Presentation on theme: "Financial Crises: Why They Occur and What to Do about Them"— Presentation transcript:
1 Financial Crises: Why They Occur and What to Do about Them E. MaskinInstitute for Advanced Study
2 Current financial crisis only latest in long sequencehistory of credit crises goes back hundreds of yearsprobably crises will continue in futureeach crisis somewhat differenteven if we “fix” mortgage loan market in U.S., something else will happenToday’s topic:why do credit market have repeated crises and other markets don’t?why does credit market require substantial intervention (and others don’t)?
3 Why is credit market different? (1) credit lifeblood for rest of economyif crisis in market for wheat, won’t bring down market for automobilesif credit market doesn’t work, enterprises in all markets will have trouble investing and meeting payrolls(2) small shock to credit market often magnifiedif some wheat growers fail, won’t cause other growers to failif some banks fail, may well cause other banks to go under(3) credit market not self-correctingif some wheat growers fail, others will step into breachno outside intervention neededif some banks fail, credit market can get “stuck” - - no banks willing to lend
4 Elaboration on points 2 and 3 Suppose drought wipes out wheat crop in the CaucausesWhat will happen?immediate effect is fall in overall wheat outputbut demand hasn’t changed - - less wheat to go aroundso price of wheat will be bid upinduces other wheat suppliers in Siberia to grow and sell more
5 So wheat market “self-correcting” crop failure hurts consumers in short run - - higher pricesbut high prices induce suppliers to expand outputso effect of drought mitigated in long runGovernment intervention not neededGovernment interference in wheat market likely to make things worseSuppose puts cap on wheat price or taxes “windfall” profitsdiscourages expansion of output that can make up for crop failurethis creates wheat shortage or black market in wheat
6 Credit market is just the opposite Suppose a few banks get into troublemake subprime mortgage loansborrowers can’t repay loans and housing prices fall, so can’t refinancethese banks have other borrowershave to call loans in on these borrowersso borrowers have to scale back activities that depended on these loansthus will have harder time repaying loans from other banksso these other banks now may get into troublemay have to call in loans from their borrowersand refuse to make new loanswhat started as a local problem (subprime mortgage lending) spreads to entire credit marketinitial problem not self-correcting (as in wheat market)gets aggravatedend up with credit crunch
7 markets with significant externalities often don’t work well on own in economics jargon, bank exerts an externality on other banks by calling in loansexternality: effect your actions have on others that you don’t take into accountwhen bank calls in loans, puts other banks in jeopardybut doesn’t factor this effect in when calls in loans (not harmed by it)markets with significant externalities often don’t work well on owntake clean air, for example
8 Why isn’t there a market for clean air? in fact, there is such a market, but so limited we hardly see itsuppose laundry next door to steel plantsmoke from steel plant interferes with laundrylaundry may offer to pay steel plant to reduce smoke (so market for smoke reduction exists)but smoke doesn’t just affect laundry - - affects many othersby paying for reduction, laundry confers benefit on these others (externality)laundry doesn’t take this into accountso likely to underpay for reduction - - smoke not reduced as much as should besolution: government imposes cap or fine on smoke emissions by steel plant
9 Solution for credit market: If some banks get into trouble, government can bail them outinfuse with capital so can continue to lendbut bailout important primarily for other banks that would be hurt if bailed-out banks failed
10 Bailout policy comes at cost: if banks anticipate being bailed out when get in troublehave incentive to take on highly risky loans, e.g., subprime mortgage loans (moral hazard)so solution to financial crisis actually makes crisis more likely!
11 Hence, bailout policy only partial solution Also need to regulate bankse.g., impose rules preventing subprime loansbailouts and regulation go togetherActually, two reasons why regulation neededprospect of bailouts induces banks to make too-risky loansbank ignores externality imposed on other banks by too-risky loans - - undervalues cost of these loans
12 If credit crisis allowed to spread to rest of economy, bailout policy may be insufficient just as important externalities in credit market, important externalities at level of whole economy
13 Suppose one employer lays off workers (because it loses credit line) workers lose incomedemand lessother employers get into troublethey lay off workersSo, “stimulus” for real (nonfinancial) economy neededpurpose: to prop up demand, so employment kept hightemporary measure: until credit market healthy again
14 Well-designed regulation/bailout package can prevent “many” crises from getting started - - rules against subprime loans would have prevented this onecan resolve them if do occurstimulus package needed if bailout applied too latecan’t hope to prevent credit crises completely and still allow for creativitycan’t anticipate all possible innovations by banksso can’t have rules that prevent only harmful innovationsBut can do a lot better than we’ve done this time