Financial Crisis, The Government Relief Measures And The Risk Of Inflation

The 2007-2008 U.S. sub-prime mortgage financial crisis triggered the most severe global financial crisis in the 21st century. In order to find out the most effective and efficient countermeasures, we compare the present U.S. financial crisis with the big 5 historical financial crises and find out the parallels and differences between them. The run-ups in U.S. equity and housing prices, public debt and current account deficit and the declining output growth closely track the average of the big 5 historical financial crises.The policy responses to resolve the crisis include monetary and fiscal policies and regulatory forbearance. Liquidity support is always the primary monetary policy. The government generally use equity injection, asset buyback and debt guarantee to bailout the distressed financial institutions. Fiscal stimulation is implemented to increase the aggregate demand in order to accelerate the economic recovery. Regulatory forbearance could encourage the frozen credit market to recover.However, government interventions always result in expensive cost. Bailout cost is directly indicated by fiscal deficit. When the government set up a special purpose vehicle to carry out the asset buyback program, bailout cost is then determined by the operation efficiency of that entity. Take asymmetric information into account, the government need to fight against adverse selection and moral hazard. Through theoretical analysis, we have found out that bailout programs that attract all banks to participate have the potential to dominate programs that attract only bad banks under the assumption of asymmetric information. Guaranteeing new debt is optimal among programs that attract all banks since it results in relatively less fiscal cost and output growth decline.No matter which bailout program the government adopts, inflation is inevitable. Tremendous fiscal deficit and banking credit explosion exacerbate inflation. Inflation pressure, coupled with the declining output growth, further increase the default risk of credit market. In order to mitigate the inflation, the government could moderately adjust the regulatory deposit reserve ratio and try to accelerate output growth. Fiscal stimulation is the most popular way to encourage the domestic demand. However, the government may reasonably amortize the total stimulation amount into several years to control the annual fiscal deficit.