GLOBAL FINANCIAL CRISIS:

Causes and Consequences

Hyeongwoo Kim

Auburn University

October 30, 2010

Prepared for the 4th KSEA-AL Symposium on Automotive Technology

US Financial CrisisUS Financial Crisis

� The collapse of the

US sub-prime

mortgage market in

2007 triggered a global 2007 triggered a global

financial crisis.

� The failure of Lehman Brothers resulted in a serious

disruption in international financial markets.� Stock prices (level, sd)

� Exchange rates (level, sd)

Global RecessionsGlobal Recessions

� This US financial crisis triggered recessions not only in

the US but also in the rest of the world.Real GDP growth rates ↓ (Fig)� Real GDP growth rates ↓ (Fig)

� Unemployment rates ↑ (Fig)� Still very high in the US (Unemployment durations ↑)

� Inflation rates ↓ (recessions) after initial increases

(expansionary M policies) (Fig)

� Policy makers tried to stop it, but less

successful� Expansionary monetary policies

� Interest rate cuts (short, long)

� Quantitative easing (US)

Policy ResponsesPolicy Responses

� Quantitative easing (US)

� Expansionary fiscal policies� Stimulus checks

� Cash for clunkers

� Government spending vs. tax cuts

� Private sectors did not respond as expected� Consumption (Fig) and Investment (Fig) barely

responded.

� International trade shrank (Fig).

Causes and ConsequencesCauses and Consequences

� The profession seems to agree on that the

crisis was triggered by the collapse of the US

sub-prime mortgage market. Then, natural

questions are,

� Why did it collapse?

� The value of the US sub-prime mortgage market

is tiny (6.7% of total mortgage debt in 2009).

Why did it spread to,

� Other financial industries?

� Other non-financial industries?

� Other countries?

Causes of the CrisisCauses of the Crisis

� Why did it collapse?

� Housing price bubble

� Unsustainable (Fig)

� Bubble is supposed to burst.

� Some blame Greenspan – unclear (Fig)� Some blame Greenspan – unclear (Fig)

� Overall asset bubbles around 2000

(Fig)

� Securitization (financial

innovations, loophole mining)

� Excessive leverage (off-balance

sheet activities)

� Moral hazard (too big to fail)

Other Financial SectorsOther Financial Sectors

� Financial activities are highly intertwined.

� The Glass-Steagall Act (Banking Act of 1933) were repealed,

� Depository Institutions Deregulation and Monetary Control Act of

1980 (Regulation Q)

� The Gramm–Leach–Bliley Act (November 12, 1999; Bank-holding � The Gramm–Leach–Bliley Act (November 12, 1999; Bank-holding

company)

� Virtually no separation of banking from securities industry now

� Update: President Obama signed the Dodd-Frank financial regulation

reform bill (July 21, 2010).

� The collapse of the sub-prime mortgage market quickly

spread to other financial industries.

NonNon--Financial Real SectorsFinancial Real Sectors

� Spill-over effects to non-financial

industries

� Caused by liquidity crunchCaused by liquidity crunch

� Excess reserves ↑ (Fig)

� Money multiplier ↓ (Fig)

� Higher borrowing costs due to high

degree uncertainty

� Risk premium ↑ (Fig)

� Credit default swap ↑

Contagion to Other CountriesContagion to Other Countries

� Financial markets are highly integrated across countries

(Financial channel)

� De-regulation (can be costly, Korea vs. China in 1997)

� Shares of foreign investors

� Mrs. Watanabe (Fig)

� Substantial increases in volumes of international trade

(Real activities channel) (Fig)

� Supposed to be good (comparative advantage)

� May become vulnerable to foreign shocks

� Exchange rate shocks (highly volatile and persistent)

Contagion to Other CountriesContagion to Other Countries

� Highly integrated international economies may imply,

� Higher degree co-movement in 2000s

� Coupling phenomenon

� Static synchronization (Fig)

� Temporary dynamic correlations (Fig)� Temporary dynamic correlations (Fig)

� Severer and more persistent adverse effects of a foreign

shock in 2000s.

� Dynamic synchronization (Fig)

� 1% ↓ in the US stock price � 0.5% and 2% ↓ in German stock

prices in the 1970s and in the 2000s, respectively, in the long-run.

� More Significant adverse effects in the 2000s both quantitatively and

qualitatively

Policy ImplicationsPolicy Implications

� Kim and Kim (2010a,

2010b) studied the recent

US financial crisis and

identified the channels of

contagion in international contagion in international

financial markets.

� Contagion occurred

abruptly and lasted for a

short period of time.

Policy ImplicationsPolicy Implications

� Kim and Kim (2010a,

2010b) studied the recent

US financial crisis and

identified the channels of

contagion in international contagion in international

financial markets.

� Substantial level effect

� Stock prices (level)

� Exchange rates (level)

Policy ImplicationsPolicy Implications

� Kim and Kim (2010a,

2010b) studied the recent

US financial crisis and

identified the channels of

contagion in international contagion in international

financial markets.

� EWS, Currency Swap

Agreements

� Strengthen the roles of

domestic agents in

financial markets

Thank you.Thank you.Thank you.Thank you.

Stock Prices

Stock Returns Volatility

Foreign Exchange Rates

FX Depreciation Rates Volatility

Real GDP Growth Rates

Unemployment Rates

CPI-based Inflation Rates

Overnight Inter-bank Rates

10-Year Government Bond Yields

Real Consumption Growth

Real Investment Growth

Exports-Imports Growth

US Money Growth

Housing Price and Fundamentals

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1880 1900 1920 1940 1960 1980 2000 2020

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Home Prices

Building CostsPopulation

Interest Rates

Source: Irrational Exuberance (2nd Edition), Robert J. Shiller

Interest Rates

Commodity Prices

Risk Premium

US Trade Openness

Mrs. Watanabe

Excess Reserves

Money Multiplier

Stock Market Synchronization

BEKK Conditional Correlations

Impulse-Response Analysis