Global Financial Instability: Framework, Events, Issues

Frederic S. Mishkin

I n the last five years, the global economy has experienced severe bouts offinancial instability that have had devastating impacts on crisis countries.Some examples of the impact on GDP are given in Table 1. In Mexico, GDP growth fell from above 4 percent in 1994 before the crisis to 26 percent in 1995. In Thailand, Malaysia, South Korea and Indonesia, GDP growth fell from above 5 percent in 1996 before the crisis to below 25 percent in 1998. These swings of over 10 percent in rates of GDP growth are of the same order of magnitude as what occurred in the United States during the Great Depression.

Two of the key questions facing policymakers today are how to reduce the risk of global financial instability and how to cope with it when it occurs. This paper starts by defining financial instability and then showing how it harms economic activity. It then uses this framework to describe what happened during the recent financial crises in Mexico and east Asia. The paper ends by raising several key policy issues; not coincidentally, these issues are addressed in the remaining papers in the symposium.

What Is Financial Instability?

Financial markets perform the essential function of channeling funds to those individuals or firms that have productive investment opportunities. If the financial system does not perform this role well, then the economy cannot operate efficiently

y Frederic S. Mishkin is A. Barton Hepburn Professor of Economics, Graduate School of Business, Columbia University and Research Associate, National Bureau of Economic Re- search, Cambridge, Massachusetts.

Journal of Economic Perspectives—Volume 13, Number 4 —Fall 1999 —Pages 3–20

and economic growth will be hampered. This function implies a capability of making judgements about which investment opportunities are more or less cred- itworthy. As a result, a financial system must struggle with problems of asymmetric information, in which one party to a financial contract has much less accurate information than the other party. For example, borrowers who take out loans usually have better information about the potential returns and risk associated with the investment projects they plan to undertake than lenders do. Asymmetric information leads to two basic problems in the financial system (and elsewhere): adverse selection and moral hazard.

Adverse selection occurs before the financial transaction takes place, when potential bad credit risks are the ones who most actively seek out a loan. For example, those who want to take on big risks are likely to be the most eager to take out a loan, even at a high rate of interest, because they are less concerned with paying the loan back. Thus, the lender must be concerned that the parties who are the most likely to produce an undesirable or adverse outcome are most likely to be selected as borrowers. This outcome is a feature of the classic “lemons problem” analysis first described by Akerlof (1970). In that example, partially informed buyers of used cars may steer away from purchasing a car at the lowest price, because they know that they are not fully informed about quality, and they fear that a low-price car may also be a low-quality car. In the case of capital markets, partially informed lenders may steer away from making loans at high interest rates, because they know that they are not fully informed about the quality of borrowers, and they fear that someone willing to borrow at a high interest rate is more likely to be a low-quality borrower who is less likely to repay the loan. Lenders will try to tackle the problem of asymmetric information by screening out good from bad credit risks. But this process is inevitably imperfect, and fear of adverse selection will lead lenders to reduce the quantity of loans they might otherwise make.

Moral hazard occurs after the transaction takes place. It occurs because a borrower has incentives to invest in projects with high risk in which the borrower does well if the project succeeds, but the lender bears most of the loss if the project fails. A borrower also has incentives to misallocate funds for personal use, to shirk and not work very hard, and to undertake investment in unprofitable projects that

Table 1 Real GDP Growth for Mexico and the East Asian Crisis Countries: 1994 –1998

Mexico Thailand Korea Malaysia Indonesia Philippines

1994 4.4 8.6 8.6 9.3 7.5 4.4 1995 26.2 8.8 8.9 9.4 8.2 4.7 1996 5.2 5.5 7.1 8.6 8.0 5.8 1997 7.0 20.4 5.5 7.7 4.6 5.2 1998 4.9 28.0 25.5 26.8 213.7 20.5

Source: World Economic Outlook (1999).

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serve only to increase personal power or stature. Thus, a lender is subject to the hazard that the borrower has incentives to engage in activities that are undesirable from the lender’s point of view, that is, activities that make it less likely that the loan will be paid back. Lenders often impose restrictions (“restrictive covenants”) on borrowers so that borrowers are less likely to engage in behavior that makes it less likely that they can pay back the loan. However, such restrictions are costly to enforce and monitor, and inevitably somewhat limited in their reach. The potential conflict of interest between the borrower and lender stemming from moral hazard again implies that many lenders will lend less than they otherwise would, so that lending and investment will be at suboptimal levels.

In the last 20 years, a growing literature has sought to explain the institutional structure of financial markets by recognizing that this structure has evolved to reduce the asymmetric information problems of adverse selection and moral hazard (Gertler, 1988; Bernanke, Gertler and Gilchrist, 1998). Of course, address- ing the problems of asymmetric information is not a one-time event, but rather an ongoing problem whose dimensions shift with each twist and turn of the economy. From this perspective, the underlying rationale for financial intermediaries— including commercial banks, thrift institutions, finance companies, insurance com- panies, mutual funds and pension funds, of which banks are the most important—is that they have both the ability and the economic incentive to address problems of asymmetric information. For example, banks have an obvious ability to collect information at the time they consider making a loan, and this ability is only increased when banks engage in long-term customer relationships and credit line arrangements. In addition, the ability of banks to scrutinize the checking account balances of their borrowers provides banks with an additional advantage in moni- toring the borrowers’ behavior. Banks also have advantages in reducing moral hazard because, as demonstrated by Diamond (1984), they can engage in lower cost monitoring than individuals, and because, as pointed out by Stiglitz and Weiss (1983), they have advantages in preventing risk-taking by borrowers since they can use the threat of cutting off lending in the future to improve a borrower’s behavior.

The natural advantages of banks in collecting information and reducing moral hazard explain why banks have such an important role in financial markets throughout the world. Indeed, the greater difficulty of acquiring information on private firms in emerging market countries explains why banks play a more impor- tant role in the financial systems in emerging market countries than they do in industrialized countries (Rojas-Suarez and Weisbrod, 1994).

Banks have an incentive to collect and produce such information because they make private loans that are not traded, which reduces free rider problems. In markets for other securities, like stocks, if some investors acquire information that screens out which stocks are undervalued and then they buy these securities, other investors who have not paid to discover this information may be able to buy right along with the well-informed investors. If enough free-riding investors can do this and the price is bid up, then investors who have collected information will earn less

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on the securities they purchase and will thus have less incentive to collect this information. Once investors recognize that other investors in securities can mon- itor and enforce restrictive covenants, they will also want to free ride on the other investors’ monitoring and enforcement. As a result, not enough resources will be devoted to screening, monitoring and enforcement. But because the loans of banks are private, other investors cannot buy the loans directly, and free-riding on banks’ restrictive covenants is much trickier than simply following the buying patterns of others. As a result, investors are less able to free ride off of financial institutions making private loans like banks, and since banks receive the benefits of screening and monitoring they have an incentive to carry it out.

Focusing on information problems leads to a definition of financial instability: Financial instability occurs when shocks to the financial system interfere with information flows so that the financial system can no longer do its job of channeling funds to those with productive investment opportunities. Indeed, if the financial instability is severe enough, it can lead to almost a complete breakdown in the functioning of financial markets, a situation which is then classified as a financial crisis.

Why Financial Instability Occurs

Financial intermediaries, particularly banks, have a very important role in financial markets since they are well-suited to engage in information-producing activities that facilitate productive investment for the economy. Thus, a decline in the ability of these institutions to engage in financial intermediation and to make loans will lead directly to a decline in investment and aggregate economic activity. When shocks to the financial system make adverse selection and moral hazard problems worse, then lending tends to dry up— even for many of those with productive investment opportunities, since it has become harder to distinguish them from potential borrowers who do not have good opportunities. The lack of credit leads individuals and firms to cut their spending, resulting in a contraction of economic activity that can be quite severe. Four factors can lead to increases in asymmetric information problems and thus to financial instability: deterioration of financial sector balance sheets, increases in interest rates, increases in uncertainty, and deterioration of nonfinancial balance sheets due to changes in asset prices. I will discuss each in turn.