[MUSIC] What causes financial crises? Financial systems themselves are inherently fragile. Financial distress in the financial system can cause severe damage to the real economy, and policy makers often mismanage the response. So let's start with a little bit about the basic structure of Financial Systems. Financial Systems as you all know, they play this critical function in the economy. They take the savings of savers and loan or invest those recourses in activity that has some positive return. People lend them that money for a very short period, they expect it to be available on demand. And banks and other firms take those resources and lend them for longer periods of time to support people who wanna borrow to finance the purchase of a home or a business, that wanna build a new factory. That's the basic function of the financial system. The structure of a typical bank, which is described here, has this thin base of common equity. A set of other forms of borrowing, long and short, deposits, secured, unsecured. And those finance the assets which are depicted on the left. This basic structure, by design, is fundamentally fragile because that equity cushion is thin and a large share of the remaining source of funds used to finance the loans of the assets of the institution can run, can be withdrawn in a crisis. And a bank doesn't have the ability to sell assets quickly to meet a withdrawal of funds in extremis, thus, the inherent fragility of a financial system. And I wanna show just a little illustration, so I'm gonna pause one second and I'm gonna show you just a little illustration about how to think about why to try to illustrate this basic point. So you wanna think about banks as inherently tippy. So a modest shock creates a risk that they can tip over, and if you think about a system as a bunch of linked banks, you see the obvious risk of them tipping over. Ideally, you want banks to look more like this with this more stable foundation. But the dilemma is people who trust their savings to a bank or lend money to a bank, it's hard for them to tell whether the bank is stable like this or whether the bank's vulnerable like this. Particularly hard to tell in the midst of a deep recession when the entire system's exposed to losses and everybody's worried about the risks that they might lose their money. So in a crisis, even banks that have this greater fundamental foundation of stability, they look like this, they look vulnerable. Here's a small illustration, a simple illustration of the difference between a bank that has a more stable base of capital, or more conservative funding structure, and one that doesn't. That narrower base signifies a greater vulnerability to shocks, greater fragility. Now this matters in part because the financial system is so closely linked with the rest of the economy. It's like the power grid in the economy. If the lights go out, the power system fails, it's very hard for the rest of the economy to function. One way to illustrate this linkage is by showing the way this basic dynamic works. So let's think about it, just move through the cycle described here. So economic growth slows because of some adverse shock, the economy slows. That creates the fear of loses. Depositors start to withdraw their funds from what they perceive to be the weaker institutions. Those institutions try to sell assets or withdraw loans, call funding, to meet the demand for withdrawals of funds. That pushes down asset prices, the price of financial securities. In response to that, banks lend less. They pull back. That reinforces, intensifies the slowdown of the economy. That makes more institutions look weaker. The cycle continues. It's a classic, vicious, self-reinforcing cycle in the context of financial distress. Third thing that matters is the response of policy makers to that shock or that distress. And as that earlier chart shows, policy makers tend to mismanage the response. In fact, often the initial response, the initial inclination of policy makers is to do things that makes the crisis worse. Why is that, or how does that manifest? Sometimes, it's just because policy makers just react too slowly, it's hard for them to appreciate the magnitude of the crisis. Sometimes, it's because they're understandably concerned about moral hazard, about the effects on incentives about acting too aggressively. Sometimes it's because of a basic conservatism in policy, people think it's better to move slowly, you take less risk in doing that. Sometimes its because of a basic lack of knowledge among policy makers about what works, about what makes sense. Because again, it's quite rare that the very severe crisis, the classic panic, happens to the same country in a short period of time. Usually these things are separated by long lags. [MUSIC]
