Economic
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
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