Chapter 31: Financial Crises, Panics, and Unconventional Monetary Policy

We believe the Federal Reserve’s large-scale asset purchase plan (so-called “quantitative easing”) should be reconsidered and discontinued. We do not believe such a plan is necessary or advisable under current circumstances. ―[an open letter from a number of economists to the chairmen of the Fed]Financial Crises, Panics, and Unconventional Monetary PolicyCopyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/IrwinChapter GoalsExplain why financial crises are dangerous and why most economists see a role for the central bank as a lender of last resortExplain the role of leverage and herding in financial bubbles and how central bank policy can contribute to a financial bubbleExplain why regulating the financial sector and preventing financial crises is so difficultDiscuss monetary policy in the post financial crisis periodFinancial Crises, Panics, and Unconventional Monetary PolicyIn 2008, the world financial system nearly stopped workingBanks were on the verge of collapseThe stock market dropped precipitouslyThe U.S. economy fell into a serious recessionCentral banks and governments across the world took extraordinary steps to try and calm the crisisCentral banks have been running unconventional monetary policy strategies to prevent problemsFinancial Crises, Panics, and Unconventional Monetary PolicyA financial sector collapse would bring all other sectors crashing downTo help prevent such a catastrophe, the Fed serves as a lender of last resortAll the other sectors need the financial sector to do businessThe fear in October 2008 was that the financial crisis on Wall Street would spread from Wall Street (the financial sector) to Main Street (the real sector), creating not a recession but a depressionAnatomy of a Financial CrisisInflation of a bubble - unsustainable rapidly rising prices of some type of assetThe bubble bursts, causing a recessionThe effects of the bursting bubble threaten the entire financial system People cut spendingFirms cut back even more, creating a downward spiral that can turn a recession into a depressionThe Financial Crisis: The Bubble BurstsIn 2005, housing prices started to level off and by 2006 housing prices began to fall precipitouslyThere was a crisis in the market for mortgage-backed securities that are bundles of mortgages sold on the securities market The Fed engaged in financial triage such as the Troubled Asset Relief Program (TARP) involving a $700 billion financial bailout of banks in an attempt to prevent the entire financial system from collapsingThe Role of Leverage and Herding in a CrisisLeverage—the practice of buying an asset with borrowed money—works with all assets and is a central part of any bubbleMonetary policy can encourage the development of a bubble Herding is the human tendency to follow the crowd. When people become convinced the price of an asset is going to rise, everyone buys more of it on credit, making the bubble largerThe Problem of Regulating the Financial SectorOnce the signs of a bubble were clear, why didn’t economists warn society that a financial crisis was about to happen?Policy makers were swayed by political interestsThere was more a failure of economic engineering and economic management than of economic scienceDue to the efficient market hypothesis, policy makers didn’t worry about the financial crisisThe events of 2008 changed the view that markets are rational and ushered in the structural stagnation viewRegulation, Bubbles, and the Financial SectorNew financial regulation was establishedDeposit insurance is a system under which the federal government promises to reimburse an individual for any losses due to bank failureGlass-Steagall Act was passed in 1933 that created deposit insurance and prohibited commercial banks from investing in the securities marketAny type of guarantee, or expectation of a bailout, can create a moral hazard problem that arises when people don’t have to bear the negative consequences of their actionsThe Law of Diminishing ControlThe law of diminishing control holds that whenever a regulatory system is set up, individuals or firms being regulated will figure out ways to circumvent those regulationsNew financial institutions and instruments circumvented bank regulationRegulations covered fewer financial instrumentsUndesirable financial practices simply moved outside the banking system and into other financial institutions Unconventional Monetary Policy in the Wake of a Financial CrisisQuantitative easing is a policy of targeting a particular quantity of money by buying financial assets from banks and other financial institutions with the newly created moneyCredit easing is the purchase of long-term government bonds and securities from private corporations to change the mix of securities held by the Fed toward less liquid and more risky assets; the purpose is to change mix of assets without increasing the quantity of moneyUnconventional Monetary Policy in the Wake of a Financial CrisisOperation Twist refers to selling short-term Treasury bills and buying long-term Treasury bonds without creating more new money; was meant to twist the yield curve by lowering long-term rates and raising short-term ratesPrecommitment policy involves the Fed committing to continue a policy for a prolonged period of timeCriticisms of Unconventional Monetary PolicyPolicies would simply prop up asset prices and prevent the structural adjustments needed for the U.S. to become competitiveIt enabled the government to run large deficitsThe Fed is left open to enormous lossesPrecommitments tie the hands of the FedThe Fed doesn’t have a reasonable exit strategyChapter Summary The financial sector provides the credit that all other sectors need for both day-to-day and long-term needsIf the financial sector were to collapse, all other sectors would crash along with itThe Fed has the resources and ability to lend to financial institutions and banks when no one else willThe stages of a financial crisis are (1) a bubble develops, (2) the bubble bursts, and (3) the economy falls into a financial crisisChapter Summary Two ingredients of a bubble are herding and leveragingIf the financial sector were to collapse, all other sectors would crash along with itGovernment regulations that guarantee bailouts create the moral hazard problemRegulations have limited impact on bank behavior because of the law of diminishing controlThe Fed implemented unconventional policies such as quantitative easing, credit easing, operation twist, and precommitment policy