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Negative feedback implosions

In the last twenty years there has been a dramatic increase in the frequency of financial crises leading to significant contraction in economic activity. The Global Financial Crisis, considered by many economists the most catastrophic financial crisis since the Great Depression of the 1930s, originated in the United States when it was observed a sharp drop (in absolute terms) in the value of financial assets.

The financial accelerator is the mechanism that theoretical macroeconomics has used to characterize how financial factors may amplify and propagate business cycles. Its heart is centred on the existence of an “external finance premium” (EFP), calculated by the difference between the cost of third-party funds raised by firms to finance their investments and the opportunity cost of internal resources.

The reason for the presence of an external finance premium is simply that there is agency problems introducing a conflict of interest between the borrower and his respective lenders. Even though creditors should be compensated for their costs, the financial contract is designed to minimize agency costs.

Furthermore, the lower the net worth of firms the greater the proportion of external resources in financing the investments and consequently, higher agency costs and EFP. So, shocks that affect the level of aggregate activity, generating changes in revenues and profits of firms and therefore in net assets, cause changes in EFP, which strengthens the initial impact of shocks by the worsening or improvement the access conditions to financing in the credit markets.

Since negative shocks in the economy reduce the net worth of borrowers (or positive shocks increase net worth), the spending and production effects of initial shocks tends to be amplified. In the Bernanke-Gertler model, economic shocks are amplified and propagate by their effects on borrower’s cash flows. For example, productivity shocks decreases current cash flows, reducing the firm capacity to finance investment projects. This net worth decrease leads to an increase in average external finance premium and new investments costs. The reduction in investment leads to a decrease in economic activity and cash flows in the following periods, amplifying and propagating the effect of the initial shock.

The main argument of the financial accelerator is the inverse relationship between the premium that borrowers have to pay when they ask for external credit in the banking system and the financial condition of the borrower.

Economists are not in agreement on whether and how responses of macroeconomic variables to monetary policy shocks differ in times of high financial stress and normal times. On one hand, it has been argued that monetary policy has not been effective during financial crises. During the recent financial crisis of 2008/09, credit standards tightened and the cost of credit increased even further, despite the Federal Reserve reducing interest rates substantially. In the other, the monetary policy has been effective and more powerful during financial crises. It reduced interest rates on default-free securities, and helped to lower credit spreads. When financial stress is low (normal times), firms and households are less sensitive to changes in their cost of credit, while during crises, firms and households are more sensitive to any change in their cost of credit.

Bernanke et al. (1999), making use of a two-sector model with the financial accelerator, showed  that firms with very limited access to external credit markets respond more strongly to an expansionary monetary policy shock than do firms with broad access to credit. So, we can conclude that a monetary expansion during financial crisis increases loans and asset prices by more than in times of low financial stress, leading to a higher decrease of the EFP which, in turn, causes stronger effects in macroeconomic variables as output, consumption, and investment. This happens because the financial accelerator is used assuming different values of the elasticity of the EFP with respect to the net worth of firms.

Is the financial accelerator able to explain the causes of the Global Financial Crisis? According to literature, it is able to offer a plausible theory.

In late 2007, the collapse of the subprime mortgage market in the United States subjected the financial intermediaries to the amortization of bad loans, which in turn led to the erosion of its capitalization. The deterioration of their balance sheets damaged the credit capacity and, consequently, the borrowers saw the supply of loans to be contracted. This credit crisis caused a reduction of real economic activity, including investment, consumption and houses prices (those sensitive to credit market behaviour). The decline in houses prices eroded the net worth of economic agents, and thus also decreased its borrowing capacity. Therefore, there was an increase in the external financing premium and amplification of existing lower investment, consumption and production.

Along with the resulting rise in unemployment, the contraction of aggregate economic activity and the reduction of houses prices increased the amount of bad loans. The profitability of financial intermediaries was then reduced and its net assets deteriorated even further. As a fish that bites its own tail, the initial shock in the financial sector seems to have caused and/or enhanced the net assets problem of economic agents and have generated a crisis through the effect of the financial accelerator.

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Author: studentnovasbe

Master student in Nova Sbe

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