The Global Financial Crisis: Causes 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

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

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

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

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.

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

Asian Currencies against USD

December 1989 = 100, monthly Index Singapore 125 Malaysia 100 South Korea 75 China 50 Philippines 25 0 Indonesia
l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l

Index 125 100 Taiwan 75 Thailand 50 25 0

Hong Kong

93

97

01

05

09

93

97

01

05

09

Sources: Bloomberg; Thomson Reuters

Real GDP
Year-ended percentage change % Australia 6 6 %

2 Euro area % US Asia*

0 Japan -5 New Zealand

-5

-10

1996

1999

2002

2005

2008

-10

* Hong Kong, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan and Thailand Sources: ABS; CEIC; Thomson Reuters

US Share Price Indices

2 January 1995 = 100 Index 600 NASDAQ 500 400 300 S&P 500 200 100 0
l l l l l l l l l l l l l l

Index 600 500 400 300 200 100 0

1995

1997

1999

2001

2003

2005

2007

2009

Source: Bloomberg

US Federal Funds Rate

% 8 7 6 5 4 3 2 1 0 -1 -2
l l l l l l l l l l l l l l l l l l l

% 8 7 Nominal 6 5 4 3 2 1 Real* 0 -1 1991 1994 1997 2000 2003 2006 -2 2009

* Real Fed Funds target calculated using core CPI updated to December 2008. Sources: RBA; US Federal Reserve

Major Countries' Share Price Indices

Index 350 300 250 200 150 Australia UK 100 Log scale, December 1994 =100 Euro area US Canada Index 350 300 250 200 150

100

Japan 40
l l l l l l l l l l l l l l

1995

1997

1999

2001

2003

2005

2007

2009

40

Source: Bloomberg

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

Current Accounts 1995-2008 (%GDP)

25

20

15
NIEs Europe ASEAN5 Middle East China USA

10
$bil

0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

-5

-10
Source IMF World Economic Outlook October 2008

Current Accounts 1995-2008 ($US)

600 400 200 0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
$bil

-200 -400 -600 -800 -1000

Source IMF World Economic Outlook October 2008

NIEs Europe ASEAN5 Middle East China USA

Investment
50 45 40 35 30

%GDP

25 20 15 10 5 0 1995 1996 1997 Malaysia 1998 1999 2000 Thailand 2001 Korea 2002 2003 Indonesia

Main drivers behind the decline in current account balance in the United States
US dot com inv estment boom 0 -100 -200 -300
US$ billion ...

Boom collapses

US fiscal deficit and public dissav ing, low personal sav ing rates

-400 -500 -600 -700 -800 -900 1991 1993 1995 1997 1999 2001 2003 2005 Japanese inv estment slump Asian financial crisis and loss of inv estor confidence

Source: OECD Economic Outlook No. 76, December 2004

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

Role of excess savings

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

Emerging Market Bond Yields

% Latin America 18 18 %

14

14

10 Asia 6

10

1995

1997

1999

2001

2003

2005

2007

2009

Sources: Bloomberg; Thomson Reuters

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

Commodity Prices in $US (Index = 100 in 2003M1)

500 450 400 350 300 250 200 150 100 50 0
20 03 20 M1 03 20 M4 0 20 3M7 03 M 20 10 04 20 M1 04 20 M4 04 20 M7 04 M 20 10 05 20 M1 05 20 M4 0 20 5M7 05 M 20 10 06 20 M1 06 M 20 4 06 20 M7 06 M 20 10 07 20 M1 07 20 M4 0 20 7M7 07 M 20 10 08 20 M1 08 M 20 4 08 M 7
Energy Food Agricultural Raw Materials Metals Beverages

Source: IMF World Economic Outlook Database October 2008

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

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

US Corporate Bond Yields (3-5 years)

Monthly % %

BBB corporates

7 Swap 5 AAA corporates 3 US government 1 1997 1999 2001 2003 2005 2007 2009

Source: Bloomberg

US Corporate Bond Spreads (3-5 years)

Spread over government yields, monthly Bps Bps

800

800

600 AAA corporates 400 A corporates 200 Swap 0 1997 1999 2001 2003 2005 2007 2009 BBB corporates

600

400

200

Source: Bloomberg

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

A example from the G-Cubed model

See

www.gcubed.com

Equity Risk Shock

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

Change in US Real GDP from 8% equity risk premium

0 0 -1 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21

-2
%deviation

-3

Temp Permanent

-4

-5

-6

Change in US Capital Stock from 8% equity risk premium

2 0 0 -2 -4 -6 -8 -10 -12 -14 -16 -18
Temp Permanent

9 10 11 12 13 14 15 16 17 18 19 20 21

Household Risk Shock

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

Change in US Consumption from 4% household risk premium

8 6 4 2 0
%deviation

12

16

20

24

28

32

36

40

44

48

52

56

60

64

68

-2 -4 -6 -8

72

Permanent Temporary

-10 -12 -14

Change in US Real GDP from 4% household risk premium

2

0 0 -2
%deviation

9 10 11 12 13 14 15 16 17 18 19 20 21

-4

Permanent Temporary

-6

-8

-10

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

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

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

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

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

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

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

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

www.sensiblepolicy.com