1 Introduction to Macroeconomics
2 Measuring the Macroeconomy
3 An Overview of Long-Run Economic Growth
4 A Model of Production
5 The Solow Growth Model
6 Growth and Ideas
7 The Labor Market, Wages, and Unemployment
8 Inflation
9 An Overview of the Short-Run Model
10 The IS Curve
11 Monetary Policy and the Phillips Curve
12 Stabilization Policy and the AS/AD Framework
13 The Global Financial Crisis: Overview
14 The Global Financial Crisis and the Short-Run Model
15 The Government and the Macroeconomy
16 International Trade
17 Exchange Rates and International Finance
18 Parting Thoughts




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Chapter 13: The Global Financial Crisis: Overview

Chapter Summary

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Key Concepts

  1. The U.S. economy has suffered several major shocks in recent years. Initially these shocks included a large decline in house prices and a spike in the prices of oil and other commodities.

  2. The decline in house prices reduced the value of mortgage-backed securities. Because of leverage, this threatened the solvency of a number of financial institutions, including major investment banks. Risk premiums rose sharply on many kinds of lending, and the stock market lost about half its value.

  3. These shocks have combined to put the U.S. economy and many economies throughout the world into a financial crisis and a deep recession, likely the largest since the Great Depression.

  4. Balance sheets are an accounting device for summarizing the assets, liabilities, and net worth (or equity) of an institution, such as a bank, a household, or a government.

  5. Leverage is the ratio of liabilities to equity. Financial institutions are typically highly leveraged; for example, $10 of assets may be financed by $1 of equity and $9 of debt, a leverage ratio of 9 to 1. Major investment banks before the financial crisis were even more highly leveraged, on the order of 35 to 1.

  6. Leverage magnifies both returns and losses, so that a small percentage change in the value of assets or liabilities can be enough to entirely wipe out equity, causing an institution to become insolvent, or bankrupt.

  7. During the height of the financial crisis, the solvency of numerous financial institutions was called into question. Because financial firms are interlinked through a complex web of loans, insurance contracts, and securities, problems in a few financial institutions can create problems in many others, which is called systemic risk.

1. Introduction

  • The financial crisis that started in the summer of 2007 and intensified in September 2008 marked the end of an era for U.S. investment banking.
  • The National Bureau of Economic Research determined that a recession began in December 2007, and it is forecasted that this will be the worst recession since the Great Depression of the 1930s.

2. Recent Shocks to the Macroeconomy

a. Housing Prices

  • In the decade leading up to 2006, housing prices rose rapidly.
    • This led to a three-fold increase in housing prices between 1996 and 2006.
  • Between mid 2006 and February 2009, housing prices plummeted by 31.6 percent.

b. The Global Saving Glut

  • The current financial turmoil was caused partly by prior financial crises.
    • The global saving glut was term used by Ben Bernanke to refer to the increase in savings by many developing countries following the various financial crises of the late 1990s.
  • As a result, the United States had an excess of savings that it sought to place in good investment opportunities.

c. Subprime Lending and the Rise in Interest Rates

  • The savings glut led to low interest rates, and many borrowers took out mortgages to buy homes between 2000 and 2006.
    • Many of these borrowers fell into the "subprime" category, meaning they did not meet mainstream lending standards because of poor credit records or high debt-to-income ratios.
  • Between 2004 and 2006, the Fed raised its interest rate from 1.25 to 5.25 percent.
    • The Taylor rule demonstrated that rates had been too low in previous years.
    • However, many subprime borrowers were now facing mortgages that were increasing from their initial teaser rates.
      • By August 2007 nearly 16 percent of subprime mortgages with adjustable rates were in default. This led to a downward spiral of the housing market.

d. The Financial Turmoil of 2007-20?

  • Before the crisis began, subprime mortgages were repackaged and sold to investors through a financial innovation known as securitization.
    • Securitization is the process of pooling a group of financial instruments, such as mortgages, and then slicing them up in a different way and selling off the pieces.
    • In principle, combining large numbers of assets can diversify the risk of any individual asset. However, the underlying mortgages were significantly riskier than investors realized.
  • As sophisticated financial instruments were developed and traded, it became difficult to know how much risk an individual bank was exposed to.
    • In August 2007, this led to a "flight to safety.".
    • The spread between Treasury bills and interbank lending interest rates exploded from 1.0 to 3.5 percentage points by September 2008..
    • A liquidity crisis is a situation in which the volume of transactions in some financial markets falls sharply, making it difficult to value certain financial assets and raising questions about the overall value of the firms holding those assets.
  • Financial markets plunged and the S&P index dropped 50 percent from its peak in November 2007.

e. Oil Prices

  • To make matters worse, oil prices were extremely volatile in this period. Over the summer of 2008 oil peaked at $140 per barrel. By the end of the year the price dropped to $40 per barrel.
    • The price increase was fueled by demands from China, India, and the Middle East, coupled with short-term supply disruptions.
    • The economic slowdown helped to alleviate oil demand pressures. However, given the magnitude of the price swing, it is possible that price speculation also played a role.

3. Macroeconomic Outcomes

  • The recession, starting in December 2007, was first visible in unemployment. By 2009 output was 3.6 percent below potential, and unemployment was up to 8.9 percent and expected to increase.

a. A Comparison to Previous Recessions

  • Compared to an average of all recessions since 1950, as of April 2009, this recession is significantly worse.
  • A striking difference about this recession is the decrease in consumption.
    • One reason that consumption has actually decreased in this recession is that declines in house and stock market prices have decreased the real wealth of households.

b. Inflation

  • Volatile oil prices caused sharp swings in inflation for all items in 2008.
  • In the current recession, core inflation (all items less food and fuel) has declined slightly.

c. Case Study: A Comparison to Other Financial Crises

  • According to a study summarizing worldwide financial crises, the typical crisis sees an unemployment rate increase of 7 percent for five years, a doubling of government debt, and a 10 percent decline in real GDP.
    • These outcomes are much worse than what the U.S. economy has seen to date.
    • This could mean that this financial crisis will not be as severe, but it may be more likely that a further decline in the economy is yet to come.

d. The Rest of the World

  • Another unique feature of this crisis is its global scope. GDP growth for the world as a whole has decreased dramatically, and the IMF expects world GDP to actually fall in 2009.
    • This means that exports will not be a source of demand for the U.S. or any other economy.

4. Some Fundamentals of Financial Economics

  • It is helpful to understand some basic financial principles in order to understand the crisis as a whole.

a. Balance Sheets

  • The problem lies largely in the balance sheets of banks, households, and governments.
    • A balance sheet is an accounting tool with assets on the left side and liabilities and net worth on the right side; the two sides sum to the same value when net worth is included.
    • Assets are items of value that an institution owns. These may include stocks, bonds, savings accounts, and even one's house.
    • Liabilities represent an amount that is owed to someone else, for example, a loan that a business borrows from a bank in order to expand.
    • Equity is the difference between total assets and total liabilities on a balance sheet. It represents the value of an institution to its shareholders or owners. Also known as net worth or capital.
  • Banks are also subject to a number of financial regulations that apply to their balance sheets.
    • The reserve requirement is a mandate that financial institutions keep a certain fraction, such as 3 percent, of their deposits in a special account with the central bank.
    • The capital requirement is the legal obligation that a financial institution have a certain ratio of its assets supported by capital (net worth) on its balance sheet—for example, 6 percent.

b. Leverage

  • Leverage explains why a relatively small shock to the entire wealth of the United States became a global crisis.
    • Leverage is the ratio of total liabilities to net worth. This ratio magnifies any changes in the value of assets and liabilities in terms of the return to shareholders.
    • This principle also applies to homeowners.
  • If a bank is highly leveraged, it may make large gains off of small increases in market prices, but a small decrease in prices may be enough to wipe out all of its equity.
    • Insolvency or bankruptcy is a situation in which the liabilities of a bank or other company exceed its assets.
  • Before the financial crisis, many investment banks were highly leveraged.

c. Bank Runs and Liquidity Crisis

  • The Great Depression of the 1930s was caused by nearly all depositors converging on banks at once and demanding the return of their deposits.
    • A bank run is a situation in which depositors or creditors worry about a financial institution's solvency and its ability to repay its deposits or short-term debt. Depositors and lenders may then withdraw their funds simultaneously. To the extent that the financial institution has illiquid assets, a worry about this kind of situation could be self-fulfilling. This concern is one motivation for deposit insurance by the government.
  • In the current crisis, a similar problem occurred on the liability side.
    • Financial institutions usually have large amounts of short-term debt, which are often financed by commercial paper.
      • After the collapse of Lehman Brothers, banks became worried about lending commercial paper to other banks that might become insolvent.
      • Interest rates spiked on commercial paper, leading to a liquidity crisis.
    • Banks frantically sold less liquid assets in order to finance daily operations, thereby reducing the value of those assets and risking insolvency.

d. Financial Wrap-Up

  • Leverage can grant amazing returns in good times, but when the market inevitably turns downward, it leads to huge losses. Because the financial system is so integrated, problems with the solvency of only a few institutions can threaten the entire system.
    • Systemic risk is a danger to the financial system or economy as a whole when financial institutions are integrated, leveraged, and subject to shocks that affect them as a group.
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