CHAPTER 9 DYNAMIC P OWERP OINT™ S LIDES BY S OLINA L INDAHL Saving, Investment, and the Financial System CHAPTER OUTLINE The Supply of Savings The Demand to Borrow Equilibrium in the Market for Loanable Funds The Role of Intermediaries: Banks, Bonds, and Stock Markets What Happens When Intermediation Fails? The Financial Crisis of 2007–2008: Leverage, Securitization, and Shadow Banking For applications, click here To Try it! questions To Video Food for Thought…. Some good blogs and other sites to get the juices flowing: Introduction In this chapter we learn how the loanable funds market: brings savers and borrowers together to make both better off. gathers savings and allocates it to the most profitable investments. promotes economic growth. BACK TO Important Definitions Saving: income that is not spent on consumption goods. Investment: purchase of new capital goods. Caution: “Investment” is defined differently by economists than by stockbrokers. BACK TO The Supply of Savings What Determines the Supply of Savings? 1. Smoothing consumption 2. Impatience 3. Market and psychological factors 4. Interest rates BACK TO The Supply of Savings 1. Individuals Want to Smooth Consumption Save during working years to provide for retirement. Savings rises as life expectancy rises (or retirement age drops) Manage fluctuations in income. Save during good times in order to ride out the bad times. BACK TO Savings Help Smooth Consumption Income Consumption Path A: consumption = income, Path B: By saving during working years, consumption can be smoothed. Saving Path B Dissaving Path A Working Years Retirement Time BACK TO The Supply of Savings 2. Individuals Are Impatient Time preference: the desire to have goods and services sooner rather than later. Anything with immediate costs and future benefits must overcome time preference. • College education People who discount future consumption more will save less now. BACK TO Professor Philip Zimbardo (of the famous Stanford prison experiment) conveys how our individual perspectives of time affect our work, health and well-being with the animation expertise at RSA Animate. Time influences who we are as a person, how we view relationships and how we act in the world. (10:09 minutes) To next Video BACK TO The Supply of Savings 3. Marketing and Psychological Factors The way choices are presented makes a difference. Example 1: Retirement savings plans Result: Participation in the savings plan was 25% higher for companies with automatic enrollment. Will he give his 401K much thought? Not necessarily. BACK TO The Supply of Savings 4. The Interest Rate Interest is the reward for savings. It’s the “price” of savings. The higher the interest rate, the greater the quantity saved. BACK TO The Supply of Savings Interest rate Supply of savings 10% The higher the interest rate, the greater the amount of savings. 5% $200 $280 Savings (billions of dollars) BACK TO The Demand to Borrow What determines the demand for borrowing? 1. Smoothing consumption 2. Financing large investments 3. The interest rate BACK TO The Demand to Borrow 1. Smoothing Consumption Lifecycle Theory of Saving Nobel laureate Franco Modigliani: By borrowing, saving, and dissaving at different times in life, workers can smooth their consumption path, improving their overall satisfaction. Governments also smooth consumption for wars, deficits, etc. BACK TO The Demand to Borrow Income Consumption By borrowing, saving, and dissaving, workers can smooth their consumption. Saving Consumption Path Income Path Borrowing Dissaving Time College, buying first home Prime working years Retirement BACK TO The Demand to Borrow 2. Borrowing Is Necessary to Finance Large Investments Without the ability to borrow many profitable investments will not happen. Example: Fred Smith and FedEx Many ventures cannot “start small.” Needed: start-up funds BACK TO The Demand to Borrow 3. The Interest Rate Determines the cost of the loan. An investment will be profitable only if its rate of return is greater than the interest rate. The higher the interest rate, the smaller the quantity demanded of savings will be: because there are fewer investments that “make the cut” of yielding a higher return than it costs to borrow the funds to finance the project. BACK TO The Demand to Borrow Interest rate The higher the interest rate, the lower the demand to borrow. 10% 5% Demand to borrow $190 $300 Savings (billions of dollars) BACK TO Equilibrium in the Market for Loanable Funds The Market for Loanable Funds: Is where suppliers of loanable funds (savers) trade with demanders of loanable funds (borrowers). BACK TO Equilibrium in the Market for Loanable Funds Interest rate Supply Surplus → ↓ i 10% Equilibrium interest rate 8% 5% Shortage → ↑ i Demand $190 $200 $250 $280 $300 Equilibrium quantity of savings/borrowing Savings/borrowing (in billions of dollars) BACK TO Equilibrium in the Market for Loanable Funds Shifts in Supply and Demand If Supply or Demand shifts, the equilibrium interest rate, quantity of savings and investment will change. Examples: The stock market crashes: household wealth drops → people save more to restore their wealth. The economy goes into a recession and investors become more pessimistic. BACK TO Shifts in Supply and Demand If Supply or Demand shifts, the equilibrium interest rate, quantity of savings and invest. If the stock market crashes, people save more to restore their wealth. Interest rate Results: 1.Lower equilibrium interest rate 2.Greater savings/borrowing Old Supply New supply 8% 5% Demand $250 $300 Savings/borrowing (in billions of dollars) BACK TO Shifts in Supply and Demand If investors become more pessimistic during a recession, they reduce their borrowing. Interest rate Supply Result: 1.Lower equilibrium interest rate 2.Lower savings/borrowing 8% 5% Old Demand New demand $200 $250 Savings/borrowing (in billions of dollars) BACK TO Try it! If the government gives a tax credit on investment, then which of the following is TRUE about the loanable funds market? a) The demand for loanable funds will increase, and the interest rate will also increase. b) The demand for loanable funds will decrease, and the interest rate will decrease. c) The supply of loanable funds will decrease, and the interest rate will increase. To next Try it! Try it! If savers don't feel safe putting their money in banks or buying bonds, what's the best way to sum up what's happening in the market for loanable funds? a) b) c) d) Supply of savings falls and the interest rate falls. Supply of savings falls and the interest rate rises. Demand for savings falls and the interest rate falls. Demand for savings falls and the interest rate To next rises. Try it! The Role of Intermediaries: Banks, Bonds, and Stock Markets Financial Institutions reduce the costs of moving savings from savers to borrowers and investors. Middlemen who help coordinate financial markets. Help move savings to more highly valued uses. We examine three financial intermediaries: 1. Banks 2. Bond markets 3. Stock markets BACK TO The Role of Intermediaries: Banks, Bonds, and Stock Markets Banks: Gather savings Reduce risk by evaluating ability to pay off loans. Spread risk When a borrower defaults on a loan, the bank spreads the loss among many depositors. Coordinate lenders and borrowers. Minimize information costs. Conclusion: Banks help gather savings and allocate it to the most productive uses. BACK TO Try it! Think-Pair-Share: Besides decreasing the number of banks, how do bank failures hinder financial intermediation? To next Try it! The Role of Intermediaries: Banks, Bonds, and Stock Markets The Bond Market A bond is a sophisticated IOU that documents who owns how much and when payment must be paid. Issuing bonds allows borrowing directly from the public. Lender: one who buys a bond Borrower: one who issues a bond Corporations and governments at all levels borrow money by issuing bonds. BACK TO The Role of Intermediaries: Banks, Bonds, and Stock Markets The Bond Market (cont.) All bonds involve a risk. Major issues are graded by rating companies: Standard and Poor’s Moody’s Grades range from lowest risk (AAA) bonds in current default (D) The higher the risk the greater the interest rate required to get lenders to buy the bonds. BACK TO The Role of Intermediaries: Banks, Bonds, and Stock Markets Collateral: something of value that by agreement becomes the property of the lender if the borrower defaults. The higher the collateral the lower the risk (and therefore interest rate) Other elements of interest rate determination: Repayment time Amount of loan Type of collateral Risk of borrower default BACK TO The Role of Intermediaries: Banks, Bonds, and Stock Markets The Bond Market: Examples Berkshire Hathaway (Warren Buffett) • Bond rating: AAA • Interest rate: 4.48% Ford Motor Company Note: lower bond ratings increase the cost of borrowing • Bond rating: B • Interest rate: 5.76% Home mortgage rates are lower than vacation loans because mortgage loans are backed by collateral. Conclusion: the higher the risk the higher will be the rate of return. BACK TO The Role of Intermediaries: Banks, Bonds, and Stock Markets The Bond Market (cont.) Governments issue bonds to borrow money. Government borrowing can crowd out private spending. Crowding-out: the decrease in private consumption and investment that occurs when government borrows more. Here’s how crowding-out works: ↑borrowing→ ↑interest rate → ↑Saving ↓consumption ↓Investment BACK TO The Role of Intermediaries: Banks, Bonds, and Stock Markets So, government borrowing Reduces private borrowing Interest rate Govt. borrows $100 billion Supply interest rate due to demand 9% b c 7% a private spending of $50 billion due to higher cost of borrowing (private demand falls from $200b to $150b) Private demand $150 $200 $250 Private demand +$100 billion govt. demand Savings/borrowing (in billions of dollars) BACK TO The Role of Intermediaries: Banks, Bonds, and Stock Markets Different kinds of U.S. bonds: T-bonds: 30 year maturity, pay interest every 6 months. T-notes: 2 to 10 year maturity, pay interest every 6 months. T-bills: mature in 2 days to 26 weeks, pay interest only at maturity. Bonds that pay interest at maturity are called zero-coupon bonds. Short-term U.S. government bonds tend to be the safest assets. BACK TO The Role of Intermediaries: Banks, Bonds, and Stock Markets Bond Prices and Interest Rates A bond can be sold any time before maturity. Sellers of bonds compete to attract lenders. Face Value (FV): how much the bond is worth at maturity. Rate of Return: the implied interest rate (%) the bond earns. FV - Price Rate of Return for a zero - coupon bond 100 Price BACK TO The Role of Intermediaries: Banks, Bonds, and Stock Markets Example: Suppose a low risk bond will pay $1,000 one year from now. If you pay $950 for the bond now, the rate of return on the bond will be: $1,000 $950 100 5.26% $950 Unless the market rate of interest is less than 5.26%, no one will buy the bond. The less paid for the bond, the greater will be the rate of return. The higher the market rate of interest, the less anyone will pay for the bond. BACK TO Try it! Suppose you paid $800 for a zerocoupon bond with a face value of $1,000. If you held that bond until maturity, then the rate of return would be a) –20% b) 20% c) –25% d) 25% To next Try it! The Role of Intermediaries: Banks, Bonds, and Stock Markets Takeaways: 1. Equally risky assets must have the same rate of return If not, there will likely be arbitrage Arbitrage: the buying and selling of equally risky assets (to exploit differences in price). Arbitrage is covered in more detail in the appendix. 2. Interest rates and bond prices move in opposite directions Changing interest rates will change a bond’s market value. This means that bond buyers face interest rate risk along with default risk. BACK TO The Role of Intermediaries: Banks, Bonds, and Stock Markets The Stock Market A stock (or a share) is a certificate of ownership in a corporation. Stocks are traded in organized markets called stock exchanges. New York Stock Exchange (NYSE) is the largest. Tokyo Stock Exchange (TSE) is the second largest. BACK TO The Role of Intermediaries: Banks, Bonds, and Stock Markets Sales of new shares: IPO (initial public offering): the first time a corporation sells stock to the public in order to raise capital Typically used to buy new capital goods. Stock markets encourage investment and growth. BACK TO What Happens When Intermediation Fails? The bridge between saving and investment breaks down. Economic growth suffers. BACK TO Richard Thaler, (Professor, The University of Chicago Booth School of Business): We Failed to Learn From the Hedge Fund Failures of the Late 90s. His message to overconfident risk managers: there’s more risk out there than you think. (2:02 minutes) BACK TO What Happens When Intermediation Fails? Insecure Property Rights Some governments fail to protect property rights. Saved funds can be confiscated, frozen, and otherwise restricted. Result: people are reluctant to put their savings in domestic institutions. Example: Argentina and Brazil Both have a history of freezing bank accounts. Argentines and Brazilians save less. Result: less investment and lower economic growth. BACK TO What Happens When Intermediation Fails? Controls on Interest Rates and Inflation Usury Laws: create legal ceilings on interest rates. Result: less saving and investment. Most American states have usury laws but: They often have loopholes (e.g., don’t apply to credit cards). They are set at levels too high to affect most loan markets. BACK TO What Happens When Intermediation Fails? Effect of Usury Laws Interest rate 8% Supply of savings Market Equilibrium Results: 1.Shortage of savings 2.Less savings/investment 3.Slower economic growth Controlled Interest rate Shortage Demand $190 $250 $300 Savings/borrowing (in billions of dollars) BACK TO What Happens When Intermediation Fails? Inflation When combined with controls on interest rates, inflation destroys the incentive to save. Nominal and real interest rates: Nominal interest rate: the named rate; the rate on paper. Real interest rate: the rate of return after adjusting for inflation. Therefore: Real rate Nominal rate - Inflation rate BACK TO Try it! If the yearly nominal interest rate on a savings account is 5%, and the rate of inflation over the same period of time is 2%, what is the real interest rate? a) 5% b) 2% c) 7% d) 3% To next Try it! What Happens When Intermediation Fails? Example: Suppose interest rates are controlled at a nominal rate of 10% and the rate of inflation is 30%. Then: Real rate 10% - 30% - 20% Result: Savers are losing 20% a year. Saving is discouraged. Less investment and slower economic growth. BACK TO Negative Interest Rates and Economic Growth Country Argentina Bolivia Chile Ghana Peru Poland Sierra Leone Turkey Venezuela Zaire Zambia Years 1975-1976 1982-1984 1972-1974 1976-1983 1976-1984 1981-1982 1984-1987 1979-1980 1987-1989 1976-1979 1985-1988 Real Interest Rate (%) -69 -75 -61 -35 -19 -33 -44 -35 -24 -34 -24 Per capita growth (%) -2.2 -5.2 -3.6 -2.9 -1.4 -8.6 -1.9 -3.1 -2.7 -6.0 -1.9 Source: Easterly (2002, p. 228) BACK TO What Happens When Intermediation Fails? Politicized Lending and Government Owned Banks Example: Japan 1990 to 2005. Many banks were bankrupt or propped up by the government (“Zombie banks”). They were not loaning funds for efficient uses. Other banks were pressured to lend money to well-connected political allies. Result: economic growth was zero during this period. BACK TO What Happens When Intermediation Fails? Bank Failures and Panics Systemic problems usually lead to large-scale economic crises. During the Depression, between 1929-1933: 11,000 banks (almost half of U.S. banks) failed. Ripple effects: Businesses could not get working capital. Many people lost their life savings, resulting in lower spending. BACK TO What Happens When Intermediation Fails? Result: Huge amounts of bad loans on the books of financial institutions. Banks could not get funds to loan. The bridge between savers and borrowers collapsed. Click the image below for a video clip. BACK TO The Financial Crisis of 2007–2008 Financial Crisis 2007-2008 Many mortgage loans were bundled and sold as if they had very low risk. Some were sold on false terms. Credit rating agencies failed at their job. People expected housing prices to continue to rise. Housing prices fell. Many people defaulted on their mortgages. BACK TO The Financial Crisis of 2007–2008: Leverage, Securitization, and Shadow Banking 1. Leverage: Since everyone assumed real estate values would only climb, both households and banks became much more “leveraged”. Owner equity is the value of the asset minus the debt, E = V − D. The leverage ratio is the ratio of debt to equity, D/E. An insolvent firm has liabilities that exceed its assets. The problem? None… unless real estate drops. BACK TO The Financial Crisis of 2007–2008: Leverage, Securitization, and Shadow Banking BACK TO The Financial Crisis of 2007–2008: Leverage, Securitization, and Shadow Banking 2. Securitization: Loans can be bundled together (“securitized”) and then sliced up and sold on the market as financial assets. This has benefits: Provides safety and liquidity for the bank selling the securitized mortgages Provides a path for others to invest in the American economy And it has costs: Securitization can hide risk and bad loans. BACK TO The Financial Crisis of 2007–2008: Leverage, Securitization, and Shadow Banking 3. The “Shadow Banking System” Alternative banks (hedge funds, money markets and investment banks) have grown up in the shadow of traditional commercial banks. 2008: these “Shadow banks” loaned $20 trillion (more than traditional banks) Shadow banks are not insured by the FDIC, nor are they heavily regulated. When investors got worried about Lehman Brothers’ solvency, it set off a wider bank panic and government bailouts. BACK TO Inside the Meltdown investigates the causes of the worst economic crisis in 70 years and how the government responded. The film chronicles the inside stories of the Bear Stearns deal, Lehman Brothers' collapse, the propping up of insurance giant AIG and the $700 billion bailout. It also examines what Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke didn't see and couldn't stop. (56 minutes) BACK TO Try it! Do you think it’s necessary for the Federal Government (and taxpayers) to bail out banks when they are on the verge of collapse? a) Yes b) No BACK TO