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CHAPTER
19
Financial Crises
MACROECONOMICS
and the FINANCIAL SYSTEM
N. Gregory Mankiw & Laurence M. Ball
© 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
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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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Financial Crises
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Common features of financial crises
Liquidity crises
if its depositors lose confidence, a bank run
depletes the bank’s 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
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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 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 can sustain itself for a long time
Financial
Crises
CHAPTER 19
5
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 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
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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
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
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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
TBTF institutions are candidates for bailouts.
Example: Continental Illinois Bank (1984)
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Financial Crises
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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 company’s
stock by the govt to increase a nearly insolvent
company’s capital when no one else is willing to buy
the company’s stock
Controversy: govt ownership not consistent with
free market principles; political influence
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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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Financial Crises
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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
Liquidity crisis in August 2007 as banks reduced
lending to other banks, uncertain about their
ability to repay
Fed funds rate increased above Fed’s target
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Financial Crises
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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
Lehman’s failure meant defaults on all Lehman’s
borrowings from other institutions, shocked the
entire financial system
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Financial Crises
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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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Financial Crises
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26-Jun-09
6-Jun-09
17-May-09
27-Apr-09
1
7-Apr-09
2
18-Mar-09
6
26-Feb-09
7
6-Feb-09
17-Jan-09
28-Dec-08
8-Dec-08
18-Nov-08
29-Oct-08
9-Oct-08
19-Sep-08
30-Aug-08
10-Aug-08
21-Jul-08
1-Jul-08
11-Jun-08
interest rate (%)
The flight to safety:
BAA corporate bond and 90-day T-bill rates
10
9
8
Corporate bond
interest rate
5
4
3
Treasury bill
interest rate
0
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
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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
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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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Financial Crises
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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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Financial Crises
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4
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
percent of labor force
10
27
8
24
unemployment
rate (left scale)
6
21
average
duration of
unemployment
(right scale)
2
18
15
weeks
The aftermath: unemployment persists
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
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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
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
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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
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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.
Proposals to consolidate regulators or add an
agency that oversees and coordinates regulators.
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Financial Crises
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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
banking problems
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Capital flight
Interest rates sharply when people sell bonds
Exchange rates depreciate sharply when people
sell the country’s 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 B’s 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
Rapid exchange rate depreciation increases the
burden of dollar-denominated debt in these
countries
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Financial Crises
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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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Financial Crises
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Crisis in Greece
Govt budget deficit,
% of GDP
16
Interest rates on
10-year govt bonds
9
14
8
12
7
Greece
10
6
8
5
6
4
Jan-06
Jul-05
Jan-05
Jul-04
Jan-04
Germany
Jul-03
2009
2008
2007
2
2006
0
2005
2
3
Jan-03
4
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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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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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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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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Financial Crises
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