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CHAPTER 20

THE CRISIS OF 2007–2010

Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010
20-1 What Cannot Keep Going
Eventually Stops
Slide
20.2

‘If these things were so large, how come


everyone missed them?’
Question asked by Her Majesty The Queen to the LSE professors
during a visit to the School in November 2008

The origin of this recession was a financial crisis which


started in the USA in the summer of 2007.
The financial crisis started in the so-called ‘sub-prime
mortgage’ market, a small part of the US housing mortgages
market intended for borrowers with a relatively high probability
of eventually not being able to repay their loan.

Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010
20-1 What Cannot Keep Going
Eventually Stops
Slide
20.3

House price movements


Figure 20.1b
The price of US houses since 1890 adjusted for inflation
Source: Bank for International Settlement

Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010
20-1 What Cannot Keep Going
Eventually Stops (Continued)
Slide
20.4

The economic crisis of 2007–2009 and its effect on the global


Figure 20.2a
economy
The performance of the US economy in 2007–2009
Source: IMF World Economic Outlook 2009

Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010
20-1 What Cannot Keep Going
Eventually Stops (Continued)
Slide
20.5

Figure 20.2b The economic crisis of 2007–2009 and its effect on the global
economy
The world economy in the crisis
Source: IMF World Economic Outlook 2009

Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010
20-2 Households ‘Under Water’
Slide
20.6

Why did the value of houses shoot up after 2000?


Why were the effects of the fall in house price so
dramatic?
• The increase in house prices was also the effect of a long
period of extremely low interest rates which made
borrowing to buy a house very attractive.
• Borrowing to buy a house was also encouraged by a
change in the rules banks followed to approve a
mortgage, which became much less strict.

Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010
20-2 Households ‘Under Water’
(Continued)
Slide
20.7

• Banks became much less careful when they were


making a loan.
• The moment house prices start falling some
households go ‘under water’!
• Households have an incentive to ‘walk away’ from
their home.
• The mortgage then goes into default and the
house is ‘foreclosed’.
• Because the value of the house is smaller than
the value of the loan which was originally granted,
the bank makes a loss.
Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010
20-2 Households ‘Under Water’
(Continued)
Slide
20.8

Defaults on US sub-prime mortgages


Figure 20.3b
Homeowners with negative equity (who own more on their mortgages than their
homes are worth; millions) (per cent of all homeowners – data are for 2008;
thereafter estimates)
Source: IMF World Economic Outlook 2009

Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010
Securitisation is a Great Invention –
Provided it is Done Right
Slide
20.9

Banks should never lose


the incentive to check
the quality of their
clients.
This can easily be done,
for instance by allowing
a bank to sell only a
fraction of each loan it
has made (say, no more
than 90%),
thus remaining exposed
to some of the risk.

Figure 20.4 The growth of securitisation (annual issues by type of security)


Source: IMF World Economic Outlook 2009

Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010
20-3 Leverage And Amplification
Slide
20.10

To understand how the effect of the fall in house prices was


amplified to the point of inducing a sharp recession, we need to
introduce the concept of ‘leverage’.

A high leverage ratio is risky: in the event of a drop in the value of


its assets, the bank might become insolvent.
However banks like having a high leverage ratio!

As long as house prices were rising, by keeping their


leverage, high banks could earn huge profits and none
failed. But this long honeymoon did not last, and many
banks were bankrupt.
Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010
28-3 Amplification Mechanisms. Leverage, Complexity,
and Liquidity
Leverage
Slide
20.11

Figure 28 – 4
Bank assets, capital,
and liabilities.
The two banks have the same assets. But
Bank B has a smaller capital ratio—
equivalently a higher leverage ratio than
Bank A.
Bank A has assets of 100, liabilities of
80, and capital of 20. Its capital ratio is
defined as the ratio of capital to assets
and is thus equal to 20%. Its leverage
ratio is defined as the ratio of assets to
capital (the inverse of the capital ratio)
and is thus equal to 5. Bank B has
assets of 100, liabilities of 95, and
capital of 5. Thus, its capital ratio is
equal to 5%, and its leverage ratio to
20.
Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010
28-3 Amplification Mechanisms. Leverage, Complexity,
and Liquidity
Leverage
Slide
20.12

Figure 28 – 4 (continued)
Bank assets, capital,
and liabilities.
Now suppose that some of the assets
in each of the two banks go bad. For
example, some borrowers go bankrupt
and cannot repay their loans.
Suppose, as a result, that for both
banks, the value of the assets
decreases from 100 to 90. Bank A now
has assets of 90, liabilities of 80, and
capital of 90 – 80 = 10. Bank B has
assets of 90, liabilities of 95, and thus
negative capital of 5 (90-95). Its
liabilities exceed its assets: In other
words, it is bankrupt.

Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010
28-3 Amplification Mechanisms. Leverage, Complexity,
and Liquidity
Leverage
Slide
20.13

Figure 28 – 4 (continued)
Bank assets, capital,
and liabilities.
Higher leverage means higher expected
profit. Suppose for example that assets
pay an expected rate of return of 5%,
and liabilities pay an expected rate of
return of 4%. Then the owners of bank A
have an expected rate of return on their
capital of (100 * 5% – 80 * 4%)/20 = 9%,
the owners of Bank B have an expected
rate of return of (100 * 5% – 95 * 4%)/5 =
24%, so more than twice as high.

Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010
28-3 Amplification Mechanisms. Leverage, Complexity,
and Liquidity
Leverage
Slide
20.14

The lesson is simple: When financial


intermediaries have a lot of capital—
equivalently when their leverage is
low—they can absorb losses without
going bankrupt. But when they have
little capital, when they are highly
leveraged, even small losses can lead
to bankruptcy.
Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010
20-3 Leverage And Amplification
(Continued)
Slide
20.15

When the value of their assets fell, some banks with high leverage went
bust. These obviously stopped lending. But also the banks which had
enough capital and survived started worrying.
The result was a credit freeze and a fire sale in the stock market.

Figure 20.5 Credit to the private non-financial sector


Source: Bank for International Settlements, 2009 Annual Report

Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010
20-4 Investment Demand, with
Banks as Intermediaries
Slide
20.16

The rate at which banks lend to firms,ρ, is usually equal to the


rate savers receive plus a spread, x:

Investment demand therefore depends on the cost of bank


loans:

The spread x depends on two factors:


• Banks’ capital, AB
• Firms’ capital, AF

Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010
20-4 Investment Demand, with Banks
as Intermediaries (Continued)
Slide
20.17

Goods and financial market equilibrium following a fall in banks’


Figure 20.6
capital which raises the external finance premium
Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010
20-4 Investment Demand, with Banks
as Intermediaries (Continued)
Slide
20.18

The external finance premium and the collapse of investment


Figure 20.7
expenditure
(a) Corporate bonds (investment grade): spreads in the euro area, the UK and the
USA. (b) Capital goods orders
Sources: IMF and Bank for International Settlements, 2009 Annual Report

Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010
20-5 international Contagion
Slide
20.19

The main channel of transmission was trade.

Figure 20.8 The collapse of US merchandise imports in 2009


Source: WTO, Short-term merchandise trade statistics, available at www.wto.org

Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010
20-5 international Contagion
(Continued)
Slide
20.20

Figure 20.9 The collapse in world trade in 2009


Source: IMF World Economic Outlook

Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010
20-6 Policy Response to the Crisis
Slide
20.21

Central banks used monetary policy to slash interest rates


to close to zero.
Governments used fiscal policy to replace private with
public demand, trying to replace the fall in private
consumption and private investment with higher
government spending.

Did policy work, i.e. was the intervention by


governments and central banks effective at limiting the
effect of the financial crisis on output and employment?

Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010
20-6 Policy Response to the Crisis
(Continued)
Slide
20.22

Figure 20.11 Monetary policy in the presence of a liquidity trap

Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010
20-6 Policy Response to the Crisis
(Continued)
Slide
20.23

The Bank of England, for instance-in March 2009, started


to buy assets from the private sector. By September 2009,
these assets accounted for almost all assets held by the
Bank of England.
Policy intervention did work to avoid a depression.

Quantitative easing in the UK


Figure 20.12
Loans to APF are the loans the Bank of
England made to the legal entity (the Asset
Purchase Facility) in charge of buying assets
from the market on behalf of the Bank
Source: Bank of England

Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010
20-7 The Legacy of the Crisis
Slide
20.24

Once the world economy emerges from the recession, two


legacies will remain:

• Expansionary monetary policies will translate into


higher inflation.

• Expansionary fiscal policies will cause an increase


in government debt across advanced economies.

Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010
20-7 The Legacy of the Crisis
(Continued)
Slide
20.25

Figure 20.15 Legacies of the crisis: public debt


Source: IMF, World Economic Outlook, July 2009 update, Fig. 1.14

Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010
Key Terms
Slide
20.26

• Sub-prime mortgages
• Regulation
• Quantitative easing

Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010