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sManBal1e_CH19 02/09/10 5:36 PM Page 537

CHAPTER

19

Financial Crises
There was a time when the credit markets had essentially frozen and when blue chip industrial companies were having trouble raising money. I knew then we were on the brink...We easily could have had unemployment of 25 percent.” —Henry M. Paulson (former Treasury Secretary), commenting on the state of the U.S. economy in 2008

hroughout this book, we have seen that many kinds of shocks can decrease an economy’s output in the short run. Examples include increases in taxes, decreases in consumer confidence, and increases in oil prices. However, one kind of shock is especially devastating to an economy: a financial crisis. Such a major disruption of the financial system typically involves sharp falls in asset prices and failures of financial institutions. In the United States, a financial crisis in the early 1930s triggered the Great Depression. A U.S. crisis that started in 2007 produced a recession that by many measures was the worst since the Depression. Financial crises have also damaged economies around the world, such as those of Argentina in 2001 and Greece in 2009–2010. Regardless of where or when they occur, financial crises are complex events; the feedbacks among different parts of the financial system and the economy make them dangerous and difficult to stop. To understand crises, we must understand the workings of financial markets and the banking system (the topics of Chapters 15–18), the short-run behavior of the aggregate economy (Chapters 9–12), and the effects of macroeconomic policies (Chapters 13–14). In this chapter, we first look at the events in a typical financial crisis and the various ways in which governments and central banks respond to them. We then use this background to examine what happened to the United States starting in 2007 and discuss some of the reforms that have been proposed in the wake of this crisis to make future financial crises less likely or less severe. Finally, we explore financial crises in emerging economies and what makes them different from those in advanced economies, including the role of the International Monetary Fund in combating crises.

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PART

VI

The Financial System and the Economy

19-1 The Mechanics of Financial Crises
No two financial crises are exactly alike, but most share a few basic features. We first discuss what happens to the financial system in a crisis and then look at how a crisis affects the rest of the economy.

Events in the Financial System
At the center of most crises are declines in asset prices, failures of financial institutions caused by insolvency or liquidity crises, or some combination of these events. Asset-Price Declines A crisis may be triggered by large decreases in the prices of stocks, real estate, or other assets. Many economists interpret these decreases as the ends of asset-price bubbles. Recall from Chapter 16 that a bubble occurs when asset prices rise far above the present value of the expected income from the assets. Then, at some point, sentiment shifts: people begin to worry that asset prices are too high and start selling the assets, pushing prices down. Falling prices shake confidence further, leading to more selling, and so on. Asset prices may fall over periods of months or years, or a crash may occur in the course of a single day. Insolvencies In a typical crisis, decreases in asset prices are accompanied by

failures of financial institutions. An institution may fail because it becomes insolvent; that is, its assets fall below its liabilities and its net worth (capital) becomes negative. A commercial bank can become insolvent because of loan defaults, increases in interest rates, and other events. When a bank becomes insolvent, regulators are likely to force its closure. Other kinds of financial institutions can also become insolvent. Hedge funds, for example, borrow money from...
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