10.2 Recent Shocks to the Macroeconomy Introduction. Housing Prices. Chapter 10 The Great Recession: A First Look

Transcription

1 Chapter 10 The Great Recession: A First Look By Charles I. Jones Media Slides Created By Dave Brown Penn State University 10.2 Recent Shocks to the Macroeconomy What shocks to the macroeconomy have caused the global financial crisis? Housing prices Global saving glut Subprime lending and rise in interest rates Previous financial turmoil Oil prices 10.1 Introduction In this chapter, we learn: The causes of the financial crisis that began in the summer of 2007 and where the economy currently stands. How the current financial crisis compares to previous recessions and to previous financial crises in the United States and around the world. Housing Prices Housing prices tripled between 1996 and Housing bubble Between mid-2006 and February 2009, housing prices plummeted by 31.6 percent. The bubble burst The financial crisis that started in the summer of 2007 and intensified in September 2008 marked the end of an era for U.S. investment banking. Several important concepts in finance, including balance sheet and leverage. The National Bureau of Economic Research determined that a recession began in December 2007 and was the worst recession since the Great Depression of the 1930s. 1

2 The Global Saving Glut The current financial turmoil was caused partly by prior financial crises. Ben Bernanke March 2005: global saving glut Glut = excess The United States had an excess of savings with desire to invest. Higher investment demand contributed to rising asset prices in the housing market. Subprime Lending and the Rise in Interest Rates The savings glut led to low interest rates, and many borrowers took out mortgages to buy homes between 2000 and Many of these borrowers were subprime poor credit records high debt-to-income ratios. Between 2004 and 2006, the Fed raised its interest rate from 1.25 to 5.25 percent. The Financial Turmoil of ? Before the crisis, subprime mortgages were sold to investors through a financial innovation known as securitization. Securitization The process of pooling a group of financial instruments, such as mortgages, and then slicing them up in a different way and selling off the pieces. Meant to diversify risk. The Taylor rule demonstrated that rates had been too low in previous years. However, many subprime borrowers were now facing mortgages that were increasing from their initial teaser rates. By August 2007 nearly 16 percent of subprime mortgages with adjustable rates were in default. This led to a downward spiral of the housing market. As mortgages were developed and traded, it became difficult to know how much risk an individual bank was exposed to. August 2007: flight to safety. Lenders put funds in T-bills 2

3 Oil Prices To make matters worse, oil prices were extremely volatile in this period. 2002: $20 per barrel. Summer of 2008: $140 per barrel. December 2008: $40 per barrel. Liquidity crisis The volume of transactions in some financial markets falls sharply. Makes it difficult to value certain financial assets. raises questions about the overall value of the firms holding those assets. Financial markets plunged and the S&P index dropped 50 percent from its peak in November The oil price increase was caused by: Demands from China, India, and the Middle East. Short-term supply disruptions. The economic slowdown helped to alleviate oil demand pressures. It is possible that price speculation also played a role. 3

4 10.3 Macroeconomic Outcomes The recession, starting in December 2007, was first visible in unemployment. By 2009: Output was 3.6 percent below potential. Unemployment was up to 8.9 percent. February 2010: 8.5 million jobs lost A Comparison to Previous Recessions Compared to an average of all recessions since 1950, this recession is significantly worse. A striking difference about this recession is the decrease in consumption that occurred. 4

5 Case Study: A Comparison to Other Financial Crises According to a study summarizing worldwide financial crises, the typical crisis sees an unemployment rate increase of 7 percent for five years, a doubling of government debt, and a 10- percent decline in real GDP. Inflation Volatile oil prices caused sharp swings in inflation for all items in In the recession, core inflation (all items less food and fuel) declined slightly. The Rest of the World Another unique feature of this crisis is its global scope. GDP actually fell in 2009, the first time this has happened in many decades. 5

6 Liability An amount that is owed to someone else. Equity The difference between total assets and total liabilities on a balance sheet. Represents the value of an institution to its shareholders or owners. Also known as net worth or capital Some Fundamentals of Financial Economics It is helpful to understand some basic financial principles in order to understand the crisis as a whole. Banks are also subject to a number of financial regulations that apply to their balance sheets. The reserve requirement A mandate that financial institutions keep a certain percent of their deposits in a special account with the central bank. The capital requirement The legal obligation that a financial institution have a certain ratio of its assets supported by capital on its balance sheet. Balance Sheets Balance sheet Accounting tool with assets on the left side and liabilities and net worth on the right side. The two sides sum to the same value when net worth is included. Assets Items of value that an institution owns. 6

7 Leverage Leverage The ratio of total liabilities to net worth. This ratio magnifies any changes in the value of assets and liabilities in terms of the return to shareholders. This principle also applies to homeowners. In the recent crisis, a similar problem occurred on the liability side. Financial institutions usually have large amounts of short-term debt, which are often financed by commercial paper. After the collapse of Lehman Brothers, banks became worried about lending to other banks. Interest rates spiked on commercial paper, leading to a liquidity crisis. If a bank is highly leveraged, it may make Large gains off of small increases in market prices. Large losses off a small decrease in prices. Insolvency Situation in which the liabilities of a bank or other company exceed its assets. Before the financial crisis, many investment banks were highly leveraged. Financial Wrap-Up Leverage Amazing returns in good times. Huge losses in market downturns. Systemic risk is a danger to the financial system or economy as a whole when financial institutions are integrated, leveraged, and subject to shocks that affect them as a group. Bank Runs and Liquidity Crises The Great Depression of the 1930s was caused by nearly all depositors converging on banks at once and demanding the return of their deposits. Bank run A situation in which depositors or creditors worry about a financial institution s solvency and its ability to repay its deposits or short-term debt. Everyone runs to withdraw all funds, and the bank can t meet all these requests. This concludes the Lecture Slide Set for Chapter 10 Macroeconomics Second Edition by Charles I. Jones W. W. Norton & Company Independent Publishers Since