Crises Midterm Review

 Fundamental Value: the perceived value of a security or business based on its fundamentals or characteristics. 

Speculation: the act of buying or selling assets with the goal of making a profit from price fluctuations. 

Bubble: When the price of an asset or security is much higher than its actual value.

Tulipmania: a period when tulips were recently introduced and bought in large quantities by many people. This caused tulip prices to shoot up. They were sold at prices higher than skilled workers' income. After reaching a peak, tulip prices crashed, leaving tulip holders bankrupt.

The Mississippi Company: One of the first examples of an economic bubble. Scottish economist John Law created the company to develop French territories in the Mississippi River valley. The company's stock was sold at inflated prices in exchange for national securities. The bubble burst in 1720 when the value of French banknotes and Mississippi Company shares dropped. 

The South Seas Company: a joint-stock company that was created in 1711 to consolidate Britain's national debt.The company was a public-private partnership that was formed to convert short-term debt into stock. The bubble was a result of corruption, bribery, and groupthink.

Poyais: Poyais was a fictional Central American country created by Scottish con man Gregor MacGregor in the 1820s. MacGregor claimed to be the prince of Poyais and used the country to defraud investors and settlers. 

Bond face value: How much a bond will be worth on its maturity date. 

Bond coupon: the interest payment made to a bondholder by the bond issuer.

Bond maturity: the date on which the bond issuer pays back everything they owe to bondholders. 

Sovereign debt: 

• (external): a country's debt to foreign lenders, including governments, banks, and international organizations. 

• (internal): a country's government debt that is owed to lenders within the country.

Fixed exchange rate: a system where a country's currency value is set at a specific rate against another currency or a basket of currencies

Floating exchange rate:  a country's currency value is based on supply and demand for other currencies. (changes over time) 

Currency maintenance: the process of managing a country's currency to maintain its value and economic stability. 

Bitcoin fundamentals: a decentralized digital currency operating on a blockchain. Key fundamentals include: Fixed monetary policy,censorship resistance, no central authority controls it.

Decentralized Finance: A financial ecosystem built on blockchains, where traditional financial services (lending, borrowing, trading, etc.) are offered without banks or intermediaries.

Traditional finance: The existing, regulated financial system that includes: Banks, insurance companies, and investment firms, central banks (like the Fed), and intermediaries. 

Northern Rock: A British bank that collapsed in 2007 due to over-reliance on wholesale funding (borrowing from other banks rather than deposits). A bank run accelerated its downfall, making it one of the first major casualties of the 2007-08 Global Financial Crisis.

Wholesale lending: Lending between large institutions (banks, hedge funds, corporations), rather than to individual consumers or small businesses. Often short-term and secured (collateralized).

Repurchase agreement (repos): A short-term borrowing arrangement where a bank or financial institution sells securities (like Treasury bonds) to another party and agrees to buy them back later at a slightly higher price. 

Deposit insurance: A government guarantee that protects depositors’ money (up to a limit) if a bank fails. In the U.S., the FDIC offers this protection.

FDIC: A U.S. government agency that: Insures bank deposits (up to $250,000 per depositor per bank), regulates and supervises banks, resolves failed banks.

Inflation: General rise in prices over time (reduces purchasing power).

Deflation: General decline in prices (increases purchasing power, but often signals economic distress).

Federal funds rate: The interest rate banks charge each other for overnight loans, set by the Federal Reserve. It’s a key benchmark for borrowing costs across the economy.

Bank run: A mass withdrawal of deposits by customers who lose confidence in a bank’s solvency. When too many people withdraw, the bank may collapse due to liquidity shortages.

Cost of credit intermediation: The total costs involved when financial institutions channel funds from savers to borrowers. Includes things like administrative costs, default risk, and regulatory costs.

Money multiplier: The idea that each dollar deposited in a bank leads to more money creation through lending. If banks keep 10% in reserve, they can lend out 90%, which gets redeposited and lent again — multiplying the original deposit.

Debt deflation hypothesis: Proposed by Irving Fisher, it describes how excessive debt can lead to:

1. Asset sales to repay debt.

2. Falling prices (deflation).

3. Increasing real debt burdens.

4. More defaults and economic contraction. A vicious cycle, often linked to financial crises.

Monetarist (Schwarz-Friedman): A school of thought led by Milton Friedman and Anna Schwartz, arguing that:

• Money supply is the main driver of economic activity.

• Controlling inflation requires controlling money supply growth.

• Bad monetary policy caused the Great Depression.

Durable goods: Goods that last a long time (usually over 3 years), like cars, appliances, and machinery. They are more sensitive to economic cycles because consumers can delay purchases in downturns.

Hedge, Speculative, Ponzi Finance (Hyman Minsky's Financial Instability Hypothesis):

• Hedge finance: Borrowers can fully repay both interest and principal from cash flows.

• Speculative finance: Borrowers can pay interest but need to roll over debt (refinance the principal).

• Ponzi finance: Borrowers can’t even cover interest; they rely on asset prices rising to keep afloat.

Leverage: The use of borrowed money to increase investment size. Higher leverage magnifies both gains and losses. Key risk factor in financial crises.

Buying stock on the margin: Borrowing money from a broker to buy stocks. If the stock price drops too much, the broker demands more collateral (a margin call), potentially forcing a sale.

Short-selling stocks or currency: Betting an asset will decline in value:

1. Borrow the asset.

2. Sell it immediately.

3. Buy it back later at a lower price.

4. Return it to the lender and pocket the difference.

Silicon Valley Bank Run (2023): A classic bank run triggered when SVB, heavily invested in long-term bonds (which lost value as interest rates rose), suffered a loss. Depositors panicked and withdrew funds rapidly, leading to the 2nd-largest U.S. bank failure.

European Sovereign Debt Crisis: Crisis where several Eurozone countries (Greece, Portugal, Spain, Ireland, etc.) struggled to repay their government debt after the Global Financial Crisis. Key factors:

• High deficits.

• Weak economies.

• Lack of independent monetary policy (all shared the euro).

• Led to austerity programs and bailouts.

Asian Financial Crisis: 

A severe financial crisis in Asia triggered by:

• Fixed exchange rates failing.

• Over-borrowing in foreign currencies.

• Capital flight.

• Currency collapses (Thailand, South Korea, Indonesia hit hardest).

• Banking collapses and economic downturns across the region.

Explain how leverage can change as asset prices rise and fall

• Leverage is using borrowed money to increase the potential return on investment. When asset prices rise, assets used as collateral become worth more so borrowers can borrow even more which increases leverage. When asset prices fall, the value of collateral drops, which means borrowers may have to sell assets, which further lower prices, so leverage shrinks quickly. 

Explain how leverage works to measure the extent of debt

• Higher leverage means more borrowed money relative to equity. It measures how much debt risk is in the system. 

Galbraith’s characterization of financial manias:

         Types of Participants

• Speculators – believe prices will keep rising and want quick profits.

• Promoters – create schemes and hype to attract others.

• Skeptics/Naysayers – warn of dangers, but get ignored.

• Public – gets swept in out of fear of missing out (FOMO).

Association of Money and Intelligence

• When prices rise, wealth = intelligence in public perception.

• People think if you're rich, you must be smart, ignoring luck/speculation.

Fear of Missing Out (FOMO)

• Even cautious investors pile in to avoid being the only one not getting rich.

Shouting Down Naysayers

• Those who warn of bubbles are labeled jealous or clueless.

• Mania crowds tend to reject all criticism.

Garber’s characterization of financial manias:

• Investors often act rationally based on available information.

• However, if underlying assumptions are wrong, the bubble bursts.

• Not everyone is irrational — but collective misjudgment can still cause crises.

 How is a country borrowing (sovereign debt) different from an individual?

Theories on why countries repay their debts

• Sovereign debt is long-term and default is a political discussion. Individual deftness is a personal financial limit and typically a shorter-term. 

• Countries repay their debt to maintain access for future borrowing, protect reputation in global markets, and avoid economic sanctions. 

Greek sovereign debt crisis

            Short-Term Financing & 2007-08 Financial Crisis

• Greece relied on short-term debt — constantly needing to refinance.

• After 2008, global investors demanded higher interest rates.

• Greece’s debt became unsustainable.

Role of the Currency Union

• In the Eurozone, Greece couldn’t print its own currency.

• Greece could not devalue its currency to boost exports.

• Locked into Euro policies, which limited options.

Asian financial crisis

     Fundamental Weakness vs. Speculative Attack

• Weakness: countries had current account deficits, weak banking systems, and over-reliance on short-term foreign debt.

• Speculative Attack: investors feared fixed exchange rates were unsustainable and pulled capital out, triggering collapse.

Fixed Exchange Rate Vulnerability

• Countries with fixed exchange rates:

  • Must hold large reserves of foreign currency.

  • When investors lose confidence, they attack the currency by selling it.

  • Central bank runs out of reserves — crisis hits.

Defining characteristics of the Great Depression

• Mass unemployment, bank failures, severe deflation, and collapse in global trade. 

Explain some of the key theories related to the Great Depression

Explain some of the key determinants of Silicon Valley Bank failure

           Uninsured Deposits

• 90%+ of deposits were uninsured (above FDIC limit).

• Depositors panicked and withdrew funds quickly (classic bank run).

Assets with Interest Rate Risk

• SVB held long-term bonds.

• Rising interest rates reduced bond values, causing losses.

• When withdrawals surged, SVB had to sell at a loss, deepening the crisis.

Explain the Minsky instability hypothesis in terms of ponzi, hedge, and speculative finance

• Ponzi: income can’t even cover interest - requires asset price increase to survive. 

• Speculative finance: income covers interest only - debt keeps growing

• Hedge finance: income covers principal + interest (low risk) 

How does Prychitko argue Austrian Business Cycle Theory complements the Minsky Instability Hypothesis?

 Austrian View: Cheap credit (low rates) causes malinvestment — bad investments in wrong sectors.

Minsky View: Long stability breeds riskier finance (hedge → ponzi).

Complementary: Both explain how easy credit and overconfidence lead to financial fragility.

How does Bitcoin function as a currency?

Bitcoin functions as a currency by serving as a digital medium of exchange that allows peer-to-peer transactions without a central authority, while also acting as a store of value due to its fixed supply, though its volatility limits its use as a stable unit of account.