by B Bernanke · Cited by 139 — Similarly, Mian and Sufi (2014b) found that, in a cross-section of U.S. counties, deterioration in household balance sheets was an important

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Dr. Ben S. Bernanke is a Distinguished Fellow in residence with the Econ omic Studies Program at the Brookings Institution, as well as a Senior Advisor to PIMCO and Citadel. The author did not receive financial support from any firm or person for this paper or from any firm or person with a financial or political interest in th is paper. With the exception of the aforementioned, they are currently not officers, directors, or board members of any organization with an interest in this paper. No outside party had the right to review this paper before circulation.

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The Real Effects of Disrupted Credit Evidence from the Global Financial Crisis Ben S. Bernanke 1 September 13, 2018 ABSTRACT Ec onomists both failed to predict the global financial crisis and underestimated its consequences for the broader economy. Focusing on the second of these failures , this paper makes two contributions. First, I review research since the crisis on the role of credit factors in the decisions of househ olds, firms, and financial intermediaries and in macroeconomic modeling. T his research provides broad support for the view that credit – market developments deserve greater attention from macroeconomists, not only for analyzing the economic effects of finan cial crises but in the study of ordinary business cycles as well. Second, I provide new evidence on the channels by which the recent financial crisis depressed economic activity in the United States. Although the deterioration of household balance sheets and the associated deleveraging likely contributed to the initial economic downturn and the slowness of the recovery, I find that the unusual severity of the Great Recession was due primarily to the panic in funding and securitization markets, which disru pted the supply of credit. This finding helps to justify in order to avoid greater damage to the real economy. 1 The author is a Distinguished Fellow at the Brookings Institution. Early versions of this paper were presented at the Nobel Symposium on Money and Banking (Stockholm) and as the Per Jacobsson Lecture at the Bank for International Settlements (Basel). I thank Olivier Blanchard, Barry Eichengreen, and Raghuram Rajan for their comments on various versions of the paper. Sage Belz and Michael Ng provided outstanding research assistance.

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1 Introduction The horrific financial crisis of a decade ago, and the deep recession that followed it, exposed two distinct failures of forecasting by economists and economic policymakers. First, although many economists (Greenspan, 2005; Rajan, 2005; Shiller, 2007 ) wor ried about low risk premiums, misaligned incentives for risk – taking, high house prices, and other excesses in the run – up to the crisis, the full nature and dimensions of the crisis, including its complex ramifications across markets, institutions, and coun tries, were not anticipated by the profession. Second, even as the severity of the financial crisis became evident, economists and policymakers significantly underestimated its ultimate impact on the real economy, as measured by indicators like GDP growth, consumption, investment, and employment. Do these failures imply that we need to remake economics, particularly macroeconomics, from the ground up, as suggested in some quarters? Of course, it is essential that we understand what went wrong. However, I think the failure to anticipate the crisis itself and the somewhat different implications for economics as a field . As I argued in a speech some years ago (Bernanke, 2010), the occurrence of a massive, and largely unanticipated, financial crisis might best be understood as a failure of economic engineering and economic management, rather than of economic science. I meant by that that our fundamental un derstanding of financial panics w hich, after all, have occurred periodically around the world for hundreds of years w as not significantly changed by recent events. (Indeed, the policy response to the crisis was importantly informed by the writings of nineteenth – century authors, notably Walter Bagehot.) Rathe r, we learned from the crisis that our financial regulatory system and private – sector risk – management techniques had not kept up with changes in our complex, opaque, and globally integrated financial markets; and, in particular, that we had not adequately identified or understood the risk that a classic financial panic could arise in a historically novel institutional setting. T he unexpected collapse of a bridge should lead us to try to improve bridge design and inspection, rather than to rethink basic phy sics . By the same token , the response to our failure to predict or prevent the crisis should be to improve regulatory and risk – management systems the economic engineering r ather than on reconstructing economics at a deep level.

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2 However, the second shortcoming, the failure adequately to anticipate the economic consequences of the crisis, seems to me to have somewhat different , and more fundamental, implications for macroeconomics . T o be sure, historical and international experien ce strongly suggested that long and deep recessions often follow severe financial crises (Reinhart and Rogoff, 2008). As a crisis – era policymaker, I was inclined by this evidence as well as by my own academic research on the Great Depression (Bernanke, 19 83) and on the role of credit – market frictions in macroeconomics (Bernanke and Gertler, 1995) toward the view that the crisis posed serious risks to the broader economy. However, this general concern was not buttressed by much in the way of usable quantit ative analyses. For example, as Kohn and Sack (2018) note in their recent study of crisis – era monetary policy, and as I discuss further below, Federal Reserve forecasts significantly under – predicted the rise in unemployment in 2009, even in scenarios desi gned to reflect extreme financial stress. This is not an indictment of the Fed staff, who well understood that they were in uncharted territory; indeed almost all forecasters at the time made similar errors. Unlike the failure to anticipate the crisis, t he underestimation of the impact of the crisis on the broader economy seems to me to implicate basic macroeconomics and requires some significant rethinking of standard models. Motivated by this observation, t he focus of this paper is the relationship betw een credit – market disruptions and real economic outcomes. I have two somewhat related but ultimately distinct objectives. The first is to provide an overview of post – crisis research on the role of credit factors in economic behavior and economic analysis . There has indeed been an outpouring of such research. Much of the recent work has been at the microeconomic level, documenting the importance of credit and balance sheet factors for the decisions of households, firms, and financial institutions. The e xperience of the crisis has generated substantial impetus for this line of work, not just as motivation but also by providing what amounts to a natural experiment, allowing researchers to study the effects of a major credit shock on the behavior of economi c agents. Moreover, as I discuss, the new empirical research at the microeconomic level has been complemented by innovative macro modeling, which has begun to provide the tools we need to assess the quantitative impact of disruptions to credit markets. B ased on this brief review, I argue that the case for including credit factors in mainstream macroeconomic analysis has become quite strong, not only for understanding extreme episodes like the recent global crisis, but possibly for the analysis and for for ecasting of more – ordinary fluctuations as well.

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3 The second objective of the paper is to provide new evidence on the specific channels by which the recent crisis depressed economic activity in the United States. Why was the Great Recession so deep? (My focus here is on the severity of the initial downturn rather than the slowness of the recovery, although credit factors probably contributed to the latter as well as the former.) Broadly, various authors have suggested two channels of effect , each of which emphasizes a different aspect of credit – market disruptions. Aikman et al. (2018) describe these two sources of damage from the crisis as (1) fragilities in the financial system, including excessive risk – taking and reliance on wholesale fu nding, which resulted in a financial panic and a credit crunch; and (2) a surge in household borrowing , of which the reversal, in combination with the collapse of housing prices, resulted in sharp deleveraging and depressed household spending. In the forme – related losses tr iggered a large – scale panic, including runs by wholesale funders and fire sales of credit – related assets, particularly securitized credit (Brunnermei e r, 2009 ; Bernanke, 2012 ). The problems were particularly severe at broker – dealers and other nonbank credit providers, which had increased both their market shares and their leverage in the years leading up to the crisis. Like the classic financial panics of the nineteenth and early twentieth centu ries, the recent panic in wholesale funding markets, rather than in retail bank deposits resulted in a scramble for liquidity and a devastating credit crunch. In this narrative, the dominant problems were on the s upply side of the credit market; and the i mplied policy im perative was to end the panic and stabilize the financial system as quickly as possible, to restore more – normal credit provision. especially mortgage debt, during the housing boom of the early 2000s. This buildup reflected beliefs (on the part of both borrowers and lenders) that rapid increases in house prices would continue , which in turn promoted a loosening of credit standards, speculative home purc hases and the extraction of home eq uity through second mortgages. Given the large increase in leverage, t he decline in house prices beginning in 2006 sharply reduced household wealth and put many homeowners into financial distress, leading to precipitate declines in consumer spending (Mian and Sufi , 201 0) . Relative to the financial fragility narrative, this approach emphasizes the decline in the effective demand for credit, rather than the effective

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5 I draw several conclusions. For macroeconomists, recent experience and research highlight the need for greater attention to credit – related factors in modeling and forecasting the economy. Standard models used by central banks and other policymakers includ e basic financial prices , such as interest rates, stock prices, and exchange rates , but do not easily accommodate financial stresses of the sort seen in 2007 – 2009, including the evident disruption of credit markets. Plausibly, this omission explains why standard approaches seriously underestimated the economic impact of the crisis. Moreover, if variations in the efficiency of credit markets were important determinants of economic performance during the Great Recessio n, they may deserve – For policymakers, better understanding why financial stresses are economically costly could help inform efforts to prevent and respond to crises. In particu lar, the policy response to the financial crisis of 2007 – 2009 focused heavily on ending the financial panic and protecting the banking system, and it included some highly unpopular measures, including the bailouts of financial institutions with taxpayer fu nds. The rationale that policymakers gave for their apparent favor itism to the financial industry d espite its culpability in many of the problems that gave rise t o the crisis in the first place was that stabilizing Wall Street was necessary to prevent an even more devastating blow to Main Street. The results of this paper support that rationale. More generally, the results support reforms that improve the resilience of the financial system to future bouts of instability, and that increase the capacity of policymakers to respond effectively to panics, even if such reforms involve some costs in terms of credit extension or growth. Although some of the empirical studies I discuss bear on the international transmission of the crisis, the focus of this paper i s on the experience of the United States. Extending the analysis to other countries and considering aspects of the crisis more prominent outside the U.S., such as sovereign debt problems, are imp ortant direction s for future research. I. Credit markets an d the external finance premium The first objective of this paper is to review recent research on the real effects of credit – market disruptions and to discuss some implications for macroeconomics. As background, I begin with some simple theory. The key ec onomic concept to be developed is the existence of

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6 an external finance premium, which may vary over time and depends on the financial health of both borrowers and lenders. The starting point is the familiar observation that the process of credit extension is rife with problems of asymmetric information between borrowers and lenders. Potential lenders are only imperfectly informed about the characteristics of borrowers, including their skills and tment opportunities or effort levels. Asymmetric information in the borrower – lender relationship implies that the extension of credit involves costs above those of funding , including the costs of screening and monitoring by the lender and the deadweight l osses arising from adverse selection or principal – agent problems. Moreover, even a fully informed lender may face costs of transmitting and verifying its information about borrowers to third parties, forcing the lender to bear liquidity risk and idiosyncr atic return risk. These various costs contribute to the existence of a transaction – specific external finance premium , or EFP, the difference between the all – in cost of borrowing and the return to safe, liquid assets like Treasury securities. In much of ec onomics (in corporate finance, for example) , the assumption of asymmetric information and theoretical frameworks (principal – agent models, incomplete contracting) based on that assumption are central to the analysis of credit relationships. In macroeconomics, mainstream analyses have paid less attention to these ideas. Certainly, to be relevant to macroeconomics, the external finance premiums associated with diverse transactions must have an aggregate or common component that is quantitative ly significant, varies over time, and is linked to broad economic conditions. I will use the term credit factors to refer to economic variables that affect the aggregate component of the external finance premium, in contrast to broader financial factors s uch as the levels of equity prices and interest rates. What affects the external finance premium? The EFP depends, inter alia , on the financial health (broadly defined) of both potential borrowers and financial intermediaries. Borrowers. side, the key intuition is that problems of asymmetric have sufficient net worth, equity, or collateral at risk to align their incentives with the goals of len For example, a large down payment by a

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7 the borrower to maintain the home properly. Thus, a borrower who can make a substantial down payment can expect easier access to credit and terms that are more favorable. Likewise, an entrepreneur able to contribute substantial equity to her startup is m ore likely to obtain outside financing and will face fewer intrusions on her business decision – making by lenders. In a macroeconomic setting, aggregate descriptors of the average financial health of borrowers (net worth, collateral, leverage) are state var iables that, at least in principle, can affect the economy – wide component of the EFP and, consequently, macroeconomic dynamics. In the financial accelerator model of Bernanke and Gertler (1989), endogenous deterioration of the net worth of borrowers in an economic downturn, and improvements in an upturn, make the aggregate EFP countercyclical. The endogenous variation in the EFP in turn increases the responsiveness of the economy to exogenous shocks. Kiyotaki and Moore (1997) and Ge an akoplos (2010) descr ibe related mechanisms. Lenders. The EFP can also be affected by the financial health of lenders. Financial making loans . Bank employees acquire both general lending skill s and specific knowledge about particular industries, firms, communities, or individual borrowers. Complementarities in the p ro vision of financial services for example, a bank has more information about a potential borrower who also holds checking and sav ings accounts with the bank f urther reduce the costs of lending. Banking organizations, by holding many illiquid loans, may also achieve greater diversification of lending risks. Although banks serve to reduce the net cost of lending, banks are themselves borrowers as well, in that they must raise funds from the ultimate savers in order to finance their loans . Consequently, the financ ial health of banks also matters for the external finance premium . For example, if banks suffer loan losses in an economic downturn, the depletion of capital will reduce their ability to attract funding, on the margin. Weakened b anks will become choosier in their lending, raising the aggregate EFP and reinforcing the financial accelerator mechanism . – insured depositors, but it may lead the deposit insurance agency, acting on behalf of at – risk taxpayers, to insist on tighter lending standards.)

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8 Woodford (2010) discusses, in the context of a simple macro mode l, how reductions in bank capital and thus the effective supply of intermediary services can depress the economy. Similarly, because liquid assets facilitate lending and risk – taking, increased cost or reduced availability of funding (due to tighter moneta ry policy, for example) also reduces the supply of bank credit. This is a variant of the so – called bank – lending channel of monetary policy; see Drechsler, Savov, and Schnabl (2018). 2 Panics. The simple balance – sheet perspective is also useful for understa nding the real effects of financial panics, i.e., systemwide runs on banks or other credit intermediaries. Generally, panics may arise in situations in which longer – term, illiquid assets are financed by very short – term liabilities, e.g., bank loans finance d by demand deposits. A large literature has examined why such financing patterns persist and why panics sometimes erupt. In the classic work by Diamond and Dybvig (1983), these arrangements allow society to marshal the necessary resources for long – term investment while simultaneously allowing individual savers to insu re against unexpected liquidity needs . T h e benefits of this setup must be weighed against the possibility of Pareto – inferior, self – In contrast, Calomiris and Kahn (1991) see short – term financing as a mechanism for lenders to discipline borrowers . I n their framework, a run or panic is simply investors exercising their prerogative of withdrawing funding from borrowers in whom they have lost confidence. An appro ach which seems particularly useful for understanding the recent crisis, and which fits nicely with the idea of a variable external finance premium, comes from Gary Gorton and coau thors (Gorton and Pennachi, 1990 ; Dang, Gorton, and Holmstrom, 2015). In th e Gorton – structured in a way that makes their value constant over almost all states of the world. Besides demand deposits, examples of information – insensitive liabilities in modern finance include short – term, over – collateralized loans (e.g., many repo 2 Early work on the bank lending channel includes Kashyap, Stein, and Wilcox (1993) and V an den Heuvel (2002). Gertler and Karadi (2011) interpret unconventional monetary policies, like quantitative easing, as a means by which

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