So far in this chapter we have discussed how the financial system works. We now discuss why the financial system might stop working and the broad macroeconomic ramifications of such a disruption.

When we discussed the theory of the business cycle in Chapter 10, Chapter 11. Chapter 12, Chapter 13 and Chapter 14, we saw that many kinds of shocks can lead to short-run fluctuations. A shift in consumer or business confidence, a rise or fall in world oil prices, or a sudden change in monetary or fiscal policy can alter aggregate demand or aggregate supply (or both). When this occurs, output and employment are pushed away from their natural levels, and inflation rises or falls.

Here we focus on one particular kind of shock. A financial crisis is 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. Not surprisingly, given the financial system’s central role, financial crises have a broad macroeconomic impact. Throughout history, many of the deepest recessions have followed problems in the financial system. These downturns include the Great Depression of the 1930s and the Great Recession of 2008–2009.

Financial crises are not all alike, but they share some common features. In a nutshell, here are the six elements that are at the center of most financial crises. The financial crisis of 2008–2009 provides a good example of each element.

1. Asset-Price Booms and Busts Often a period of optimism, leading to a large increase in asset prices, precedes a financial crisis. Sometimes people bid up the price of an asset above its fundamental value (that is, the true value based on an objective analysis of the cash flows the asset will generate). In this case, the market for that asset is said to be in the grip of a speculative bubble. Later, when sentiment shifts and optimism turns to pessimism, the bubble bursts and prices begin to fall. The decline in asset prices is the catalyst for the financial crisis.

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In 2008 and 2009, the crucial asset was residential real estate. The average price of housing in the United States had experienced a boom earlier in the decade. This boom was driven in part by lax lending standards; many subprime borrowers—those with particularly risky credit profiles—were lent money to buy a house while offering only a very small down payment. In essence, the financial system failed to do its job of dealing with asymmetric information by making loans to many borrowers who, it turned out, would later have trouble making their mortgage payments. The housing boom was also encouraged by government policies that promoted homeownership and was fed by excessive optimism on the part of home-buyers, who thought prices would rise forever. The housing boom, however, proved unsustainable. Over time, the number of homeowners falling behind on their mortgage payments rose, and sentiment among home-buyers shifted. Housing prices fell by about 30 percent from 2006 to 2009. The nation had not experienced such a large decline in housing prices since the 1930s.

2. Insolvencies at Financial Institutions A large decline in asset prices may cause problems at banks and other financial institutions. To ensure that borrowers repay their loans, banks often require them to post collateral. That is, a borrower has to pledge assets that the bank can seize if the borrower defaults. Yet when assets decline in price, the collateral falls in value, perhaps below the amount of the loan. In this case, if the borrower defaults on the loan, the bank may be unable to recover its money.

As we discussed in Chapter 4, banks rely heavily on leverage, the use of borrowed funds for the purposes of investment. Leverage amplifies the positive and negative effect of asset returns on a bank’s financial position. A key number is the leverage ratio: the ratio of bank assets to bank capital. A leverage ratio of 20, for example, means that for every $1 in capital put into the bank by its owners, the bank has borrowed (via deposits and other loans) $19, which then allows the bank to hold $20 in assets. In this case, if defaults cause the value of the bank’s assets to fall by 2 percent, then the bank’s capital will fall by 40 percent. If the value of bank assets falls by more than 5 percent, then its assets will fall below its liabilities, and the bank will be insolvent. In this case, the bank will not have the resources to pay off all its depositors and other creditors. Widespread insolvency within the financial system is the second element of a financial crisis.

In 2008 and 2009, many banks and other financial firms had in effect placed bets on real estate prices by holding mortgages backed by that real estate. They assumed that housing prices would keep rising or at least hold steady, so the collateral backing these loans would ensure their repayment. When housing prices fell, however, large numbers of homeowners found themselves underwater: the value of their homes was less than the amount they owed on their mortgages. When many homeowners stopped paying their mortgages, the banks could foreclose on the houses, but they could recover only a fraction of what they were owed. These defaults pushed several financial institutions toward bankruptcy. These institutions included major investment banks (Bear Stearns and Lehman Brothers), government-sponsored enterprises involved in the mortgage market (Fannie Mae and Freddie Mac), and a large insurance company (AIG).

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3. Falling Confidence The third element of a financial crisis is a decline in confidence in financial institutions. While some deposits in banks are insured by government policies, not all are. As insolvencies mount, every financial institution becomes a possible candidate for the next bankruptcy. Individuals with uninsured deposits in those institutions pull out their money. Facing a rash of withdrawals, banks cut back on new lending and start selling off assets to increase their cash reserves.

As banks sell off some of their assets, they depress the market prices of these assets. Because buyers of risky assets are hard to find in the midst of a crisis, the assets’ prices can sometimes fall precipitously. Such a phenomenon is called a fire sale, similar to the reduced prices that a store might charge to get rid of merchandise quickly after a fire. These fire-sale prices, however, cause problems at other banks. Accountants and regulators may require these banks to revise their balance sheets and reduce the reported value of their own holdings of these assets. In this way, problems in one bank can spread to others.

In 2008 and 2009, the financial system was seized by great uncertainty about where the insolvencies would stop. The collapse of the giants Bear Stearns and Lehman Brothers made people wonder whether other large financial firms, such as Morgan Stanley, Goldman Sachs, and Citigroup, would meet a similar fate. The problem was exacerbated by the firms’ interdependence. Because they had many contracts with one another, the demise of any one of these institutions would undermine all the others. Moreover, because of the complexity of the arrangements, depositors could not be sure how vulnerable these firms were. The lack of transparency fed the crisis of confidence.

4. Credit Crunch The fourth element of a financial crisis is a credit crunch. With many financial institutions facing difficulties, would-be borrowers have trouble getting loans, even if they have profitable investment projects. In essence, the financial system has trouble performing its normal function of directing the resources of savers into the hands of borrowers with the best investment opportunities.

The tightening of credit was clear during the 2008–2009 financial crisis. Not surprisingly, as banks realized that housing prices were falling and that previous lending standards had been too lax, they started raising standards for those applying for mortgages. They required larger down payments and scrutinized borrowers’ financial information more closely. But the reduction in lending did not affect only home-buyers. Small businesses found it harder to borrow to finance business expansions or to buy inventories. Consumers found it harder to qualify for a credit card or car loan. Thus, banks responded to their own financial problems by becoming more cautious in all kinds of lending.

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5. Recession The fifth element of a financial crisis is an economic downturn. With people unable to obtain consumer credit and firms unable to obtain financing for new investment projects, the overall demand for goods and services declines. Within the context of the IS–LM model, this event can be interpreted as a contractionary shift in the consumption and investment functions, which in turn leads to similar shifts in the IS curve and the aggregate demand curve. As a result, national income falls and unemployment rises.

Indeed, the recession following the financial crisis of 2008–2009 was a deep one. Unemployment rose from about 4.5 percent in early 2007 to 10 percent in late 2009. Worse yet, it lingered at a high level for a long time. Even after the recovery officially began in June 2009, growth in GDP was so meager that unemployment declined only slightly. The unemployment rate remained above 8 percent until late 2012.

6. A Vicious Circle The sixth and final element of a financial crisis is a vicious circle. The economic downturn reduces the profitability of many companies and the value of many assets. The stock market declines. Some firms go bankrupt and default on their business loans. Many workers become unemployed and default on their personal loans. Thus, we return to steps 1 (asset-price busts) and 2 (financial institution insolvencies). The problems in the financial system and the economic downturn reinforce each other. Figure 20-2 illustrates the process.

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In 2008 and 2009, the vicious circle was apparent. Some feared that the combination of a weakening financial system and a weakening economy would cause the economy to spiral out of control, pushing the country into another Great Depression. Fortunately, that did not occur, in part because policymakers were intent on preventing it.

That brings us to the next question: Faced with a financial crisis, what can policymakers do?

Because financial crises are both severe and multifaceted, macroeconomic policymakers use various tools, often simultaneously, to try to control the damage. Here we discuss three broad categories of policy responses.

Conventional Monetary and Fiscal Policy As we have seen, financial crises raise unemployment and lower incomes because they lead to a contraction in the aggregate demand for goods and services. Policymakers can mitigate these effects by using the tools of monetary and fiscal policy to expand aggregate demand. The central bank can increase the money supply and lower interest rates. The government can increase government spending and cut taxes. That is, a financial crisis can be seen as a shock to the aggregate demand curve, which can, to some degree, be offset by appropriate monetary and fiscal policy.

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Policymakers did precisely this during the financial crisis of 2008–2009. To expand aggregate demand, the Federal Reserve cut its target for the federal funds rate from 5.25 percent in September 2007 to approximately zero in December 2008. It then stayed at that low level for the next six years. In February 2008 President Bush signed into law a $168 billion dollar stimulus package, which funded tax rebates of $300 to $1,200 for every taxpayer. In 2009 President Obama signed into law a $787 billion stimulus, which included some tax reductions but also significant increases in government spending. All of these moves were aimed at propping up aggregate demand.

There are limits, however, to how much conventional monetary and fiscal policy can do. A central bank cannot cut its target for the interest rate below zero. (Recall the discussion of the liquidity trap in Chapter 12.) Fiscal policy is limited as well. Stimulus packages add to the government budget deficit, which is already enlarged because economic downturns automatically increase unemployment-insurance payments and decrease tax revenue. Increases in government debt are a concern because they place a burden on future generations of taxpayers and call into question the government’s own solvency. In the aftermath of the financial crisis of 2008–2009, the federal government’s budget deficit reached levels not seen since World War II. As noted in Chapter 19, in August 2011, Standard & Poor’s responded to the fiscal imbalance by reducing its rating on U.S. government debt below the top AAA level for the first time in the nation’s history, a decision that made additional fiscal stimulus more difficult.

The limits of monetary and fiscal policy during a financial crisis naturally lead policymakers to consider other, and sometimes unusual, alternatives. These other types of policy are of a fundamentally different nature. Rather than addressing the symptom of a financial crisis (a decline in aggregate demand), they aim to fix the financial system itself. If the normal process of financial intermediation can be restored, consumers and businesses will be able to borrow again, and the economy’s aggregate demand will recover. The economy can then return to full employment and rising incomes. The next two categories describe the major policies aimed directly at fixing the financial system.

Lender of Last Resort When the public starts to lose confidence in a bank, they withdraw their deposits. In a system of fractional-reserve banking, large and sudden withdrawals can be a problem. Even if the bank is solvent (meaning that the value of its assets exceeds the value of its liabilities), it may have trouble satisfying all its depositors’ requests. Many of the bank’s assets are illiquid—that is, they cannot be easily sold and turned into cash. A business loan to a local restaurant, a car loan to a local family, and a student loan to your roommate, for example, may be valuable assets to the bank, but they cannot be easily used to satisfy depositors who are demanding their money back immediately. A situation in which a solvent bank has insufficient funds to satisfy its depositors’ withdrawals is called a liquidity crisis.

The central bank can remedy this problem by lending money directly to the bank. As we discussed in Chapter 4, the central bank can create money out of thin air by, in effect, printing it. (Or, more realistically in our electronic era, it creates a bookkeeping entry for itself that represents those monetary units.) It can then lend this newly created money to the bank experiencing greater-than-normal withdrawals and accept the bank’s illiquid assets as collateral. When a central bank lends to a bank in the midst of a liquidity crisis, it is said to act as a lender of last resort.

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The goal of such a policy is to allow a bank experiencing unusually high withdrawals to weather the storm of reduced confidence. Without such a loan, the bank might be forced to sell its illiquid assets at fire-sale prices. If such a fire sale were to occur, the value of the bank’s assets would decline, and a liquidity crisis could then threaten the bank’s solvency. By acting as a lender of last resort, the central bank stems the problem of bank insolvency and helps restore the public’s confidence in the banking system.

During 2008 and 2009, the Federal Reserve was extraordinarily active as a lender of last resort. As we discussed in Chapter 4, such activity traditionally takes place at the Fed’s discount window, through which the Fed lends to banks at its discount rate. During this crisis, however, the Fed set up a variety of new ways to lend to financial institutions. The financial institutions included were not only traditional commercial banks but also so-called shadow banks. Shadow banks are a diverse set of financial institutions that perform some functions similar to those of banks but do so outside the regulatory system that applies to traditional banking. Because the shadow banks were experiencing difficulties similar to those of commercial banks, the Fed was concerned about these institutions as well.

For example, from October 2008 to October 2009, the Fed was willing to make loans to money market mutual funds. Money market funds are not banks, and they do not offer insured deposits. But they are in some ways similar to banks: they take in deposits, invest the proceeds in short-term loans such as commercial paper issued by corporations, and assure depositors that they can obtain their deposits on demand with interest. In the midst of the financial crisis, depositors worried about the value of the assets the money market funds had purchased, so these funds were experiencing substantial withdrawals. The shrinking deposits in money market funds meant that there were fewer buyers of commercial paper, which in turn made it hard for firms that needed the proceeds from these loans to finance their continuing business operations. By its willingness to lend to money market funds, the Fed helped maintain this particular form of financial intermediation.

It is not crucial to learn the details of the many new lending facilities the Fed established during the crisis. Indeed, many of these programs were closed down as the economy started to recover because they were no longer needed. What is important to understand is that these programs, both old and new, have one purpose: to ensure that the financial system remains liquid. That is, as long as a financial institution had assets that could serve as reliable collateral, the Fed stood ready to lend it money so that its depositors could withdraw their funds.

Injections of Government Funds The final category of policy responses to a financial crisis involves the government’s use of public funds to prop up the financial system.

The most direct action of this sort is a giveaway of public funds to those who have experienced losses. Deposit insurance is one example. Through the Federal Deposit Insurance Corporation (FDIC), the federal government promises to make up for losses that a depositor experiences when a bank becomes insolvent. In 2008, the FDIC increased the maximum deposit it would cover from $100,000 to $250,000 to reassure bank depositors that their funds were safe. (This increase in the maximum insured deposit was originally announced as temporary, but it was later made permanent.)

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Giveaways of public funds can also occur on a more discretionary basis. For example, in 1984 a large bank called Continental Illinois found itself on the brink of insolvency. Because Continental Illinois had so many relationships with other banks, regulators feared that allowing it to fail would threaten the entire financial system. As a result, the FDIC promised to protect all of its depositors, not just those under the insurance limit. Eventually, it bought the bank from shareholders, added capital, and sold it to Bank of America. This policy operation cost taxpayers about $1 billion. It was during this episode that a congressman coined the phrase “too big to fail” to describe a firm so central to the financial system that policymakers would not allow it to enter bankruptcy.

Another way for the government to inject public funds is to make risky loans. Normally, when the Federal Reserve acts as lender of last resort, it does so by lending to a financial institution that can pledge good collateral. But if the government makes loans that might not be repaid, it is putting public funds at risk. If the borrowers do indeed default, taxpayers end up losing.

During the financial crisis of 2008–2009, the Fed engaged in a variety of risky lending. In March 2008, it made a $29 billion loan to JPMorgan Chase to facilitate its purchase of the nearly insolvent Bear Stearns. The only collateral the Fed received was Bear’s holdings of mortgage-backed securities, which were of dubious value. Similarly, in September 2008, the Fed loaned $85 billion to prop up the insurance giant AIG, which faced large losses from having insured the value of some mortgage-backed securities (through an agreement called a credit default swap). The Fed took these actions to prevent Bear Stearns and AIG from entering a long bankruptcy process, which could have further threatened the financial system.

A final way for the government to use public funds to address a financial crisis is for the government itself to inject capital into financial institutions. In this case, rather than being just a creditor, the government gets an ownership stake in the companies. The AIG loans in 2008 had significant elements of this: as part of the loan deal, the government got warrants (options to buy stock) and so eventually owned most of the company. (The shares were sold several years later.) Another example is the capital injections organized by the U.S. Treasury in 2008 and 2009. As part of the Troubled Asset Relief Program (TARP), the government put hundreds of billions of dollars into various banks in exchange for equity shares in those banks. The goal of the program was to maintain the banks’ solvency and keep the process of financial intermediation intact.

Not surprisingly, the use of public funds to prop up the financial system, whether done with giveaways, risky lending, or capital injections, is controversial. Critics assert that it is unfair to taxpayers to use their resources to rescue financial market participants from their own mistakes. Moreover, the prospect of such financial bailouts may increase moral hazard because when people believe the government will cover their losses, they are more likely to take excessive risks. Financial risk taking becomes “heads I win, tails the taxpayers lose.” Advocates of these policies acknowledge these problems, but they point out that risky lending and capital injections could actually make money for taxpayers if the economy recovers. (Indeed, in December 2014, the federal government estimated that TARP ended up yielding a $15 billion profit.) More important, they believe that the costs of these policies are more than offset by the benefits of averting a deeper crisis and more severe economic downturn.

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In addition to the question of how policymakers should respond when facing a financial crisis, there is another key policy debate: How should policymakers prevent future financial crises? Unfortunately, there is no easy answer. But here are five areas where policymakers have been considering their options and, in some cases, revising their policies.

Focusing on Shadow Banks Traditional commercial banks are heavily regulated. One justification is that the government insures some of their deposits through the FDIC. Policymakers have long understood that deposit insurance produces a moral hazard problem. Because of deposit insurance, depositors have no incentive to monitor the riskiness of banks in which they make their deposits; as a result, bankers have an incentive to make excessively risky loans, knowing they will reap any gains while the deposit insurance system will cover any losses. In response to this moral hazard problem, the government regulates the risks that banks take.

Much of the crisis of 2008–2009, however, concerned not traditional banks but rather shadow banks—financial institutions that (like banks) are at the center of financial intermediation but (unlike banks) do not take in deposits insured by the FDIC. Bear Sterns and Lehman Brothers, for example, were investment banks and, therefore, subject to less regulation. Similarly, hedge funds, insurance companies, and private equity firms can be considered shadow banks. These institutions do not suffer from the traditional problem of moral hazard arising from deposit insurance, but the risks they take may nonetheless be a concern of public policy because their failure can have macroeconomic ramifications.

Many policymakers have suggested that these shadow banks should be limited in how much risk they take. One way to do that would be to require that they hold more capital, which would in turn limit these firms’ ability to use leverage. Advocates of this idea say it would enhance financial stability. Critics say it would limit these institutions’ ability to do their job of financial intermediation.

Another issue concerns what happens when a shadow bank runs into trouble and nears insolvency. Legislation passed in 2010, the so-called Dodd-Frank Act, gave the FDIC resolution authority over shadow banks, much as it already had over traditional commercial banks. That is, the FDIC can now take over and close a nonbank financial institution if the institution is having trouble and the FDIC believes it could create systemic risk for the economy. Advocates of this new law believe it will allow a more orderly process when a shadow bank fails and thereby prevent a more general loss of confidence in the financial system. Critics fear it will make bailouts of these institutions with taxpayer funds more common and exacerbate moral hazard.

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Restricting Size The financial crisis of 2008–2009 centered on a few very large financial institutions. Some economists have suggested that the problem would have been averted, or at least would have been less severe, if the financial system had been less concentrated. When a small institution fails, bankruptcy law can take over as it usually does, adjudicating the claims of the various stakeholders, without resulting in economy-wide problems. These economists argue that if a financial institution is too big to fail, it is too big.

Various ideas have been proposed to limit the size of financial firms. One would be to restrict mergers among banks. (Over the past half century, the banking industry has become vastly more concentrated, largely through bank mergers.) Another idea is to impose higher capital requirements on larger banks. Advocates of these ideas say that a financial system with smaller firms would be more stable. Critics say that such a policy would prevent banks from taking advantage of economies of scale and that the higher costs would eventually be passed on to the banks’ customers.

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Reducing Excessive Risk Taking The financial firms that failed during the financial crisis of 2008–2009 did so because they took risks that resulted in the loss of large sums of money. Some observers believe that one way to reduce the risk of future crises is to limit excessive risk taking. Yet because risk taking is at the heart of what many financial institutions do, there is no easy way to draw the line between appropriate and excessive risks.

Nonetheless, the Dodd-Frank Act included several provisions aimed at limiting risk taking. Perhaps the best known is the so-called Volcker rule, named after Paul Volcker, the former Federal Reserve chairman who first proposed it. Under the Volcker rule, commercial banks are restricted from making certain kinds of speculative investments. Advocates say the rule will help protect banks. Critics say that by restricting the banks’ trading activities, it will make the market for those speculative financial instruments less liquid.

Making Regulation Work Better The financial system is diverse, with many different types of firms performing various functions and having developed at different stages of history. As a result, the regulatory apparatus overseeing these firms is highly fragmented. The Federal Reserve, the Office of the Comptroller of the Currency, and the FDIC all regulate commercial banks. The Securities and Exchange Commission regulates investment banks and mutual funds. Individual state agencies regulate insurance companies.

After the financial crisis of 2008–2009, policymakers tried to improve the system of regulation. The Dodd-Frank Act created a new Financial Services Oversight Council, chaired by the Secretary of the Treasury, to coordinate the various regulatory agencies. It also created a new Office of Credit Ratings to oversee the private credit rating agencies, which were blamed for failing to anticipate the great risk in many mortgage-backed securities. The law also established a new Consumer Financial Protection Bureau, with the goal of ensuring fairness and transparency in how financial firms market their products to consumers. Because financial crises are infrequent events, often occurring many decades apart, it will take a long time to tell whether this new regulatory structure works better than the old one.

Taking a Macro View of Regulation Policymakers have increasingly taken the view that the regulation of financial institutions requires more of a macroeconomic perspective. Traditionally, financial regulation has been microprudential: its goal has been to reduce the risk of distress in individual financial institutions, thereby protecting the depositors and other stakeholders in those institutions. Today, financial regulation is also macroprudential: its goal is also to reduce the risk of system-wide distress, thereby protecting the overall economy against declines in production and employment. Microprudential regulation takes a bottom-up approach by focusing on individual institutions and assessing the risks that each of them faces. By contrast, macroprudential regulation takes a top-down approach by focusing on the big picture and assessing the risks that can affect many financial institutions at the same time.

For example, macroprudential regulation could have addressed the boom and bust in the housing market that were the catalysts for the 2008–2009 financial crisis. Advocates of such regulation argue that as house prices increased, policymakers should have required larger down payments when homebuyers purchased a house with a mortgage. This policy might have slowed the speculative bubble in house prices, and it would have led to fewer mortgage defaults when house prices later declined. Fewer mortgage defaults, in turn, would have helped protect many financial institutions that had acquired stakes in various housing-related securities. Critics of such a policy question whether government regulators are sufficiently knowledgeable and adept to identify and remedy economy-wide risks. They worry that attempts to do so would add to the regulatory burden; an increase in required down payments, for instance, makes it harder for less wealthy families to buy their own homes.

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Without doubt, in light of what was learned during and after the financial crisis, financial regulators will pay renewed attention to macroeconomic stability as one of their goals. In this sense, macroprudential regulation takes its place alongside the traditional tools of monetary and fiscal policy. Yet how active policymakers should be in using this tool remains open to debate.5