped into a recession. After modelling the interaction of three markets with different speed of adjustment—money, stocks and goods—for a closed economy we expand it to an open economy and lastly study the spillovers of a financial market crisis between countries (from a large to a small country) by introducing the transmission channels of external trade or cross-border financial transactions. A long-lasting monetary easing as exhibiting by the Fed and the ECB since 2007 and 2008, respectively could—according to our model—generate another boom-bust cycle.

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Notes

  1. This term was coined by Krugman (2009) to differentiate the economic situation in 2009 from that of the “Great Depression” in 1929–1933. The “Great Depression” received its name from Lionel Robbins (1934).

  2. Some (see Cassidy 2008) have dubbed this constellation a “Minsky moment” (Minsky 1986).

  3. Some of this literature comprises: Krugman (2008), Akerlof and Shiller (2009), Larosière Report (2009), European Commission (2009b), Stiglitz (2010), Lewis (2010), Roubini and Mihm (2010), Tichy (2010). A comprehensive investigation into common traits and differences between past financial market and economic crises is offered by Reinhart and Rogoff (2009). Comparisons of the development of the main macroeconomic and foreign trade variables during the Great Depression 1929 with that during the Great Recession 2009 can be found in Eichengreen and O’Rourke (2009) and in Aiginger (2009). DG ECFIN jointly with Université Libre de Bruxelles (ULB) and University of British Columbia (UBC) organized a conference on “Advances in international macroeconomics—Lessons from the crisis”, in Brussels on 23–24 July 2010 (see DG ECFIN 2010).

  4. Only to mention a few of such platforms of discussion, e.g. see the “Global Crisis Debate” on VoxEU: http://www.voxeu.org/ or the newly created Institute for New Economic Thinking (INET): http://intereconomics.org/ or Ökonomenstimme: http://www.oekonomenstimme.org/.

  5. Jan In’t Veld et al. (2010) use an estimated open economy DSGE model with financial frictions for the US and the ROW, to evaluate various competing explanations about the recent boom bust cycle (innovation in US mortgage market (securitisation/expansion of sub prime lending); savings glut/flight to safety hypothesis; monetary policy; TFP growth; stock market and housing bubble). Accordingly, the loose monetary policy and more so bubbles in the stock and housing market played an essential role in the US crisis.

  6. This financial supervision framework will consist of a new European Systemic Risk Board (ESRB) and three new European Supervisory Authorities (ESAs) for the financial services sector: A European Banking Authority (EBA) based in London, a European Insurance and Occupational Pensions Authority (EIOPA) in Frankfurt and a European Securities and Markets Authority (ESMA) in Paris. The new authorities will be made up of the 27 national supervisors. This framework is to give Europe the control tower and the radar screens it needs to detect the risks which can accumulate across the financial system as we witnessed in the run up to and at the height of the financial crisis (see European Commission 2010 and for more information on the EU Financial Supervision System, see: http://ec.europa.eu/internal_market/finances/committees/index_en.htm).

  7. The empirical "three-market barometer" (i.e., indicators for the stock market, the goods market and the money market) of the Austrian Institute for Business Cycle Research (today WIFO), introduced by its founder, F.A. von Hayek in Austria along the lines of the Harvard Barometer, predicted relatively well the crisis of the 1930s (Tichy 1973, pp. 61–62).

  8. Other approaches to deal with the "irrational exuberance" of stock market behaviour are those of the catastrophe theory, developed by René Thom (1927). Zeeman (1974) tried to analyse theoretically the behaviour of stock market crashes. Aschinger (1987, 2001) applied this methodology to the 1987 US stock market crash. The catastrophe theory approach, however, has not very much economic “flesh” in it. Hayek (1929) introduced the notion of overheating in its business cycle theory.

  9. The extremely loose monetary policy of the Fed during the period 2002–2005 apparently has caused such a special precondition. The relationship of monetary policy and stock market behaviour in our model (Eqs. 1 and 2) may apply only to such a special case of risk-neutrality. Normally, bonds and shares are far from being perfect substitutes.

  10. The long-run rate (i*) can be thought as to be determined by a Taylor rule or to be in line with the long-run real interest rate according to the Fisher equation (Fisher 1930).

  11. Equation 3 is obtained by taking the logarithm of the money market equilibrium condition \( M/P = Y^{\phi } \exp ( - \lambda i) \).

  12. Stock market prices can be identified with indices like the Dow Jones Industrial (DJI) or the DAX or the ATX etc.

  13. The rate of convergence to equilibrium is a function of the adjustment coefficient in the error correction mechanism θ in (2). In case of perfect foresight, in order to correctly predict the actual path of stock market prices it must be true that \( \theta = \nu \). The consistent adjustment coefficient, \( \tilde{\theta } \), obtained as the solution to Eq. (2) if \( \theta = \nu \), is a function of the structural parameters of the economy (see Dornbusch 1976, p. 1167): \( \tilde{\theta }(\lambda ,\delta ,\sigma ,\pi ) = \pi (\sigma /\lambda + \delta )/2 + \left[ {\pi^{2} (\sigma /\lambda + \delta )^{2} /4 + \pi \delta /\lambda } \right]^{1/2} \).

  14. For solving differential equations, see Chiang (1984), chapter 14.

  15. The IS curve represents the combination of goods prices relative to stock market prices at constant prices. Therefore it would be more appropriate to call this curve the \( \dot{p} = 0 \) curve.

  16. In case of rational expectations concerning the adjustment path of stock market prices—in analogy to the solution for rational expectations concerning the development of exchange rate changes in Dornbusch (1976, p. 1170)—one can obtain the following equation of the overshooting phenomenon (by substituting the expression of footnote 9): \( dp^{sm} /dm^{d} = 1 + 1/\lambda \tilde{\theta } = 1 + 1//(\pi (\sigma /\lambda + \delta )/2 + [ {\pi^{2} (\sigma /\lambda + \delta )^{2} /4 + \pi \delta /\lambda }]^{1/2} ) \).

  17. The complete relative price argument in this equation is (\( e + p^{*} - p \)) where \( p^{*} \) is the logarithm of the foreign price level. Setting the foreign price level equal to unity implies that \( p^{*} = 0 \).

  18. With this usual model specification we consider also the transmission of world raw material prices from one country to the other. According to Schulmeister (2009) the huge boom in world raw material and oil prices up to the middle of 2008 was the forerunner of the present global economic crisis.

  19. For the explanations of boom-bust cycles, see also Tornell and Westermann (2002).

  20. Brunnermaier and Sannikov (2009) try to save the reputation of DSGE models (attacked heavily by Buiter 2009) by constructing a macroeconomic model with a detailed financial sector in order to capture the interbank trade which collapsed after the Lehman Brothers failure and was one of the reasons to cause the “Great Recession”. A New Keynesian (NK) model with durable goods and collateral constraints (credit squeeze) by Monacelli (2009) tries to capture features of the GFC. Kiyotaki and Moore (1997) demonstrated earlier in their model of credit cycles that the dynamic interaction between credit limits and asset prices turns out to be a powerful transmission mechanism by which the effects of shocks persist, amplify, and spill over to other sectors.

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  1. Austrian Institute of Economic Research (WIFO), Arsenal, 1103, Vienna, Austria

    Fritz Breuss

  2. Vienna University of Economics and Business (WU), Vienna, Austria

    Fritz Breuss

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Breuss, F. Global financial crisis as a phenomenon of stock market overshooting. Empirica 38, 131–152 (2011). https://doi.org/10.1007/s10663-010-9140-5

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