Question

1. Why did American commercial and investment banks make many more risky loans and investments in 2008 than in 1980? To what extent were policy mistakes by the government responsible for the financial meltdown?

2. Suppose the demand for money increases at the existing interest rate. How should the government adjust its level of spending if it wishes to prevent real output from changing? Illustrate your answer with an IS-LM diagram

3. Compare the effectiveness of contractionary monetary policy differ when the economy is operating at full employment with the effectiveness of expansionary monetary policy when the economy is in a severe recession

4. What is the correct policy response when banks become insolvent after a financial bubble bursts?

Answer 1

25 Major Factors That Caused or Contributed to the Financial Crisis:---

Most people have an opinion about what or who caused the financial crisis of 2008-09. It was securitization. Or greed. Or deregulation. Or any number of other things that, truth be told, probably did play a role in the unusually severe economic downturn.

But after reading a good portion of the books written about the crisis from a variety of viewpoints -- journalists, regulators, and private-sector participants -- I've concluded that it can't be boiled down to one, two, or even a handful of root causes. It was instead the product of dozens of factors. Some of these are widely known, but many others are not

Prior to the Crisis

Before the financial crisis hit in 2008, regulations passed in the U.S. had pressured the banking industry to allow more consumers to buy homes. Starting in 2004, Fannie Mae and Freddie Mac purchased huge numbers of mortgage assets including risky Alt-A mortgages. They charged large fees and received high margins from these subprime mortgages, also using the mortgages as collateral for obtaining private-label mortgage-based securities.

Many foreign banks bought collateralized U.S. debt as subprime mortgage loans were bundled into collateralized debt obligationsand sold to financial institutions around the world.

When increasing numbers of U.S. consumers defaulted on their mortgage loans, U.S. banks lost money on the loans, and so did banks in other countries. Banks stopped lending to each other, and it became tougher for consumers and businesses to get credit.

After the 2008 Global Financial Crisis

With the U.S. falling into a recession, the demand for imported goods plummeted, helping to spur a global recession. Confidence in the economy took a nosedive and so did share prices on stock exchanges worldwide.

1. Mark-to-market accounting. In the early 1990s, the Securities and Exchange Commission and the Financial Accounting Standards Board started requiring public companies to value their assets at market value as opposed to historical cost -- a practice that had been discredited and abandoned during the Great Depression. This pushed virtually every bank in the country into insolvency from an accounting standpoint when the credit markets seized in 2008 and 2009, thereby making it impossible to value assets.

2. Ratings agencies. The financial crisis couldn't have happened if the three ratings agencies -- Standard & Poor's, Fitch, and Moody's -- hadn't classified subprime securities as investment grade. Part of this was incompetence. Part of it stemmed from a conflict of interest, as the ratings agencies were paid by issuers to rate the securities.

3. Infighting among financial regulators. Since its inception in 1934, the FDIC has been the most robust bank regulator in the country -- the others have, at one time or another, included the Office of the Comptroller of the Currency, the Federal Reserve, the Office of Thrift Supervision, the Securities and Exchange Commission, the Federal Savings and Loan Insurance Corporation, and an assortment of state regulatory agencies. But thanks to infighting among regulators, the FDIC was effectively excluded from examining savings and investment banks within the OTS's and SEC's primary jurisdiction between 1993 and 2004. Not coincidentally, those were the firms that ended up wreaking the most havoc.

4. Securitization of loans. Banks traditionally retained most of the loans that they originated. Doing so gave lenders incentive, albeit imperfectly, to underwrite loans that had only a small chance of defaulting. That approach went by the wayside, however, with the introduction and proliferation of securitization. Because the originating bank doesn't hold securitized loans, there is less incentive to closely monitor the quality of underwriting standards.

5. Credit default swaps. These are fancy financial instruments JPMorgan Chasedeveloped in the 1990s that allowed banks and other institutional investors to insure against loan defaults. This situation led many people in the financial industry to proclaim an end to credit risk. The problem, of course, is that credit risk was just replaced by counterparty risk, as companies such as American International Group accumulated far more liability than they could ever hope to cover.

6. Economic ideology. As the 1970s and '80s progressed, a growing cohort of economists began proselytizing about the omniscience of unrestrained free markets. This talk fueled the deregulatory fervor coursing through the economy at the time, and it led to the belief that, among other things, there should be no regulatory body overseeing credit default swaps.

7. Greed. The desire to get rich isn't a bad thing from an economic standpoint. I'd even go so far as to say that it's necessary to fuel economic growth. But greed becomes bad when it's taken to the extreme. And that's what happened in the lead-up to the crisis. Homeowners wanted to get rich quick by flipping real estate. Mortgage originators went to great lengths, legal and otherwise, to maximize loan volumes. Home appraisers did the same. Bankers were paid absurd amounts of money to securitize toxic subprime mortgages. Rating agencies raked in profits by classifying otherwise toxic securities as investment-grade. Regulators were focused on getting a bigger paycheck in the private sector. And politicians sought to gain popularity by forcing banks to lend money to their un-creditworthy constituents.

8. Fraud. While very few financiers have been prosecuted for their role in the financial crisis, don't interpret that to mean that they didn't commit fraud. Indeed, the evidence is overwhelming that firms up and down Wall Street knowingly securitized and sold toxic mortgage-backed securities to institutional investors, including insurance companies, pension funds, university endowments, and sovereign wealth funds, among others.

9. Short-term investment horizons. In the lead-up to the crisis, analysts and investors castigated well-run firms such as JPMorgan Chase and Wells Fargo for not following their peers' lead into the riskiest types of subprime mortgages, securities, and derivatives. Meanwhile, the firms that succumbed to the siren song of a quick profit -- Citigroup, for instance -- were the first to fail when the house of cards came tumbling down.

10. Politics. Since the 1980s, bankers and politicians have formed an uneasy alliance. By conditioning the approval of bank mergers on the Community Reinvestment Act, politicians from both sides of the aisle have effectively blackmailed banks into providing loans to un-creditworthy borrowers. While banks and institutional investors absorbed the risks, politicians trumpeted their role in expanding the American dream of homeownership.
2-- Increases in government spending increase aggregate demand
and therefore tax collections. But tax collections rise by less
than the increase in government spending, so increased
government spend increases the budget deficit

3--

Expansionary and Contractionary Fiscal Policy--

Fiscal Policy

Fiscal policy is the use of government spending and tax policy to influence the path of the economy over time. Automatic stabilizers, which we learned about in the last section, are a passive type of fiscal policy, since once the system is set up, Congress need not take any further action. On the other hand, discretionary fiscal policy is an active fiscal policy that uses expansionary or contractionary measures to speed the economy up or slow the economy down.

Expansionary fiscal policy occurs when the Congress acts to cut tax rates or increase government spending, shifting the aggregate demand curve to the right. Contractionary fiscal policy occurs when Congress raises tax rates or cuts government spending, shifting aggregate demand to the left.

Figure 1 uses an aggregate demand/aggregate supply diagram to illustrate a healthy, growing economy. The original equilibrium occurs at E₀, the intersection of aggregate demand curve AD₀ and aggregate supply curve AS₀, at an output level of 200 and a price level of 90.

One year later, aggregate supply has shifted to the right to AS₁ in the process of long-term economic growth, and aggregate demand has also shifted to the right to AD₁, keeping the economy operating at the new level of potential GDP. The new equilibrium (E₁) is at an output level of 206 and a price level of 92. One more year later, aggregate supply has again shifted to the right, now to AS₂, and aggregate demand shifts right as well to AD₂. Now the equilibrium is E₂, with an output level of 212 and a price level of 94. In short, the figure shows an economy that is growing steadily year to year, producing at its potential GDP each year, with only small inflationary increases in the price level.

Figure 1. A Healthy, Growing Economy. In this well-functioning economy, each year aggregate supply and aggregate demand shift to the right so that the economy proceeds from equilibrium E₀ to E₁ to E₂. Each year, the economy produces at potential GDP with only a small inflationary increase in the price level. But if aggregate demand does not smoothly shift to the right and match increases in aggregate supply, growth with deflation can develop.

In the real world, however, aggregate demand and aggregate supply do not always move neatly together, especially over short periods of time. Aggregate demand may fail to grow as fast as aggregate supply, or it may even decline causing a recession. This could be caused by a number of possible reasons: households become hesitant about consuming; firms decide against investing as much; or perhaps the demand from other countries for exports diminishes. For example, investment by private firms in physical capital in the U.S. economy boomed during the late 1990s, rising from 14.1% of GDP in 1993 to 17.2% in 2000, before falling back to 15.2% by 2002. Conversely, increases in aggregate demand could run ahead of increases in aggregate supply, causing inflationary increases in the price level. Business cycles of recession and boom are the consequence of shifts in aggregate supply and aggregate demand. As these occur, the government may choose to use fiscal policy to address the difference.

Expansionary Fiscal Policy

Expansionary fiscal policy increases the level of aggregate demand, through either increases in government spending or reductions in taxes. Expansionary policy can do this by:

1. increasing consumption by raising disposable income through cuts in personal income taxes or payroll taxes;
2. increasing investments by raising after-tax profits through cuts in business taxes; and
3. increasing government purchases through increased spending by the federal government on final goods and services and raising federal grants to state and local governments to increase their expenditures on final goods and services.

Contractionary fiscal policy does the reverse: it decreases the level of aggregate demand by decreasing consumption, decreasing investments, and decreasing government spending, either through cuts in government spending or increases in taxes. The aggregate demand/aggregate supply model is useful in judging whether expansionary or contractionary fiscal policy is appropriate.

Consider first the situation in Figure 2, which is similar to the U.S. economy during the recession in 2008–2009. The intersection of aggregate demand (AD₀) and aggregate supply (AS₀) is occurring below the level of potential GDP. At the equilibrium (E₀), a recession occurs and unemployment rises. (The figure uses the upward-sloping AS curve associated with a Keynesian economic approach, rather than the vertical AS curve associated with a neoclassical approach, because our focus is on macroeconomic policy over the short-run business cycle rather than over the long run.) In this case, expansionary fiscal policy using tax cuts or increases in government spending can shift aggregate demand to AD₁, closer to the full-employment level of output. In addition, the price level would rise back to the level P₁associated with potential GDP.

Figure 2. Expansionary Fiscal Policy. The original equilibrium (E₀) represents a recession, occurring at a quantity of output (Yr) below potential GDP. However, a shift of aggregate demand from AD₀to AD₁, enacted through an expansionary fiscal policy, can move the economy to a new equilibrium output of E₁ at the level of potential GDP. Since the economy was originally producing below potential GDP, any inflationary increase in the price level from P₀ to P₁ that results should be relatively small.

Should the government use tax cuts or spending increases, or a mix of the two, to carry out expansionary fiscal policy? After the Great Recession of 2008–2009, U.S. government spending rose from 19.6% of GDP in 2007 to 24.6% in 2009, while tax revenues declined from 18.5% of GDP in 2007 to 14.8% in 2009.

This very large budget deficit was produced by a combination of automatic stabilizers and discretionary fiscal policy. The Great Recession meant less tax-generating economic activity, which triggered the automatic stabilizers that reduce taxes. Most economists, even those who are concerned about a possible pattern of persistently large budget deficits, are much less concerned or even quite supportive of larger budget deficits in the short run of a few years during and immediately after a severe recession.

The Politics of Expansionary Fiscal Policy

The choice between whether to use tax or spending tools often has a political tinge. As a general statement, conservatives and Republicans prefer to see expansionary fiscal policy carried out by tax cuts, while liberals and Democrats prefer that expansionary fiscal policy be implemented through spending increases. The Obama administration and Congress passed an $830 billion expansionary policy in early 2009 involving both tax cuts and increases in government spending, according to the Congressional Budget Office. However, state and local governments, whose budgets were also hard hit by the recession, began cutting their spending—a policy that offset federal expansionary policy.

The conflict over which policy tool to use can be frustrating to those who want to categorize economics as “liberal” or “conservative,” or who want to use economic models to argue against their political opponents. But the AD–AS model can be used both by advocates of smaller government, who seek to reduce taxes and government spending, and by advocates of bigger government, who seek to raise taxes and government spending. Economic studies of specific taxing and spending programs can help to inform decisions about whether taxes or spending should be changed, and in what ways. Ultimately, decisions about whether to use tax or spending mechanisms to implement macroeconomic policy is, in part, a political decision rather than a purely economic one.

4--After several years of steady growth, stock market prices began to rise rapidly in 1995, more than tripling over the next five years. In 2000, stock prices began a prolonged decline. Shortly thereafter, in March 2001, the longest expansion in history ended, and the economy entered a recession. By September 2002, the Standard and Poor's 500 Index had fallen by nearly half from its peak. In hindsight, it is clear that some of the appreciation in stock prices in the 1990s was caused by a "bubble," a rise in price that cannot be attributed to underlying economic fundamentals, but is instead caused by "irrational exuberance."

Around the same time that the stock market boom was coming to an end, the housing boom began. House prices have doubled since 1997 and increased more than 50% from 2003 to 2006. Since 2006, prices have stagnated, while sales and housing construction have declined precipitously. In August 2007, problems with subprime mortgages led to widespread financial turmoil. This has led some analysts to conclude that a similar asset bubble has infected the housing market.

These experiences have led some critics to question the Federal Reserve's (Fed's) policy of non-intervention toward bubbles. If bubbles reflect harmful economic imbalances, they argue, then the proper policy response is to raise interest rates to neutralize them. This proposal faces two main drawbacks. First, bubbles cannot be accurately identified and their magnitude cannot be estimated until after the fact. Theory suggests that the Fed would be able to accurately identify bubbles only if it knew more than the thousands of professionals participating in those markets who believed high prices to be justified. Second, aggressively raising interest rates to counteract a bubble risks instigating the very recession that critics ostensibly wish to avoid. The relative shallowness and brevity of the 2001 recession is seen as evidence in favor of a hands-off policy response to a bubble.

Fed Chairman Ben Bernanke has argued that the Fed should respond to a bubble only insofar as it causes inflation or growth to rise above sustainable levels, but need not be concerned about eliminating a bubble for its own sake. Bubbles lead to higher investment in the affected industry and consumption spending (by making households feel wealthier). According to Bernanke's philosophy, the Fed could raise interest rates in response to a bubble if this spending increase were inflationary.

Assuming Bernanke's philosophy were correct, the issue of whether the Fed has responded to bubbles aggressively enough in practice to prevent them from igniting inflationary pressures remains. The Fed waited until 1999 to raise interest rates during the stock market boom, and cut rates in 2007 in response to financial turmoil. Both of these episodes have been marked by rising inflation, and if increases in house prices were recorded in the owner-occupied shelter portion of the consumer price index, recorded inflation would be even higher today. Critics also argue that the Fed's passive approach to a growing bubble is inconsistent with its aggressive rate reductions following a bubble's deflation, and this inconsistency sends a message to investors to take on excessive risk. This report will be updated as events warrant.

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