MACROECONOMICS I May 9th, 2014 Class 10. Financial Crises • Final Exam date • HW Assignment #4 is due: May 16th, 2014 • Need to schedule our missed class • Project deadline: Before exam N!B! Project is an individual, not a group assignment Announcements Impossible Trinity § Three desirable objectives that impossible to achieve simultaneously üFixed exchange rate regime üFull capital mobility üMonetary policy autonomy Only 2 objectives out of three Can be achieved simultaneously • Impossible Trinity: Case 1 § Fixed exchange rate regime + perfect capital mobility TE The central bank of Argentina maintains a fixed exchange rate for peso against the USD and allow for perfect capital mobility. üWhat effect would the expansionary monetary policy have on the economy? Ms => i => Withdrawal / Inflow of foreign investment => To preserve the exchange rate => Foreign exchange interventions => Ms Supply of the USD N!B! A central bank loses control over Ms and, in general, over the monetary policy Impossible Trinity: Case 2 § Monetary autonomy + perfect capital mobility TE The U.S. Fed as a strong monetary authority üWhat effect would the expansionary monetary supply have on the economy? Ms => i => Withdrawal / Inflow of foreign investment => => the USD depreciates / appreciates N!B! Sacrificing the exchange rate stability Impossible Trinity: Case 3 § Monetary autonomy + fixed exchange rate TE The Bank of China maintains a fixed exchange rate of Yuan against the USD. üWhat effect would the expansionary monetary policy have on the economy? Ms => i => Withdrawal / Inflow of foreign investment => => the USD depreciates / appreciates N!B! Control over the capital outflow Defining Financial Crisis • A rapid financial disintermediation caused by financial panic Financial sector: Banks + Stock market Key function: financial intermediation – transfer of savings to productive investment •Bank = Illiquid assets (loans) + Liquid liabilities (deposits) Bank run: savers liquidate their assets in financial institutions due to prospective risks • Depositors lose faith in the quality of assets held by a bank • Self-fulfilling nature (psychology) Defining Financial Crisis §Financial crisis manifests itself in the following ways: • Banks’ failure • Stock market crushes • Currency crisis (sharp depreciation) Problems in the banking sector, as a rule, precede the currency crisis N!B! Crisis originates when the flow of financial capital suddenly stops and reverses § Financial Crises in 1990s • Mexico in 1995 • Thailand, Indonesia, and South Korea in 1997-1998 • Russia in 1998 • Brazil in 1998 –1999 § Major prerequisites • Fiscal deficits • Capital overshooting • Excess leverage • Inefficient supervision of financial systems § Major consequences • Large swings in Current Account International contagion • Depreciation of currency • Drop in output (6- 8 %) Asian Financial Crises in 1990s Thailand, Indonesia, South Korea, Philippines, and Malaysia in 1997-1998 • Financial liberalization + Fast growth => Massive inflow of foreign capital • Short-term loans to the banks from foreign investors • “Sudden stop” in 1997 § Reasons Risky lending practices (“relationship lending”) Poor supervision of the financial system Liquidity crisis Speculative attacks on exchange rates Financial Crisis of 2008-2009 Prelude: Housing bubble Bubble - a surge in the market caused by speculation • explosion of activity in this market causing overinflated prices • high prices are not sustainable and the prices eventually crush => Þbubble bursts TE From the late 1990s till 2006, house prices in the US increased by 130 % Source: www.federalreserve.gov Housing Prices in Other Countries Source: Blanchard et al, 2011 The Housing Bubble § House prices were driven by üPsychology: housing prices will be rising in the future ü Low interest rates (Great moderation) • The US inflation was low => low interest rate • House prices are not part of CPI ü Deterioration of lending standards • Increasing share of sub-prime mortgages (no down payment and no documentation) More people are attracted to the mortgage market => house prices rise Source: www.federalreserve.gov Deterioration of Mortgage Loan Standards Banks do not bear higher risks • Mortgages do not remain on the balance of banks • Pooling mortgages and selling them as financial securities Mortgage-backed securities (MBS) § Selling future streams of income for a lump-sum amount today • Investors cannot check the quality of every mortgage in the financial instrument • Rely on the assessment of rating agencies => Weaker quality control Securitization Securitization (Cont.) • Foreign banks • Pension Funds • Investment Companies • Wealthy individuals Securitization (Cont.) Money Markets funds and the commercial paper market The Consequences of the Bubble Burst TE The US prices of existing single-family houses • 30 % drop in house prices • Households “under water” • Negative wealth from 12 million mortgages out of 55 million • 5 million mortgages’ defaults • All mortgage-related securities’ holders suffered losses But: 30 % drop in house prices could not trigger such massive crisis Source: www.federalreserve.gov Vulnerability of the Financial System §Too much leverage (excessive debt) Leverage ratio = Assets / Own Capital - - What happens if the value of assets increases by 20 %? Returns on assets: 100 % for Bank 1; 400 % for bank 2 §Complex financial instruments §Banks’ failure to monitor and manage §Short-term funding (commercial papers) §Gaps in the regulatory structure (no control over important financial firms and investment banks, government sponsored enterprises ) Bank Assets Liabilities Capital Leverage Bank 1 100 80 20 5 Bank 2 100 95 5 20 The Crisis Unfolds Drop in house prices => Mortgage defaults => Losses for securities’ holders •Complex nature of mortgage-backed securities • Spread all over the financial system and the world N!B! No one knew where to expect losses from ÞGreat uncertainty in financial markets ÞBeginning of runs on major financial companies: investors pulling funds from everywhere • Financial companies faces the problems with liquidity Two possible solutions: file for bankruptcy or search for additional capital inflows Large Financial Firms Under Pressure Timeline (2008) Bear Sterns March 16th Fannie and Freddie Sep 7th Lehman Brothers Merrill Lynch Sep 15th AIG Sep 16th Wash Mutual Bank Sep 25th Wachovia Oct 3rd Broker-dealer firms Insurance companies Government-sponsored enterprises Next class: Inflation N!B! Homework assignment # 4 is on the way Deadline: May 23rd, before the class