Transcript
Page 1: Mankiw-Ball - Financial Crises

CHAPTERCHAPTER 1919CHAPTERCHAPTER

Financial CrisesFinancial Crises1919

Financial CrisesFinancial Crises

MACROECONOMICSand the FINANCIAL SYSTEMN G M ki & L M B ll

© 2011 Worth Publishers, all rights reserved PowerPoint® slides by Ron Cronovich

N. Gregory Mankiw & Laurence M. Ball

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In this chapter, you will learn:In this chapter, you will learn:p , yp , y

common features of financial crises

how financial crises can be self-perpetuating

various policy responses to crises

about historical and contemporary crises,about historical and contemporary crises, including the U.S. financial crisis of 2007-2009

h it l fli ht ft l l i fi i lhow capital flight often plays a role in financial crises affecting emerging economies

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Common features of financial crisesCommon features of financial crisesAsset price declines

involving stocks, real estate, or other assetsmay trigger the crisismay trigger the crisisoften interpreted as the ends of bubbles

Financial institution insolvenciesa wave of loan defaults may cause bank failureshedge funds may fail when assets bought with borrowed funds lose valuefinancial institutions interconnected, so insolvencies can spread from one to another

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so insolvencies can spread from one to another

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Common features of financial crisesCommon features of financial crisesLiquidity crises

if its depositors lose confidence, a bank run depletes the bank’s liquid assetsp qif its creditors have lost confidence, an investment bank may have trouble sellinginvestment bank may have trouble selling commercial paper to pay off maturing debtsin such cases the institution must sell illiquidin such cases, the institution must sell illiquid assets at “fire sale” prices, bringing it closer to insolvencyinsolvency

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Financial crises and aggregate demanda c a c ses a d agg egate de a dFalling asset prices reduce aggregate demand

consumers’ wealth fallsuncertainty makes consumers and firmsuncertainty makes consumers and firms postpone spendingthe value of collateral falls making it harder forthe 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 demanda c a c ses a d agg egate de a dCredit crunch: a sharp decrease in bank lending

may occur when asset prices fall and financial institutions failforces consumers and firms to reduce spending

Th f ll i d d th fi i l i iThe fall in agg. demand worsens the financial crisisfalling output lower firms’ expected future earnings, reducing asset prices furtherfalling demand for real estate reduces prices morebankruptcies and defaults increase, bank panics more likely

5CHAPTER 19 Financial CrisesOnce a crisis starts, it can sustain itself for a long timeOnce a crisis starts, it can sustain itself for a long time

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CASE STUDYDi t i th 1930Disaster in the 1930s

Sharp asset price declines: the stock market fell p p13% on 10/28/1929, and fell 89% by 1932

Over 1/3 of all banks failed by 1933 due to loanOver 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 fallFederal Reserve allowed money supply to fall, creating deflation, which increased the real value of debts and increased defaults

6CHAPTER 19 Financial Crisesof debts and increased defaults

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Financial rescues: emergency loansFinancial 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 emergencyas 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 Reserve to a bank, approved if Fed judges bank solvent and with sufficient collateral

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Financial rescues: “bailouts”Financial rescues: 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 spreadinginsolvent institution from spreading

Costs of “bailouts”direct: use of taxpayer funds indirect: increases moral hazard increasingindirect: increases moral hazard, increasing likelihood of future failures and need for future bailouts

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bailouts

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“Too big to fail”Too big to failThe larger the institution, the greater its links to other institutions

Links include liabilities, such as deposits or , pborrowings

Institutions deemed too big to fail (TBTF)Institutions deemed too big to fail (TBTF)if they are so interconnected that their failure would threaten the financial systemwould threaten the financial system

TBTF institutions are candidates for bailouts. Example: Continental Illinois Bank (1984)

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Risky RescuesRisky RescuesRisky loans: govt loans to institutions that may not be repaid

institutions bordering on insolvencyg yinstitutions with no collateralExample: Fed loaned $85 billion to AIG (2008)Example: Fed loaned $85 billion to AIG (2008)

Equity injections: purchases of a company’s t k b th t t i l i lstock by the govt to increase a nearly insolvent

company’s capital when no one else is willing to buy th ’ t kthe company’s stock

Controversy: govt ownership not consistent with

10CHAPTER 19 Financial Crisesfree market principles; political influence

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The U.S. financial crisis of 2007-2009The U.S. financial crisis of 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, prestigious institutions like g p gLehman Brothers

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The subprime mortgage crisisThe subprime mortgage crisis2006-2007: house prices fell, defaults on subprime mortgages, huge losses for institutions holding subprime mortgages or the securities g p g gthey backed

Huge lenders Ameriquest and New CenturyHuge lenders Ameriquest and New Century Financial declared bankruptcy in 2007

Li idit i i i A t 2007 b k d dLiquidity 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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Disaster in September 2008Disaster in September 2008After 6 calm months, a financial crisis exploded:

Fannie Mae, Freddie Macnearly failed due to a growing wave of mortgagenearly failed due to a growing wave of mortgage defaults, U.S. Treasury became their conservator and majority shareholder, promised to cover lossesand majority shareholder, promised to cover losses on their bonds to prevent a larger catastrophe

L h B thLehman Brothers declared bankruptcy, also due to losses on MBS

Lehman’s failure meant defaults on all Lehman’s borrowings from other institutions, shocked the

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entire financial system

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Disaster in September 2008Disaster 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,Money market funds no longer assumed safe, nervous depositors pulled out (bank-run style) until Treasury Dept offered insurance on MM depositsy p p

Flight to safetyPeople sold many different kinds of assets causingPeople 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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prices to rise and interest rates to fall to near zero

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

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An economy in freefallAn economy in freefallFalling stock and house prices reduced consumers’ wealth, reducing their confidence and spending.

Financial panic caused a credit crunch:Financial panic caused a credit crunch: bank lending fell sharply because

b k ld t ll l t itibanks could not resell loans to securitizersbanks worried about insolvency from further llosses

Previously “safe” companies unable to sell y pcommercial paper to help bridge the gap between production costs and revenues

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The policy responseThe policy responseTARP – Troubled Asset Relief Program (10/3/2008)

$700 billion to rescue financial institutionsinitially intended to purchase “troubled assets” likeinitially intended to purchase troubled assets like subprime MBSlater used for equity injections into troubledlater used for equity injections into troubled institutionsresult: U S Treasury became a major shareholderresult: U.S. Treasury became a major shareholder in Citigroup, Goldman Sachs, AIG, and others

F d l R t i i lFederal Reserve programs to repair commercial paper market, restore securitization, reduce

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mortgage interest rates

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The policy responseThe policy responseMonetary policy: Fed funds rate reduced from 2% to near 0% and has remained there

The fiscal stimulus package (February 2009):ta c ts and infrastr ct re spending costl nearltax cuts and infrastructure spending costly nearly 5% of GDPC i l B d t Offi ti t it b t dCongressional Budget Office estimates it boosted real GDP by 1.5 – 3.5%

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The aftermathThe aftermathThe financial crises eases

Dow Jones stock price index rose 65% from 3/2009 to 3/2010Many major financial institutions profitable in 20092009Some taxpayer funds used in rescues will probably never be recovered but these costsprobably never be recovered, but these costs appear small relative to the damage from the crisiscrisis

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The aftermath: unemployment persistsp y p2710

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The aftermathThe aftermathConstraints on macroeconomic policy

Huge deficits from the recession and stimulus constrain fiscal policyp yMonetary policy constrained by the zero-bound problem: even a zero interest rate not low penough to stimulate aggregate demand and reduce unemployment

Moral hazardThe rescues of financial institutions will likelyThe rescues of financial institutions will likely increase future risk-taking and the need for future rescues

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rescues

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Reforming financial regulation: R l ti b k fi i l i tit tiRegulating nonbank financial institutions

Nonbank financial institutions (NBFIs) do not enjoy ( ) j yfederal deposit insurance, so were less regulated than banks

Since the crisis, many argue for bank-like reg lation of NBFIs incl dingregulation of NBFIs, including:

greater capital requirementsrestrictions on risky asset holdingsgreater scrutiny by regulators

Controversy: more regulation will reduce profitability and maybe financial innovation

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profitability and maybe financial innovation

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Reforming financial regulation: Add i “t bi t f il”Addressing “too big to fail”

Policymakers have been rescuing TBTF y ginstitutions since Continental Illinois in 1984

Since the crisis proposals toSince the crisis, proposals tolimit size of institutions to prevent them from b i TBTFbecoming TBTFlimit scope by restricting the range of different businesses that any one firm can operatebusinesses 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 &

23CHAPTER 19 Financial Crisesscope

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Reforming financial regulation: Di i i i k t kiDiscouraging excessive risk-taking

Most economists believe excessive risk-taking is a gkey cause of financial crises.

Proposals to discourage it include:Proposals to discourage it include:requiring “skin in the game” – firms that arrange i k t ti t t k f th i krisky transactions must take on some of the risk

reforming ratings agencies, since they d ti t d th i ki f b i MBSunderestimated the riskiness of subprime MBS

reforming executive compensation to reduce i ti f ti t t k i k bl iincentive for executives to take risky gambles in hopes of high short-run gains

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Reforming financial regulation: Ch i l t t tChanging regulatory structure

There are many different regulators, though not by y g g yany logical design.

Many economists believe inconsistencies andMany economists believe inconsistencies and gaps in regulation contributed to the 2007-2009 financial crisisfinancial crisis.

Proposals to consolidate regulators or add an agency that oversees and coordinates regulators.

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

establishes a new Financial Services Oversight gCouncil to coordinate financial regulationa new Office of Credit Ratings will examine ratinga new Office of Credit Ratings will examine rating agencies annuallyFDIC gains authority to close a nonbank financial institution if its troubles create systemic riskprohibits holding companies that own banks from sponsoring hedge fundsp g grequires that companies that issue certain risky securities have “skin in the game” and retain atsecurities have skin in the game and retain at least 5% of the default risk

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Financial crises in emerging economiesg gEmerging economies: middle-income countries

Financial crises more common in emerging economies than high income countries andeconomies 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 defaultrising govt debt & fears of defaultpolitical instabilityb ki bl

27CHAPTER 19 Financial Crisesbanking problems

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Capital flightCapital flightInterest rates sharply when people sell bonds

Exchange rates depreciate sharply when people sell the country’s currencysell the country s currency

Contagion: the spread of capital flight from one country to another

occurs when problems in Country A makeoccurs when problems in Country A make people worry that Country B might be next, so they sell Country B’s assets and currency,so they sell Country B s assets and currency, causing the same problems therelike a bank panic

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like a bank panic

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Capital flight and financial crisesCapital flight and financial crisesBanking problems can trigger capital flight

Capital flight causes asset price declines, which worsens a financial crisisworsens 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

R id h t d i ti i thRapid exchange rate depreciation increases the burden of dollar-denominated debt in these

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countries

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Crisis in GreeceCrisis in GreeceCaused by rising govt debt, fear of default

Asset holders sold Greek govt bonds, which caused interest rates on those bonds to risecaused 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 Eurozonep y p

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Crisis in Greece

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The International Monetary FundThe International Monetary FundInternational Monetary Fund (IMF): an international institution that lends to countries experiencing financial crises

established 1944the “international lender of last resort”the international lender of last resort

How countries use IMF loans:govt uses to make payments on its debtcentral bank uses to make loans to bankscentral bank uses to prop up its currency in foreign exchange markets

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CHAPTER SUMMARYCHAPTER 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 toinstitutions. Rescues range from riskless loans to institutions with liquidity crises, giveaways, risky loans and equity injectionsloans, and equity injections.

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CHAPTER SUMMARYCHAPTER 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 crisisevolved into a broad financial and economic crisis in the U.S. Stock prices fell, prestigious financial institutions failed lending was disrupted andinstitutions failed, lending was disrupted, and unemployment rose to near 10%.

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CHAPTER SUMMARYCHAPTER 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 intypical include capital flight and sharp decreases in exchange rates, which can be caused by high government debt, political instability, and banking g , p y, gproblems. The International Monetary Fund can help with emergency loans.

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