MACROECONOMICS

FINANCIAL SYSTEM
N. Gregory Mankiw & Laurence M. Ball
CHAPTER

and the

Financial Crises 19
Modified for EC 204 by Bob Murphy
PowerPoint slides by Ron Cronovich

2011 Worth Publishers, all rights reserved

In this chapter, you will learn:

common features of financial crises how financial crises can be self-perpetuating various policy responses to crises about historical and contemporary crises, including the U.S. financial crisis of 2007-2009 crises affecting emerging economies

how capital flight often plays a role in financial

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Financial Crises

Common features of financial crises

Asset price declines involving stocks, real estate, or other assets may trigger the crisis often interpreted as the ends of bubbles Financial institution insolvencies a wave of loan defaults may cause bank failures hedge funds may fail when assets bought with
borrowed funds lose value financial institutions interconnected, so insolvencies can spread from one to another
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Financial Crises

Common features of financial crises

Liquidity crises if its depositors lose confidence, a bank run
depletes the banks liquid assets if its creditors have lost confidence, an investment bank may have trouble selling commercial paper to pay off maturing debts in such cases, the institution must sell illiquid assets at fire sale prices, bringing it closer to insolvency

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Financial crises and aggregate demand

Falling asset prices reduce aggregate demand consumers wealth falls uncertainty makes consumers and firms postpone
spending the value of collateral falls, making it harder for firms and consumers to borrow

Financial institution failures reduce lending banks become more conservative since more
uncertainty over borrowers ability to repay

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Financial Crises

Financial crises and aggregate demand

Credit crunch: a sharp decrease in bank lending may occur when asset prices fall and financial
institutions fail forces consumers and firms to reduce spending

The fall in agg. demand worsens the financial crisis falling output lower firms expected future earnings,
reducing asset prices further falling demand for real estate reduces prices more bankruptcies and defaults increase, bank panics more likely

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Once a Financial crisis starts, it can sustain itself for a long time Crises

CASE STUDY

Disaster in the 1930s

Sharp asset price declines: the stock market fell
13% on 10/28/1929, and fell 89% by 1932 defaults and a bank panic

Over 1/3 of all banks failed by 1933, due to loan A credit crunch and uncertainty caused huge fall in
consumption and investment

Falling output magnified these problems Federal Reserve allowed money supply to fall,

creating deflation, which increased the real value of debts and increased defaults
Financial Crises

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Financial rescues: emergency loans

The self-perpetuating nature of crises gives
policymakers a strong incentive to intervene to try to break the cycle of crisis and recession. as a lender of last resort, providing emergency loans to institutions to prevent them from failing. to a bank, approved if Fed judges bank solvent and with sufficient collateral
Financial Crises

During a liquidity crisis, a central bank may act

Discount loan: a loan from the Federal Reserve

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Financial rescues: bailouts

Govt may give funds to prevent an institution
from failing, or may give funds to those hurt by the failure institution from spreading

Purpose: to prevent the problems of an insolvent Costs of bailouts direct: use of taxpayer funds indirect: increases moral hazard, increasing

likelihood of future failures and need for future bailouts

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Too big to fail

The larger the institution, the greater its links to
other institutions Links include liabilities, such as deposits or borrowings

Institutions deemed too big to fail (TBTF)

if they are so interconnected that their failure would threaten the financial system Example: Continental Illinois Bank (1984)

TBTF institutions are candidates for bailouts.

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Risky Rescues
Risky loans: govt loans to institutions that may not
be repaid institutions bordering on insolvency institutions with no collateral Example: Fed loaned $85 billion to AIG (2008)

Equity injections: purchases of a companys

stock by the govt to increase a nearly insolvent companys capital when no one else is willing to buy the companys stock Controversy: govt ownership not consistent with free market principles; political influence
Financial Crises

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The U.S. financial crisis of 2007-2009

Context: the 1990s and early 2000s were a time
of stability, called The Great Moderation

2007-2009: stock prices dropped 55% unemployment doubled to 10% failures of large, prestigious institutions like
Lehman Brothers

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The subprime mortgage crisis

2006-2007: house prices fell, defaults on
subprime mortgages, huge losses for institutions holding subprime mortgages or the securities they backed Huge lenders Ameriquest and New Century Financial declared bankruptcy in 2007 lending to other banks, uncertain about their ability to repay Fed funds rate increased above Feds target
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Liquidity crisis in August 2007 as banks reduced

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Disaster in September 2008

After 6 calm months, a financial crisis exploded:

Fannie Mae, Freddie Mac

nearly failed due to a growing wave of mortgage defaults, U.S. Treasury became their conservator and majority shareholder, promised to cover losses on their bonds to prevent a larger catastrophe

Lehman Brothers
declared bankruptcy, also due to losses on MBS Lehmans failure meant defaults on all Lehmans borrowings from other institutions, shocked the entire financial system
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Disaster in September 2008

American International Group (AIG)
about to fail when the Fed made $85b emergency loan to prevent losses throughout financial system

The money market crisis

Money market funds no longer assumed safe, nervous depositors pulled out (bank-run style) until Treasury Dept offered insurance on MM deposits

Flight to safety
People sold many different kinds of assets, causing price drops, but bought Treasuries, causing their prices to rise and interest rates to fall to near zero
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interest rate (%)

10
11-Jun-08 1-Jul-08 21-Jul-08 10-Aug-08 30-Aug-08 19-Sep-08 9-Oct-08 29-Oct-08 18-Nov-08 8-Dec-08 28-Dec-08 17-Jan-09 6-Feb-09 26-Feb-09 18-Mar-09 7-Apr-09 27-Apr-09 17-May-09 6-Jun-09 26-Jun-09

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The flight to safety: BAA corporate bond and 90-day T-bill rates

Financial Crises
Corporate bond interest rate Treasury bill interest rate
16

An economy in freefall
Falling stock and house prices reduced consumers
wealth, reducing their confidence and spending. bank lending fell sharply because: banks could not resell loans to securitizers banks worried about insolvency from further losses commercial paper to help bridge the gap between production costs and revenues
Financial Crises

Financial panic caused a credit crunch;

Previously safe companies unable to sell

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The policy response

TARP Troubled Asset Relief Program (10/3/2008) $700 billion to rescue financial institutions initially intended to purchase troubled assets like

subprime MBS later used for equity injections into troubled institutions result: U.S. Treasury became a major shareholder in Citigroup, Goldman Sachs, AIG, and others

Federal Reserve programs to repair commercial

paper market, restore securitization, reduce mortgage interest rates
Financial Crises
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The policy response

Monetary policy:
Fed funds rate reduced from 2% to near 0% and has remained there

The fiscal stimulus package (February 2009): tax cuts and infrastructure spending costly nearly

5% of GDP Congressional Budget Office estimates it boosted real GDP by 1.5 3.5%

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The aftermath
The financial crises eases Dow Jones stock price index rose 65% from
3/2009 to 3/2010 Many major financial institutions profitable in 2009 Some taxpayer funds used in rescues will probably never be recovered, but these costs appear small relative to the damage from the crisis

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percent of labor force

10 2 4 6 8

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The aftermath: unemployment persists

Financial Crises
unemployment rate (left scale) average duration of unemployment (right scale)
15 18

Dec-2007 Jan-2008 Feb-2008 Mar-2008 Apr-2008 May-2008 Jun-2008 Jul-2008 Jul-2008 Aug-2008 Sep-2008 Oct-2008 Nov-2008 Dec-2008 Jan-2009 Feb-2009 Mar-2009 Apr-2009 May-2009 Jun-2009 Jul-2009 Aug-2009

weeks
21

21

24

27

The aftermath
Constraints on macroeconomic policy Huge deficits from the recession and stimulus
constrain fiscal policy Monetary policy constrained by the zero-bound problem: even a zero interest rate not low enough to stimulate aggregate demand and reduce unemployment

Moral hazard The rescues of financial institutions will likely

increase future risk-taking and the need for future rescues

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Reforming financial regulation: Regulating nonbank financial institutions Nonbank financial institutions (NBFIs) do not enjoy
federal deposit insurance, so were less regulated than banks regulation of NBFIs, including: greater capital requirements restrictions on risky asset holdings greater scrutiny by regulators

Since the crisis, many argue for bank-like

Controversy: more regulation will reduce

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profitability and maybe financial innovation

Financial Crises

Reforming financial regulation: Addressing too big to fail Policymakers have been rescuing TBTF

institutions since Continental Illinois in 1984.

Since the crisis, proposals to limit size of institutions to prevent them from
becoming TBTF limit scope by restricting the range of different businesses that any one firm can operate

Such proposals would reverse the trend toward

mergers and conglomeration of financial firms, would reduce benefits from economics of scale & scope
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Reforming financial regulation: Discouraging excessive risk-taking Most economists believe excessive risk-taking is a
key cause of financial crises.

Proposals to discourage it include: requiring skin in the game firms that arrange

risky transactions must take on some of the risk reforming ratings agencies, since they underestimated the riskiness of subprime MBS reforming executive compensation to reduce incentive for executives to take risky gambles in hopes of high short-run gains
Financial Crises

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Reforming financial regulation: Changing regulatory structure There are many different regulators, though not by
any logical design.

Many economists believe inconsistencies and gaps

in regulation contributed to the 2007-2009 financial crisis. agency that oversees and coordinates regulators.

Proposals to consolidate regulators or add an

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Financial Crises

CASE STUDY

The Dodd-Frank Act (July 2010)

establishes a new Financial Services Oversight
Council to coordinate financial regulation agencies annually

a new Office of Credit Ratings will examine rating FDIC gains authority to close a nonbank financial
institution if its troubles create systemic risk sponsoring hedge funds

prohibits holding companies that own banks from requires that companies that issue certain risky
securities have skin in the game and retain at least 5% of the default risk

Financial crises in emerging economies

Emerging economies: middle-income countries Financial crises more common in emerging Capital flight: a sharp increase in net capital
outflow that occurs when asset holders lose confidence in the economy, caused by rising govt debt & fears of default political instability banking problems
Financial Crises

economies than high-income countries, and often accompanied by capital flight.

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Capital flight
Interest rates rise sharply when people sell bonds Exchange rates depreciate sharply when people
sell the countrys currency

Contagion: the spread of capital flight from one

country to another occurs when problems in Country A make people worry that Country B might be next, so they sell Country Bs assets and currency, causing the same problems there like a bank panic
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Capital flight and financial crises

Banking problems can trigger capital flight Capital flight causes asset price declines, which
worsens a financial crisis

High interest rates from capital flight and loss in

confidence cause aggregate demand, output, and employment to fall, which worsens a financial crisis burden of dollar-denominated debt in these countries
Financial Crises

Rapid exchange rate depreciation increases the

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Crisis in Greece
Caused by rising govt debt, fear of default Asset holders sold Greek govt bonds, which
caused interest rates on those bonds to rise

Facing a steep recession, Greece could not

pursue fiscal policy due to debt, or monetary policy due to membership in the Eurozone

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Crisis in Greece
16 14 12 10 8 6 4 2
2005 2006 2007 2008 2009

Govt budget deficit, % of GDP

9 8 7 6 5 4 3
Jan-03 Jul-03

Interest rates on 10-year govt bonds

Greece

Germany
Jan-04 Jan-05 Jan-06 Jul-04 Jul-05

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32

The International Monetary Fund

International Monetary Fund (IMF):
an international institution that lends to countries experiencing financial crises established 1944 the international lender of last resort

How countries use IMF loans: govt uses to make payments on its debt central bank uses to make loans to banks central bank uses to prop up its currency in
foreign exchange markets
Financial Crises
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CHAPTER SUMMARY
Financial crises begin with asset price
declines, financial institution failures, or both. A financial crisis can produce a credit crunch and reduce aggregate demand, causing a recession, which reinforces the financial crisis. institutions. Rescues range from riskless loans to institutions with liquidity crises, giveaways, risky loans, and equity injections.

Policy responses include rescuing troubled

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CHAPTER SUMMARY
Financial rescues are controversial because
of the cost to taxpayers and because they increase moral hazard: firms may take on more risk, thinking the government will bail them out if they get into trouble. evolved into a broad financial and economic crisis in the U.S. Stock prices fell, prestigious financial institutions failed, lending was disrupted, and unemployment rose to near 10%.
Financial Crises

Over 2007-2009, the subprime mortgage crisis

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CHAPTER SUMMARY
Financial reform proposals include: increased
regulation of nonbank financial institutions; policies to prevent institutions from becoming too big to fail; rules that discourage excessive risk-taking; and new structures for regulatory agencies.

Financial crises in emerging market economies

typical include capital flight and sharp decreases in exchange rates, which can be caused by high government debt, political instability, and banking problems. The International Monetary Fund can help with emergency loans.
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