Volatility Of The 2008 Financial Crisis
Paul E. Cottrell
April 30, 2016
Warren Buffett’s 2018 Activist Investment
This paper will provide information on what happened in the financial crisis of 2008 and how to graph volatility outside of the option market. We will investigate the causes of the financial crisis, as well as some of the social inequalities that still exist today. We will explore household debt, deregulation, military expenditures, financial stimulus, and bailout packages. We will reference Timothy Giethner’s perspective on the 2008 financial crisis and how the recovery has been progressing as of 2012, in terms of civilian employment and GDP. Next we will investigate the stylized facts of the crisis and which markets should be reviewed. A study of the different markets is conducted using volatility, correlation and returns in three important trading markets — all volatility 3d graphing is performed using the Poseidon software.
Volatility Of The 2008 Financial Crisis – Introduction
What Happened In 2008?
The financial crisis of 2008 was the worst financial crisis since the Great Depression of the 1930’s. Many books have been written on why the 2008 crisis happened. Irwin (2013) stated that central bankers knew that the housing bubble was a serious problem, but the central banks’ policy makers failed to have the imagination to understand the confluence of events that could magnify and bring down the whole global economy. In Geithner (2014), lack of firepower to bailout institutions in the banking sector was lacking in the early stages for the crisis. In terms of risk models, in Derman (2011), quant models are based on assumptions and those assumptions can become invalid over time—leading to inappropriate pricing of assets and risk assessments. Others have suggested that over indebtedness in the public and private sector was to cause of the decline of developed economies (Ferguson, 2013). The point of this book is not to comprehensively explain the crisis of 2008, but to suggest that economic systems evolve and emergent properties result, albeit some good and some bad properties. It is fair to say that the lack of imagination and the true risk of contagion are good starting points. We need better tools for assessing risk in the financial system, whereby we can evaluate endogenous and exogenous risk.
The financial crisis of 2008 resulted in the threat of total global financial collapse, whereby even the assumptions of free market capitalism and democracy were seriously questioned. This was a dangerous time and still is as of this writing. For example, European countries are still floundering economically, especially in the peripheral nations of the European Union. European countries tied to the Euro currency no longer have the ability to adjust their own monetary policy, and in that respect have lost economic sovereignty and self–determination. The problems are not just in Europe. There seems to be a global trend of a zero interest rate policy in developed nations, which is new to central bankers’ experiences. Is it possible that monetary policy that created the great moderation has led to new monetary dynamics that the central banks will have a hard time modulating? For example, when the United States of America starts to eliminate quantitative easing and the economy starts to wobble, will the Federal Reserve reverse their tightening policy? It is not at all clear that the central banks are in control of zero interest rate policy epochs. For example, in an inflationary situation the central banks can just raise rates, which they have a lot of room to do so—but this might led to further erosion of aggregate demand. For an extreme increase in aggregate demand the central banks can modulate the economy. This is not the case in a deflationary condition where the rates are already zero bound. What can the central banks do if the aggregate demand continues to erode with zero bound rates? The only thing that the central bank can do is severe asset purchases of all kinds—even ketchup.
The financial crisis also involved massive financial bailouts of banks, larger corporations, and citizens. For example—even though Lehman was not bailed out—General Motor, AIG, Chrysler Motors, and many banking firms were. Even with the bailouts the money markets were not functioning properly and a severe recession ensued. In the United States quantitative easing was initiated by purchasing many different asset backed securities but other countries were forced into austerity policies, especially in the European region—creating more financial harm than good. This austerity was promoted by Germany and the IMF when countries, such as Greece, were in trouble of defaulting on their sovereign bonds. At the time of this writing the ECB is starting to adopt a different stance and invoking a lender-of-last-resort policy regime and asset purchase buyer.
Some Of The Causes
What were some of the causes of the 2008 crisis? We will start a more in-depth analysis, primarily from Geithner (2014) as source material. I would suggest there were five main causes of the crisis, but there are other important causes not covered in this writing. The following five major causes are: (a) record income inequality, (b) record household debt, (c) relaxed financial regulation, (d) decline of household discretionary income, and (e) an over extension of overseas operations. With these five major causes, a confluence of factors became magnified causing the economic system to collapse. These dynamics can be explained through chaos theory.
Any one of the five major causes most likely would not bring down the whole financial system, but when added together there are special nonlinear dynamics exhibited. As more aspects of a system are defined there are more degrees-of-freedom. With a system of high degrees-of-freedom, unexpected system dynamics result due to strange chaotic attractors. This is true even with a totally deterministic system, whereby no random functions are present in the system. In financial markets there are stochastic variations making this type of system a nondeterministic system—leading to even more strange chaotic attractions. When a certain threshold is reached a new system dynamic emerges. Let’s look at some details of the five major causes of the crisis.
In terms of record income inequality, Piketty (2014) showed that income inequality is cyclical. See Figure 1 of income inequality in the United States over the last hundred years or so. One can conclude that very similar income inequalities exist as of this writing compared to the late 1920’s. The first big drop of income inequality was after the 1929 stock market crash. But the biggest drop in income inequality was during World War II. After the war it took approximately 4 decades for the income inequality in the United States to rise. A big part of this rise was deregulation of markets coupled with low taxation policies initiated in the Reagan and Thatcher era. More of the executive compensation, especially starting in the 1990’s, is through stock options—leading to exponential grown in income for the managerial class of workers. We see this in the average income of the executive staff of a publicly held company earning much more than the average worker—the multiple might be as high as 400 times more within some companies.
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