Economic Crises

April 26 Final Exam

Short Essays

1. Many economists think that a flexible exchange rate acts like a shock absorber in the face of external economic shocks. Explain what this means and why it is (or might be) true.
Flexible exchange rates act as a shock absorber - Canadas experience following the Asian Crisis - commodity prices and the Canadian dollar world price of raw materials fell by 30 percent, world is prepared to pay less for our raw materials. This led to dramatic depreciation of CAD. - compare BC and Ontario situations. BC produced a lot of raw materials whose demand fell. The core of manufacturing in Canada is in Ontario (and Quebec) and the resource sectors are largely in the West and very East. When Asian economies go under the tank and reduce their demand for raw materials the BC economy goes down, they cant sell stuff to Asia anymore. But the Canadian dollar depreciates by 10 or 15 percent. A depreciating currency helps everybody who is exporting given whatever the price youre exporting at. Depreciation is a net plus to Ontario, because its machines, etc. gets a bump up in exports. The boost to Ontario offsets the negative to BC somewhat. What happened in 2002-2006 when world demand increased (China and India phenomenon and U.S economic boom) drove up prices, the Canadian dollar appreciated. Ontario was damaged while the East and West of Canada boomed.

2. Describe and explain the connection(s) between the financial sector and the real economy. Why is this connection relevant to the appropriate policy response (in Canada, say) to the global financial crisis of 2007-09?
When financial markets are functioning well, they play a background role in the overall behavior of the real economy. At the same time, when the economy is stable, macroeconomic considerations might appear to play a more secondary role in the functioning of financial markets. Taken together, this suggests that in stable times it might be tempting to analyze the behavior of the real economy and financial markets separately, each of them being a black box to the other, not worth opening. This approach is also convenient: Economists can build economic models without introducing too many financial details; financial wizards can price assets without thinking too much about macroeconomic risks; and business schools can build curricula where economics and finance are taught with little

reference to each other. This is all very well in a stable world. But a stable world is not a perfect world. And imperfections can eventually break the stability. It has long been understood that imperfections in the financial market can generate and amplify economic fluctuations, driving the dynamics of a crisis. These imperfections typically stem from transaction costs or asymmetric information. An entrepreneur who needs to borrow funds typically knows more about the quality of her project than the lender. Moreover, the success of the project and the likelihood of the loan being repaid will depend on the behavior of the entrepreneur. This information gap is an imperfection that the financial system needs to address. Financial intermediaries for instance, banks play an important role in partly bridging this information gap through screening and monitoring of prospective borrowers. Another way is for the borrower to put some skin in the game by pledging collateral for example, real estate which becomes a key determinant of borrowing capacity. Appreciating the role of information and the importance of collateral helps to explain how a financial crisis, such as the Great Depression, can unfold by setting in motion an adverse feedback loop between the real economy and financial markets. Collateral facilitates credit. If a weakening economy reduces the value of collateral, access to credit will be reduced. Reduced access to credit constrains consumption and capital investment, further weakening the economy and closing the loop the value of collateral that can be pledged. And if along the way, some banks are forced to shut their doors, the information gap at the origin of this problem becomes even harder to bridge. Policy makers must thus drive an economy out of crisis by breaking the adverse feedback loop. While the links between the financial sector and the real economy are sometimes smooth and continuous, they can also be highly non-linear. These non-linear effects can manifest themselves by the slow buildup of imbalances in stable times when many have been lulled into a false sense of security followed by abrupt crashes. The second key area of work for economists and financial professionals concerns the need to understand better risk-taking behavior and how system-wide forces contribute to the development of imbalances. We see excessive risk-taking behavior develop during periods of stability when people become complacent and believe the good times are here to stay. They become overconfident and underestimate risk. Contract incentives can also induce excessive risk-taking behavior. Lets take an example of an insurance company that has promised premium holders returns of 6 per cent, while the long-term bond rate is 4 per cent. To meet its obligations when the short-term rate is low, the insurance company has no choice but to take on greater risk, either directly or through investments in alternative assets. We also see how incentives encourage risk-taking at financial institutions where compensation depends on short-run returns. Although, the financial crisis is seen as having many significant causes, the compensation structure of some institutions is viewed as an important contributing factor. Through these channels, a tranquil macroeconomic environment can lead to the buildup of risks and financial imbalances on the balance sheets of banks. These imbalances can increasingly expose the wider economy to the risk of financial crisis. If confidence disappears, banks call back credit, balance sheets shrink and a difficult readjustment is needed, with negative effects on financial and economic

stability. In particular, the buildup of big leverage within the financial system can unwind swiftly, causing more stringent general financing conditions.

3. Explain how a financial institution creates mortgage-backed securities that are less risky than any one of the underlying residential mortgage assets. How does the process of securitization fit into your explanation?
A mortgage-backed security is a security whose cash flows are linked to the performance of an underlying pool of assets, which in this case are mortgages. The reason behind their popularity in the past two decades, and more recently in the 2008 financial crisis, has been due to the reduced risk of the MBS with respect to the underlying residential mortgage assets; a modern financial application of the law of large numbers. Depending on the receivers credit background and collateral quality, holding an individual mortgage asset may be very risky at times. Thus, by diversifying through holding a portfolio of numerous mortgage assets one essentially reduces exposure to complete credit default. The credit risk of mortgage-backed securities depends on the likelihood of the borrower paying the promised cash flows (principal and interest) on time. The credit rating of MBS is fairly high because: 1. Most mortgage originations include research on the mortgage borrower's ability to repay, and will try to lend only to the credit-worthy (This was the case prior to the rise of predatory lending). An important exception to this would be "no-doc" or "low-doc" loans (which are not subprime as they compensate for financial documentation with larger deposits) 2. Some MBS issuers, such as Fannie Mae, Freddie Mac, and Ginnie Mae, guarantee against homeowner default risk. In the case of Ginnie Mae, this guarantee is backed with the full faith and credit of the US Federal government. This is not the case with Fannie Mae or Freddie Mac, but these two entities have lines of credit with the US Federal government; however, these lines of credit are extremely small when compared with the average amount of money circulated through Fannie Mae or Freddie Mac in one day's business. Additionally, Fannie Mae and Freddie Mac generally require private mortgage insurance on loans in which the borrower provides a down payment that is less than 20% of the property value. 3. Pooling many mortgages with uncorrelated default probabilities creates a bond with a much lower probability of total default, in which no homeowners are able to make their payments. Although the risk neutral credit spread is theoretically identical between a mortgage ensemble and the average mortgage within it, the chance of catastrophic loss is reduced. 4. If the property owner should default, the property remains as collateral. Although real estate prices can move below the value of the original loan, this increases the solidity of the payment guarantees and deters borrower default. The process of pooling together masses of residential mortgages to create mortgage-backed securities falls under the many applications of securitization. Thus it is through securitization that mortgages with uncorrelated probabilities of default can be used to create securities with a higher distance to complete

default than the average distance of the underlying pool. Securitization, in many cases, also involves many credit enhancements such as spread accounts and credit default swap insurance to boost the ratings of the MBS. In reference to the above example to Fannie Mae and Freddie Mac, these credit enhancements can be used to significantly improve the ratings of the created MBS. Finally, it is also assumed that the originator involved in the securitization would prudently investigate the credit backgrounds of the consumers and quality of the MBS before distributing to other investors. This, as was seen in the Inside Job, was not the case in the time leading up to the 2008 crisis. It must be noted that the above paragraphs concern residential mortgage-backed securities and commercial mortgage-backed. There is also the case of the collateralized mortgage obligation that must be considered as securitization truly transforms the underlying pool of assets here. Instead of splitting the pie into equal slices as in MBS and CMBS, the pie here is arranged in to multiple tranches whose income stream is determined by the deal structure. The most senior tranches are often rated AAA as they only suffer losses after the mezzanine and equity level tranches have seen the present value of their investment drop to zero. By distributing the income of the underlying pool of mortgages to different investors with different risk preferences, the banks essentially can create an ultra-safe security from a pool of relatively safe assets. The most junior tranches of these CMOs are often not rated.

4. What is the difference between conventional and unconventional monetary policy? Use examples from Canada or the United States over the past three years to illustrate your arguments.
Implementation of Conventional Monetary Policy In normal times, when financial markets are fully operational, monetary policy decisions around the world are guided predominately by achieving inflation targets and by concerns regarding short run aggregate demand. Since the onset of the global financial crisis, conventional monetary policy has been implemented in response to the substantial contraction in aggregate demand and the deterioration of the global financial market conditions. Central banks worldwide undertook conventional monetary action with speed and determination. In the United States, the target federal funds rate was cut rapidly from 525 basis points in September 2007 to 0 25 basis points by December 2008. Almost every other country followed the same path, reducing interest rates on average by 330 basis points in developed countries and 300 basis points in emerging economies. The full cut in interest rates was not passed on to households and businesses and hence substantial and aggressive monetary easing was required. This was due to the wider credit spreads and to the restrictive lending standards that reduced the banks willingness and ability to lend. Overall, there was a breakdown of the monetary transmission mechanism and this has resulted in interest rates reaching their lowest levels. Unconventional Monetary Policy Options

In most countries, interest rates have reached zero or their effective lower bound, around 25 50 basis points. However, despite these low interest rates, a number of additional policy tools have been utilized; referred to as unconventional monetary policy tools. They directly target the cost and availability of external finance. The three types considered here are quantitative easing, credit easing and commitments in future interest rates. The choice of tool has largely depended on institutional characteristics and will have a varying impact on financial systems and economic activity. The Federal Reserve and The Bank of England have both pursued quantitative easing in 2009. Quantitative easing refers to increasing the size of the central banks reserves by purchasing securities, traditionally longerterm, in large quantities. This puts upward pressure on their prices and downward pressure on their yield and attempts to stimulate investment in long-term securities. In addition, banks then have access to additional liquidity that can be used to extend new credit. During the height of the crisis, when credit markets were at their tightest, quantitative easing has been an appropriate form of policy as it seeks to influence the supply of credit, rather than the demand for credit as in traditional monetary policy. The next form of unconventional monetary policy resembles quantitative easing in that it usually involves an expansion of the central banks balance sheet (if unsterilized); however the focus is not on the quantity of reserves but rather the composition of loans and securities on the asset side. The credit easing approach focuses on easing credit conditions by stimulating more active trade in certain assets and through a process of portfolio substitution. The resultant improvement in credit conditions and reduction in credit spreads has a stimulatory effect on aggregate demand. This policy has been adopted by the United States since December 2007. The Fed established several lending programs essentially to provide liquidity and improve the credit markets. The Term Auction Facility helps to ensure financial institutions have access to short-term credit. Also, the Commercial Paper Funding Facility (CPFF) has allowed financial and nonfinancial firms to place their commercial paper, where strains in the credit market had threatened their ability to do so. Evidence from the US thus far, indicates these initiatives have been effective in reducing interest rates, improving the functioning in the credit markets, providing liquidity and preventing further downward pressure on asset prices. In exceptional circumstances, such as those recently faced, central banks can choose to commit to keeping target overnight interest rates low for an extended period. This commitment works by lowering forward interest rate expectations, resulting in lower longer term yields and hence stimulating investment. The success of this policy depends greatly on the credibility of the central bank. The more credible the central bank, the greater the chance of this policy being effective. It is also important that inflation expectations are well anchored. Canada has not engaged in quantitative or credit easing, but in April 2009 the Bank of Canada committed to keep the target overnight rate at 25 basis points until the end of the second quarter of 2010, conditional on the inflation outlook. The result of this policy was deemed by the bank as being significant and lasting, in the form of a 10-20 basis point decline in the implied yields on government bonds out to one year. Other countries that have utilized this tool include the United States and the United Kingdom.

5. Explain the nature of the policy tri-lemma in open-economy macroeconomics. How does it relate to the cause or propagation of financial crises? Use examples from class to support your argument. 6. Explain the concept of contagion among global investors. What role has it played in Asian financial and economic crises? Can anything be done to prevent contagion? 7. State and explain John K. Galbraith's ''common denominators'' of financial crises. Identify examples of each of these common denominators from the film Inside Job.

Two crucial supporting roles played by: 1. Very short financial memories (amnesia) domestic crises sovereign debt (often held by foreign creditors) History is for those who dont understand the new reality This time is different! 2. a widespread belief that money reveals intelligence capitalism: money measures success, so can intelligence be far behind? Large lenders (at large FIs) are also seen to be intelligent and important. Most ordinary people do not understand financial markets so those involved must be very smart But the truth emerges after the crash financial genius is before the fall and then the truth is quickly forgotten (ex: Madoff) The three common features: 1. Some new product or financial instrument: tulips? (1636) joint stock companies? Financial deregulation? Mortgage-backed securities? SECURITIZATION INSIDE JOB 2. But there is rarely genuine innovation in financial markets: we reinvent the wheel many times over most is the creation of debt backed to some extent by real assets Galbraith: All crises have involved debt that has become dangerously out of scale in relation to the underling means of payment! leverage. 3. After the crash.the blame: recrimination against central individuals and scrutiny of new instruments push for new regulations the speculative episode itself is all but ignored as the underlying problem! Why? o Classical faith in (approximately) free markets o So, need a cause external to the markets nobody says it serves us right, we live in a system where this run up of asset prices, speculative euphoria is inevitable. Galbraiths central point is that it is inevitable youre going to have these periods. We never blame the system because its wonderful (hardwired faith in the system).