GFC Cause and Consequences

8/3/2019 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

200

300

400

500

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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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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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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GFC Cause and Consequences