Notes on Mishkin Chapter 9
("Financial Crises and the Subprime Meltdown")
Econ 353: Money, Banking, and Financial Institutions
- Last Updated: 28 March 2015
- Latest Course Offering: Spring 2011
- Course Instructor:
Professor Leigh Tesfatsion
tesfatsi AT iastate.edu
- Econ 353 Home Page:
- Financial Development and Economic Growth
- Financial Crises and Aggregate Economic Activity
- Financial Crises: Case Studies
- General Form of Financial Crises in the United States
- Illustration: U.S. Great Depression (see ppt notes)
- Illustration: 2007-2011 U.S. Subprime Financial Crisis (see ppt notes)
- General Form of Financial Crises in Developing Countries: Overview
- Illustration: The 1994-5 Financial Crisis in Mexico
- Basic Concepts and Key Issues for Mishkin Chapter 9
Financial Development and Economic Growth
The economic growth of a country refers to changes in the size
of its economy as measured, for example, by changes in GDP. Countries can
exhibit negative as well as positive economic growth rates. The economic
development of a country refers to changes in the infrastructure,
organizational, and governance aspects of its economy that affect the
standard of living of its citizens.
As Mishkin stresses, poorly functioning financial markets can result in
slow or stagant economic growth and economic development by impeding the flow
of funds from savers to investors. Financial markets tend to function poorly
when legal systems are weak, standard accounting practices are absent, and/or
government regulation is either inadequate or inappropriate.
With regard to the legal system, we saw in earlier discussion that
safeguards such as collateral and restrictive covenants in debt contracts are
needed to overcome the adverse selection and moral hazard problems endemic to
financial markets. These safeguards cannot function properly, however, in
the absence of a well-established legal system that provides fair and
impartial enforcement of contract provisions and an orderly means for
managing creditor (debt-holder) claims in the case of defaults and
bankruptcies. When these safeguards are absent, the channeling of funds from
savers to investors can be severely inhibited, resulting in slow or even
stagnant economic growth and development.
With regard to accounting, we saw in earlier discussion that asymmetric
information leading to adverse selection and moral hazard can severely
disrupt financial markets. Standard accounting methods, widely adopted and
impartially enforced, can help to ameliorate these information problems.
With regard to the role of government, we saw in earlier discussion that
some amount of financial market regulation by government appears desirable to
ameliorate the free-rider problems arising in securities markets that are
difficult to overcome by private means alone. However, inappropriate
intervention by government in financial markets on behalf of favored or
politically powerful borrowers can result in inefficient investment, in the
sense that the funds available for investment are not directed to their most
productive uses. The danger is particularly great when banks are
nationalized by governments and so cannot function independently of political
objectives and controls.
Mishkin argues that developing (or emerging market) countries are
particularly prone to financial market problems
because their legal systems and accounting practices tend to be less well
established and their governments tend to play a much larger role in
financial market activity. As will be seen below, however, even "developed"
countries are not immune to financial crises.
Financial Crises and Aggregate Economic Activity
A financial crisis is a major disruption in financial markets
that is characterized by a sharp decline in asset prices and the failure
of many financial and nonfinancial firms.
For example, the United States experienced major financial crises in
1819, 1837, 1857, 1873, 1884, 1893, and 1907, in the first three years of
the "Great Depression" (1929-1939), and in 2007-2011. Morever, the U.S. narrowly avoided a
major financial crisis in the latter part of the 1980's, generally known as the savings
and loan crisis.
Mishkin (along with many other economists) is a strong advocate
of the view that financial crises primarily result from information problems.
In particular, he argues that financial crises arise when disruptions to
the financial system (from whatever source) cause such a large surge in
adverse selection and moral hazard problems that financial markets are unable
to channel funds efficiently from savers to investors.
- As an example of a different viewpoint, the Nobel laureate Milton
Friedman (1912-2006) believed that government monetary policy was the main source of
financial crises, such as the Great Depression. More precisely,
he believed that these financial crises were largely the result of
unexpected and inappropriate shocks by government to the money supply, and
that financial as well as other markets would tend to function in a stable
and efficient manner in the absence of this type of government intervention.
Adherents of this viewpoint are generally known as monetarists.
In particular, Mishkin argues that financial crises in relatively well developed
countries such as the U.S. tend to be triggered by FOUR TYPES OF FACTORS: (1) increases in interest rates; (2) increases in lender uncertainty; (3) asset
market effects on balance sheets; and (4) problems in the banking sector.
Mishkin also argues that financial crises in emerging market countries (e.g., Mexico,
Argentina, Thailand) tend to be triggered by these four factors PLUS ONE ADDITIONAL FACTOR:
(5) government fiscal imbalances.
Government fiscal imbalances can lead investors to fear default on government debt,
which in turn can spark a foreign exchange crisis (i.e., a form of BOP crisis) in which
the value of the domestic currency falls sharply as investors rapidly pull their money out of the country.
- Factor 1. Increases in Interest Rates
- Suppose the market for loanable funds is currently in a demand=supply
equilibrium at some interest rate i*, as depicted in the diagram below.
Suddenly, for some reason, there is a leftward shift in the supply curve for
loanable funds. That is, at each interest rate level, lenders are less
willing than before to supply loanable funds. Consequently, at the original
interest rate level i*, there is now an excess demand for loanable funds.
Such a situation is referred to as a credit crunch.
Bond Market in Initial Equilibrium at i*:
Interest New Supply
Rate i n Curve
| d n o Old Supply
i'|............d o Curve
| n d o
| n d o
| n d o
| n o d Demand
| n o d Curve
| n o d
As discussed in Mishkin (Chapter 5), interest rates in a credit crunch
will tend to rise until the economy is once again at a point where the demand
and supply curves for loanable funds intersect. However, if the leftward
shift in the supply curve is substantial, the new intersection point will
occur at a very high interest rate i' -- see the diagram above.
In this case, adverse selection may become a problem. Those most
willing to pay high interest rates are those undertaking highly risky
projects that promise the possibility of a high return rate (though not with
high probability). Investors wishing to pursue modestly risky investment
projects with modest expectations of gain may be discouraged from borrowing
and may well exit the market for loanable funds.
Lenders, anticipating this adverse selection effect, may then become
discouraged from lending, which would shift the supply curve even further to
In short, the original shock to the supply curve that caused it to shift
to the left could be followed by further leftward shifts due to adverse
selection effects, amplifying the negative impact of the original shock on
lending and borrowing activity. The result could be a substantial decline in
investment, hence dimmed prospects for economic growth and development.
- Factor 2. Increases in Lender Uncertainty
- Suppose a negative financial shock occurs -- perhaps an unexpected
failure of a major financial firm previously thought to have been in good
financial condition. This kind of surprising negative event can lead to
increased uncertainty among lenders concerning the attributes and prospects
of potential borrowers.
Given this increased uncertainty, lenders may become more reluctant to
lend at any given interest rate -- i.e., the supply curve for loanable funds
may shift to the left. As previously explained, this leftward shift
(resulting in higher interest rates) could then induce adverse selection
effects in financial markets, causing further leftward shifts in the supply
curve and hence further reductions in lending and borrowing activity.
- Factor 3. Asset Market Effects on Balance Sheets (Real Net Worth)
- As Mishkin stresses, the state of corporate balance sheets has important
implications for the severity of adverse selection and moral hazard problems
in financial markets.
The real net worth of a corporation is the difference between
what it owns (its assets) and what it owes (its liabilities), measured in
real (purchasing power) terms.
In general, the creditors of a corporation are entitled to take
ownership of its assets in case of default. Thus, as discussed by Mishkin in
earlier sections of Chapter 8, the real net worth of corporations plays a
similar role to collateral in helping to ease lenders' fears regarding both
adverse selection and moral hazard and in helping to encourage more
responsible behavior on the part of corporate borrowers.
Consequently, negative shocks to the real net worth of corporations
exacerbate adverse selection and moral hazard problems in financial markets
and make lenders less willing to lend.
Mishkin argues that negative shocks to real net worth can be caused by a
variety of preceding shocks, as follows:
- Negative Stock Market Shock:
- All else equal, a decline in stock market prices means a decline in
corporate real net worth because stock prices are the current market
valuation of corporate assets.
- Negative Inflation Rate Shock:
- If the debt payments specified in corporate debt contracts are fixed
in nominal terms, a decrease in the expected inflation rate can have a
substantial negative impact on the real value of corporate net worth.
- To understand this, let P(T) denote the aggregate price level in
period T. The expected inflation rate from period T to T+1 is then given by
e P (T+1) - P(T)
(1) inf (T,T+1) = -----------------
where Pe(T+1) denotes the expected aggregate price level in
- Recall that the real interest rate is defined to be the difference
between the nominal interest rate and the expected inflation rate. Thus, the
real interest rate from period T to T+1 is given by
- ireal(T) = inom(T) -
- It follows from (2) that, for any given nominal interest rate, a
decrease in the expected inflation rate corresponds to an
increase in the real interest rate.
- For example, suppose at the start of period T that the nominal interest
rate is 5 percent and the expected inflation rate is 3 percent, implying by
definition (2) that the real interest rate is 2 percent. Suppose the
expected inflation rate then decreases from 3 percent to 1 percent, with no
change in the nominal interest rate of 5 percent. Then the real interest
rate increases to 4 percent.
- This increase in the real interest rate increases the real burden of debt
on corporate borrowers, and hence the real value of their liabilities,
without affecting the real value of their physical assets. It follows that
corporate net worth declines in real terms.
- To avoid this problem, corporations in countries with highly volatile
domestic inflation rates sometimes issue debt denominated in the currencies
of foreign countries whose inflation rates are expected to be more stable
- This is not a risk-free strategy, however. As will next be seen,
negative shocks to the domestic exchange rate can have substantial negative
effects on corporate real net worth when corporate debt is denominated in
- Negative Exchange Rate Shock:
- To illustrate how negative exchange rate shocks can negatively
affect corporate real net worth, suppose Russia's exchange rate measuring the
value of Russian currency (rubles) in terms of U.S. currency (dollars)
depreciates from 1.0 dollar per ruble to 0.50 dollars per ruble, so
that each ruble is now worth only 50 cents instead of a dollar.
- Consider a Russian corporation whose debt is denominated in dollar terms
-- i.e., whose debt payments are specified as fixed dollar amounts. For
concreteness, suppose the Russian corporation is obliged to make a $1000 debt
payment at the end of the coming year. To make this debt payment will now
cost the Russian corporation 2000 rubles rather than 1000 rubles.
- Consequently, all else equal, a depreciation or devaluation of a
country's domestic exchange rate will increase the real debt burden (hence
the real liabilities) of any corporation whose debt is denominated in foreign
- On the other hand, since corporate assets are typically denominated in
domestic currency, a depreciation or devaluation of the domestic exchange
rate will generally not have any direct effect on the real value of corporate
assets. It follows that corporate real net worth will tend to decline
following a depreciation or devaluation of a country's domestic exchange
- Positive Interest Rate Shock:
- As previously noted, increased interest rates on financial instruments
can increase adverse selection in financial markets and hence make lenders
less willing to lend. In this case, the supply curve for loanable funds will
shift left. This will tend to cause interest rates to increase even further,
thus amplifying the original adverse selection problem.
- In addition, an increase in interest rates on financial instruments also
has a direct negative impact on the real net worth of households or
firms who are borrowers.
- All else equal, an increase in interest rates on financial instruments
means that household and firm borrowers must now pay more for
loanable funds. Consequently, they experience a decrease in their
cash flow, defined as the difference between their cash receipts and their
- Decreased cash flow in turn means that households and firms are less
liquid, which increases the uncertainty of lenders regarding the ability of
households and firms to meet their debt obligations. As previously
noted, increases in lender uncertainty can lead to leftward shifts in the
supply curve for loanable funds, which leads to further increases in interest
- In short, putting the two effects of increased interest rates together,
both tend to lead to leftward shifts in the supply curve for loanable funds
and hence to further interest rate increases and amplified adverse selection
- Factor 4. Problems in the Banking Sector
- Problems in the banking sector are another factor that can cause
For example, if banks suffer a deterioration in their balance sheets for
whatever reason, they will have fewer resources to lend and bank lending will
decline. This decline, in turn, will lead to a contraction in investment
spending and a slow-down in economic activity.
In particular, if the decline in bank lending is sufficiently severe, it can
lead to a "bank panic." A bank panic (or bank run) is said to
occur when large numbers of depositors -- for whatever reason -- lose faith
in banks and seek to withdraw their funds all at the same time, leading to
many bank failures.
Why do banks fail in the face of a bank run?
As will be studied more carefully in Mishkin (Chapter 10), banks in the
United States and other industrialized countries are organized as
fractional reserve systems. This means that only a small fraction of each dollar of
deposits is actually kept on hand by banks for deposit withdrawals -- the
rest is lent out to borrowers. The amount left on hand is generally only
enough to handle normal day-to-day demand for deposit withdrawals.
Consequently, in bank panics, these amounts on hand are quickly exhausted.
Unless a bank's loans can be called in early, or the bank receives liquidity
assistance from some other source, the bank will suffer
is, the bank will be unable to meet its legal obligations to its creditors (i.e., its depositors).
Moreover, the attempts by banks during bank panics to liquify their
loans -- i.e., to call in their loans early, demanding full repayment of loan
principal plus interest due -- can cause these loans to go "bad" in the sense
that borrowers cannot make the required payments. Consequently, even if a
bank avoids failure, the net worth of the bank may be reduced, implying that
it will be less willing and able to lend in periods subsequent to the bank
panic. Also, many ongoing investment projects will be temporarily or even
permanently disrupted due to the early call in of loans.
In summary, then, bank panics reduce the amount of lending by banks due
both to loan liquification and to outright bank failures. The supply curve
for loanable funds thus shifts to the left, causing an increase in interest
rates and a contraction in lending and investment. As discussed above, the
increase in interest rates may then induce further leftward shifts in the
supply curve due to increased adverse selection effects.
- Important Distinction: Bankruptcy versus Insolvency
- The distinction between "bankruptcy" and "insolvency" plays a
critical role in the discussion of the 1980s U.S. savings and loan crisis in Mishkin Chapter 11.
- The term "bankruptcy" is a non-technical term with no legal status.
However, a firm is generally said to be bankrupt if it is no longer
able to meet its legal obligations to its financial creditors (e.g., to make
interest payments on its outstanding bonds, to provide for the withdrawal of
funds in checking deposit accounts, and so forth). In contrast, a firm is
insolvent if it has a negative net worth, meaning the present value of
its liabilities exceeds the present value of its assets. An insolvent firm
is necessarily bankrupt. However, a bankrupt firm can still be solvent even
though unable to meet its current creditor obligations. The bankruptcy of a
solvent firm can arise if the firm's current asset
holdings are not sufficiently liquid to permit it to generate a cash flow to
meet its current obligations to its creditors.
- Until 2005, the principal law governing bankrupcty in the United States was the
Bankruptcy Reform Act of 1994. Under this act, firms are either "liquidated"
(Chapter 7 bankruptcy) or "re-organized" (Chapter 11 bankruptcy).
Firms that are insolvent are generally liquidated under Chapter 7 bankruptcy. This means that the firm ceases operation, any remaining assets of the firm are sold, and the proceeds of this sale are distributed to creditors in accordance with certain absolute priority rules (e.g., debt holders prior to equity holders). Consequently, under Chapter 7 bankruptcy, the debts of a firm are essentially forgiven (or discharged.
In contrast, firms that are bankrupt but still solvent are typically re-organized into a new corporate entity under Chapter 11 bankruptcy. In this case the firm's creditors typically receive cash
and/or securities in the new corporation, i.e., their credit claims are
rescheduled rather than extinguished. However, they are not permitted to sue the old corporation for recovery of their claims.
The Bankruptcy Reform Act of 1994 was amended by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (Public Law No. 109-8, 119 Stat. 23, April 20, 2005). This 2005 Reform Act increases the evidence needed to qualify for the filing of a Chapter 7 bankruptcy. Advocates of the 2005 Reform Act argue that it will increase individual and business fiscal responsibility. Opponents of the 2005 Reform Act argue that it will cause financial hardship for individuals who seek debt relief caused by extenuating circumstances such as illness, divorce, or long-term unemployment.
- Factor 5. Government Fiscal Imbalances
Government fiscal imbalances (budget deficits) are a particular problem for
many emerging market economies.
Government fiscal imbalances can lead to increased fears
of default on the government debt, forcing the government to sell any new
bond issue to banks rather than to private investors (assuming government can
exert sufficient pressure on banks to buy its bonds).
This is dangerous,
since subsequent actions by investors (both foreign and domestic) to protect
themselves against default by selling their holdings of government bonds can
lead to sharp contractions in government bond prices and hence to sharp
declines in the balance sheets of the banks holding government bonds. This
can then trigger "problems in the banking sector" as described in the discussion
of Factor 4, above.
In addition, the actions of foreign investors to take
their money out of the country (referred to as capital outflow or capital flight) can
also spark a foreign exchange crisis (i.e., a form of balance of payments crisis as elaborated in Mishkin Chapter 21).
Financial Crises: Case Studies
A. Financial Crises in the United States
In Figure 1 (p. 197), Mishkin diagrams the typical sequence of events that
has occurred during past U.S. financial crises.
- First Stage: Precipitating Factors
- In the first stage of the financial crisis, a sharp rise in interest
rates on debt instruments occurs due to some external event, accompanied by a
corresponding decline in stock market prices as savers move their funds out
of equity and into debt instruments.
- As previously discussed, the rise in interest rates exacerbates adverse
selection problems, and the decline in the stock market (and hence in
corporate real net worth) exacerbates both adverse selection and moral hazard
- In addition, in this first stage, there has frequently also been an
unexpected failure of some major financial or nonfinancial firm previously
thought to have been in good financial condition. This increases lender
uncertainty regarding borrower attributes and prospects, exacerbating
adverse selection problems.
As a result of these first stage events, there is an overall decline in
lending and investment activity and a worsening of general economic
- Second Stage: Bank Panic
- In the second stage of the crisis, as a direct result of first stage
events, depositors begin to lose confidence in banks and other depository
institutions and attempt to withdraw their funds at a greater than normal
rate. Banks and other depository institutions begin to experience
difficulties meeting their withdrawal demands, which causes increased fears
among depositors and increased withdrawal demands.
Banks and other depository institutions now begin to call in loans and even
to fail. The early call-in of loans in turn causes some firms to fail. The
result is a further contraction in lending and investment, further increases
in interest rates, a worsening of adverse selection and moral hazard
problems, and a further decline in general economic activity.
- Final Stage(s):
- Mishkin now distinguishes between two possible scenarios that have
occurred in the final stages of U.S. financial crises.
- First Scenario: Sorting Out and Recovery
- In this first scenario, public and private authorities work to separate
bankrupt financial and nonfinancial firms into two categories: (1) firms that
are solvent --i.e., that have a positive net worth -- but that are
experiencing cash-flow (liquidity) problems due to the bank panic; and (2)
firms that are insolvent. The first category of firms are offered liquidity
assistance, whereas the second category are allowed to fail.
- Once this sorting out is accomplished, and liquidity assistance is
provided to solvent but bankrupt firms, uncertainty in financial markets
declines, lender confidence returns, interest rates start to fall, and the
stock market starts to recover. The financial crisis is over.
- Second Scenario: Debt Deflation and Delayed Recovery
- In this second scenario, the economic downturn resulting from the first
two stages induces a decline in the inflation rate (disinflation).
- If this decline is severe enough, the result can be deflation, i.e., an
inflation rate that is negatively valued, meaning that the aggregate price level
P(T+1) - P(T)
(3) inf(T,T+1) = -------------- < 0 .
- Any decrease in the inflation rate (e.g., from 3 percent to 1 percent)
will result in an increased burden of corporate debt due to higher real
interest rates, and hence a lower value for corporate real net worth.
However, if this decrease in the inflation
rate is so great as to result in a negatively valued inflation rate (e.g.,
-10 percent), the increase in the burden of corporate debt will be substantial.
- Mishkin refers to the process by which debt burdens increase and net
worth decreases as a result of actual price declines as debt deflation.
- In the second scenario, then, as a result of severe debt deflation, a
large number of firms are reduced to insolvency (negative net worth) and the
financial crisis becomes serious and prolonged.
- As Mishkin notes (page 201), severe debt deflation occurred during
the first few years (1930-1933) of the Great Depression (1929-1939). The
aggregate price level in the U.S. dropped dramatically from 1930 to 1933 by
about 25 percent, depending on the precise price measure used. [Note:
National income accounting was not introduced in the U.S. until the late
B. Financial Crises in Emerging Market Countries: Overview
In recent years a number of different emerging market countries have experienced serious financial crises. By and large, these crises have not been anticipated by analysts and commentators. Countries that had been experiencing solid gains in growth and development for a number of years suddenly experienced sharp declines in economic activity for no apparent reason.
For example, take a look at the research articles and news commentary at the Global Economics web site maintained by Nouriel Roubini (Stern School of Business, New York University) focusing on the
East Asian crisis.
In Chapter 9 Mishkin discusses financial crises that have arisen relatively recently in a number of different emerging market countries. He argues that the asymmetric information analysis presented in Chapter 8 can help to explain why these crises occurred and why many of these crises were so deep and prolonged.
In Figure 3 (p. 207) Mishkin diagrams the typical sequence of events that has occurred during past financial crises in emerging market countries. In his discussion of this figure, Mishkin argues that asymmetric information problems help to explain this sequence of events.
Mishkin also notes that the sequence of events depicted in Figure 3 (p. 207) for financial crises in emerging market countries differs somewhat from the sequence of events depicted in Figure 1 (p. 197) for U.S. financial crises. He argues that this difference reflects differences in institutional features between emerging market countries and the US.
The following section focuses on one particular emerging market financial crisis for concrete illustration: namely, the Mexican financial crisis from 1994 to 1995.
C. Illustration: The 1994-1995 Financial Crisis in Mexico
This typical sequence of events for crises in emerging market economies is illustrated concretely below for the 1994-1995 Mexican financial crisis.
- Stage one: Precipitating Factors
- Deterioration in Banks' Balance Sheets:
- Mexican banks were privatized in the early 1990s and financial markets
were deregulated. A lending boom ensued in which bank loans to private
nonfinancial businesses accelerated dramatically, from 10 percent of GDP in
1988 to over 40 percent of GDP in 1994. Most of these loans were of short
duration, typically less than one month.
- Unfortunately, due to lack of experience on the part of bank managers and
regulators, procedures for applicant screening, monitoring, and enforcement
were not carefully maintained and losses began to mount. The result was a
decline in the net worth of banks and a contraction in their lending
- Increase in Interest Rates:
- Another factor precipitating the Mexican financial crisis was a rise in
interest rates abroad, in particular a rise in short-term interest rates in
the United States beginning in 1994.
- Note: For a fuller understanding of the Mexican financial crisis, it would be
necessary to take into account that it occurred in the context of a 1994-1995
dollar crisis for the U.S. -- the dollar consistently fell against most major
currencies during 1994. The world was awash with U.S. dollar reserves,
in part due to a chronic U.S. current account deficit.
A desire to support the U.S. dollar (and to encourage foreign
lending to the U.S.) was a key reason why the U.S. Federal Reserve Board
increased U.S. short-term interest
rates on four different occasions during the first half of 1994.
- All else equal, interest parity leads to the following predictions. An increase in U.S. interest
rates relative to Mexican interest rates will lead to increased demand for U.S.
dollar-denominated debt instruments. This in turn will lead to increased demand for U.S. dollars relative
to pesos, and to a a corresponding increase in the pesos-per-dollar exchange rate E,
until a point is reached where investors started to anticipate a fall in E back to a
more "normal" level.
- As part of a reform plan initiated in 1987 to stabilize the Mexican economy,
however, the Mexican government had decided to limit the movement of the peso
against the dollar. Consequently, they were committed to maintaining the
current pesos-per-dollar exchange rate E.
- To prevent the rise of E, Mexico thus raised
interest rates on its short-term financial instruments. For reasons
explained above, this increase led to increased adverse selection problems in
Mexican financial markets, in the sense that the pool of loan applicants was
now more heavily weighted toward high risk borrowers. As a consequence,
banks were less willing to lend.
- Stock Market Decline:
- The increase in Mexican interest rates on short-term financial
instruments drew savings away from the Mexican stock market (the Bolsa),
leading to a substantial decline in stock market prices and hence to a
decline in corporate net worth. For reasons explained above, this led to
increased adverse selection and moral hazard problems, making banks less
willing to lend to corporations.
- Increase in Uncertainty:
- In addition, the increase in Mexican short-term interest rates reduced the
cash flow (liquidity) of households and firms in Mexico as well as causing an
overall deterioration in their net worth due to increased debt burdens.
- Also, the Mexican economy was hit by several serious political shocks in
1994: namely, an uprising in the southern state of Chiapas; and the
assassination of a well-known political figure (Luis Donaldo Colosio, the
presidential candidate of the ruling party).
- Banks thus became less certain about the ability of households and firms to
make debt payments, which further amplified adverse selection and moral
- Stage Two: Foreign Exchange Crisis
- Efforts by Mexico to protect the peso by increasing interest rates
failed. The Mexican central bank was forced to devalue the peso (i.e., to let E rise) on December
20, 1994. This, combined with the deteriorating conditions in Mexican
financial markets generally, due to stage one events, led to a strong flight
from the peso.
- By March 1995, the peso had lost half of its value. Actual and expected
inflation rates both increased dramatically. First, import prices were
higher for Mexican consumers. Second, higher import prices led to
price increases by domestic producers since the risk of losing customers to
foreign competitors was reduced.
- Also, because many Mexican firms had debts denominated in dollars, the
devaluation of the peso tended to result in an increase in their debt
burdens, in the sense that each dollar of debt payment now cost more in terms
of pesos. [This increased debt burden was offset to some extent by Mexican
inflation, since each peso was now worth less in real terms in Mexico.]
- Nominal interest rates on debt denominated in pesos also rose dramatically
(exceeding 100 percent a year) as lenders attempted to maintain real interest
rates at profitable levels in the face of accelerating inflation rates.
These soaring interest rates caused major cash-flow (liquidity) problems for
both households and firms.
- The Mexican stock market crashed as foreign investors increasingly fled,
unnerved by the uncertainty of political and economic conditions in Mexico.
This stock market crash seriously eroded corporate net worth.
The immediate catalyst for the stock market crash was the rapid pulling out,
by mutual fund managers, of the $45 billion in mutual fund cash that Mexico
had attracted from the rest of the world, primarily the United States, in the
early 1990s. In 1993 Mexico experienced a net capital inflow of
about $20 billion. By the fourth quarter of 1994, however, Mexico was
experiencing a net capital outflow at an annual rate of about $10
- For reasons previously discussed, these stage two events greatly
exacerbated adverse selection and moral hazard problems and led to further
- Stage Three: Banking Crisis
- The events outlined in stage one and stage two also led to a worsening of
the banking crisis.
- Loan defaults by households and firms resulted in substantial decreases
in Mexican bank assets. Also, the peso devaluation sharply increased Mexican
bank liabilities, since many short-term liabilities held by Mexican banks
were denominated in foreign currency. Consequently, the net worth of Mexican
banks decreased, forcing a cut-back in lending activity.
- On the other hand, increased adverse selection and moral hazard
problems arising from stage one and stage two events meant that Mexican banks
were also much less willing to lend to households and firms in any case, even
when not prevented from doing so by decreases in their net worth.
- Bottom Line Assessment of the Mexican Financial Crisis:
- The Mexican financial crisis was both serious and prolonged. The
Mexican economy did not begin to recover until 1996, after Mexico had
received substantial liquidity assistance.
- Specifically, in 1995 the Clinton administration put together a $49.8
billion loan guarantee package that combined guarantees from the U.S.
Treasury's Exchange Stabilization Fund -- controversial, since these were
funds normally used to support the dollar -- together with assistance from
the International Monetary Fund (IMF) and from other countries through the
Bank for International Settlements.
- At the time, this guarantee package constituted the largest international rescue package that had ever been assembled. The U.S. gambled that Mexico was basically solvent, that it was simply experiencing a temporary cash-flow problem which appropriate liquidity assistance could alleviate. The subsequent recovery of
the Mexican economy appears to support this assessment.
- The Mexican financial crisis, along with those of other emerging market countries in recent times, has led global financial analysts to call for the more formal development of an international safety net.
- One proposal concerns the permanent formation of an international
lender-of-last-resort institution that would function in a manner similar to the Federal Reserve discount window in the U.S. The purpose of such an institution would be to relieve temporary liquidity problems caused by rapid movements of capital into and out of countries.
- A key issue here, however, is a fear of creating moral hazard problems
(incentives for higher risk taking). It is not clear how monitoring and
enforcement of loan contracts between sovereign countries could effectively
be carried out to prevent this moral hazard.
- Another proposal has been to empower the IMF to become a kind of global
Securities and Exchange Commission that could require governments to
continually provide up-to-date publicly available information
regarding their financial condition. Such public disclosures might help to
reduce uncertainty and unwarranted panics on the part of international
investors. This, in turn, might help to prevent the large sudden movements
of capital into and out of countries that seem to have been a key
precipitating factor in many of the financial crises that have plagued
developing countries in recent times.
- One problem with this proposal, however, is that, at least until
recently, the IMF itself contributed to the lack of public disclosure
concerning international financial transactions. Prior to the mid-1990s,
the IMF consistently refused to release publicly either its loan contracts or
the financial condition assessments upon which these loans contracts have
- In the face of increasing anti-IMF sentiment, however, the IMF took steps to make its activities more transparent.
- For example, according to IMF documents (www.imf.org), since May 1997 the IMF has published detailed summaries of Article IV consultations with IMF member countries --- including IMF Executive Board's assessment --- for countries that have agreed to their release.
The difficulty here would seem to lie in the proviso that a
country must agree before information is released. It is not clear to what
extent individual IMF member countries would be willing to agree to such a
release, even if they are not in any actual financial difficulty.
Basic Concepts and Key Issues for Mishkin Chapter 9
- Basic Concepts for Mishkin Chapter 9:
- economic growth
- economic development
- financial crisis
- credit crunch
- real net worth
- cash flow
- bank panic (or bank run)
- bank failure (bankruptcy)
- debt deflation
- The International Monetary Fund (IMF) again
- Key Issues for Mishkin Chapter 9:
- How do poorly functioning financial markets hurt economic
growth and development?
- Under what conditions do financial markets tend to function poorly?
- Are financial crises largely caused by information problems?
- How can interest rate increases trigger or worsen adverse
- How can increases in lender uncertainty trigger or worsen
- How can net worth declines trigger or worsen financial crises?
- How can stock market declines cause net worth to decline?
- How can inflation rate declines cause net worth to decline?
- How can exchange rate changes cause net worth to decline?
- How can interest rate increases cause net worth to decline?
- How can bank panics trigger or worsen financial crises?
- According to Mishkin, what has been the typical sequence of events for U.S. financial crises?
- What happened during the U.S. Great Depression?
- What happened during the U.S. Subprime Financial Crisis?
- Why do aggregate price level declines result in increased debt burdens?
- How can debt deflation trigger or worsen financial crises?
- Why is it important to distinguish between cash flow
(liquidity) problems and insolvency?
- According to Mishkin, what has been the typical sequence of events for recent financial crises in developing countries?
- What happened during the 1994-1995 Mexican financial crisis?
- How was Mexico assisted out of its financial crisis?
- What controversies have arisen regarding this assistance to Mexico?
- What kinds of proposals have been made regarding the institution of an international global safety net?
- What are the potential advantages and disadvantages of these proposals?
Copyright © 2011 Leigh Tesfatsion. All Rights Reserved.