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Financial Crisis Paper Notes

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James Wain & Pip Reeve

1

19/01/2011

'Policy responses to the Crisis and to the Great Recession, Plus Some Important Longer-Term Perspectives' By James Wain and Pip Reeve Policy Responses to the Crisis and the Great Recession

1.

INTRODUCTION

In this paper I will focus primarily on the issues faced by the US and the UK government, although I will also draw on examples from Japan and the Nordic countries. To begin with, following the crisis discussed above, the Monetary Policy Committee (MPC) and the Federal Reserve (Fed) were faced with a number of significant issues. As a result of the financial crisis, the UK was suffering from strong disinflationary dynamics including; stretched private balance sheets, weak asset prices, fragile banks and faltering demand. Meier suggests that 'averting a sustained inflation undershooting has moved to the top of the central banks' agendas.'1 Ordinarily, the 'conventional tool of monetary policy today is control over short term nominal interest rates.'2 This means that, until recently, the Monetary Policy Committee (MPC) has set policy by targeting a short-term interbank rate. However, it is clear that these rates cannot be lowered indefinitely and are therefore limited by a zero floor. Economic theory of the liquidity trap shows that at zero interest rates, holding cash is a serious alternative to bank deposits; in fact, the demand for money balances will become infinitely elastic. A problem faced by the MPC and the Fed is that even a zero policy rate may still be too high 'to stimulate an economy gripped by strong deflationary forces.'3 Indeed Meier claims that the 'correct' policy rate for the UK would be approximately -5%. As this is clearly not feasible, the MPC and central banks from around the world must face using more unconventional options. Unconventional monetary policy can be effective to the extent that it can directly reduce risk premia and ease quantitative restrictions in financial markets, as well as convincing the public of a less rigid than expected future policy stance.

2. CAUSES OF THE FINANCIAL CRISIS It used to be the case that mortgages were held by the banks that made the loans, and so the banks themselves were able to closely manage any problems with these individual loans. In the US, in 1938, the US government founded the Fanny Mae (Federal National Mortgage Association, FNMA) in order to increase liquidity to the home mortgage market. FNMA purchased mortgages from these individual banks, which allowed banks to create mortgages at lower prices. Although home ownership increased, the US government introduced Freddie Mac in 1970 (Federal Home Loan Mortgage Corporation, FHLMC) in order to make loans and loan guarantees. Freddie Mac then pooled the mortgages that it purchased and went on to sell 'mortgage backed securities' to investors on the open market.

After 1992, 'sub prime' mortgages were provided by Fannie and Freddie which were much higher risk. Because of the risk premium effect, bundling these sub-prime mortgages can be much more profitable than bundling prime mortgages. Between 1998 and 2006 there was a


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'Panacea, Curse or Non-event: Unconventional Monetary Policy in the United Kingdom' IMF Working Paper, Meier - August 09 2 'Panacea, Curse or Non-event: Unconventional Monetary Policy in the United Kingdom' IMF Working Paper, Meier - August 09 3 'Panacea, Curse or Non-event: Unconventional Monetary Policy in the United Kingdom' IMF Working Paper, Meier - August 09

James Wain & Pip Reeve

2

19/01/2011

housing boom in the US and the UK and many other countries, partly induced by low interest rates and the availability of mortgages. This meant that existing house prices were bid up as mortgage rates fell. As long as house prices continued to rise, the asset values of the houses supporting the sub-prime mortgages were more than sufficient to support the relatively risky loans. Eventually, the housing bubble 'popped,' when house prices began to fall, which in turn induced a fall in the price of formerly low risk mortgage backed securities. Bernanke says that the 'proximate cause of the crisis was the turn of the housing cycle in the US.'4 He goes on to say that there were, however, also many other aspects including; declines in underwriting standards, breakdowns in lending oversight, increasing reliance on complex and opaque credit instruments that proved fragile under stress and unusually low compensation for risk taking.

This created a 'credit crisis' for all of the institutions holding large amounts of those assets. Most mortgages initially remained fairly low risk, however, as they were insured by Fannie Mae or Freddie Mac or a variety of other institutions. As mortgages began to fall through, and houses were repossessed, these mortgage insurers had to pay out far more than they were taking in interest payments. However, they had insufficient reserves to make these payments. This meant that their credit ratings rapidly declined and their stock prices fell, meaning they were unable to raise new money to make their 'guaranteed payments.' Consequently, many of these institutions went bankrupt including Bear Stearns in 2008. These factors lead to a significant slowdown in economic growth and a reduction in consumer spending, mainly due to the lack of credit and the wealth effects arising from the reduction in house prices.

3. POLICY INITIATIVES A variety of different policy options were available to central banks around the world. Meier mentions several different


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'The Crisis and the Policy Response' Bernanke 2009

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