19 Financial Crises MACROECONOMICS and the FINANCIAL SYSTEM N. Gregory Mankiw & Laurence M. Ball CHAPTER This final chapter provides a framework for thinking about financial crises, with analysis of Greece’s recent troubles and lengthy, fascinating analysis of the U.S. financial crisis of 2007-2009. The difficulty level is slightly lower than average for this book, but students find this material extremely interesting and topical. 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 CHAPTER 19 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 No two financial crises as exactly alike, but most of them share a few basic features. CHAPTER 19 Financial Crises

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 CHAPTER 19 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 CHAPTER 19 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 can sustain itself for a long time CHAPTER 19 Financial Crises

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 Earlier in the book, we used the IS-LM/AD-AS model to study the Great Depression. We revisit it now as a case study of a classic financial crisis. CHAPTER 19 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 CHAPTER 19 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 CHAPTER 19 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) This section of the chapter has a short case study on Continental Illinois, the seventh largest commercial bank at the time. The case study explains that hundreds of smaller banks had accounts at Continental, and Continental’s failure might have caused a nationwide wave of failures, and a bank panic. The Federal Reserve loans billions of dollars to Continental, and the FDIC waived its usual limit on deposit insurance. CHAPTER 19 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 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 Previously, we have seen that the central bank can make loans to solvent institutions experiencing temporary liquidity crises. These loans are riskless because (a) the borrowing institution puts up significant collateral, and (b) the borrowing institution is solvent and unlikely to fail if it is not forced to sell its illiquid assets at fire-sale prices. What about institutions that are bordering on insolvency and have no collateral? The central bank can make loans to them, too, but such loans are not riskless. Equity injections can save a TBTF institution from insolvency, but the practice is controversial: one fear is that politics may affect the behavior of a firm with part government ownership, such as when popular sentiment about huge executive bonuses led the U.S. Treasury to impose restrictions on executive compensation as a condition for equity injections. CHAPTER 19 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 CHAPTER 19 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 Fed’s target CHAPTER 19 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 Lehman’s failure meant defaults on all Lehman’s borrowings from other institutions, shocked the entire financial system CHAPTER 19 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 CHAPTER 19 Financial Crises

CHAPTER 19 Financial Crises

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 CHAPTER 19 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 CHAPTER 19 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% CHAPTER 19 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 CHAPTER 19 Financial Crises

CHAPTER 19 Financial Crises

The aftermath Constraints on macroeconomic policy Moral hazard 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 CHAPTER 19 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 Examples of nonbank financial institutions include hedge funds, investment banks, and insurance companies. CHAPTER 19 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 Proposals to limit size include strict limits on assets or liabilities, as well as incentives to prevent growth. The incentive-based proposals include making capital requirements a function of size. The Glass-Steagall Act (1933) effectively separated commercial and investment banking. The 1999 repeal of this Act contributed to the conglomeration trend. But in response to the financial crisis of 2008-2009, many are calling for the return of Glass-Steagall, or something like it. CHAPTER 19 Financial Crises

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 Ratings agencies’ income comes, in part, from the corporations they rate, creating a conflict of interest. Reforming executive compensation is very controversial. Many believe that the government should not be in the business of regulating wages, including the wages of executives. CHAPTER 19 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. CHAPTER 19 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 The Dodd-Frank Act was approved almost completely along party lines (Democrats for, Republicans against).

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 Financial crises are more common in emerging economies CHAPTER 19 Financial Crises

Capital flight Interest rates rise 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 CHAPTER 19 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 CHAPTER 19 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 CHAPTER 19 Financial Crises

CHAPTER 19 Financial Crises

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 CHAPTER 19 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. CHAPTER 19 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%. CHAPTER 19 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