Financial Crises: The Great Depression and the Great ...esims1/slides_crises_fall2020.pdfGreat Depression I The Great Depression is generally dated to be from 1929-1933 I The unemployment

Financial Crises: The Great Depression and theGreat Recession

ECON 40364: Monetary Theory & Policy

Eric Sims

University of Notre Dame

Fall 2020

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Readings

I Mishkin Ch. 12

I Bernanke (2002): “On Milton Friedman’s Ninetieth Birthday”

I Wheelock (2010): “Lessons Learned?”

I Gorton (2010): “Questions and Answers”

I Mishkin (2011): “Over the Cliff”

I Cecchetti (2009): “Crisis and Responses”

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The Financial System and the Economy

I The financial system funnels savings into investment

I Because of information asymmetries and desire by savers tohold liquid assets, financial intermediation is extremelyimportant for funneling to work well

I Although there isn’t an exact definition, we can think of afinancial crisis as a situation in which financial intermediationdoes not work well

I Without effective financial intermediation, investment andaggregate demand collapse, and the economy goes into arecession

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Short-Term Debt

I Financial crises are everywhere and always caused by problemsrelated to short-term debt (Doug Diamond, 2007)

I Intermediaries finance illiquid, long-term assets withshort-term, liquid liabilities

I When things start going south, holders of these short-term,liquid liabilities “want out”

I This creates liquidity pressures for intermediaries – they needcash but have invested in long-term, illiquid assets

I To come up with cash, they need to sell assets / reduce thesupply of credit

I But this causes asset prices to fall in the aggregate, whichmakes balance sheets look worse, which increases pressure onliability holders to “run”

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Why is Short-Term Debt a Problem?

I Short-term debt promised fixed face value redemptions – i.e.$1 in deposits redeemable for $1 in cash

I But the asset side of a balance sheet “floats” in value, andeveryone trying to sell at the same time causes assets to losevalue

I This becomes a problem – e.g. you have to pay out $1 in cashfor assets that used to be worth $1 but are now worth $0.8

I With fixed value, short-term debt, liquidity pressures caneasily turn into a solvency problem

I In contrast, without debt finance (but in particular short-termdebt, which can be withdrawn or not rolled over on shortnotice), institutions cannot become insolvent

I e.g. difference between standard mutual fund (floating sharevalue) and money market mutual fund (fixed share value)

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Stages of Financial Crises

I Mishkin’s book lays out three stages of a financial crisis thatare common:

1. Phase one: credit/asset boom and bust2. Phase two: banking crisis3. Stage three: debt deflation

I We will discuss each of these before looking at specifics fromthe Great Depression and Great Recession

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Phase One: Initial Phase

I Financial crises often follow periods of excessive credit growth(banks and other financial institutions making increasinglyrisky loans) and asset price booms

I Eventually, the party stops

I With loans going bad, financial institutions try to de-leverageby cutting back on lending

I With asset prices falling, the collateral of non-financial firmsdeteriorates, which makes it harder for them to access credit

I As a result, credit declines, investment declines, and economicactivity contracts

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Phase Two: Banking CrisisI Deteriorating balance sheets due to loans going bad and asset

price declines lead some financial institutions to be insolvent(negative equity)

I But then fear takes over: depositors and other short termfunders begin to fear that otherwise healthy banks / financialinstitutions might also go out of business

I Information asymmetry is important here: if you know that 10percent of banks are bad, most banks are not bad. But yourdownside risk is sufficiently high that you have an individualincentive to “run” anyway

I But financial system can’t deal with runs because of maturitymismatch

I To try to deal with runs, banks and financial institutions tryto sell off illiquid assets, which can result in fire sale dynamics– everyone trying to do this leads to falling prices, whichmeans selling doesn’t raise much money and falling assetprices exacerbate other issues

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Debt Deflation

I The large decline in aggregate demand often leads theaggregate price level to fall

I This is potentially bad for several reasons:

1. Expectations of falling prices push real interest rates up,particularly if the central bank is constrained by the zero lowerbound

2. Falling prices increases the real burden of debt

I Higher real interest rates result in less demand, which canresult in even further falls in prices (“deflationary spiral”)

I Increasing real burden of debt makes credit markets operateless well

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Great Depression

I The Great Depression is generally dated to be from 1929-1933

I The unemployment rate in the US rose to 25 percent (incomparison, only 10 percent during Great Recession, andpeaked very temporarily at 14 percent in COVID recession)

I Worldwide GDP fell by an estimated 15 percent

I Associated with the stock market collapse in October 1929and ensuing banking panics in the early 1930s

I Close to one-third of commercial banks failed

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Stock Market

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Bank Runs

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Credit Market Distress

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Decline in Economic Activity

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Deflation

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fred.stlouisfed.orgSource:U.S.BureauofLaborStatistics

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Friedman and Schwartz

I A fairly strong consensus about the severity of the GreatDepression comes out of Friedman and Schwartz’s AMonetary History of the United States

I The main thrust of the argument is summarized in Bernanke(2002)

I In essence, excessively tight monetary policy allowed anordinary recession to become a full-fledged financial crisis anddepression

I Bank failures shot through the roof, and the money supplydeclined precipitously

I This worsened financial conditions and led to the observeddeflation

I Fed either did not understand its role as lender of last resort(which is why it was founded) or misinterpreted market signals(particularly the stigma associated with discount lending)

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Bank Failures

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Non-Accommodative Monetary Policy

Reserve credit surged briefly following the stockmarket crash and during the banking panics ofOctober-December 1930, September-December1931 (which followed the United Kingdom’s deci-sion to leave the gold standard), and January-March 1933. On each occasion, the increase inFederal Reserve credit (and its impact on themonetary base) was quickly reversed. Moreover,as Figure 5 shows, when Federal Reserve creditfinally began to grow in 1932, it only temporarilyhalted the decline in the broader money stock.This pattern is in marked contrast with the behav-ior of Federal Reserve credit and the monetaryaggregates in 2008-09. Although the Fed did notincrease the monetary base significantly untilSeptember 2008, the broader monetary aggregatescontinued to grow and the price level continuedto rise, albeit slowly, throughout the financialcrisis.21 In addition, the monetary base rosesharply in the final four months of 2008 andremained large throughout 2009 (see Figure 2).

Why did the Fed permit its credit to contractafter each financial shock of 1929-33? Meltzer(2003) argues that Fed officials misinterpretedthe signals from money market interest rates anddiscount window borrowing. Consistent withguidelines developed during the 1920s, duringthe Depression, Fed officials inferred that lowlevels of interest rates and borrowing meant thatmonetary conditions were exceptionally easy, andthat there was no benefit—and possibly somerisk—from adding more liquidity. Federal ReserveBank of New York Governor Benjamin Strongexplained the use of the level of discount windowborrowing as a guide to policy as follows:

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Crash PanicGold

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Figure 5

Federal Reserve Credit and the Monetary Aggregates

SOURCE: Federal Reserve credit (see Figure 4); St. Louis adjusted monetary base (FRED; http://research.stlouisfed.org/aggreg/newbase.html); money stock (Friedman and Schwartz, 1963; Appendix A, Table A-1).

21 Although not apparent in the year-over-year growth rate shown inFigure 3, M2 growth slowed markedly between mid-March 2008and mid-September 2008, which Hetzel (2009) contends is evidenceof a tightening of monetary policy, along with the lack of anyreduction in the FOMC’s federal funds rate target between April 30and October 8, 2008.

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Bernanke’s Famous Quote

I In 2002, on the occasion of Milton Friedman’s 90th birthday,Ben Bernanke, then a Fed governor, said:

“Regarding the Great Depression. You’re right, we did it.We’re very sorry. But thanks to you, we won’t do it again.”

I This quote proved to be quite prescient with the financialcrisis and ensuing Great Recession with Bernanke as chair ofthe Fed

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The Financial Crisis and Great Recession

I These terms are often used synonymously

I The Great Recession is officially dated from December 2007to June 2009. Most of the decline in output occurred in thefall of 2008 and winter/spring of 2009

I The financial crisis precedes that somewhat, typically dated tohaving begun in late summer of 2007

I The financial crisis has its origins in problems in the UShousing market, particularly so-called “subprime” mortgages

I Conventional causal chain of events:

Housing Market Collapse → Financial Crisis → Recession

I We have some idea of how a financial crisis can lead to arecession. But how can a housing market collapse lead to afinancial crisis?

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Housing Prices

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Subprime Balance Sheet

I Why do declines in house prices matter?

I Can trigger defaults by pushing homeowners underwater

I Suppose someone gets a no-down payment home loan:

Assets Liabilities + Equity

Home $100,000 Mortgage $100,000Equity $0

I If the value of the home goes up, homeowner can refinance –take out a loan to pay off the existing mortgage, and then haspositive equity

I But if value of home declines, homeowner is underwater andhas negative equity

I No incentive to keep paying the mortgage at that point andmortgage can go into default

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Mortgage Delinquency

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fred.stlouisfed.orgSource:BoardofGovernorsoftheFederalReserveSystem(US)

DelinquencyRateonSingle-FamilyResidentialMortgages,BookedinDomesticOffices,AllCommercialBanksPercent

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Defaults

I Mortgages going into default means that owner of mortgage(e.g. a bank) takes a loss

I Financial system at large was broadly exposed to the housingmarket via mortgage backed securities (MBS)

I In the traditional banking system, the loss from a mortgagegoing into default would be felt by the bank that issued theloan

I Not so in the modern banking system, where the loss wasdistributed to holders of MBSs

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Traditional Banking

I In traditional banking, the bank funds itself with deposits(short term liabilities) and invests in longer term, illiquid loansto households and businesses

I Banks “borrow” (get liabilities) at a lower interest rate thanthey lend (make loans), thereby earning a profit

Traditional Banks loans Households Firms

deposits Households Firms

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From Traditional Banking to Modern Banking

I A variety of factors have led traditional banking (funding inthe form of deposits, and then holding on to loans) to ceaseto be profitable

I Furthermore, there are now very large institutional investors(e.g. pension funds, life insurance companies) that have adesire for demand deposit like liabilities that are safe, liquid,and offer some return

I This has given rise to securitization, which has been going onfor decades but became well-known in the last decade

I In securitization, a financial entity buys loans from issuers(e.g. traditional banks) and bundles a bunch of loans into onefixed income product

I These securitized loans then serve as collateral for short termdemand deposit-like liabilities that institutional investors desire

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Shadow Banking

Traditional Banks

loans Households Firms

$ Shadow Banks loans

Institutional Investors

repo

Securitized loans serve as collateral for repo

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Shadow Banking ContinuedI In modern banking, traditional banks (increasingly) rely upon

the shadow banking system for fundingI Shadow banks buy loans which earn interest (e.g. monthly

mortgage payments). These purchases fund the traditionalbanks

I Shadow banks fund themselves from “deposits” from largeinstitutional investors – e.g. repurchase agreements (repos)

I Repo: you buy an asset for a given price on a given date, withan agreement to sell the asset back to the owner on a futurespecified date at an agreed upon price

I When you sell it back for more than you buy, this difference iseffectively interest

I Think about a repo like a deposit, and the actual asset(frequently, securitized loans) serves as collateral and hencemakes the deposit safe. If the issuer refuses or is unable tobuy back, you get to keep the asset

I Repos typically very short term (e.g. overnight), so quiteliquid 28 / 45

Haircuts

I Haircut: the (percentage) difference in the amount of therepo and the value of collateral

I For example: I “deposit” $90 million in exchange for $100million in collateral. Haircut is 10 percent

I Idea: haircut protects “depositor” in the event that repoissuer doesn’t make good on the promise and the “depositor”is stuck with the collateral, which might lose value

I Prior to crisis, haircuts were (essentially) zero

I Haircuts rose markedly during crisis

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13

be a big problem for McDonald’s, Burger King, Wendy’s and so on. They would go bankrupt. That’swhat happened.

The evidence is in the figure below, which shows the increase in haircuts for securitized bonds (andother structured bonds) starting in August 2007.

The figure is a picture of the banking panic. We don’t know how much was withdrawn because we don’tknow the actual size of the repo market. But, to get a sense of the magnitudes, suppose the repomarket was $12 trillion and that repo haircuts rose from zero to an average of 20 percent. Then thebanking system would need to come up with $2 trillion, an impossible task.

Source: Gorton and Metrick (2009a).

Q. Where did the losses come from?

A. Faced with the task of raising money to meet the withdrawals, firms had to sell assets. They were noinvestors willing to make sufficiently large new investments, on the order of $2 trillion. In order tominimize losses firms chose to sell bonds that they thought would not drop in price a great deal, bondsthat were not securitized bonds, and bonds that were highly rated. For example, they sold Aaa ratedcorporate bonds.

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Shadow Bank Balance Sheet

I Suppose a shadow bank (e.g. Bear Sterns) has the followingbalance sheet before the crisis with no haircut

Assets Liabilities + Equity

Mortgage Securities $120 million Repos $100 millionOther assets $40 million Borrowings $40 million

Equity $20 million

I Equity finances $20 million of the mortgage securities, reposthe other $100 million

I Shadow bank makes money by paying less for its liabilities(say 3 percent for repo) than it earns on its assets (say 6percent on mortgage securities)

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A Haircut is Like a Withdrawal

I Suppose that the haircut goes from 0 to 40 percent

I This means large institutional investor will only “deposit” $60million in exchange for $100 million in securities

I This is just like a withdrawal of $40 million

Assets Liabilities + Equity

Mortgage Securities $120 million Repos $60 millionOther assets $0 Borrowings $40 million

Equity $20 million

I To maintain equity, shadow bank must self off its other assetsto be able to hold the $120 million in mortgage securities

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From Subprime to General Financial Distress

I The subprime mortgage market was not large enough to causea widespread crisis on its own – roughly $1.2 trillion out of$20 trillion in outstanding credit at the time

I Subprime mortgages started deteriorating well before theheight of the financial panic in Fall 2008

I The issue is one of asymmetric information – the distributionof risks was not well known or understand, and the financialsystem was increasingly interconnected

I Gorton likens this to an e-coli scare – there’s not much e-coli,but since you don’t know where it is, you don’t buy any beef

I Likewise, institutional investors didn’t know what was goodcollateral or bad, started demanding very high haircuts

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Fire Sales

I Faced with large “withdrawals,” shadow banks have to sellassets to raise funds to finance the collateral underlying therepos

I Lots of institutions trying to sell at the same time with fewbuyers: big decline in price, which makes the entire enterpriseof selling to raise funds less effective

I Naturally, try to sell the “best” assets to fetch the highestprice

I But when everyone is doing this, you get perverse outcomes(next slide)

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14

These kinds of forced sales are called “fire sales” – sales that must be made to raise money, even if thesale causes to price to fall because so much is offered for sale, and the seller has no choice but to takethe low price. The low price reflects to distressed, forced, sale, not the underlying fundamentals. Thereis evidence of this. Here is one example. Normally, Aaa rated corporate bonds would trade at higherprices (lower spreads) than, say, Aa rated bonds. In other words, these bonds would fetch the mostmoney when sold. However, when all firms reason this way, it doesn’t turn out so nicely.

The figure below shows the spread between Aa rated corporate bonds and Aaa rated corporate bonds,both with five year maturities. This spread should always be positive, unless so many Aaa ratedcorporate bonds are sold that the spread must rise to attract buyers. That is exactly what happened!!

Source: Gorton and Metrick (2009a).

The figure is a snapshot of the fire sales of assets that occurred due to the panic. Money was lost inthese fire sales. To be concrete, suppose the bond was purchased for $100, and then was sold, hopingto fetch $100 (its market value just before the crisis onset). Instead, when all firms are selling the Aaarated bonds the price may be, say, $90 – a loss of $10. This is how actual losses can occur due to firesales caused by the panic.

Q. How could this have happened?

A. The development of the parallel banking system did not happen overnight. It has been developingfor three decades, and especially grew in the 1990s. But bank regulators and academics were not awareof these developments. Regulators did not measure or understand this development. As we have seen,

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End Result

I Massive decline in bond prices (other than government bonds)across the board, with huge increases in yields, due to firesales

I Value of collateral destroyed, high yields: credit markets stopfunctioning

I Credit completely dries up

I Economic activity contracts

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Banking Panic

I What we had was a good old-fashioned banking panicI Although different than previous panics (e.g. Great

Depression)I Not a run by people on banks, but by institutions on other

institutionsI These institutions (the shadow banking system) were not

regulated as banksI There was nothing like FDIC deposit insurance like there was

for regular banksI And because they weren’t technically banks, they couldn’t

borrow from the Fed

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Back to Bernanke’s Quote

I Bernanke assured Friedman that “they” (the Fed) “wouldn’tdo it again”

I The Fed either explicitly or implicity tried “whatever it takes”to provide liquidity to the financial system more broadly, notjust traditional banks

I The Fed relied on Section 13(3) of the Federal Reserve Act,which allows the Fed to “lend to any individual, partnership orcorporation” in “unusual and exigent” circumstances

I The Fed significantly increased the size of its balance sheet(the value of the assets it holds) and significantly increasedthe monetary base

I To a much smaller degree, it increased the money supply (or,perhaps more accurately, kept the money supply fromdeclining)

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Notable Fed InterventionsI December 2007: Term Auction Facility (TAF): basically a way

to make anonymous discount lending/borrowingI March 2008: Term Securities Lending Facility (TSLF):

expanded available collateral for Fed loans – e.g. taking“toxic” mortgage securities out of the marketplace andreplacing them with government debt

I October 2008: Commercial Paper Funding Facility (CPFF):took commercial paper (short term unsecured corporate debt)as collateral

I November 2008: Term Asset-Backed Securities Loan Facility(TALF): similar to TSLF, but took securitized consumer loansas collateral

I Dollar swap lines: a way to help foreign central banks provideliquidity to financial institutions which needed dollar funding

I “Bailouts” or “Engineered Rescues” of Bear Stearns, AIG,Fannie Mae and Freddie Mac

I Notably didn’t do anything for Lehman Brothers43 / 45

base, which consists of currency in circulationand the reserves held by depository institutions.16

As the figure shows, the monetary base was rela-tively constant until September 2008, when theFed stopped using open market sales to preventits lending to banks and other financial firms fromincreasing the System’s total assets. Figure 3 showsthat the growth rate of the M2 monetary aggregatealso increased sharply in the fourth quarter of2008 and remained correlated with monetarybase growth throughout 2009.

Chairman Bernanke (2009a) has describedthe Fed’s response to the financial crisis as “crediteasing” to distinguish the policy from the “quanti-tative easing” approach that Japan and some othercountries have at times adopted. Unlike a pure

quantitative easing policy, which targets thegrowth of the monetary base or a similar narrowmonetary aggregate, the Fed’s credit-easing policywas at least as much concerned with the alloca-tion of credit supplied by the Fed to the financialsystem as with the quantity. Indeed, beforeSeptember 2008, the Fed focused exclusively onreallocating an essentially fixed supply of FederalReserve credit to the financial firms with the great-est demand for liquidity.17

Policy entered a new phase in September2008, when the Fed’s rescue operations and laterits large purchases of U.S. Treasury and agencydebt and mortgage-backed securities caused the

16 Figure 2 shows the St. Louis Adjusted Monetary Base, which is ameasure of the base that is adjusted for changes in reserve require-ments over time. Other measures of the monetary base, includingunadjusted measures, show essentially the same relationship withthe Federal Reserve balance sheet. These data are available fromthe Federal Reserve Bank of St. Louis(http://research.stlouisfed.org/fred2/).

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Federal Reserve Assets and the Monetary Base (2007-09)

17 Thornton (2009a) notes that the Fed’s initial attempt to satisfyheightened liquidity concerns without increasing the monetarybase contrasted with its use of open market operations to increasethe monetary base sharply at the century date change (Y2K) inDecember 1999 and following the terrorist attacks on September 11,2001. He argues that the Fed may have been reluctant to increasethe monetary base to better control the federal funds rate or becauseFed officials viewed targeted credit allocation as a more effectivemeans of encouraging banks to lend and avoid selling illiquid assets.

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System’s total assets and the monetary base tomore than double in size. However, the Fed’sobjective in purchasing mortgage-backed securi-ties was to reduce mortgage interest rates and pro-mote recovery of housing markets, rather thansimply to increase the total amount of credit avail-able to the financial system. Nonetheless, theprogram helped to increase the growth of broadermonetary aggregates and thereby likely reducedthe risk of deflation.

THE FED’S RESPONSE TO THECRISES OF 1929-33

The Federal Reserve’s response to the financialcrisis and recession of 2007-09 was markedly moreaggressive than the Fed’s anemic response to theGreat Depression. The Fed’s policy failures duringthe Great Depression are legendary. The Fed—specifically, the Federal Reserve Bank of NewYork—reacted swiftly to the October 1929 stockmarket crash by lowering its discount rate and

lending heavily to banks. However, the Fed largelyignored the banking panics and failures of 1930-33and did little to arrest large declines in the pricelevel and output. This section reviews FederalReserve policy during the Great Depression anddiscusses prominent explanations for the Fed’sbehavior.

Fed Policy from the Stock Market Crashto Bank Holiday

Figure 4 shows the level and composition ofFederal Reserve credit during 1929-34, providingone measure of the Fed’s response to the majorfinancial crises of the Great Depression.18 Follow -ing the stock market crash, the Federal ReserveBank of New York used open market purchases

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Figure 3

Monetary Base and M2 Growth (2007-09)

18 In recent years, Federal Reserve credit has been by far the largestcomponent of Federal Reserve assets. However, before World War II,the Federal Reserve Banks held significant gold reserves and otherassets aside from Federal Reserve credit. Hence, for the GreatDepression period, we present data on Federal Reserve credit,rather than total assets, for better comparison with policy duringthe recent financial crisis.

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