Everything You Need to Know About the Financial Crisis

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This post is a guest contribution by Doug Diamond* and Anil Kashyap** of the University of Chicago’s Graduate School of Business.

1) Why has the stock market been so erratic for the last two weeks?
The stock market’s value depends on the future profitability of firms. In a sluggish economy, the stock market typically falls well before unemployment peaks. The declines last week reflected the concern that the economy is headed toward a sharp slowdown for an extended period of time.

For some time, the basis for this concern was a fear that lending throughout the economy was drying up. Without credit, most businesses would not be able to function, and many individuals would have to cut their spending.

Until this week, it appeared to be increasingly possible that there could be widespread bank failures that would impair the lending capacity of the banking system for a long time. We agree with the words of words of Ben Bernanke this week: “As in all past crises, at the root of the problem is a loss of confidence by investors and the public in the strength of key financial institutions and markets …”

Banks are vulnerable to loss of confidence because they rely on short-term funding. This fear causes two problems. First, banks hoard their own cash and become especially reluctant to lend to other banks. Second, nonfinancial institutions pull back their lending to banks to avoid any chance of being defaulted upon. These problems reinforce the fear and keep lending markets frozen. It is rational for investors to reduce exposure to the stock market in this kind of a cycle.

There are several pieces of evidence suggesting that the markets are fragile and especially concerned with the health of the banks.

One indication is that lending rates for three-month loans between banks steadily rose during the last month, and they kept rising last week even after central banks around the world cut interest rates. These interbank borrowing rates only started to decline this week after the steps described below were announced.

A second is that last Friday afternoon, the Dow Jones industrial average stock index began climbing sharply, precisely at the time of the announcement that no banks were going to fail as a result of settling the credit-default swap contracts that paid off the losses on bonds of Lehman Brothers.

Finally, earlier this week, stock markets around the world rallied on the news that the U.S. and European governments had agreed on steps to prevent large banks from failing. These anecdotes hardly prove that the systemic banking concerns were paramount, but they are consistent with that view.

Click here for the full report.

* Douglas Diamond is the Merton H. Miller Distinguished Service Professor of Finance at the University of Chicago’s Graduate School of Business. He joined the faculty in 1979 and specializes in the study of financial intermediaries, financial crises and liquidity.

** Anil Kashyap is the Edward Eagle Brown Professor of Economics and Finance at the University of Chicago’s Graduate School of Business. Kashyap joined the faculty in 1991 and currently teaches courses on “Corporation Finance” and “Understanding Central Banks”.

Source: Steven Levitt, Freakonomics, The New York Times, October 15, 2008.

 

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2 comments to Everything You Need to Know About the Financial Crisis

  • Some Random Guy

    “We agree with the words of words of Ben Bernanke this week: “As in all past crises, at the root of the problem is a loss of confidence by investors and the public in the strength of key financial institutions and markets …” ”

    What a collection of BS!!!
    The ROOT of the problem are:

    1 – The Fractional Reserve System and “Monetarism”
    2 – The orgy of cheap $$$ that Grenspan unleashed
    3 – The idiocy of legislators when they de-regulated banks

    GEEESHHHH!!!!

    Even my cat knows this!!!

  • masjim

    Does not selling by banks, hedge funds, and other institutions to cover their obligations also contribute to the collapse of stock prices?

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