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Financial Crises: Why They Occur and
What to Do about Them
E. Maskin
Institute for Advanced Study
• current financial crisis only latest in long sequence
• history of financial crisis in U.S. goes back to 19th
century
• probably crises will continue in future
– each crisis somewhat different from predecessors
– even if we fix mortgage loan market in U.S.(where current crisis started), something new will happen
– even if anticipated, not all crisis may be preventable
• however, can do much better at limiting crises
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Today’s topics
• Why does credit market have repeated crises and other markets do not?
• Why does credit market require substantial ex post
intervention (and others do not)?
• What can be done ex ante to prevent/limit crises?
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To understand what caused this crisis (and other crises)
should first eliminate factors that were not causes
• irrationality
- on part of bankers
- on part of borrowers
• panic
• greed
• lack of ethics
• overconsumption in U.S./ oversaving in China
• opaqueness of derivatives
• bankers’ bonuses
• banks too big to fail
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Why is credit market different?
(1) credit lifeblood for rest of economy
− if crisis in market for rice, won’t bring down market for automobiles
− if credit market doesn’t work, enterprises in all markets will have trouble investing and meeting payrolls
(2) small shock to credit market often magnified
− if some rice growers fail, won’t cause other growers to fail
− if some banks fail, may well cause other banks to go under
(3) credit market not self-correcting
− if some rice growers fail, others will step into breach no outside intervention needed
− if some banks fail, credit market can get “stuck” - - no banks willing to lend
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Elaboration on points 2 and 3
• Suppose flood wipes out rice crop in Yunan
• What will happen?
– immediate effect is fall in overall rice output
– but demand hasn’t changed - - less rice to go around
– so price of rice will be bid up
– induces other rice suppliers in Yangtze River Valley to grow and sell more
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• So rice market “self-correcting”
– crop failure hurts consumers in short run - - higher prices
– but high prices induce suppliers to expand output
– so effect of drought mitigated in long run
• Government intervention not needed
• Government interference in rice market likely to make things worse
• Suppose puts cap on rice price or taxes “windfall”
profits
– discourages expansion of output that can make up for crop failure
– this creates rice shortage or black market in rice
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• Credit market is just the opposite
• Suppose a few banks get into trouble
– made risky subprime mortgage loans
– borrowers can’t repay loans
– banks highly leveraged – don’t have enough capital to maintain other operations
• these banks have other borrowers
– have to call loans in on these borrowers
– so borrowers have to scale back activities that depended on these loans
– thus will have harder time repaying loans from other banks
• so these other banks now get into trouble
– have to call in loans from their borrowers
– refuse to make new loans
• what started as local problem (subprime mortgage lending) spreads to
entire credit market (systemic risk)
• initial problem not self-correcting (as in rice market)
– gets aggravated
– end up with credit crunch
– not due to panic, but to rational responses by bankers and borrowers
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• in economics terminology, bank exerts an externality on
other banks by being highly leveraged and making risky loans
– externality: effect your actions have on others that you don’t take into account
– when bank highly leveraged and makes risky loans, puts other banks in jeopardy
– but doesn’t factor this effect in when leverages itself and makes loans (not harmed by it)
– not irrational or unethical or overly greedy
• markets with significant externalities often don’t work well on own
– take clean air, for example
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• Why isn’t there a market for clean air?
• in fact, there is such a market, but so limited we hardly see it
• suppose laundry next door to steel plant
– smoke from steel plant interferes with laundry
– laundry may offer to pay steel plant to reduce smoke (so market for smoke reduction exists)
– but smoke doesn’t just affect laundry - - affects many other enterprises
– by paying for reduction, laundry confers benefit on other enterprises (externality)
– laundry doesn’t take this into account
– so likely to underpay for reduction - - smoke not reduced as much as should be
• solution: government imposes cap or fine on smoke emissions by steel plant
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Need two solutions for credit market
• ex post : after banks get into trouble
• ex ante : to prevent crisis in first place
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Ex post solution for credit market:
If some banks get into trouble,
• government can bail them out
– infuse with capital so can continue to lend
• but bailout important primarily for other
banks that would be hurt if bailed-out banks failed
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Bailout policy comes at cost:
• if banks anticipate being bailed out when get in trouble
– have incentive to take on highly risky loans, e.g., subprime mortgage loans (moral hazard)
• so ex post solution to financial crisis actually makes crisis more likely!
• so also need ex ante solution :
regulation
– constraints on what banks can do
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Actually, two reasons why regulation needed
• prospect of bailouts induces banks to make too-risky loans (moral hazard)
• bank ignores externality imposed on other banks by too-risky loans and leverage - - undervalues cost of these loans and leverage
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Principal forms of regulation
• minimum standards for loans
- borrowers must be sufficiently credit worthy
• limits on leverage / capital requirements
- given lending, need minimum capital level
- limiting leverage limits bank’s liquidity
- another way of accomplishing same thing :
increasing interest rate
- leverage limitations ↔ monetary policy
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• restrictions on derivatives
- derivatives allow risks to be shared with others
- risk-sharing useful
- however, encourages riskier lending
- so, because of externality, should restrict derivative trading
• regulation of bankers’ bonuses
- many complaints about these bonuses
- however, bonuses per se not problem
- problem : rewarding bankers for success without punishing failure –
encourages risky lending
- solution : bankers must return bonuses (or other punishment) if loans fail
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• regulating size of banks
- problem with big banks not
too big too fail
- several small banks failing has same effect as one big bank failing
• problem with big banks :
because of externality
- bank takes too much risk
- in particular, doesn’t diversify sufficiently
- so too likely to fail
- small banks also too likely to fail
- but several small banks less like to fail than one big bank, because each does
something different
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• Have argued that can understand current financial crisis without
appealing to
- irrationality
- panic
- greed
- lack of ethics
- opaqueness of derivatives
- bonuses
- too big to fail
• Crisis brought on by
- externality (one bank’s risk-taking affects other banks )
- moral hazard (prospect of bailouts)
• Solution
- bailouts
- regulation
needed to correct externality
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moral hazard created by bailouts
• Well-designed regulation/bailout package
– can prevent many crises from getting started - - rules against subprime loans would have prevented this one
– can resolve them if do occur
– historically, regulation worked from 1940~1980
• Can’t hope to prevent credit crises completely and still allow for creativity
– can’t anticipate all possible innovations by banks
– so can’t have rules that prevent only harmful innovations
• But can do a lot better than we’ve done this time
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