Leverhulme Centre 6th Form Conference, June 26th 2012

The Global Financial Crisis and the World Economy

Professor David Greenaway

And some films…….

Context and Origins

Origins• Capital market liberalisation• Global macro imbalances• Global savings glut• Accomodative monetary policy• Strong global growth • The ‘end of boom and bust’• The search for yield and underestimation of risk• Regulatory vacuums

From Sub-Prime Crisis to Credit Crunch

What is Sub-Prime Lending?Sub-prime borrowers typically have weakened

credit histories that include payment delinquencies, and possibly more severe problems such as charge-offs, judgements and bankruptcies. They also display reduced repayment capacity as measured by credit scores, debt to income ratios, or other criteria that may encompass borrowers with incomplete credit histories.

US Treasury Department guidelines, issued in……. 2001

Why Did We Have a Sub-Prime Crisis?

• An international savings glut• Low interest rates and liquid financial markets• Search for yield• Ever more sophisticated, but ever more opaque,

financial engineering• Underestimation of risk• Inflation in asset values, especially real estate /

housing• Housing price slowdown and contagion in 2007 /

2008

Why Do We Have a Credit Crunch?

• Information ‘black holes’– uncertainty over the magnitude of toxic debt– uncertainty over the location of toxic debt

• Banks stopped lending to each other– uncertainty over the location of toxic debt– uncertainty over their own exposure

• Banks cut back on retail lending– provision for write-offs– need to rebuild balance sheets

Policy Responses

Government Intervention• Interest rate cuts:

– United States (5.25 to 0.3%)– Eurozone (4.25 to 1.0%)– United Kingdom (5.75 to 0.5%)

• Support for the financial system:– US, UK and Eurozone: $8,995 billion (and

rising)• Liquidity support: $1,950 billion• Asset purchases: $2,525 billion• Guarantees: $4,480 billion

‘The Aftermath of Bankning Crises’

‘The Aftermath of Financial Crises’

• Reinhart and Rogoff anatomy of aftermath of financial crises in industrialised and emerging economies

• Headlines:– “...asset market collapses are deep and

prolonged....”– “...profound declines in output and

employment...”– “...real value of government debt tends to

explode...”

Asset Market Collapses• Real estate / housing

– Average peak to trough decline of 35.5%– Average decline duration of 6 years– Extremes: declines of 50-60% (Finland, Philippines,

Colombia, Hong Kong); duration, 17 years (Japan)• Equity markets

– Average peak to trough decline of 55.9%– Average decline duration of 3.4 years– Extremes: decline of 90% (Iceland); duration, 5

years (Malaysia, Thailand, Spain)

Unemployment and Output• Unemployment

– Average increase of 7 percentage points over 4.8 years

– Extremes: 20 percentage points (US); duration, 12 years (Japan)

• Output– Average decline, 9.3% over 1.9 years– Extremes: 29% (US); duration, 4 years (US,

Finland, Argentina)

Real Government Debt• Average increase in government debt 3

years after crisis (excluding current crisis) of 86.3%

• Extremes: 280% (Finland, Colombia)

Global Recession

Global Recession• The global financial crisis has pushed all

major OECD economies into recession• Many emerging economies have slower or

negative growth due to a collapse in export markets

• There is uncertainty regarding the depth and duration of recession

• There is a possibility of deflation in some economies

Globalisation of Recession

• Transmission across borders– Integrated capital markets– Lower capital flows – Banking failures– Fall in export demand– High import content of exports

Impact on World Trade• World trade only recorded negative growth

in one year between 1950 and 2008• World trade slowed sharply in the final

quarter of 2008• World trade declined by 12% in 2009, due

to:– decline in capital flows (credit crunch)– decline in demand (recession)– High import content of exports (globalisation)

The Future?

Key Risk Factors• Unexpected ‘bad news’ (scale of losses /

capacity to finance debt)• Increased protectionism• Slow recovery• Recession becomes deflation• Disorderly break-up of Eurozone

Resilience Of Global Systems

• Major ‘shocks’ of last 30 years of twentieth century:– Oil shocks of 1973-74 and 1980-81– Collapse of Bretton Woods system– Debt crisis of mid 1970’s– High (and hyper) inflation– Collapse of the European Monetary System– Collapse of Soviet bloc in Europe– Asian crisis

Some Longer-term Implications• Low and stable inflation not sufficient to avoid cycles• Globalisation of financial system has added to risks• Financial system can be a powerful driver of

economic fluctuations• Regulatory frameworks need to be reformed to limit

this source of volatility• Greater international surveillance of imbalances

may be necessary• Economic modellers and policy-makers need to

improve understanding of feedbacks from financial system to economic activity