THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 234

202 PA R T I I I Financial Institutions funds mean fewer loans and a credit freeze The lending boom turns into a lending crash As we have seen, banks and other financial intermediaries play a crucial role in financial markets because they are well suited to collect information about businesses and industries This ability in turn enables these institutions to distinguish good loan prospects from bad ones When financial intermediaries deleverage and cut back on their lending, no one else can step in to collect this information and make these loans The ability of the financial system to cope with the asymmetric information problems of adverse selection and moral hazard is therefore severely hampered (as shown in the arrow pointing from the first factor in the top row of Figure 9-1) As loans become scarcer, firms are no longer able to fund their attractive investment opportunities; they decrease their spending and economic activity contracts Asset prices, in the stock market and real estate, can be driven well above their fundamental economic values by investor psychology (dubbed irrational exuberance by Alan Greenspan when he was Chairman of the U.S Federal Reserve) The result is an asset-price bubble, such as the tech stock-market bubble of the late 1990s or the recent housing-price bubble in the United States that we will discuss later in this chapter Asset-price bubbles are often also driven by credit booms, in which the large increase in credit is used to fund purchases of assets, thereby driving up their price When the bubble bursts and asset prices realign with fundamental economic values, the resulting decline in net worth increases asymmetric information (as shown by the arrow pointing from the second factor in the top row of Figure 9-1), making borrowers less credit-worthy and causing a contraction in lending and spending along the lines we discussed in the previous section The asset-price bust can also, as we have seen, lead to a deterioration in financial institutions balance sheets, which causes them to deleverage, further contributing to the decline in economic activity ASSET PRICE BOOM AND BUST Many Canadian financial crises were precipitated by increases in interest rates, either when interest rates shot up in the United States or when bank panics led to a scramble for liquidity in Canada that produced sharp upward spikes in interest rates Higher interest rates lead to declines in cash flow for households and firms and a reduction in the number of good credit risks who are willing to borrow, both of which increase adverse selection and moral hazard (as shown by the arrow pointing from the third factor in the top row of Figure 9-1), causing a decline in economic activity SPIKES IN INTEREST RATES Canadian financial crises have almost always started when uncertainty is high, either after a recession has begun or the stock market has crashed The failure of a major financial institution is a particularly important source of heightened uncertainty that features prominently in financial crises Examples in Canadian history are the Bank of Upper Canada in 1866, the Home Bank in 1923, and the bank panic of 1879 Since good financial information is harder to come by in a period of high uncertainty, adverse selection and moral hazard problems increase, leading to a decline in lending and economic activity (as shown by the arrow pointing from the last factor in the top row of Figure 9-1) INCREASE IN UNCERTAINTY