Economics Chapter 11 Homework The Argentine economy grew rapidly until 1998

Unlock access to all the studying documents.

View Full Document

loan demand.

An increase in volatility of output leads to an increase in the lending rate and an

ambiguous effect on the amount borrowed.

APPLICATION

The Costs of Default

This application considers empirical measures of the costs of default from a recent Bank

of England study and other research.

Financial Market Penalties

■ Countries that default are excluded from further borrowing until the default is

resolved through negotiations with creditors.

● During the 1980s, defaulters were denied access to credit markets for an

average of 4.5 years.

* Seven of eight nondefaulters had credit ratings of BBB+ or better; 12 of

13 defaulters had ratings of BB- or worse.

* This seems to apply to countries with a variety of incomes per capita and

debt-to–GDP ratios.

* Before 1914, defaulters paid an average of 1% extra per year.

Broader Macroeconomic Costs and the Risk of Banking and Exchange Rate Crises

■ The default will damage the domestic financial system. This can lead to a banking

crisis.

● Domestic banks hold a large share of their bonds in government debt and may

be pressured to hold an even larger share immediately before a default.

● When banks face a shortfall in credit (because of sovereign default), they may

■ There is also a good chance of an exchange rate crisis.

● The increase in risk premiums on loans to the government will likely lead to

an increase in interest rates on bank deposits, especially if investors expect the

exchange rate peg to break.

* A risk premium shock will reduce money demand. Foreign exchange

reserves decline as the central bank tries to defend the peg.

● The central bank may be under pressure to conduct a sterilized sale of reserves

and to act as a lender of last resort, expanding domestic credit.

● Rising interest rates will further reduce investment, making it harder for

borrowers to honor private debts, further exacerbating the crisis.

A decrease in output and an increase in risk premiums are expected during a default

crisis, but they may trigger banking and exchange rate crises, making it more likely the

government will break its contingent commitment. The relationships between crises and

the contingent commitment are illustrated in Figure 22-14.

APPLICATION

The Argentina Crisis of 2001–2002

In earlier chapters, we have seen that both investors’ expectations and economic

fundamentals play a role in crises, often sparking twin or triple crises. In practice, it is

Background

■ The Convertibility Plan included a one-to-one peg against the U.S. dollar. This

helped Argentina recover from the 1991 hyperinflation.

■ The Argentine economy grew rapidly until 1998, with the government borrowing

large amounts at low interest rates. Argentina’s external debt rose.

■ The 1997 crisis in Asia led to an increase in emerging markets risk premiums,

Dive

■ Argentina’s public debt soared from 41% of GDP (1998) to 64% (2001).

Government tax revenues declined and social expenditures increased during the

recession.

banks’ balance sheets.

■ The government was faced with three unpleasant choices:

● They could maintain the exchange rate peg. This implies cutting off the

expansion of domestic credit to honor the Convertibility Plan, pushing the

Crash

■ Fiscal compromise was impossible, as the two main political forces could not

agree.

● President Fernando de la Rúa controlled Buenos Aires, but the Peronist party

ran the provincial governments. The provinces collected the tax revenue and

spent it all rather than send any to the capital. Neither group was willing to

■ The IMF tried to act as the lender of last resort. Despite skepticism expressed by

the IMF staff, they approved one last big loan in August, but it didn’t last long.

■ Banks had been persuaded (to put the best face on it) into holding large amounts

of dollar-denominated government debt in 2001. The debt carried a high nominal

The End

■ Argentina’s economy was in the “vicious circle” dynamic described in Figure 22-

14.

■ The IMF offered a loan under very restrictive conditions. The government

declined to accept these conditions.

■ This triggered political unrest and threatened a coup. President de la Rúa fled the

country by helicopter. His numerous successors defaulted on the external debt

(the largest sovereign default until then), allowing the Argentine peso to float.

● The peso quickly devalued to 4 per U.S. dollar.

■ Taxes were raised, spending was cut, turning a bad recession into an economic

meltdown.

■ The lesson: Argentina tried to follow inconsistent economic policies. In adopting

Postscript

■ Since 2001, there have been no major crises, with many countries building up

foreign exchange reserves.

H E A D L I N E S

Is the IMF “Pathetic”?

This article considers the IMF’s role and effectiveness as a lender of last resort.

Background:

■ Following the Asian crisis in 1997 and Argentina’s crises in 2001, politicians

have continued to blame the IMF for the extent of the crises.

Key points:

■ John Lipsky said, “It’s ironic to my mind that people say the fund isn’t needed

anymore because nothing in the global financial system is broken at the moment.”

■ His column argues that both the IMF and World Bank are needed.

● The IMF was not set up to handle crises in the 1990s, but it can be called upon

the instant a crisis spreads from one country to another, as a sort of “fire

Discussion questions:

■ As private financial flows increase in volume, do you believe the IMF will have

the financial resources to serve as a lender of last resort for advanced economies?

■ The end of the column cites persistent U.S. current account deficits and the fact

4 Case Study: The Global Macroeconomy and the Global Financial

Crisis

Since the year 2007, the global economy has experienced two major adverse events. The

first, the Global Financial Crisis, lasted from 2007 to 2009. The subsequent Great

Recession was still having an impact several years later. (According to the NBER, the

recession officially ended in June 2009. Teaching Tip 4 gives you an opportunity to let

your students see what makes a recession.)

This chapter applies the tools developed in the textbook to study these dual crises.

There are three major topics:

1. The short-run and long-run causes of the financial crisis

Backdrop to the Crisis

Forecasting events that have already occurred is fairly easy. Policymakers do not have

Preconditions for the Crisis The crisis was mainly caused by investments whose market

prices unexpectedly declined. This implies savings were not allocated wisely. Where did

these savings originate and what was their eventual destination?

The source of the savings were emerging market (EM) economies that ran current

account surpluses. While their investment rates were high, their saving rates were even

higher. Those surpluses could not just evaporate. They were offset by developed market

As was discussed in earlier chapters, the increase in EM savings was simply a matter

of self-insurance against consumption variability. Since the cost of a crisis is very high

for these countries and there is no assurance of external help, EM countries followed the

The nature of the financial account flows was also unusual. Initially, the EM

governments acquired official foreign assets. These flows were far larger than private

In the DM countries, the initial impact was an increased demand for government

securities. This naturally increased the prices of those securities and lowered the yields.

Since all financial assets are substitutes, an increase in the prices of government securities

caused increases in the prices of private securities. Yields fell across the economy.

Borrowers could acquire funds at the lowest interest rates seen in many years.

outcome is not required in the real world. Some observers noted the resemblance to many

earlier credit boom–bust cycles. But never in recorded history had there been a boom like

what happened in the early 2000s. Figure 22-16 tells the whole story. Bank assets relative

to GDP in 14 developed countries rose to 200%. The bank loans–GDP ratio rose to

100%.

Exacerbating Policies and Distortions Why did these flows from EM to DM countries

increase so markedly between 2004 and 2007? And why did they lead to such bad results

across such a broad range of countries? At this point, it’s difficult to provide a definitive

answer. But there are five analyses that are very plausible:

1. The EM countries deliberately maintained undervalued exchange rates. This

promotes exports, leading to a balance of trade surplus and a corresponding financial

outflow. Unfortunately, there is little empirical evidence to support this hypothesis.

3. A third group points to the failure of regulation and supervision. According to

these analysts, the Fed, the ECB, the Bank of England, and many other central banks

4. Yet another set of economists point to government failure as a major cause.

Governments, this group argues, distorted private incentives. The U.S. government

implicitly backed Fannie Mae and Freddie Mac. Those two entities purchased and/or

guaranteed large shares of the U.S. mortgage market. When they went broke, the implicit

5. One more faction points to evidence of market failure. Irrational investors, the

instinct to follow the herd, imperfect information, asymmetric information, and any other

market failure buzz phrase you can think of—all are thrown into the large pot that

Summary Banking crises have been with us ever since there have been banks. It does not

Panic and the Great Recession

The financial collapse was marked by capital fleeing risk and seeking safety. In this

respect, the panic of 2007 was no different from most previous crashes. This time the

A Very Modern Bank Run Given the 30:1 leverage ratio some investment banks were

using, it’s not surprising that a small decline in the prices of the underlying assets caused

enormous losses for those institutions. Loan markets froze as various financial

institutions realized that their soon-to–be counterparties were facing risks of unknown

timing and magnitude. Deposit insurance prevented conventional runs on banks. But

many banks relied on short-term loans, which became very expensive.

Financial Decelerators The combined effects of little liquidity and falling asset prices

hit the real economy hard. Policymakers around the world tried various combinations of

monetary and fiscal policy. Global investors sold any assets denominated in any currency

The End of the World Was Nigh U.S. stock markets hit bottom in March 2009. Taking

inspiration from the Book of Revelations, the S&P 500 bottomed out at 666. Three of the

five largest U.S. investment banks had failed or been acquired. The U.S. Treasury and

Congress started the Troubled Asset Relief Program (TARP), a $700 billion bailout fund.

Consumer and business confidence approached zero. Calm was restored by April.

Europe Germany probably fared the best of the European economies. The problem

countries were on the edges of the continent: the economic problems of Portugal, Ireland,

Greece, and Spain are shown in Figure 22-19. Italy was also in trouble. The acronym

PIIGS (Italy is the second I) was used to refer to this group of economies. It is no

coincidence that all these countries were members of the Eurozone. The Irish government

The Baltic countries—Estonia, Latvia, and Lithuania—chose to maintain their pegs to

the euro and watched their economies tank. Spain’s housing boom and bust was not as

large as Ireland’s. Portugal and Greece suffered from the more traditional problem of

huge budget deficits when the Great Recession caused tax revenues to vanish. (Greece

was also hurt by its credibility problems, stemming from the decision to report falsified

economic data.)

Each of these countries saw the ratings on government debt downgraded to junk

levels. The only reason some governments avoided default was a bailout package

assembled by the ECB, the EU, and the IMF.

The Rest of the World The United States and Eurozone took the brunt of the collapse.

Japan, of course, is still mired in its 20-year-long slump, so it’s difficult to tell what

impact the financial panic had there. But emerging market economies recovered quickly.

These economies had been saving for a rainy day with large stocks of foreign exchange

5 Conclusion

The model of default offers several important insights. But larger questions about the

source of output volatility remain unanswered. If the source is bad institutional

Conclusion: Lessons for Macroeconomics

As of late 2010, we simply could not tell how the crisis would play out. We needed more

research on institutional issues, especially details of financial market operations and how

they would affect the real economy. Once again, the economics profession has learned

TEACHING TIPS

Teaching Tip 1: The textbook raises an interesting issue: How many members of the

Eurozone are actually in compliance with the rules for membership (summarized in Table

21-3)? The IMF publishes its World Economic Outlook that includes annual estimates of

key economic data for most countries. (The full data set is available in Excel-compatible

format at the link below.) Divide the class into 17 teams (one per Eurozone member

Teaching Tip 2: The Excel workbook for this chapter includes two tables of interest

rates for 44 countries. One worksheet summarizes the 2009 data. The other is the raw