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 Dotcom bubble 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

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

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

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

Preliminary model results Energy/commodity price hikes from /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

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

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

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

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 can’t 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 can’t do much to stabilize the supply side but can help smooth demand in the short run Macro policy’s main role is to raise confidence rather than as an end in itself Regulatory reform and institutional reform is critical for handling future shocks