L29 - Current Issues from Macroeconomics (Financial Crisis)

Question 1

What is a Financial Crisis?

Answer 1

A major disruption in the financial system that

impedes the economy’s ability to intermediate between those who want to save and those who want to borrow and invest.

Question 2

What is the anatomy of a crisis?

Answer 2

1)Asset-Price Booms and Busts:
Periods of optimism lead to Large increases in asset prices which will land that market into a speculative bubble.

2) Insolvencies at Financial Institutions:
A large decline in asset prices may cause problems at banks and other financial institutions.

3) Falling Confidence:
A decline in confidence in financial institutions is another ingredient in the making of a financial crisis.

4. Credit Crunch.
   Would-be borrowers have trouble getting loans, even if they have profitable investment projects.
5. Recession.
   When people are unable to obtain credit and firms are unable to obtain financing for new investment projects, the overall demand for goods and services declines.
6. The stock market declines.
   Some firms go bankrupt and default on their loans. Then we return to step 1 (asset-price busts), and 2 (financial institution insolvencies).
7. A Vicious Circle.
   The economic downturn reduces the
   profitability of many companies and the value of many assets.

Question 3

What is the Chronology of the Financial Crisis?

Answer 3

• 2006 and 2007: credit quality problems emerge in US housing market. (House prices begin to fall)
• June 2007: failure of two major hedge funds sponsored by Bear Stearns.
• August 2007: spreads in inter-bank and credit markets rose sharply; (inter-bank lending to exposed institutions dried up)
• September 2007: collapse of Northern Rock
• Late 2007- early 2008: mark-to-market losses on bank assets; (liquidity begins to fall.,Concerns about some major institutions grow.)
• February, 2008: UK government nationalised Northern Rock.
• March 2008: US government-assisted rescue of Bear Stearns by JP Morgan Chase.

-Summer of 2008: liquidity concerns and estimates of
markto-market losses grow; (house prices fall in the US, UK and other countries.)

-July 2008: US government extends funding guarantees to Fannie Mae and Freddie Mac to ensure their viability.
Anxiety about some investment banks and UK mortgage banks intensifies.

-September, 2008: US Treasury bailed out two largest
mortgage lenders, Freddie Mac and Fannie Mae,.
Lehman Brothers, US investment bank giant went bankrupt; (Triggered financial panic around the world.)

-January, 2009: UK government persuades Lloyds bank to buy insolvent Halifax Bank of Scotland,(HBOS). UK taxpayers raises stake in RBS to 84% to prevent bankruptcy.

-2012: The Euro crisis rumbles on;
Sovereign debt crisis in Greece, Spain, etc.

Question 4

What was the Government Intervention in 2008?

Answer 4

• Recapitalisation, guarantees and central bank support.
• Support packages combine government recapitalisation, guarantees of medium-term funding, and a significant extension of central bank liquidity support.
• Banking systems were underpinned by clear understanding that no major systemically important bank would be allowed to go bankrupt,and that retail deposits would be protected

Question 5

How does QE as a policy affect aggregate demand?

Answer 5

By affecting the following:

• Interest rates
• Money supply
• Asset prices and spending
• Confidence
• The first wave of quantitative easing was implemented when the Bank of England purchased £ 200 billion worth of bonds between March 2009 and February 2010.
• They announced a pause at that point, but started further asset purchases in October 2011 to a total value of an additional £ 175 billion.