Transcript 1 - Goethe-Universität

Lecture 10
THE NEED FOR SYSTEMIC STABILITY
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Factors driving the financial sector
• The financial system is in a continuing flux
driven by transactions costs motives.
• The developments of forex markets
demonstrate the importance of cost reduction.
• The strategies are
–
–
–
–
Bundling of funds (economies of scale)
Risk reduction through diversification
Explicit Hedging
Expertise (legal, technological)
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Information inefficiencies
• Market participants can have insufficient
information about their counterparts
(asymmetric information). It leads to
– Adverse selection. This is an information
problem occurring before the transaction:
Potential bad credit risks are those who
seek loans most actively.
– Moral hazard. This occurs after the transaction: Borrowers may take on big risks.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Adverse selection: The ‘lemons problem’
• A ‘lemon’ is a bad car
purchased second hand.
• Akerlof studied the usedcar market and found an
asymmetric information
problem:
– Potential buyers can’t tell a
‘lemon’ from a good car.
– They offer an average price,
between the value of a
lemon and a good car.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
George Akerlof
*1940, Nobel Prize 2001
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The ‘lemons problem’
• The owner of a used car
knows whether the car is
good or bad.
• If the car is a lemon, he is
of course happy to sell at
the average price.
• If the car is good, the
owner has little incentive
to sell at average prices.
• Transaction volumes are
low and the market may
even break down.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
• Similar problems arise in
the securities markets
(bonds, and stocks).
• An investor will only pay a
price that reflects the
average quality of firms.
• Bad firms are happy to
take loans from investors.
• Good firms are not willing
to borrow on this market.
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Moral hazard in equity contract (1)
• Equity contracts (shares) are subject to a
particular ‘principal-agent problem’.
• Stockholders (principals) are not the same as
managers (agents). This separation involves
moral hazard because managers may act in
their own interest.
• Example: Steve has an ice-cream shop, and
you become his silent partner. The capital is
shared at 10:90. Profits are also shared in
these proportions.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Moral hazard in equity contract (2)
• Option 1: Steve works hard and provides good
service, but earns only 10% or the profit.
• Option 2: Steve does not provide good service,
and uses the capital to buy artwork for his
office, a luxury car for business; he thus
acquires ‘fringe benefits’ at your expense.
• Option 3: Steve is not only a poor manager, but
also dishonest. In this case the moral hazard
problem may become extreme.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Elimination of asymmetric information (1)
• A first solution to the problem is the
private production and sale of information.
• There are professional rating agencies
(Standard and Poor’s, Moody’s, Value Line),
and you can set up costly monitoring and
auditing (state verification) of the firm.
• But there is s ‘free-rider problem’ to this. If you
buy a security, people my simply copy your
behavior without paying for the information.
• This erodes potential extra profits, and you
may not have bought the information in the
first place.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Elimination of asymmetric information (2)
• A second possibility could be to involve the
government in regulating the market.
• The objective is to make firms reveal honest
information by adhering to standard
accounting practices and to disclose pertinent
information.
• Government can also impose stiff criminal
penalties to contain fraud.
• Government regulation may ease the
asymmetric information problems, but it is
difficult to eliminate them totally.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Elimination of asymmetric information (3)
• A third solution is to involve financial
intermediaries as experts in the production of
information.
• A private loan is not traded, so others cannot
watch and imitate (no free rider).
• This explains why indirect finance is more
important than direct finance.
• Larger firms (because they are better known)
obtain easier access to capital markets than
smaller firms.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Systemic instability and financial crises
• Financial crises are characterized by abrupt
declines in asset prices and by insolvencies of
financial and non-financial firms.
• Such crises are reoccurring in many countries.
They are caused by a sharp increase in adverse
selection and moral hazard problems.
• Four categories of factors trigger crises:
–
–
–
–
Increases in interest rates;
Increases in uncertainty;
Asset market effects on balance sheets; and
(Multiple) bank failures.
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Asset market effects on balance sheets
• Balance sheets have important repercussions
on the financial system:
– A deterioration (fall in stock or housing prices) of
the balance sheet reduces the ‘net worth’ of a firm.
– Lenders are less willing to lend because of
reduced collateral.
– This induces moral hazard because borrowers take
higher risks.
– The increase in moral hazard makes lending less
attractive … this reduces economic activity.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Typical financial crises
Deterioration of
a bank’s balance sheet
Increase in
interest rates
Stock market
decline
Increase in
uncertainty
Adverse selection and
moral hazard problems worsen
Economic activity declines
Bank panic
Adverse selection and
moral hazard problems worsen
Economic activity declines
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The stock market and speculative frenzies
• Stock markets have indeed often
created havoc to the economy and
to people’s life
• Early example: the ‘tulip bubble’ in the
Netherlands (approximately 1620 to 1637)
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The tulip boom
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• The boom involved rare tulips
• Bulb prices rose steadily
throughout the 1630s,
as ever more speculators
wedged into the market.
• In 1633, a farmhouse in Hoorn
changed hands for three bulbs
• In 1637 the bubble stretched
……. and burst !!
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Precedents of the crisis
• The basis of the bubble was an economic
boom caused by shocking “new technologies”
(Amsterdam merchants were at the center
of the new and lucrative East Indies trade)
• But enabling the bubble was leverage
through credit, future contracts, and an
innovative climate of Dutch finance (that
coined new instruments such as options)
Did the burst of the bubble
drag down the Dutch economy?
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Financial crisis:The US stock market 1871-1914
Financial
crises have
been frequent
and persistent
throughout
economic
history
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What causes stock market volatility?
• Financial crises exhibit a similar pattern:
– Promising novel technologies or markets
– A psychologically boosted investment
frenzy
– Financial leverage and concentration
of resources into an emerging segment
of the economy
– Over-expansion of a sector and its bust
– Contagion of the overall economy
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Examples
• This pattern was typical for
– The railway frenzy of the mid-19th century
– The initiation of electrical appliances
at the turn of the last century
But the best analyzed event
in economic history is the one following
the expansion of the ‘roaring 1920s’ …..
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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How do financial bubbles affect activity?
The NY stock
market crashed on
Friday, October
1929, initiating a
persistent and long
downturn of the
economy
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Development of Stock Market Index
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Repercussions on the real economy
US Unemployment rate, 1929-1942
25
official series
20
Quelle: M.R. Darby,
Three-and-a-half
Million Employees
Have been mislaid,
Journal of political
Economy,
1976
15
10
Adjusted
series
5
1930
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
1935
1940
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Impact on people’s lives
Top CEOs had a especially hard time !
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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What dragged the economy down?
• The impact was then
– Increase of personal savings (and hence
a reduction of consumer spending) due to
a perceived reduction of personal wealth
– Change in consumer behavior
due to higher unemployment
– Credit implosion with an induced reduction
of demand, notably fixed investment
– Reduction of housing investment
due to prior over-investment
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The Great Depression: Further problems
• And :
– A general loss in consumers’ and investors’
confidence
– Change in spending behavior
due to insolvencies and bankruptcies
– Disintermediation due to a lack of liquidity
– Negative impact on public investment
due to a fall in tax revenue
– Policy failures, e.g. “strategic trade policies”
(Smoot-Hawley Act)
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The Great Depression: US imports
Monthly data. Imports from 75 Countries (in bill. Gold $)
January
December
1929
February
1930
1931
November
March
1932
November
1933
April
October
May
September
August
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
July
June
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The Great Depression: Monetary policy
• Policy failure
of central banking:
– Reduction
in the supply
of money
– High real interest rates
– Failure of financial
institutions
Anna Schwartz
Milton Friedman
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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What have we learned since?
• Social protection, especially of the old
and the unemployed
• Consolidation of financial sector to avoid credit
implosion, insolvency and break-downs
• Fiscal and monetary management
• International institutions to provide international
means of payment (IMF)
and to protect free trade (WTO)
• International cooperation and integration
• And in particular ………..
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Our leaders are much brighter !!
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Today
we are technically
more advanced and
smarter than
our grandparents!
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
However:
“animal spirits”
are persistent
and remain
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Irrational exuberance: “A bubble that will burst!”
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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…and it did!
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The 1920s and 30s
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The central bank and systemic stability
• The health of the economy and the
effectiveness of monetary policy depend on a
sound financial system. Through supervising
and regulating financial institutions, the ECB
is better able to make policy decisions.
• But should it intervene?
• Rescue failing banks?
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