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Economic effects of shutdown?• Which model should we use?

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Financial panics past and present

1873

• Speculation in railroads and land was the tech boom-and-bust of the 19th century. Western lands and railroads had a asset price bubble. Then they crashed in 1873 investments. Banks failed because they were heavily exposed in these speculative investments and they had insufficient deposits to cover withdrawals. In 1873, the bank of Jay Cooke and Company collapsed, and in its wake, another 5,000 businesses went under.

• Lesson 1: Most panics have their roots in bad fundamentals.

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The great panics of American history

1893

• The Panic of 1893 began when rumor spread of the collapse of the Philadelphia and Reading Railroad. Investors dumped more than 1 million shares of the company in one afternoon. That set off a chain reaction, as people fled from stocks and tried to convert into currency and gold. By the end of 1893, nearly 20,000 businesses had closed their doors, millions were out of work, and armies of unemployed workers had descended on Washington demanding food and aid.

Lesson 2: In a precarious situation, a rumor can cause a crisis because of multiple equilibria.

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Balance Sheet of Run-Prone Banking: Good equilibrium

Assets |Liabilities __________________________________________

||

Bonds 20 | Deposits 90

|Mortgages 80 | Equity

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Balance Sheet of Run-Prone Banking: After shock and bad equilibrium

Assets |Liabilities ________________________________________

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Bonds 20 | Deposits 90

|Mortgages 80 - 40 | Equity 10 - 40

||||||||

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Insolvent

The Great Depression 1929-1933

• The Fed went into business in reaction to the Panic of 2007. Even with the Fed at the helm, the Great Depression had a series of bank crises. (More on this next week.)

Lesson 3: Having a strong central bank does not prevent bank runs.

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Asset bubbles and panics:

Lesson 4. Panics and financial crises often follow asset price booms 9

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1870 1875 1880 1885 1890 1895 1900 1905 1910

Stock prices Panic

The Meltdown of 2008

• Real housing prices rose 120% from 1995 to 2006.• Parties always end. When the housing bubble burst, this

revealed trillions of dollars of bad investments held by commercial banks, investment banks, as well as outside the financial system.

• Investment banks had massive short-run liabilities (repos etc.) and large illiquid assets (such as asset backed securities). When large investors got nervous, they withdrew their funds.

• Poof, Bear Stearns dissappeared. Poof, Lehman disappeared. By the end of 2008, there were no large independent investment banks left in America. That was the crisis that started the Great Recession.

Lesson 5: Financial systems are inherently unstable because banks transform illiquid long-term assets into liquid short-term liabilities.

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Lessons from past panics

1. Most panics have their roots in bad fundamentals.2. In a precarious situation, a rumor can cause a panic because there are multiple equilibria.3. Having a strong central bank (the Fed) does not prevent bank runs.4. Panics and financial crises often follow asset price booms.5. Financial systems are inherently unstable because banks transform illiquid long-term assets into liquid short-term liabilities.

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T

Original good equilibrium

Health of banking system

T

Housing prices decline (or railroads or land or …)

Health of banking system

Further stresses push system past tipping point, and system rushes to new bad equilibrium

T

Health of banking system

System returns to locally stable “bad equilibrium”

T

Health of banking system

Even when financial crisis is over, you are stuck in the bad equilibrium (no Bear, no Lehman, Greece default, junk everywhere).

(a) (b)

(c) (d)

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Original good equilibrium

Health of banking system

T

Housing prices decline (or railroads or land or …)

Health of banking system

Further stresses push system past tipping point, and system rushes to new bad equilibrium

T

Health of banking system

System returns to locally stable “bad equilibrium”

T

Health of banking system

Even when financial crisis is over, you are stuck in the bad equilibrium (no Bear, no Lehman, Greece default, junk everywhere).

A small panic model•This is the banking equivalent of Romer debt model.•Assume that banks start with an initial amount of capital and net worth, W0. They have initial liabilities as deposits or repos, D0 = 1. Their assets are illiquid like houses. When depositors withdraw their deposits, the bank is forced to sell assets in a fire sale, and can realize only a fraction (v) of their value. Therefore, when deposits fall to D, bank net worth is the following:(1) W = W0 – v(1-D)• Banks have a survival probability of P, which is a function of

their net worth. Generally, banks fail when W < 0.(2) P = g(W) = g(W0 – v(1-D)) = f(D)• Finally, depositors run when they think the bank will fail,

i.e., the perceived probability of solvency declines.(3) D = h(P), h’(P) < 0.• Equations (2) and (3) are the equations of the survival and

runs behavior. The solution is (D*, P*). We will see that there are stable and unstable equilibria.

Solvency (P) and deposits (D)

P = probof survival

D = deposits

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The solvency equation

P = probof survival

D = deposits

01

1

P = g(W) = g(W0 – f(1-D)) = f(D)

The “runs” equation

P = probof survival

D = deposits

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1

D = h(P)

Three equilibria: two stable, one unstable

P = probof survival

D = deposits

01

1

D = h(P)

P = f(D)

Three equilibria: two stable, one unstable

P = probof survival

D = deposits

01

1

D = h(P)

P = f(D)

UNSTABLE REGIME

Fear of panic shifts D (deposit function) : single bad equilibrium

P = probof survival

D = deposits

01

1

D = h(P)

P = f(D)

UNSTABLE REGIME

Bad bank investments or depression shift P function: single bad equilibrium

P = probof survival

D = deposits

01

1

D = h(P)

P = f(D)

UNSTABLE REGIME

Remedies for panics and bank runs• Governments guarantee small bank deposits (< $100,000).

- This stabilizes against panic of “little People.”

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Deposit insurance: single good equilibrium

P = probof survival

D = deposits

01

1

D = h(P)

P = f(D)

Remedies for panics and bank runs• Until 2008, governments implicitly protected large

commercial banks:– An unwritten rule was that they are “too big to fail”

(TBTF), i.e., the central bank will prevent their bankruptcy because of systemic risks.

– In 2008 crisis, the government experimented with allowing a TBTF financial institution to go bankrupt (Lehman), and this caused a system meltdown.

– Capitalism lasted 36 hours.• After the Lehman meltdown, government protected

systemically unstable elements (money market mutual funds, large banks, AIG)

• Dodd-Frank Act (2009) helped fix some of the worst problems, but the inherent instability of the financial system remains.

• This is a problem that won’t go away…. Stay tuned.

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