1 Financial Crisis (addendum)

Savings and Loan Crisis (the S&L Crisis) Deposit insurance creates moral hazard Relaxed regulation permitted riskier investments S&L in the U.S. speculated on real-estate loans Liabilities were savings deposits Property value bust led 1,043 financial institutions to fail Total cost of S&L crisis was $153 billion (cost to tax payer $124 billion); 2.7 percent of GDP

British Currency Crisis (Black Wednesday) Great Britain joined the European Exchange Rate Mechanism (ERM), which pegged its currency to the DeutschMark Objective was to maintain credibility relative to the DeutschMark Germany raised interest rates out of fear of inflation due to German reunification (1-1 conversion) Great Britain was in a recession Speculative attack led to large loss of reserves Great Britain withdrew from ERM Estimated cost of £3.3 billion George Soros made over $1 billion by selling Sterling short

Economic Crisis in Mexico (Mexican Peso Crisis) Low credibility due to hyperinflation from Fixed exchange rate to the U.S. Dollar Too much stimulation of the economy during 1994 election leading to high spending and deficits Speculative attack led to loss of reserves, which were insufficient to maintain the value of the peso

Asian Financial Crisis Crony capitalism unsound banking led to investments whose rate of return began to fall Fixed exchange rate to the U.S. Dollar Banks borrowed in dollars but lent in local currency, making them susceptible to a currency crisis Speculative attack and “bank run” led to loss of reserves Dramatic rise in problem loans Governments became burdened with bailout expenses IMF engineered bailouts tied to a Structural Adjustment Package requiring reduced govt spending and deficits, allowing banks to fail, and higher interest rates

Russian Financial Crisis (the Ruble Crisis) Fixed exchange rate Chronic fiscal deficit Declining GDP/productivity; low oil prices “Bank Run” to dump Ruble led to large loss of international reserves Russia –Devalued Ruble –Defaulted on domestic debt –Moratorium on payments on foreign debt Quick recovery due to surge in oil prices

7 Value of Russian Rubble

Argentine Financial Crisis Fixed exchange rate to maintain credibility and low inflation following a period of hyperinflation Growing government debt GDP began to decline in 1999 (by 4%) Loss of confidence and capital flight led to a rise in interest payments that worsened the fiscal situation Domestic run on banks to convert pesos to dollars, leading eventually to conversion of all dollar accounts to peso accounts IMF provided loans to allow an injection of dollars Fixed exchange rate abandoned in Jan 2002 Led to very severe recession

Global Financial Crisis Excessive leverage by financial institutions Maturity mismatch and excessive dependence of real estate Credit rating mistakes permitted risky mortgage-related investments Collapse of real estate led to classic “bank run” that dried up funding by non-bank financial institutions Shortage of liquidity

? European Sovereign Debt Crisis Low interest rates due to membership in EU Large fiscal deficits and consequent large debt/gdp levels worldwide, but especially in Portugal, Italy, Greece, and Spain Stagnant GDP growth and weak government response Rising interest payments on sovereign debt to reflect default risk Lack of independent monetary policy to stimulate the economy or devalue the debt Reluctance by EU to bailout without significant reforms