Chapter 9 Saving Investment and the Financial System

Chapter 9 Saving, Investment, and the Financial System MODERN PRINCIPLES OF ECONOMICS Third Edition

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 2

Introduction § Savings are necessary for capital accumulation. § The more capital an economy can invest, the greater is GDP per capita. § Connecting savers and borrowers increases the gains from trade and smoothens economic growth. 3

Definition Saving: Income that is not spent on consumption goods. Investment: The purchase of new capital goods. 4

Supply of Savings § Four of the major factors that determine the supply of savings: • • Smoothing consumption. Impatience. Marketing and psychological factors. Interest rates. 5

Smoothing Consumption § If you consume what you earn every year, consumption is high during your working years. § After retirement consumption drops precipitously. § You can smooth your consumption by saving during the working years and dissaving during the retirement years. § Saving also builds a cushion for unemployment or unexpected health problems. 6

Smoothing Consumption 7

Impatience § Most individuals prefer to consume now rather than later. § The more impatient a person, the more likely that person’s savings rate will be low. § Impatience is reflected in any economic situation where people must compare costs and benefits over time. § Criminals, addicts, alcoholics, and smokers all tend to discount the future more heavily. 8

Definition Time preference: The desire to have goods and services sooner rather than later (all else being equal). 9

Marketing and Psychological Factors § Individuals save more if saving is presented as the natural or default alternative. § The retirement savings plan participation rate was 25% higher in businesses that used automatic enrollment rather than opt in. § The default also mattered for how much was saved. § Simple psychological changes, combined with marketing, can change how much people save. 10

The Interest Rate Interest rate Supply of savings 10% The higher the interest rate, the greater the quantity saved 5% $200 $280 Savings (billions of dollars) 11

Self-Check Which of the following is a major factor in determining the supply of savings? a. GDP. b. Patience. c. Investment. Answer: b – patience is one of the major factors, along with consumption smoothing, interest rates, and marketing and psychological factors. 12

The Demand to Borrow § One reason people borrow is to smooth consumption. § Many young people borrow to invest in their education. § Borrowing moves some sacrifices into future periods when students’ income is higher. § By borrowing, saving, and dissaving, workers can smooth their consumption over their lifetime. 13

The Demand to Borrow The lifecycle theory of savings puts the demand to borrow and save together. 14

The Demand to Borrow § Businesses borrow to finance large projects. § Often the people with the best business ideas are not the people with the most savings. • Example: Fred Smith and Fed. Ex • Many ventures cannot “start small” § The ability to borrow greatly increases the ability to invest. § Higher investment increases the standard of living and the rate of economic growth. 15

The Demand to Borrow The lower the interest rate, the greater the quantity of funds demanded. 16

Definition Market for loanable funds: Occurs when suppliers of loanable funds (savers) trade with demanders of loanable funds (borrowers). Trading in the market for loanable funds determines the equilibrium interest rate. 17

The Demand to Borrow § Interest Rates – the “price” of money § 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: § There are fewer investments that “make the cut” of yielding a higher return than it costs to borrow the funds to finance the project 18

Equilibrium in Loanable Funds § In equilibrium, the quantity of funds supplied equals the quantity of funds demanded. § The interest rate adjusts to equalize savings and borrowing. § If the interest rate is higher than equilibrium, the quantity of savings supplied > the quantity of savings demanded, creating a surplus. § With a surplus of savings, suppliers will bid the interest rate down as they compete to lend. 19

Equilibrium in Loanable Funds Interest rate Supply of savings Equilibrium 8% interest rate $250 Demand to borrow Equilibrium quantity of savings/borrowing Savings/borrowing (in billions of dollars) 20

Equilibrium in Loanable Funds Interest rate Supply of savings 10% 8% Demand to borrow $280 $250 $190 Surplus Savings/borrowing (in billions of dollars) 21

Equilibrium in Loanable Funds Interest rate Supply of savings 10% 8% 6% Demand to borrow $300 $250 $200 Shortage Savings/borrowing (in billions of dollars) 22

Self-Check If there is a shortage of loanable funds, the interest rate will: a. Increase. b. Decrease. c. Stay the same. Answer: a – increase; if there is a shortage, borrowers will bid the rate up. 23

Shifts in Supply and Demand § Changes in economic conditions will shift the supply or demand curve. § The shift will change the equilibrium interest rate and quantity of savings. § Example: § If the stock market crashes, people save more to restore their wealth 24

People Become More Thrifty Interest rate 8% Supply of savings New supply of savings Lower interest rate 5% Demand to borrow $250 $300 Greater savings and borrowing Savings/borrowing (in billions of dollars) 25 25

Shifts in Supply and Demand § Example: § Investors become more pessimistic during a recession and reduce their borrowing § Causes demand curve for loanable funds to shift inward (a reduction in demand). 26

Investors Become Less Optimistic Interest rate 8% Supply of savings Lower interest rate 5% Demand to borrow New demand to borrow $200 $250 Lower savings and borrowing Savings/borrowing (in billions of dollars) 27 27

Definition Financial intermediaries: Such as banks, bond markets, and stock markets reduce the costs of moving savings from savers to borrowers and investors. 28

The Role of Intermediaries § Equilibrium in the market for loanable funds does not come about automatically. § Savers move their capital to find the highest returns. § Entrepreneurs must find the right investments and the right loans. § Financial intermediaries (“middlemen”) reduce the costs of moving savings from savers to borrowers and help mobilize savings toward productive uses. 29

Banks § Banks receive savings from many individuals and pay them interest. § They loan these funds to borrowers, charging them interest. § Banks earn profit by charging more for their loans than they pay for the savings. § They earn this money by providing services such as evaluating investments and spreading risk. 30

Banks § By specializing in loan evaluation, banks are better able to decide which business ideas make sense. § It would be wasteful if every saver spent time evaluating the same business. § Banks coordinate lenders and minimize information costs. § Banks spread default risk across many lenders. § Banks also play a role in the payments system. 31

Self-Check The main function of financial intermediaries is to: a. Make capital investments. b. Provide investment advice. c. Mobilize savings towards productive uses. Answer: c – financial intermediaries reduce the costs of moving savings to investors and mobilize the savings towards productive uses. 32

The Bond Market § Investors can more easily find information about large, well-known corporations. • They are therefore more willing to bypass banks and lend to these companies directly. § Governments use bonds extensively as well § A corporation acknowledges its debt to a member of the public by issuing a bond, or corporate IOU. § The bond contract lists how much is owed, the rate of interest, and when payment is due. 33

The Bond Market § Bonds are a way to raise a large sum of money for long-lived assets, and pay it back over a long period of time. § All bonds involve default risk, or the risk that the borrower will not pay back the loan. • A risky company has to pay higher interest to compensate lenders for a greater risk of default. § Interest rates differ depending on the borrower, repayment time, amount of the loan, type of collateral, and many other features. 34

The Bond Market • 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. 35

Definition Collateral: Something of value that by agreement becomes the property of the lender if the borrower defaults. 36

Self-Check Something of value that becomes the property of the lender if the borrower defaults is called: a. Collateral. b. Interest. c. A bond. Answer: a – this is called collateral. 37

Definition Crowding out: The decrease in private consumption and investment that occurs when government borrows more. 38

The Bond Market Interest rate 9% 7% Supply of savings Government borrows $100 b b c a Private demand $150 $200 $250 Private +$100 b govt. demand Savings/borrowing An increase in government borrowing crowds out private consumption and investment. 39

The Bond Market Supply of savings Interest rate 9% 7% b c a The higher interest rate draws forth more savings; private consumption falls. Private demand $150 $200 $250 Private +$100 b govt. demand Savings/borrowing An increase in government borrowing crowds out private consumption and investment. 40

The Bond Market Supply of savings Interest rate 9% 7% b c a The higher interest rate also reduces the demand to borrow and invest. Private demand $150 $200 $250 Private +$100 b govt. demand Savings/borrowing An increase in government borrowing crowds out private consumption and investment. 41

U. S. Government Bonds § Treasury securities are desirable because they are easy to buy and sell and the U. S. government is unlikely to default. § T-bonds – 30 -year bonds; pay interest every 6 months. § T-notes – maturities ranging from 2 to 10 years; pay interest every 6 months. § T-bills – maturities of a few days to 26 weeks; pay only at maturity. § Zero-coupon bonds – pay only at maturity. 42

Bond Prices and Interest Rates § The value of a bond at maturity is called the face value (FV). § The rate of return, or implied interest rate, on a zero-coupon bond can be calculated as: § If you pay $909 for a 1 -year bond with a face value of $1, 000: 43

Bond Prices and Interest Rates § Equally risky assets must have the same rate of return. § If they didn’t, no one would buy the asset with the lower rate of return. § The price would fall until the rate of return was competitive with other investments. § This is called an arbitrage principle. 44

Definition Arbitrage: The buying and selling of equally risky assets; arbitrage ensures that equally risky assets earn equal returns. 45

Bond Prices and Interest Rates § Interest rates and bond prices move in opposite directions. § When interest rates go up, bond prices fall; when interest rates go down, bond prices rise. § This tells us that in addition to default risk, people who buy bonds also face interest rate risk. Interest rates Bond prices 46

Bond Prices and Interest Rates § Assume a long term bond that pays $50/year § Assuming all other factors are constant: • If the prevailing interest rate were 10%, what would you pay to own the bond? • If interest rates fell to 5%, what would you pay to own the bond? § As interest rates fall, the market value of the bond rises, and vice-versa § What happens when interest rates are zero? • Bond market • Stock market 47

Self-Check The risk that a borrower will not pay the loan back is called: a. Default risk. b. Interest rate risk. c. Crowding out. Answer: a – this is called default risk. 48

The Stock Market § Businesses can fund their activities by issuing stock, or shares of ownership. § Stocks are traded on organized markets called stock exchanges. § Stock markets encourage investment and growth. § Buying and selling existing shares of stock does not increase net investment in the economy. § When a firm sells new shares to the public (IPO), the proceeds often fund investment. 49

Definition Stock: or a share is a certificate of ownership in a corporation. (equity) Initial public offering (IPO): The first time a corporation sells stock to the public in order to raise capital. 50

When Intermediation Fails § The bridge between savers and borrowers can be broken in many ways. 51

Insecure Property Rights § Some governments do not offer secure property rights to savers. § Savings may be confiscated, frozen, or subject to other restrictions. § When Argentina froze bank accounts in 2001, many banks went under and Argentinians lost their savings. § Russia has at times confiscated or restricted the value of shareholders’ holdings. § This negatively affects savings and investment. 52

Controls on Interest Rates § Price controls on interest rates also cause the loanable funds market to malfunction. § Usury laws impose a maximum ceiling on the interest rate that can be charged on a loan. § Most U. S. states have usury laws, although often they have loopholes: • they don’t stop most credit card borrowing. • they are set at levels too high to influence most loan markets. • Credit card loan sharking at 29. 99% 53

Controls on Interest Rates Interest rate Market Equilibrium 8% Controlled Interest rate Supply 1. Shortage of savings 2. Less savings and investment 3. Slower economic growth Shortage Demand $190 $250 $300 Savings/borrowing A Ceiling on Interest Rates Creates a Shortage of Savings

Politicized Lending § In many countries, most large banks are owned by the government. § Government-owned banks are useful for directing capital to political supporters. • Useful to authoritarian regimes § One study found that the larger the fraction of government-owned banks a country had in 1970, the slower the growth in per capita GDP and productivity over the next several decades. § In the US, Countrywide Mortgage Company made many “sweetheart” loans to Congress 55

Bank Failures and Panics § At the onset of America’s Great Depression between 1929 and 1933, almost half of all U. S. banks failed. § Many people lost their life savings. § Spending decreased, which meant that many businesses lost their customers and revenue. § Businesses were unable to get loans or daily working capital and therefore failed. § It took many years before the American economy recovered. 56

The Financial Crisis of 2007 -2008 § Leading up to the crisis, Americans borrowed more than ever. § The borrowing was centered in the housing and banking sectors. § In the 1990 s and 2000 s, lenders became convinced that house prices were unlikely to fall. § They became willing to lend with much lower down payments. § At the height of the housing boom in 2006, 17% of mortgages were made with 0% down. 57

Definition Owner equity: The value of the asset minus the debt, or E = V − D. Leverage ratio: The ratio of debt to equity, or D/E. 58

The Financial Crisis of 2007 -2008 Leverage § A house worth $400, 000 with 20% down and a mortgage of $320, 000: Equity = $400, 000 - $320, 000 = $80, 000 Leverage ratio = $320, 000 / $80, 000 = 4 § A house worth $400, 000 with 10% down and a mortgage of $360, 000: Equity = $400, 000 - $360, 000 = $40, 000 Leverage ratio = $360, 000 / $40, 000 = 9 59

Definition Insolvent: A firm that is insolvent has liabilities that exceed its assets. Any recent examples? 60

The Financial Crisis of 2007 -2008 Securitization § The seller of a securitized asset gets cash. § The buyer gets a stream of future payments. § Mortgage loans were “securitized, ” or bundled together and sold as financial assets. § Bad loans were dumped on unsuspecting investors around the world. 61

The Financial Crisis of 2007 -2008 Securitization § Housing prices started to fall in 2007. § Many owners owed more on their mortgage than their house was worth. § Delinquency and foreclosure rates more than doubled. § Many banks and financial intermediaries ended up with loans and assets of questionable value. 62

The Financial Crisis of 2007 -2008 Shadow Banking § Commercial banks fund themselves largely through deposits. § These deposits are insured by the Federal Deposit Insurance Corporation (FDIC). § Investment banks are funded by investors and are not insured by the FDIC. § Shadow banking includes investment banks, hedge funds, money market funds, and others. 63

The Financial Crisis of 2007 -2008 § The shadow banking system is less heavily regulated and monitored than traditional banks. § For years, regulators and policymakers were Lehman Brothers declared bankruptcy in 2008. unaware of its importance. § At its peak in 2008 the shadow banking system lent $20 trillion, considerably more than did traditional banks. OLI SCARFF/GETTY IMAGES 64

The Financial Crisis of 2007 -2008 The Crisis § As house prices fell, highly leveraged home owners defaulted on their mortgages. § Highly leveraged banks were pushed towards insolvency. § It wasn’t always clear who owned what or who faced the worst losses. § Investors became unwilling to extend short-term funding to shadow banks. § Credit markets froze up - WAFD § ("We're all freaking doomed. ") 65

The Financial Crisis of 2007 -2008 § A fire sale is the vicious circle in which the forced sale of a financial asset drives down the price of related assets, forcing more sales, further driving down the price. 66

The Financial Crisis of 2007 -2008 § The government has taken steps to avoid this happening again. § After the Lehman Brothers failure, the Federal Reserve took over AIG when it was failing and guaranteed its debts. § New financial regulations are bringing the shadow banking system “out of the shadows”. § Banks of all kinds are required to hold more equity, reducing the amount of their leverage. 67

Self-Check Banks that are funded by investors and are not insured by the FDIC are called: a. Traditional banks. b. Commercial banks. c. Shadow banks. Answer: c – shadow banks. 68

Takeaway § Saving and borrowing allow individuals, firms, and governments to smooth their consumption over time. § Financial intermediaries bridge the gap between savers and borrowers. § Financial intermediaries also collect savings, evaluate investments, diversify risk, and help finance new and innovative ideas. 69

Takeaway § Insecure property rights, inflation, politicized lending, and bank failures and panics can all contribute to the breakdown of financial intermediation. § The 2007– 2008 crisis was brought about by high leverage and falling asset prices that created a panic and sharply reduced the amount of lending in the economy. 70