The Global Financial Crisis and the Great

Recession: Causes and

ConsequencesClaes Berg

Advisor to the Governor

Outline What happened? What are the reasons? Macroeconomic factors Microeconomic factors What are the consequences? Economic Theory Monetary Policy Inflation Targeting and Financial Stability Financial Stability Policy New Systemic Risk Measures Conclusions

Phase 1 Outbreak. The acute crisis related to the

housing market in the USA broke out in earnest in June 2007 and the first phase lasted until September 2008. Many borrowers with low credit ratings (”sub prime”) had been allowed for a period to take out mortgages as a result of a weakened regulatory framework and unreliable assessments on the part of the lenders. When house prices started to fall in the USA these house owners were the first to have problems, but the crisis spread to the entire mortgage market.

Phase 2 Systemic crisis and countermeasures. When

the Lehman Brothers investment bank failed on 15 September 2008 it triggered a period marked by panic and collapse of confidence, since the bank had counterparties throughout the world and interbank rates rose dramatically. A very deep and globally synchronised downturn started, which lasted until the end of the first quarter of 2009

Phase 3 The measures start to have an effect. A slow

recovery in the global economy started between the second and fourth quarters of 2009. Fiscal policy became increasingly expansive as a result of automatic stabilisers and stimulus measures. The economy made the clearest recovery in Asia, partly as a consequence of demand in China being maintained by central government stimulus measures.

Phase 4 Recovery but government finances

unsustainable in the long-term. From early 2010 world economic recovery stabilised, the situation on the global financial markets calmed down and crisis measures started to be withdrawn. The two track global recovery continued – with advanced countries growing more slowly than emerging economies. Focus increased on large budget deficits and national debt in several countries.

Difference between interbank rates and expected monetary policy (Basis spread)

Basis points

Sources: Reuters EcoWin and the Riksbank

Note. The spread is calculated as the difference between the three-month interbank rate and the three-month overnight index swap.

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50

100

150

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400

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10

0

50

100

150

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400

Sweden

Euro area

USA

United Kingdom

Global GDP Growth

Fiscal Balances

What Are the Reasons? Macroeconomic

factors The Great Moderation

and low inflation Low global interest

rates Low federal funds rate

in the USA Global imbalances:

High level of savings in other countries invested in the USA

Microeconomic factors

Weak regulatory framework for financial supervision

Incorrect credit evaluation

A shadow banking system without financial supervision

Financial leverage

Real House Prices and Growth Rate of Nominal Credit

Real Federal Funds Rate

Savings and InvestmentPercent of GDP

Savings Investment

Countries 2001 2008 2001 2008

USA 16,4 11,9 19,1 17,5

UK 15,4 15,1 17,4 16,8

China 37,6 59 36,3 49

Emerging economies in

Asia

27,6 32,1 24,2 30,1

Japan 26,9 26,7 24,8 23,5

Germany 19,5 25,7 19,5 19,3

Oil exporting countries 33,3 50,8 24,8 26,7

World 21,4 24,2 21,5 23,9

Global Imbalances (Current Account)

CDS-spreads for Financial Institutions

Balance Sheet Effects

Upward spiral Downward spiral

Reduced positions

Funding problems

Losses Price falls

Higher margins

Losses

Increased positions

Increased leverage

Profits Price increases

Lower margins

Increased profits

p

World trade volumeWorld Trade Monitor index, 2000 = 100, seasonally

adjusted data

Source: Netherlands Bureau for Economic Policy Analysis

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150

200

250

91 93 95 97 99 01 03 05 07 09

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100

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World trade totalEmerging economiesAdvanced economies

Average Change in Growth Rates

Average change in growth rates

(2008-2009 minus 2005-2007)

GDP Consumption Investment Exports

Eastern Europe -7,8 -8,7 -25,6 -13

CIS -7,3 -6,6 -25,2 -6,8

Industrial

countries

-4,6 -3,4 -15,3 -10,8

Western

Hemisphere

-3,7 -4,3 -11,8 -7,5

Emerging Asia -3,1 -1 -11,8 -7,6

Africa -1,9 1,8 0,9 -4,1

Middle East -1,4 -0,7 -2,7 -8,2

Central Bank Policy Ratespercent

Central Bank´s Balance Sheetspercent of GDP

General Governement Fiscal Balancepercent of GDP

General Government Gross DebtPercent of GDP

Swedish Policy Action in the Financial Crisis Central bank Longer term loans to banks Relaxed collateral requirements Lending in domestic currency and USD Swap lines with the Federal Reserve Emergency liquidity assistance to banks Interest rate cuts Government Increased deposit insurance Borrowing Guarentees to banks Capital injections Public administration of failed banks

What are the Consequences for Economic Theory? Return to old Keynesian

models! Efficient markets

hypothesis is wrong! New Keynesian models!

Develop new models! Complementary

channels! Several interest rates! Allow expert judgement!

No: Multiplier effects are uncertain!

No: not related to financial stability

Yes: with financial frictions

Yes Yes Yes Yes

What are the Consequences for Monetary Policy? Before the crisis Objectives: Stable

inflation and stable real economy

Financial variables indicator variables

Not possible to identify asset price bubbles in advance

Dichotomy between monetary policy and financial stability policy

After the crisis Objectives: Stable

inflation and stable real economy

An additional objective may also be to reduce the risk of financial crisis

Forecast based monetary policy: financial frictions taken into account

More coordination between mp and fsp

Flexible Inflation Targeting Forward looking procedure Use all available information (incl.

judgement) when setting interest rates Projections for inflation and the output

gap should satisfy a sequence of target criteria (not a point-in-time criterion)

Inflation Targeting and Financial Stability

Woodford (2010, 2011) discuss two aspects of this question:

(1) the appropriate monetary policy response to financial crisis, after one occurs

(2) whether monetary policy can reduce the likelihood of occurrence of a crisis, before the next crisis occurs

Monetary policy response to a financial crisis after it occurs Cúrdia & Woodford (2009, 2010) Time-varying financial frictions (”credit

spreads”) affect both the IS relation and the AS relation

Affecting the expected future path of short-run real rates is still the primary tool of the central bank (rather than the current short rate as such)

Projections for output and inflation should still satisfy a target criterion

The average interest rate rather than the policy rate determines how the target criterion is satisfied

Monetary policy response to a financial crisis after it occurs Flexible inflation targeting is better than a

spread adjusted Taylor rule The optimal degree of response to

changes in the credit spread depends on the degree of anticipated persistence of the disturbance

A forecast-targeting central bank will take into account many credit spreads, their expected persistence and other judgemental factors

The crisis in a simplified

model

Aggregate demand/inflation Inflation target = 2 Equilibrium real interest rate = 2 Monetary Policy Rule: Real interest rate = 2 + a•(Inflation – 2) +

b•Resource utilisation Resource utilisation = c – d•Real interest

rate Substitute the interest rate from MPR into

the equation above => Aggregate demand/inflation: Resource utilisation= e - f•(Inflation – 2)

Aggregate supply/inflation Firms´ price setting behaviour Adaptive expectations: Inflationt = Inflationt-1 + g•Resource utilisation +

Supply shock Rational expectations: Inflationt = InflationE + g•Resource utilisation +

Supply shock

A rising credit spread between interbank rates and expected policy rates (Basis spread)

0

50

100

150

200

250

300

350

400

jan-07

apr-07

jul-07

okt-07

jan-08

apr-08

jul-08

okt-08

jan-09

apr-09

jul-09

okt-09

0

50

100

150

200

250

300

350

400Sweden

Euro area

USA

United Kingdom

Sources: Reuters EcoWin and the Riksbank

The crisis in a simplified model Real interest rate = Real policy rate +

Credit spread Resource utilisation = c – d•(Real policy

rate + Credit spread) Monetary Policy Rule: Real interest rate = 2 + a•(Inflation – 2) +

b•Resource utilisation New Aggregate demand/inflation: Resource utilisation= e - f•Credit spread -

f•(Inflation – 2)

Transmission of the crisis Aggregate demand/inflation shifts down to the

left: The Credit spread increases the real interest

rate Investment and consumption are dampened by

falling asset prices and weaker balance sheets Exports is weakened during a international

crisis: Lower international demand Financial crisis reduces firms´ access to trade credit

The crisis in a simplified model

Low Normal High

0

1

2

Resource utilisation

Infla

tion

(%)

A

B

C

D

Aggregate supply beforethe crisis

Aggregate demand beforethe crisis

Aggregate demandduring the crisis

Aggregate supply duringthe crisis

Can monetary policy can reduce the likelihood of a crisis?

Woodford (2010, 2011) Loosening monetary policy increases

leverage of intermediaries: easier for an unexpected shock to trigger crisis

Monetary policy affects risk of financial crisis and should not be the complete solution: macroprudential tools also needed

A financial stability objective is introduced in the flexible IT framework

Can monetary policy can reduce the likelihood of a crisis?

Credit frictions introduced in the intertemporal IS relation

Measures distortion in allocation of expenditure due to credit frictions

Corresponds also to a credit spread between long-term bond yields

Two-state Markov-switching model: low-credit-spread (normal) state high-credit-spread (crisis) state

Can monetary policy reduce the likelihood of a crisis?

Loss function: inflation, output (gap) + loss from inefficient composition of expenditure due to credit frictions

The target criterion: inflation and output + the rate at which the expected loss from financial crisis increases per unit increase in leverage

What matters for the target criterion is leverage of intermediaries and marginal crisis risk, not credit as such

What are the Consequences for Financial Stability Policy? Prudential policy instruments can be used to offset

the emergence of financial imbalances, such as instruments that directly affect the banks’ lending.

New methods for analysing how risks arise and be used to calculate the banks' fees for government support measures.

The Basel Committee has agreed to raise banks’ capital and liquidity requirements to increase their resilience in crises.

In Europe a new body, the European Systemic Risk Board (ESRB), is being set up to play a system-focused macro role.

44

Core Concept of Contingent Claims Analysis (CCA): Merton Model

Assets = Equity + Risky Debt = Equity + Default-Free Debt – Expected Loss = Implicit Call Option + Default-Free Debt – Implicit Put

Option

Assets

Equity or Jr Claims

Risky Debt

• Value of liabilities derived from value of assets.• Liabilities have different seniority.• Randomness in asset value.

Source: Gray, D and S Malone (2008)

The Government Borrowing Guarantee in Sweden Broad category of liabalities from 3 months to 5

years For liabilities less than one year: a uniform fixed

fee set at 0.5 per cent of the guaranteed amount For liabilities with maturities greater than one

year the fee will be risk-based Based on CDS spreads 1/01 2007 – 31/08 2008

plus 0.5 percentage points

The CCA Price of the Insurance Contingent claims analysis can be applied to set

the price of the fee. The implicit put option associated with the debt

of the banks gives the value of the insurance. The value can be converted to a spread which

gives the risk-based premium expected to cover the cost of the guarantee for a given horizon.

Guarantee Fees, Swedish Banks, contingent claims analysis, Basis Points

Source: IMF (2010), Sweden – Staff Report for the 2010 Article IV Consultation.

Conclusions The crisis will lead to more focus on the

interconnections between the real economy and the financial system and the balance sheets of households, firms, banks and the sovereign.

Contingent Claims Analysis can provide guidance for decision-makers, both in the financial sector and the political system.

Monetary policy can probably to some extent counteract future crises, but a more effective strategy must come from a new macro-prudential framework.

More work on inflation targeting and financial stability is needed.

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