How does it Cope with an Adverse Shock?

Highlighting the features of a debt run-up, and then illustrate how our financial economy copes with an adverse shock in a world without central bank interventions.

Welcome back to the second part of the articles about the Diabolic System of Money in Banking article series. In part two, we will highlight the features of a debt run-up, and then illustrate how our financial economy copes with an adverse shock in a world without central bank interventions.

In this article, discussion about, How an adverse shock is endogenously amplified through the liquidity spiral and the disinflation spiral.

Photo by Andrea Piacquadio from Pexels

In particular, we will focus on two adverse feedback loops, the Liquidity Spiral and the Disinflation Spiral. You will also learn about the new paradox of prudence. So far, we have set up the economy. The financial system facilitates bobbling and lending across agents. The government, along with the central bank offers some safe assets in the form of reserves.

Let's start by noting that it is a buildup of short term debt that makes the economy vulnerable to the financial crisis. There are three aspects of economics that we would like to highlight upfront. First, the run-up in debt can occur in different sectors from crisis to crisis. For example, in Japan in the 1980s, the debt level increased significantly in the corporate sector.

 In contrast, in the United States in the 2000s, again up of debt occurred in the household sector, while the corporate sectors that increased only marginally second. Typically when there is a run-up in debt, whichever sector may be, the financial sector is also issuing more debt. The third status fact is that the government stepped price a sharp sharply after the crisis erupts. The debt turn up can be benign and simply be a sign of financial deepening. But what if the economy experiences an adverse shock when the economy stopped functioning? How does an indebted economy cope with an adverse shock in a world in which the government and central bank Pass? Suppose some of the employers suffer an adverse shock, and as a consequence, they are less likely to pay back their debt.
To see how the shock is amplified into a large financial crisis, 
it is useful to split up the impact of this adverse shock into four steps. 

 - Firstlythe direct impact of the shock on the assets of the banks.

 - Secondly, the response of the bank's shrinking the balance sheet. 

 Third, the impact on asset prices.  And

  -  Fourth, the impact on the real value of inside money. 

So, the First step is the immediate impact of the adverse shock on the impose ability to repay their loans. This directly translates into a decline in the value of the bank's assets. Looking at the acid side of the bank's balance sheet, a decline in the value of credit safer 5% with a much larger percentage decline in equity liabilities in form of inside money stays the same in all the losses have to be absorbed by the equity. Since equity declines in percentage terms by much more than bank assets, the asset to equity ratio of the banks that is celebrity ratio is shooting up.

The Second step is the bank's response. The high level of trust issues caused by the adverse shock triggers a response by the banks to try to bring it back down by shrinking the balance sheet. First, they will extend less new credit to the Emperor's who then can buy fewer homes and invest in fewer machines. Second, banks will also try to sell off all loans all credit. If banks are hit, then they are would like to sell the assets at the same time. But if no bank wants to buy, who will be willing to buy these assets, the only ones that are potentially willing to buy these assets are the savers directly. However, remember that savers are not as good as banks at enforcing the repayment of the loans and they cannot diversify as well as the banks are able to, Hence, they are not willing to pay much for these assets, and asset prices will drop.

The Third step is the liquidity spiral. As banks fire sell the old loans and credit assets are worthless, resulting in further losses and a decline in bank equity. This triggers further fire zones, rising risk premia, And So,

The Fourth step. Paradoxically, each individual banks effort to deliver that is to be my rodent is macro imprudent, as it increases overall volatility. Our paradox of prudence is to risk-taking what Keynes paradox of Thrift is to saving. Each individual's attempt to save more reduces other's income and ultimately overall savings. Here, each individual banks attempt to reduce its risk increases the overall systemic macro risk. The fourth step is a disinflationary spiral on the liability side of the banks.

As banks shrink the balance sheet, they also shrink the amount of money they are creating. In other words, the supply of insert money declines, and with it, the money multiplier. In addition, households money demand rises, since households are now exposed to additional idiosyncratic risk, which banks seized to diversify away, without the intervention of the central bank, outside money is fixed. As banks shrink the balance sheet total money supply declines.

As this happens, the value of money rises, goods are getting cheaper. This inflation is kicking in. As the value of money increases, so does the value of banks' liability, as shown graphically, they call banks or savers money, so savers are benefiting while banks are losing. It's increasing the value of money hurts the bank's equity even further.

Again, the decline in equity raises celebratory issues further feeding the liquidity spiral and the debt disinflationary spiral, overall risk premia rise and investors demand a higher compensation for taking on risk.

       To recap we have separated the shock in four steps, which of course occur simultaneously. 
@Graph Captured from
  1. -First, there was an initial shock that impaired assets.
  2. -Second, the response of the banks was to shrink the balance sheets, cut back on new loans, and finally all outstanding credit.
  3. -Third, this led to a liquidity spiral, lowering asset prices and forcing further sell-offs forth. The decline in the supply of inside money and the rise in the amount of money led to disinflation, which increases the real value of debt that banks owe to the savers. 

All this significantly lowered bank's equity and give rise to risk premia. In some, a small shock has large persistent effects on the real economy in hurt especially the levered sector, including banks.

We have analyzed the impact of an adverse shock on financial stability, and we have gained a better understanding of the interaction. We have seen that the banks are hit on both sides of the balance sheets on the asset side. And on the liability side, we have two spirals, the liquidity spiral and the disinflationary spiral. Because of the liquidity spiral, you have less new credit, fire sales, declines in asset prices, declines in investment and economic growth. On the liability side, the disinflation spiral is at work, deposits decline, the real value of money in death rises, the money multiplier collapses.

Overall, banks aftershocks are amplified and can persist. Both lead to systemic risk endogenously generated by the system to sum-up, part two This video series taught us how spirals amplify a small adverse shock. If central bank stays passive, Click on Part Three to learn How Monetary Policy can Containthe Amplification.



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Beyond Narrative | Blog Where Every Single Word Matters: How does it Cope with an Adverse Shock?
How does it Cope with an Adverse Shock?
Highlighting the features of a debt run-up, and then illustrate how our financial economy copes with an adverse shock in a world without central bank interventions.
Beyond Narrative | Blog Where Every Single Word Matters
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