Section A: Overview, Long Run Questions Flashcards
What did Bordo (2008) say about financial crises?
“Financial crises are an old problem. They go back to the origins of capitalism and beyond”
How many crisis did Kindleberger say there has been, and between what years?
38 from 1636 to 1997
Why were tulips valuable in 1636 in Holland?
Tulips, Asian wild flowers, cultivated for Dutch gardens to show wealth. 17th Century Holland was rich (nouveau riche) this fuelled demand. Very rare bulbs, with at times only 12 tulips in the whole of Holland. High demand and low supply increased prices.
What emerged to facilitate the purchase of tulips?
People bought tulips as an investment. Derivatives, forward contracts, borrowing etc all emerged to facilitate trade
How much was one tulip worth in 1637?
Same a luxury Amsterdam City House
When did the Tulipmania bubble burst?
February 1937, bubble bursts at an auction in Haarlem, prices decline dramatically in days!
What type of company did John Law set up and when?
Sets up a joint stock company (innovation in France) to exploit the riches of the Mississippi valley in 1719
Share prices of Law’s Mississippi company 1719/20?
1719: Shares at 500 livers. 1720: Shares at 18,000 livres
Why did the Mississippi bubble burst?
Bad news came back from the USA that the project was a failure, Law tried to stem to the news but the bubble burst in 1720.
Similarities between Mississippi bubble and Tulipmania?
- Exogenous event, highly profitable investment
- Commodity turned into an investment
- Over indebtedness and financial innovation
- Inexperienced investors
- Euphoria pushes up prices
- Innovations technical and difficult to understand
What did Kindleberger say about crashes?
“Whenever the outsiders go in, the insiders go out and the crash follows”
Definition of a bubble?
A financial asset exhibits a bubble when its price exceeds the present value of the future income (e.g. interest or dividends).
What is the problem with understanding bubbles?
hey appear to undermine key assumptions of economics, as the price should equal the PV
What did Greenspan, governor of the FED say about bubbles?
Cannot predict bubbles, CB can only clean up afterwards. PV, uses expectations and therefore bubbles can only be seen with hindsight
Why did Shiller suggest bubbles occur?
Irrational Exuberance: Stock markets are overvalued as psychologically driven volatility is an inherent characteristic of all markets. Predicted housing crash/tech bubble.
Possible solutions to the bubbles paradox?
- Give up rationality assumption
- Principal-agent relations/asymmetric info might explain bubbles
Why did Mill/Marx say bubbles occur?
Mill “Of the tendency of profits to a minimum”;
Marx “Law of the tendency for the rate of profit to fall”
What is Wallerstein’s theory to explain bubbles?
World Systems Theory, all have ups/downs but return moving equilibrium, this is not what it was before the crash. This equilibrium cannot be maintained, the system will collapse- structural crisis. Capitalism causes crises.
Why did people believe the market wouldn’t collapse in 2007?
Globalisation Tech Boom US Financial System Monetary policy Securitized debt
Who wrote the famous paper, “This time is different”?
Reinhart and Rogoff, 2009
What is a financial crisis?
Financial market volatility marked by serious illiquidity and insolvency amongst financial market participants
What is a banking crisis?
Financial distress resulting in erosion of most/all aggregate banking system capital
What is a currency crisis?
Forced change in parity, international rescue, abandonment of pegged exchange rate (IMF, a drop of 10%+ over 3 months is classified as a currency crisis)
What is a twin crisis?
When currency and banking crisis occur in the same or immediately adjoining years
Example of appreciation causing currency problems in Switzerland
During Eurozone crisis, investors used CHF as it has been historically most stable (150 years). CB only defended the peg in one direction (shouldn’t pay less than 1.2 for 1 Euro). 15% appreciation forced the removal of the peg, due to concern with lax EU monetary policy.
Was the Swiss currency appreciation a currency crisis?
NOT A CURRENCY CRISIS, as it didn’t undermine financial stability.
Why would Greece face a currency crisis if they left the Euro?
Greece would have a currency crisis without the Euro as their own currency would depreciate rapidly.
Why could a Greek currency crisis lead to contagion?
2/3 of Greek debt held abroad, 1/3 held domestically. Greek banking crisis, can spread beyond the borders due to the debt being held abroad- needed the IMF rescue.
What is a government debt crisis?
Struggle to pay back the debt, not on wider question of meeting obligations. Withhold payment of salaries, delay paying suppliers etc to carry on paying debt back.
Overview of what Bordo published about the frequency of crises?
- 21 countries examined
- 0 banking 1945-71, due to the fixed peg system of Bretton woods.
- Currency crisis, linked to democratisation and capital controls.
- Banking and twin crisis on the rise.
- Majority occur in emerging countries
Features of the Gold Standard
Monetary Autonomy
Stability
NO capital mobility
Features of Bretton Woods (1944-71)
Monetary Autonomy
Capital mobility
LACK OF Stability
Features of the modern system of monetary exchange? Since 1973
NO Monetary Autonomy
Capital mobility
Stability
Who termed the trilemma?
Obstfeld and Rogoff (2005):
How is severity of a crash measured
Measured by the difference between pre-crisis trend growth and actual growth over the years prior to full recovery (GDP loss).
Have crisis become more severe?
No evidence of this according to Bordo
Kindleberger (2005) quote on manias and collapse?
“Speculative manias gather speed through expansion of money and credit… every mania has been associated with the expansion of credit”
Who controls the monetary base?
The central bank (sum of all liquid CB liabilities e.g. bank notes)
Kindleberger theory on why crises occur?
- Lax monetary policy
- Inadequate regulation
- Global imbalances
What does the fundamental school argue about crisis?
Fragile economies, preceded by distress signals in various sectors of the economy.
Why did Krugman (1979) argue currency crises occur?
Currency crisis a result of inconsistent fiscal and monetary policies.
Who came up with the self fulfilling prophecy argument for crises? Quote?
Calvo (1995) “If investors deem you unworthy, no funds will be forthcoming, and, thus, unworthy you will be”
Example of a credibility crisis with sound fundamentals?
ERM crisis, 1992/3 when Spain, Italy and UK leave due to speculative attacks on their peg. German CB changed the interest rate which was a problem as German unification prolonged the German business cycles. All made a quick recovery afterwards.
Symptoms of crisis? Long list?
- Exaggerated credit cycles in stock/credit markets
- Expansionary monetary and fiscal policies
- Bank Runs
- Capital flights
- Recessions
- Real exchange rate appreciation, loss of competitiveness/deterioration of the current account
- Unsustainable foreign debt concentrated at short maturities
- High domestic and foreign real interest rates
What study do Kaminksy and Reinhard conduct in 1999?
Sample of currency and banking crises from 20 countries between 1970-95, examine a range of symptoms
Findings of Kaminksy and Reinhard in 1999?
Currency Crises preceded by: booms in monetary aggregates and debt build-up, recessions, large current account deficits, less exports overvalued exchange rate
Twin crises more extreme: Credit/GDP ratio increases at rates 20% higher. Excess M1 grows much faster. Significant slowdown in economy and stocks.
Borio and Lowe (2002) said what increases the probability of a crisis?
Positive deviation of credit-to-income ratio from the trend largely increases probability of a crisis
Bordo and Wheelock (2006) argue price booms lead to what?
Asset price booms typically arise with low/falling CB policy rates, this leads to over indebtedness as people borrow against assets.
Reinhart and Rogoff (2008/9) evidence on asset prices?
Provide evidence for link between asset prices and crisis . Focus on housing prices (very excessive rises compared to inflation) and banking crises.
What is the Taylor rule?
Monetary policy rule that stipulates how much the CB should change the nominal interest rate in response to Divergence of actual inflation rates from target rates
-Output gap (actual GDP difference from potential GDP)
Did the FED follow the Taylor Rule? Consequences if not?>
Fed seemed to follow this rule until 2001 (from 1987). Rule violation meant cheap money, fuelled housing boom
Why did Taylor (2009) argue the FED had fuelled the 2008 crisis?
Used the deviation of from the rule to place some blame for the crisis with the Federal reserve, inadequate monetary policy. His paper offers counterfactual evidence of house prices if the Fed followed the rule.
Greenspans (2009) thoughts on the deviation from the Taylor Rule?
Taylor’s used old trends, so the relationships don’t hold today.
Low US interest rate may reflect a global savings glut. Not mutually exclusive, both could suggest inadequate supervision- hard to deny monetary expansion did not contribute.
What did Moser (2003) say about adverse shocks?
“Propagation of adverse shocks that have potential to trigger financial crises”
What did Nurkse (1944) say a devaluation can cause?
Devaluation makes goods cheaper internationally, it pressures other countries to devalue as well to increase competitiveness. This therefore becomes a policy decision to encourage expansionary output. (contagion)
Example of contagion in Latin America in 1825-28?
Massive capital inflows (1822-25) into young republics due to economic and political factors. However, Peru defaults in 1826 followed by Chile and Gran Colombia. By 1828, all LA countries except Brazil had defaulted.
What was the Baring crisis in 1890?
Massive capital inflows to Argentina cause a bubble. Baring Bank declares insolvency to the BofE, crisis largely confined to Argentina and Brazil. Key as threatened London’s stability.
What was the Tequila crisis (1994)?
Major repercussions across Brazil and Argentina, LA currency turbulence.
2 types of contagion?
- Fundamentals-based contagion (financial links/trade)
- Pure contagion (not fundamentals but investor sentiment- the wakeup call).
Ways that crisis spread and cause contagion?
- Trade links (too slow, 1/2 yr)
- Wake up call
- Finance links
- Herding banks follow other banks leads
- Common creditors
Why did Kaminsky et al (2003) say there is Financial Contagion
- Capital flow cycles
- Surprise crises/ Anticipated catastrophes: If it is anticipated banks have time to adjust their portfolios, however, in a surprise they all cut and run
- Common highly leveraged creditors: Banks can transmit a crisis
Example of a bank transmitting a crisis?
US banks lending 22% of their emerging market budget to Mexico. Then when if a crisis hits it can have large consequences for an otherwise unconnected country.
Did Bordo (2011) find contagion is more common today?
No, contagion is also a historic phenomenon as well this is despite many reported case studies and widespread perception of more common contagion in recent years.
What is the role of the lender of last resort?
Prevention and mitigation of crises by lending in periods when no other lender is either capable or willing to lend in sufficient volume
Where did the concept of a lender of last resort originate?
Thornton’s (1802) book. He experienced GB when the Gold standard was suspended in 1797 until 1821. Britain was on paper money, the pound fluctuated. He realised paper money offered new opportunities, bank had to take a more active role.
Bagehot (1873) quote from his Lombard Street book on the lender of last resort?
n a crisis, the lender of last resort should lend freely, at a penalty rate, on the basis of collateral that is marketable in the ordinary course of business when there is no panic”
Bagehot’s 6 rules for CB, LofLR
- CB is the only one
- CB should lend on anything marketable under normal circumstances
- CB loans should be at a rate of interest above the market rate (cannot end up the only lender)
- Transparency, principles stated in advance
- CB should distinguish between illiquid but solvent, and insolvent institutions
- In a panic, CB must ensure liquidity in the market but not to individual firms
Problems with the rule that CB should be the only lender of last resort?
1.) At the time many countries either didn’t have a bank of note issue or had multiple entities (e.g. Italy had 6 at the start of the 19th Century).
Problems with the rule that CB should lend on anything marketable under normal circumstances
Lending on all items a contradiction to the Gold Standard rules. Bank of England given permission to break the rules in times of crisis to get around this. Today, the currency board liquidity provision is limited by the amount of foreign currency you have.
Problem with CB lending at a penalty rate?
3.) Penalty rate can make the banking crisis/situation worse e.g. Greek paid 2/3% more than other countries but this can lead to further insolvency
Problem with CB publishing rule in advance/transparency?
How do you make ideas known in advance as this ignores the context. Strategic ambiguity might be a helpful tool.
Reasons for CB not be strategically ambiguous?
Reduces risk of politically motivated actions, encourages stabilizing behaviour (build up of good collateral assets) and reduces likelihood of a self-fulfilling crisis.
Problem with saving the market but not individual firms?
Is this even possible to achieve? Goodhart and Huang (1998) argue this view de facto means rejecting the lender of last resort.
Capie, 1999, historical background to CB lending?
Founded as banks of note issue in 19th Century, one bank got the privilege of issuing, continued to also be a bank. Conflict of interest problem, as it could be helpful to shut down competitors etc.
How did England reduce the conflict of interest for note issuing banks?
1844 Bank Act, which separated bank into Issuing and Banking sections.
Example of CB undermining competitors?
Buyst and Maes (2007) demonstrate the slow transformation of the NB of Belgium lack of a clear policy sometimes undermined competitors and other times they saved other banks.
When does Capie consider European banks as CBs?
After WW1
When did Britain nationalise the CB?
1946
Moral hazard problem of Central banks?
Exacerbates moral hazard (too big to fail, deposit insurance). Pre-existing problem however policies can make it worse
Ways to reduce moral hazard problem of CBs?
- Better supervision
- Penalties for those who made mistakes
- Encourage better private sector monitoring.
Why do some want an international CB?
This necessary is a currency crisis as national banks cannot product foreign exchange. Capital mobility needs an institution to help prevent too many crises.
Issues with IMF?
- Accused of a Western biased
- Slow, undemocratic
- Cannot create money
- Lacks credibility
Is the IMF a CB?
- Any package is influenced by politics so lacks ability to help the market
- Must save a country, not the market (breaks Bagehot)
- Has offered loans at a penalty rate (Brazil, Russia)
IMF resources/ changes in modern day?
- IMF resources trebled to $750 billion, issued its first bond and is politically more sensitive which has increased its de-facto role as lender of last resort internationally.
Problems with the US supporting other countries banks?
- Gives a large influence over other countries politics
- Cannot raise their own interest rates if other countries cannot sustain it (2008, FED had to back down)
What did Bordo (2011) find about the severity of crisis?
Shows crises have become less severe due to government intervention. Emerging markets struggle as they lack the political/financial power to stop them
Example of a crisis improving the public finances?
Nordic countries in the 90s. Nationalise the banks at a cheap price and if confidence improves sell the banks for a profit
Example of direct costs to the public finances from a crisis?
- Bail-out costs
- capital injection
- Guarantees for private sector liabilities
- Central Bank support
Example of indirect costs to the public finances from a crisis?
- Fall off in the tax revenue
- Costs of economic stimulus package
Why do the US spend more stimulating their economy after a crisis?
Less benefits in the USA, there are less automatic stabilizers. Had to fall back on active economic stimulus packages
What does the IMF estimate a 10% fall in real house prices leads to?
Falling tax revenues of about 0.27% GDP
What does the IMF estimate a 10% fall in equity prices does to tax?
Falling tax revenues of about 0.08% of GDP
What did Reinhart and Rogoff (2009) show about UK debt to GDP pre/post 2008?
UK had debt to GDP ratio of 40% before 2008, now its nearing 90%, in 2010 the deficit was as bad as Greece! Increase in real public debt in 3 years after the crisis 86% increase
Why is a high debt to GDP ratio a problem?
There is a limit to how many times you can increase your debt to GDP ratio, another crisis could be catastrophic for the West.
What is Fiscal space?
How much room do you have for fiscal manoeuvre before you risk a government debt crisis
Problem with the concept of IMF fiscal space?
- The end is the cliff edge
- IMF previously said expansionary policies should only be used by countries with a GDP ratio of less than 60% (no longer say it!)
What is fiscal dominance?
When monetary policy is largely determined by fiscal needs (would rather have a rule e.g. inflation target or gold standard).
What is a zombie bank?
Only kept liquid from CB money (concern for Italian banks)
