THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 247

CHAPTER Financial Crises and the Subprime Meltdown 215 politicians and bureaucrats who are not acting in the public interest Not surprisingly, then, the cost to the society of the principal agent problem is particularly high in emerging-market economies The second path through which emerging-market countries experience a financial crisis is government fiscal imbalances that entail substantial budget deficits that need to be financed The recent financial crisis in Argentina in 2001 2002 was of this type; other recent crises, for example in Russia in 1998, Ecuador in 1999, and Turkey in 2001, also have some elements of deficit-driven fiscal imbalances When Willie Sutton, a famous bank robber, was asked why he robbed banks, he answered, Because that s where the money is Governments in emergingmarket countries have the same attitude When they face large fiscal imbalances and cannot finance their debt, they often cajole or force banks to purchase government debt Investors who lose confidence in the ability of the government to repay this debt unload the bonds, which causes their prices to plummet Now the banks that are holding this debt have a big hole on the asset side of their balance sheets, with a huge decline in their net worth The deterioration in bank balance sheets then causes a decline in bank lending and can even lead to a bank panic Severe fiscal imbalances spill over into and weaken the banking system, which leads to a worsening of adverse selection and moral hazard problems PATH TWO: SEVERE FISCAL IMBALANCES Other factors also play a role in the first stage in some crises For example, another precipitating factor in some crises is a rise in interest rates that comes from events abroad, such as a tightening of monetary policy When interest rates rise, riskier firms are most willing to pay the higher interest rates, so the adverse selection problem is more severe In addition, the higher interest rates reduce firms cash flows, forcing them to seek funds in external capital markets in which asymmetric problems are greater Increases in interest rates abroad that raise domestic interest rates can then increase adverse selection and moral hazard problems (as shown by the arrow from the third factor in the top row of Figure 9-3) Because asset markets are not as large in emerging-market countries as they are in advanced countries, they play a less prominent role in financial crises Assetprice declines in the stock market do, nevertheless, decrease the net worth of firms and so increase adverse selection problems There is less collateral for lenders to grab on to, so moral hazard problems increase because with lower net worth the owners of firms have less to lose if they engage in riskier activities Asset-price declines can therefore have some role in worsening adverse selection and moral hazard problems directly (as shown by the arrow pointing from the second factor in the first row of Figure 9-3) as well as indirectly by causing a deterioration in banks balance sheets from asset write-downs As in advanced countries, when an emerging-market economy is in a recession or a prominent firm fails, people become more uncertain about the returns on investment projects In emerging-market countries, another source of uncertainty can come from the political systems, which are often notoriously unstable When uncertainty increases, it becomes harder for lenders to screen out good credit risks from bad and to monitor the activities of firms to whom they have loaned money, so that adverse selection and moral hazard problems worsen (as shown by the arrow pointing from the last factor in the first row of Figure 9-3) ADDITIONAL FACTORS