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MACROECONOMICS

and the

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

Financial
Crises
19
Modified for EC 204
by Bob Murphy

2011 Worth Publishers, all rights reserved

PowerPoint slides by Ron Cronovich

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

how capital flight often plays a role in financial


crises affecting emerging economies

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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

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

Once19
a
CHAPTER

CASE STUDY

Disaster in the 1930s


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

Over 1/3 of all banks failed by 1933, due to loan


defaults and a bank panic

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
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Financial Crises

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.

During a liquidity crisis, a central bank may act as


a lender of last resort, providing emergency
loans to institutions to prevent them from failing.

Discount loan: a loan from the Federal


Reserve to a bank, approved if Fed judges bank
solvent and with sufficient collateral
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Financial Crises

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 insolvent


institution from spreading

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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Financial Crises

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

TBTF institutions are candidates for bailouts.


Example: Continental Illinois Bank (1984)
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Financial Crises

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
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Financial Crises

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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Financial Crises

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

Liquidity crisis in August 2007 as banks reduced


lending to other banks, uncertain about their
ability to repay
Fed funds rate increased above Feds target
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Financial Crises

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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Financial Crises

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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Financial Crises

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Financial Crises

16

An economy in freefall
Falling stock and house prices reduced consumers
wealth, reducing their confidence and spending.

Financial panic caused a credit crunch;


bank lending fell sharply because:
banks could not resell loans to securitizers
banks worried about insolvency from further
losses

Previously safe companies unable to sell


commercial paper to help bridge the gap between
production costs and revenues
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Financial Crises

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
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Financial Crises

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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Financial Crises

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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Financial Crises

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Financial Crises

21

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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Financial Crises

Reforming financial regulation:


Regulating nonbank financial
institutions
Nonbank financial institutions (NBFIs) do not enjoy
federal deposit insurance, so were less regulated
than banks

Since the crisis, many argue for bank-like


regulation of NBFIs, including:
greater capital requirements
restrictions on risky asset holdings
greater scrutiny by regulators

Controversy: more regulation will reduce


profitability and maybe financial innovation
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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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Financial Crises

Reforming financial regulation:


Discouraging excessive risktaking
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
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Financial Crises

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.

Proposals to consolidate regulators or add an


agency that oversees and coordinates regulators.

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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

a new Office of Credit Ratings will examine rating


agencies annually

FDIC gains authority to close a nonbank financial


institution if its troubles create systemic risk

prohibits holding companies that own banks from


sponsoring hedge funds

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


economies than high-income countries, and 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
rising govt debt & fears of default
political instability
CHAPTER
19 Financial
Crises
banking
problems

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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Financial Crises

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

Rapid exchange rate depreciation increases the


burden of dollar-denominated debt in these
countries
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Financial Crises

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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Financial Crises

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Financial Crises

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
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Financial Crises

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. Rescues range from riskless loans to
institutions with liquidity crises, giveaways, risky
loans, and equity injections.

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Financial Crises

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


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%.
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Financial Crises

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.
CHAPTER 19

Financial Crises

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