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Subject BUSINESS ECONOMICS

Paper No and Title 5, MACROECONOMIC ANALYSIS AND POLICY

Module No and Title 34, THE GLOBAL FINANCIAL CRISIS

Module Tag BSE_P5_M34

BUSINESS PAPER No. : 5, MACROECONOMIC ANALYSIS AND POLICY

ECONOMICS MODULE No. : 34, THE GLOBAL FINANCIAL CRISIS
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TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. The Crisis: How it all started
4. Role of Banks and Financial Intermediaries
5. Policy Measures
5.1 Conventional Monetary Policy
5.2 Fiscal Policy and Quantitative Easing
6. Recovery after the Crisis
7. Summary

BUSINESS PAPER No. : 5, MACROECONOMIC ANALYSIS AND POLICY

ECONOMICS MODULE No. : 34, THE GLOBAL FINANCIAL CRISIS
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1. Learning Outcomes
After studying this module, you shall be able to -

 Understand the need to analyze a the causes and implications of an economic crisis
 Learn how the Global Financial Crisis unfolded
 Understand the mechanism at work that resulted in the crisis
 Comprehend the role of financial intermediaries in causing and spread of the crisis
 Identify certain features inherent in the working of banks (e.g., leverage, complexity of
financial instruments and liquidity) that shaped their role in the financial crisis
 Study the policy measures adopted by US Federal Reserve to overcome the crisis
 Examine the process of recovery after the crisis

2. Introduction
Any economic or financial crisis results in wide scale economic devastation. The Great
Depression of the 1930s had wreaked economic havoc causing prolonged and widespread
unemployment and massive destruction of wealth. But on a positive note, it provided ample scope
for research into the factors responsible for such a situation. It also exposed the vulnerabilities
inherent in working of an economy and brought the key role of government intervention in such
situations to the center stage of economic discourse. Thus valuable lessons can be drawn from a
study of any crisis. The Global Financial Crisis (GFC) is one of the largest crises that has affected
the world in recent times. According to Krugman (2008) “….like diseases (that) have become
resistant to antibiotics, the economic maladies that caused the Great Depression (are) making a
comeback”.

The global financial crisis was triggered by a decline in housing prices in the U.S. during 2006-
07. As it unfolded, the crisis exposed the fragility of the financial system and soon engulfed most
banks and financial institutions. The financial institutions’ ability to lend declined sharply and as
a result the cost of borrowing soared while investment demand plummeted. A crucial link
between savings and investments was ruptured, resulting in reduced aggregate expenditure and
hence sharp decline in economic activity. The present module attempts to explain how this crisis
originated, its adverse effects and what policy measures were taken to counter its negative impact
on income and employment1.

1The discussion in this Section is based on Chapter 9 in Blanchard, O. and D. Johnson, Macroeconomics,
6th Edn, Pearson : USA; and on Krugman, P. (2008) : “The Return of Depression Economics and the Crisis
of 2008”, Penguin Books : London.
.
BUSINESS PAPER No. : 5, MACROECONOMIC ANALYSIS AND POLICY
ECONOMICS MODULE No. : 34, THE GLOBAL FINANCIAL CRISIS
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3. The Crisis: How it all started

In 2006, housing prices in the U.S. started declining. Policy makers anticipated that this would
lead to a reduction in aggregate demand and growth. However, very few could foresee that this
would have a substantial impact on the financial sector and result in a full-blown financial crisis.
This is the basic crux of the factors leading to the onset of the crisis that forms the subject matter
of this section.

The prices of houses in the U.S. had started increasing in the early2000s and then stabilized in
2006; thereafter, towards the end of 2006 and in 2007, house prices started declining rapidly. Let
us try to analyze why housing prices behaved in this manner. The prices started rising in 2000 due
to arise in demand for houses. This increase in demand for houses was partly driven by prevailing
low rates of interest, owing to the easy money policy followed by the US Fed chief Alan
Greenspan. The low rates made housing loans attractive as mortgage rates were low. Also, in the
early 2000s, the dot.com stock market crash had shaken the economy; in its aftermath, the real
estate sector seemed to offer a safer, more attractive investment option as compared to the stock
market. Thus, house prices rose as the demand for houses was high.

In addition, mortgage lenders were not reluctant to lend even to low net-worth, risky borrowers,
referred to as subprime mortgages or simply subprimes. The subprimes had existed even during
the 1990s, though these increased enormously in volume after 2000, particularly from mid-2000.
Most economists viewed the rise in housing demand as a positive phenomenon, as a natural
concomitant of a booming economy. But some economists like Robert Shiller warned that the rise
in housing prices was a bubble that could soon burst.

When the housing prices started declining in 2006 some borrowers realized that the value of
mortgage they held was actually higher than the value of the houses they owned; these are termed
underwater investments. It is now clear that the crisis was triggered with the fall in housing
prices. However, its effects were enormous and they spread from the real estate sector to all other
sectors of the economy as well. To understand why this happened, it is crucial to examine the role
of banks and related financial institutions in this process.

4. Role of Banks and Financial Intermediaries

Banks are financial intermediaries that accept funds from those who have surplus cash to lend to
those who wish to borrow from them. The world over, banks are required to meet certain
stipulated norms laid down by the central banks of the countries in which they operate. Amongst
the several stipulations, one is to maintain adequate capital. An adequate level of capital ensures
that a bank can survive even in times when the value of its assets plunges. Capital adequacy
norms are measures that act as a safeguard against the risk of bankruptcy.

During the crisis, it was found that the banks actually had inadequate capital reserves. Also, the
liabilities (e.g., deposits) of banks were short term while their assets (e.g., housing mortgages)
were long term. This is commonly referred to as the problem of maturity mismatch. Due to this,
the banks found themselves in a situation where they were both insolvent (inadequate capital) and

BUSINESS PAPER No. : 5, MACROECONOMIC ANALYSIS AND POLICY

ECONOMICS MODULE No. : 34, THE GLOBAL FINANCIAL CRISIS
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illiquid (short on ready cash to meet liabilities). Since majority of banks and related financial
institutions faced similar incentives and faced similar problems, this spread very soon from one
institution to the other and ultimately the whole financial system collapsed. In particular, the
problems in banks arouse along several fronts discussed below:

1. Capital Inadequacy and Excessive Leverage: A financial entity’s leverage ratio may be
defined as the ratio of capital to assets. Many banks had very high leverage ratios during the
financial crisis. The banks and financial institutions, in pursuit of higher profits in an era of
low interest rates, increased their leverage. This added to the riskiness in their operations, so
much so that ultimately the higher risks resulted in collapse of the entire financial system.
Various explanations have been put forward to explain the excessive risk taking behavior of
banks. First, banks created new, innovative and complex financial instruments such as
structured investment vehicle (SIVs) to escape the regulatory requirements of minimum
capital ratio. Second, given the complex financial instruments, banks could have
underestimated the risks involved. Third, during the boom period, bankers were probably
tempted to make the most of the financial innovations to earn more profits.
2. Financial Innovation: A new development in the financial intermediation activity during the
1990s and 2000s was securitization. In securitization, the returns on securities are based on a
bundle of assets such as loans or mortgages. It is a good way of diversifying risks. For
instance, banks were able to ‘take off’ mortgages from their balance sheets by selling them
off to other banks or investors as ‘mortgage backed securities’ and raise funds in the process.
However, such activities can be extremely risky, especially if the underlying risks are not
properly estimated. During the financial crisis, the rating agencies too miscalculated the risks
associated with mortgage based securities. When the housing prices fell drastically, the
mortgages on which these securities were based went bad.

Another aspect of the financial innovations was that it brought into existence a number of non-
bank financial institutions (e.g., investment banks) that were not regulated by the Fed, but
essentially performed a similar function of financial intermediation. These have been
referred to as a parallel banking system or, as the shadow banking system. While these
entities also suffered from the problems of high risk taking and maturity mismatch, they
were not regulated like banks.

3. Reliance on Wholesale Funding: Another development that took place in the financial
markets was availability of other sources of finance apart from retail deposits (i.e., savings
and current bank accounts of individuals). The concept of wholesale funding became popular,
wherein banks created short-term debt instruments (e.g., mortgage based securities) to raise
funds from other banks and financial institutions. In this way the banking system, indeed the
larger financial system became involved with a fairly similar pool of assets. The problem was
that these assets mostly derived their values either directly or indirectly from the pool of
housing mortgages, a chunk of which comprised subprime loans.

C = The weakness of this system was exposed during the financial crisis, as banks, financial
institutions and investors became concerned about the value of the assets they held. With all the
parties (including banks) attempting to simultaneously get rid of the assets, their prices plunged

BUSINESS PAPER No. : 5, MACROECONOMIC ANALYSIS AND POLICY

ECONOMICS MODULE No. : 34, THE GLOBAL FINANCIAL CRISIS
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as there were hardly any takers. So banks found it hard to sell these assets and were often
compelled to sell them at very low prices, known as “fire sale prices” prices. The development
of this unregulated financial structure also contributed to the financial crisis. According
to Krugman (2008), “As the shadow banking system expanded to rival or even surpass
conventional banking in importance, politicians and government officials should have
realized that we were creating the kind of financial vulnerability that made Great
Depression possible- and that they should have responded by extending regulation and
financial safety net to cover these new institutions”.

Based on these problems, the occurrence of the crisis can be summarized in terms of the
following two mechanisms that were at work.

First, the crisis started when the housing prices started declining. Due to this some mortgages
turned bad. This implied high riskiness of banks’ assets. At the same time, owing to high
leverage, there was a sharp fall in the capital ratio of the banks. In order to escape from this
situation, banks started selling their assets. But, due to difficulties associated with valuation, in
most cases, the assets had to be sold at very low, “fire sale prices”. This served to worsen banks’
balance sheets, further reduced the capital ratio and put more pressure on banks to sell their
assets, resulting in further declines in asset prices.

Second, due to the sheer complexity of the financial instruments involved, (e.g., mortgage based
securities and derivatives based on these), it became difficult to assess the value of assets and cast
doubts on banks’ solvency. Accordingly, investors stopped lending to banks. So banks had a
shortage of liquidity and actually faced the threat of bank runs.

Due to the working of these mechanisms, the financial system had collapsed completely by
September, 2008. The financial crisis gradually turned into a macroeconomic crisis resulting in
loss in investor confidence and a general rise in the cost of borrowing due to lack of funds or
liquidity shortage, so that potential borrowers were unable to borrow. This resulted in widespread
anxiety and uncertainty among economic agents. It also resulted in a sharp fall in consumer
spending. The fear of the global economy slipping into another Great Depression began looming
large. Such a decrease in demand for goods can be explained by a significant leftward shift of the
IS curve in the IS-LM framework. In response to these adverse conditions, policy makers took
several measures. These are discussed in the next section.

5. Policy Measures
As the crisis dealt a severe blow to the financial intermediaries, the immediate and most urgent
policy measures attempted to strengthen the financial sector. A number of ‘emergency’ measures
were taken by the US government to restore confidence in financial institutions; e.g., deposit
insurance was raised from $100,000 to $250,000 per account; the government began to guarantee
new debt issued by banks; the government put in place measures to make adequate liquidity
available in the financial system; and a new program to clean up the banks was also introduced.
All these collective measures were taken to restore sufficient flow of liquidity in the financial
system, reduce bankruptcy and failure of banks and other financial institutions, as well as to
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ECONOMICS MODULE No. : 34, THE GLOBAL FINANCIAL CRISIS
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stabilize the financial system. Both monetary and fiscal policies were used to achieve these
objectives.

5.1 Conventional Monetary Policy

Interest rates in The U.S. had been close to zero since 2008. So, it could not have been reduced
further to ease the liquidity problems. Such a situation where interest rates are extremely low or
close to zero, is described as a liquidity trap. Recall from our discussion in the earlier modules on
the IS-LM framework that when the economy is in a liquidity trap, people are indifferent between
holding money and bonds, so that monetary policy become ineffective.

Under normal circumstances, the money demand curve is downward sloping and an increase in
money supply reduces the interest rate (Figure 1a). In case a liquidity trap occurs at the zero rate
of interest (as in case of the US), the money demand function becomes horizontal and is aligned
with the horizontal axis (Figure 1b). In this case any increase in money supply is held by the
public with no consequent reduction in interest rates; interest rates do not fall further as they are
already zero.

Figure 1 (a) Figure 1 (b)

This was the situation in the US during the financial crisis. The interest rate on treasury bills was
zero and the U.S. economy was in a liquidity trap. In this case conventional monetary policy was
completely ineffective in reviving aggregate demand and output.

BUSINESS PAPER No. : 5, MACROECONOMIC ANALYSIS AND POLICY

ECONOMICS MODULE No. : 34, THE GLOBAL FINANCIAL CRISIS
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5.2 Fiscal Policy and Quantitative Easing

What about the role of fiscal policy when the economy is in a liquidity trap? Once again, recall
from our discussion in earlier modules, that fiscal policy is very effective in reviving aggregate
demand and output under such conditions, where there is no crowding out. In fact the role of
fiscal policy in the US crisis, brought back Keynesian economics and its importance during the
Great Depression, to the very heart of policy and academic discourse.

However fiscal policy that was discussed separately in some of the previous modules too has
limitations. Under normal circumstances, a onetime fiscal stimulus may be sufficient for
increasing the level of output. But in a deep recession, a onetime increase in government
expenditure may fail to revive business and consumer confidence and have relatively small
impact on aggregate demand and output. In such cases, the government will have to continuously
incur several rounds of expenditure hikes to boost economic activity. Obviously this means the
government will have to run higher deficits and look for ways to finance it. It may have to
borrow, which would result in higher public debt. In the long run, the rising public debt and its
cost of debt servicing may make it unsustainable to rely solely on fiscal policy.

In case of the US, the policymakers also adopted certain unconventional monetary measures,
known as quantitative easing. This involved the US Federal Reserve, doing something rather
unusual; it started buying up financial assets (e.g., securitized debt instruments) issued by the
private financial sector. This was done to stabilize and restore confidence in the financial markets.
The US Feb took on its books (balance sheet), ‘toxic’ assets that all other economic agents were
extremely reluctant to hold at that time. Since this was a departure from the Fed’s standard
practice of holding government securities, this was an unconventional monetary policy response
put in place due to failure of traditional monetary channels.

6. Recovery after the Crisis

After the housing bubble burst the U.S. economy experienced the worst ever financial crisis. Has
the U.S. economy in particular and the world economy in general, recovered after the crisis?
There is little doubt that there have been signs of recovery, but the pace has been quite slow.
Some economists believe slow recovery is also a sign that the natural level of output (long run
equilibrium output) itself has declined after crisis.

The banking and financial collapse during the crisis has made the financial regulators alert. So all
new developments, such as new products and innovations, new kinds of financial intermediation
as well as the entire financial markets are under close scrutiny to prevent any further instability.
While more effective regulation is currently being viewed as beneficial for the economy, it also
adds to the cost of financial intermediation for borrowers and lenders. This may have contributed
to the decline in the natural level output.

The unemployment rate in U.S. during 2011 was around 9% while the pre - crisis estimates put it
at about 6% (the natural rate of unemployment). It is now clear that such a large increase in
unemployment cannot be attributed to supply side factors alone. The lack of aggregate demand is
equally responsible for the depth of the recession and the slow pace of recovery. The problem is
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ECONOMICS MODULE No. : 34, THE GLOBAL FINANCIAL CRISIS
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compounded by the fact that monetary policy and fiscal policy have their limitations. Hence, the
natural rate of output may not be easy to achieve.

But overtime the U.S. economy is likely to be put on a higher growth trajectory as business and
consumer confidence and aggregate demand picks up. The demand for goods and services though
low at present would not remain so for long. The recovery is sure, but may take time to happen.

A number of policy measures would have to be taken to ensure this; and the banking and
financial system needs to be restructured. Owing to the crisis there has been lower investment in
housing, but with population growth, housing demand is likely to increase, so housing price
increases and real estate booms are bound to recur. Such situations have to be monitored carefully
in the future.

7. Summary
 A financial crisis results in wide scale economic devastation and loss of consumer and
investor confidence.
 The Global Financial Crisis (GFC) is one of the largest crises to have affected the world in
recent times.
 The crisis was triggered by a decline in housing prices in U.S. during 2006-07.
 The crisis exposed the fragility of the financial system as it soon engulfed most banks and
financial institutions.
 During the crisis, banks had inadequate capital reserves and suffered from severe problems
of maturity mismatches.
 Many banks had very high leverage ratios and hence high risks during the financial crisis.
 During the financial crisis, the rating agencies miscalculated the risks associated with
complex financial instruments such as mortgage based securities.
 By September, 2008, the financial crisis gradually turned into a macroeconomic crisis
resulting in loss in investor confidence and there was a deep recession during the financial
crisis.
 During the crisis, the interest rate on treasury bills had fallen to zero and U.S. economy was
in a liquidity trap; so traditional monetary policy was ineffective.
 Expansionary fiscal policy to boost economic activity results in higher deficits and higher
public debt.
 Unconventional monetary policy or quantitative easing was also used by the US Fed.
 In the long run, rising public debt and the cost of debt servicing may make it expansionary
fiscal policy unsustainable.
 The U.S. economy is now on the road to recovery but the pace has been quite slow.
 The recovery is slow because the natural rate of output has declined after crisis.
 More effective financial regulation may be beneficial for the economy but adds to the cost
of financial intermediation.
 The banking and financial system needs to be restructured.
 Recovery is sure but may take time to happen.

BUSINESS PAPER No. : 5, MACROECONOMIC ANALYSIS AND POLICY

ECONOMICS MODULE No. : 34, THE GLOBAL FINANCIAL CRISIS