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CHAPTER

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FinancialCrises Financial Crises

MACROECONOMICS and the FINANCIAL SYSTEM


N. Gregory M ki & L N G Mankiw Laurence M. Ball M B ll
2011 Worth Publishers, all rights reserved PowerPoint slides by Ron Cronovich

Inthischapter,youwilllearn: p ,y
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 fli ht often plays a role i fi h it l flight ft l l in financial i l 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 p q 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 cases, assets at fire sale prices, bringing it closer to insolvency

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Financial c ses and aggregate demand a c a crises a d agg egate de a d


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 falls, firms and consumers to borrow Financial institution failures reduce lending banks become more conservative since more uncertainty over borrowers ability to repay
Financial Crises

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Financial c ses and aggregate demand a c a crises a d agg egate de a d


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 Th f ll i agg. d demand worsens th fi d the financial crisis i l i i 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 crisis starts, it can sustain itself for a long time Financial Crises

CASE STUDY

Disaster in the 1930s Di t i th 1930


Sharp asset p p 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 1933, 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 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. y y During a liquidity crisis, a central bank may act as a lender of last resort, providing emergency resort 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 rescues: bailouts 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 hazard, likelihood of future failures and need for future bailouts
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Too big to fail Too fail


The larger the institution, the greater its links to other institutions Links include liabilities, such as deposits or , p 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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Risky Rescues
Risky loans: govt loans to institutions that may not be repaid institutions bordering on insolvency g y institutions with no collateral Example: Fed loaned $85 billion to AIG (2008) Equity injections: purchases of a companys stock by the govt to i t k b th t t increase a nearly i l insolvent l companys capital when no one else is willing to buy the th companys stock t k Controversy: govt ownership not consistent with free market principles; political influence
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The U.S. financial crisis of 2007-2009 2007 2009


Context: the 1990s and early 2000s were a time of stability, called The Great Moderation 2007-2009: 2007 2009: stock prices dropped 55% unemployment doubled to 10% failures of large, p g prestigious institutions like g 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 g p g g they backed Huge lenders Ameriquest and New Century Financial declared bankruptcy in 2007 Liquidity i i in August 2007 as b k reduced Li idit crisis i A t banks d d lending to other banks, uncertain about their ability to repay Fed funds rate increased above Feds target g
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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 B th L h Brothers declared bankruptcy, also due to losses on MBS Lehmans failure meant defaults on all Lehmans borrowings from other institutions, shocked the entire fi ti financial system i l t
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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 y p p Treasury Dept offered insurance on MM deposits Flight to safety People sold many different kinds of assets, causing assets price drops, but bought Treasuries, causing their prices to rise and interest rates to fall to near zero
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i interest rate (%) )


10 0 11-Ju un-08 1-Jul-08 21-Jul-08 10-Au ug-08 30-Au ug-08 19-Se ep-08 9-O Oct-08 29-O Oct-08 18-No ov-08 8-De ec-08 28-De ec-08 17-Ja an-09 6-Fe eb-09 26-Fe eb-09 18-Ma ar-09 7-Apr-09 27-Apr-09 17-Ma ay-09 6-Ju un-09 26-Ju un-09 1 2 3 4 5 6 7 8 9

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

Corporate bond interest rate

Treasury bill interest rate

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 b k could not resell l ld t ll loans t securitizers to iti banks worried about insolvency from further losses Previously safe companies unable to sell y p commercial paper to help bridge the gap between p production 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 like troubled assets subprime MBS later used for equity injections into troubled institutions result: U.S. Treasury became a major shareholder US in Citigroup, Goldman Sachs, AIG, and others

Federal R F d l Reserve programs to repair commercial t i i l paper market, restore securitization, reduce mortgage interest rates t i t t t
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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 c ts ta cuts and infrastructure spending costl nearl infrastr ct re costly nearly 5% of GDP Congressional B d t Offi estimates it b C i l Budget Office ti t boosted t d 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 recovered appear small relative to the damage from the crisis

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pe ercent of labor force o r


10 4 2 6 8

unemployment rate (left scale) average duration of unemployment (right scale)


15 18

The aftermath: unemployment p p y persists

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

w weeks

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The aftermath
Constraints on macroeconomic policy Huge deficits from the recession and stimulus constrain fiscal policy p y Monetary policy constrained by the zero-bound p 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 fi R l ti b k financial i tit ti i l institutions


Nonbank financial institutions (NBFIs) do not enjoy ( ) j y federal deposit insurance, so were less regulated than banks Since the crisis, many argue for bank-like regulation NBFIs, including: reg lation of NBFIs incl ding 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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Reforming financial regulation: Addressing too big to f il Add i t bi t fail


Policymakers have been rescuing TBTF y g institutions since Continental Illinois in 1984 Since the crisis proposals to crisis, limit size of institutions to prevent them from becoming TBTF b i
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 Di i i i k t ki


Most economists believe excessive risk-taking is a g key cause of financial crises. Proposals to discourage it include: requiring skin in the game firms that arrange risky t i k transactions must take on some of the risk ti tt k f th i k reforming ratings agencies, since they underestimated th riskiness of subprime MBS d ti t d the i ki f b i reforming executive compensation to reduce incentive f executives t take risky gambles i i ti for ti to t k i k bl in hopes of high short-run gains
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Reforming financial regulation: Changing regulatory structure Ch i l t t t


There are many different regulators, though not by y g g y any logical design. Many economists believe inconsistencies and gaps in regulation contributed to the 2007-2009 financial crisis crisis. Proposals to consolidate regulators or add an agency that oversees and coordinates regulators.

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CASE STUDY

The D dd F Th Dodd-Frank A t (J l 2010) k Act (July


establishes a new Financial Services Oversight g 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 p g g requires that companies that issue certain risky securities have skin in the game and retain at skin game least 5% of the default risk

Financial crises in emerging economies g g


Emerging economies: middle-income countries Financial crises more common in emerging economies than high income countries and high-income countries, 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 b ki problems bl
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Capital flight
Interest rates sharply when people sell bonds Exchange rates depreciate sharply when people sell the countrys currency country s 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, Bs 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 p y , financial crisis Rapid R id exchange rate d h t depreciation i i ti increases th the burden of dollar-denominated debt in these countries ti
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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 p policy due to membership in the Eurozone y p

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Crisis in Greece
16 14 12 10 8 6 4 2 0 200 05 200 06 200 07 200 08 200 09

Govt budget deficit, % of GDP

9 8 7

Interest rates on 10-year 10 year govt bonds

Greece
6 5 4 3 2 Jul-0 03 Jul-0 04 Jan-0 03 Jan-0 04 Jan-0 05 Jul-0 05 Jan-0 06

Germany

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

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CHAPTERSUMMARY
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 failed, disrupted, unemployment rose to near 10%.
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CHAPTERSUMMARY
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 g government debt, political instability, and banking ,p y, g problems. The International Monetary Fund can p g y help with emergency loans.
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