Chapter 9 - The Crisis
The Crisis
In late 2006, U.S. housing prices began to decline, leading to a major financial crisis that few economists had anticipated.
The financial system proved to be more fragile than perceived, causing banks to become bankrupt or near bankruptcy, reducing lending, increasing interest rates, and decreasing spending and output.
Policy makers responded with financial, monetary, and fiscal measures, including decreasing interest rates and major fiscal expansions.
Monetary and fiscal policies have encountered limits, such as interest rates near zero (a "liquidity trap") and increases in public debt.
While growth turned positive after 2010, the recovery remains slow, and unemployment is expected to stay high.
This chapter analyzes the crisis, focusing on the U.S., using the IS–LM and AS–AD models.
9-1 From a Housing Problem to a Financial Crisis
The decline in housing prices, starting in 2006, had unforeseen effects on the financial system.
Housing Prices and Subprime Mortgages
The Case-Shiller index shows a sharp increase in U.S. housing prices from 2000 to 2006, followed by a significant decline.
From a value of 100 in 2000, the index rose to 226 in mid-2006 but then declined to 162 by the end of 2008 and stabilized at around 150.
The price increase from 2000 to 2006 was partially justified by low interest rates, which increased demand for housing.
Mortgage lenders became more willing to provide loans to risky borrowers, resulting in a rise in subprime mortgages.
By 2006, about 20% of all U.S. mortgages were subprime.
Subprime mortgages were initially seen as a positive development, allowing more people to buy homes, but this assumption relied on continued increases in housing prices.
The assumption that housing prices would not decrease seemed reasonable, as prices had not decreased during the 2000–2001 recession.
When housing prices declined, many borrowers found themselves owing more than the value of their house, a situation known as being underwater.
Many mortgages were riskier than lenders or borrowers realized, often with low initial interest rates that increased sharply over time.
As borrowers defaulted, banks faced large losses, estimated at around billion dollars in mid-2008, equivalent to about 2% of U.S. GDP.
The effects were amplified due to the role of banks and their function as financial intermediaries.
The Role of Banks
Banks act as financial intermediaries, receiving funds from savers and lending to borrowers.
A bank balance sheet includes assets (e.g., reserves, loans, mortgages, government bonds), liabilities (e.g., checkable deposits, borrowing from investors), and capital.
Banks hold capital to limit the risk of bankruptcy.
If assets decline in value and liabilities remain constant, a bank without sufficient capital can become bankrupt.
A bank can face issues of solvency (assets worth less than liabilities) or illiquidity (inability to sell assets quickly to meet obligations).
The crisis involved a combination of too little capital, liquid liabilities, and illiquid assets, which paralyzed the financial system.
Leverage
Capital ratio is the ratio of capital to assets.
Leverage ratio is the ratio of assets to capital (inverse of the capital ratio).
A bank with a high leverage ratio faces a greater risk of bankruptcy from asset losses.
Leverage Ratio =
Capital Ratio =
Example:
Bank A: Assets of , Liabilities of , Capital of . Capital ratio is 20%, leverage ratio is 5.
Bank B: Assets of , Liabilities of , Capital of . Capital ratio is 5%, leverage ratio is 20.
If assets decrease to :
Bank A: Capital becomes .
Bank B: Capital becomes , leading to bankruptcy.
High leverage ratios in the 2000s increased the risk of bankruptcy for many banks.
Banks chose to take on more risk for higher expected profits.
Reasons for high leverage:
Underestimation of risk due to good economic times.
Compensation and bonus systems incentivizing high returns without fully accounting for bankruptcy risk.
Use of financial structures like SIVs to avoid capital ratio regulations.
Complexity
Securitization, the creation of securities based on a bundle of assets (e.g., loans or mortgages), grew in the 1990s and 2000s.
Mortgage-based securities (MBS) are titles to returns from a bundle of mortgages.
Collateralized debt obligations (CDOs) involve issuing different types of securities based on claims on the underlying assets (e.g., senior and junior securities).
Securitization aimed to diversify risk and increase investor involvement.
However, it also created complexity, making it difficult to assess the value of underlying bundles when mortgages went bad.
These complex assets became known as toxic assets.
Investors became reluctant to hold these assets or lend to institutions holding them.
Liquidity
Banks increasingly relied on borrowing from other banks or investors through short-term debt, a process known as wholesale funding.
SIVs (structured investment vehicles) were entirely funded through wholesale funding.
Wholesale funding gave banks more flexibility but increased the risk of funding shortages if investors stopped lending.
Banks might be forced to sell assets at very low prices (fire sale prices) if they faced a shortage of funds.
Amplification Mechanisms
Solvency and liquidity concerns reinforced each other as the crisis worsened.
High leverage meant that declines in housing prices led to sharp declines in bank capital, forcing them to sell assets at fire sale prices.
The complexity of securities made it difficult to assess the solvency of banks, leading investors to stop lending and forcing further asset sales.
Banks became reluctant to lend to each other, as reflected in the increase in the Ted spread (the difference between the riskless rate and the Libor rate).
The bankruptcy of Lehman Brothers on September 15, 2008, intensified these concerns, leading to a paralyzed financial system and a macroeconomic crisis.
9-2 The Use and Limits of Policy
The financial crisis led to:
A large increase in interest rates.
A dramatic decrease in confidence.
Initial Policy Responses
Measures to strengthen the financial system:
Federal deposit insurance increased from to per account.
The Federal government guaranteed new debt issues by banks to continue wholesale funding.
The Federal Reserve provided widespread liquidity through liquidity facilities, allowing banks and other financial institutions to borrow from the Fed.
The government introduced the Troubled Asset Relief Program (TARP) to clean up banks by increasing their capital.
Fiscal and monetary policies were used aggressively:
The Fed decreased the T-bill rate from 5% in July 2007 to zero by December 2008.
The U.S. government implemented the American Recovery and Reinvestment Act in February 2009, calling for billion in new measures.
The U.S. budget deficit increased from 1.7% of GDP in 2007 to 9.0% in 2010.
These measures were insufficient to avoid a large decrease in output, with U.S. GDP falling by 3.5% in 2009.
The Limits of Monetary Policy: The Liquidity Trap
The Fed has kept the T-bill rate at zero since December 2008.
When the interest rate is equal to zero, expansionary monetary policy becomes powerless due to the liquidity trap.
Once people hold enough money for transaction purposes, they are indifferent between holding money or bonds.
In the presence of a liquidity trap, the LM curve becomes flat at for values of income less than .
Conventional monetary policy has limits, but unconventional measures like credit easing or quantitative easing can be used, although their effects are often small.
The Limits of Fiscal Policy: High Debt
Continuing large deficits lead to steadily higher public debt.
In advanced countries, the ratio of government debt to GDP increased from 46% in 2006 to 70% in 2011.
High debt implies that taxes may have to increase or spending may have to decrease.
Worries about repayment of debt can lead to higher interest rates on government bonds.
9-3 The Slow Recovery
Output growth is positive, but the recovery is very slow, with persistent high unemployment, raising concerns of a "lost decade."
Japan's Experience
Japan's stock market crashed in early 1990's
Nikkei index (Japanese stock prices) rose from in 1980 to in 1990, then fell to within 2 years
By mid 1990's interst rates were below 1%
Government spending dramatically increased
Government debt-to-gdp was at 13% in 1991 and is now above 120%
GDP growth averaged 4.4% in 1980s to 1.4% in 1990s and 0.9% in 2000s
This warns other advanced countries that recovery may take a long time
Some economists argue that the banking crisis has decreased the natural level of output.
Banking Crises Affect Output
Banking crisis can lead to large decreases in output on the medium run (affects natural level of output)
From 1970 to 2002, IMF identified 88 banking crises and looked at behavior of GDP in years following each crisis
Financial crises lead to decrease in output relative to trend even in medium run
Decline in output is broken down as one-third relating to decrease in employment and two-thirds relating to decrease in productivity ( both relative to trend)
This shows that banking system plays important role in the economy
Banking crises weaken the ability of banking system to allocate funds
This makes economy less productive
In the U.S., the unemployment rate remains high, suggesting that the aggregate demand side is also an issue.
Aggregate Demand Failure
Insufficient aggregate demand is considered the issue which points at three things
Limits of policy as conventional monetary policy isn't working
Presence of liquidity trap suggests that the standard adjustment process to bring output back to it's natural level will fail
In liquidity trap, an increase in real money stock, , has no effect on interst rate and thus adjustment mechanism that returns output back to it's natural level in the AS-AD model also doesn't work
The adjustment mechanism that typically takes output back to its natural level fails in the liquidity trap.
The economy may experience a continuous decrease in the price level without an increase in output.
There is hope that aggregate demand will eventually recover due to:
Repair of the banking system over time.
Decreasing housing stock leading to increased prices and higher investment.
Pent-up demand for durable goods and equipment.
Summary
The crisis was triggered by a decrease in housing prices, amplified by effects on the banking system.
Low capital ratios, complex assets, and illiquidity led to a reluctance to lend and a decrease in spending.
Fiscal, monetary, and financial policies were used, but they faced sharp limits.
The conventional monetary policy no longer works due to the liquidity trap.
Large budget deficits led to a large increase in debt.
The recovery is slow, and the demand side is the main issue because the standard adjustment mechanism is failing.
Here are 10 important questions and their solutions based on the notes, which could be relevant for your end-semester exam:
Question: Explain how the decline in housing prices led to a financial crisis in 2008.
Solution: The decline in housing prices, particularly after 2006, caused many borrowers to be underwater on their mortgages. This led to defaults, which caused significant losses for banks holding these mortgages. The rise of subprime mortgages and the complexity of mortgage-backed securities amplified these effects, leading to a widespread financial crisis.
Question: What are subprime mortgages and why did they contribute to the crisis?
Solution: Subprime mortgages are loans given to borrowers with higher credit risk. They contributed to the crisis because they were based on the assumption that housing prices would continue to rise. When prices declined, many subprime borrowers defaulted, leading to substantial losses for lenders.
Question: Describe the role of banks as financial intermediaries and how their balance sheets are structured.
Solution: Banks act as financial intermediaries by taking deposits from savers and lending to borrowers. A bank's balance sheet includes assets (e.g., reserves, loans) and liabilities (e.g., deposits). Capital is the difference between assets and liabilities and is used to absorb losses.
Question: Explain the concepts of leverage ratio and capital ratio. How did high leverage ratios contribute to the financial crisis?
Solution: The leverage ratio is the ratio of assets to capital, while the capital ratio is the ratio of capital to assets. High leverage ratios mean banks had insufficient capital to absorb losses when asset values declined, increasing the risk of bankruptcy.
Question: What is securitization and how did mortgage-based securities (MBS) and collateralized debt obligations (CDOs) amplify the financial crisis?
Solution: Securitization is the process of bundling assets (like mortgages) into securities that can be sold to investors. MBS and CDOs, which are types of securitized products, became complex and difficult to value, especially when underlying mortgages went bad, leading to toxic assets and investor reluctance.
Question: Define wholesale funding and explain how it increased liquidity risk for banks.
Solution: Wholesale funding is when banks rely on short-term borrowing from other banks or investors. This reliance increased liquidity risk because if investors stopped lending, banks could face funding shortages and might be forced to sell assets at fire sale prices.
Question: What policy responses were implemented to address the financial crisis? Give examples of both monetary and fiscal policies.
Solution: Policy responses included increasing federal deposit insurance, guaranteeing bank debt, and providing liquidity through the Federal Reserve. Fiscal policies included the American Recovery and Reinvestment Act. Monetary policies involved decreasing the T-bill rate to near zero.
Question: Explain the concept of a liquidity trap and how it limited the effectiveness of monetary policy during the crisis.
Solution: A liquidity trap occurs when interest rates are near zero, and expansionary monetary policy becomes ineffective because people are indifferent between holding money and bonds. In this situation, the LM curve becomes flat, limiting the impact of monetary policy on output.
Question: How did high levels of public debt limit the effectiveness of fiscal policy during the recovery?
Solution: High levels of public debt raised concerns about future taxes and government spending, which could lead to higher interest rates on government bonds and reduce the effectiveness of fiscal stimulus.
Question: Describe the key factors contributing to the slow recovery following the financial crisis.
Solution: The slow recovery was due to factors such as the banking crisis impacting the natural level of output, insufficient aggregate demand, the presence of a liquidity trap