Economics Chapter 20 Homework Supplement 209 The Tax Treatment Housing

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

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?

478 | CHAPTER 20 The Financial System: Opportunities and Dangers

Chapter Supplements

This chapter includes the following supplements:

20-2 How Does Financial Development Affect Growth?

20-3 Does Financial Development Cause Growth?

20-4 Financial Development and Industrial Structure

20-6 The Money Multiplier During the Financial Crisis of 2008–2009

20-8 The Fed’s Senior Loan Officer Survey

20–10 More on the Fed’s Rescue Programs

20–12 Greenspan Warns About Government Budget Surpluses

20–14 Additional Readings

Lecture Notes | 479

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

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

Sharing Risk

The financial system provides a mechanism for helping people share risks. Even if someone

could finance an investment project out of his own saving, he might not to do so because of the

risk that the project might not pay off. Such a person might prefer to share the risk instead of

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

!Supplement 20–1,

“The Perils of

Employee Stock

Ownership”

480 | CHAPTER 20 The Financial System: Opportunities and Dangers

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.

Fostering Economic Growth

By channeling funds from savers to investors with good projects, the financial system increases

overall productivity for the economy and leads to a rise in living standards. Chapters 8 and 9 of

the text discuss the Solow growth model, where output per worker depends positively on the rate

of saving. But that discussion glossed over the important issues raised in this chapter by

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.

!Supplement 20–2,

“How Does

Financial

Development

Affect Growth?”

Lecture Notes | 481

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

due to differences in the quality of legal institutions. This variation in financial systems is a

source of variation in living standards. Higher–income countries tend to have a larger stock

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.

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.

20–2 Financial Crises

Sometimes the financial system breaks down, leading to severe macroeconomic consequences.

2008–2009.

The Anatomy of a Crisis

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.

!Supplement 20–3,

“Does Financial

Development

Cause Growth?”

Economic

Growth”

2. Insolvencies at Financial Institutions. Failures of financial institutions often accompany asset–

price 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,

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

contracts with each other, fears arose that this interdependence meant the entire system was in

danger.

4. Credit Crunch. With many financial institutions in trouble, households and firms find it more

Banks tightened mortgage credit during the financial crisis of 2008–2009 as they realized

housing prices were falling and previous lending standards had been too loose. In addition, small

businesses faced tighter credit standards, and consumers found it harder to qualify for a credit

5. Recession. When a credit crunch occurs, firms and individuals who rely on borrowing are

!Supplement 20–6,

“The Money

!Supplement 20–7,

“Banks Hoard

Reserves During

Loan Officer

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.

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.

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

!Figure 20-1

484 | CHAPTER 20 The Financial System: Opportunities and Dangers

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.

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.

!Supplement 20–11,

“Exit Strategies for

the Fed”

Lecture Notes | 485

Policies to Prevent Crises

Besides the debate over how best to respond to a crisis once it has begun, another key policy

question is how policymakers can best prevent crises from happening in the future. In response

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

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 Dodd–

Making Regulation Work Better. Because the financial system developed over

many years, the regulatory structure is highly fragmented, with different agencies overseeing

different types of financial institutions. The Fed, the Office of the Comptroller of the Currency,

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

!Supplement 20–12,

“Greenspan Warns

About Government

Budget Surpluses”

!Supplement 20–13,

“The Squam Lake

Report”

486 | CHAPTER 20 The Financial System: Opportunities and Dangers

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

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

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

488

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.

489

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.1 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

1 See Asli Demirguc–Kunt and Ross Levine. “Finance, Financial Sector Policies, and Economic Growth,” World Bank Policy Research Working

Paper 4469, January 2008.

2 Thorsten Beck, Ross Levine, and Norman Loayza, “Finance and the Sources of Growth,” Journal of Financial Economics 58 (2000): 261–300.

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.1