The concept that fiscal contraction can result in growth is commonly known as "expansionary austerity".

Expansionary austerity is the idea that through the reduction of government spending (to reduce the deficit, and slow the rate at which the government’s debt increases) it’s people might change their spending habits due to the EXPECTED future tax levels. As the government spends less money, taxes should not rise in the future and therefore instead of saving, people would feel better about spending their earning now therefore creating more demand which pushes the economy towards recovery.

Another important point is general confidence of companies, private housholds and financial markets. Austerians argue that a clear commitment to consolidation can restore their believe in sound financial policies and therefore increase their spendings and investment. This effect can in theory outweigh governmental spending cuts. This net positive effect is meant by the expression “expansionary”.

The IMF underestimated the multiplier of government spending. The multiplier shows what effect  a change in government spending has on the whole economy.

By underestimating the multiplier, the IMF thought that the effect of reducing government would be smaller than the effective cut in spending. For example a multiplier of 0.5 means that if the government cuts spending by 1%, the effect on GDP would only be a contraction of 0.5%.

Newest investigations by the IMF show higher numbers for the multiplier. The IMF also reports that in the past fiscal contraction was supported by a expansionary monetary policy by central banks (lower interest rates). In today’s situation this medicine is no longer available because interest rates are already at historically low levels. So the effects of austerity on the economy would be worse than compared to the past.

This finding is important because it may change policymakers willingness to implement budget cuts and change their view about the optimal strategy to deal with rising deficits and slow growth rates.   

Fishers two fundamental forces are over-indebtedness and deflation following soon after. He says that these two factors will set up serious disturbances in all, or nearly all, other economic variables. And that if these two were absent, other disturbances were not powerful enough to cause a severe depression.

In times of economic growth a lot of debt is accumulated, investment levels are high as well as profits (boom).

At some point in time either creditors or debtors (or both) decide that the level of debt is no longer sustainable and should be reduced (loss of confidence, exact trigger not mentioned). Companies start to pay down their debt by liquidating assets. As all companies do that at the same time this leads to sharp decline in asset prices. This effect leads to a lower value for remaining assets which in turn can even outweigh the repayment in debt.

This means that despite a repayment of debt is done, the ratio of debt to assets further rises. The mentioned fall in prices causes the deflation (swelling of the dollar). This interaction between debt repayment and further decline of asset prices causes a so called “bad equilibrium” (kind of vicious cycle).

A public debt overhang is an episode where the gross public debt/ GDP ratio exceeds 90 percent for five years or more. This ratio of debt/GDP holds for other kinds of debt too such as private-, external- and pension-debt.

What is dangerous about the periods where debt-overhangs exist is that on average GDP growth decreases sufficiently. Reinhart and Rogoff show that periods where debt is over 90% of GDP are associated with roughly 1% lower growth while at lower debt thresholds, the correlation with growth is small. This implies a massive cumulative output loss, considered that the duration of the average debt-overhang period is 23 years.

Other than that high debt levels are of course dangerous for other reasons as well. High public debt can for example slow growth through higher distorting taxes or lower government spending (in order to maintain or reduce the debt level). As well as of course the ever-present and maybe growing uncertainty of default.

High consumer debt for example may lead to a cut back in consumer spending and thus potentially weaken aggregate demand.

The problem with an external debt overhang is that the government has very little ways to reduce the debt since neither inflation nor financial represion is feasable.

Sustainable debt is the level of debt which allows a debtor country to meet its current and future debt service obligations in full, without recourse to furtherdebt relief or rescheduling, avoiding accumulation of arrears, while allowing an acceptable level of economic growth. (UCTAD Definition).

While a plausible definition (like the one given above) is relatively easy to give it is not easy to determine criteria when a country leaves the path of sustainability. Reinhart and Rogoff collected empirical data on growth rates for a variety of countries and find a significant lower growth for countries that have a debt/GDP ratio higher than 90% (2,3 instead of 3,5% p.a.). The difference is significant and accumulates over years causing lower wealth levels for countries that suffer from a so called “debt overhang”. Although this does not necessarily cause a sovereign default, these high debt levels are not sustainable because they harm economic growth siginificantly.

There are a lot of other indicators (debt/GDP mainly, but some more specialised like external debt/exports, short term debt /debt (causes vulnerabilites ...)) . In general the ratios grow when debt grows faster than the economy does (or exports, or... ). If this is the case for longer periods the debt can get unsustainable (higher interest rates or even loss of confidence and default if levels get too high).

External debt (or foreign debt) is that part of the total debt in a country that is owed to creditors outside the country

Generally, there are 4 categories of external debt:

1. Public and publicly guaranteed debt

2. Private non-guaranteed credits

3. Central bank deposits

4. Loans due to the IMF

Internal/Domestic debt is debt that is owed to creditors residing in the same country as debtors (jurisdiction and currency are both domestic)

Internal debt's complement is external debt.

(Partly) unfunded implicit payment obligations in medical aid programs and future pension payments.

Actuarial debt is somewhat special as it is difficult to calculate and often not very transparent (and conditions of payment can change in the future...)

Pros:

Clear commitment to reduce debt overhang strengthens markets confidence in governments’ solvency.

Lower expected future tax burdens.

Both could in theory lead to higher private consumption and investment. Eventually lower interest rates for government bonds.

Long term: can lead to higher growth rates (compare Reinhart, Rogoff and debt overhang that harms long term growth perspectives) if debt overhang is successfully reduced.

Cons:

Short term effects are definitely very negative: lower investment/ spending often not fully compensated by private investment /spending.

Unemployment rises.

Interest rates do not necessarily become smaller. If done too early after recession possibly forces economy again into recession and therefore have even negative effects on debt/GDP ratio (compare Greece, Spain, etc. ... )   

A key aspect of the crisis was the increased use by banks of short-term wholesale funding and the risks that it posed when these short-term markets dried up. The greater use of short-term wholesale funding was the key to the buildup of vulnerabilities in the system, including excess leverage and maturity mismatch.

Perhaps insufficiently recognized was that the wholesale providers of funds had also changed—instead of interbank markets acting to move unsecured funds where needed, other intermediaries, such as money market mutual funds, were growing suppliers of funds while traditional, more stable depositors were not. Secured lending through repurchase operations also grew immensely, greasing the funding markets.

This change in the providers of funds brought about the emergence of the shadow banking system – thus leading these funding activities out of regulated banking markets. What this means is that short term banking funding (although of course related to the banking system) is not subject to actual banking regulation and supervision anymore. This made it extremely difficult to monitor risks and exposures created by the shadow banking system.

Then there was the credit risk of the newly used collateral in the repo market. In this market mostly securitized debt obligations were used as such collateral. Since these products are generally not frequently traded it was difficult to apply an actual valuation and a proper liquidation time. Hence creating an inappropriate value.

In sum, the buildup of vulnerabilities to systemic liquidity risk occurred through shortcomings in liquidity risk management at individual institutions, poor market practices, the complexity of the infrastructures of funding markets, and regulatory gaps.

The freezing up of the interbank funding and money markets necessitated massive crisis intervention, cross-border coordination, and adjustments to central bank liquidity operations to stabilize the financial system and restore orderly market conditions.

Central banks had to step in and take over the role of money markets in distributing liquidity in the system as banks and other lenders shunned transacting, particularly beyond very short-term maturities, due to rising counterparty risk concerns in the repo market. In some places, central banks are still actively supporting money markets.

Central banks also have become buyers of last resort of distressed assets, and governments have needed to guarantee bank debt.

These measurements were necessary to preserve the interbank funding market from a complete collapse and a following meltdown of the financial system.

Also had the central banks to act as buyers of distressed assets to prevent the banking system from a massive round of insolvencies.

The shift of short term funding from unsecured interbank markets to the newly emerged repo markets forced the banks to supply collateral for these transactions to make up for counterparty risk.

For the unsecured funding markets it is not unusual that these tend to shut down in an environment of financial distress and uncertainty, since no collateral is provided. But during the recent financial crisis even the secured (by collateral) short term interbank funding markets tended to shut down.

In regard to the collateral this was mainly due to the fact that no one was able to provide an accurate valuation of the mainly used collateral. In these markets the mainly used collaterals were securitized debt obligation which basically composed of CDO’s created by a huge part from housing loans, that of course contained subprime loans. Since these collaterals were not frequently traded and, if they were traded only in so called OTC transactions, it was hard to provide an accurate valuation besides the nominal value as well as a proper liquidation period, especially in times of financial distress.

When these shortcoming became obvious to the market participants, with growing default rates in the housing markets, the formerly used collateral became useless and triggered the shutdown of the short term secured interbank funding market (REPO).

An economy with structural problems suffers from a large trade deficit, high inflation, and a weak currency, which lead to high interest rates, i.e. affects the supply-side of the economy. Problems occur on a mirco-economic level (because of weak institutions, too much state influence causing inefficiencies, no incentives for innovation, etc. ).

I dont really understand the second part of the question. What is meant by these terms??Does cyclical in this case mean “balance sheet reform”? Maybe someone could explain that a little bit (maybe Prof Gerber mentioned something during class? ). For me cyclical means that government can do little against it and it will cure itself ...

A balance sheet recessionis a recession in which despite extremely low interest rates, businesses try to hide their debt & pay it off as quickly as possible to bring it back down to reasonable levels.

They do no longer try to maximize profits but try to reduce their debt (debt-minimization instead of profit-maximization). This is triggered by the burst of an asset price bubble which caused a devaluation of assets while liabilities (amount of money used to buy the asssets) is unchanged. Suddenly a firm’s balance sheet is in big trouble. Such a triggering event is necessary to bring a large enough amount of companies to simultaneously do the same thing: paying down debt. What is right for one company causes trouble for the whole economy when done simultaneously by many companies.

They do this by reducing their staff & and cutting their spending which in turn causes people to spend less money on goods and services that those companies provide which goes on to decrease business revenue and cause even more cuts and so forth.

Cash Flows are not reinvested but used to pay down debt, causing a decline in aggregate demand. This repayment of debt causes a decline in loans (no one is willing to borrow any more!!) If public savings are not reduced or government borrows more, this repayment of loans would cause a decline in loans.

Not all savings would be reinvested (despite interest rates being at zero, because companies do no longer maximize profits but repay debt) and a part of the money that is saved would simply accumulate in the banking system. It is no longer lended out, causing a deflationary spiral (interruption of channeling household savings into corporate investments) what further worsens the decline asset prices and further forces companies to repay debt and so on... Aggregate demand shrinks by the exact amount of money that is “lost” in the deflationary spiral.  

This concept is useful because financial crisis can be a possible trigger for a balance-sheet recession (because of a slump in asset prices). Treatment of this disease is completely different from a normal recession (large government borrowing and spending necessary to stop deflationary spiral until corporations are willing to borrow again).

I think here almost everything can be written ... for example:

This argument was maybe true in the very beginning of the crisis in Greece when nobody was prepared for a greek default. In this case there could have been a very quick shock transition. Directly through government bonds in the portfolios of banks, insurance companies, etc. and even further through a ‘speculative attacks’ on other euro countries.

Market could have interpreted Greece’s exit as a lack of commitment of the other states to save the Euro. Markets could have lost confidence in Italy, Spain, Portugal, Ireland and this could easily have become kind of a self-fulfilling prophecy. But with time many private creditors have written down their positions in Greek bonds so most of the losses in the private sector are already realised. ECB, IMF and the other Eurozone countries (through EFSF) are now large creditors of greece. If Greece would leave the Eurozone it is most likely that they would have to realise losses, but this would no longer affect the private sector so heavy and companies and governments now had enough time to make plans for Greece’s exit. For me contagion should no longer be the primary argument against a greek exit.  

Answers could also mention political issues (European integration/idea) that may outweigh economic arguments...

Explain each statement or answer each question and explain your answer:

b.      Would Richard Koo view Greece’s problems as structural or cyclical?  Why?

Explain each statement or answer each question and explain your answer:

c.       Does the European Commission (and the IMF and ECB) view Greece’s problems as structural or cyclical?  Why?

Explain each statement or answer each question and explain your answer:

d.      Greece’s debt is unsustainable.

In my opinion this is true for several reasons. First of all the debt level (even after a haircut on private debt in 2011) is much higher than in most other countries in the world (150% debt / GDP ration in Q2 2012). This is above the level of 90% that Reinhart / Rogoff have identified as non harming for a country’s long term growth perspectives (it doesn’t really matter in this case if the ‘red line’ is 90%, it could also be 80% or 120% --> Greece level of debt is far above that).

Not only that the debt level is high, Greece also has no access to free capital markets for reasonable interest rates so it is not able to finance (or even only to roll over its old debt) on their own.

Situation is even worse when it comes to the rate of change in debt/GDP ratio. With a still shrinking economy (2012: about: about -6%) while running a public deficit the debt burden will continue to raise in the next years. This process is dramatically fast in the case of Greece so I don’t see how Greece could finance that without a further bailout or haircut on its debt.

Spain had a very well managed public deficit. Rates were low until crisis started, this means that deficit was under control and debt/GDP ratio was far lower than for countries like France and Germany. Government can therefore not be blamed for acting irresponsible.

Problems were in the private sector. Housing price bubble and excessive bank loans in this area fueled by capital inflows. When the bubble burst, government had to take over much of the debt. Even worse were the effects on economic output. Many people lost their jobs in the construction sector, banks suffered from high default rates in loans. Unemployment and negative GDP growth caused high costs for the government that tried to restart the economy with a fiscal stimulus.

Automatic stabilizers and declining tax revenues also contributed to a quickly rising deficit (more than 10% of GDP). investors lost confidence in the governments ability to repay its debt and interest rates startet to rise. The government now tries to deal with the problem by raising taxes, cutting spendings and implement structural reforms as well as they recapitalize banks with the help from other European States (by ESFM).

Mismanagement of the public deficit therefore was not the reason for the crisis, but one could argue that a better supervision of banks and earlier countermeasures against the housing bubble could have been in the power of the government although their influence maybe limited because the ECB sets interest rates.

- Joining the EU allowed it to use the Euro, which was much less prone to devalutation than the drachma.

- investors believed that member states would not let another member default on its debt, and that it would be bailed out in event of a crisis

- Foreign capital markets were flush with capital that needed to be invested

- In order to become a member of the EU, Greece had to meet certain economic standards and criteria.

Japan, after fifteen or so years, began to show signs of recovery. Greece’s situation just keeps getting worse. The austerity measures imposed on it by the IMF are doing little to restore confidence in the Greek system, neither have the bailouts. Japan’s experience represents an entirely different animal; there, capital was available, just not being used because firms and consumers were more concerned about paying down debt.

In Greece, deficits and debt have historically remained problematic, and now, it is not that there is idle capital in Greece, it’s that no one is willing to provide any capital for fear that the country will not learn its lesson, and continue to operate business-as-usual. Greece’s problems are tied to its membership to the european union, unlike Japan who maintained control over its own sovereign currency. The best, and this term I use relatively, option would be to allow Greece to exit the Eurozone, face a massive drachma devaluation, and work outside the monetary and fiscal policy restraints imposed on it by the union to repair its damaged economy.

"I firmly believe that in the current circumstances, confidence-inspiring policies will foster and not hamper economic recovery, because confidence is the key factor today."

He favors fiscal discipline (spending cuts and tax hikes) combined with structural reforms. Both would restore confidence which is what he thinks is the main issue in the current crisis. He supports Germany in efforts to enforce this by common rules for all Eurozone countries and demands a system of sanctions and incentives to enforce these policies on a multilateral level.

His position is that these measures would encourage private investments and not lead to stagnation. He also denies risks of deflation that could be associated with contractionary fiscal policies. This position regarding austerity is contrary to classic IS/LM theory. In this framework the money market and the market for goods have to be in equilibrium. Austerity would decrease public spending and therefore shift the IS-curve to left because of a reduced demand for goods equal to the amount of spending cuts. Ceteris paribus (unchanged LM-curve, all other variables equal) the new equilibrium would be at lower level of interest rates and lower Output. This is because governmental spending is seen as an exogenous variable:

[image]  (equilibrium of goods market)

(But IS/LM says nothing about an increase in public spending because of higher confidence).  

The justification for holding such seemingly obviously incorrect beliefs were twofold: firstly it was thought that the benefits of consolidating deficits and ultimately the debt, and taking those associated cuts in GDP would outweigh the costs in the long run. Secondly, Trichet along with many other high-ranking economic organisations (namely the IMF) believed the multiplier of government spending to be much, much lower than it in fact turned out to be in reality.

problems with a country’s micro-level activities that result in poor quality production, higher unemployment / worker dissatisfaction (strikes), high inflation, and a weak currency

An economy with structural problems suffers from a large trade deficit, high inflation, and a weak currency, which lead to high interest rates, i.e. affects the supply-side of the economy. Problems occur on a mirco-economic level (because of weak institutions, too much state influence causing inefficiencies, no incentives for innovation, etc. ).

a peculiar type of economic recession which is not caused by short term supply shocks, but by businesses paying off debt instead of borrowing and spending.  Characterized by businesses change of motive from profit maximization to debt minimization.

Businesses attempting to fix their balance sheets, through debt-minimization

assets whose values do not change based on acquisition of more / less information regarding those same assets; debt considered safe from most risk: T-bills.

The belief that financial crises are a thing of the past that can no longer happen to our country in the here and now. It involves the careless assumption that the old rules of valuation are no longer applicable, and that any boom experienced is based on sound fundamentals, solid structural reforms, good policy, and technological innovation.

A syndrome affecting most major economies in which risks are ignored in favor of the belief that all economic debt issues have been solved already.  Leads to overconfidence, over indebtedness, and an eventual collapse of debt, and then recession

The merger or collapse of many banks. Generally associated and caused by bank runs. Loss of confidence leads depositors to withdraw funds which collapses bank reserves and deals to devaluation of debt, raising cost of capital and leading to recession.

Banking Crisis as defined by R&R: comes in two types:

Type I (Systemic) = more severe; occurs when bank runs lead to the closure, merging or takeover by the public sector of one or more financial institutions.

Type II (Financial Distress) = milder; a crisis that is contained or confined to a particular sector, but the public sector must still close, merge, takeover or provide large-scale assistance to an important financial institution, which marks the start of a string of similar outcomes for other financial institutions.

Debt Crisis as defined by R&R: again comes in two forms: External and Domestic.

External Debt Crisis involves the straight default on a government’s external debt obligations (default on loans held by foreigners under foreign jurisdiction, usually denominated in a foreign currency).

Domestic Debt Crisis involves the failure of a government to meet a principal or interest payment on the due date / within the grace period, and can involve the forcible conversion of foreign currency deposits into the local currency (same as above, except here, the debt is held by domestic creditors under domestic jurisdiction, denominated in the domestic currency).

Inflation Crisis as defined by R&R: though inflation can be onerous at much lower levels, the cutoff to mark a period of inflation crisis in the post-WWII era is 40% per year. (Note, to encompass the post-WWII era as well as the pre-WWII era, they adopted a threshold of 20% per year). Hyperinflation, a subset, experiences inflation rates of 40% per MONTH, but these episodes are a fairly modern occurrence.

Debt intolerance is a term coined by R+R and Miguel Savastano referring to the inability of emerging markets to manage levels of external debt that, under the same circumstances, would be manageable for developed countries, making a direct analogy to lactose-intolerant individuals.

FROM NOTES: The extreme duress that many developing countries experience with external debt that would seem manageable to a developing country.

The Reputation Effect = the assumption that countries, desirous of continued access to open capital markets will work against default in order to maintain their reputation as reliable borrowers

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The Institution Effect = the notion that countries will work against default with a creditor because doing so would cause immediate problems to their outstanding loans with other creditors, their assets abroad (think seizure or repossession), as well as trade.

FROM NOTES: Institution Effect: Investors think that a developing countries' institutions are weak, so they will only lend if it takes place in another country where the legal environment is stronger

Default essentially means a debtor has not paid a debt which he or she is required to have paid.

A default is the failure to pay back a loan. Default may occur if the debtor is either unwilling or unable to pay his or her debt.

A sovereign default is the failure or refusal of the government of a sovereign state to pay back its debt in full. 

Possibly the same thing as domestic default: Default over debts owed in the domestic currency and subject to domestic laws

A pattern where global investors turn with interest toward a market. Capital flows in volume into the “hot” financial market. The exchange rate tends to appreciate, asset prices to rally, and local commodity prices to boom. These favourable asset price movements improve national fiscal indicators and encourage domestic credit expansion. These, in turn, exacerbate structural weaknesses in the domestic banking sector even as those local institutions are courted by global financial institutions seeking entry into a hot market.

1. Slow burn

2. Fast and furious (ex. after Lehman Bros collapsed)

Theory forwarded by Fisher, it states that at any time when there exists a state of over-indebtedness, liquidation (because of the alarm of either debtors / creditors or both) will begin.

This debt liquidation leads to a contraction of deposit currency (loans are being paid off), which leads to a fall in the level of prices that will eventually affect the net worth of businesses.

This will induce businesses to lay off workers, and shrink output, or even go bankrupt, which in in turn lead to a crisis of confidence, causing money hoarding and eventually a fall in the nominal rate and a rise in the real rate of interest.

See p. 160 in The Holy Grail of Macroeconomics

In a yang economy, private sector balance sheets are healthy and companies seek to maximize profits. In this world, the smaller and less intrusive government is, the better it is for the economy. Having a forward-looking corporate sector with a strong appetite for funds also means that monetary policy is highly effective. Fiscal policy, on the other hand, should be avoided, because of its potential to crowd out private investment. In the yang phase, therefore, monetary policy should be the main tool of economic policymakers. All economic theory in the literature that is based on corporate profit maximization is in a yang phase.

In a yin economy, the situation is reversed. During this phase, private-sector firms have sustained damage to their balance sheets as a result of the fall in asset prices, and are therefore focused on shoring up their financial health by minimizing liabilities. With many firms stuggling to minimize debt at the same time, a fallacy of composition problem sets in, as noted, and the economy heads toward a contractionary equilibrium known as a depression. In this phase, monetary policy is ineffective, because firms are all rushing to pay down debt, and private-sector demand for funds is essentially nonexistent.

The IMF describes several changes in finance that increased the systemic risk of our financial systems.  What were these changes and how did they add to risk?

Debt Crises

- External

- Domestic

Banking Crises

- Systemic: Bank runs that lead to closure, merging, or takeover of one or more financial institutions by the public sector.

- Mild (Financial Distress): If no runs: closure, merging, takeover, or large-scale government assistance of an important financial institution (or a group of important financial institutions)

Currency Crises: Delavuation/depreciation of 15% p.a. compared to US dollar or relevant anchor currency

Inflation Crises: 12 months of inflation above 20%

Debt-intolerance is the explanation R&R gives for this.

This is especially the case for lower and middle income countries. Some tend to be more debt intolerant than others. Three factors determine a country’s ability to carry debt:

- soft factors (non economic factors) such as institutions, corruption and governance. they tend to be more important than ratios of capital to labour or differences in income per capita.

- capital market integration (integration of country’s financial market with rest of the world) (only positive if banks are not poorly regulated and macroeconomic policies are reasonable) --> poor access to capital markets is more seen as a result than a reason for default

- procyclical nature of capital flows to emerging markets. --> explains why sudden external shocks hit some countries so hard

More generally R+R postulate that countries in most cases could repay their debt (ability). They argue that during many defaults payments for external debt would have been only a few percentage points of GDP.

More important is the question if countries are willing to repay their debt. Governments simply do a cost-benefit analysis. If costs for serving their obligations are higher than the benefits they declare default (mostly partial default with rescheduling of payments, haircuts, lower interest rates ... --> compare for example Brady-Plan in the case of Latin America).

Benefits in the case of sovereign countries would be a better reputation which means easier access to capital markets in the future. Central to this argument is the fact the countries in most cases cannot be forced to repay their debt (like companies can) because nobody would attack a country with an army (nowadays) to force a repayment. International jurisdiction is in most cases insufficient to really force a country to repay its debt.

Reputation Effects: They don't want to damage their reputations by defaulting (not supported by evidence). If a country is no longer willing to serve its debt obligations it will lose credibility. Capital markets in the future will be less willing to lend ot the country, so if countries do not want to lose access to international capital they have an interest in repaying their debt (or at least most of it).

Institutional Effects: Investors think that a developing countries institutions are weak, so they will only lend or make a loan if it takes place in some other country where the legal environment is stronger.

The declaration of default can cause a loss of other foreign assets that are owned by the debtor (now or in the future) in the creditors country or another country that recognizes the rights of the creditor. (Example: country defaults on foreign bank A. It starts lending from foreign bank B. A foreign court could force foreign bank B to give away all payments that it recieves for the new loan to bank A).

Trade Disruption: Defaulting can hurt trade possibilities

Dependency of Foreign Deposit Insurance: A foreign company that wants to invest will be afraid of having its plants and equipment seized in the case of default

Banking crises usually amplify recessions, but don't usually cause recessions

R+R mention a relationship between banking crisis in advanced economies and following external default in emerging market countries. The emergence of a banking crisis in an advanced economy can significantly drag down its economic activity leading to fewer imports from emerging market countries. This limits their availability of hard currency and can make it more difficult to service their external debt (if denominated in foreign currency).

Another point they mention is that a banking crisis in an advanced economy produces a sudden stop in lending to other countries, especially higher risk emerging market countries. With credit hard to obtain, economic activity in emerging market countries face a serial contraction, putting even more pressure on the ability of debt servicing or even the ability to roll over debt.

Also can banking crisis in one country lead to a loss of confidence in neighbouring or similar countries.

What are the aftermath effects of a banking crisis such as the subprime crisis?

The examination of severe financial crises has shown that these crises had a deep and lasting effect on asset prices, output and employment. Unemployment increases and housing price decline have extended for five and six years, respectively. Real government debt has increased by an average of 86% after three years.

The decrease of housing prices reaches an average of 35% over six years and the decrease of asset prices a decrease of 56% over three and a half years. The unemployment rate rises an average of 7% during the down phase of the cycle which lasts on average for more than four years. Output falls more than 9% although this happens on a shortes scale of roughly two years.

The steep increase in government debt is mostly due to costs of bailing out and recapitalizing the banking system. Also a very big factor of debt increase is the collapse of tax revenues that governments suffer in the wake of deep and prolonged output contractions.

In the special case of Japan, the countercyclical fiscal policy efforts contributed to the debt build up.

High capital mobility

Capital flow bonanzas

Financial liberalization

What R+R say is that there is a very high correlation between banking crises and liberalization of capital mobility. What they have shown is that periods of high international capital mobility have repeatedly prouced international banking crises. In many cases the liberalization of the financial sector has taken place within the preceding five years of a banking crisis (with financial innovation as a variant of the liberalization process). Hence a typical economic pattern in the run-up to banking crises is a sustained surge in capital inflows, also called a “capital flow bonanza”.

Global / regional crisis are worst case scenarios because countries can’t just export themselves out of their economic problems.

Contagion means that a crisis in country A affects country B although country B by itself wouldn’t suffer from economic problems. Two cases can be distinguished.

First a fast and furious transmission (hours or days). For example sudden crisis of confidence that dries out the interbanking markets worldwide within days or losses on portfolios of banks or pension funds etc. that are (partly) invested in foreign markets.

The second form of transmission is much slower but also important (spillover effects). This includes for example a weaker demand in country A that affects exports from country B, another one would be a common lender.

Different from this contagion are crisis that hit countries simultaneously because of common ‘domestic’ macroeconomic fundamentals. For example if several countries have a housing price bubble that can burst at the same time (important in last global financial crisis, for example Spain and US).

Financial Liberalization: (Benefits: More efficient allocation of capital vs. Cost: Increased probability of a financial crisis)

Beginning of a Banking Crisis: (financial liberalization increases access to capital -> frequently leads to riskier lending practices -> boom in asset prices -> balance sheet problems i.e. Koo)

Currency Crash: (Banks begin to bolster the banking system by supplying them with more credit, which increases the money supply) (Fixed exchange rates make currency crashes more serious, governments lose credibility)

Increase in Inflation: Due to the devaluation of currency that results from supporting the banks, by increasing the money supply. Increases odds of default if the value of external debt has increased due to the weakening of domestic currency.

Peak of Banking Crisis (If NO Default)

Default: One of two types

Peak of Banking Crisis (If there IS a default)

The first step in the prototypical sequencing of a financial crisis is financial liberalization. This enables banks the access to external credit and leads them to riskier lending practices at home.

After a while, following a boom in lending and asset prices, weakness in bank balance sheets become clear and problems in the banking sector begin. These problems are more like to appear in shakier institutions than in the major banks.

The next step emerges when the central bank begins to support the troubled financial institutions by extending credit to them. This can cause a currency crash, if the exchange rate is heavily managed (does not have to be pegged), since there is a policy inconsistency between acting as lender of the last resort and maintaining the exchange rate. The studies by R+R have shown that in this case the central banks tend to act as a lender of last resort rather than focusing on the exchange rate.

The depreciation of the currency that follows, worsens the the situation through three main factors. It creates currency mismatch in the assets the the institutions borrowed in foreign currency, making these borrowings more expensive. It usually worsens inflation. And last but not least, it increases the risk of external default, if the government has debt denominated in foreign currency.

At this point the banking crisis either peaks following the currency crash (if there is no sovereign debt crisis) or keeps getting worse as the crisis mounts and the economy marches towards a sovereign default.

Basically R+R turn out three main points.

The first point is a system of early warning indicators. They cannot predict the exact time of crisis, but can show vulnerabilities that demand policy actions. There are many macroeconomic indicators that can be used as leading indicators of crisis, like fast rising housing prices for banking crisis or deviations from trend of exchange rates in the case of currency crisis.

. This leads directly to the second point. R+R demand a new international institution that would provide transparent data and help to enforce sound regulations in times of international capital markets. (for example unified standards for reporting of public debt, agency would be harder to lobby for national banks than national regulators and politcs are).

The third point they mention is the so called ‘graduation’ of countries'. While banking crisis up to now seem to happen in all countries at least sovereign defaults can be prevented (some countries managed to avoid them for long periods). But graduation is difficult and it takes decades

Something else maybe even more important in the future: investors, politicians, central bankers, etc should ever keep in mind the ‘this time is different’ warning. This means that warning that come from basic indicators should be taken serious. Historically, sooner or later, every bubble bursted and nothing has been different than in times before. Normal rules of valuation do not suddenly change. So everybody should be cautious when they see a new bubble arising. Most likely it will again be a bubble, and nothing is so different this time that would justify that “this time is different”.

They also demand more accurate historical data (to which they contribute with their book) to study typical patterns and to do statistical analysis.

Compare and contrast the four books you read on the subprime crisis (or its near cousins):

a.       Krugman’s The Return of Depression Economics

b.      Lewis’s The Big Short

c.       Koo’s The Holy Grail of Macroeconomics

d.      Reinhart and Rogoff’s This Time is Different.

Focus on

Your answer should talk about their (1) views on causation and prevention, (2) methods of analysis, (3) theoretical perspectives, and (4) areas of agreement.