CH-20 The Financial System: Opportunities and Dangers – Macroeconomics : Chapter Notes

CHAPTER 20 The Financial System: Opportunities and Dangers Notes to the Instructor Chapter Summary This chapter focuses on the financial system. It provides an overview of the key elements and functions of the financial system along with a discussion of problems arising in financial markets due to asymmetric information. This chapter also describes how government policy can improve the functioning of the financial system by creating incentives for saving to be channeled into the best investments. The chapter closes with an extended discussion of financial crises and the tools policymakers use both for responding to such crises and for trying to prevent them. Comments The material presented in this chapter is intended to provide an overview of the financial system and financial crises. Instructors should have a relatively easy time covering this material, probably doing so in one to two classes. The discussion of asymmetric information may be new to many students, and so that section of the chapter may require additional emphasis by the instructor. The analysis of how financial markets can enhance an economy’s long-run growth provides the opportunity for drawing connections with the models of economic growth presented in Chapters 8 and 9. Some instructors may find it useful to review quickly the standard Solow growth model when teaching this section of the chapter. The case studies for this chapter cover the role of microfinance in economic development and provide important details about recent financial crises in the United States and Europe. Use of the Dismal Scientist Web Site Go to the Dismal Scientist Web site and download annual data on bond yields for Moody’s Aaa bonds and Baa bonds from the past five years. Use the last day of the year in each case. Compare the yields, noting in particular how the difference (spread) between these yields has changed. Can you relate the pattern in the yield spread to the onset of the financial crisis in 2008–2009? As a second exercise, download monthly data over the past five years for the money supply (M1) and for the monetary base. Graph the ratio of the money supply to the monetary base. Discuss the sharp decline in this ratio, which represents the money supply multiplier, during the financial crisis of 2008–2009. Now download data on bank reserves, currency held by the public, and bank deposits (M1) for the same time period. Graph the currency–deposit ratio and the reserve– deposit ratio. From these data, can you explain why the money supply multiplier declined so much? 477 Chapter Supplements This chapter includes the following supplements: 20-1 The Perils of Employee Stock Ownership 20-2 How Does Financial Development Affect Growth? 20-3 Does Financial Development Cause Growth? 20-4 Financial Development and Industrial Structure 20-5 Unit Banking and Economic Growth 20-6 The Money Multiplier During the Financial Crisis of 2008–2009 20-7 Banks Hoard Reserves During the Financial Crisis 20-8 The Fed’s Senior Loan Officer Survey 20-9 The Tax Treatment of Housing 20-10 More on the Fed’s Rescue Programs 20-11 Exit Strategies for the Fed 20-12 Greenspan Warns About Government Budget Surpluses 20-13 The Squam Lake Report 20-14 Additional Readings Lecture Notes Introduction The financial system is an integral part of the economy. When the system functions properly, it channels funds from savers to investors. By increasing productivity, the financial system helps spur economic growth and raise the standard of living. Sometimes, however, the system breaks down. The financial crisis of 2008–2009 is a very stark example of a breakdown, with consequences that resulted in a deep recession. This chapter introduces the topic of the financial system and discusses in detail the problems that sometimes arise when the system experiences crises. 20-1 What Does the Financial System Do? The financial system is a general term for the set of institutions in the economy that help allocate funds from savers to investors and provide a means for households and firms to share risk. Financing Investment Earlier in the text, the financial system was modeled as a single market for loanable funds whereby saving was channeled into investment projects. In practice, the financial system is more complex and involves a variety of mechanisms for allocating saving. One component of the financial system is the set of financial markets, which allow households to directly invest their saving by purchasing securities. Two important kinds of securities traded on financial markets are bonds and stocks. Bonds are securities that promise to pay the buyer a set amount of money at certain times in the future and are issued by corporations and governments. Stocks are ownership shares in corporations. Similar to a bond, a share of stock entitles its holder to a flow of income. But unlike a bond that pays a set amount to its holder, a share of stock pays an uncertain amount to its holder, which varies with the performance of the corporation. Raising investment funds by issuing bonds is known as debt finance, and raising funds by issuing stock is known as equity finance. Debt and equity are types of direct finance because the person purchasing the bond or stock knows the investment project his saving finances. But note that when a person purchases stock on a stock exchange (or a bond from an existing bondholder), no new funds are raised—only a change in ownership of the security occurs. Another component of the financial system is the set of financial intermediaries, which provide households an indirect means for investing their saving. A bank is one type of financial intermediary. Banks raise funds by accepting deposits, which include checking and saving deposits that people and firms use to make payments, and then loan out these funds to companies and individuals. Other types of financial intermediaries include mutual funds, pension funds, and insurance companies. Unlike purchases of stocks or bonds in financial markets, a saver using a financial intermediary is generally unaware of the investments that their saving is funding, and so this is considered indirect financing. Sharing Risk The financial system provides a mechanism for helping people share risks. Even if someone Supplement 20-1, could finance an investment project out of his own saving, he might not to do so because of the “The Perils of Employee Stock risk that the project might not pay off. Such a person might prefer to share the risk instead of Ownership” bearing it by himself, because he is risk averse. Financial markets allow an investor to share this risk with other people who buy securities issued by the investor. And the investor may decide to purchase securities in other companies with some of his own saving, achieving diversification of wealth among many assets. Diversification allows savers to earn good returns from securities while limiting the risk of loss. Financial intermediaries also promote diversification, with mutual funds being among the most important. Mutual funds sell shares to savers and then use these funds to purchase securities from a large number of businesses. This reduces risk because it is unlikely that the fortunes of all of these businesses will rise and fall together. But diversification has its limits: Although it can eliminate most of the idiosyncratic risk associated with an individual business, it cannot reduce systematic risk whereby macroeconomic events (for example, a recession) affect many businesses simultaneously. Dealing with Asymmetric Information Because the amount stocks pay varies with the performance of a corporation, while the amount bonds pay does not, stocks generally are riskier than bonds. Bondholders also get paid before stockholders in the event of a bankruptcy, making stocks again more risky, but bondholders still might receive little or nothing back if the debt issuer goes out of business. Compounding the difficulties savers face when assessing the risks of competing investment projects are problems associated with asymmetric information. These problems occur because investors generally have more information about their investment project than the savers who provide the funds. Two types of asymmetric information are relevant: adverse selection and moral hazard. Adverse selection in financial markets occurs when the seller of securities has more information than the buyers of securities so that the buyers run the risk of overpaying for the securities. In other words, a firm is more willing to issue stocks and bonds when its prospects are poor, so that earnings on its stock are likely to be low and default risk on its bonds is high. This creates a problem for buyers of these securities, since they have less information about the firm’s prospects than the firm itself. In some cases, this may lead to buyers’ being unwilling to purchase securities from sellers. Similarly, a financial intermediary such as a bank may not be willing to make a loan if it is unsure about the borrower’s prospects. The second problem associated with asymmetric information in financial markets is moral hazard, which occurs after a transaction has been made. Here, the risk is that the seller of securities may take actions to reduce the value of the securities, hurting the buyers of these securities. The buyers lack information on the seller’s behavior that is needed to prevent this from occurring. Since buyers are aware that they cannot control the seller’s behavior, this problem in some cases may lead to buyers’ initially refusing to purchase securities from the seller. The same concerns may cause a bank to deny a loan request. The financial system has developed ways to limit the effects of adverse selection and moral hazard. For example, banks require detailed review of loan applications by lending officers who are skilled at evaluating businesses, thereby reducing concerns about adverse selection. Likewise, bank loans often have clauses that restrict how the proceeds may be spent, and lending officers may check on the business after the loan is made, helping reduce moral hazard. Banks charge fees reflected in the spread between the interest rate charged on loans and the interest rate paid on deposits as compensation for reducing these problems associated with asymmetric information. Fostering Economic Growth By channeling funds from savers to investors with good projects, the financial system increases Supplement 20-2, overall productivity for the economy and leads to a rise in living standards. Chapters 8 and 9 of “How Does Financial the text discuss the Solow growth model, where output per worker depends positively on the rate Development of saving. But that discussion glossed over the important issues raised in this chapter by Affect Growth?” assuming that saving automatically flows to investors with the most productive projects. In reality, the most productive investors receive funds only if the financial system works well. An economy might have a high saving rate but remain poor if saving does not flow to its most productive use. Financial systems vary greatly across countries. Some, like the United States, have large stock and bond markets and banks that provide lots of funds. Other countries have relatively underdeveloped financial systems, in which issuing securities or obtaining bank loans is difficult so that investors have trouble obtaining funds for their projects. These differences across countries are due in part to differences in the degree of government regulation, which can reduce problems associated with asymmetric information. In securities markets, for example, disclosure requirements for public companies can lessen adverse selection so that savers are more willing to purchase securities. Likewise, the government efforts in prosecuting fraud and other financial crimes help reduce moral hazard. Finally, deposit insurance helps offset losses if a bank fails, lessening the consequences of adverse selection and moral hazard, making savers more likely to deposit funds into banks. As noted, the degree of development of financial systems varies across countries, in part Supplement 20-3, “Does Financial due to differences in the quality of legal institutions. This variation in financial systems is a Development source of variation in living standards. Higher-income countries tend to have a larger stock Cause Growth?” market capitalization (the value of all stocks issued by companies in the country as a share of GDP) as compared with lower-income countries. Likewise, higher-income countries tend to have a larger value of bank loans relative to GDP as compared with poorer countries. But analyses of the connection between the financial system and income levels need to Supplement 20-4, carefully assess causality. Financial development could cause economic growth, but countries “Financial might grow wealthier for other reasons, and the growth itself could then lead to a more- Development and developed financial system. Or a third factor might affect both growth and financial Industrial Structure” development. Even so, many economists believe that poor nations can boost their growth Supplement 20-5, prospects by reforming their legal institutions so as to improve the functioning of their financial “Unit Banking and system. Economic Growth” Case Study: Microfinance: Professor Yunus’s Profound Idea Muhammad Yunus, an economics professor in Bangladesh, founded the Grameen Bank in 1976 with the goal of providing small business loans to poor entrepreneurs, especially women, who could not obtain funds elsewhere. Microfinance loans aim to lift people out of poverty by providing financial support in situations where traditional bank loans are not available and other loans are much too expensive in terms of the interest cost. Today, microfinance institutions (MFIs) exist in many countries and even in poor neighborhoods of New York and other U.S. cities, providing funds to millions of borrowers. MFIs often require people to borrow money in groups, helping lower the cost of making loans. And MFIs stop financing the entire group if just a single borrower defaults, thereby using peer pressure to help reduce the moral hazard problem of borrowers’ squandering their loans. Default rates on microfinance loans are low, averaging between 2 percent and 5 percent at many MFIs. In recognition that many people believe microfinance has helped to reduce poverty, Muhammad Yunus and the Grameen Bank received the Nobel Peace Prize in 2006 for their work. 20-2 Financial Crises Sometimes the financial system breaks down, leading to severe macroeconomic consequences. A financial crisis is significant disruption of the financial system that limits intermediation between savers and investors. Many of the deepest recessions have occurred following crises in the financial system, including the Great Depression of the 1930s and the recent recession of 2008–2009. The Anatomy of a Crisis Although no two financial crises are exactly the same, some basic elements are common in nearly all crises. The crisis first affects the financial system and then spills over into the economy as the crisis worsens. 1. Asset-Price Booms and Busts. Financial crises are typically preceded by a period of optimism, leading to large increases in asset prices. In some cases, the price of an asset rises above its true value based on objective assessment of its expected future cash flow, giving rise to a speculative bubble. When optimism shifts to pessimism, the bubble bursts and asset prices begin to decline. This may happen rapidly or over an extended period of time. During the financial crisis of 2008–2009, house prices declined sharply after having experienced a boom earlier in the decade. The boom resulted in part from relaxed lending standards, which were reflected in increased numbers of subprime mortgage loans. Government policy encouraging home ownership and the unwarranted belief by homebuyers that prices would continue to rise also fueled the bubble. The financial system failed to effectively handle the problem of asymmetric information when it made loans to borrowers who later had trouble making mortgage payments. As the number of homeowners falling behind on their mortgage payments increased, optimism faded among homebuyers, and prices fell. The United States had not witnessed such a broad-based and large decline in housing prices since the Great Depression. 2. Insolvencies at Financial Institutions. Failures of financial institutions often accompany assetprice declines, when the institutions’ assets fall below the value of liabilities. As discussed in Chapter 4, the use of leverage by banks magnifies the effect of changes in asset values on the banks’ financial condition. A commercial bank may become insolvent because of loan defaults, increases in interest rates, or other events, triggering regulators to force closure. Other financial institutions can also become insolvent when the value of their assets decline and their net worth turns negative, forcing them out of business. Because financial institutions have debts to one another, insolvency can easily spread when one institution no longer makes payments on its debts to others. During the mid- to late-2000s, numerous banks and financial firms had invested in mortgages backed by residential real estate. As housing prices declined, large numbers of homeowners found they owed more on their mortgage than their houses were worth. Many of these homeowners defaulted on their mortgages, leading banks to foreclose on the loans. The banks recovered only a small part of what they were owed, and these defaults moved several financial institutions toward bankruptcy. 3. Falling Confidence. When an institution is solvent but doesn’t have enough liquid assets to make the payments it has promised, it can be forced into failure if its creditors demand payment, triggering a fire sale of illiquid assets at prices below their true value. Although government deposit insurance helps prevent this from happening, not all deposits are insured. With insolvency rising among financial institutions, speculation grows about which institution will be the next to go bankrupt. People pull their money out of uninsured deposits, forcing banks to cut lending and sell assets. Declining asset prices in turn affect other banks because they are required to revise their balance sheets to reflect the lower value of their assets. Nondepository institutions, such as hedge funds and investment banks, also experience liquidity crises when they cannot raise funds to pay off maturing debts. These institutions often borrow by taking out short-term loans and issuing commercial paper. When creditors lose confidence and these sources of funds dry up, the institution can be forced into a fire sale of assets and become insolvent. During the financial crisis of 2008–2009, the financial system faced huge uncertainty about how far insolvency would spread. And because the major financial firms had many contracts with each other, fears arose that this interdependence meant the entire system was in danger. Supplement 20-6, 4. Credit Crunch. With many financial institutions in trouble, households and firms find it more “The Money difficult to borrow money, leading to a credit crunch in which some borrowers are unable to Multiplier During borrow or must pay high interest rates. Because the value of borrowers’ collateral has declined the Financial with the general decline in asset prices, banks and other institutions are reluctant to lend. Crisis of 2008— 2009” Outright failures of financial institutions also can cause a credit crunch. A failed commercial bank stops lending and leads other commercial banks to adopt more conservative lending practices. A failed investment bank no longer provides securitization services and thus reduces funds available to banks for loans. Banks tightened mortgage credit during the financial crisis of 2008–2009 as they realized Supplement 20-7, “Banks Hoard housing prices were falling and previous lending standards had been too loose. In addition, small Reserves During businesses faced tighter credit standards, and consumers found it harder to qualify for a credit the Financial card or a car loan. Overall, banks responded to their financial troubles by instituting tougher Crisis” conditions on lending. Supplement 20-8, “The Fed’s Senior 5. Recession. When a credit crunch occurs, firms and individuals who rely on borrowing are Loan Officer forced to reduce spending. The inability to obtain financing lowers consumer and investment Survey” spending, pushing the economy into recession. In addition, the decline in asset prices can lead to a direct drop in aggregate demand. This occurs in part through a fall in wealth, which reduces consumer spending. The decline in asset prices also can reduce confidence and increase uncertainty, leading firms and consumers to reduce their spending. Figure 20-2 The recession that followed the crisis of 2008–2009 was quite severe, with unemployment rising above 10 percent and lingering at high levels for years. 6. A Vicious Circle. The recession that develops can exacerbate the financial crisis because stock prices may fall further once firms’ expected profits are lower, and diminished demand for real estate may cause real estate prices to decline. A reduction in demand for loans due to the recession can worsen the financial condition of financial firms, leading to additional bank failures. And high unemployment itself leads to increased defaults on loans, further weakening financial firms. A vicious circle sets in that deepens the recession. Figure 20-1 FYI: The TED Spread Credit risk can be measured by the spread between two interest rates on assets of similar maturity. One closely followed interest rate spread is the so-called TED spread. This spread is the difference between the interest rate on three-month interbank loans (Eurodollars in London) and the interest rate on three-month U.S. Treasury bills. During the financial crisis of 2008– 2009, the TED spread jumped to almost 500 basis points (5 percentage points) from its usual range of 10–50 basis points, indicating how concerned investors were about the solvency of the banking system. Case Study: Who Should Be Blamed for the Financial Crisis of 2008–2009? Many groups bear some responsibility for the financial crisis. The Federal Reserve kept interest rates low for an extended period of time following the 2001 recession. Low interest rates helped fuel household borrowing and the housing bubble. Homebuyers themselves sometimes borrowed more than they could afford or bought houses in the belief that prices would keep rising at a rapid pace. The sharp decline in housing prices led these homeowners to default on their mortgages. Mortgage brokers encouraged excessive borrowing by providing mortgage products with low initial interest rates that later rose sharply and by offering no-documentation loans to households who otherwise wouldn’t qualify for mortgages because they had no income or assets. Investment banks packaged risky mortgages into securities and sold them to unwitting investors. Rating agencies gave high ratings to some mortgage-backed securities that actually were quite risky. Regulators allowed banks and other financial institutions to take on (what turned out to be) large risks because they did not believe a substantial decline in housing prices could happen. They also did not anticipate the systemic effects such a decline would have if it did occur. Government policymakers have for many years encouraged homeownership through tax policy Supplement 20-9, “The Tax and the government-sponsored enterprises Fannie Mae and Freddie Mac, which promote Treatment of mortgage lending. These efforts to encourage homeownership led to riskier borrowers getting Housing”” mortgages. In the end, rather than assess blame for this particular crisis, we perhaps should instead view financial crises as rare but intrinsic events of market economies and focus on how policymakers can respond to such crises when they occur. Policy Responses to a Crisis Because financial crises usually are deep and multidimensional, policymakers use a number of tools, often at the same time, to limit the damage. Conventional monetary and fiscal policy can be used to support aggregate demand and employment, helping to lessen the economic recession that results from a crisis. During the financial crisis of 2008–2009, policymakers acted to boost aggregate demand. The Fed cut its target for the federal funds rate from 5.25 percent in September 2007 to near zero in December Supplement 20-10, “More on the Fed’s Rescue Programs” Supplement 20-11, “Exit Strategies for the Fed” 2008 and then kept it at that level for the next three years. Presidents Bush and Obama both signed legislation that provided fiscal stimulus to the economy. Conventional policies, however, have limits: A central bank cannot cut its target for the interest rate below zero, and fiscal stimulus adds to the budget deficit. Increases in government debt may raise concern that future generations will be burdened in paying it off, and a large enough increase in the debt may call into question a government’s solvency. Following the crisis of 2008–2009, the federal government’s budget deficit reached a post–World War II high, spurring calls by some politicians to cut government spending. And in August 2011, Standard & Poor’s lowered its rating on U.S. government debt below the top grade for the first time in history, limiting (although probably only slightly) the government’s ability to pursue additional fiscal stimulus. The central bank can act as a lender of last resort to financial institutions, helping prevent liquidity crises from leading to insolvency. Typically, this role involves the central bank’s lending directly to a commercial bank that is experiencing large and sudden withdrawals. Even if the bank is solvent, in the sense that assets exceed liabilities, it may be unable to easily sell assets to pay for these withdrawals if its assets are illiquid. The central bank’s loan allows the bank to avoid a fire sale of assets, which would lower their value and threaten the bank’s solvency. During 2008 and 2009, the Fed set up new ways to lend in addition to its usual discount window and provided funds not only to conventional banks but also other financial institutions sometimes called shadow banks. One example are the loans the Fed made to money market mutual funds from October 2008 to October 2009, when these funds were experiencing large withdrawals. The withdrawals meant that money market funds were less able to purchase commercial paper, which made it difficult for firms to finance their business operations. By making loans to these money market funds and accepting commercial paper as collateral, the Fed helped support this type of financial intermediation. A number of other lending facilities were developed by the Fed during the crisis to maintain liquidity for the financial system. Many of these were closed down as the economy began to recover. Injections of government funds can be used in a financial crisis to help support the financial system. The most direct approach is to give public funds to those who have experienced losses—deposit insurance being one example. During the financial crisis in 2008, the Federal Deposit Insurance Corporation (FDIC) increased the coverage amount for deposits from $100,000 to $250,000 in an attempt to reassure bank depositors that their funds were safe. A more discretionary approach is to give away funds to prevent the failure of a large, troubled financial institution and avert the consequences such failure would have for the overall financial system. This occurred in 1984 during the rescue of Continental Illinois National Bank and Trust Company, which cost taxpayers about $1 billion and led to a congressman coining the phrase “too big to fail.” Instead of outright giveaways, the government might make risky loans. Usually, when the Fed makes loans to financial institutions as a lender of last resort, it requires good collateral. But during the financial crisis of 2008–2009, the Fed made loans to institutions in return for low-quality collateral in the form of risky mortgage-backed securities. This was done to assist JPMorgan Chase in its purchase of a nearly insolvent Bear Stearns ($29 billion) and to prevent the collapse of AIG ($85 billion), an insurance company that faced huge losses from credit default swaps on mortgage-backed securities. A final approach is to use public funds to purchase ownership stakes in financial institutions. The AIG loans in 2008 were partly of this form in that the government received warrants (options to purchase stock) and ultimately owned most of the company. An even clearer example was the Troubled Asset Relief Program (TARP) organized by the U.S. Treasury in 2008 and 2009, which injected capital into banks in return for stock. The aim of the TARP was to keep banks solvent and the financial intermediation process working. The use of public funds to support the financial system is controversial, and critics have argued that taxpayers shouldn’t be forced to pay for the mistakes of financial market players. Some critics also point to the possibility that financial bailouts may increase moral hazard. While recognizing these concerns, advocates note that risky lending and capital injections may actually pay off for taxpayers once the economy recovers, and the benefit of avoiding an even deeper economic downturn is worth the cost of these policies. Policies to Prevent Crises Supplement 20-12, “Greenspan Warns Besides the debate over how best to respond to a crisis once it has begun, another key policy About Government question is how policymakers can best prevent crises from happening in the future. In response Budget Surpluses” to the financial crisis of 2008–2009, policymakers have been assessing options in four areas and, in some instances, have revised their policies. Focusing on Shadow Banks. Traditional banks are heavily regulated in part because of the moral hazard problem that arises when the government insures bank deposits in an effort to limit bank runs. Government regulation limits this moral hazard problem by restricting the risks that banks can take. But during 2008–2009, the central players in the crisis were not traditional banks but shadow banks, which are financial institutions that perform intermediation functions but do not take in deposits insured by the FDIC. Investment banks, hedge funds, insurance companies, and private equity firms can be viewed as shadow banks. Although these institutions do not face the moral hazard problem resulting from deposit insurance, the risks they take may still be a concern because failure of these institutions can have macroeconomic effects. Some policymakers have proposed limiting the amount of risk these institutions can take on by requiring that they hold more capital, thereby restricting their use of leverage. Another concern is what should happen to these institutions if they are close to insolvency. The Dodd-Frank Act, which was passed by Congress and signed into law by President Obama in 2010, extended resolution authority of the FDIC to include shadow banks. Just like with traditional banks, the FDIC can now take over and close a troubled nonbank financial institution if the FDIC fears the institution’s failure could cause systemic risk for the economy. Supporters of the law believe that a more orderly resolution process helps maintain confidence in the financial system, but opponents fear it will make taxpayer-funded bailouts more likely and worsen the moral hazard problem for these institutions. Restricting Size. Some have proposed restricting the size of financial institutions to prevent them from becoming too big to fail. One approach would restrict mergers among these institutions. Another approach would require higher capital requirements for larger institutions. Advocates argue that a financial system with smaller firms will be more stable because failure of one firm won’t have economy-wide repercussions. Opponents note that smaller institutions can’t reap the economies of scale that larger ones can, raising costs to consumers of financial services. Reducing Excessive Risk Taking. Some have argued that financial firms failed during the crisis of 2008–2009 because they took on excessive risk. But exactly what is too much risk is difficult to judge in an industry where risk taking is part of its function. The DoddFrank Act included provisions intended to limit risk taking by financial institutions. One provision is the so-called Volcker Rule (named after former Fed Chairman Paul Volcker, who proposed it), which restricts commercial banks from making certain types of speculative investments. Supporters argue the rule will protect banks, but critics fear such restrictions will reduce liquidity in markets for speculative financial instruments. Making Regulation Work Better. Because the financial system developed over Supplement 20-13, many years, the regulatory structure is highly fragmented, with different agencies overseeing “The Squam Lake different types of financial institutions. The Fed, the Office of the Comptroller of the Currency, Report” and the FDIC are all involved with overseeing commercial banks. The Securities and Exchange Commission regulates investment banks and mutual funds. Other agencies regulate futures markets. State agencies oversee insurance companies. The Dodd-Frank Act tried to improve the system of regulation by creating the Financial Services Oversight Council, chaired by the Secretary of the Treasury, to coordinate policy across the various regulatory agencies. The Dodd-Frank Act also established a new Office of Credit Ratings to monitor private credit-rating companies. In addition, the Dodd-Frank Act created a new Consumer Financial Protection Bureau to provide fairness and transparency in the way financial institutions market products to consumers. Taking a Macro View of Regulation. The traditional approach to financial regulation has been microprudential, with the goal of reducing the risk of problems developing at individual financial institutions and helping to protect depositors and other stakeholders. In recent years, regulation has also been macroprudential, with the aim of reducing system-wide distress and insulating the economy from declines in output and employment. Some people argue that macroprudential regulation might have dampened the run-up in real estate prices and their subsequent decline that sparked the 2008–2009 financial crisis. For example, regulators could have required larger down payments for home purchases as house prices increased, thereby limiting the mortgage exposure of households and leading to fewer mortgage defaults as house prices fell. Other people question whether government regulators are prescient enough to identify and offset economy-wide risks. Some fear that such efforts might only add to the regulatory burden, for example, by limiting the ability of less-wealthy households to purchase homes. FYI: CoCo Bonds One proposal for reforming the financial system is to introduce a new type of financial instrument known as “contingent, convertible debt,” sometimes called CoCo bonds. Financial institutions would sell debt that can be converted into equity when the institutions are judged to have insufficient capital. Effectively, this would represent a recapitalization of financial institutions during a financial crisis, similar to what happened in 2008–2009. But unlike the rescues that occurred then, the recapitalization would use private rather than taxpayer funds. Some bankers oppose this proposal because these CoCo bonds would have to pay a higher interest rate to buyers than conventional debt (thereby lowering the bankers’ profits), since the buyers are taking on the risk that their bond will be converted to equity in a crisis. But these bonds would give financial institutions an incentive to limit risk (for example, by reducing leverage and instituting strict lending standards), thereby reducing the probability that conversion actually would occur, which in turn would reduce the cost of this “insurance.” By encouraging financial institutions to limit the risks they take, these bonds could lower the overall likelihood of financial crises. CoCo bonds are a relatively new financial innovation, with the European Banking Authority establishing guidelines for issuance of such bonds in 2011. Offerings of these bonds rose from about zero in 2010 to $64 billion in 2014. Case Study: The European Sovereign Debt Crisis During early 2010, the belief that the central governments of Europe would honor their debt obligations came into question with the recognition that Greece’s debt had risen to 116 percent of GDP, well above the European average of 58 percent. In addition, evidence emerged that Greece had misreported its finances for many years and had no credible plan for slowing the rise of its debt. Standard & Poor’s lowered Greece’s credit rating to junk status. Fear of possible default sent the prices of Greek debt plummeting, and the interest rate on new borrowing soared. By November 2011, the interest rate was over 100 percent. Many European banks held Greek debt and as its value fell, these banks moved toward insolvency. Policymakers feared that an outright Greek default could lead to bank failures, a more general crisis in confidence, a credit crunch, and an economic recession. Some feared the breakup of the eurozone might occur with Greece, and possibly other members, abandoning the common currency known as the euro and returning to their own national currencies. Governments in the stronger European economies, such as Germany and France, arranged loans to Greece to forestall immediate default. These loans were not popular with voters in Germany or France, who felt their tax dollars shouldn’t be used to bail out a profligate Greek government. At the same time, voters in Greece also were dissatisfied with the austerity conditions (cuts in spending and increases in taxes) that accompanied the loans. And Greece was not the only country with these problems. Fears increased that if Greece were allowed to default, other countries—including Portugal, Ireland, Spain, and Italy—would follow. A decline in the value of sovereign debt for all of these countries would threaten the European banking system and, with it, the rest of the world as well. The policy response to the crisis did succeed in maintaining the monetary union. But the economic fallout from the crisis was significant. As of late 2014, the unemployment rate was 25 percent in Greece, 24 percent in Spain, and 14 percent in Portugal. The continuing economic weakness reduced inflation in Europe to nearly zero at the end of 2014, far below the European Central Bank’s target of 2 percent. In response to concern that deflation might take hold, the European Central Bank cut its policy rate to zero and in early 2015 embarked on a program of asset purchases known as quantitative easing. How the crisis will evolve is uncertain. As this edition heads to press, negotiations aimed at reducing what Greece owes are making progress. Yet much remains to be decided in terms of how much the richer countries of Europe ultimately will contribute to help solve Greece’s fiscal problems. 20-3 Conclusion Financial crises have been a cause of many of the worst recessions, both in the United States and around the world. Conventional monetary and fiscal policies often are insufficient for ending these crises. To contain these crises, policymakers sometimes must take aggressive actions ranging from significant expansion of the central bank’s role as a lender of last resort to emergency loans and equity injections for financial institutions. The financial crisis of 2008– 2009 has made clear that, even with its solid financial institutions and extensive regulatory structure, the United States is at risk of severe financial crises. As a means of reducing this risk, economists and policymakers have put forward many reforms of financial regulation. Some of these reforms have been adopted, although it remains to be seen how effective they will be in preventing future crises. But despite the problems caused by crises in the financial system, we should not dismiss the important benefits that the system provides by matching savers with investors and promoting economic growth. ADDITIONAL CASE STUDY 20-1 The Perils of Employee Stock Ownership A common way that Americans save for retirement is through 401(k) plans, named for the congressional act that created them. Companies administer these plans for their employees. Most 401(k) plans provide a number of assets from which to choose. Often the choices include shares in mutual funds, which are financial firms that buy and hold a large number of stocks and bonds. Purchasing mutual fund shares is a good way to diversify a person’s retirement account. Many companies also include the stock of the company itself as an investment option for their employees. People who put most of their 401(k) savings into their company’s stock end up with assets that are not diversified. They may do this out of loyalty to the company or in the belief that the company’s prospects are strong. But the decision to put most retirement saving into your company’s stock has the potential for disaster if the company fails. This happened at Enron, the energy company that went bankrupt in 2001. Enron workers had 58 percent of their 401(k) funds in Enron stock, and many watched their accounts evaporate as the stock price plunged from $85 to 30 cents per share. The disaster was even worse, as most workers were laid off when the company failed. Financial advisers have used the example of Enron to urge greater diversification in 401(k) plans. One analysis estimates that the average percentage of 401(k) funds in company stock declined from 19 percent in 1999 to 10 percent in 2008. In addition, the Pension Protection Act of 2006 requires that companies allow workers to sell company stock after three years of service. Before the passage of this act, workers were often required to hold stock indefinitely in return for the companies’ contribution to their 401(k) accounts. Some economists continue to express concern that too much 401(k) wealth remains in company stock. LECTURE SUPPLEMENT 20-2 How Does Financial Development Affect Growth? As discussed in Chapter 20, a well-functioning financial system allocates saving to investors with the most productive projects. This suggests that countries will benefit from financial development through higher productivity growth. Evidence from research at the World Bank indeed has shown that countries with more developed financial systems experience more rapid economic growth. But as we learned in Chapters 8 and 9 when studying the Solow growth model, economic growth is determined by not only productivity growth but also by factor accumulation. Financial development therefore might influence the overall supply of saving and capital accumulation for an economy, spurring economic growth through a channel apart from improved productivity. To assess this possibility, Thorsten Beck, Ross Levine, and Norman Loayza developed a data set for 63 countries over the period of 1960–1995 and considered the channels through which financial intermediary development might affect economic growth. They measured intermediary development by using the value of credits issued by financial intermediaries to the private sector divided by GDP. Using data for private saving rates and the growth rate of physical capital per capita, the authors found little evidence in support of the factor accumulation channel. Using data for total factor productivity growth, the authors found very strong support in favor of the productivity channel. They concluded that a wellfunctioning financial system improves resource allocation and enhances productivity growth, which in turn drives long-run economic growth. LECTURE SUPPLEMENT 20-3 Does Financial Development Cause Growth? As discussed in Chapter 20, countries with greater stock market capitalization or more bank loans are also countries with higher per-capita GDP. But evidence of such correlations does not imply that financial development necessarily causes a higher standard of living. Countries with higher per-capita GDP might simply be better able to afford developed financial markets. Or a factor such as a high rate of saving could lead to both high per-capita GDP (as predicted by the Solow model in Chapter 8) and more-developed financial markets (to allocate the larger amount of funds implied by a high rate of saving). Research done at the World Bank has assessed the direction of causation by relating a country’s financial development as of the early 1960s to its growth of per-capita GDP in subsequent decades. These studies find that countries starting with a more-developed financial system experience faster economic growth in the following decades compared to those countries starting with less-developed systems. This approach helps solve the causality question because financial development in the past cannot have been “caused” by subsequent economic growth. Another approach to addressing causality involves finding a variable that helps predict financial development but otherwise is not influenced by economic growth. This approach uses an econometric technique known as instrumental variables, where in this case the instrument is the variable that helps predict financial development. One instrument that economists have used for this purpose is to look at the place of origin for a given country's current system of commercial law. Most systems of commercial law originated from one of four places: England, France, Germany, or Scandinavia. There are differences among the systems—for example, financial interests are best protected under the English system and least protected under the French system. These differences in legal origin are good predictors of the degree of financial development, because they are reflected in accounting standards, contract enforcement, and creditor protection. And country of origin is unlikely to have been “caused” by subsequent economic growth because these systems were spread through conquest and colonization. Research that uses country of origin as an instrumental variable supports the view that causation runs from financial development to economic growth. This evidence suggests the importance of a financial channel through which a country’s legal system influences economic growth. LECTURE SUPPLEMENT 20-4 Financial Development and Industrial Structure Further evidence on the importance of the financial system for economic growth comes from microeconomic studies of industrial structure. Research has shown that countries with well-developed financial systems usually have certain types of industries that thrive. In particular, industrial sectors that rely more heavily on external finance to fund their investment projects should grow faster in countries that have a more-developed financial system compared with countries that have a less-developed system. Young firms and those that don’t generate large cash flow are more likely to use external finance to fund investment projects than older, established firms and those that generate large cash flow—those firms are more likely to use internal finance to fund projects. And certain industries are just technologically more (or less) likely to need outside finance. For example, drug companies require large amounts of funding to bring products to market, but tobacco companies do not. Countries with well-developed financial systems are therefore more likely to have a disproportionate number of young, external-financedependent firms composed of certain types of industries than countries with less-developed systems. Evidence on the composition of industrial sectors across countries supports this link with financial development. And, since firms that are more heavily dependent on external finance grow faster in financially developed economies, those economies will experience faster overall economic growth. ADDITIONAL CASE STUDY 20-5 Unit Banking and Economic Growth Prior to WWII, federal law allowed a bank to conduct business only in one state, and some state laws restricted each bank to only one branch location. Supporters of unit banking believed that allowing multiple branches would lead to banks becoming too large and powerful. But most economists now believe that unit banking was detrimental to the economy for several reasons: Large banks benefit from economies of scale, multiple branches in many states reduce risk by allowing diversification of a bank’s operations, and multiple branches make it more likely that a town or city will have several banks competing with each other for business. Recent research shows that U.S. states where banks were allowed to have branches experienced better economic performance than states that did not allow branches. This research compared economic growth rates for states with branch banking to those without over the period 1900 to 1940 and found that states with branch banking had greater volumes of lending and higher growth rates. From the early 1970s through the mid-1990s, 35 states further relaxed restrictions on intrastate branch banking. A study by Jith Jayaratne and Philip E. Strahan shows that the relaxation of bank branch restrictions led to an increase in income growth for those states. The authors estimated the change in growth before and after the reforms for those states relaxing restrictions and compared this to a control group of states that were not affected by the reforms. This study also showed that the main channel through which these reforms influenced economic growth was the quality of the loans rather than the volume of them. Better loan quality implies better allocation of funds to productive investments, raising economic growth. The authors interpret this effect on loan quality as evidence that causality runs from financial reform to economic growth rather than the reverse. They argue that banks would be unlikely to improve the quality of their loan portfolio in anticipation of better future prospects, although they might have increased the volume of lending in such circumstances. LECTURE SUPPLEMENT 20-6 The Money Multiplier During the Financial Crisis of 2008–2009 As discussed in Chapter 4, the money multiplier measures the ratio of the money supply to the monetary base. Each dollar of the monetary base gives rise to a multiple expansion in credit as banks make loans from the funds they receive in deposits. Figure 1 shows the money multiplier for the money supply measure known as M1. As the financial crisis intensified during the fall of 2008, the money multiplier declined sharply, as banks became cautious about lending (see Supplements 20-7 and 20-8). The multiplier fell from a value of about 1.7 before the crisis to 0.8 by late 2009. Note: Money supply measure is M1. Source: Board of Governors of the Federal Reserve System and author’s calculations. Figure 2 plots the level of the money supply and monetary base. The monetary base increased rapidly during the crisis, eventually rising above M1. This expansion in the monetary base was reflected in the more than quadrupling of the Fed’s balance sheet as it flooded the economy with liquidity through numerous facilities and programs. Unlike during the Great Depression of the 1930s, the money supply continued to grow during the recent crisis, as a result of the extraordinary actions taken by the Fed. Source: Board of Governors of the Federal Reserve System. LECTURE SUPPLEMENT 20-7 Banks Hoard Reserves During the Financial Crisis Banks typically hold relatively low amounts of reserves compared to their deposits, as they seek to lend out as much of their funds as possible while meeting required reserve minimums set by regulators. But as uncertainty skyrocketed during September 2008, banks began to hoard reserves. With the Federal Reserve providing liquidity to financial markets through various lending facilities, reserves available to the banking system increased sharply. As Figure 1 illustrates, the ratio of bank reserves to deposits shot up rapidly during late 2008 and then increased further during 2009–2011. The ratio historically had been around 0.07 but hit a high of 1.7 in 2011. As discussed in Chapter 4, during the financial crisis of the early 1930s, the reserve–deposit ratio also increased when a bank panic caused banks to curtail their lending. But unlike during the crisis of the early 1930s, the currency–deposit ratio did not rise during the recent crisis. As shown in Figure 1, it actually declined slightly. Even so, the increase in the reserve– deposit ratio caused the money multiplier to drop sharply (see Supplement 20-6). But because the Fed had tripled the monetary base, the money supply continued to expand, in contrast to the 1930s, when the Fed did not increase reserves sufficiently to keep the money supply from plummeting. Note: Reserves are for all depository institutions, currency is currency in circulation, and deposits are those associated with the money supply measure, M1. Source: Board of Governors of the Federal Reserve System and author’s calculations. ADDITIONAL CASE STUDY 20-8 The Fed’s Senior Loan Officer Survey To gain insight into how lending conditions may be changing in the economy, the Federal Reserve carries out a quarterly Senior Loan Officer Survey at commercial banks. The survey asks detailed questions about whether the respondent’s institution is tightening or easing credit to potential borrowers. In addition, it asks about demand for loans and changes in the terms of loans. As illustrated in Figure 1, banks generally tighten lending standards during recessions and ease standards during recoveries. For example, the recession of the early 1990s witnessed a tightening of standards for commercial and industrial loans (C&I), commercial real estate loans, and residential mortgage loans. Likewise, during the financial crisis of 2008–2009, standards were tightened sharply for all three types of loans. But interestingly, during the recession of the early 2000s, while standards were tightened for C&I and commercial real estate loans, they were little changed for residential mortgage loans— perhaps helping to fuel the nascent bubble in house prices that developed over the next several years. Note: Data show the difference between the percentage of banks that reported tightening standards minus the percentage of banks that reported easing standards. C&I loans are those made to commercial and industrial enterprises that are not secured by real estate. Data for C&I loans in the figure are for loans to large and middlemarket firms. Data for commercial real estate loans starting in 2013 Q4 are for loans with construction and land development purposes. Prior to the second quarter of 2007 data for residential mortgage loans are for all such loans, while from the second quarter of 2007 data are for residential mortgage loans available only to prime borrowers. Source: Senior Loan Officer Opinion Survey on Bank Lending Practices, Board of Governors of the Federal Reserve System. The sudden tightening in conditions for C&I and commercial real estate loans during the third quarter of 1998 coincides with the default by Russia on its debt and the continuing fallout of the Asian currency crisis. These events fueled uncertainty in financial markets, leading banks to become more cautious in their lending policies. Figure 2 shows the change in lending standards on credit card and other consumer loans, the data for which were collected beginning only in 1996. Standards for these consumer loans tightened slightly during the recession of the early 2000s and then quite strongly during the recent financial crisis. But standards also tightened, particularly for credit cards, in the mid-1990s, when the economy was booming. This tightening of standards occurred in response to deterioration in the performance of credit card loans and as a result of banks’ desire to encourage households to substitute secured, home-equity lines for unsecured credit card balances and other consumer loans. Note: Data show the difference between the percentage of banks that reported tightening standards minus the percentage of banks that reported easing standards. From the second quarter of 2011, data for other consumer loans exclude auto loans. Source: Senior Loan Officer Opinion Survey on Bank Lending Practices, Board of Governors of the Federal Reserve System. These data on lending standards at banks are helpful for gaining insight into the factors behind credit crunches—situations in which firms and households find it difficult to borrow money. As discussed in Chapter 20, credit crunches can arise when asset-price declines lead to a drop in the value of collateral pledged by borrowers, making them ineligible for additional loans (or even renewal of an existing loan). Such credit crunches do not necessarily reflect any change in lending standards but simply the inability of borrowers to meet existing standards. The data from the Senior Loan Officer Survey show that lending standards can change quite a bit in response to financial market conditions, providing an additional channel through which a financial crisis might produce a credit crunch with all of its negative consequences for the economy. LECTURE SUPPLEMENT 20-9 The Tax Treatment of Housing Tax laws in the United States subsidize homeownership and may well have contributed to the frenzy in the housing market during the house-price bubble of the mid-2000s. While it is true that the huge expansion in subprime mortgage lending provided access to credit for many households that previously could not qualify to buy a home, the tax breaks available under the personal income tax code made these loans seem even more affordable. A homeowner can be viewed as a landlord who also rents his own house. But he is a landlord with special tax treatment. The United States does not tax him on the imputed rent (the rent he “pays” himself), yet it allows him to deduct mortgage interest. Thus, when computing his taxable income, he can subtract part of the cost of owning a home, but he does not have to add any of the benefit. The size of this subsidy depends on the rate of inflation, because homeowners are allowed to deduct their nominal interest payments when computing taxable income. For example, when inflation and nominal interest rates rose sharply in the 1970s, the tax benefits of owning a home rose as well. When inflation and nominal interest rates fell in the 1980s, 1990s and 2000s, the tax benefits became smaller. Some economists have criticized the tax treatment of homeownership, arguing that, because of this subsidy, the United States invests too much in housing compared to other forms of capital. They support reducing the subsidy, perhaps by limiting the deductibility of mortgage interest and using the extra tax revenue to lower tax rates. The political response to this idea is mixed: Although voters prefer lower tax rates, homeowners are not ready to give up the mortgage interest subsidy that they have benefited from for so many years. LECTURE SUPPLEMENT 20-10 More on the Fed’s Rescue Programs In a speech given in April 2009, Federal Reserve Chairman Ben Bernanke outlined a framework for understanding the various programs in the Fed’s response to the financial crisis. He organized his remarks around the components of the Fed's balance sheet—its assets and liabilities—and how its new programs had altered these components. Bernanke notes that the need for these new programs (or “tools,” as he calls them) had arisen because conventional monetary policy had done all it could by reducing the federal funds target rate to a range of 0 to 0.25 percent, close to its lower bound. These new tools were intended, according to Bernanke, “to further improve the functioning of credit markets and provide additional support to the economy.” The actions taken by the Fed in using these new tools had significant effects on both the size and composition of its balance sheet. Most importantly, the balance sheet more than doubled, from roughly $870 billion before the crisis to over $2 trillion in 2010. Starting with the asset side of the balance sheet, Bernanke notes that for many decades the Fed’s asset holdings were almost entirely composed of Treasury securities. But starting in late 2007, holdings of Treasury securities declined, and holdings of other financial assets increased sharply. Bernanke groups these assets into three broad categories: liquidity programs for financial firms, direct lending to borrowers and investors, and purchases of high-quality assets. The Fed provided liquidity to financial firms through its discount window, through swap arrangements with foreign central banks, and through the Term Auction Facility (TAF) and the Primary Dealer Credit Facility. To ensure liquidity to another category of financial institution, the Fed established two programs to support money market mutual funds, including the Money Market Investor Funding Facility (MMIFF). These programs were intended to ensure adequate liquidity to financial institutions so as to prevent panic caused by insufficient access to funds. To improve the functioning of credit markets, the Fed established programs to lend directly to market participants. These included the Commercial Paper Funding Facility (CPFF) and the Term Asset-Backed Loan Facility (TALF). The goal of these programs was to bolster demand for commercial paper and assetbacked securities, so as to meet funding needs of investors and borrowers in these markets and help restart the securitization process. These programs represented a somewhat unconventional approach, as they went beyond simply lending funds to financial institutions. But, as Bernanke argues, these programs did not engage in credit allocation since both were directed at broad markets, not particular sectors or classes of borrowers. The Fed’s open-market purchases of high-quality securities—including Treasury bonds, debt issued by Fannie Mae and Freddie Mac, and mortgage-backed securities guaranteed by Fannie and Freddie— were intended to lower the cost and improve the availability of credit for households and businesses. By lowering mortgage rates, the Fed aimed to help support the housing market. Bernanke notes that the Fed did provide financing to individual systemically important institutions, using emergency lending powers to support the purchase of Bear Stearns by JP Morgan Chase and to prevent the default of AIG. He argues that these loans were very different from the Fed’s other liquidity programs but were necessary to prevent major disruptions in financial markets. And he points out that this lending represented only about 5 percent of the Fed’s asset holdings. He said that he would work with the Obama administration and Congress toward developing a formal resolution authority for such systemically important nonbank financial institutions. On the liability side of its balance sheet, Bernanke points to the large increase in outstanding reserve balances. He notes that the Fed would have to move at some point to drain reserves from the economy and that it has appropriate tools to do so (see Supplement 20-11). LECTURE SUPPLEMENT 20-11 Exit Strategies for the Fed As mentioned in Supplement 20-10, the Fed’s balance sheet more than doubled during the financial crisis of 2008–2009 as a result of various programs to provide support to the economy. By early 2010, with the economy recovering and the financial crisis contained, discussion turned to the question of when and how the Fed should begin to shrink the outstanding sums of money it had put into the economy. Some economists and policymakers expressed concern that the large amount of bank reserves held on deposit at the Fed could prove inflationary if banks decided to withdraw these reserves and lend them out. Fed Chair Ben Bernanke outlined his views in testimony prepared for Congress. He notes that the Fed has several mechanisms for implementing its exit strategy. For the near term, he points to the new ability of the Fed to pay interest on excess reserves held by banks. Prior to 2008, bank reserves paid no interest, but beginning in October of that year the Fed started paying interest to banks. An increase in the interest rate on reserves lowers the incentive for banks to lend out their reserves, thereby limiting expansion in the money supply and helping contain inflationary pressures. Bernanke also discusses mechanisms for actually removing reserves from the system. First, he describes reverse repurchase agreements (“reverse repos”), where the Fed sells securities from its portfolio and agrees to buy them back at a later date for a slightly higher price. During the interim, the level of reserves is lowered, and if done on a rolling basis, a sustained decline in reserves can be achieved. Second, Bernanke discusses introducing term deposits for banks at the Fed—similar to a certificate of deposit—on which the bank would receive interest but would be restricted from cashing the deposit for a period of time. This would serve to lower the amount of reserves available for lending during the term of the deposit. Third, he describes how the Treasury could sell securities to the public and then deposit the proceeds in an account at the Fed, effectively draining reserves from the economy. In fact, this mechanism had been used early on during the financial crisis in an attempt to keep the Fed’s new lending programs from expanding its balance sheet. Finally, Bernanke notes that the Fed could sell some of the long-term securities it had purchased during the financial crisis. These include mainly mortgage-backed securities and some long-term government debt. But selling such securities could risk pushing long-term interest rates upward and potentially hinder the recovery of the housing market. ADDITIONAL CASE STUDY 20-12 Greenspan Warns About Government Budget Surpluses Chapter 20 discusses the use of equity injections into financial institutions by the Treasury. This was done under authority granted by the Troubled Asset Relief Program (TARP) passed by Congress in October 2008 during the financial crisis. These equity injections are controversial in part because they may worsen the moral hazard problem in banking, but also because they represent the government taking an ownership stake in private companies. A commonly expressed fear is that politics could trump sound financial decisions when the government is in control of private companies. But because much of the TARP funds have (or will be) repaid with interest (some analysts estimate that the final cost of the $700 billion program may only be $40 billion), the government’s “management” role has for the most part been limited and brief. Nearly a decade before the financial crisis, however, similar concerns about government involvement in the economy arose, under very different circumstances. The federal government had been running budget surpluses, and the projections were that the total federal debt would be paid off within the first decade or so of the twenty-first century. Some policymakers and economists, including Alan Greenspan who was then chair of the Federal Reserve Board, weighed in with warnings that paying off the debt and continuing to run budget surpluses would require the government to start investing in the private sector. In testimony before a congressional committee in January 2001, Greenspan argued that reducing the budget deficit and debt to zero was desirable: But continuing to run surpluses beyond the point at which we reach zero or near-zero federal debt brings to center stage the critical longer-term fiscal policy issue of whether the federal government should accumulate large quantities of private (more technically nonfederal) assets. At zero debt, the continuing unified budget surpluses currently projected imply a major accumulation of private assets by the federal government…. I believe … that the federal government should eschew private asset accumulation because it would be exceptionally difficult to insulate the government’s investment decisions from political pressures. Thus, over time, having the federal government hold significant amounts of private assets would risk suboptimal performance by our capital markets, diminished economic efficiency, and lower overall standards of living than would be achieved otherwise. At about the same time, Greenspan also addressed concerns regarding how monetary policy would operate in an environment with little government debt to buy and sell. Since most open market operations historically have been done through purchase and sale of short-term Treasury securities, paying off most or all of the debt would mean that the market for Treasury securities would become thin and possibly go out of existence. As Greenspan noted in testimony during February 2001: The prospective decline in Treasury debt outstanding implied by projected federal budget surpluses does pose a challenge to the implementation of monetary policy. The Federal Reserve has relied almost exclusively on increments to its outright holdings of Treasury securities as the “permanent” asset counterpart to the uptrend in currency in circulation, our primary liability. Because the market for Treasury securities is going to become much less deep and liquid if outstanding supplies shrink as projected, we will have to turn to acceptable substitutes. Last year the Federal Reserve System initiated a study of alternative approaches to managing our portfolio. His testimony then goes on to discuss these alternatives, some of which are familiar from the recent actions taken by the Fed during the financial crisis. Greenspan proposed that repurchase agreements in mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac might be one option for managing monetary policy. He also discussed repurchase agreements with the collateral of certain debt obligations of U.S. state and foreign governments, something allowed under the Federal Reserve Act. And he raised the question of whether it might be necessary to expand the use of the discount window or to request authority from Congress for acquiring a broader variety of assets via open market operations. The Fed established a number of new lending programs during the financial crisis, including the Term Asset-Backed Loan Facility (TALF), which made loans to financial institutions against collateral of assetbacked securities, and the Term Auction Facility (TAF), which eased access to discount-window funds. The Fed’s direct purchase of over a trillion dollars’ worth of mortgage-backed securities issued by Fannie and Freddie, which was intended to support the housing market, represented an enhanced use of the Fed’s open market operations. Although similar to what Greenspan had testified about, these new approaches to conducting monetary policy were adopted for very different reasons, under far different circumstances. LECTURE SUPPLEMENT 20-13 The Squam Lake Report The Squam Lake Report: Fixing the Financial System was published in the summer of 2010 and provides guidelines for reform of financial markets. The report was the work of a group of 15 academic economists who had first come together at Squam Lake in New Hampshire in the fall of 2008 during the financial crisis. These economists provide a set of recommendations in their report, some of which were reflected in the financial reform legislation passed by Congress and signed into law by President Obama in July 2010. The recommendations include: A Single Systemic Regulator to oversee the health of the entire financial system. This role would be assigned to the central bank. A New Information Infrastructure of Financial Markets to provide greater transparency for the risk exposure of individual financial institutions and the potential systemic risks arising from institutions’ common exposure or vulnerability to common shocks. Reforming Capital Requirements to ensure that financial institutions are better able to withstand systemic shocks. Capital and liquidity standards would be tightened, particularly for systemically important financial institutions, and capital standards would be more closely linked to an institution’s risk. Improving Resolution Options for Systemically Important Financial Institutions, so that the government can resolve failing institutions in an orderly process and avoid potentially destabilizing effects of an institution’s collapse. Providing Clearinghouses and Exchanges for Trade of Derivative Securities to reduce systemic risk and guard against contagion during periods of stress. Derivatives would in some cases be standardized and cleared through regulated counterparties. And information about derivatives trades would be provided to regulators so that they could assess whether such trades are concentrating risk or transmitting shocks throughout the financial system. As the financial reform process moves forward and new rules and regulations are put in place under the financial reform law (known as the Dodd-Frank Act) the recommendations of the Squam Lake Report are likely to continue to serve as useful guidelines. LECTURE SUPPLEMENT 20-14 Additional Readings The Journal of Economic Perspectives published a collection of papers from a symposium on the “Early Stages of the Credit Crunch” in the Winter 2009 issue (Vol. 23, No. 1) that are particularly useful for sorting out the causes of the financial crisis. In addition, the Journal of Economic Perspectives published papers from a symposium on “Macroeconomics after the Financial Crisis” in the Fall 2010 issue (Vol. 24, No. 4) and a symposium on “Financial Regulation after the Crisis” in the Winter 2011 issue (Vol. 25, No. 1). The Squam Lake Group’s Web site provides a number of working papers that focus on various aspects of regulatory reform (www.squamlakegroup.org). These papers served as the background to the Squam Lake Report discussed in Supplement 20-13. For details of the Federal Reserve’s various crisis lending programs and how they affected its balance sheet, see www.federalreserve.gov/monetarypolicy. See also the series of four lectures on the Fed and the financial crisis presented by Chairman Ben Bernanke, available on the Federal Reserve Web site at www.federalreserve.gov/newsevents/lectures/about.htm. Reports and information on the Treasury Department’s TARP and other elements of the government’s rescue programs are available at www.financialstability.gov. A number of books on the financial crisis written for a general audience have been published. These include Too Big to Fail, by Andrew Sorkin (Viking Penguin, 2009), and In Fed We Trust: Ben Bernanke’s War on the Great Panic, by David Wessel (Crown Business, 2009), both of which provide behind-thescenes views of the policy response to the crisis. For a more detailed look at the mechanics of the financial system and the logic of government rescue programs, see Too Big to Save? How to Fix the U.S. Financial System, by Robert Pozen (John Wiley and Sons, 2009). For a lively take on the subprime mortgage disaster, see The Big Short: Inside the Doomsday Machine, by Michael Lewis (W.W. Norton, 2010). Instructor Manual for Macroeconomics Gregory N. Mankiw 9781464182891, 9781319106058