Response to the 2008 Financial Crisis and International Cooperation

From Baripedia

The objective of this course is to present the financial crisis of 2008 - 2009 using the Aggregate Demand and Supply (AD - OA) model that we have developed in the last sessions.

We will start with the causes of the crisis, its consequences and the response of governments around the world.

We will stress the importance of a coordinated economic policy response at the international level in the case of a global crisis.

Often when we talk about the latest financial crisis we hear the gradual deregulation of the financial market that continued during the 1980s and 1990s being blamed for the crisis. In reality, as we shall see, several causes contributed to its onset.

The boom of 2002 - 2007 and the crisis in the real estate market[edit | edit source]

The boom of 2002 - 2007[edit | edit source]

Consumer boom fuelled by easier access to credit in the United States.

Increased money supply in the US in response to the crisis following the new technology bubble (2000) and on 11/09/2001.

High commodity prices + China's growth: NCO of emerging countries is increasing rapidly.

Financial innovations 1 (Collateral Debt Obligations, CDOs, cf. below) also facilitate access to credit (loans granted to insolvent debtors).

Intromacro boum de 2002 2007 1.png

This situation of overproduction and economic boom led to an increase in the anticipated price level → contraction of short-term supply (also favoured by the rise in oil prices) → shift of the AO curve to the left and additional price increases.

Intromacro boum de 2002 2007 2.png

The outbreak of the crisis[edit | edit source]

Intromacro éclatement de la crise 1.png

The Fed begins to worry about inflation and raises the policy rate (which reduces the supply of money and raises market interest rates). This caused a sharp decline in aggregate demand and broke the real estate bubble, resulting in lower investment (as returns on real estate investment decline) and financial innovations such as CDOs (see below) are proving to be very very risky. The financial crisis is spreading to the real economy (strong ↓ of Y).

The collateral debt obligations[edit | edit source]

It is a very sophisticated financial product created by very smart Wall Street operators, the consequences of which few people really understood...

Basically, we assemble a part of very risky toxic assets (subprimes) that have a very high return (because of their risk). Putting them together diversifies the risk. They are then divided into small parts: "securitized" into bonds and traded on the subprime market. NB: CDO transactions are not subject to any form of regulation.

These securities were rated triple AAA by rating agencies (= low risk), because the risk is diversified and the money is received first in case of bankruptcy. NB1: However, with a CDO you cannot get rid of systemic risk! NB2: Irrational expectations about the future development of the real economy (inefficient markets, cf. section 6) and unfounded forecasts of share values from ↑ .

If the economy stagnates a little, then all issuers of bad assets (junk bonds) may go bankrupt and investors holding triple AAA CDOs end up with a worthless piece of paper.

This is what happened when the real estate bubble burst in the US (CDOs include a lot of real estate loans) → huge losses for the banks that held a lot of these securities in their assets → the real estate crisis is rapidly turning into a crisis for the whole banking sector.

Course of the crisis[edit | edit source]

As interest rates have begun to rise (due to the Fed's restrictive monetary policy), borrowers of credit are coming under pressure (this is particularly true for subprime mortgage categories):

  • significant increase in the number of defaults → ↑ of home sales and foreclosures;
  • falling house prices and losses for banks that had many CDOs in their portfolios as mortgage borrowers default on their loans;
  • failures of many banks and financial institutions around the world (interdependencies);
  • Significant contraction in the credit market and the impact on many companies (emblematic case: automotive industry).
  • falling output, sharp rise in unemployment: the financial crisis is spreading to the real economy.

Monetary stimulus[edit | edit source]

The Fed is trying to respond to the crisis with monetary expansion and a policy of support for the banking sector (despite the problems of moral hazard or moral hazard).

Problem: the demand for money is perfectly elastic. We are in a liquidity trap situation (cf. ch. 13 and 14) where agents (including firms) prefer not to invest and resort to credit. Consequently, monetary policy is completely ineffective, and aggregate demand does not react.

Why is the demand for money perfectly elastic? The real estate market crisis quickly turns into a financial and banking sector crisis and agents no longer have confidence in the financial system. Major financial institutions (such as Bearn Sterns and Lehman Brothers) fail, and this was seen as the real kick-off of the crisis by market participants (even though the crisis had in fact already started before that).

Fiscal stimulus[edit | edit source]

Only the fiscal tool remains to react to the crisis. But, however...

  1. We need a rapid and counter-cyclical response (and, as we know, fiscal policy interventions are not necessarily → delays).
  2. The Keynesian multiplier becomes smaller and smaller with the crisis because consumers tend to save more out of fear of the future (the cpmc is decreasing) => less efficient fiscal policy.
  3. Some authors (e.g., Barro, Lucas) also think that a fiscal response will not be effective because the crowding out of private investment that it provokes will be too great (at the same time, one could ask, what crowding out effect if nobody invests anyway?).
  4. If the economy is open, a fiscal stimulus will help its trading partners, because it favours imports → positive externalities... and in a world where there are positive externalities, there is underprovision of this good, here fiscal stimulus (one waits for the other to do something to benefit from the positive effects of his intervention) → crucial international cooperation.

International coordination[edit | edit source]

Protectionism[edit | edit source]

Not only is there a risk of under-intervention (see end of previous section), but governments will do everything possible to keep the positive effect of the recovery within their frontières→ attitude inward oriented :

  • Increasing protectionism around the world...
  • Subsidies from domestic auto companies .
  • Subsidies from domestic banks on condition that they don't make loans abroad...
  • Buy America provisions in the American fiscal stimulus package, Gordon Brown's "British jobs to British workers"...
  • Increasing the supply of money or buying foreign currency to depreciate the domestic currency and thus make domestic goods relatively cheaper...

Importance of international coordination[edit | edit source]

All this makes fiscal stimulus less effective because:

  • Protectionism drives up prices and thus shrinks the world market.
  • Subsidies given in a discriminatory manner according to nationality do not necessarily go to the most efficient companies that could create more jobs.

A cooperative effort by countries to jointly revive the world economy could solve these problems (G-20 meetings).

The recovery of the world economy could be achieved at a lower cost if all countries participated in its construction instead of trying to "export" their unemployment to the rest of the world.

Current situation[edit | edit source]

Interventions by governments and central banks have had some of the desired effect. Today the world economy is in a phase of growth, albeit slow and modest.

In some countries the fiscal stimulus has resulted in very high levels of public debt (PIIGS debt crisis: Portugal, Italy, Ireland, Greece, Spain). See next page.

One very worrying underlying problem remains: the major global imbalances (global imbalances): see section 9. China and the other newly industrialised countries are injecting considerable liquidity into the world economy (the lax monetary policy in the USA at the beginning of the 2000s was not the only cause of the latest financial crisis).

It also remains to be seen what reforms should be adopted in order to try to reduce the risk of a new financial crisis of such magnitude occurring again: reform of the banking sector, new financial market regulations, strengthening of supervision, increased international coordination, etc.

Euro crisis[edit | edit source]

With recovery dragging on, a consequence of the intervention action of governments in several countries is the significant increase in public debt, which is particularly problematic for some of the countries belonging to the European Monetary Union.

Case of Greece (the most dramatic): austerity policy demanded to reduce the public deficit → Unwanted effects: contraction of aggregate demand (in times of crisis!) and, potentially, tax cuts.

Traditionally, in this type of situation, a possible solution would be to simultaneously stimulate the economy with an expansive monetary policy that would lead to a devaluation of the currency and, consequently, an improvement in net exports → not possible within the framework of the European Monetary Union (single currency).

Three other options :

  • Greece exits from the Monetary Union (for the moment nobody wants it);
  • The European Central Bank has an expansive monetary policy (option chosen for now);
  • Greece defaults (huge costs).

Rescue plan for Cyprus[edit | edit source]

Several member countries of the European Monetary Union have found themselves in difficulty in recent years and have requested the intervention of the European Union and the International Monetary Fund (European Stability Mechanism).

More recent case: Cyprus

Rescue plan in detail :

  • Puncture of up to 60% on bank accounts over 100'000 euros;
  • In-depth restructuring of the island's first bank, the Bank of Cyprus, and "orderly" bankruptcy of the island's second bank, Laïki (it will be split between a "bad bank", a bad bank that will gradually disappear, and a "good bank", where deposits below 100,000 euros, which benefit from a public guarantee in the European Union, will be grouped together → major losses for bondholders and uninsured depositors above 100,000 euros);
  • Introduction of capital controls + limits on bank withdrawals to a maximum of 120 euros per day;
  • Implementation of a restrictive fiscal policy (tax increases, reduction of civil service staff, privatisation of some public companies, increase in corporate taxes from 10% to 12.5%).

Austerity or growth?[edit | edit source]

Should the government cut spending and keep the public deficit under control or should it intervene to revive economic growth without worrying too much about the level of debt?

« Growth in a Time of Debt »

— Carmen Reinhart and Ken Rogoff (RR) American Economic Review, Vol. 100 No. 2, May 2010

Study widely cited by many European and American politicians, supporting the idea that a deficit fiscal policy could be unfavourable to growth (statistical analysis based on historical data covering a period of 200 years and several dozen countries);

Main result: growth falls dramatically and becomes negative when the public deficit exceeds 90% of GDP.

Recently three authors, Thomas Herndon, Michael Ash and Robert Pollin (HAP), have shown that much of the results of this paper are simply not correct (errors in the data and in the statistical manipulations), thus justifying the release of a new capability for the link between high public debt and economic growth.

Main results of the PAH study :

  • Empirical evidence shows that, when the (public debt)/GDP ratio exceeds 90%, the average growth rate is 2.2% (and not -0.1, as shown in RR);
  • The relationship between growth and public debt varies enormously over time and across countries, implying that it is very difficult to draw generalised conclusions.

Main conclusion :

  • We are not suggesting that governments should be free to borrow and spend profligately. But government deficit spending, pursued judiciously, remains the single most effective tool we have to fight against mass unemployment caused by severe recessions."
  • In periods of deep recession, the rise in government deficits and debt has been a consequence of the crisis and certainly not the cause of the decline in economic performance.

Annexes[edit | edit source]

  • Damage assessment, The Economist, 16.05.2009, sur les effets possibles de la crise économiques sur le niveau de production de plein emploi.
  • Redefining recession, The Economist, 13.09.2008, sur les difficultés de mesure et de définition du concept de récession.
  • The global slumpometer, The Economist, 08.11.2008, sur ce qu’on entend par « récession globale ».
  • The slump goes on: why?, Paul Krugman et Robin Wells, The New York Review of Books, 30.11.2010, pour une analyse de la crise proposée par Paul Krugman, Prix Nobel pour l’Economie en 2008, et Robin Wells.
  • Pourquoi les crises reviennent toujours, Paul Krugman, 01.07.1997, sur la baisse de la demande comme origine des crises et le célèbre exemple de la coopérative de baby-sitting de Krugman.

References[edit | edit source]