1. Federal Planning Bureau Economic analyses and forecasts The financial crisis and its consequences for the real economy IBFP- 27.11.2009 Henri Bogaert

2. Federal Planning Bureau Economic analyses and forecasts Outline Origins of the crisis Where do we stand now? The near future

3. Federal Planning Bureau Economic analyses and forecasts Origins of the crisis

4. Federal Planning Bureau Economic analyses and forecasts Four joint driving forces combining macro and micro policy errors Macroeconomic policies Financial market regulation 1. Speculative bubbles3. Financial innovations and deregulation 2. “Organized” global imbalances 4. “Asymmetric information” leading to the collapse of the interbank market

5. Federal Planning Bureau Economic analyses and forecasts Transmission channels of monetary policy 5 Accommodating monetary policy Low interest rate Impact on real economy Channel n° 1 Reduced cost of capital Increase of Investment Channel n° 2 Reduced mortgage and credit costs Increase of housing investment and durables Growth of GDP Inflation Tightening of monetary policy

6. Federal Planning Bureau Economic analyses and forecasts What went wrong? 6 Accommodating monetary policy from 2001 to 2006 Development of asset price bubbles Impact on real economy Channel n° 1 Reduced cost of capital Increase of Investment Channel n° 2 Wealth effect and indebtedness Increase of housing investment and durables Growth of GDP: no boom No Inflation No Tightening of monetary policy

7. Federal Planning Bureau Economic analyses and forecasts US monetary policy Following the bursting of the technology bubble, rates were slashed to fight deflation Real fedfundsrate close to 0% or even negative for 5 years Making credit very cheap Increased risk taking, resulting in historically low risk spreads Pushing up asset prices (financial & houses)

8. Federal Planning Bureau Economic analyses and forecasts When expectation of price increase is based on past increase

9. Federal Planning Bureau Economic analyses and forecasts US and euro area monetary policy

10. Federal Planning Bureau Economic analyses and forecasts US stock market Stock indices rose by almost 100% in the 5 years to mid 2007

11. Federal Planning Bureau Economic analyses and forecasts US house prices House prices rose by almost 90% between early 2001 and mid 2006 The belief in ever increasing house prices was a major cause for the current crisis From mid 2006 onwards, house prices start to decline This resulted in a plunge of the prices of mortgage related financial products

12. Federal Planning Bureau Economic analyses and forecasts US household indebtness (debt-to-income ratio)

13. Federal Planning Bureau Economic analyses and forecasts US Private Consumption / GDP ratio

14. Federal Planning Bureau Economic analyses and forecasts Very high asset price inflation did not lead to high growth and consumer price inflation ! Increasing share of durable goods has been produced in emerging countries, especially China At low wage cost And at undervalued exchange rates, large imbalances and sterilization in emerging countries But internal factors have also played a role: –Credibility of Central Banks –Increasing competition –Reduction of taxes

15. Federal Planning Bureau Economic analyses and forecasts Current account deficits & surpluses (2008, in bn USD) Largest current account surplusesLargest current account deficits OPEC459,9US-706,1 China426,1Spain-153,7 Germany235,3Italy-78,8 Japan157,1France-64,8 Russia102,4Greece-51,6 Norway88,0Australia-46,6 Netherlands65,7UK-46,5

16. Federal Planning Bureau Economic analyses and forecasts Consequences of the crisis for the real economy and where do we stand now?

17. Federal Planning Bureau Economic analyses and forecasts When the bubbles burst… 17 Tightening of monetary policy from 2007 onwards Burst of asset price bubbles + collapse of global banking system Impact on real economy Channel n° 1 Interest rates increase and credit conditions tightened Drop of Investment Channel n° 2 Deleveraging and increase of saving ratio Drop of housing investment and consumption Recession Fear of deflation Massive monetary and fiscal support

18. Federal Planning Bureau Economic analyses and forecasts The drop of world trade growth was comparable to 1929

19. Federal Planning Bureau Economic analyses and forecasts World GDP growth since 1930

20. Federal Planning Bureau Economic analyses and forecasts Massive interventions stabilized financial markets US interbank rate Spread between interbank and official rates soared during the crisis This spread has disappeared in the US, the euro area and elsewhere

21. Federal Planning Bureau Economic analyses and forecasts But also massive support from the budget Increased government spending (stimulus plans), lower tax receipts resulted in large budget deficits Which will result in rapid increases in debt levels Risk of higher long term interest rates Stimulus can not last for very long

22. Federal Planning Bureau Economic analyses and forecasts Cost of capital: Corporate bond spreads have normalized Corporate bond market spreads have diminished, but will probably remain more elevated than in 2005-2007

23. Federal Planning Bureau Economic analyses and forecasts Wealth effects: equity and house prices are rising Stock indices have soared by 50% or more since low early March House prices are again starting to rise in the US, the UK Most asset prices are rising

24. Federal Planning Bureau Economic analyses and forecasts The global recession has ended Near term optimism caused by a combination of temporary factors : - fiscal stimulus - inventory rebuilding rather than by solid private consumption and investment growth

25. Federal Planning Bureau Economic analyses and forecasts The near future

26. Federal Planning Bureau Economic analyses and forecasts Growth will resume slowly... 2008200920102011 US0,4-2,52,22 Japan-0,7-5,91,10,4 Euro Area0,6-40,71,5 Belgium (BFP)1,1-3,10,41,9 Inflation4,501,51,6 Employment Change71,2-35-5917,6 Unemployment Rate7,08,29,49,6

27. Federal Planning Bureau Economic analyses and forecasts But, unemployment will be unacceptably high

28. Federal Planning Bureau Economic analyses and forecasts Danger of early exit, exhibit 1:Greece Source: FT, Barclays, OECD ABCD Bank assets (in bn € ) ECB funding (in bn € ) B/A Debt/GDP in 2010 GR481387,9111,8 IR1650985,980,3 BE1163403,4106,4 GE75192212,984,1 ES3427842,568,2 NL2208401,876,6 LX1150191,7 n/a FR77071011,394,2 IT3730300,8127,3

29. Federal Planning Bureau Economic analyses and forecasts Banks’ healthstill fragile S&P’s risk-adjusted capital (RAC) ratios study of 45 world’s leading banks RAC reflects leverage Resembles new capital ratio regime expected to be set by the Base committee early next year Completely different picture of banks’ strength to that under current Basel II rules (Tier1) Especially German & Japanese banks fair badly Only 9 of 45 banks RAC of above 8%, minimum level to cover forecast levels of stress Implication: Banks will need to raise billions of capital RACTier 1 HSBC9,28,3 Dexia910,6 ING Bank8,99,3 Goldman Sachs Group8,313,8 Morgan Stanley8,115,8 KBC Bank7,79,7 BNP Paribas?7,27,8 JPMorgan Chase79,7 Deutsche Bank6,110,1 UBS2,213,2 Citigroup2,112,7 Mizuho Financial Group26,4 Global average of 456,19,7

30. Federal Planning Bureau Economic analyses and forecasts And the fiscal challenge in 2011 will be difficult to manage OECD areaUSEuro area Fiscal balance-7.7-9.7-6.0 Debt103.8100.792.7 Deficits and debts are unsustainable Fiscal consolidation is necessary worldwide But would slow the economic growth during several years Timing of consolidation controversial

31. Federal Planning Bureau Economic analyses and forecasts Two rebalancing acts needed That would lead to a sustainable recovery : –From public to private spending: otherwise debts would continue to rise and risk pushing interest rates higher –Shift from domestic to foreign demand in the US & shift from foreign to domestic demand in Germany, China and the rest of Asia  Will take time

32. Federal Planning Bureau Economic analyses and forecasts Outcome? Three scenarios Pessimistic: –Fiscal and monetary exit strategy happens too soon –Private demand does not take over role of government spending, while banks tighten credit standards & prices –Economic activity nosedives –New problems surface in the financial sector Towards the next bubble: –Monetary and fiscal too loose for too long –Asset prices are boosted by the lenghty surge in liquidity –Governments, central banks allow more inflation to erode debt –Bubble collapses bringing us back to the situation of late 2008, but starting with much higher debt rates Global rebalancing: –Timing of monetary and fiscal exit is just ‘right’ –Chinese domestic demand become drivers of world economy (Germany?) –US households repair balance sheet (deleveraging, saving more), US growth more driven by external sector

33. Federal Planning Bureau Economic analyses and forecasts