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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.1
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
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
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
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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.
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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
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.
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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
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 middle–
market 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.
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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.
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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
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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
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.
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 asset–
backed securities, so as to meet funding needs of investors and borrowers in these markets and help restart
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.
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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
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
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
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
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
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.
1 Testimony of Chairman Alan Greenspan, “Outlook for the Federal Budget and Implications for Fiscal Policy,” Before the Committee on the
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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.1 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.
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.
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20–14 Additional Readings
The Journal of Economic Perspectives published a collection of papers from a symposium on the “Early
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