Econ 101 Introduction to Economics IECON/MAN SectionsBilkent UniversityFall 2011-2012Homework IDue: October 21, 2011You should submit your homework to Turnitin before 17:301) Read the following essay and answer the question at the end:Subprime crisis: Greenspan’s LegacyTito Boeri and Luigi Guiso23 August 2007http://www.voxeu.org/index.php?q=node/488The subprime crisis has its origin in Greenspan’s low interest rate policy. His successor should take care to reassure the markets in the short runwithout laying the foundations for a new overreaction “a la Greenspan”.It’s difficult to predict how long the crisis in the world’s financialmarkets will last. Its dynamics recalls that of previous crises, such asthat of 1998 (the Russian default and the collapse of LTCM), whichhave by now been forgotten by many. An excess of liquidity (i.e. anabundance of loans at low cost) has suddenly been transformed intoa dearth of liquidity; many dealers find it hard to sell the assets intheir portfolios. The present crisis bears little resemblance to the 1929Great Depression, contrary to what some politicians and commentators assert. Fortunately Fed President Ben Bernanke has studiedthe Great Depression in depth. According to the analysis he did asan academic1, the “Great Depression” was unleashed by a collapseof production and consumption, amplified by a drastic reduction inthe supply of bank credit which came about largely because the Fedfailed to act as a lender of last resort. Exactly the opposite is happening today. The world economy continues to grow at sustained ratessince central banks have so far fulfilled their roles of supplying thenecessary liquidity to the market. The only (perhaps nonnegligible)aspect that the current crisis shares with the Great Depression is thatits epicenter is the US.Back to the presentIt’s useful to disentangle the causes of the crisis. Three factorscontribute to the current crisis that was triggered by the expectationof defaults on subprime mortgages in the US.• The low financial literacy of US households;• The financial innovation that has resulted in the massive securitization of illiquid assets, and;• The low interest rate policy followed by Alan Greenspan’s Fedfrom 2001 to 2004.The third cause is by far the most important. Without Greenspan’spolicy, the present crisis probably would have never occurred.Low Financial LiteracyThe first ingredient of the crisis is a blend of bad information, financial inexperience and myopia of consumers/investors. They fellfor the prospect of getting a mortgage at rates never seen before andthen extrapolating these rates out for thirty years. This myopia wasencouraged and indeed exploited by banks and other lenders eagerto attract and retain clients. This is surprisingly similar to what hasbeen seen in the past when banks and intermediaries have advisedtheir clients to invest in financial assets ill-suited to their ability tobear risk. In both cases, a biased advisor is the reflection of a clearconflict of interest in the financial industry. Financial literacy is lownot only in financially backward countries (as one would expect),but also in the US. Only two out of three Americans are familiar withthe law of compound interest; less than half know how to measurethe effects of inflation on the costs of indebtedness. Financial literacy is particularly low among those who have taken out subprimemortgages. The intermediaries exploited this financial illiteracy.SecuritizationThe second ingredient is the pace of financial innovation duringthe last ten years and the securitization that it produced. Today it iseasy to “liquidify” a portfolio of illiquid credits (typically a combination of bank loans or mortgages) so they can be packaged into investor portfolios. Any bank with distressed loans has used this technique to securitize its own credits. Like all financial innovations, thistoo has pros and cons. The advantage is that by making an illiquidcredit liquid, one can achieve important efficiency gains; investorscan take longer-term positions and so earn a higher return. It alsospreads the risk of insolvency across a much wider group, reducingthe level of risk exposure of any individual agent. But securitizationsalso have their disadvantages. They weaken the incentives of financial intermediaries to monitor the behavior of the original borrower.In addition, since a credit that has become risky can be liquidatedmore easily, banks have less incentive to screen borrowers carefully.This opens the credit-markets doors to poor quality borrowers.Low interest ratesThe first two factors aren’t new. Without the third factor thelegacy of the “central banker of the century” the crisis probablywould have never occurred. The monetary policy of low interestrates introduced by Alan Greenspan in response to the post-9/11recession and the collapse of the new economy “bubble” injectedan enormous amount of liquidity into the global monetary system.This reduced short-term interest rates to 1% their lowest level in 50years. What’s more, Greenspan spent the next two years maintaining interest rates at levels significantly below equilibrium. Interestrates were kept at low levels for a long time, and were often negativein inflation-adjusted terms. The result was no surprise. Low returnson traditional investments pushed investors and lenders to take bigger risks to get better returns. Financial intermediaries, in search ofprofits, extended credit to families and companies with limited financial strength. Investors with varying degrees of expertise dulyreallocated their portfolios towards more lucrative but riskier assetsin an attempt to increase their wealth and preserve its purchasingpower. The low borrowing rates for both short and long-term maturity attracted throngs of borrowers families above all who wereseduced by the possibility of acquiring assets that for had alwaysbeen beyond their means. At the same time, house prices soared,ultimately encouraging the additional extension of credit; the valueof real estate seemed almost guaranteed.The song of the Keynesian sirensThanks Alan! Today we’re paying the cost of your overreaction tothe 2001 recession. The ECB was wisely prudent and only let itselfbe partially tempted by Keynesian arguments for reduced interestrates (which were already absurdly low) as a tool for attacking European stagnation. Many would like the ECB to lower rates now, arguing that to avoid a new “Great Depression” Europe needs Keynesianpolicy of the type followed in the USA, Great Britain and Germanyafter the 1929 collapse.We think it is far better to avoid repeating Greenspan’s error, andto avoid monetary policies that are too accommodating for too long.At present, central banks are acting correctly by injecting liquidityinto the system. In such crises, one must be afraid of fear. Expectations can unleash downward spirals that make the most pessimisticprophecies come true. In addition, the market crisis hits everyoneindiscriminately even those who did not make money by extending mortgages too readily. Last Friday’s press release of the FederalOpen Market Committee didn’t clarify whether half-point cut in thediscount rate as intended to merely prevent a downward expectations spiral or whether it was the prelude to yet another overreaction to the market crisis. It’s important to show soon that the lessonof Greenspan’s error has been learned. We should not overreact, ashas been done so many times in the past, by sowing the seeds of afuture crisis today.Question: Considering the opinion piece above and assuming that we could go backin time and change things, discuss the opportunity costs of avoiding the subprimemortgage crisis.2) Consider an economy with two countries, say A and B. They both use labor toproduce wheat and iron and these are the only two goods they produce. The tablebelow give the production per month for each worker in each country:Tons of wheat Tons of IronCountry A 30 10Country B 60 15Each country has a labor force of 1,000 workers.a. Draw the PPF’s for both countries.b. Which country has an absolute advantage in production of wheat? Whichcountry has an absolute advantage in production of iron?c. Which country has a comparative advantage in wheat production (relativeto iron production)? Which country has a comparative advantage in ironproduction (relative to wheat production)?d. Show that by specialization and trade both countries can have quantities ofwheat and iron that are beyond their PPF.
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