Intermediate Macroeconomics - II , Economics (H), Semester IV

UNIT III – FISCAL AND MONETARY POLICY

FINANCIAL CRISES

In this topic, we will examine the dynamics of financial crises in the advanced countries,
studying the financial crises of 2007-08 alongside.

Typically financial crises in advanced economies have progressed in three broad stages.

Stage One: Initiation of Financial crisis

One reason for this could be mismanagement of financial innovation. Financial innovation
(introduction of new types of loans and financial products) usually encourage lending
institutions to go on a lending spree, which, if is also accompanied with financial
liberalization (reduction of restrictions on financial institutions and markets) may reduce the
incentives for financial institutions to manage risk appropriately and hence may result in high
risk lending.

Second reason for a financial crisis could be presence of Asset Price Bubbles, typically a
credit driven bubble. A credit driven bubble is due to excess credit in the market which
increases the demand for assets which further raise the prices of such assets. Owners of such
assets become more wealthy and further ask for more loans as the value of assets which they
can keep as collateral has increased. Financial institutions also see an improvement in their
balance sheets with increase in the worth of collateral and they respond by lending more. This
increased lending further increases the demand and hence the prices of these assets.
Therefore, this is a kind of feedback loop where a credit boom drives up asset prices, which
further encourages credit boom, driving asset prices further up. When prices of assets rise
way above their fundamental economic values (based on realistic expectations of assets
future income streams), a situation of asset price bubble arises.

(There could also be presence of optimistic expectations driven bubble, driven only by overly
expectations. These kinds of bubbles have lesser risk for the financial system.)

This overly risky lending or the bursting of this asset price bubble causes a situation of
financial turmoil in the markets. With asset price bust, the value of collateral with the
financial institutions see a decline, thereby deteriorating the balance sheets of the respective
institutions. The lenders also in the wake of a fall in the value of the collateral that they have
pledged are more likely to make risky investments. Therefore, due to a decrease in the net
worth of financial institutions, they start deleveraging by cutting down their lending, thereby
decreasing aggregate demand in the economy.

Stage Two: Banking Crisis

With lesser banks, future lending becomes more difficult, more firms fail, get liquidated and
gradually uncertainty in financial markets decline and the economy is set for a recovery.

Stage Three: Debt Deflation

If the economic recession caused due to a financial crisis results in a sharp decline in price
levels, than this may further aggravate the problem. As interest payments are usually fixed in
nominal terms, an unanticipated decrease in price level will unambiguously increase the real
interest payments thereby increasing the borrowing firm’s real value of liabilities. However,
the price fall will not increase the firm’s value of assets, which results in a fall in firm’s net
worth in real terms. This will further increase the problem of adverse section and moral
hazard and thus lending and economic activity faces a long potential future decline.

The Global Financial Crisis

The global financial crisis refers to the extreme stress in global financial markets and banking
systems between 2007 and 2009. The seeds of the financial crisis were sown with the
increased financial liberalization and deregulation of financial markets in the US since
1970’s. There was easy availability of credit and excess of foreign funds in the market. With
the asset price bubble, easy loans were given to subprime borrowers by keeping these assets
as collateral. With a change in business model being followed by US banks, banks sold these
leans to a third party through a special investment vehicle, and in turn various such loans
were packed/bundled to create new financial securities known as asset or mortgage backed
securities, which were sold to other financial institutions like pension and hedge funds. So,
financial markets were not managing risk well and banks which were taking too much risk
became more prone and vulnerable to a financial shock. With the eventual bust of this asset
price bubble, housing prices fell drastically. US consumers, who had high debt ratios, in the
situation of recession and unemployment that followed, found them unable to pay off their
interest payments and lenders could not recover their principals by selling the collateral. The
prices of mortgage backed securities fell, reducing the net worth of investment banks and the
entire shadow banking system came under stress. Banks stopped making further loans, their
balance sheets deteriorated, creating a panic kind situation in the minds of all investors who
tried pulling out their money from banks. The failure of many financial firms and financial
institutions like Lehman Brothers in 2008 triggered a panic in the financial markets globally.
Response to bubbles

Greenspan, the Chairman of Federal Reserve until 2006, took a categorical decision of not
interfering in the financial markets even in the view of asset price bubbles as his stand was
such bubbles are nearly impossible to identify.

However, after the financial crisis, Central Bankers around the world and academicians alike,
criticized Greenspan’s decision and argued that financial markets subject to the presence of
problems arising from moral hazard, adverse selection and externalities, are not perfect and
thus are prone to market failure and thus require some kind of interference for maintaining
stability. They also argued that government officials do have information about asset price
bubble formation in the housing markets. So, these credit driven bubbles are easy to identify
and can be checked for a potential threat.

But even if there is a strong case that Central Bank should respond to such bubbles, but a
much bigger question is the way Central Bank should respond. Prima facie, it may appear
logical to use a contractionary monetary policy by squeezing out the liquidity from the money
market. However, there are apprehensions in the use of this simplest policy measure due to
the following three reasons:
1. There is a lot of uncertainty in the way high real interest rates will work, especially in
a scenario when the bubble is being sustained with an expectation of high rates of
return from assets.
2. Even after ignoring the above point, for the bubble to bust, interest rates need to
increase by a substantial margin which may result into huge economic recession.
3. This tool of monetary policy may push down the prices of all the assets in the market
even if the bubble is present in only few assets.

In view of all the above mentioned points, the best way to tackle asset price bubbles is
through financial regulation and better supervision. There is no substitute for effective
financial regulation. Financial regulation either through Central Bank or the government can
prevent excessive risk taking ability of banks and other financial institutions, thereby
preventing excessive lending and a credit driven asset bubble. Such regulatory policy in the
credit markets in the aggregate sense is referred to as macro prudential regulation.

(The above material is prepared with the help of reading as prescribed by Delhi School of
Economics, Reference: Mishkin – Chapter 15)