THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 234

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PA R T I I I

Financial Institutions
funds mean fewer loans and a credit freeze. The lending boom turns into a lending crash.
As we have seen, banks and other financial intermediaries play a crucial role
in financial markets because they are well suited to collect information about businesses and industries. This ability in turn enables these institutions to distinguish
good loan prospects from bad ones. When financial intermediaries deleverage and
cut back on their lending, no one else can step in to collect this information and
make these loans. The ability of the financial system to cope with the asymmetric
information problems of adverse selection and moral hazard is therefore severely
hampered (as shown in the arrow pointing from the first factor in the top row of
Figure 9-1). As loans become scarcer, firms are no longer able to fund their attractive investment opportunities; they decrease their spending and economic activity
contracts.
Asset prices, in the stock market and real estate,
can be driven well above their fundamental economic values by investor psychology (dubbed irrational exuberance by Alan Greenspan when he was
Chairman of the U.S. Federal Reserve). The result is an asset-price bubble, such
as the tech stock-market bubble of the late 1990s or the recent housing-price bubble in the United States that we will discuss later in this chapter.
Asset-price bubbles are often also driven by credit booms, in which the large
increase in credit is used to fund purchases of assets, thereby driving up their
price. When the bubble bursts and asset prices realign with fundamental economic
values, the resulting decline in net worth increases asymmetric information (as
shown by the arrow pointing from the second factor in the top row of Figure 9-1),
making borrowers less credit-worthy and causing a contraction in lending and
spending along the lines we discussed in the previous section.
The asset-price bust can also, as we have seen, lead to a deterioration in financial institutions balance sheets, which causes them to deleverage, further contributing to the decline in economic activity.

ASSET PRICE BOOM AND BUST

Many Canadian financial crises were precipitated

by increases in interest rates, either when interest rates shot up in the United States
or when bank panics led to a scramble for liquidity in Canada that produced sharp
upward spikes in interest rates.
Higher interest rates lead to declines in cash flow for households and firms and
a reduction in the number of good credit risks who are willing to borrow, both of
which increase adverse selection and moral hazard (as shown by the arrow pointing from the third factor in the top row of Figure 9-1), causing a decline in economic activity.

SPIKES IN INTEREST RATES

Canadian financial crises have almost always
started when uncertainty is high, either after a recession has begun or the stock
market has crashed. The failure of a major financial institution is a particularly
important source of heightened uncertainty that features prominently in financial
crises. Examples in Canadian history are the Bank of Upper Canada in 1866, the
Home Bank in 1923, and the bank panic of 1879. Since good financial information
is harder to come by in a period of high uncertainty, adverse selection and moral
hazard problems increase, leading to a decline in lending and economic activity
(as shown by the arrow pointing from the last factor in the top row of Figure 9-1).

INCREASE IN UNCERTAINTY