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Financial Crises
CHAPTER 19
Financial Crises
Financial Crises
CHAPTER 19
Financial Crises
Financial institution failures reduce lending banks become more conservative since more
uncertainty over borrowers ability to repay
Financial Crises
CHAPTER 19
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
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Once a crisis starts, it can sustain itself for a long time Financial Crises
CASE STUDY
Falling output magnified these problems Federal Reserve allowed money supply to fall,
creating deflation, which increased the real value of debts and increased defaults
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Financial Crises
Financial Crises
Costs of bailouts direct: use of taxpayer funds indirect: increases moral hazard, increasing
likelihood of future failures and need for future bailouts
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Financial Crises
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)
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2007-2009: stock prices dropped 55% unemployment doubled to 10% failures of large, prestigious institutions like
Lehman Brothers
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Lehman Brothers
declared bankruptcy, also due to losses on MBS
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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
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1-Jul-08
21-Jul-08 10-Aug-08 30-Aug-08 19-Sep-08 9-Oct-08 29-Oct-08 18-Nov-08 8-Dec-08 28-Dec-08
17-Jan-09
6-Feb-09 26-Feb-09 18-Mar-09 7-Apr-09 27-Apr-09 17-May-09 6-Jun-09 26-Jun-09
The flight to safety: BAA corporate bond and 90-day T-bill rates
An economy in freefall
Falling stock and house prices reduced consumers
wealth, reducing their confidence and spending.
banks could not resell loans to securitizers banks worried about insolvency from further
losses
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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%
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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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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
weeks
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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
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Reforming financial regulation: Regulating nonbank financial institutions Nonbank financial institutions (NBFIs) do not enjoy
federal deposit insurance, so were less regulated than banks
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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
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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
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Reforming financial regulation: Changing regulatory structure There are many different regulators, though not by
any logical design.
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CASE STUDY
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Capital flight
Interest rates sharply when people sell bonds Exchange rates depreciate sharply when people
sell the countrys currency
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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
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Crisis in Greece
Govt budget deficit, % of GDP
9 8 7
16 14 12
10
8 6 4 2 0 2005 2006 2007 2008 2009
Greece
6 5 4 3 2 Jul-03 Jan-03 Jan-04 Jan-05 Jul-05
Germany
Jul-04
Jan-06
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
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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.
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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.
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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.
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