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:
http://www2.econ.iastate.edu/classes/econ353/tesfatsion/

  1. Financial Development and Economic Growth
  2. Financial Crises and Aggregate Economic Activity
  3. Financial Crises: Case Studies
    1. General Form of Financial Crises in the United States
    2. Illustration: U.S. Great Depression (see ppt notes)
    3. Illustration: 2007-2011 U.S. Subprime Financial Crisis (see ppt notes)
    4. General Form of Financial Crises in Developing Countries: Overview
    5. Illustration: The 1994-5 Financial Crisis in Mexico
  4. 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.

NOTE:
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
     i*|....... n...........d
       |       n           o d    Demand
       |      n           o    d  Curve
       |     n           o       d
       |---------------------------------- Loanable
       0                                   Funds

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 the left.

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
            e             P (T+1)  -  P(T)
(1)      inf (T,T+1)  =  -----------------
                               P(T)

where Pe(T+1) denotes the expected aggregate price level in period T+1.

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

(2)

ireal(T) = inom(T) - infe(T,T+1).

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 over time.

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 foreign currencies.

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 currencies.

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 rate.

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 cash expenditures.

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 rates.

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 problems.

Factor 4. Problems in the Banking Sector

Problems in the banking sector are another factor that can cause financial crises.

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 bankruptcy. That 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 problems.

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 conditions.

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 is falling:

                             P(T+1) - P(T)
(3)           inf(T,T+1)  =  --------------   <   0   .
                                 P(T)

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 1930s.]


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 activity.

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 hazard problems.

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 billion.

For reasons previously discussed, these stage two events greatly exacerbated adverse selection and moral hazard problems and led to further economic decline.

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 been based.

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:

Key Issues for Mishkin Chapter 9:

Copyright © 2011 Leigh Tesfatsion. All Rights Reserved.