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Krugman3e_Chapter_35_KrugmanWells_sample 12/10/10 3:23 PM Page 1 Supplemental Chapter V IEW W D VIE FROM PURVEYOR OF DRY GOODS TO DESTROYER OF WORLDS WO R I WO R LD V LD O RL W Crises and Consequences IEW 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, 1 Krugman3e_Chapter_35_KrugmanWells_sample 12/10/10 3:23 PM Page 2 2 K r u g m a n / We l l s, E c o n o m i c s 2 e 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 Krugman3e_Chapter_35_KrugmanWells_sample 12/10/10 3:23 PM Page 3 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. 3 Krugman3e_Chapter_35_KrugmanWells_sample 12/10/10 3:23 PM Page 4 4 K r u g m a n / We l l s, E c o n o m i c s 2 e 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 Krugman3e_Chapter_35_KrugmanWells_sample 12/10/10 3:23 PM Page 5 CRISES AND CONSEQUENCES 5 WO R 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 LD IEW Bad Day at Northern Rock D VIE WO R LD V IN ACTION O RL W ➤ ECONOMICS V IEW W 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. Krugman3e_Chapter_35_KrugmanWells_sample 12/10/10 3:23 PM Page 6 6 K r u g m a n / We l l s, E c o n o m i c s 2 e ➤➤ ➤ ➤ ➤ ➤ 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 Krugman3e_Chapter_35_KrugmanWells_sample 12/10/10 3:23 PM Page 7 CRISES AND CONSEQUENCES 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. Krugman3e_Chapter_35_KrugmanWells_sample 12/10/10 3:23 PM Page 8 8 K r u g m a n / We l l s, E c o n o m i c s 2 e 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. Krugman3e_Chapter_35_KrugmanWells_sample 12/10/10 3:23 PM Page 9 CRISES AND CONSEQUENCES 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 Krugman3e_Chapter_35_KrugmanWells_sample 12/10/10 3:23 PM Page 10 10 ➤➤ ➤ ➤ ➤ ➤ ➤ K r u g m a n / We l l s, E c o n o m i c s 2 e QUICK REVIEW 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.