American Economic Policy, as told by Martin Feldstein at Harvard University: Lecture 10, Preventing and Responding to Financial Crises
“Good morning, our subject today is financial crises and policy responses. I’m going to focus mostly on the crisis of 2008, which seems like it has been going on forever.”
So begins Larry Summers in addressing the students attending the 10th lecture of the course “American Economic Policy” that he is co-teaching with Marty Feldstein and others.
“It was a scary moment and had substantial consequences. The US gross domestic product dropped by 10%, and today is estimated to be 10% lower than would be predicted by the pre-crash trend. That’s $1.7 trillion a year, or $20,000 for the average family of four. Unemployment reached highest level since the depression: 10% in the aftermath of this event, and even today there are several million more people unemployed or out of the labour force as a result.”
What I would like to do today is the most basic economics behind a crisis of this sort, and in the next lecture I give to use it to talk about policy responses to crises.
The function of financial markets
If you think about it events like this pose a deep challenge to economic reasoning. The most basic thing you learn in standard economics would be something like this: markets find equilibrium, it would be supply and demand. Markets work on their own, no one has to worry as long as prices and wages adjust. If you just let flexible markets work, the system will tend to equilibrate.
So if you think about the events like what I’ve just described, they don’t seem to be explained by this theory. The whole thing seems to falling apart rather than coming together. I want to sketch the main aspects that contribute to this, and at the centre of a major recession or depression is what happens in financial markets.
Let’s think in abstract terms about the functioning of financial markets. We take this for granted. Any economy has a basic problem. Take me as an example. I want to save for retirement, for a rainy day, to invest in my children’s schooling. I have these desires to save. At the same time I don’t really have the knowledge to buy a machine, or somehow translate my savings into interest based growth. I don’t know how to invest in machinery and equipment, or build a bridge. And besides I just have a bit of money compared to the cost of these things.
On the other hand there are people with great ideas who need money, or people who want to own a house but don’t have the money, or institutions like universities that like Harvard want to build a new campus and don’t have the money.
The function of a financial system is to connect people who desire to save with those who want to invest.
This can happen through financial intermediaries, like banks, that take my savings and lend it to a store or company that can invest in inventories that anticipate selling. Or it can happen through financial markets. I buy stock of Google and Larry Page takes the money and invests it in a driverless car or whatever.
The central function of a financial market is to take those who wish to defer consumption to those who want to deploy capital productively.
If you think about this for a minute there is a basic aspect of this function: “maturity transformation.”
Lets assume I have put aside my savings for a rainy day. What is really important to me? I want to be able to get my hands on my savings whenever I need them. I want to be able to take my money out of the bank, or sell my stock. I want liquidity. But let’s say you want to buy a house. It would not be a good deal for you to borrow from me if I say that you have to pay me back whenever I want.
The idea is something like a grand insurance scheme. A lot of us put money in the bank, the bank lends it in a way it can’t get it back immediately figuring that as long as it keeps some money in a vault not everyone will want the money back at the same time. So lending for the long-term is okay. There’s a lot of people who hold stock, but not everyone wants to sell at the same time.
The financial system involves savers getting liquidity, and the lenders having capital for the long-term.
You couldn’t really have a functioning economy without something like this. You need financial intermediation.
Individuals don’t have the skills to lend, say making credit worthy checks. So financial intermediaries are performing a service. Hedge funds are another example of financial intermediaries that perform a service in currency markets.
Financial intermediation is central to the way in which a modern economy works. And central to how it doesn’t work when things go wrong.
What can go wrong?
I want to take a very simple financial situation and think about it in terms of supply and demand.
Let’s assume you are an investor with a good deal of confidence. You are very optimistic about a particular firm, and want to own as much of it that you can. So the first idea is to buy stock. Let’s say you have a $1,000 and you buy $1,000 worth of stock. If the value of the stock increases by say 50% you stand to make $500. If the stock were to fall in value by say 30%, you stand to lose $300.
All very good, but you are so confident of this that you want to buy more. You really like the firm but you don’t have a lot of money. So you can borrow the money to buy more stock. Say you take your $1,000 and borrow another $1,000 in order to buy $2,000 worth of the stock. Now when the value of the stock increases by 50%, your return doubles and you now make $1,000. But if it falls in value by 30%, your return goes down by 60%.
A 50% move translates to a 100% move in the original money. This is why they call debt “leverage,” all the swings are magnified by the borrowing.
Let’s dwell on the case where you see the stock value fall by 30%. You have stock worth $1400, equity worth $400 and debit worth $1000.
The company you invested in doesn’t care. But the bank that lent you the money worries about your capacity to pay back the loan. The bank wants its money back or at least 30% of the loan as collateral. It wants you to pay back $300. Maybe it will even ask for more back because the stock looks riskier than originally imagined.
The bank will take the stock if you don’t pay the $300 and then sell it. You might pay the money, or decide yourself to sell the stock, and keep your $400. The natural response is that there will be selling of the stock.
This is quite odd from the point of view of economics. The law of supply looks odd: prices fell and supply is increasing. This is the opposite of the way we think of supply and demand: prices falling and supply going up.
You can imagine this leading to a vicious circle, and that the system does not look stable.
Leverage and natural behaviour leads to markets that are highly prone to instability. This is a system with a positive, not a negative feedback. It is not like a thermostat that pushes the temperature of your house back to a desired level, or like a ball rolling back and forth in a bowl until it settles at the bottom, or like the classic model of supply and demand that leads to an equilibrium price.
Rather it is like two microphones being held very close to each other that feed into each other and create a very loud noise, or a ball balanced on the very top of an inverted bowl, moving faster away from the top the further it gets from it. Systems with this positive feedback are unstable.
An economic system with leverage will display positive feedback. This is a first way to understand market crashes and instability.
A bank run is a manifestation of this. And confidence in the financial system is crucial in preventing them.
Why is it that if you drive around Massachusetts through the little towns, the most impressive building in the town is always the bank? It is built that way to inspire confidence. Confidence is central to the bank’s success.
This is not unique to banks. You would not want to buy a Tesla if you thought the company was about to go bankrupt. You don’t because you fear having a spare parts problem in the future.
While it is common to many activities, it is clearest for banks.
It is also true for other kinds of things, say a mutual fund invested in houses. The issue of confidence is central to financial activity, that without confidence there is forced selling, and the possibility that leverage leads to positive feedback, which leads to instability.
At the center of financial crises is a bank run phenomenon. Now-a-days this can happen instantaneously with computer technology. It happens faster, but is essentially the same thing as people lining up in front of the banks in the 1930s demanding their money back.
What happens to one bank if there is a run on another? There may be an erosion of wider confidence. But there is more to it. If one bank is in trouble, then it will start selling its assets. Selling of assets will lower the value of the other bank’s assets. One bank causes a reputational effect, and potentially a direct effect. Bank run phenomena lead to fire sale effects that cause contagion to the remainder of the financial system.
There are additional elements of positive feedback during crises. The chain of events looks something like this.
- liquidations drive prices down
- asset price declines hit bank capital
- financial strains exacerbate economic problems as banks demand repayments of loans
- Keynesian multiplier effects kick as lower income and wealth result in successive waves of lower incomes and spending
- deflationary spiral takes place in which people postpone consumption in anticipation of lower future prices
- fear raises borrowing costs
The way to understand a crisis, is as a lack of confidence that in the presence of leverage leads to positive feedback and lower spending. What to do about them, what the policy response should be, is the topic I will address the next time lecture to this class.
Here are the readings:
Laura Alfaro and Renee Kim, “U.S. Subprime Mortgage Crisis: Policy Reactions (B),” Harvard Business School, 9-709-045, June 3, 2010.
Charles Kindleberger, Manias, Panics and Crashes: A History of the Financial Crisis, Wiley, 4th ed., 2000, Chapter 2, pp. 21-32.
Paul Krugman, “Crisis Endgame,” New York Times, September 19, 2008.
David Leonhardt, “More Than One Way to Take Over a Bank,” New York Times, March 1, 2009: MM11.
Andrew Ross Sorkin, “Imagine the Bailouts are Working,” New York Times, April 12, 2010: B1.
Lawrence H. Summers, “Responding to an Historic Economic Crisis: The Obama Program,” Remarks at The Brookings Institution, March 13, 2009.
“Volcker and Derivatives,” Wall Street Journal, June 24, 2010.
Paul Krugman, “Making Financial Reform Fool-Resistant,” New York Times, April 5, 2010: A19.
Paul Krugman, “Financial Reform 101,” New York Times, April 2, 2010: A23.
Jeremy Stein, “Should Megabanks be Broken Apart?” New York Times, December 7, 2010.
Lawrence H. Summers, “The Future of Finance,” Financial Times View from the Top Conference, October 7, 2010, transcript reprinted.
John B. Taylor, “The Dodd-Frank Financial Fiasco,” Wall Street Journal, July 1, 2010
Elizabeth Warren, “It’s Time to Simplify Financial Regulation,” Wall Street Journal, October 1, 2010.
Congressional Oversight Report, January Oversight Report: An Update on TARP Support for the Domestic Automotive Industry, January 13, 2011.
Malcolm Gladwell, “Overdrive,” The New Yorker, November 1, 2010.
Paul Ingrassia, “Two Cheers for the Detroit Bailout,” Wall Street Journal, August 2, 2010.
Steven Rattner, Overhaul: An Insider’s Account of the Obama Administration’s Emergency Rescue of the Auto Industry, Houghton Mifflin Harcourt, 2010, Chapter 2, pp. 20-42.
Matthew J. Slaughter, “An Auto Bailout Would Be Terrible for Free Trade,” Wall Street Journal, November 20, 2008: A21.
Lawrence Summers, “Remarks at the Council on Foreign Relations,” transcript reprinted in Wall Street Journal, June 12, 2009.
Jack and Suzy Welch, “GM: The Case Against a Bailout,” Bloomberg Businessweek, November 18, 2008, 12:01 AM.
Todd J. Zywicki, “Chrysler and the Rule of Law,” Wall Street Journal, May 13, 2009: A19.