MACROECONOMICS
MACROECONOMICS
FINANCIAL SYSTEM
FINANCIAL SYSTEM
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common features of financial crisescommon features of financial crises
how financial crises can be self-perpetuatinghow financial crises can be self-perpetuating
various policy responses to crisesvarious policy responses to crises
,,
including the U.S. financial crisis of 2007-2009 including the U.S. financial crisis of 2007-2009
oow w ccaapp tta a gg t t oo tteen n pp aayys s a a rroo e e n n nnaanncc aa
crises affecting emerging economies crises affecting emerging economies
Common features of financial crises
Common features of financial crises
Asset price declinesAsset price declines
involving stocks, real estate, or other assetsinvolving stocks, real estate, or other assets
often interpreted as the ends of often interpreted as the ends of bubblesbubbles
Financial institution insolvenciesFinancial institution insolvencies
a wave of loan defaults may cause bank failuresa wave of loan defaults may cause bank failures
hedge funds may fail when assets bought withhedge funds may fail when assets bought with
borrowed funds lose value borrowed funds lose value
Common features of financial crises
Liquidity crises
if its depositors lose confidence, a bank run
de letes the bank’s li uid assets
if its creditors have lost confidence, an
inv m n nk m h v r l llin
commercial paper to pay off maturing debts
,
Financial crises and a
re ate demand
Falling asset prices reduce aggregate demand
consumers’ wealth falls
postpone spending
,
firms and consumers to borrow
Financial institution failures reduce lending
banks become more conservative since more
Financial crises and a
re ate 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
e a n agg. eman worsens e nanc a cr s s
falling output lower firms’ expected future earnings,
reducing asset prices further
falling demand for real estate reduces prices more
CASE STUDY
sas er n e
s
Shar asset rice declines: the stock market fell
13% on 10/28/1929, and fell 89% by 1932 ,
defaults and a bank panic
A credit crunch and uncertainty caused huge fall in
consumption and investment
Falling output magnified these problems
, creating deflation, which increased the real value o e s an ncrease e au s
Financial rescues: emer enc loans
The self-perpetuating nature of crises givespolicymakers a strong incentive to intervene to tr to break the c cle of crisis and recession. During a liquidity crisis, a central bank may act
as a , prov ng emergency
loans to institutions to prevent them from failing.
Discount loan: a loan from the Federal
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 nso ven ns u on rom sprea ng
Costs of “bailouts”
direct: use of taxpayer funds
,
“Too bi to fail”
The larger the institution, the greater its links to
other institutions
Links include liabilities such as de osits or
borrowings
if they are so interconnected that their failure
TBTF institutions are candidates for bailouts.
Risk Rescues
Risky loans: govt loans to institutions that may not
be repaid
institutions borderin on insolvenc institutions with no collateral
Equity injections: purchases of a company’s
stoc y t e govt to ncrease a near y nso vent
company’s capital when no one else is willing to buy t e company s stoc
Controversy: govt ownership not consistent with
The U.S. financial crisis of 2007-2009
Context: the 1990s and early 2000s were a timeof stability, called “The Great Moderation”
- stock prices dropped 55%
unemployment doubled to 10%
failures of lar e, resti ious institutions like
The sub rime mort a e crisis
2006-2007: house prices fell, defaults onsubprime mortgages, huge losses for institutions holdin sub rime mort a es or the securities
they backed
Financial declared bankruptcy in 2007
qu y cr s s n ugus as an s re uce lending to other banks, uncertain about their
ability to repay
Disaster in Se tember 2008
After 6 calm months, a financial crisis exploded:
Fannie Mae, Freddie Mac
defaults, U.S. Treasury became their conservator on their bonds to prevent a larger catastrophe
e man ro ers
declared bankruptcy, also due to losses on MBS
Disaster in Se tember 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
nervous depositors pulled out (bank-run style) until Treasur De t offered insurance on MM de osits
Flight to safety
,
The flight to safety: - -10 7 8 Corporate bond 5 6 r a t e ( % interest rate 3 4 n t e r e s t 1 2 i Treasury bill 0
An econom in freefall
Falling stock and house prices reduced consumers’
wealth, reducing their confidence and spending.
bank lending fell sharply because
an s cou no rese oans o secur zers
banks worried about insolvency from further
osses
Previousl “safe” com anies unable to sell
commercial paper to help bridge the gap between roduction costs and revenues
The olic res onse
TARP – Troubled Asset Relief Program (10/3/2008)
$700 billion to rescue financial institutions
“ ”
subprime MBS
institutions
. .
in Citigroup, Goldman Sachs, AIG, and others
The olic res onse
Monetary policy:
Fed funds rate reduced from 2% to near 0% and has remained there
The fiscal stimulus package (February 2009):
ax cu s an n ras ruc ure spen ng cos y near y 5% of GDP
ongress ona u ge ce es ma es oos e real GDP by 1.5 – 3.5%
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
Some taxpayer funds used in rescues will
,
The aftermath: unemplo ment persists
27 10 24 8 f o r c e 21 6 f l a b o r e e k s rate (left scale)r c e n t average duration of p unemployment (right scale) 15 2 2 0 0 7 2 0 0 8 2 0 0 8 2 0 0 8 2 0 0 8 2 0 0 8 2 0 0 8 2 0 0 8 2 0 0 8 2 0 0 8 2 0 0 8 2 0 0 8 2 0 0 8 2 0 0 8 2 0 0 9 2 0 0 9 2 0 0 9 2 0 0 9 2 0 0 9 2 0 0 9 2 0 0 9 2 0 0 9 e c a
n b e a r p r a y u n J u l J u l u
g e p t c o v e c a
n b e a r p r a y u n J u l u g
The aftermath
Constraints on macroeconomic policy
Huge deficits from the recession and stimulus
constrain fiscal policy
Monetary policy constrained by the zero-bound
roblem: even a zero interest rate not low enough to stimulate aggregate demand and reduce unemployment
Reforming financial regulation:
egu at ng non an
nanc a nst tut ons
Nonbank financial institutions NBFIs do not en o
federal deposit insurance, so were less regulated than banks
Since the crisis, many argue for bank-like
regu a on o s, nc u ng:
greater capital requirements
restrictions on risky asset holdings greater scrutiny by regulators
Reforming financial regulation:
ress ng oo g o a
Polic makers have been rescuin TBTF
institutions since Continental Illinois in 1984 ,
limit size of institutions to prevent them from
ecom ng
limit scope by restricting the range of different
Such proposals would reverse the trend toward
Reforming financial regulation:
scourag ng excess ve r s - a ng
Most economists believe excessive risk-takin is a
key cause of financial crises.
requiring “skin in the game” – firms that arrange
r s y ransac ons mus a e on some o e r s
reforming ratings agencies, since they
un eres ma e e r s ness o su pr me
reforming executive compensation to reduce
ncen ve or execu ves o a e r s y gam es n hopes of high short-run gains
Reforming financial regulation:
ang ng regu a ory s ruc ure
There are man different re ulators, thou h not b
any logical design.
gaps in regulation contributed to the 2007-2009 .
Proposals to consolidate regulators or add an
CASE STUDY
e o
- ran c u y
establishes a new Financial Services Oversi ht
Council to coordinate financial regulation agencies annually
FDIC gains authority to close a nonbank financial
institution if its troubles create systemic risk
prohibits holding companies that own banks from
s onsorin hed e funds
requires that companies that issue certain risky
Financial crises in emer in economies
Emerging economies : middle-income countries
Financial crises more common in emerging
- ,
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
Ca ital fli ht
Interest rates sharply when people sell bonds
Exchange rates depreciate sharply when people ’
Contagion: the spread of capital flight from one
country to another
people worry that Country B might be next,
h ll n r ’ n rr n
causing the same problems there
Ca ital fli ht and financial crises
Banking problems can trigger capital flight Capital flight causes asset price declines, which
High interest rates from capital flight and loss in confidence cause aggregate demand, output, and em lo ment to fall which worsens a
financial crisis
Crisis in Greece
Caused by rising govt debt, fear of default Asset holders sold Greek govt bonds, which
Facing a steep recession, Greece could not pursue fiscal policy due to debt, or monetary
Crisis in Greece
Govt budget deficit, Interest rates on
8 9 14 16 -7 10 12 Greece 5 8 4 4 Germany
The International Monetar Fund
International Monetary Fund (IMF):
an international institution that lends to countries experiencing financial crises
established 1944
“ ”
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
CHAPTER SUMMARY
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 with liquidity crises, giveaways, risky
CHAPTER SUMMARY
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
in the U.S. Stock prices fell, prestigious financial
, ,
