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Crises and Consequences
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n 1844 Henry Lehman, a German immigrant,
2008, the firm declared bankruptcy, the largest bank-
opened a dry goods store in Montgomery, Alabama.
ruptcy to date in the United States. What happened next
Over time, Lehman and his brothers, who followed
shocked the world.
him to America, branched out into cotton trading, then
When Lehman went down, it set off a chain of events
into a variety of financial activities. By 1850, Lehman
that came close to taking down the entire world financial
Brothers was established on Wall Street; by 2008, thanks
system. Because Lehman had hidden the severity of its
to its skill at trading financial assets, Lehman Brothers
vulnerability, its failure came as a nasty surprise.
was one of the nation’s top investment banks. Unlike
Through securitization (a concept we defined in the
commercial banks, invest-
chapter “Money, Banking,
ment banks trade in finan-
and the Federal Reserve
cial assets and don’t accept
System”), financial insti-
deposits from customers.
tutions
In
September
throughout
the
2008,
world were exposed to real
Lehman’s luck ran out. The
estate loans that were
firm had misjudged the
quickly deteriorating in
Press Association via AP Images
>>
prospects for the U.S. housing market and found itself
heavily exposed to subprime mortgages—loans to
home buyers with too little
income or too few assets to
The collapse of Lehman Brothers, the once-venerable investment bank, set off a chain of events that led to a worldwide
financial panic.
qualify for standard (also
value as default rates on
those loans rose. Credit
markets
froze
because
those with funds to lend
decided it was better to sit
on the funds rather than
lend them out and risk los-
called “prime”) mortgages. In the summer and fall of
ing them to a borrower who might go under like Lehman
2008, as the U.S. housing market plunge intensified and
had. Around the world, borrowers were hit by a global
investments related to subprime mortgages lost much of
credit crunch: they either lost their access to credit or
their value, Lehman was hit hard.
found themselves forced to pay drastically higher interest
Lehman had been borrowing heavily in the short-term
credit market—often using overnight loans that must be
rates. Stocks plunged, and within weeks the Dow had
fallen almost 3,000 points.
repaid the next business day—to finance its ongoing
Nor were the consequences limited to financial mar-
operations and trading. As rumors began to spread about
kets. The U.S. economy was already in recession when
how heavily Lehman was exposed to the tanking housing
Lehman fell, but the pace of the downturn accelerated
market, its sources of credit dried up. On September 15,
drastically in the months that followed. By early 2009,
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the United States was losing more than 700,000 jobs a
the Federal Reserve rode to the rescue and coordinated a
month. Europe and Japan were also suffering their worst
winding-down of the firm’s operations. Because the
recessions since the 1930s, and world trade plunged even
Federal Reserve resolved the LTCM crisis quickly, its fall
faster than it had in the first year of the Great Depression.
didn’t result in a blow to the economy at large.
All of this came as a great shock because few people
Financial panics and banking crises have happened
imagined that such events were possible in twenty-first-
fairly often, sometimes with disastrous effects on output
century America. Yet economists who knew their history
and employment. Chile’s 1981 banking crisis was fol-
quickly recognized what they were seeing: it was a mod-
lowed by a 19% decline in real GDP per capita and a
ern version of a financial panic, a sudden and widespread
slump that lasted through most of the following decade.
disruption of financial markets. Financial panics were a
Finland’s 1990 banking crisis was followed by a surge in
regular feature of the U.S. financial system before World
the unemployment rate from 3.2% to 16.3%. Japan’s
War II; as we discussed in the chapter “Money, Banking,
banking crisis of the early 1990s led to more than a
and the Federal Reserve System,” the financial panic that
decade of economic stagnation.
hit the United States in 2008 shared many features with
In this chapter, we’ll examine the causes and conse-
the Panic of 1907, whose devastation prompted the cre-
quences of banking crises and financial panics. We’ll
ation of the Federal Reserve system. Financial panics
begin by examining what makes banking vulnerable to
almost always include a banking crisis, in which a signif-
a crisis and how this can mutate into a full-blown
icant portion of the banking sector ceases to function.
financial panic. Then we’ll turn to the history of such
On reflection, the panic following Lehman’s collapse
crises and their aftermath, exploring why they are
was not unique, even in the modern world. The failure of
so destructive to the economy. Finally, we’ll look at
Long-Term Capital Management in 1998 also precipitat-
how governments have tried to limit the risks of finan-
ed a financial panic: global financial markets froze until
cial crises.
WHAT YOU WILL LEARN IN THIS CHAPTER:
➤
What the differences are between
depository banks and shadow banks
➤
What happens during financial
panics and banking crises
➤
Why, despite their differences,
both types of banks are subject to
bank runs
➤
Why the effects of panics and
crises on the economy are so
severe and long-lasting
➤
How regulatory loopholes and the rise
of shadow banking led to the banking
crisis of 2007–2009
➤
How the new regulatory framework
seeks to avoid another banking crisis
Banking: Benefits and Dangers
As we learned in earlier chapters, banks perform an essential role in any modern
economy. In the chapter “Savings, Investment Spending, and the Financial
System,” we defined a bank as a financial intermediary that provides liquid financial assets in the form of deposits to savers and uses its funds to finance illiquid
investment spending needs of borrowers. Thus, banks perform the important functions of providing liquidity to savers and directly influencing the level of the
money supply. Commercial banks such as Bank of America or Citibank, as well as
savings and loan institutions and credit unions, satisfy our definition of a bank
because they accept deposits.
Lehman Brothers, however, was not a bank according to our definition because it
did not accept deposits. Instead, it was in the business of speculative trading for its
own profit and the profit of its investors. Yet Lehman got into trouble in much the
same way that a bank does: it experienced a loss of confidence and something very
much like a bank run—a phenomenon in which many of a bank’s depositors try to
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CRISES AND CONSEQUENCES
withdraw their funds due to fears of a bank failure. Lehman was part of a larger category of institutions called shadow banks. Shadow banking, a term coined by the
economist Paul McCulley of the giant bond fund Pimco, is composed of a wide variety of types of financial firms: investment banks like Lehman, hedge funds like LongTerm Capital Management, and money market funds. (As we will explain in more
detail later, “shadow” refers to the fact that these financial institutions are neither
closely watched nor effectively regulated.) Like ordinary banks, shadow banks are vulnerable to bank runs because they perform the same economic task: allowing their
customers to make a better trade-off between rate of return, or yield, and liquidity.
(From now on, we will use the term depository banks for banks that accept deposits
to better distinguish them from shadow banks, which do not.)
The Trade-off Between Rate of Return and Liquidity
Imagine that you live in a world without any banks. Further imagine that you have
saved a substantial sum of money that you don’t plan on spending anytime soon.
What can you do with those funds?
One answer is that you could simply store the money—say, put it under your bed
or in a safe. The money would always be there if you need it, but it would just sit
there, not earning any interest.
Alternatively, you could lend the money out, say, to a growing business. This would
have the great advantage of putting your money to work, both for you, since the loan
would pay interest, and for the economy, since your funds would help pay for investment spending. There would, however, be a potential disadvantage: if you needed the
money before the loan was paid off, you might not be able to recover it.
It’s true that we asked you to assume that you had no plans for spending the
money soon. But it’s often impossible to predict when you will want or need to make
cash outlays; for example, your car could break down or you could be offered an
exciting opportunity to study abroad. Now, a loan is an asset, and there are ways to
convert assets into cash. For example, you can try to sell the loan to someone else.
But this can be difficult, especially if you need cash on short notice. So, in a world
without banks, it’s better to have some cash on hand when an unexpected financial
need arises.
In other words, without banks, savers face a trade-off when deciding how much of
their funds to lend out and how much to keep on hand in cash: a trade-off between
liquidity, the ability to turn one’s assets into cash on short notice, and the rate of
return, in the form of interest or other payments received on one’s assets. Without
banks, people would make this trade-off by keeping a large fraction of their wealth
idle, sitting in safes rather than helping pay for productive investment spending.
Banking, however, changes that, by allowing people ready access to their funds even
while those funds are being used to make loans for productive purposes.
The Purpose of Banking
Banking, as we know it, emerged from a surprising place: it was originally a sideline
business for medieval goldsmiths. By the nature of their business, goldsmiths needed
vaults in which to store their gold. Over time, they realized that they could offer safekeeping services for their customers, too, because a wealthy person might prefer to
leave his stash of gold and silver with a goldsmith rather than keep it at home, where
thieves might snatch it.
Someone who deposited gold and silver with a goldsmith received a receipt, which
could be redeemed for those precious metals at any time. And a funny thing happened: people began paying for their purchases not by cashing in their receipts for
gold and then paying with the gold, but simply by handing over their precious metal
receipts to the seller. Thus, an early form of paper money was born.
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Maturity transformation is the conversion of short-term liabilities into longterm assets.
A shadow bank is a nondepository
financial institution that engages in
maturity transformation.
Meanwhile, goldsmiths realized something else: even though they were obligated to return a customer’s precious metals on demand, they didn’t actually need to
keep all of the treasure on their premises. After all, it was unlikely that all of their
customers would want to lay hands on their gold and silver on the same day, especially if customers were using receipts as a means of payment. So a goldsmith could
safely put some of his customers’ wealth to work by lending it out to other businesses, keeping only enough on hand to pay off the few customers likely to demand
their precious metals on short notice—plus some additional reserves in case of
exceptional demand.
And so banking was born. In a more abstract form, depository banks today do the
same thing those enterprising goldsmiths learned to do: they accept the savings of
individuals, promising to return them on demand, but put most of those funds to
work by taking advantage of the fact that not everyone will want access to those funds
at the same time. A typical bank account lets you withdraw as much of your funds as
you want, anytime you want—but the bank doesn’t actually keep everyone’s cash in
its safe or even in a form that can be turned quickly into cash. Instead, the bank lends
out most of the funds placed in its care, keeping limited reserves to meet day-to-day
withdrawals. And because deposits can be put to use, banks don’t charge you (or
charge very little) for the privilege of keeping your savings safe. Depending on the
type of account you have, they might even pay you interest on your deposits.
More generally, what depository banks do is borrow on a short-term basis from
depositors (who can demand to be repaid at any time) and lend on a long-term basis
to others (who cannot be forced to repay until the end date of their loan). This is
what economists call maturity transformation: converting short-term liabilities
(deposits in this case) into long-term assets (bank loans that earn interest). Shadow
banks, such as Lehman Brothers, also engage in maturity transformation, but they do
it in a way that doesn’t involve taking deposits.
Instead of taking deposits, Lehman borrowed funds in the short-term credit markets and then invested those funds in longer-term speculative projects. Indeed, a
shadow bank is any financial institution that does not accept deposits but that, like
a bank, engages in maturity transformation—borrowing over the short term and lending or investing over the longer term. And just as bank depositors benefit from the
liquidity and higher return that banking provides compared to sitting on their money,
lenders to shadow banks like Lehman benefit from liquidity (their loans must be
repaid quickly, often overnight) and higher return compared to other ways of investing their funds.
A generation ago, depository banks accounted for most banking. After about 1980,
however, there was a steady rise in shadow banking. Shadow banking has grown so
popular because it has not been subject to the regulations, such as capital requirements and reserve requirements, that are imposed on depository banking. So, like the
unregulated trusts that set off the Panic of 1907, shadow banks can offer their customers a higher rate of return on their funds. As of July 2007, generally considered
the start of the financial crisis that climaxed when Lehman fell in September 2008,
the U.S. shadow banking sector was about 1.5 times larger, in terms of dollars, than
the formal, deposit-taking banking sector.
As we pointed out in the chapter “Money, Banking, and the Federal Reserve
System,” things are not always simple in banking. There we learned why depository
banks can be subject to bank runs. As the cases of Lehman and LTCM so spectacularly illustrate, the same vulnerability afflicts shadow banks. Next we explore why.
Bank Runs Redux
Because a bank keeps on hand just a small fraction of its depositors’ funds, a bank
run typically results in a bank failure: the bank is unable to meet depositors’ demands
for their money and closes its doors. Ominously, bank runs can be self-fulfilling
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Old-fashioned bank runs, with crowds of depositors lining up to withdraw their
money before it’s too late, are rare in the modern world, in large part because depositors assume that the government will protect them. Often, however, the extent of
this protection actually written into law is relatively limited. Notably, in 2007 British
depositors were only protected against all losses for the first £2,000 of their account—
around $3,000—with 90% protection up to £35,000, and none thereafter.
Depositors at the British bank Northern Rock decided that this wasn’t enough
protection once they became worried about the bank’s solvency, that is, whether it
had enough assets to cover its liabilities. The result was a bank run right out of the
history books.
The bank got into trouble by overextending itself: to expand its home mortgage
lending, it began borrowing from the money markets. This source of funding dried
up when world housing markets began to slump. The Bank of England, Britain’s
equivalent of the Federal Reserve, announced that it would lend money to
Northern Rock to make up the shortfall—but this announcement had the effect of
highlighting the bank’s problems, and nervous depositors started lining up outside
its doors.
Photo via Newscom
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Bad Day at Northern Rock
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➤ ECONOMICS
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prophecies: although a bank may be in fine financial shape, if enough depositors
believe it is in trouble and try to withdraw their money, their beliefs end up dooming
the bank.
To prevent such occurrences, after the 1930s the United States (and most other
countries) adopted wide-ranging banking regulation in the form of regular audits
by the Federal Reserve, deposit insurance, capital requirements and reserve
requirements, and provisions allowing troubled banks to borrow from the Fed’s
discount window.
Shadow banks, though, don’t take deposits. So how can they be vulnerable to a
bank run? The reason is that a shadow bank, like a depository bank, engages in
maturity transformation: it borrows short term and lends or invests longer term. If
a shadow bank’s lenders suddenly decide one day that it’s no longer safe to lend it
money, the shadow bank can no longer fund its operations. Unless it can sell its
assets immediately to raise cash, it will quickly fail. This is exactly what happened
to Lehman.
Lehman borrowed funds in the overnight credit market (also known as the repo
market), funds that it was required to repay the next business day, in order to fund
its trading operations. So Lehman was on a very short leash: every day it had to be
able to convince its creditors that it was a safe place to park their funds. And one day,
that ability was no longer there. The same phenomenon happened at LTCM: the
hedge fund was enormously leveraged (that is, it had borrowed huge amounts of
money)—also, like Lehman, to fund its trading operations. One day its credit simply
dried up, in its case because creditors perceived that it had lost huge amounts of
money during the Asian and Russian financial crises of 1997–1998.
Bank runs are destructive to everyone associated with a bank: its shareholders, its
creditors, its depositors and loan customers, and its employees. But a bank run that
spreads like a contagion is extraordinarily destructive, causing depositors at other
banks to also lose faith, leading to a cascading sequence of bank failures and a banking crisis. This is what happened in the United States during the early 1930s as
Americans in general rushed out of bank deposits—the total value of bank deposits
fell by 35%—and started holding currency instead. Until 2008, it had never happened again in the United States. Our next topic is to explore how and why bank
runs reappeared.
Nervous depositors lined up outside
Northern Rock Bank, hoping to withdraw their funds before it was too late.
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➤➤
➤
➤
➤
➤
QUICK REVIEW
There is a trade-off between liquidity and yield, or rate of return.
Without banks, people would make
this trade-off by holding a large
fraction of their wealth in idle cash.
Banks allow savers to make a superior choice in their liquidity–yield
trade-off because they engage in
maturity transformation. With
banks, savers can have immediate
access to their funds as well as
earn interest on those funds.
Since 1980 there has been a steady
rise in shadow banking because
shadow banks—nondepository
financial institutions that engage in
maturity transformation—have
largely been unregulated, allowing
them to pay a higher rate of return
to savers. At the time of the
Lehman failure, shadow banking
was about 1.5 times larger than the
depository banking sector.
Because shadow banks, like depository banks, engage in maturity
transformation, they can also be hit
by bank runs. Shadow banks
depend on short-term borrowing to
operate; when short-term lenders
won’t lend to a shadow bank, their
refusal causes the bank to fail.
The run began on September 14, 2007, and continued for four days, ending only
when the British government announced that it would guarantee all deposits at
the bank. In 2008 the bank was nationalized, becoming a government-owned
institution. ▲
< < < < < < < < < < < <
➤ CHECK YOUR UNDERSTANDING
1
1. Which of the following are examples of maturity transformations? Which are subject to a bankrun-like phenomenon in which fear of a failure becomes a self-fulfilling prophecy? Explain.
a. You sell tickets to a lottery in which each ticket holder has a chance of winning a
$10,000 jackpot.
b. Dana borrows on her credit card to pay her living expenses while she takes a year-long
course to upgrade her job skills. Without a better-paying job, she will not be able to pay
her accumulated credit card balance.
c. An investment partnership invests in office buildings. Partners invest their own funds and
can redeem them only by selling their partnership share to someone else.
d. The local student union savings bank offers checking accounts to students and invests
those funds in student loans.
Solutions appear at end of chapter.
Banking Crises and Financial Panics
Bank failures are common: even in a good year, several U.S. banks typically go under
for one reason or another. And shadow banks sometimes fail, too. Banking crises—
episodes in which a large part of the depository banking sector or the shadow banking sector fails or threatens to fail—are relatively rare by comparison. Yet they do
happen, often with severe negative effects on the broader economy. What would
cause so many of these institutions to get into trouble at the same time? Let’s take a
look at the logic of banking crises, then review some of the historical experiences.
The Logic of Banking Crises
When many banks—either depository banks or shadow banks—get into trouble at the
same time, there are two possible explanations. First, many of them could have made
similar mistakes, often due to an asset bubble. Second, there may be financial contagion, in which one institution’s problems spread and create trouble for others.
A banking crisis occurs when a large
part of the depository banking sector or
the shadow banking sector fails or
threatens to fail.
In an asset bubble, the price of an asset
is pushed to an unreasonably high level
due to expectations of further price gains.
Shared Mistakes In practice, banking crises usually owe their origins to many
banks making the same mistake of investing in an asset bubble. In an asset bubble,
the price of some kind of asset, such as housing, is pushed to an unreasonably high
level by investors’ expectations of further price gains. For a while, such bubbles can
feed on themselves. A good example is the savings and loan crisis of the 1980s, when
there was a huge boom in the construction of commercial real estate, especially office
buildings. Many banks extended large loans to real estate developers, believing that
the boom would continue indefinitely. By the late 1980s, it became clear that developers had gotten carried away, building far more office space than the country needed. Unable to rent out their space or forced to slash rents, a number of developers
defaulted on their loans—and the result was a wave of bank failures.
A similar phenomenon occurred between 2002 and 2006, when the fact that
housing prices were rising rapidly led many people to borrow heavily to buy a house
in the belief that prices would keep rising. This process accelerated as more buyers
rushed into the market and pushed prices up even faster. Eventually, however, the
market runs out of new buyers and the bubble bursts. At this point asset prices fall;
in some parts of the United States, housing prices fell by half between 2006 and
2009. This, in turn, undermines confidence in financial institutions that are
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exposed to losses due to falling asset prices. This loss of confidence, if it’s sufficiently severe, can set in motion the kind of economy-wide vicious circle that marks a
banking crisis.
Financial Contagion
In especially severe banking crises, a vicious downward spiral of financial contagion occurs among depository banks as well as shadow banks:
each institution’s failure increases the odds that another will fail.
As already noted, one underlying cause of contagion arises from the logic of bank
runs. In the case of depository banks, when one bank fails, depositors are likely to
become nervous about others. Similarly in the case of shadow banks, when one fails,
lenders in the short-term credit market become nervous about lending to others. The
shadow banking sector, because it is largely unregulated, is especially prone to fearand rumor-driven contagion.
There is also a second channel of contagion: asset markets and the vicious circle
of deleveraging, a phenomenon we learned about earlier. When a financial institution is under pressure to reduce debt and raise cash, it tries to sell assets. To sell
assets quickly, though, it often has to sell them at a deep discount. The contagion
comes from the fact that other financial institutions own similar assets, whose
prices decline as a result of the “fire sale.” This decline in asset prices hurts the
other financial institutions’ financial positions, too, leading their creditors to stop
lending to them. This knock-on effect forces more financial institutions to sell
assets, reinforcing the downward spiral of asset prices. This kind of downward spiral was clearly evident in the months immediately following Lehman’s fall: prices
of a wide variety of assets held by financial institutions, from corporate bonds to
pools of student loans, plunged as everyone tried to sell assets and raise cash. Later,
as the severity of the crisis abated, many of these assets saw at least a partial recovery in prices.
Combine an asset bubble with a huge, unregulated shadow banking system and
a vicious circle of deleveraging and it is easy to see, as the U.S. economy did in
2008, how a full-blown financial panic—a sudden and widespread disruption of
financial markets that happens when people lose faith in the liquidity of financial
institutions and markets—can arise. A financial panic almost always involves a
banking crisis, either in the depository banking sector, or the shadow banking sector, or both.
Because banking provides much of the liquidity needed for trading financial assets
like stocks and bonds, severe banking crises can then lead to disruptions of the stock
and bond markets. Disruptions of these markets, along with a headlong rush to sell
assets and raise cash, lead to a vicious circle of deleveraging. As the panic unfolds,
savers and investors come to believe that the safest place for their money is under
their bed, and their hoarding of cash further deepens the distress.
So what can history tell us about banking crises and financial panics?
Historical Banking Crises: The Age of Panics
Between the Civil War and the Great Depression, the United States had a famously crisis-prone banking system. Even then, banks were regulated: most banking
was carried out by “national banks” that were regulated by the federal government and subject to rules involving reserves and capital, of the kind described
below. However, there was no system of guarantees for depositors. As a result,
bank runs were common, and banking crises, also known at the time as panics,
were fairly frequent.
Table 1 on the next page shows the dates of these nationwide banking crises and
the number of banks that failed in each episode. Notice that the table is divided into
two parts. The first part is devoted to the “national banking era,” which preceded the
7
A financial contagion is a vicious
downward spiral among depository
banks as well as shadow banks: each
institution’s failure increases the likelihood that another will fail.
A financial panic is a sudden and widespread disruption of the financial markets that occurs when people lose faith
in the liquidity of financial institutions
and markets.
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TABLE
1
Number of Bank Failures: National Banking Era and Great Depression
Panic Dates
National Banking Era
Number of Failures
Panic Dates
Great Depression
Number of Failures
September 1873
101
November–December 1930
806
May 1884
42
April–August 1931
573
November 1890
18
September–October 1931
827
May–August 1893
503
June–July 1932
283
October–December 1907
73*
February–March 1933
Bank holiday
*This understates the scale of the 1907 crisis, because it doesn’t take into account
the role of trusts.
ssa.gov
A typical scene outside a bank during the
banking crises of the Great Depression.
1913 creation of the Federal Reserve—which was supposed to put an end to such
crises. It failed. The second part of the table is devoted to the epic waves of bank failures that took place in the early 1930s.
The events that sparked each of these panics differed. In the nineteenth century,
there was a boom-and-bust cycle in railroad construction somewhat similar to the
boom-and-bust cycle in office building construction during the 1980s. Like modern
real estate companies, nineteenth-century railroad companies relied heavily on borrowed funds to finance their investment projects. And railroads, like office buildings,
took a long time to build. This meant that there were repeated episodes of overbuilding: competing railroads would invest in expansion, only to find that collectively they
had laid more track than the traffic actually warranted. When the overbuilding
became apparent, business failures and debt defaults followed, and this in turn could
start an overall banking crisis. The Panic of 1873 began when Jay Cooke and Co., a
financial firm with a large stake in the railroad business, failed, starting a run on
banks in general. The Panic of 1893 began with the failure of the overextended
Philadelphia and Reading Railroad.
As we’ll see later in this chapter, the major financial panics of the nineteenth
and early twentieth century were followed by severe economic downturns.
However, the banking crises of the early 1930s made previous crises seem minor
by comparison. In four successive waves of bank runs, about 40% of the banks in
America failed. In the end, Franklin Delano Roosevelt declared a temporary closure
of all banks—the so-called bank holiday—to put an end to the vicious circle.
Meanwhile, the economy plunged, with real GDP shrinking by a third and a sharp
fall in prices as well.
There is still considerable controversy about the banking crisis
of the early 1930s. In part, this controversy is about cause and
effect: did the banking crisis cause the wider economic crisis, or
vice versa? (No doubt causation ran in both directions, but the
magnitude of these effects remains disputed.) There is also controversy about the extent to which the banking crisis could have been
avoided. Milton Friedman and Anna Schwartz, in their famous
Monetary History of the United States, argued that the Federal
Reserve could and should have prevented the banking crisis—and
that if it had, the Great Depression itself could also have been prevented. However, this view has been disputed by other economists.
In the United States, the experience of the 1930s led to banking reforms that prevented a replay for more than 70 years.
Outside the United States, however, there were a number of
major banking crises.
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Modern Banking Crises
According to a 2008 analysis by the International Monetary Fund (IMF), no fewer
than 127 “systemic banking crises” occurred around the world between 1970 and
2007. What the IMF meant by this was crises in which multiple banks experienced
difficulties that were also associated with debt problems outside the banking system. To be sure, most of these crises occurred in small, poor countries, and few were
as severe as, say, the U.S. Panic of 1873 or 1893, let alone the banking collapse of
the 1930s.
Yet some advanced countries suffered major banking crises at the beginning of
the 1990s, most notably Finland, Sweden, and Japan—at the time the world’s
second-largest economy. None of these crises were marked by bank runs, which
made them different from old-fashioned panics. What happened instead in all three
cases was that banks lent heavily into a real estate bubble, a bubble that their lending helped to inflate. Figure 1 shows real estate prices, adjusted for inflation, in the
three countries from 1985 to 1995. As you can see, in each case, a sharp rise was followed by a drastic fall. When real estate prices fell, many borrowers who had bet on
rising prices defaulted on their loans, pushing large parts of each country’s banking
system into insolvency.
1
Japan
130
120
110
100
Finland
95
19
94
19
93
19
92
19
91
19
90
19
89
19
88
19
19
87
90
85
Source: Bank of Finland; Statistics Sweden; Japan
Real Estate Institute; Bank for International
Settlements; OECD.
Sweden
19
During the period 1985 to 1995, Finland,
Sweden, and Japan each experienced a
banking crisis due to a real estate bubble.
Here you can see how real housing prices
(housing prices adjusted for inflation) in
each country rose dramatically and then fell
sharply. The sharp fall in housing prices
pushed a significant part of each country’s
banking sector into insolvency.
Real housing
price index
(1985=100)
140
86
Real Housing Prices in Three
Banking Crises
19
FIGURE
Year
LD
IEW
WO R
Erin Go Broke
D VIE
WO R LD V
IN ACTION
O RL
W
➤ ECONOMICS
V IEW W
In the next section we will learn how troubles in the banking system soon translate
into troubles for the broader economy.
For much of the 1990s and 2000s, Ireland was celebrated as an economic success story:
the “Celtic Tiger” was growing at a pace the rest of Europe could only envy. But the miracle came to an abrupt halt in 2008, as Ireland found itself facing a huge banking crisis.
Like the earlier banking crises in Finland, Sweden, and Japan, Ireland’s crisis grew
out of excessive optimism about real estate. Irish housing prices began rising in the
1990s, in part a result of the economy’s strong growth. However, real estate developers
9
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K r u g m a n / We l l s, E c o n o m i c s 2 e
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Although individual bank failures
are common, a banking crisis is
a rare event. A banking crisis
will typically severely harm the
broader economy.
A banking crisis can occur because
banks (depository or shadow or
both) make similar mistakes, such
as investing in an asset bubble, or
because of financial contagion.
Contagion can occur either through
bank runs or through a vicious circle of deleveraging, since banks
often own similar assets. Because
it is largely unregulated, shadow
banking is particularly vulnerable
to contagion.
In 2008, the combination of an
asset bubble with a huge, unregulated shadow banking sector and a
vicious circle of deleveraging created a full-blown financial panic. As
savers and investors hoarded their
cash and cut spending, the economy went into a steep decline.
Between the Civil War and the Great
Depression, the United States suffered numerous banking crises and
financial panics, each followed by a
severe economic downturn. The
banking crisis of the 1930s precipitated wide-ranging bank reform in
the United States, which prevented
another banking crisis until 2008.
Banking crises occur frequently
throughout the world, usually in
small, poor countries. At the
beginning of the 1990s there were
also banking crises in Finland,
Sweden, and Japan, all driven by
real estate bubbles.
began betting on ever-rising prices, and Irish banks were all too willing to lend these
developers large amounts of money to back their speculations. Housing prices tripled
between 1997 and 2007, home construction quadrupled over the same period, and
total credit offered by banks rose far faster than in any other European nation. To
raise the cash for their lending spree, Irish banks supplemented the funds of depositors with large amounts of “wholesale” funding—short-term borrowing from other
banks and private investors.
In 2007 the real estate boom collapsed. Home prices started falling, and home
sales collapsed. Many of the loans that banks had made during the boom went into
default. Now, so-called ghost estates, new housing developments with hardly any residents, dot the landscape. In 2008, the troubles of the Irish banks threatened to turn
into a sort of bank run—not by depositors, but by lenders who had been providing the
banks with short-term funding through the wholesale interbank lending market. To
stabilize the situation, the Irish government stepped in, guaranteeing all bank debt.
This created a new problem, because it put Irish taxpayers on the hook for potentially huge bank losses. Until the crisis struck, Ireland had seemed to be in good fiscal shape, with relatively low government debt and a budget surplus. The banking
crisis, however, led to serious questions about the solvency of the Irish government—
whether it had the resources to meet its obligations—and forced the government to
pay high interest rates on funds it raised in international markets.
Like most banking crises, Ireland’s led to a severe recession. The unemployment
rate rose from less than 5% before the crisis to more than 13% in August 2010—and
it was still rising at the time of writing. ▲
< < < < < < < < < < < <
➤ CHECK YOUR UNDERSTANDING 2
1. Regarding the Economics in Action “Erin Go Broke,” identify the following:
a. The asset bubble
b. The channel of financial contagion
2. Again regarding “Erin Go Broke,” why do you think the Irish government tried to stabilize the
situation by guaranteeing the debts of the banks? Why was this a questionable policy?
Solutions appear at end of chapter.
The Consequences of Banking Crises
If banking crises affected only banks, they wouldn’t be as serious a concern as they
are. In fact, however, banking crises are almost always associated with recessions, and
severe banking crises are associated with the worst economic slumps. Furthermore,
experience suggests that recessions caused in part by banking crises inflict sustained
economic damage, with economies taking years to recover.
Banking Crises, Recessions, and Recovery
A severe banking crisis is one in which a large fraction of the banking system
either fails outright (that is, goes bankrupt) or suffers a major loss of confidence
and must be bailed out by the government. Such crises almost invariably lead
to deep recessions, which are usually followed by slow recoveries. Figure 2 illustrates this phenomenon by tracking unemployment in the aftermath of two banking crises widely separated in space and time: the Panic of 1893 in the United
States and the Swedish banking crisis of 1991. In the figure, t represents the year
of the crisis: 1893 for the United States, 1991 for Sweden. As the figure shows,
these crises on different continents, almost a century apart, produced similarly
bad results: unemployment shot up and came down only slowly and erratically so
that, even five years after the crisis, the number of jobless remained high by precrisis standards.