Edward Gramlich in his presentation during the Jackson Hole yearly central bankers symposium of August 31, 2007, said that, 'productivity often improves in fits and starts, in other words, booms and busts play a prominent role. In the 19th century, the United States benefited from the canal boom, the railroad boom, the minerals boom, and financial boom. The 20th century saw another financial boom, a stock market boom, a post-war boom, and a dotcom boom. The details differ, but each of these cases feature initial discoveries or breakthroughs, widespread adoption, widespread investment, and then a collapse where prices cannot keep up, and many investors lose a lot of money. When the dust clears, there is financial carnage, many investors learning to be more careful next time, but there are often the fruits of the boom still around the benefits of productivity'. Indeed, the current financial crisis is another episode of excess investment due to unwarranted expectations of the results of an innovation. Investors thought the financial innovation they were using protected them from any risk. The slicing up of dubious loans and their repackaging minimizes risk by spreading it. It does not eliminate this risk, and that is what investors had forgotten. But that is not the whole story, and Gramlich acknowledges it when he said, 'the subprime market was the Wild West'. It is the lack of adequate regulation, that allowed for predatory lending and 'no-doc' loans, which, combined with the financial innovations of the last decade, was the major source of the subprime crisis. The quantity of liquidity available in the market is an amplifying factor, for when liquidity is high, interest rates are low and the appetite for risk goes up. In a liquidity scarce market, there would never have been a market for residential mortgage backed securities (RMBS); therefore, there could not have been a subprime crisis.
[...] It has to be clearly temporary otherwise jeopardising long term confidence in the US economy and thus pushing rates up In a globalised world, there necessarily will be spill-over effects on the world economy; but this crisis may also present us with the opportunity of shifting to a more sustainable structure of the world economy a. The resilience of the emerging economy is going to be tested 9 First, the financial crisis has had an effect on exchange rates. The dollar was propped by large investment flows. [...]
[...] The second difference between financial issues and insurance markets is that unwarranted lack of confidence, like excessive confidence, can hurt the economy through the financial accelerator. One related advantage in central bank intervention is that solvent institutions will need to hold less cash because investors know they are backed up, so they can take on more productive but illiquid assets. To solve the liquidity crisis, central banks have used several tools. First, the Fed cut back its rates, while the ECB refrained from raising its own rate although it had made clear early this summer that it intended to do so. [...]
[...] In the same way it explains why risk premiums are so low and why risk appetite is so high. This saving glut provided fertile soil to the current crisis. The availability of Asian and oil exporter cash pushed down mortgage rates by weighing down long-term interest rates. b. What then could be done to fight off such excessive saving tendencies in order to have an adequate amount of liquidity? The two sources of this glut are very different. For the Gulf States, the message as always is: develop your economies and take better care of your populations. [...]
[...] The financial crisis, even if mitigated, will have negative effects on the real economy. B. There will be an impact on US and World real economy growth but its size will depend on United States' policy and the resilience of the emerging economies 1. The consequences of this crisis on the US economy will cut back at growth a. This crisis will cut back the growth of the US economy There are two channels through which the financial turmoil will impact the real economy. [...]
[...] The financial accelerator explains how excess liquidity or a change in expectations due to innovation lead to the formation of bubbles. The model was built using companies but can be extended to households. Their hypothesis is that lenders insure themselves against default thanks to a risk premium that varies according to the expected results of the firm. Firms, have an optimal investment level 5 proportional to their value, under constraint of borrowing costs. If company results are expected to go up, the risk premium goes down, so borrowing costs follow suit and therefore investment goes up. [...]
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