Mankiw-Ball - Financial Crises

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CHAPTER

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FinancialCrises Financial Crises

MACROECONOMICS and the FINANCIAL SYSTEMN. 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 ,ycommon 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 crisesAsset 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 anotherCHAPTER 19

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Common features of financial crisesLiquidity 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 dFalling 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 repayFinancial Crises

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Financial c ses and aggregate demand a c a crises a d agg egate de a dCredit 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 likelyCHAPTER 19

Once a crisis starts, it can sustain itself for a long time Financial Crises

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CASE STUDY

Disaster in the 1930s Di t i th 1930Sharp 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 defaultsCHAPTER 19

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Financial rescues: emergency loansThe 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 collateralCHAPTER 19

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Financial rescues: bailouts bailoutsGovt 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 bailoutsCHAPTER 19

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Too big to fail Too failThe 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)CHAPTER 19

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Risky RescuesRisky 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 influenceCHAPTER 19

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The U.S. financial crisis of 2007-2009 2007 2009Context: 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 crisis2006-2007: 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 gCHAPTER 19

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Disaster in September 2008After 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 tCHAPTER 19

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Disaster in September 2008American 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 zeroCHAPTER 19

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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 freefallFalling 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 revenuesCHAPTER 19

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The policy responseTARP 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 tCHAPTER 19

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The policy responseMonetary 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 aftermathThe 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 r10 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 aftermathConstraints 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 dem