Lecture 10

1. Lecture 10 THE NEED FOR SYSTEMIC STABILITY

2. Factors driving the financial sector • The financial system is in a continuing flux driven by transactions costs motives. • The developments of forex markets demonstrate the importance of cost reduction. • The strategies are • Bundling of funds (economies of scale) • Risk reduction through diversification • Explicit Hedging • Expertise (legal, technological)

3. Information inefficiencies • Market participants can have insufficient information about their counterparts (asymmetric information). It leads to • Adverse selection. This is an information problem occurring before the transaction:Potential bad credit risks are those who seek loans most actively. • Moral hazard. This occurs after the trans-action: Borrowers may take on big risks.

4. Adverse selection: The ‘lemons problem’ • A ‘lemon’ is a bad car purchased second hand. • Akerlof studied the used-car market and found an asymmetric information problem: • Potential buyers can’t tell a ‘lemon’ from a good car. • They offer an average price,between the value of a lemon and a good car. George Akerlof *1940, Nobel Prize 2001

5. The owner of a used car knows whether the car is good or bad. If the car is a lemon, he is of course happy to sell at the average price. If the car is good, the owner has little incentive to sell at average prices. Transaction volumes are low and the market may even break down. Similar problems arise in the securities markets (bonds, and stocks). An investor will only pay a price that reflects the average quality of firms. Bad firms are happy to take loans from investors. Good firms are not willing to borrow on this market. The ‘lemons problem’

6. Moral hazard in equity contract (1) • Equity contracts (shares) are subject to a particular ‘principal-agent problem’. • Stockholders (principals) are not the same as managers (agents). This separation involves moral hazard because managers may act in their own interest. • Example: Steve has an ice-cream shop, and you become his silent partner. The capital is shared at 10:90. Profits are also shared in these proportions.

7. Moral hazard in equity contract (2) • Option 1: Steve works hard and provides good service, but earns only 10% or the profit. • Option 2: Steve does not provide good service, and uses the capital to buy artwork for his office, a luxury car for business; he thus acquires ‘fringe benefits’ at your expense. • Option 3: Steve is not only a poor manager, but also dishonest. In this case the moral hazard problem may become extreme.

8. Elimination of asymmetric information (1) • A first solution to the problem is the private production and sale of information. • There are professional rating agencies (Standard and Poor’s, Moody’s, Value Line), and you can set up costly monitoring and auditing (state verification) of the firm. • But there is s ‘free-rider problem’ to this. If you buy a security, people my simply copy your behavior without paying for the information. • This erodes potential extra profits, and you may not have bought the information in the first place.

9. Elimination of asymmetric information (2) • A second possibility could be to involve the government in regulating the market. • The objective is to make firms reveal honest information by adhering to standard accounting practices and to disclose pertinent information. • Government can also impose stiff criminal penalties to contain fraud. • Government regulation may ease the asymmetric information problems, but it is difficult to eliminate them totally.

10. Elimination of asymmetric information (3) • A third solution is to involve financial intermediaries as experts in the production of information. • A private loan is not traded, so others cannot watch and imitate (no free rider). • This explains why indirect finance is more important than direct finance. • Larger firms (because they are better known) obtain easier access to capital markets than smaller firms.

11. Systemic instability and financial crises • Financial crises are characterized by abrupt declines in asset prices and by insolvencies of financial and non-financial firms. • Such crises are reoccurring in many countries. They are caused by a sharp increase in adverse selection and moral hazard problems. • Four categories of factors trigger crises: • Increases in interest rates; • Increases in uncertainty; • Asset market effects on balance sheets; and • (Multiple) bank failures.

12. Asset market effects on balance sheets • Balance sheets have important repercussions on the financial system: • A deterioration (fall in stock or housing prices) of the balance sheet reduces the ‘net worth’ of a firm. • Lenders are less willing to lend because of reduced collateral. • This induces moral hazard because borrowers take higher risks. • The increase in moral hazard makes lending less attractive … this reduces economic activity.

13. Typical financial crises Increase inuncertainty Stock marketdecline Increase ininterest rates Deterioration of a bank’s balance sheet Adverse selection andmoral hazard problems worsen Economic activity declines Bank panic Adverse selection andmoral hazard problems worsen Economic activity declines

14. The stock market and speculative frenzies • Stock markets have indeed often created havoc to the economy and to people’s life • Early example: the ‘tulip bubble’ in the Netherlands (approximately 1620 to 1637)

15. The tulip boom • The boom involved rare tulips • Bulb prices rose steadily throughout the 1630s, as ever more speculators wedged into the market. • In 1633, a farmhouse in Hoorn changed hands for three bulbs • In 1637 the bubble stretched ……. and burst !!

16. Precedents of the crisis • The basis of the bubble was an economic boom caused by shocking “new technologies” (Amsterdam merchants were at the center of the new and lucrative East Indies trade) • But enabling the bubble was leverage through credit, future contracts, and an innovative climate of Dutch finance (that coined new instruments such as options) Did the burst of the bubble drag down the Dutch economy?

17. Financial crisis:The US stock market 1871-1914 Financial crises have been frequent and persistent throughout economic history

18. What causes stock market volatility? • Financial crises exhibit a similar pattern: • Promising novel technologies or markets • A psychologically boosted investment frenzy • Financial leverage and concentration of resources into an emerging segment of the economy • Over-expansion of a sector and its bust • Contagion of the overall economy

19. Examples • This pattern was typical for • The railway frenzy of the mid-19th century • The initiation of electrical appliances at the turn of the last century But the best analyzed event in economic history is the one following the expansion of the ‘roaring 1920s’ …..

20. The NY stock market crashed on Friday, October 1929, initiating a persistent and long downturn of the economy How do financial bubbles affect activity?

21. Development of Stock Market Index

22. US Unemployment rate, 1929-1942 25 20 15 10 5 official series Quelle: M.R. Darby, Three-and-a-half Million Employees Have been mislaid, Journal of political Economy,1976 Adjusted series 1930 1935 1940 Repercussions on the real economy

23. Impact on people’s lives Top CEOs had a especially hard time !

24. What dragged the economy down? • The impact was then • Increase of personal savings (and hence a reduction of consumer spending) due to a perceived reduction of personal wealth • Change in consumer behavior due to higher unemployment • Credit implosion with an induced reduction of demand, notably fixed investment • Reduction of housing investment due to prior over-investment

25. The Great Depression: Further problems • And : • A general loss in consumers’ and investors’ confidence • Change in spending behavior due to insolvencies and bankruptcies • Disintermediation due to a lack of liquidity • Negative impact on public investment due to a fall in tax revenue • Policy failures, e.g. “strategic trade policies” (Smoot-Hawley Act)

26. 1929 1930 1931 1932 1933 The Great Depression: US imports November Monthly data. Imports from 75 Countries (in bill. Gold $) January February December March November April October May September August June July

27. The Great Depression: Monetary policy • Policy failure of central banking: • Reduction in the supply of money • High real interest rates • Failure of financial institutions Anna Schwartz Milton Friedman

28. What have we learned since? • Social protection, especially of the old and the unemployed • Consolidation of financial sector to avoid credit implosion, insolvency and break-downs • Fiscal and monetary management • International institutions to provide international means of payment (IMF) and to protect free trade (WTO) • International cooperation and integration • And in particular ………..

29. Our leaders are much brighter !!

30. Today we are technically more advanced and smarter than our grandparents! However: “animal spirits” are persistent and remain

31. Irrational exuberance: “A bubble that will burst!”

32. The 1920s and 30s …and it did!

33. The central bank and systemic stability • The health of the economy and the effectiveness of monetary policy depend on a sound financial system. Through supervising and regulating financial institutions, the ECB is better able to make policy decisions. • But should it intervene? • Rescue failing banks?