mbchap19 financial crises ball and mankiw 2011

7/29/2019 MBChap19 Financial Crises Ball and Mankiw 2011

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MACROECONOMICSand the

FINANCIAL SYSTEM

2011 Worth Publishers, all rights reserved PowerPoint slides by Ron Cronovich

N. Gregory Mankiw& Laurence M. Ball

Financial CrisesModified for EC 204by Bob Murphy


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CHAPTER 19 Financial Crises

Inthischapter,youwilllearn:

common features of financial crises

how financial crises can be self-perpetuating

various policy responses to crises

about historical and contemporary crises, includingthe U.S. financial crisis of 2007-2009

how capital flight often plays a role in financial

crises affecting emerging economies


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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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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 paperto pay off maturing debts

in such cases, the institution must sell illiquid

assets at fire sale prices, bringing it closer toinsolvency


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Financial crises and aggregate demand

Falling asset prices reduce aggregate demand

consumers wealth falls

uncertainty makes consumers and firms postponespending

the value of collateral falls, making it harder for

firms and consumers to borrow

Financial institution failures reduce lending

banks become more conservative since moreuncertainty over borrowers ability to repay


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Financial crises and aggregate demand

Credit crunch: a sharp decrease in bank lending

may occur when asset prices fall and financialinstitutions 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 panicsmore likely


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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 valueof debts and increased defaults


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Financial rescues: emergency loans

The self-perpetuating nature of crises givespolicymakers a strong incentive to intervene totry to break the cycle of crisis and recession.

During a liquidity crisis, a central bank may actas a lender of last resort, providing emergencyloans to institutions to prevent them from failing.

Discount loan: a loan from the Federal Reserve

to a bank, approved if Fed judges bank solventand with sufficient collateral


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Financial rescues: bailouts

Govt may give funds to prevent an institutionfrom failing, or may give funds to those hurt bythe failure

Purpose: to prevent the problems of an insolventinstitution from spreading

Costs of bailouts

direct: use of taxpayer funds

indirect: increases moral hazard, increasinglikelihood of future failures and need for futurebailouts


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Too big to fail

The larger the institution, the greater its links toother institutions

Links include liabilities, such as deposits orborrowings

Institutions deemed too big to fail(TBTF)if they are so interconnected that their failure wouldthreaten the financial system

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


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Risky Rescues

Risky loans: govt loans to institutions that may notbe repaid

institutions bordering on insolvency

institutions with no collateral

Example: Fed loaned $85 billion to AIG (2008)

Equity injections: purchases of a companysstock by the govt to increase a nearly insolvent

companys capital when no one else is willing to buythe companys stock

Controversy: govt ownership not consistent withfree market principles; political influence


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The U.S. financial crisis of 2007-2009

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

2007-2009:

stock prices dropped 55%

unemployment doubled to 10%

failures of large, prestigious institutions likeLehman Brothers


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The subprime mortgage crisis

2006-2007: house prices fell, defaults onsubprime mortgages, huge losses for institutionsholding subprime mortgages or the securitiesthey backed

Huge lenders Ameriquest and New CenturyFinancial declared bankruptcy in 2007

Liquidity crisis in August 2007 as banks reducedlending to other banks, uncertain about theirability to repay

Fed funds rate increased above Feds target


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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 mortgagedefaults, U.S. Treasury became their conservator

and majority shareholder, promised to cover losseson 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 theentire financial system


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Disaster in September 2008

American International Group (AIG)

about to fail when the Fed made $85b emergencyloan 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 safetyPeople sold many different kinds of assets, causingprice drops, but bought Treasuries, causing their

prices to rise and interest rates to fall to near zero


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CHAPTER 19 Financial Crises 16

The flight to safety:

BAA corporate bond and 90-day T-bill rates

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interestra

te(%)

Corporate bond

interest rate

Treasury bill

interest rate


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An economy in freefall

Falling stock and house prices reduced consumerswealth, 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 furtherlosses

Previously safe companies unable to sellcommercial paper to help bridge the gap betweenproduction costs and revenues


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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 likesubprime MBS

later used for equity injections into troubledinstitutions

result: U.S. Treasury became a major shareholderin Citigroup, Goldman Sachs, AIG, and others

Federal Reserve programs to repair commercialpaper market, restore securitization, reducemortgage interest rates


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The policy response

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

The fiscal stimulus package (February 2009):

tax cuts and infrastructure spending costly nearly5% of GDP

Congressional Budget Office estimates it boostedreal GDP by 1.5 3.5%


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The aftermath

The financial crises eases

Dow Jones stock price index rose 65% from3/2009 to 3/2010

Many major financial institutions profitable in2009

Some taxpayer funds used in rescues willprobably never be recovered, but these costsappear small relative to the damage from the

crisis


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CHAPTER 19 Financial Crises 21

The aftermath: unemployment persists

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percentof

laborforce

weeks

unemployment

rate (left scale)

average

duration of

unemployment

(right scale)


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The aftermath

Constraints on macroeconomic policy

Huge deficits from the recession and stimulusconstrain fiscal policy

Monetary policy constrained by the zero-boundproblem: even a zero interest rate not lowenough to stimulate aggregate demand andreduce unemployment

Moral hazard

The rescues of financial institutions will likelyincrease future risk-taking and the need for futurerescues


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Reforming financial regulation:

Regulating nonbank financial institutions

Nonbank financial institutions (NBFIs) do not enjoyfederal deposit insurance, so were less regulatedthan banks

Since the crisis, many argue for bank-likeregulation of NBFIs, including:

greater capital requirements

restrictions on risky asset holdings

greater scrutiny by regulators

Controversy: more regulation will reduceprofitability and maybe financial innovation


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Addressing too big to fail

Policymakers have been rescuing TBTFinstitutions since Continental Illinois in 1984.

Since the crisis, proposals to

limit size of institutions to prevent them frombecoming TBTF

limit scope by restricting the range of differentbusinesses that any one firm can operate

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


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Discouraging excessive risk-taking

Most economists believe excessive risk-taking is akey cause of financial crises.

Proposals to discourage it include:

requiring skin in the game firms that arrangerisky transactions must take on some of the risk

reforming ratings agencies, since theyunderestimated the riskiness of subprime MBS

reforming executive compensation to reduceincentive for executives to take risky gambles inhopes of high short-run gains


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Changing regulatory structure

There are many different regulators, though not byany logical design.

Many economists believe inconsistencies and gapsin regulation contributed to the 2007-2009 financialcrisis.

Proposals to consolidate regulators or add anagency that oversees and coordinates regulators.


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CASE STUDY

The Dodd-Frank Act (July 2010)

establishes a new Financial Services OversightCouncil to coordinate financial regulation

a new Office of Credit Ratings will examine ratingagencies annually

FDIC gains authority to close a nonbank financialinstitution 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 atleast 5% of the default risk


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Financial crises in emerging economies

Emerging economies: middle-income countries

Financial crises more common in emergingeconomies than high-income countries, and often

accompanied by capital flight. Capital flight: a sharp increase in net capital

outflow that occurs when asset holders loseconfidence in the economy, caused by

rising govt debt & fears of default political instability

banking problems


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Capital flight

Interest rates rise sharply when people sell bonds

Exchange rates depreciate sharply when peoplesell the countrys currency

Contagion: the spread of capital flight from onecountry to another

occurs when problems in Country A make peopleworry 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, whichworsens a financial crisis

High interest rates from capital flight and loss inconfidence cause aggregate demand, output,and employment to fall, which worsens afinancial crisis

Rapid exchange rate depreciation increases theburden of dollar-denominated debt in thesecountries


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CHAPTER 19Financial Crises

Crisis in Greece

Caused by rising govt debt, fear of default

Asset holders sold Greek govt bonds, whichcaused interest rates on those bonds to rise

Facing a steep recession, Greece could notpursue fiscal policy due to debt, or monetarypolicy due to membership in the Eurozone


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CHAPTER 19Financial Crises 32

Crisis in Greece

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Govt budget deficit,% of GDP

Interest rates on10-year govt bonds

Greece

Germany


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The International Monetary Fund

International Monetary Fund (IMF):an international institution that lends to countriesexperiencing 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 inforeign exchange markets


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CHAPTERSUMMARY

Financial crises begin with asset pricedeclines, financial institution failures, orboth. A financial crisis can produce a credit crunchand reduce aggregate demand, causing a

recession, which reinforces the financial crisis.

Policy responses include rescuing troubledinstitutions. Rescues range from riskless loans toinstitutions with liquidity crises, giveaways, risky

loans, and equity injections.


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CHAPTERSUMMARY

Financial rescues are controversial becauseof the cost to taxpayers and because they increasemoral 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 crisisevolved into a broad financial and economic crisisin the U.S. Stock prices fell, prestigious financial

institutions failed, lending was disrupted, andunemployment rose to near 10%.


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CHAPTERSUMMARY

Financial reform proposals include: increasedregulation 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 inexchange rates, which can be caused by high

government debt, political instability, and bankingproblems. The International Monetary Fund can help

with emergency loans.

mbchap19 financial crises ball and mankiw 2011

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