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MACROECONOMICS MACROECONOMICS and the FINANCIAL SYSTEM FINANCIAL SYSTEM © 2011 Worth Publishers, all rights reserved PowerPoint® slides by Ron Cronovich N. Gregory Mankiw & Laurence M. Ball Financial Crises 19 CHAPTER Modified for EC 204 by Bob Murphy

Financial Crisis Mankiw

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Page 1: Financial Crisis Mankiw

MACROECONOMICSMACROECONOMICSand the

FINANCIAL SYSTEMFINANCIAL SYSTEM

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

N. Gregory Mankiw & Laurence M. Ball

Financial Crises19CHAPTER

Modified for EC 204 by Bob Murphy

Page 2: Financial Crisis Mankiw

CHAPTER 19 Financial Crises

In this chapter, you will learn: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

Page 3: Financial Crisis Mankiw

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

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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

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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

Page 6: Financial Crisis Mankiw

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

Page 7: Financial Crisis Mankiw

CHAPTER 19 Financial Crises

CASE STUDYDisaster 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

Page 8: Financial Crisis Mankiw

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

Page 9: Financial Crisis Mankiw

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

Page 10: Financial Crisis Mankiw

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)

Page 11: Financial Crisis Mankiw

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

Page 12: Financial Crisis Mankiw

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

Page 13: Financial Crisis Mankiw

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

Page 14: Financial Crisis Mankiw

CHAPTER 19 Financial Crises

Disaster in September 2008After 6 calm months, a financial crisis exploded:

Fannie Mae, Freddie Macnearly 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

Page 15: Financial Crisis Mankiw

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 safetyPeople 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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16CHAPTER 19 Financial Crises

Page 17: Financial Crisis Mankiw

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

Page 18: Financial Crisis Mankiw

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

Page 19: Financial Crisis Mankiw

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%

Page 20: Financial Crisis Mankiw

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

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21CHAPTER 19 Financial Crises

Page 22: Financial Crisis Mankiw

CHAPTER 19 Financial Crises

The aftermath Constraints on macroeconomic policy

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

Page 23: Financial Crisis Mankiw

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

Page 24: Financial Crisis Mankiw

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

Page 25: Financial Crisis Mankiw

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

Page 26: Financial Crisis Mankiw

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.

Page 27: Financial Crisis Mankiw

CASE STUDYThe 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

Page 28: Financial Crisis Mankiw

CHAPTER 19 Financial Crises

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

Page 29: Financial Crisis Mankiw

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

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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

Page 31: Financial Crisis Mankiw

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

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32CHAPTER 19 Financial Crises

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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

Page 34: Financial Crisis Mankiw

CHAPTER 19 Financial Crises

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 to institutions with liquidity crises, giveaways, risky loans, and equity injections.

Page 35: Financial Crisis Mankiw

CHAPTER 19 Financial Crises

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 crisis in the U.S. Stock prices fell, prestigious financial institutions failed, lending was disrupted, and unemployment rose to near 10%.

Page 36: Financial Crisis Mankiw

CHAPTER 19 Financial Crises

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 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.