Chapter 15a

363 15 Recall from Chapter 1 that financial crises are major disruptions in financial mar- kets characterized by sharp declines in asset prices and firm failures. Beginning in August 2007, defaults in the mortgage market by subprime borrowers (borrowers with weak credit records) sent a shudder through the financial markets, leading to the worst U.S. financial crisis since the Great Depression. Alan Greenspan, former chairman of the Fed, described the 2007–2009 financial crisis as a “once-in-a-century credit tsunami.” Wall Street firms and commercial banks suffered losses amounting to hun- dreds of billions of dollars. Households and businesses found they had to pay higher rates on their borrowings, and that it was much harder to obtain credit. World stock markets crashed, with U.S shares falling by as much as half from their peak in October 2007. Many financial firms, including commercial banks, investment banks, and insur- ance companies, went belly up. The recession that began in December 2007 worsened by the fall of 2008, leading to steep declines in economic activity. Financial crises are a major source of economic fluctuations. Indeed, all deep recessions and depressions are linked to major financial crises. Why did the 2007–2009 financial crisis occur? Why have financial crises been so prevalent through- out U.S. and world history, and why are they almost always followed by severe con- tractions in economic activity? In this chapter we will use our understanding of the financial system and informa- tion issues from Chapter 14 as a backdrop for examining the dynamics of financial crises in advanced countries like the United States. We apply the analysis to the two worst U.S. financial crises in the last one hundred years—the Great Depression of 1930–1933 and the 2007–2009 financial crisis—to explain how these crises have evolved and how they affected the economy.1 Preview Financial Crises and the Economy 1In a Web chapter available at the Companion Website, www.pearsonhighered.com/mishkin, we extend the analysis to emerging market economies, economies in an early stage of market development that have recently opened up to the flow of goods, services, and capital from the rest of the world. 364 PART FIVE • FINANCE AND THE MACROECONOMY Asymmetric Information and Financial Crises We established in Chapter 14 that a fully functioning financial system is critical to a robust economy. The financial system performs the essential function of channeling funds to individuals or businesses with productive investment opportunities. If capital goes to the wrong uses or does not flow at all, the economy will operate inefficiently or go into an economic downturn. Asymmetric Information Problems In Chapter 14, we saw how the smooth functioning of financial markets is impeded when one party in a financial transaction does not know enough about the other party or its investments to make accurate decisions. Recall that this lack of information, known as asymmetric information, creates two basic types of problems in the financial system: 1. Adverse selection, in which lenders must select from a pool of bad (adverse) credit risks, because the most undesirable potential borrowers are the most active in seeking out a loan 2. Moral hazard, when there is the risk (hazard) that the borrower has better information than the lender about whether it will engage in activities that are undesirable (immoral) from the point of view of the lender Because the adverse selection and moral hazard problems make it less likely that a borrower will pay back a loan, lenders may decide they would rather not make a loan, even though there are good credit risks in the marketplace. Agency Theory and Financial Crises Academic finance literature calls the analysis of how asymmetric information problems can generate adverse selection and moral hazard problems agency theory. Agency the- ory provides the basis for our definition of a financial crisis: a financial crisis occurs when an increase in asymmetric information from a disruption in the financial system prevents it from channeling funds efficiently from lender-savers to borrower-spenders, the house- holds and firms with productive investment opportunities. Dynamics of Financial Crises As earth-shaking and headline-grabbing as the most recent financial crisis was, it was only one of a number of financial crises that have hit industrialized countries like the United States over the years. These experiences have helped economists uncover insights into present-day economic turmoil. Financial crises in advanced economies have progressed in two and sometimes three stages. To understand how these crises have unfolded, refer to Figure 15.1, which traces the stages and sequence of financial crises in industrialized economies. Stage One: Initiation of Financial Crisis Financial crises can begin in several ways: mismanagement of financial liberalization/ innovation, asset-price booms and busts, or a general increase in uncertainty caused by failures of major financial institutions. CHAPTER 15 • FINANCIAL CRISES AND THE ECONOMY 365 MISMANAGEMENT OF FINANCIAL INNOVATION/LIBERALIZATION. The seeds of a financial crisis are often sown when an economy introduces new types of loans or other financial products, known as financial innovation, or when countries engage in financial liberalization, the elimination of restrictions on financial markets and insti- tutions. (Recall from Chapter 14 that financial institutions are of two types: financial intermediaries, such as banks, that act as intermediaries between savers and borrowers, and other financial institutions that facilitate transactions in financial markets like investment banks.) In the long run, financial liberalization promotes financial develop- ment and encourages a well-run financial system that allocates capital efficiently. Adverse Selection and Moral Hazard Problems Worsen Economic Activity Declines Economic Activity Declines Banking Crisis STAGE ONE Initiation of Financial Crisis STAGE TWO Banking Crisis STAGE THREE Debt Deflation Unanticipated Decline in Price Level Adverse Selection and Moral Hazard Problems Worsen Economic Activity Declines Adverse Selection and Moral Hazard Problems Worsen Consequences of Changes in FactorsFactors Causing Financial Crises Asset Price Decline Increase in Uncertainty Deterioration in Financial Institutions’ Balance Sheets FIGURE 15.1 Sequence of Events in Financial Crises in Advanced Economies The solid arrows trace the sequence of events during a typical finan- cial crisis; the dotted arrows show the addi- tional set of events that occur if the crisis develops into a debt deflation. The sections separated by the dashed horizontal lines, show the different stages of a financial crisis. 366 PART FIVE • FINANCE AND THE MACROECONOMY However, financial liberalization has a dark side: in the short run, it can prompt finan- cial institutions to go on a lending spree, called a credit boom. Unfortunately, lenders may not have the expertise, or the incentives, to manage risk appropriately in these new lines of business. Even with proper management, credit booms eventually outstrip the ability of institutions—and government regulators—to screen and monitor credit risks, leading to overly risky lending. Government safety nets such as deposit insurance weaken market discipline and increase the moral hazard incentive for banks to take on greater risk than they otherwise would. Since lender-savers know that government-guaranteed insurance protects them from losses, they will supply even undisciplined banks with funds. Banks and other financial institutions can make risky, high-interest loans to borrower-spenders. They will walk away with nice profits if the loans are repaid, and rely on government deposit insurance, funded by taxpayers, if borrower-spenders default. Without proper monitor- ing, risk-taking grows unchecked. Eventually, losses on loans begin to mount and the value of the loans (on the asset side of the balance sheet) falls relative to liabilities, thereby driving down the net worth (capital) of banks and other financial institutions. With less capital, these financial insti- tutions cut back on their lending to borrower-spenders, a process called deleveraging. Furthermore, with less capital, banks and other financial institutions become riskier, causing lender-savers and other potential lenders to these institutions to pull out their funds. Fewer funds mean fewer loans to fund productive investments and a credit freeze: the lending boom turns into a lending crash. When financial institutions stop collecting information and making loans, they limit the financial system’s ability to address the asymmetric information problems of adverse selection and moral hazard (as shown in the arrow pointing from the first factor, “Deterioration in Financial Institutions’ Balance Sheets,” in the top row of Figure 15.1). As loans become scarce, borrower-spenders are no longer able to fund their productive investment opportunities: they decrease their spending. Thus autonomous consumption expenditure and investment decline so that aggregate demand, C + I + G + NX, falls causing economic activity to contract. ASSET-PRICE BOOM AND BUST. Prices of assets such as equity shares and real estate can be driven by investor psychology (dubbed “irrational exuberance” by Alan Greenspan when he was chairman of the Federal Reserve) well above their fundamental economic values, that is, their values based on realistic expectations of the assets’ future income streams. The rise of asset prices above their fundamental economic values is an asset-price bubble. Examples of asset-price bubbles are the tech stock market bubble of the late 1990s and the recent housing price bubble that we will discuss later in this chap- ter. Asset-price bubbles are often also driven by credit booms, in which the large increase in credit is used to fund purchases of assets, thereby driving up their price. When the bubble bursts and asset prices realign with fundamental economic values, stock and real estate prices tumble, companies see their net worth (the difference between their assets and their liabilities) decline, and the value of collateral they can pledge drops. Now these companies have less at stake because they have less “skin in the game” and so they are more likely to make risky investments because they have less to lose, the problem of moral hazard. As a result, financial institutions tighten lending standards for borrower- spenders and lending contracts (as shown by the downward arrow pointing from the sec- ond factor, “Asset Price Decline,” in the top row of Figure 15.1). CHAPTER 15 • FINANCIAL CRISES AND THE ECONOMY 367 The asset-price bust also causes a decline in the value of financial institutions’ assets, thereby causing a decline in their net worth and hence a deterioration in their balance sheets (shown by the arrow from the second factor to the first factor in the top row of Figure 15.1), which causes them to deleverage, steepening the decline in aggre- gate demand and economic activity. INCREASE IN UNCERTAINTY. U.S. financial crises have usually begun in periods of high uncertainty, such as just after the start of a recession, a crash in the stock market, or the failure of a major financial institution. Crises began after the failure of Ohio Life Insurance and Trust Company in 1857; the Jay Cooke and Company in 1873; Grant and Ward in 1884; the Knickerbocker Trust Company in 1907; the Bank of the United States in 1930; and Bear Stearns, Lehman Brothers, and AIG in 2008. With information hard to come by in a period of high uncertainty, adverse selection and moral hazard problems increase, reducing lending and economic activity (as shown by the arrow pointing from the last factor, “Increase in Uncertainty,” in the top row of Figure 15.1). Stage Two: Banking Crisis Deteriorating balance sheets and tougher business conditions lead some financial insti- tutions into insolvency, when net worth becomes negative. Unable to pay off depositors or other creditors, some banks go out of business. If severe enough, these factors can lead to a bank panic, in which multiple banks fail simultaneously. To understand why bank panics occur, consider the following situation. Suppose that as a result of an adverse shock to the economy, 5% of the banks have such large losses on their loans that they become insolvent. Because of asymmetric information, lender-savers are unable to tell whether their bank is a good bank or one of the 5% that are insolvent. Depositors (lender-savers) at bad and good banks recognize that they may not get back 100 cents on the dollar for their deposits (either because there is no deposit insurance or limited amounts of it) and will want to withdraw them. Banks operate on a first-come- first-served basis, so depositors have a very strong incentive to show up at the bank first (run to the bank): if they are later in line, the bank may not have enough funds left to pay them anything. Uncertainty about the health of the banking system in general can lead to runs on banks, both good and bad, which will force banks to sell off assets quickly to raise the necessary funds. These fire sales of assets may cause their prices to decline so much that the bank becomes insolvent, even if the resulting contagion can then lead to multiple bank failures and a full-fledged bank panic. With fewer banks operating, information about the creditworthiness of borrower- spenders disappears. Increasingly severe adverse selection and moral hazard problems in financial markets deepen the financial crisis, causing declines in asset prices and the failure of firms throughout the economy who lack funds for productive investment opportunities. Figure 15.1 represents this progression in the Stage Two portion. Bank panics were a feature of all U.S. financial crises during the nineteenth and twentieth centuries, occurring every twenty years or so until World War II—1819, 1837, 1857, 1873, 1884, 1893, 1907, and 1930–1933.2 Eventually, public and private authorities shut down insolvent firms and sell them off or liquidate them. Uncertainty in financial markets declines, the stock market recovers, 2For a discussion of U.S. banking and financial crises in the nineteenth and twentieth centuries, see Frederic S. Mishkin, “Asymmetric Information and Financial Crises: A Historical Perspective,” in Financial Markets and Financial Crises, ed. R. Glenn Hubbard (University of Chicago Press: Chicago, 1991), 69–108. 368 PART FIVE • FINANCE AND THE MACROECONOMY and balance sheets improve. Adverse selection and moral hazard problems diminish and the financial crisis subsides. With the financial markets able to operate well again, the stage is set for an economic recovery. Stage Three: Debt Deflation If, however, the economic downturn leads to a sharp decline in the price level, the recov- ery process can be short-circuited. In stage three in Figure 15.1, debt deflation occurs when a substantial unanticipated decline in the price level sets in, leading to a further deterioration in firms’ net worth because of the increased burden of indebtedness. In economies with moderate inflation, which characterizes most advanced coun- tries, many debt contracts with fixed interest rates are typically of fairly long maturity, ten years or more. Because debt payments are contractually fixed in nominal terms, an unanticipated decline in the price level raises the value of borrowing firms’ liabilities in real terms (increases the burden of the debt) but does not raise the real value of borrow- ing firms’ assets. The borrowing firm’s net worth in real terms (the difference between assets and liabilities in real terms) thus declines. To better understand how this decline in net worth occurs, consider what happens if a firm in 2012 has assets of $100 million (in 2012 dollars) and $90 million of long-term liabilities, so that it has $10 million in net worth. If the price level falls by 10% in 2013, the real value of the liabilities would rise to $99 million in 2012 dollars, while the real value of the assets would remain unchanged at $100 million. The result would be that real net worth in 2012 dollars would fall from $10 million to $1 million ($100 million minus $99 million). The substantial decline in real net worth of borrowers from a sharp drop in the price level causes an increase in adverse selection and moral hazard problems facing lenders. Lending and economic activity decline for a long time. The most significant financial crisis that displayed debt deflation was the Great Depression, the worst eco- nomic contraction in U.S. history. The Mother of All Financial Crises: The Great Depression With our framework for understanding financial crises in place, we are prepared to analyze how a financial crisis unfolded during the Great Depression and how it led to the worst eco- nomic downturn in U.S. history. Stock Market Crash In 1928 and 1929, prices doubled in the U.S. stock market. Federal Reserve officials viewed the stock market boom as excessive speculation. To curb it, they pursued an autonomous tightening of monetary policy to raise interest rates and decrease aggregate demand. The Fed got more than it bargained for when the stock market crashed in October 1929, falling by 40% by the end of 1929, as shown in Figure 15.2. Our aggregate demand and supply analysis shows how the autonomous tightening of monetary policy and the stock market crash pushed the economy into a recession. Higher real interest rates from the Fed action caused investment to decline, while lower stock prices reduced household wealth, so that consumer spending fell. As a result of the declines in both these components of aggregate demand, the aggregate demand curve shifted to the left Application CHAPTER 15 • FINANCIAL CRISES AND THE ECONOMY 369 Source: Dow-Jones Industrial Average (DJIA). Global Financial Data. www.globalfinancialdata.com/ index_tabs.php?action=detailedinfo&id=1165 80 100 70 90 S to ck P ric es (D ow -J on es In d us tr ia l A ve ra ge , S ep te m b er 1 92 9 = 1 00 ) 60 50 40 30 20 10 0 19311929 1930 1933 1934 1935 1936 1937 19391938 19401932 Stock market peak Stock market trough in December 1932 at 10% of September 1929 peak value FIGURE 15.2 Stock Price Data During the Great Depression Period Stock prices crashed in 1929, falling by 40% by the end of 1929, and then continued to fall to only 10% of their peak value by 1932. from AD1 to AD2 in Figure 15.3. The aggregate demand and supply analysis then indicates that the economy moved from point 1 to point 2, with both output and inflation declining, and unemployment rising. Bank Panics By the middle of 1930, stocks recovered almost half of their losses and credit market con- ditions stabilized. What might have been a normal recession turned into something far worse, however, when severe droughts in the Midwest led to a sharp decline in agricul- tural production, with the result that farmers could not pay back their bank loans. The resulting defaults on farm mortgages led to large loan losses on bank balance sheets in agricultural regions. The weakness of the economy and the banks in agricultural regions in particular prompted substantial withdrawals from banks, building to a full-fledged panic in November and December 1930 with the stock market falling sharply. For more than two years, the Fed sat idly by through one bank panic after another, the most severe spate of panics in U.S. history. After what would be the era’s final panic in March 1933, President Franklin Delano Roosevelt declared a bank holiday, a temporary closing of all banks. “The only thing we have to fear is fear itself,” Roosevelt told the nation. The damage was done, however, and more than o