Mankiw-Ball - Financial Crises

MACROECONOMICS and the FINANCIAL SYSTEM .

regory

an w

aurence

. a

In this cha ter, ou will learn: 

common features of financial crises



how financial crises can be self-perpetuating



various policy responses to crises



, including the U.S. financial crisis of 2007-2009



ow cap ta g t o ten p ays a ro e n nanc a crises affecting emerging economies

CHAPTER 19

Financial Crises

1

Common features of financial crises 

Asset price declines involving stocks, real estate, or other assets   



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, interconnected,  



CHAPTER 19

Financial Crises

2

Common features of financial crises 

Liquidity crises if its depositors lose confidence, a bank run de letes the bank’s li uid assets if its creditors have lost confidence, an inv m n nk m h v r l llin commercial paper to pay off maturing debts , assets at “fire sale” prices, bringing it closer to 





CHAPTER 19

Financial Crises

3

Financial crises and a 

re ate demand

Falling asset prices reduce aggregate demand consumers’ wealth falls  

postpone spending 



, firms and consumers to borrow

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

CHAPTER 19

Financial Crises

4

Financial crises and a 

re ate 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 e a n agg. eman worsens e nanc a cr s s 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

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

CHAPTER 19

5

CASE STUDY

sas er n 

e

s

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



A credit crunch and uncertainty caused huge fall in consumption and investment



Falling output magnified these problems , creating deflation, which increased the real value o e s an ncrease e au s

CHAPTER 19

Financial Crises

6

Financial rescues: emer enc loans 

The self-perpetuating nature of crises gives policymakers a strong incentive to intervene to tr to break the c cle of crisis and recession.



During a liquidity crisis, a central bank may act as a , prov ng emergency loans to institutions to prevent them from failing.



Discount loan: a loan from the Federal R rv t a bank a r v d if F d ud solvent and with sufficient collateral

CHAPTER 19

Financial Crises

bank

7

Financial rescues: “bailouts” 

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



Purpose: to prevent the problems of an nso ven ns u on rom sprea ng



Costs of “bailouts” 

direct: use of taxpayer funds , likelihood of future failures and need for future

CHAPTER 19

Financial Crises

8

“Too bi to fail” 

The larger the institution, the greater its links to other institutions 

Links include liabilities such as de osits or borrowings

if they are so interconnected that their failure 

TBTF institutions are candidates for bailouts. Example: Continental Illinois Bank (1984)

CHAPTER 19

Financial Crises

9

Risk Rescues 

Risky loans: govt loans to institutions that may not be repaid institutions borderin on insolvenc institutions with no collateral   



Equity injections: purchases of a company’s stoc y t e govt to ncrease a near y nso vent company’s capital when no one else is willing to buy t e company s stoc 

Controversy: govt ownership not consistent with free market principles; political influence

CHAPTER 19

Financial Crises

10

The U.S. financial crisis of 2007-2009 

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

stock prices dropped 55% unemployment doubled to 10% failures of lar e, resti ious institutions like Lehman Brothers

CHAPTER 19

Financial Crises

11

The sub rime mort a e crisis 

2006-2007: house prices fell, defaults on subprime mortgages, huge losses for institutions holdin sub rime mort a es or the securities they backed 

Financial declared bankruptcy in 2007 

qu y cr s s n ugus as an s re uce lending to other banks, uncertain about their ability to repay 

Fed funds rate increased above Fed’s target

CHAPTER 19

Financial Crises

12

Disaster in Se tember 2008 After 6 calm months, a financial crisis exploded: 

Fannie Mae, Freddie Mac 

defaults, U.S. Treasury became their conservator on their bonds to prevent a larger catastrophe e man ro ers   declared bankruptcy, also due to losses on MBS 

Lehman’s failure meant defaults on all Lehman’s borrowings from other institutions, shocked the en re nanc a sys em

CHAPTER 19

Financial Crises

13

Disaster in Se tember 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 

nervous depositors pulled out (bank-run style) until Treasur De t offered insurance on MM de osits 

Flight to safety 

, price drops, but bought Treasuries, causing their CHAPTER 19

Financial Crises

14

The flight to safety: -

-

10

8

Corporate bond  interest rate 

7

   %    ( 6   e    t   a   r 5    t   s 4   e   r   e    t   n 3    i 2

Treasury bill 

1 0

   8    0     n    J      1    1

   8    0      l   u    J      1

   8    0      l   u    J      1    2

   8    8    8    8    0   -    0   -    0   -    0     g   g   p    t   c    A     -    A   -    S   -    9    0    0    9    1    3    1

   8    0      t   c      9    2

   8    0     v

   8    0     c

   8    0     c

   9    0     n    J    N     -    D   -    D   -    7    8    8    8    1    1    2

   9    0      b    F      6

   9    0      b    F      6    2

   9    9    9    9    9    0    0    0    0    0           r   r   r   y     n   a   p   p    A    J    M   -    A   -    M     -    7      7    7    6    8    2    1    1

   9    0     n    J      6    2

An econom in freefall 

Falling stock and house prices reduced consumers’ wealth, reducing their confidence and spending.



bank lending fell sharply because 



an s cou no rese oans o secur zers banks worried about insolvency from further osses

Previousl “safe” com anies unable to sell commercial paper to help bridge the gap between roduction costs and revenues

CHAPTER 19

Financial Crises

16

The olic res onse 

TARP – Troubled Asset Relief Program (10/3/2008) $700 billion to rescue financial institutions “ ” subprime MBS  





institutions . . in Citigroup, Goldman Sachs, AIG, and others

e era eserve programs o repa r commerc a paper market, restore securitization, reduce mor gage n eres ra es CHAPTER 19

Financial Crises

17

The olic res onse 

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



The fiscal stimulus package (February 2009): ax cu s an n ras ruc ure spen ng cos y near y 5% of GDP ongress ona u ge ce es ma es oos e real GDP by 1.5 – 3.5%

CHAPTER 19

Financial Crises

18

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 Some taxpayer funds used in rescues will , appear small relative to the damage from the

CHAPTER 19

Financial Crises

19

The aftermath: unemplo ment persists 10   e   c   r 8   o    f   r   o    b   a    l    f 6    t   n   e   c   r   p

2

27

24   s    k 21   e   e

rate (left scale) average  duration of  unemployment  (right scale)    7   8   8   8   8   8   8   8   8   8   8   8   8   8   9   9   9   9   9   9   9   9    0   0   0   0   0   0   0   0   0   0   0   0   0   0   0   0   0   0   0   0   0   0    0   0   0   0   0   0   0   0   0   0   0   0   0   0   0   0   0   0   0   0   0   0    2   2   2   2   2   2   2   2   2   2   2   2   2   2   2   2   2   2   2   2   2   2   r   y   n   l    l   g   p   t   v   c   n   b   r   r   y   n   l   g   c   n   b   r   u   u   u   e   c   o   e   a   e   a   p   a   u   u   u   a   p   a   u   J   e   a   e    J    J    A    A   S   O   N   D   J    F   M   A   M   J    A    D   J    F   M    M   J

15

The aftermath 

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





Moral hazard increase future risk-taking and the need for future

CHAPTER 19

Financial Crises

21

Reforming financial regulation: egu at ng non an nanc a nst tut ons 

Nonbank financial institutions NBFIs do not en o federal deposit insurance, so were less regulated than banks



Since the crisis, many argue for bank-like regu a on o s, nc u ng: greater capital requirements restrictions on risky asset holdings greater scrutiny by regulators   



Controversy: more regulation will reduce

CHAPTER 19

Financial Crises

22

Reforming financial regulation: ress ng oo g o a 

Polic makers have been rescuin TBTF institutions since Continental Illinois in 1984 





, limit size of institutions to prevent them from ecom ng limit scope by restricting the range of different

Such proposals would reverse the trend toward mergers and conglomeration of financial firms, would reduce benefits from economics of scale & scope

CHAPTER 19

Financial Crises

23

Reforming financial regulation: scourag ng excess ve r s - a ng   

Most economists believe excessive risk-takin is a key cause of financial crises. 





requiring “skin in the game” – firms that arrange r s y ransac ons mus a e on some o e r s reforming ratings agencies, since they un eres ma e e r s ness o su pr me reforming executive compensation to reduce ncen ve or execu ves o a e r s y gam es n hopes of high short-run gains

CHAPTER 19

Financial Crises

24

Reforming financial regulation: ang ng regu a ory s ruc ure 

There are man different re ulators, thou h not b any logical design. gaps in regulation contributed to the 2007-2009 .



Proposals to consolidate regulators or add an agency that oversees and coordinates regulators.

CHAPTER 19

Financial Crises

25

CASE STUDY

e 

o

- ran

c

uy

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



FDIC gains authority to close a nonbank financial institution if its troubles create systemic risk



prohibits holding companies that own banks from s onsorin hed e funds



requires that companies that issue certain risky “ ” least 5% of the default risk

Financial crises in emer in economies 

Emerging economies : middle-income countries



Financial crises more common in emerging , often accompanied by capital flight.



Capital flight: a sharp increase in net capital outflow that occurs when asset holders lose confidence in the economy, caused by   

political instability an ng pro ems

CHAPTER 19

Financial Crises

27

Ca ital fli ht 

Interest rates sharply when people sell bonds



Exchange rates depreciate sharply when people ’



Contagion: the spread of capital flight from one country to another 

people worry that Country B might be next, h ll nr ’ n rr n causing the same problems there 

CHAPTER 19

Financial Crises

28

Ca ital fli ht and financial crises 

Banking problems can trigger capital flight



Capital flight causes asset price declines, which



High interest rates from capital flight and loss in confidence cause aggregate demand, output, and em lo ment to fall which worsens a financial crisis ap exc ange ra e eprec a on ncreases burden of dollar-denominated debt in these coun r es

CHAPTER 19

Financial Crises

e

29

Crisis in Greece 

Caused by rising govt debt, fear of default



Asset holders sold Greek govt bonds, which



Facing a steep recession, Greece could not pursue fiscal policy due to debt, or monetary olic due to membershi in the Eurozone

CHAPTER 19

Financial Crises

30

Crisis in Greece Interest rates on -

Govt budget deficit, 16

9

14

8

12

7

Greece 

10 8

5 4

4

0

Germany     5    0    2

6    0    2

7    0    2

8    0    2

9    0    2

2

   3     n   a    J

3      l   u    J

4     n   a    J

4      l   u    J

5     n   a    J

5      l   u    J

6     n   a    J

The International Monetar Fund 

International Monetary Fund (IMF): an international institution that lends to countries experiencing financial crises  



established 1944 “

”

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   

CHAPTER 19

Financial Crises

32

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.



Policy responses include rescuing troubled . institutions with liquidity crises, giveaways, risky , .

CHAPTER 19

Financial Crises

33

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.



Over 2007-2009, the subprime mortgage crisis in the U.S. Stock prices fell, prestigious financial , , unemployment rose to near 10%.

CHAPTER 19

Financial Crises

34