GFC Cause and Consequences
Transcript of GFC Cause and Consequences
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The Global Financial Crisis:Causes and Consequences
Warwick J McKibbinCAMA, 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 aglobal economic model to understand the keyshocks
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Philosophical Debate
Populist view is that we need a new economic
framework and we need to throw away ourempirical knowledge of how economies work
Alternative view is that our current frameworkswork well but we need to better understand thenature 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 weobserve
It is unhelpful to create simplified straw men andcut them down one by one until there is nothingleft.
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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 late2007
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; economicgrowth and global trade
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l l l l l l l l l l l l l l l l l l l0
25
50
75
100
125 Singapore
South
Korea
Index
December 1989 = 100, monthly
Hong Kong
Indonesia
l l l l l l l l l l l l l l l l l l l 0
25
50
75
100
125
Malaysia
Philippines
Thailand
Taiwan
Index
Asian Currencies against USD
Sources: Bloomberg; Thomson Reuters
China
0597 01 0993 0597 01 0993
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2
4
6
2
4
6
-10
-5
0
5
-10
-5
0
5
Real GDPYear-ended percentage change
* Hong Kong, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan
and Thailand
Sources: ABS; CEIC; Thomson Reuters
2008
Australia
%%
% %
USEuro area
New ZealandJapan
Asia*
2005200219991996
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l l l l l l l l l l l l l l0
100
200
300
400
500
600
0
100
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600
Index Index
US Share Price Indices2 January 1995 = 100
NASDAQ
20011997 20031999
Source: Bloomberg
2005
S&P 500
200920071995
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l l l l l l l l l l l l l l l l l l l-2
-1
0
1
2
3
4
5
6
7
8
-2
-1
0
1
2
3
4
5
6
7
8
%%
US Federal Funds Rate
1994 2000
Real*
Nominal
Sources: RBA; US Federal Reserve
* Real Fed Funds target calculated using core CPI updated to December 2008.20091991 20061997 2003
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l l l l l l l l l l l l l l40
100
40
100
Major Countries' Share Price Indices
Japan
Australia
US
UK
IndexIndexLog scale, December 1994 =100
Euro area Canada
250300
350
200
150
250300
350
200
150
Source: Bloomberg
1997 2003 2005 20091999 2001 20071995
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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 thannational investment run current accountsurpluses
Countries with national investment greaterthan national savings run current accountdeficits
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Current Accounts 1995-2008
(%GDP)
-10
-5
0
5
10
15
20
25
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
$bil
NIEs
Europe
ASEAN5
Middle East
China
USA
Source IMF World Economic Outlook October 2008
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Current Accounts 1995-2008
($US)
-1000
-800
-600
-400
-200
0
200
400
600
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
$bil
NIEs
Europe
ASEAN5
Middle East
China
USA
Source IMF World Economic Outlook October
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Investment
0
5
10
15
20
25
30
35
40
45
50
1995 1996 1997 1998 1999 2000 2001 2002 2003
%GDP
Malaysia Indonesia Thailand Korea
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1 Main drivers behind the decline in current account balance in the
United States
-900
-800
-700
-600
-500
-400
-300
-200
-100
0
1991 1993 1995 1997 1999 2001 2003 2005
US$billion
...
US fiscal deficit and
public dissav ing, low
personal sav ing rates
Japanese investment slump
US dot com inv estment boomBoom collapses
Asian financial cris is and
loss of investor confidence
Source: OECD Economic Outlook No. 76, December 2004
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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 takingled to apparent mispricing of risk
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l l l l l l l l l l l l l l2
6
10
14
18
2
6
10
14
18
%
Emerging Market Bond Yields
1997 2003
Latin America
Asia
1999
%
Sources: Bloomberg; Thomson Reuters
200920072001 20051995
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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 globalmonetary policy but lags in relative priceadjustment
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Commodity Prices in $US
(Index = 100 in 2003M1)
0
50
100
150
200
250
300
350
400
450
500
2003
M1
2003
M4
2003
M7
2003
M10
2004
M1
2004
M4
2004
M7
2004
M10
2005
M1
2005
M4
2005
M7
2005
M10
2006
M1
2006
M4
2006
M7
2006
M10
2007
M1
2007
M4
2007
M7
2007
M10
2008
M1
2008
M4
2008
M7
EnergyFood
Agricultural Raw Materials
Metals
Beverages
Source: IMF World Economic Outlook Database October
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Preliminary model results
Energy/commodity price hikes from 2004
1/3 due to the emergence of rapidly growingdeveloping economies
1/3 due to the lagged effects of loose US
monetary policy through fixed exchange rates onglobal 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 ofconfidence Paulson plan
Stock market slump and housing price decline reducesconsumption and investment
Recession in the industrial world Recession globally
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1
3
5
7
9
1
3
5
7
9
%
AAAcorporates
US government
%
BBB corporates
Source: Bloomberg
Swap
1999
MonthlyUS Corporate Bond Yields (3-5 years)
2001 2003 2005 2007 20091997
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0
200
400
600
800
0
200
400
600
800
US Corporate Bond Spreads (3-5 years)Spread over government yields, monthly
Bps
AAA corporates
A corporates
BBB corporates
Source: Bloomberg
Swap
Bps
1999 2001 2003 2005 2007 20091997
Wh i h f h l i i ?
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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 futureincome streams
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A example from the G-Cubed model
See
www.gcubed.com
E i Ri k Sh k
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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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Change in US Real GDP from 8% equity risk premium
-6
-5
-4
-3
-2
-1
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21
%deviation
Temp
Permanent
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Change in US Capital Stock from 8% equity riskpremium
-18
-16
-14
-12
-10
-8
-6
-4
-2
0
2
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21
Temp
Permanent
H h ld Ri k Sh k
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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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Change in US Consumption from 4% household riskpremium
-14
-12
-10
-8
-6
-4
-2
0
2
4
6
8
0 4 8 12 16 20 24 28 32 36 40 44 48 52 56 60 64 68 72
%deviation
Permanent
Temporary
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Change in US Real GDP from 4% household riskpremium
-10
-8
-6
-4
-2
0
2
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21
%deviation
Permanent
Temporary
C Sh k
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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 demandside shock not just insufficient demand
On the global polic responses
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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 permanentfiscal policy
Composition matters for supply versus demand
response
Role of Policy
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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 changeincentives to invest and save with permanent
effects on the level of income
3 Scenarios
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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
Early signs of recovery?
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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 puttingstrain on the Euro
Eastern Europe looking more like East Asia in1997
2 scenarios
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2 scenarios
1) Risk returns to pre 2007 levels
Strong recovery with demand stimulusoverlaying
Governments have borrowed heavily and nowneed to finance large deficits
Rising global interest rates as public andprivate compete
3 scenarios
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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
Summary and conclusion
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Summary and conclusion
A series of shocks over the past decade but the bigshock 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 theproblem 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 shortrun
Macro policys main role is to raise confidence ratherthan as an end in itself
Regulatory reform and institutional reform is critical forhandling future shocks
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www.sensiblepolicy.com