The Crisis

Initial Economic Forecasts and the Unfolding Crisis

In late 2006, as U.S. housing prices began to fall, most economists predicted adverse effects on housing investment and consumption, leading to slower growth.
A few economists foresaw a mild recession, but almost none anticipated the scale of the economic crisis that followed, which became the largest since the Great Depression.
The decline in housing prices triggered a significant financial crisis due to the unexpected fragility of the financial system.

The Financial System's Collapse

Within months, numerous banks and financial institutions faced bankruptcy or near-bankruptcy.
This resulted in banks' inability or unwillingness to lend, causing increased interest rates for borrowers and a subsequent drop in spending and output.

Policy Responses to the Crisis

Policymakers responded with financial, monetary, and fiscal measures.
Central banks lowered interest rates and governments initiated fiscal expansions.
These policies likely prevented an even more drastic decline in output.
However, monetary and fiscal policies faced limitations:
- Interest rates controlled by central banks approached zero, leading to a "liquidity trap."
- Fiscal expansions and reduced government revenues led to substantial increases in public debt.

Challenges in Recovery

These limitations made it difficult to use policy effectively for economic recovery.
While growth turned positive after 2010, the recovery remained slow with high unemployment forecasts.

Chapter Overview

The chapter revisits the sequence of events from Chapter 1 with more detail, focusing on the U.S. initially and later expanding to the global crisis.
Section 9-1: examines the start of the crisis, the decline in housing prices, and its impact on the financial system.
Section 9-2: explores the macroeconomic effects of the housing and financial crises, including the evolution of output and policy responses.
Section 9-3: discusses the recovery phase.
The chapter uses and extends the IS–LM and AS–AD models to analyze the crisis.

From a Housing Problem to a Financial Crisis

Housing Price Decline and its broader effects

In 2006, when U.S. housing prices began to decline, most economists predicted a decrease in aggregate demand and a slowdown in growth.
Few foresaw a major macroeconomic crisis, underestimating the impact on the financial system.

Housing Prices and Subprime Mortgages

Figure 9-1 illustrates the Case-Shiller index of U.S. housing prices from 2000 onward, normalized to 100 in January 2000.
The index shows a significant price increase in the early 2000s, followed by a large decrease.
From 2000 to mid-2006, the index rose from 100 to 226, then stabilized and slightly declined in 2006 before rapidly declining from 2007.
By the beginning of the financial crisis in 2008, the index had fallen to 162 and has since stabilized around 150.

Factors Contributing to the Housing Price Increase

Low Interest Rates: The 2000s saw unusually low interest rates, reducing mortgage rates and increasing housing demand, thus pushing up prices.
Subprime Mortgages: Mortgage lenders increasingly offered loans to riskier borrowers, known as subprime mortgages, which became more prevalent in the 2000s.
- By 2006, about 20% of all U.S. mortgages were subprime.
At the time, subprime mortgages were viewed positively by many economists because they enabled more people to buy homes.
The assumption was that housing prices would continue to increase, making the mortgages safer for both lenders and borrowers.

Retrospective View of Housing Market Developments

In retrospect, these developments were seen as less benign.
Housing prices could decrease, leading to borrowers owing more than their house's value (underwater mortgages).
Mortgages were riskier than lenders or borrowers realized.
Borrowers often took mortgages with low initial interest rates that would sharply increase over time, making payments unsustainable.
When housing prices declined and borrowers defaulted, banks faced large losses.

Magnitude of Mortgage Losses

By mid-2008, losses on mortgages were estimated at around $300$ billion, approximately $2$ % of U.S. GDP.
Initially, it was thought that the U.S. financial system could absorb the shock, limiting the adverse effect on output.
However, the decline in housing prices triggered amplification mechanisms that were stronger than anticipated.

The Role of Banks as Financial Intermediaries

Banks act as financial intermediaries, receiving funds from savers and lending to borrowers.
Figure 9-2 presents a simplified bank balance sheet with assets of $100$ , liabilities of $80$ , and capital of $20$ .
Liabilities include checkable deposits or borrowings from investors and other banks.
Assets include reserves, loans to consumers and firms, mortgages, government bonds, and other securities.

Importance of Bank Capital

Capital is essential for limiting the risk of bankruptcy.
Without capital, if assets decrease in value while liabilities remain constant, the bank becomes bankrupt.

Potential Problems for Banks

If assets decline in value below liabilities, the bank becomes insolvent.
A bank can face illiquidity if investors demand their funds back quickly, and the bank cannot sell assets rapidly enough.

Crisis Factors

The crisis involved a combination of factors: insufficient bank capital, liquid liabilities, and illiquid assets.
This led to solvency and liquidity problems that paralyzed the financial system.

Leverage

Leverage is the extent to which an entity uses borrowed money.
Bank A has assets of $100$ , liabilities of $80$ , and capital of $20$ ; its capital ratio (capital to assets) is $20$ % and leverage ratio (assets to capital) is $5$ .
Bank B has assets of $100$ , liabilities of $95$ , and capital of $5$ ; its capital ratio is $5$ % and leverage ratio is $20$ .
If assets decrease from $100$ to $90$ , Bank A's capital becomes $10$ , while Bank B's capital becomes $-5$ , resulting in bankruptcy.
High leverage increases the risk of bankruptcy even with limited asset losses, as seen during the crisis.

Reasons for High Leverage

Higher leverage increases expected profit.
- If assets yield a $5$ % return and liabilities cost $4$ %, Bank A's return on capital is $((100 * 0.05) - (80 * 0.04)) / 20 = 9$ %.
- Bank B's return is $((100 * 0.05) - (95 * 0.04)) / 5 = 24$ %.
Banks underestimated risks, and compensation systems incentivized high returns without considering bankruptcy risks.
Banks avoided regulations by creating new financial structures like SIVs (Structured Investment Vehicles).

Complexity and Securitization

Securitization, the creation of securities based on bundled assets, grew in the 1990s and 2000s.
Mortgage-based securities (MBS) are titles to returns from thousands of mortgages.
Securitization enables more investors to participate, reducing borrowing costs.
Collateralized debt obligations (CDOs) issue different types of securities, such as senior and junior securities, to cater to varying risk appetites. CDOs were further securitized into CDO2s.
Securitization diversifies risk and involves more investors but has a cost.
Risk rating agencies missed the risk that, when underlying mortgages go bad, the valuation of MBSs and CDOs becomes extremely difficult and created toxic assets.
This led investors to be reluctant to hold these assets or lend to institutions holding them.

Liquidity and Wholesale Funding

Banks increasingly used wholesale funding, borrowing from other banks or investors through short-term debt, to finance asset purchases.
SIVs were entirely funded through wholesale funding.
Wholesale funding offers flexibility but carries a cost: if investors worry about asset values and stop lending, banks may face funding shortages and sell assets at fire sale prices.

Amplification Mechanisms of the Crisis

Solvency and liquidity concerns amplified each other as the crisis worsened.
High Leverage: As housing prices declined and mortgages went bad, high leverage led to sharp declines in bank capital, forcing asset sales at fire-sale prices.
Complexity of Securities: The complexity of securities (MBSs, CDOs) and bank balance sheets made it difficult to assess solvency, causing investors to stop lending and forcing further asset sales and price declines.
Banks became reluctant to lend to each other, as indicated by the increased Ted spread (the difference between the riskless rate and the Libor rate) after September 2008, when Lehman Brothers declared bankruptcy.

The Use and Limits of Policy

The economic impacts of the financial crisis included:
- A large increase in borrowing rates.
- A sharp decrease in confidence.
The financial crisis significantly impacted interest rates, with those for riskier firms rising sharply relative to government bond rates, making borrowing expensive.
Consumer and business confidence dropped sharply in September 2008 due to fears of another Great Depression, leading to decreased spending.
A sharp decrease in consumption was caused by lower confidence and lower housing and stock prices.

Initial Policy Responses to Strengthen the Financial System

Increased federal deposit insurance from $100,000$ to $250,000$ per account to prevent depositor runs.
The Federal government guaranteed new debt issues by banks to continue wholesale funding.
The Federal Reserve provided widespread liquidity to the financial system by creating liquidity facilities to allow banks and other financial institutions to borrow from the Fed, using a broader range of assets as collateral.
The government introduced the Troubled Asset Relief Program (TARP).
- The initial plan to remove complex assets from banks’ balance sheets was abandoned because assessing the value of the assets was too difficult.
- The new goal was to increase bank capital by having the government acquire shares in the banks.
- As of September 2009, total spending under TARP was $360$ billion, with $200$ billion used to purchase shares in banks.
The Fed directly intervened by purchasing private securities, especially mortgage-backed securities.
Fiscal and monetary policies were used aggressively.
The Fed decreased the T-bill rate starting in the summer of 2007, bringing it down to zero percent by December 2008.
The U.S. government used fiscal policy, with tax reductions and spending increases, including the American Recovery and Reinvestment Act, passed in February 2009, which called for $780$ billion in new measures.
The U.S. budget deficit increased from $1.7$ % of GDP in 2007 to $9.0$ % in 2010.
A large decrease in output still occurred despite these financial, fiscal, and monetary policies, with U.S. GDP falling by $3.5$ % in 2009.

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, people are indifferent between holding money and bonds; thus, expansionary monetary policy becomes powerless.
When the interest rate is at zero, increasing the money supply has no effect on the interest rate because people are willing to hold more money at the same rate.
When one takes into account the possibility of a liquidity trap, the LM curve is flat at $i = 0$ for values of income less than $Y'$ .
The economy falls into a liquidity trap when the interest rate is equal to zero, and expansionary monetary policy no longer has an effect on output.

Unconventional Monetary Policy

Unconventional monetary policies include:
- Credit easing
- Quantitative easing

Limits of Fiscal Policy: High Debt

Even if monetary policy has reached sharp limits, fiscal policy also has limits because government must continue to run deficits to sustain higher demand and output, leading to higher public debt.
In advanced countries, the ratio of government debt to GDP has increased from $46$ % in 2006 to $70$ % in 2011; in the United States, the ratio has increased from $42$ % in 2006 to $72$ % in 2011.
High debt implies that investors worry about repayment of the debt, and they start asking for higher interest rates on government bonds, making it even harder for the government to repay the debt.

The Slow Recovery

Output growth is now positive in the United States, but the recovery is very slow, and unemployment is predicted to remain high for many years, causing worries of a “lost decade.”
Zero interest rates and large budget deficits have not succeeded in getting the Japanese economy back to normal.

Potential Reasons for Slow Recovery

Banking crisis has decreased the natural level of output.
The weak recovery that we observe may be the best the economy can deliver.

Aggregate Demand Perspective

Insufficient aggregate demand is the issue.
Limits of policy.
At the core of the adjustment is the aggregate demand relation: $Y = Y(M/P, G, T)$

The Liquidity Trap and Adjustment Failure

When the economy is in the liquidity trap, with the interest rate equal to zero, an increase in the real money stock, $M/P$ , has no effect on the interest rate.
The process of adjustment that typically takes output back to its natural level in the medium run also fails.

Liquidity Trap AS-AD Model

If the economy is in the liquidity trap, the aggregate demand relation takes the following form: $Y = Y(G, T)$

Potential for Future Recovery

Aggregate demand will eventually recover as the banking system is repaired, and low housing investment and deferred consumption and investment increase demand in the future.

Key Takeaways

The trigger of the crisis was a decrease in housing prices.
The effect of lower housing prices was amplified by the effects on the banking system.
Policies were used, but they did not prevent the recession.
Conventional monetary policy no longer works, and the U.S. economy is in a liquidity trap.
The recovery is slow, and unemployment is expected to remain high for some time.