The dangerously indebted property developer Evergrande could well be the catalyst. But even if Chinese authorities manage to prevent a full-fledged financial meltdown, a deep and persistent economic slump would be unavoidable. The only way to avoid this conclusion is to believe that long-run real interest rates today which are negative in many cases are at or close to their fundamental values. I suspect that both the long-run real safe interest rate and assorted risk premiums are being artificially depressed by distorted beliefs and enduring bubbles, respectively.
Whenever the inevitable price corrections materialize, central banks, supervisors, and regulators will need to work closely with finance ministries to limit the damage to the real economy.
Significant deleveraging by all four sectors households, nonfinancial corporates, financial institutions, and governments will be necessary to reduce financial vulnerability and boost resilience. Orderly debt restructuring, including sovereign debt restructuring in several highly vulnerable developing countries, will need to be part of the overdue restoration of financial sustainability.
Central banks, acting as lenders of last resort LLR and market makers of last resort MMLR , will once again be the linchpins in what is sure to be a chaotic sequence of events. Their contributions to global financial stability have never been more important. Since LLR and MMLR operations are conducted in the twilight zone between illiquidity and insolvency, these central-bank activities have marked quasi-fiscal characteristics. Thus, the crisis now waiting in the wings will inevitably diminish central bank independence.
Willem H. Buiter is an adjunct professor of international and public affairs at Columbia University. He was global chief economist at Citigroup from to Raghuram G. That year several large financial firms experienced financial distress , and many financial markets experienced significant turbulence.
In response, the Federal Reserve provided liquidity and support through a range of programs motivated by a desire to improve the functioning of financial markets and institutions, and thereby limit the harm to the US economy. The Federal Reserve has provided unprecedented monetary accommodation in response to the severity of the contraction and the gradual pace of the ensuing recovery. In addition, the financial crisis led to a range of major reforms in banking and financial regulation, congressional legislation that significantly affected the Federal Reserve.
The recession and crisis followed an extended period of expansion in US housing construction, home prices, and housing credit. This expansion began in the s and continued unabated through the recession, accelerating in the mids. Average home prices in the United States more than doubled between and , the sharpest increase recorded in US history, and even larger gains were recorded in some regions.
Home ownership in this period rose from 64 percent in to 69 percent in , and residential investment grew from about 4. Roughly 40 percent of net private sector job creation between and was accounted for by employment in housing-related sectors. The expansion in the housing sector was accompanied by an expansion in home mortgage borrowing by US households.
A number of factors appear to have contributed to the growth in home mortgage debt. However, other analysts have suggested that such factors can only account for a small portion of the increase in housing activity Bernanke Moreover, the historically low level of interest rates may have been due, in part, to large accumulations of savings in some emerging market economies, which acted to depress interest rates globally Bernanke Others point to the growth of the market for mortgage-backed securities as contributing to the increase in borrowing.
Historically, it was difficult for borrowers to obtain mortgages if they were perceived as a poor credit risk, perhaps because of a below-average credit history or the inability to provide a large down payment. The result was a large expansion in access to housing credit , helping to fuel the subsequent increase in demand that bid up home prices nationwide.
After home prices peaked in the beginning of , according to the Federal Housing Finance Agency House Price Index, the extent to which prices might eventually fall became a significant question for the pricing of mortgage-related securities because large declines in home prices were viewed as likely to lead to an increase in mortgage defaults and higher losses to holders of such securities. Large, nationwide declines in home prices had been relatively rare in the US historical data, but the run-up in home prices also had been unprecedented in its scale and scope.
Ultimately, home prices fell by over a fifth on average across the nation from the first quarter of to the second quarter of This decline in home prices helped to spark the financial crisis of , as financial market participants faced considerable uncertainty about the incidence of losses on mortgage-related assets. In August , pressures emerged in certain financial markets, particularly the market for asset-backed commercial paper, as money market investors became wary of exposures to subprime mortgages Covitz, Liang, and Suarez In September, Lehman Brothers filed for bankruptcy, and the next day the Federal Reserve provided support to AIG , a large insurance and financial services company.
A financial crisis is often associated with a panic or a bank run during which investors sell off assets or withdraw money from savings accounts because they fear that the value of those assets will drop if they remain in a financial institution. Other situations that may be labeled a financial crisis include the bursting of a speculative financial bubble , a stock market crash , a sovereign default , or a currency crisis.
A financial crisis may be limited to banks or spread throughout a single economy, the economy of a region, or economies worldwide. A financial crisis may have multiple causes. Generally, a crisis can occur if institutions or assets are overvalued, and can be exacerbated by irrational or herd-like investor behavior.
For example, a rapid string of selloffs can result in lower asset prices, prompting individuals to dump assets or make huge savings withdrawals when a bank failure is rumored. Contributing factors to a financial crisis include systemic failures, unanticipated or uncontrollable human behavior, incentives to take too much risk, regulatory absence or failures, or contagions that amount to a virus-like spread of problems from one institution or country to the next.
If left unchecked, a crisis can cause an economy to go into a recession or depression. Even when measures are taken to avert a financial crisis, they can still happen, accelerate, or deepen. Financial crises are not uncommon; they have happened for as long as the world has had currency. Some well-known financial crises include:. As the most recent and most damaging financial crisis event, the Global Financial Crisis, deserves special attention, as its causes, effects, response, and lessons are most applicable to the current financial system.
The crisis was the result of a sequence of events, each with its own trigger and culminating in the near-collapse of the banking system. It has been argued that the seeds of the crisis were sown as far back as the s with the Community Development Act, which required banks to loosen their credit requirements for lower-income consumers, creating a market for subprime mortgages.
The amount of subprime mortgage debt, which was guaranteed by Freddie Mac and Fannie Mae , continued to expand into the early s when the Federal Reserve Board began to cut interest rates drastically to avoid a recession. The combination of loose credit requirements and cheap money spurred a housing boom, which drove speculation, pushing up housing prices and creating a real estate bubble. In the meantime, the investment banks, looking for easy profits in the wake of the dot-com bust and recession, created collateralized debt obligations CDOs from the mortgages purchased on the secondary market.
Because subprime mortgages were bundled with prime mortgages, there was no way for investors to understand the risks associated with the product. When the market for CDOs began to heat up, the housing bubble that had been building for several years had finally burst.
As housing prices fell, subprime borrowers began to default on loans that were worth more than their homes, accelerating the decline in prices. When investors realized the CDOs were worthless due to the toxic debt they represented, they attempted to unload the obligations. However, there was no market for the CDOs. The subsequent cascade of subprime lender failures created liquidity contagion that reached the upper tiers of the banking system.
Two major investment banks, Lehman Brothers and Bear Stearns, collapsed under the weight of their exposure to subprime debt, and more than banks failed over the next five years. Several of the major banks were on the brink of failure and were rescued by a taxpayer-funded bailout. The U. Government responded to the Financial Crisis by lowering interest rates to nearly zero, buying back mortgage and government debt, and bailing out some struggling financial institutions.
With rates so low, bond yields became far less attractive to investors when compared to stocks. One big upshot of the crisis was the adoption of the Dodd-Frank Wall Street Reform and Consumer Protection Act , a massive piece of financial reform legislation passed by the Obama administration in Dodd-Frank brought wholesale changes to every aspect of the U.
Notably, Dodd-Frank had the following effects:. A financial crisis is when financial instruments and assets decrease significantly in value.
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