The Financial Crisis

(Chapter 37 in Mankiw and Taylor)

The macro-economy in the short run

• Economic growth is not constant

• There are ups and downs – recessions and booms

– With real incomes, inflation and unemployment changing

• What explains these “business cycles”?

• What if anything can policymakers do to prevent periods of falling real income and rising unemployment?

• Today we’ll look at the most recent recession, the “Great Recession”

The background to the Great Recession

• The origins of the crisis can be traced back to the deregulation of financial markets in the 1980s/1990s

– Aimed to improve supply-side of economy

• And 1990s was the period of the “Great Moderation”

– Confidence grew, as “boom and bust” some believed had been abolished

• House prices kept on rising; interest rates were low; borrowing became easier; steady economic growth

• Various restrictions on banks and building societies were relaxed

• Aim for investors was to find “risk-free” high-return investments

Bubbles and speculationUK house prices: Halifax price index

Bubbles and speculationUS house prices: Case-Shiller price index

Bubbles and speculation

• The housing market bubble led to riskier loans being made in both the UK and US

• Sub-prime market– Extending mortgages to people previously excluded

from the market, due to poor credit history etc.

• Lenders could charge a higher rate of interest (which they liked)

• Normally, this loan gave the bank both a liability and an asset (since the mortgage generated a stream of cash flows in the form of the mortgage payments)

Securitisation• Securitisation: the creation of asset-backed securities

– Parcelled up the debt

– Appeared on the basis of ‘historical’ data (over the last 10 boom years!) to be risk-free

– One example was, Collaterised Debt Obligations (CDO)

• (Investment) banks took these assets off-balance sheet

– Therefore they did not require reserves to cover the assets; as it appeared they had reduced their exposure to risk – until house prices fell

• Took out Credit Default Swaps (CDS); i.e. insurance on the asset-backed securities

Asymmetric information, bonuses and risk• Drive for bonuses prompted risk-taking, in a benign

climate (Great Moderation)

• Banks reassured buyers of CDOs that they were not “lemons” by using credit rating agencies to analyse the risk independently

The Bubble Bursts

• CDS are good business when the risk of default is low

– Many buyers of CDSs didn’t own the underlying asset

– Market was huge: > value of US stock market

• Mortgage defaults began to increase, in part as central banks (in US and UK, too) increased interest rates in the face of rising inflation in 2006-7

• House prices fell → more mortgage defaults

• CDS etc. led to an increasingly interconnected financial system

• Banks had to take these bad (and depreciating) assets back onto their balance sheets

– Limited their ability to lend

Moral Hazard

• Given the weakening position of the (investment) banks, central banks had to decide whether to step in and save the banks from collapse

• The government is acting like an insurance company; therefore there is less need for the investment banks to reduce their risks as they know they will be saved

– Central bank as “lender of last resort”

Banking collapse• Lehman Brothers collapsed (and the Fed let it, unlike Bear

Sterns and Merrill Lynch) on 15 Sept. 2008– Had been heavy involved in sub-prime and CDS market

– Built its business by borrowing to finance its activities

• Led to billions of dollars of claims on Lehman CDS, as Lehman had effectively defaulted on its promise to pay back its bonds– Payment which had to be met by those who sold the protection

• So these banks and insurers (e.g. AIG) who had sold CDSs were now under strain themselves as they didn’t have the funds to pay out– And the interbank market had dried up (as banks no longer

trusted each other), so couldn’t borrow themselves; so in the end the Fed did step in to save AIG and prevent complete collapse

The Path to Global Recession• Financial meltdown to real economy downturn

• Consumers cut back on expenditure, as house prices fell (“wealth effect” on consumption)

• Led to job losses, declines in business confidence and further cut backs in expenditure and in turn income

• Tight credit market (the credit crunch) made it difficult for small firms to raise money

– Firms hoarded money (rebuilt their capital buffers, requirements) and did not lend it out

• Led to rising unemployment and sharp downturns in economic activity

What does this mean in terms of the AD-AS model?

• Shift in aggregate demand

– Wave of pessimism – Aggregate demand shifts left

– Short-run• Output falls

• Price level falls

– Long-run• Short-run aggregate supply curve shifts right

• Output – natural rate

• Price level – falls

A Contraction in Aggregate Demand

PriceLevel

Quantity of Output

A fall in aggregate demand is represented with a leftward shift in the aggregate-demand curve from AD1 to AD2. In the short run, the economy moves from point A to point B. Output falls from Y1to Y2, and the price level falls from P1 to P2. Over time, as the expected price level adjusts, the short-run aggregate-supply curve shifts to the right from AS1 to AS2, and the economy reaches point C, where the new aggregate-demand curve crosses the long-run aggregate-supply curve. In the long run, the price level falls to P3, and output returns to its natural rate, Y1.

Long-run aggregate supply

Y1

Short-run aggregate supply, AS1

Aggregate demand, AD1

P1 A

AD2

P2

B

Y2

AS2

P3

C

1. A decrease in aggregate demand . . .

2. . . . causes output to fall in the short run . . .

3. . . . but over time, the short-run aggregate-supply curve shifts . . .

4. . . . and output returns to its natural rate.

Eurozone crisis

• The banking (debt) crisis led to a sovereign debt crisis, as government took on the banks’ debts

• Particularly acute in Europe

• Interest rate spreads (relative to Germany) rose dramatically for peripheral EMU countries

– Increased their cost of borrowing

– Illiquidity led to insolvency

– More on EMU in the next lecture!

The conduct of monetary policy• The freezing of credit markets prompted central banks to

intervene– They lent money to banks (at a penalty rate), when the market

would not

– Swapped mortgage securities for government bonds

• Banks acted as lenders of last resort– BoE eventually guaranteed (Northern Rock) deposits

• Eased monetary policy too– Through 2008 central banks lowered interest rates, close to zero

– Quantitative easing: BoE increased money supply (and therefore it was hoped business lending) by buying assets from the public

• Asset (bond) prices rise; yields fall

• Aim is to increase AD

Implications of the crisis• Death of the Efficient Markets Hypothesis?

– Markets do appear to have miscalculated the price of risk. Prices did not reflect true risk

• Central banks should focus on financial stability as well as inflation: the role of regulation

• Solve the “too big to fail” problem

– Separation of retail from investment (casino) banking

– Would then let these casino banks fail

• Inflation measures should include assets, such as housing

– If housing had been included in the CPI perhaps the BoE would have pricked the housing bubble by raising interest rates to bring down inflation

Regulation• Some claim weak regulation (and understanding) of

the banks contributed to their excessive leverage and risk-taking

– Define role of the different regulators

• Mortgage lending was too lax (lending at 125% of house value)

– Regulation should control this

• Control banks off-balance sheet activities

• Control bankers’ pay – and thereby discourage excessive risk-taking and privatisation of capital gains but socialisation of capital losses

Summary I

• Deregulation and a benign economic climate encouraged banks to become more risk seeking

• Some of this risk could be insured against through new products such as credit default swaps

• Banks in the US increased lending to the sub-prime housing market

• The resulting effects on the housing market of easier access to mortgages increased demand and prices

• Mortgage lending (along with other loans) were securitised by banks

Summary II

• Securitisation in association with CDS increased the interdependency of the financial system globally

• When interest rates started to rise to combat inflation, defaults in the sub-prime market began to grow

• As the defaults increased the liabilities of banks to the debt which had been built up grew along with their liabilities to CDS claims

• The banking crisis led to a sharp reduction in interbank lending as credit dried up

• Tight credit and the collapse of the housing market fed through to the real economy and unemployment began to grow and led to recession by 2008

Summary III

• The EMH formed the basis for policy making and regulation in many global financial markets

• Efficient markets rely on the ability of the market to understand information in pricing risk

• Financial institutions developed a range of new products based on assumptions of limited risk

• A lack of understanding of these models from bankers through to regulators and central bankers undermined a key basis of efficient markets

Summary IV

• When the crisis hit, central banks responded by reducing interest rates and developing new techniques to complement fiscal stimuli

• Both central banks and regulators have come in for criticism about their role in the crisis and their response after

• Ongoing debate and discussions about how best to avoid such a financial crisis in the future will continue