blanchard crisis

Blanchard, Amighini and Giavazzi, Macroeconomics: A European Perspective, 1st Edition, © Pearson Education Limited 2010

CHAPTER 20THE CRISIS OF 2007–2010

20-1 What Cannot Keep Going Eventually Stops

‘If these things were so large, how come everyone missed them?’

Question asked by Her Majesty The Queen to the LSE professorsduring a visit to the School in November 2008

The origin of this recession was a financial crisis which started in the USA in the summer of 2007.

The financial crisis started in the so-called ‘sub-prime mortgage’ market, a small part of the US housing mortgages market intended for borrowers with a relatively high probability of eventually not being able to repay their loan.

Figure 20.1b House price movementsThe price of US houses since 1890 adjusted for inflationSource: Bank for International Settlement

20-1 What Cannot Keep Going Eventually Stops

Figure 20.2a The economic crisis of 2007–2009 and its effect on the global economyThe performance of the US economy in 2007–2009Source: IMF World Economic Outlook 2009

20-1 What Cannot Keep Going Eventually Stops (Continued)

Figure 20.2b The economic crisis of 2007–2009 and its effect on the global economyThe world economy in the crisisSource: IMF World Economic Outlook 2009

20-1 What Cannot Keep Going Eventually Stops (Continued)

20-2 Households ‘Under Water’

Why did the value of houses shoot up after 2000? Why were the effects of the fall in house price so dramatic?• The increase in house prices was also the effect of a long

period of extremely low interest rates which made borrowing to buy a house very attractive.

• Borrowing to buy a house was also encouraged by a change in the rules banks followed to approve a mortgage, which became much less strict.

• Banks became much less careful when they were making a loan.

• The moment house prices start falling some households go ‘under water’!

• Households have an incentive to ‘walk away’ from their home.

• The mortgage then goes into default and the house is ‘foreclosed’.

• Because the value of the house is smaller than the value of the loan which was originally granted, the bank makes a loss.

20-2 Households ‘Under Water’ (Continued)

Figure 20.3b Defaults on US sub-prime mortgagesHomeowners with negative equity (who own more on their mortgages than their homes are worth; millions) (per cent of all homeowners – data are for 2008; thereafter estimates)Source: IMF World Economic Outlook 2009

20-2 Households ‘Under Water’ (Continued)

Securitisation is a Great Invention –Provided it is Done Right

Banks should never lose the incentive to check the quality of their clients. This can easily be done, for instance by allowing a bank to sell only a fraction of each loan it has made (say, no more than 90%),thus remaining exposed to some of the risk.

Figure 20.4 The growth of securitisation (annual issues by type of security)Source: IMF World Economic Outlook 2009

20-3 Leverage And Amplification

To understand how the effect of the fall in house prices was amplified to the point of inducing a sharp recession, we need to introduce the concept of ‘leverage’.

A high leverage ratio is risky: in the event of a drop in the value of its assets, the bank might become insolvent.However banks like having a high leverage ratio!

As long as house prices were rising, by keeping their leverage, high banks could earn huge profits and none failed. But this long honeymoon did not last, and many banks were bankrupt.

28-3 Amplification Mechanisms. Leverage, Complexity, and Liquidity

Leverage

Bank A has assets of 100, liabilities of 80, and capital of 20. Its capital ratio is defined as the ratio of capital to assets and is thus equal to 20%. Its leverage ratio is defined as the ratio of assets to capital (the inverse of the capital ratio) and is thus equal to 5. Bank B has assets of 100, liabilities of 95, and capital of 5. Thus, its capital ratio is equal to 5%, and its leverage ratio to 20.

Bank assets, capital, and liabilities.

Figure 28 – 4

The two banks have the same assets. But Bank B has a smaller capital ratio—equivalently a higher leverage ratio than Bank A.

Now suppose that some of the assets in each of the two banks go bad. For example, some borrowers go bankrupt and cannot repay their loans.Suppose, as a result, that for both banks, the value of the assets decreases from 100 to 90. Bank A now has assets of 90, liabilities of 80, and capital of 90 – 80 = 10. Bank B has assets of 90, liabilities of 95, and thus negative capital of 5 (90-95). Its liabilities exceed its assets: In other words, it is bankrupt.

Leverage

Figure 28 – 4 (continued)

Higher leverage means higher expected profit. Suppose for example that assets pay an expected rate of return of 5%, and liabilities pay an expected rate of return of 4%. Then the owners of bank A have an expected rate of return on their capital of (100 * 5% – 80 * 4%)/20 = 9%, the owners of Bank B have an expected rate of return of (100 * 5% – 95 * 4%)/5 = 24%, so more than twice as high.

Leverage

Figure 28 – 4 (continued)

The lesson is simple: When financial intermediaries have a lot of capital—equivalently when their leverage is low—they can absorb losses without going bankrupt. But when they have little capital, when they are highly leveraged, even small losses can lead to bankruptcy.

Leverage

When the value of their assets fell, some banks with high leverage went bust. These obviously stopped lending. But also the banks which had enough capital and survived started worrying. The result was a credit freeze and a fire sale in the stock market.

20-3 Leverage And Amplification (Continued)

Figure 20.5 Credit to the private non-financial sectorSource: Bank for International Settlements, 2009 Annual Report

20-4 Investment Demand, with Banks as Intermediaries

The rate at which banks lend to firms,ρ, is usually equal to the rate savers receive plus a spread, x:

Investment demand therefore depends on the cost of bank loans:

The spread x depends on two factors:• Banks’ capital, • Firms’ capital,

20-4 Investment Demand, with Banks as Intermediaries (Continued)

Figure 20.6 Goods and financial market equilibrium following a fall in banks’ capital which raises the external finance premium

Figure 20.7 The external finance premium and the collapse of investment expenditure(a) Corporate bonds (investment grade): spreads in the euro area, the UK and the USA. (b) Capital goods ordersSources: IMF and Bank for International Settlements, 2009 Annual Report

20-4 Investment Demand, with Banks as Intermediaries (Continued)

20-5 international Contagion

The main channel of transmission was trade.

Figure 20.8 The collapse of US merchandise imports in 2009Source: WTO, Short-term merchandise trade statistics, available at www.wto.org

20-5 international Contagion (Continued)

Figure 20.9 The collapse in world trade in 2009Source: IMF World Economic Outlook

20-6 Policy Response to the Crisis

Central banks used monetary policy to slash interest rates to close to zero.Governments used fiscal policy to replace private with public demand, trying to replace the fall in private consumption and private investment with higher government spending.

Did policy work, i.e. was the intervention by governments and central banks effective at limiting the effect of the financial crisis on output and employment?

20-6 Policy Response to the Crisis (Continued)

Figure 20.11 Monetary policy in the presence of a liquidity trap

The Bank of England, for instance-in March 2009, started to buy assets from the private sector. By September 2009, these assets accounted for almost all assets held by the Bank of England.Policy intervention did work to avoid a depression.

Figure 20.12 Quantitative easing in the UKLoans to APF are the loans the Bank of England made to the legal entity (the Asset Purchase Facility) in charge of buying assets from the market on behalf of the BankSource: Bank of England

20-6 Policy Response to the Crisis (Continued)

20-7 The Legacy of the Crisis

Once the world economy emerges from the recession, two legacies will remain:

• Expansionary monetary policies will translate into higher inflation.

• Expansionary fiscal policies will cause an increase in government debt across advanced economies.

20-7 The Legacy of the Crisis (Continued)

Figure 20.15 Legacies of the crisis: public debtSource: IMF, World Economic Outlook, July 2009 update, Fig. 1.14

Key Terms

• Sub-prime mortgages• Regulation • Quantitative easing

blanchard crisis

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