What does it mean when someone refers to the “Doom Cycle,” or “Doom Loop”?

The Doom Cycle

http://www.rooseveltinstitute.org/new-roosevelt/doom-cycle

What does it mean when someone refers to the “Doom Cycle,” or “Doom Loop”?

**This concept will be discussed in detail at the Roosevelt Institute’s March 3rd conference in New York, ‘Make Markets Be Markets’, and also in a report written by Simon Johnson, Rob Johnson (Director of the Roosevelt Institute’s Project on Global Finance), Nobel Laureate Joe Stiglitz (Chief Economist of the Roosevelt Institute), Elizabeth Warren, and others.  Stay tuned for updates on this much-anticipated event.

The “Doom Cycle” is a phrase often used to refer to the current boom-bust-bailout structure of the financial sector that leads to economic crises. Simon Johnson has been a major proponent of shedding light on this cycle, which he believes begins with risky investments and dangerous financial practices that lead to increased growth and profitability, but soon bust — bringing the financial sector to its knees after its inevitable collapse. After the bust comes the bailout, which, although may be necessary at the time, is more harmful in the long run because it does not address the fundamental structural flaws of our financial system. This vicious cycle only continues to grow, and with no salient regulation will continue in perpetuity, bringing with it crisis after crisis.

The “Doom Loop” has been defined in the New York Times as: “a virtueless circle in which banks take ever-greater risks to boost returns (secure in the knowledge the state will underwrite them), and governments are forced to break their promises “never again” to bankroll losses (further encouraging banks to take dangerous risks).”

What is the significance?

The “Doom Cycle” is one of the most significant ideas within the discourse on the current economic crisis. What the “Doom Cycle” offers is an explanation and a solution to the current financial crisis and the conditions which helped to create it. The “Doom Cycle” serves as a framework through which we can begin to address the economic condition of America in the twenty-first century. If we are to avoid another financial meltdown, leading thinkers believe that serious reforms are necessary. Without them, another, worse crisis may be inevitable. Through this idea, we gain a paradigmatic view of the financial system, and are able to understand the attitude and atmosphere that fosters a cycle of risk, gain, and collapse.

Who’s talking about it?

Simon Johnson has been outspoken on this issue, and has written extensively on the “Doom Loop,” and the next impending financial crisis. The “Doom Loop” has also gained popularitydue to a paper published by Andrew G Haldane, Executive Director, Financial Stability, Bank of England, and Piergiorgio Alessandri. Johnson often refers to this paper as an invaluable resource for understanding the “Doom Loop.”

Inflation, Policy Rate and Output gap

Olivier Blanchard Chief Economist IMF

October 22, 2012 by From InpaperMagzine

Excerpt from speech at – In the Wake of the Crisis – conference March 7 2011

http://www.imf.org/external/mmedia/view.aspx?vid=817354499001

Before the economic crisis began in 2008, mainstream economists and policymakers had converged on a beautiful construction for monetary policy. To caricature just a bit: we had convinced ourselves that there was one target, inflation, and one instrument, the policy rate. And that was basically enough to get things done.

One lesson to be drawn from this crisis is that this construction was not right: There are many targets and many instruments. How the instruments are mapped on to the targets and how these instruments are best used are complicated problems, but we need to solve them.

Future monetary policy is likely to be much messier than the simple construction we developed earlier. There was one target, stable inflation, and there was one instrument, the policy rate or more precisely the policy rate rule, and that was basically enough. If you had the right rule for the policy rate, you would achieve low and stable inflation. The use of a rule, implicit or explicit, gave the central bank credibility and delivered a stable economy.

The implicit assumption was that stable inflation would deliver economic stability in the sense of a stable output gap. This was the case in
many formal academic models. In these models, if you maintained stable inflation, you would also maintain a stable output gap. The two went together, so there was no reason to look at the output gap separately.

Realism on the part of central bankers made them realise that this was an extreme proposition, that there could be (at least in the short run) some distance between the two, and that they also had to worry about the output gap. That led to something called flexible inflation targeting, in which central banks allowed for temporary deviations from the inflation target to stabilise what they thought was the output gap.

We learned two main lessons from the current crisis. The first is that even with stable inflation and a stable output gap, things might not be going well behind the — macroeconomic — scene. For example, tensions can build up in the financial sector, and financial instability eventually translates into major problems in terms of output and activity. This realization has led to a general consensus that the list of targets must now include financial stability as well as macroeconomic stability.

There is also agreement that the debate as it was framed pre-crisis — whether you should use the policy rate to try to achieve both macro- and financial stability — was not the right debate. There are many instruments out there, not just the policy rate, and there is no reason to rely only on the policy rate.

The second lesson is that the link between inflation stability and the output gap is probably much weaker than was originally thought. In a number of countries, the behavior of inflation appears to have become increasingly divorced from the evolution of the output gap.

If this is the case, then central bankers who care about macro-stability cannot be content just to keep inflation stable. They have to watch both inflation and the output gap, measured as best as they can. Nobody will watch the output gap for them.

We need to think about monetary policy in a broad sense as having many targets — at least inflation, output, and risk — and having many instruments. We can have some allocation of instruments, but we must also realise that most instruments are going to affect all three targets in some way.

But if central banks start being in charge of many instruments, nearly all of them having an effect on a specific segment of the economy, then the question of independence comes up. The interactions between the various instruments and objectives argue for one decider, presumably the central bank. But how much independence you then can give to it is an open question.

The notion that the central bank uses many instruments reminds one of earlier monetary policies, such as those of the 1950s, in which too many tools and too many interventions led to distortions and sometimes perverse outcomes. This is a challenge. Still, we have to accept the fact that monetary policy should probably be thought of in that form — many instruments and many targets.

Let me conclude by repeating my basic message. We have moved from a one-target, one-instrument world to one where there are many targets and many instruments. And we are just starting to begin the long and difficult process of exploring what such a new framework may look like.

Extracts from ‘Monetary policy in the wake of the crisis’