Extreme Situations: Financial Crises

Open market operations aren’t the only tool by which the government affects the economy. For the reason that the long-term interest rate is an average of expected future short-term interest rates expectations of future Federal Reserve policy closely tied to central-bank credibility are as well important influences on aggregate demand today. Even more important nevertheless are the existence of deposit insurance to insulate bank depositors from the effects of financial crises as well as the expectation that should a financial crisis become deep enough the Federal Reserve will act as a lender of last resort. In tremendous situations such alternative policy levers become important tools to try to stem depressions.

For almost four hundred years market economies have undergone financial crises episodes when the prices of stocks or of other assets crash everyone attempts to move their wealth into safer forms at once and the consequent panic among investors can lead to a prolonged and serious depression. Controlling such financial crises has been one of the responsibilities of monetary policy makers for more than a century and a half.

A financial crisis like the financial panics in East Asia in 1998 sees investors as a group suddenly and often not extremely rationally become convinced that their investments have become overly risky. Therefore they try to exchange their investments for high-quality bonds and cash. However as everyone tries to do this at once they create the risk that they hoped to avoid- stock and real estate prices crash and interest rates spike upward as everyone tries to increase their holdings of relatively safe liquid assets.

The sharp increase in real interest rates that occurs in a financial crisis can severely reduce investment and send the economy into a deep depression. Furthermore once the crisis gathers force the ability of monetary policy tools to boost investment may well be limited. Financial crises are go together by steep rises in risk premiums. They are habitually accompanied by sharp rises in term premiums as well as investors decide that they want to hold their wealth in as liquid a form as possible as well as financial crises frequently generate deflation as well.

All of these drive a large wedge among the short-term nominal safe interest rates that the central bank controls as well as the long-term real interest rate relevant for the determination of investment and aggregate demand. The central bank may perhaps have done all that it can do to reduce interest rates and it mayn’t be enough- real interest rates may remain high.

Lenders of Last Resort:

In such a situation a central bank is able to do a lot of good very easily by rapidly expanding the money supply therefore that the increase in the demand for liquid assets to hold does not lead to a spike in interest rates as well as a crash in other asset prices. It can as well do a lot of good by lending directly to institutions that are fundamentally solvent that will if the crisis is stemmed and resolved rapidly be able to function profitably however that are temporarily illiquid in the sense that no one is willing to lend to them because no one is confident that the crisis will be resolved. Such a lender of last resort is able to rapidly reduce risk and term premiums as it reduces safe short-term nominal interest rates and end the financial crisis.

The problem is that a central bank is able to also do a lot of harm if it bails out those institutions that have gone bankrupt and therefore encourages others in the future to take excessive risks hoping that the central bank will in its turn bail out them in the future.

Therefore the central bank has to (a) expand the money supply and lend freely to institutions that are merely illiquid that is caught short of cash but fundamentally sound while (b) forcibly liquidating institutions that are insolvent those that could not at all repay what they owe even if the panic were stemmed immediately. This is a neat trick to do one with no doing the other.

There are institutional steps that a central bank is able to take in advance to reduce the chance that the economy will suffer a financial crisis and reduce the damage that a financial panic will do. The first as well as most obvious is to do a good job as a supervising regulator over the banking system. Depositors will panic as well as pull their money out of a bank when they fear that it is bankrupt that it no longer has enough capital as well as that the capital plus the value of the loans that it has made are together lower than the value of the money it owes back to its depositors. If banks are kept back well capitalized and if banks that fail to meet standards for capital sufficiency are rapidly taken over and closed down then the risk of a full-fledged financial panic is small.

The potential difficulty with this strategy of supervision and surveillance is that it may be politically difficult to carry out. Bankers are finally often wealthy and influential people with substantial political connections. The Bank regulators are mid-level civil servants subject to pressure as well as influence from the high politicians.

Deposit Insurance and Moral Hazard:

The most recent main financial crisis in the United States the Great Depression was as well the most destructive. Banks closed at the beginning of 1933 in excess of one in three of the banks that had existed in 1929 had closed its doors. When banks unsuccessful people who had their money in them were out of luck years might pass prior to any portion of their deposits would be returned. Therefore fear of bank failure leads to an immediate increase in households' and businesses' holdings of currency relative to deposits. In the huge Depression this flight from banks reduced the money supply.

With 6,000 banks weakening in the first three years of the Depression more and more people felt that putting their money in a bank wasn’t much better than throwing it away. Since a increase in the currency-to-deposits ratio carries with it a fall in the money multiplier fear of bank failures shrunk the money stock. That merely deepened the Depression. A little had to be done to prop up depositors' confidence.

One of the restructurings of President Franklin D. Roosevelt's fresh Deal program in the 1930s was the institution of deposit insurance provided by the Federal Deposit Insurance Corporation—the FDIC. If your bank unsuccessful the government would make sure your deposits didn’t disappear. The aim was to reduce monetary instability by eliminating bank failure-driven swings in the money supply and interest rates.

Since the 1930s federal deposit assurance has acted as a monetary automatic stabilizer. A financial fear gathers force when investors conclude that they need to pull their money out of banks and mutual funds because such investments are too risky. Deposit insurance get rid of the risk of keeping your money in a bank even if the bank goes belly-up, your deposit is still secure. Therefore there is no reason to seek to move your money to any safer place. Deposit insurance has busted one of the significant links in the chain of transmission that used to make financial panics so severe.

The accessibility of deposit insurance and the potential existence of a lender of last resort do not come for free. These institutions create possible problems of their own problems that economists discuss under the heading of moral hazard. If depositors be familiar with that the Federal Deposit Insurance Corporation has guaranteed their deposits they will not make inquiries into the kinds of loans that their bank is making. Bank owners as well as managers may decide to make deliberately risky high-interest loans. If the economy booms as well as the loans are repaid then they make a fortune. If the economy goes into the recession and the risky firms to which they have loaned go bankrupt they declare bankruptcy too as well as leave the FDIC to deal with the depositors. It turn into a classic game of heads-I-win-tails-you-lose.

The principal way to protector against moral hazard is to make certain that decision makers have substantial amounts of their own money at risk. Making risky loans utilizing government-guaranteed deposits as your source of funding is a lot less attractive if your personal wealth is the first thing that is taken to pay off depositors if the loans go bad. Therefore deposit insurance and lenders of last resort function best only if there is sufficient supervision and surveillance- only if the central bank as well as the other bank regulatory authorities are keeping close watch on banks and making sure that every bank has adequate capital therefore that it is the shareholders' and the managers' funds rather than those of the FDIC that are at risk if the loans made go bad.

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