Leading Up To The Financial Crisis

Leading up to the Financial Crisis Leading up to the financial crisis

The turmoil that occurred in the financial market during 2007-2008 has prompted the most

extreme crisis since the Great Depression and it had many huge repercussions on the

economy. It was the worst economic disaster to date and it occurred despite the Feds

efforts to prevent it. The Federal Reserve is the central bank of the United Stated. Over the

years, its role in banking and economy have expanded however it could be said that fed can

adjust their Monetary policies depending on how the economy is performing.

Money supply measures the amount of money in an economy at a particular time and it

includes notes, coins and deposits which can be converted into cash at a fast pace.

A Pro-cyclical financial system is one where money supply increases during a boom and falls

during a recession. An explanation for the procyclicality of the financial system is due to

asymmetric information between borrowers and lenders. Asymmetric Information occurs

when one party to a transaction possesses greater material knowledge than the other

buyer, and for this reason it can also be known as information failure. An example of this

could be Credit Rating Agencies giving false A Grade ratings to subprime mortgages (which is

evaluated in more detail further on). During a recession or a period of low confidence,

information asymmetries can mean that borrowers with projects find it difficult to obtain

funding, even though they may be profitable. When economic conditions are bad,

borrowers with a good credit history may struggle to get financing and vice versa. However,

when these conditions finally improve they are able to get financing and can therefore

contribute to the economy. This is known as the financial accelerator. There were

numerous different causes of the financial crisis however most believe that the Banking

System and the FED were partly responsible. The crisis started in the US in 2007, and the

end of a large housing boom. Main causes for the financial crisis include prolonged period of

abnormally low interest rates and changes in regulation. Not only changes to regulation but

poor regulation can also be blamed because these factors leading up to inflation may not

have occurred given the economy was properly regulated. It was the poor.

Banks

There were many factors that led to the financial crisis, one would be the fall in

house prices which made it difficult for homeowners who now had mortgage payments they

couldn’t afford. It was suggested that the main reason for the financial recession was

because banks could not regulate themselves and were therefore lending too much. For

example, banks were criticised for misjudging risk. Mortgage brokers neglected due

diligence thus allowing more loans to be handed out and therefore increasing the amount

being lent. In addition, the creation and large amount of subprime mortgages contributed.

These mortgages were given to people less likely to qualify for a normal mortgage and these

had adjustable interest rates let to an increased amount of loans.

Banks would fund these loans by creating more money, thus the more loans being

handed out then the larger the injection of new money into the economy, thus increasing

money supply during a boom and causing it to be pro-cyclical.

Futhermore, credit rating agencies were also criticized for classifying subprime securities as

investment grade, thus increasing amount of loans and once again increasing money supply

within the economy. (Maxfield, 2018). Credit rating agencies converted F-rated subprime

mortgages into A-rated securities which in turn allowed a steady flow of cash into the

housing market which led to the housing crisis. It is not confirmed why rating agencies did

this, it could be said it was due to personal incentive from being paid by those being rated

or it may the lenders paying them for incorrect credit ratings, allowing them to drive the

price of stocks up. It let them drive prices up.

In 2007, Northern Rock Bank (based in the UK), ran short of liquid assets and as a result

asked the Bank of England for an emergency loan. It resulted in depositors rushing to the

bank in order to withdraw funds as only 90% of deposits were insured. It also resulted in the

UK’s first bank run in over a century, causing the Bank of England to approve the loan. This

is an example of bank behaviour during the crisis and how they intervened and gave out

loans in certain circumstances. Even though the loan benefited depositors, it caused them

to lose confidence which may have had further negative multiple effects on the UK

economy during the crisis.

Another example of firms that had a lot to lose during the crisis was Fannie Mae and Freddie

Mac, due to subprime mortgages. They held on too many subprime mortgages, causing

them to suffer huge losses in 2007. They were not about to default or declare bankruptcy as

it would have disrupted mortgage lending and causes losses to banks that held trillions of

dollars in Fannie and Freddie Bonds. However, in 2008 the government took Fannie and

Freddie into conservatorship and they became the Federal National Mortgage Association

(Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).

The FED

The Federal Reserve bank was made in 1912 and its role is to influence interest rates and

money supply that influences output and inflation. They have different response models,

which they use depending on the conditions and characteristics in the economy.

The FED stabilises economic growth and controls money supply using 3 main methods:

1)Open Market Operations

2) Changes in Discount Rate

3)Changes in reserve requirement

1) Open Market Operations can be carried out in order to expand or contract the amount of

money in the banking system. It consists of the by Fed buying or selling government

securities to the public. An example of the FED using open market operations was in August

2010 when the federal funds rate increased above the Fed’s target. This caused the Fed to

respond by purchasing large amounts of government bonds which injected money into the

economy and thus reducing interest rates (Econ.ucla.edu, 2018).

2). The Fed could decrease the number of funds required in reserve which allows banks to

increase amount of loans being lent out and thus contributing to a procyclical money supply

cycle. Selling securities would contract money supply however buying the securities would

expand the money supply, injecting money into the economy.

3) Changing discount rates effects the financial institutions that borrow from the Fed

reserve. It helps to reduce liquidity problems for banks and assists in assuring the basic

stability of financial markets.

The FED could be to blame for causing the financial crisis, one reason is due to them setting

low interest rates. Low interest rates would stimulate an economy and increase money

supply. For example, it reduces a consumers incentive to save thus making it more attractive

to spend and increasing aggregate demand and leading to a positive multiplier effect from

then on, benefiting an economy. It could be likely that the fed purposely set low interest

rates to maintain the strength of the economy which was suffering from inadequate

aggregate demand as a result of the collapse of the tech bubble.

An other example of how the FED reacted to changes in money supply was in 2008 when

they bailed out large investment bank “Bear Stearns”. This bank held large amounts of

subprime mortgages and suffered a huge loss when the prices of these securities fell post

2008. Other financial institutions stopped lending to them as they were scared that the

bank would default on its obligations. As the bank almost prepared to file for bankruptcy

the Fed made an attempt at its first financial rescue during the crisis. In March the Fed

loaned $30 billion to rival investment bank JP Morgan to purchase Bear Stearns. There have

been criticisms of this example, some suggesting that it increased moral hazard by saving

Bear’s creditors therefore they should not have bailed them out. In response to the criticism

of bailing out individual firms, the Fed expanded its liquidity provision. They expanded its

liquidity provision to the commercial paper market, directly providing a provision of credit

to whomever they considered in the most need of liquidity. On the contrary, the Fed have

also been criticised for not bailing out certain firms after the crisis. Similarly to Bear Stearns,

the Lehman Brothers had a large amount of losses, particularly on mortgage-backed

securities. Even though the federal reserve sought to arrange a last minute takeover by

Barclays, it fell through at the last minute which led to the Lehman Brothers declaring

bankruptcy in September 2008. The Fed were criticised for not baling out The Lehman

Brothers as they did Bear Stearns.

The federal funds rate is the interest rate charged by commercial banks to other

banks who are borrowing money. Before the financial crisis, the fed used Open Market

Operations to adjust the supply of reserve balances, to keep control of the federal funds

rate. Today, the federal funds rate is 15% however towards the end of 2008 the Fed cut its

funds rate from 2% to zero. It affects the amount of cash banks must legally hold. By

lowering it banks are able to loan out a larger proportion of their cash in an attempt to

control and increase money supply and help stimulate economic growth in the economy.

Relating to the federal reserve rate, the use of monetary policy to control money supply can

become constrained due to the zero lower bound (which can also be known as the liquidity

trap). This is when a nominal interest cannot be below zero because nobody will be willing

to make a loan in return for negative nominal interest. This can also be known as a liquidity

trap and it prevented the fed from stimulating the economy at its full potential.

Having already dramatically lowering the fed funds rate to practically zero, The Fed

started using quantitative easing in order to combat that financial crisis.

Quantitative easing is a method also used by the Fed to increase money supply. It’s an

expansion of the open market operations of a central bank. The Fed took steps to lower

interest rates even further, and launched Quantitative easing. They spent trillions of dollars

on government bonds and mortgage-backed securities and between 2008 and 2017. As

shown on the graph, the Fed’s balance sheet dramatically increased from $900 billion to

$4.5 trillion. (Schulze, 2018).

The purpose of using this type of expansionary monetary policy is to lower interest rates

thus allowing banks to make more loans and add liquidity to capital markets. This in turn

should have the same effect as increasing money supply. The aim was for banks to use this

money to buy assets to add liquidity to capital markets which in turn should have the same

effect as increasing money supply. The Fed’s attempt and use of quantitative easing has

been recorded as the most successful attempt as using this method. It added $2 trillion to

the money supply making it the largest expansion. (The Balance, 2018). On the other hand,

even though it succeeded in increasing money supply during the crisis, it also has its

disadvantages. Debt on the fed’s balance sheet doubled to $4.486 trillion in the space of 6

years (The Balance, 2018). In addition, the Fed’s low interest rate policy made it cheaper for

the government to continue borrowing and spending, therefore causing Total US Public

Debt to near $20 trillion in 2017. This can be depicted on the following graph below,

particularly between Q1 2008 and Q1 2009 as this was when public debt rose the quickest

and by the largest amount (Schulze, 2018).

Taylor’s Rule and Evaluation of Graph

Taylors rule is a formula developed in the early 1900’s and was named after John Taylor, a

Stanford economist. It was created to give estimations for how a central bank should set

interest rates and it has revolutionized the way many policymakers at central banks think

about monetary policy. The Taylor rule has evolved over the years and various versions have

been incorporated into macroeconomic models. It suggests that the rule would recommend

a higher interest rate when inflation is above its target. On the contrary, it would suggest a

low interest rate when inflation is below full employment level and therefore below it’s

target. The rule helps policy makers balance these different conditions and aims to find an

appropriate interest rate which works towards the target. Central banks attempt to reach

this new target interest rate by using different types of monetary policy methods such as

open market operations.

Taylors rule implies that real interest rates should be determined according to three factors.

It considers where inflation is currently in comparison to the target that The Fed wishes to

achieve and how far economic activity is from full employment level (This is the level where

all resources are being maximised and being used to their full potential). The third factor is

that it takes into account the level of interest rate required to be consistent with full

employment.

During the recession, Taylor recommended that rates should be negative. This is to

encourage spending and borrowing thus increasing aggregate demand and stimulating

economic growth within an economy. However due the zero-bound rule, which was

discussed, before the Fed were not able to.

The graph shows the two correlations generally being in sync, with the taylor rule predicted

FFR generally following the actual federal fund rate. However, the most dramatic difference

in these two trends was in 2009, where the taylor rule predicted an extremely negative FFR

however the Actual Federal Fund Rate remained positive and was 0.15. It was here, in June

1st 2009 that the Taylor Rule predicted its lowest value, -3.4.

The recession could be the reason why Taylors rule predicted such a negative value.

The reason why Taylors rule may have recommended such a negative interest rate was due

to the economy being in an extremely negative output therefore a low interest rate would

make it more attractive to consumers to spend, increasing aggregate demand and

ultimately stimulating growth in an economy. However, the Actual Federal Fund Rate can be

explained by the zero lower bound and the liquidity trap (which suggests an interest rate

below zero is not possible because no one would make a loan in return for negative

interest).

The two trends cross on multiple occasions, indicating that there are few instances where

the Taylor Rule Predicted FFR and the actual FFR were close in value. An example of the

two being similar in value was in 1st April 2001, where the Actual FFR was 4.33 however the

taylor predicted FFR was 4.1.

Before the financial crisis, from 01/05/2004 and 01/05/2006 both FFR values are shown to

be increasing, having a positive correlation. Since 01/01/2009, the actual fund rate remains

steady, close to zero however the Taylor Rule Predicted FFR fluctuates. The latest figures in

the date is dated 01/07/2017 and shows the largest difference in figures, the actual FFR was

1.15 and the Taylor rule predicted FFR was 27.5. Even though both methods predicted or

used positive interest rates, there is a large difference of 26.35. This shows just how

methods of choosing appropriate interest rates have changed over the years, they have

evolved and changed resulting in different outcomes.

After the Crisis

Almost a decade after the financial crisis we can now evaluate whether certain measures

taken by Banks or the Fed have helped economy grow and work towards helping to control

money supply and work towards a positive output gap. Federal bank raised concerns with

its use of emergency lending to bail out failing investment banks however there have been

positive effects on macroeconomic objectives in response to the Fed’s low interest rate

policies. For example, unemployment levels in the US in particular have reacted positively

(The Center for Popular Democracy, 2018). On the other hand, even though the US

unemployment rate may have improved it is still high at 4.3% and critical indicators show

American families are still struggling and have a lower standard of living.