The Global Financial Crisis: Causes and Consequences

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The Global Financial CrisisCauses and
Consequences

• Warwick J McKibbin
• CAMA, Australian National University
• The Lowy Institute for International Policy,
  Sydney
• The Brookings Institution, Washington DC

Presentation to Wednesday Lowy Lunch,8 April 2009
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Overview

• Some Context
• Understanding the World since 1997
• The Global Finance Crisis unfolding
• Key characteristics
• Understanding the nature of the crisis
• The main shocks
• Possible Scenarios looking Ahead
• Pessimism or optimism?
• The Global Macroeconomic Policy Response
• Summary and Conclusion

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The Context

• From a project on understanding the global
  financial crisis with Dr Andy Stoeckel using a
  global economic model to understand the key
  shocks

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Philosophical Debate

• Populist view is that we need a new economic
  framework and we need to throw away our empirical
  knowledge of how economies work
• Alternative view is that our current frameworks
  work well but we need to better understand the
  nature of the shocks impacting on the world

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3 observations

• Modern economies thrive on liquidity and
  confidence
• The world is a complex place and it is unlikely
  that there is a single cause of anything we
  observe
• It is unhelpful to create simplified straw men
  and cut them down one by one until there is
  nothing left.

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Major Shocks Since 1997

• Asia crisis (1997/98)
• Rising bond spreads 1999-2001
• Dotcom bubble 98-2000 burst 2001
• US monetary relaxation from 2001 to mid 2004
• US monetary tightening mid 2004 to june 2006 then
  cuts from late 2007
• Productivity surge in China manufacturing
  (relative price shock)
• Rise in commodity prices, oil, food, 2004-late
  2007
• Bond spreads rise from mid 07
• Stock markets peak in Oct 2007
• Collapse of Lehman Bros - Collapse of stock
  markets economic growth and global trade

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Rising Global Imbalances

• Global Savings in excess of global investment
• low long term real interest rates
• National savings and investment imbalances
• Countries with national savings greater than
  national investment run current account surpluses
• Countries with national investment greater than
  national savings run current account deficits

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Sources of current account imbalances

• Fall in Asia investment
• Fall in US (public and private saving)
• Fluctuations in US investment
• Rising oil prices
• High Chinese savings relative to investment

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Role of excess savings

• Search for yield
• Low real interest rates encouraging risk taking
  led to apparent mispricing of risk

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Relative Price shocks

• Fall in relative price of manufacturing relative
  to commodities
• Rise in relative price of future consumption
  relative to current consumption (a rise in risk)
• Rise in inflation globally from loose global
  monetary policy but lags in relative price
  adjustment

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Preliminary model results

• Energy/commodity price hikes from 2004
• 1/3 due to the emergence of rapidly growing
  developing economies
• 1/3 due to the lagged effects of loose US
  monetary policy through fixed exchange rates on
  global liquidity
• 1/3 due to speculation

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The Global Financial Crisis

• Contraction of the US Housing market (excess
  capacity)
• Massive de-leveraging by financial institutions
  with MBS exposure
• Transparency problems in securitized assets
  (regulatory breakdown)
• Lehman Bros collapse Sept 2008
• Credit markets freeze due to unknown counter
  party risk
• US and UK Governments slow to react to loss of
  confidence Paulson plan
• Stock market slump and housing price decline
  reduces consumption and investment
• Recession in the industrial world
• Recession globally

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What is the core of the latest crisis?

• Collapse in US housing market reducing
  household wealth and consumption
• Rise in risk
• Existing capital requires a higher return
• Need to scale back capital
• Fall in equity markets also reduces wealth
• Rise in household risk premia reduces future
  income streams

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A example from the G-Cubed model

• See
• www.gcubed.com

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Equity Risk Shock

• Suppose equity risk premia rise by 8 forever
• Versus equity risk premia rising 8,6,4,2,0

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Household Risk Shock

• Suppose household discount them future at 4 per
  year forever
• Household discount rate rises 4,2,0..

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Core Shocks

• In the US and UK it is a financial crisis
• In other countries it is a fall in exports and a
  loss of domestic confidence
• This is both a supply side shock and a demand
  side shock not just insufficient demand

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On the global policy responses

• In a single economy
• Monetary policy effective
• Fiscal policy less effective
• In a global economy
• Coordinated monetary policy less effective
• Coordinate fiscal policy more effective
• Temporary fiscal policy more effective than
  permanent fiscal policy
• Composition matters for supply versus demand
  response

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Role of Policy

• Monetary policy shifts demand from the future to
  the present
• Fiscal policy largely shifts demand from the
  future to the present plus it can change
  incentives to invest and save with permanent
  effects on the level of income

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3 Scenarios

• Risk premia remain high
• Long process of capital destruction
• Demand stimulus cant change this but can soften
  the blow

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Early signs of recovery?

• Optimism
• Commodity prices slightly rising
• Chinese foreign investment rising
• Pessimism (and key risks)
• European economies fiscal liabilities putting
  strain on the Euro
• Eastern Europe looking more like East Asia in
  1997

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2 scenarios

• 1) Risk returns to pre 2007 levels
• Strong recovery with demand stimulus overlaying
• Governments have borrowed heavily and now need to
  finance large deficits
• Rising global interest rates as public and
  private compete

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3 scenarios

• 2) Risk premia fall to back to 1990s levels
• US and UK in long asset adjustment period
• Developing countries return to growth momentum
  quickly

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Summary and conclusion

• A series of shocks over the past decade but the
  big shock is a loss of confidence (risk shock)
• Large financial and real implications of this
  type of shock
• Trade is not the major channel of transmission
  but the problem is a synchronized loss of
  confidence
• Monetary and fiscal policies cant do much to
  stabilize the supply side but can help smooth
  demand in the short run
• Macro policys main role is to raise confidence
  rather than as an end in itself
• Regulatory reform and institutional reform is
  critical for handling future shocks

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