THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 229

CHAPTER 9

Financial Crises and the Subprime Meltdown

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FACTO RS CAU SI NG FI N AN CIA L CRIS ES
In the previous chapter we saw that a well-working financial system solves asymmetric information problems so that capital is allocated to its most productive uses.
A financial crisis occurs when an increase in asymmetric information from a disruption in the financial system causes severe adverse selection and moral hazard problems that render financial markets incapable of channelling funds efficiently from
savers to households and firms with productive investment opportunities. When
financial markets fail to function efficiently, economic activity contracts sharply.
To understand why financial crises occur and, more specifically, how they lead
to contractions in economic activity, we need to examine the factors that cause
them. Six categories of factors play an important role in financial crises: asset market effects on balance sheets, deterioration in financial institutions balance sheets,
banking crises, increases in uncertainty, increases in interest rates, and government fiscal imbalances. We will examine each of these factors and their impact on
lending, investment, and economic activity.

Asset Market
Effects on
Balance
Sheets

The state of borrowers balance sheets has important implications for the severity
of asymmetric information problems in the financial system.
A sharp decline in the stock market is one factor that
can cause a serious deterioration in borrowing firms balance sheets. In turn, this
deterioration can increase adverse selection and moral hazard problems in financial markets and provoke a financial crisis. A decline in the stock market means
that the net worth of corporations has fallen, because share prices are the valuation of a corporation s net worth. The decline in net worth makes lenders less willing to lend because, as we have seen, the net worth of a firm plays a role similar
to that of collateral. When the value of collateral declines, it provides less protection to lenders, meaning that losses on loans are likely to be more severe. Because
lenders are now less protected against the consequences of adverse selection, they
decrease their lending, which in turn causes investment and aggregate output to

decline. In addition, the decline in corporate net worth as a result of a stock market decline increases moral hazard by providing incentives for borrowing firms to
make risky investments, as they now have less to lose if their investments go sour.
The resulting increase in moral hazard makes lending less attractive another reason why a stock market decline and the resultant decline in net worth leads to
decreased lending and economic activity.

STOCK MARKET DECLINE

In economies with moderate
inflation, which characterizes most industrialized countries, many debt contracts
with fixed interest rates are typically of fairly long maturity (ten years or more). In
this institutional environment, unanticipated declines in the aggregate price level
also decrease the net worth of firms. Because debt payments are contractually
fixed in nominal terms, an unanticipated decline in the price level raises the value
of borrowing firms liabilities in real terms (increases the burden of their debt) but
does not raise the real value of firms assets. The result is that net worth in real
terms (the difference between assets and liabilities in real terms) declines. A sharp
drop in the price level therefore causes a substantial decline in real net worth for
borrowing firms and an increase in adverse selection and moral hazard problems
facing lenders. An unanticipated decline in the aggregate price level thus leads to
a drop in lending and economic activity.

UNANTICIPATED DECLINE IN THE PRICE LEVEL