International Economics

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Global Economic Crisis I

The Global Economic Crisis

Welcome to the fourth module of this course on International Economics! For this
lesson, we will try to model the global financial crisis and explore the differences
between a sharp rises in global risk that is permanent versus one that expected to
be temporary. Another objective is to show the impact of the policy response of the
different countries, especially the fiscal response with a dynamic, intertemporal
general equilibrium model that fully integrates the financial and real sectors of the
economy is used to unravel and understand the mechanisms at work. And the last
objective is to showcase the model which incorporates wealth effects, expectations
and financial markets for bonds, equities and foreign exchange as well as trade and
financial flows. It is a suitable tool to analyze the impact of the crisis and policy
responses on global trade and financial flows.
Financial crises are not new phenomenon and the world economy has from time to
time been hit by crises wherein the current crisis is most probably not the last one.
However, several factors combined to make this one the most severe crisis since the
Great Depression of the 1930s, including macroeconomic problems, failures in
financial markets and shortcomings in the implementation of policy. The financial
sector has grown complex and its actors have become very big, sometimes too big to
control. These institutions and their products therefore have become difficult to
regulate and supervise. Even the internal control of the financial institutions
themselves failed in several cases. System-wide risks therefore became much larger
than ever before. Furthermore, remuneration policies added to the buildup of risks.
Governments and central banks have the responsibility of upholding financial
stability through proper supervision and regulation of the financial markets and its
institutions. However, the supervisory structures in many regions were fragmented
which led to an absence of responsibility for system-wide risks. The supervisory and
regulatory structure failed to keep pace with the evolution of the financial markets.
Moreover, when financial companies become very large in relation to the overall
economy, public finances are exposed to large risks. The collapse of Lehman
Brothers in September 2008 sent a wave of fear around world financial markets.
Banks virtually stopped lending to each other.
The risk premium on interbank borrowing rose sharply to 5 percent, whereas
typically it was close to zero. Although authorities scrambled to inject liquidity into
financial markets, the damage was done. The risk premium on corporate bonds shot
up even more to over 6 percent. Large CAPEX projects were shelved, the corporate
sector virtually stopped borrowing, trade credit was hard to get and, with falling
demand, particularly for investment goods and manufacturing durables like cars,
trade volumes collapsed. The result is that the global financial crisis has seen the
largest and sharpest drop in global economic activity of the modern era. In 2009,

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most major developed economies find themselves in a deep recession. The fallout
for global trade, both for volumes and the pattern of trade has been dramatic. The
OECD predicts world trade volumes could shrink by 13 percent in 2009 from 2008
levels. Governments have responded with an easing of monetary and fiscal policy
that in turn have their own effects on activity and financial and trade flows. The
downturn in activity is causing unemployment to rise sharply and, with it, a political
response to protect domestic industries through various combinations of domestic
subsidies and border protection. There is potential for protectionism to rise further.
The focus of the analysis is on disentangling the many influences of the financial
crisis on the global economy and in particular to see how well the model can explain
the macroeconomic and sectoral responses to the crisis in confidence that we model
through risk shocks. The “crisis” is defined here as the bursting of the housing
market bubble in late 2007, the ensuing collapse in the sub-prime mortgage market
and related financial markets and the subsequent collapse of Lehman Brothers in
2008 which resulted in a sharp increase in risk premia around the world. The
problem in precisely modeling the crisis is that there are already shocks in the
baseline that affect subsequent global dynamics independently of the crisis.
Here we are focusing only on the additional shocks from the crisis. The problem is
that some of the seeds of the financial crisis were sown in the decade before the
crisis. There were a series of large global events, such as the bursting of the dotcom
bubble in 2001 and the rapid growth of China, that were already reshaping the
pattern and level of world trade before the 2007-2008 financial crisis hit. Some of
these events, like the large disparities between savings and investment in China (a
surplus) and in the United States (a deficit) led to large differences between exports
and imports for each nation so that large current account surpluses were
accumulating in China and large deficits in America.
Some people attribute these growing global imbalances as contributing causes of the
crisis, and there is some truth in that. But the focus of this module is on the impact of
the crisis itself on world trade and not on trying to disentangle the various
contributing factors to the crisis, as important as that issue is. Therefore, besides
population and productivity trends shaping the baseline for the world, some of the
key events over the last decade influencing the baseline would be:
First, there was the Asian financial crisis of 1997-98, which saw Asian economies
generate large current account surpluses that had to be invested offshore to keep
their nominal exchange rates low. Capital flowed out of Asia into US dotcom stocks
driving up equity prices. Next was the bursting of the dotcom bubble, which saw the
booming NASDAQ over 1998–2000 burst in 2001. Fearing a downturn and possible
deflation, the US Federal Reserve eased monetary policy in 2001 in a series of steps
until 2004. Some argue that they eased too much for too long. But, with easy credit
and a rising housing market, a boom in house prices followed and a period of high
growth in credit and leveraged loans. Risk premia hit low levels and leveraged deals
became common as investors chased yields in an environment of lax regulatory
oversight.

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Rising demands from China (and, to some extent, India), plus a booming world
economy saw commodity prices rise across oil, minerals and food from late 2004 to
late 2007. The shock to the global economy from this commodity price boom was as
big as the first oil shock in the 1970s. Rising prices and inflation caused monetary
authorities to tighten policy from mid-2004 to June 2006. Each of these major
events set up their own dynamics for the course of the world economy and helped
shape the underlying baseline. Some of these events such as the easing and
tightening of monetary policy are endogenous to the model and already
incorporated in the baseline.
It is important to appreciate that the results reported here are deviations from
baseline from the financial crisis, as defined here. What is important is the relative
contribution of different effects and to disentangle the impacts of the financial crisis
on the global economy in the short to medium run. The five shocks to represent the
crisis and the policy responses the above events have led to the now well-known
global downturn. All official forecasting agencies, such as the IMF and OECD, have
described this downturn and so will not be expanded here.
As the IMF notes “Global GDP is estimated to have fallen by an unprecedented 5
percent in the fourth quarter (annualized), led by advanced economies, which
contracted by around 7 percent”. Japan has been particularly hard hit with a fourth
quarter GDP (2008) plummeting by 13 percent. Demand for durable goods has been
particularly hard hit. With the downturn there has been a sharp upturn in savings
by households (and commensurate reduction in consumption), driven by a
reappraisal of risk by households and a loss of net worth with falling house prices
and equity prices. So shocks need to be devised to account for: 1) The bursting of the
housing bubble and loss in asset prices and household wealth with consumers
cutting back on spending and lifting savings. 2) A sharp reappraisal of risk with a
spike in bond spreads on corporate loans and interbank lending rates with the cost
of credit, including trade credit, rising with a commensurate collapse of stock
markets around the world. A massive policy response including a monetary policy
easing, bailouts of financial institutions and fiscal stimulus.
Shock 1: The bursting of the housing bubble

Falling house prices has a major effect on household wealth, spending and
defaults on loans held by financial institutions. Events in the United States
typify a global phenomenon. From 2000 to 2006, house prices in some areas
doubled to subsequently collapse. These changes in some areas have generated
dramatic news headlines but, overall the United States index of house prices
has fallen by 6.2 percent in real terms from the 1st quarter 2008 to the same
quarter in 2009.While house prices were rising so strongly, credit was
supplied liberally to meet the demand as perceptions of risk fell.
The rising wealth boosted confidence and spending. The housing bubble was a
global phenomenon centered mainly on the Anglo-Saxon world. The housing
bubble was the result of a long period of low interest rates by the US Federal

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Reserve. The Federal Reserve cut interest rates by a total of 550 basis points in
a series of steps between 2001 and 2004. Some believe (for example the
“Austrian school” and John Taylor), that monetary policy was too loose for too
long and this is what gave rise to the asset price bubble and commodity price
spike.
Taylor argues that had the Federal Reserve followed the Taylor rule, interest
rates would have risen much sooner and the bubbles not appear to the same
extent. While low interest rates were due to fears of deflation and led to a
boom in US housing, low interest rates were not just the result of the Fed’s
actions. US bond yields were also low because of low world rates (with
Japanese bond yields at a little over 1 percent and short term interest rates at
zero). There was also an international aspect to low US interest rates with
Japan and Europe only recovering very slowly from the 2000-01 downturn and
in turn placing pressure on the US to keep interest rates low. In Japan there
were fears of re- emergent deflation. That is the principal reason why interest
rates were kept low in the US for an unusually long term — until mid-2004
when the Fed began a very sharp tightening cycle. The low interest rates
through 2003-04 — besides fueling a boom in bank lending, rising asset prices
and rising demand in China and other developing countries — also fueled a
commodity price boom.
However, only a part of the dwelling boom and the commodity boom can be
attributed to the actions of the Fed. The up-trend in US house prices was
evident as early as 2000. As small investors abandoned the stock market in
2001, they dived into the housing market, driving up and sustaining the price
rises. Similarly, the surge in commodity prices through 2005 to 2008, which
took most analysts by surprise, had as much to do with developments in China,
and the lagged response of supply, as they did with an increase in demand in
North America. Where the real problem lay was in the combination of the two.
The bursting of the housing bubble is modeled as a surprise fall in the expected
flow of services from housing investment – larger in the United States, United
Kingdom and Europe but still significant throughout the world. In the model,
the household in each economy is modeled as solving an intertemporal
consumption problem subject to an intertemporal budget constraint. The
result is a time profile for the consumer in each country of consumption of
goods from all countries based on expected future income and expected
relative goods prices. The household also chooses investment in a capital good.
The household capital stock combines housing, and other durable goods. For
simplicity of exposition we will refer to this capital good as “housing” from
here on.
The investment decision by households is modeled analogously to how we
model the investment decisions of firms within an intertemporal framework
subject to adjustment costs for capital accumulation. The household invests in
housing to maximize consumption from the stream of future service flows that

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housing provides. This stream of services is analogous to a production function

based on inputs of capital and a productivity term. We model the housing part
of the crisis as a fall in the productivity of the service flow from the housing
stock. The drop in housing productivity in the United States is assumed to be
10 percent lower in 2009 and is calibrated to give, along with the other shocks,
the drop in house prices in the US of the order of 6 per cent, roughly what has
been observed for the last year. A plausible scenario is where productivity
returns to “normal” by 2013.
Shock 2: Rising Equity Risk Premia

The surprise up-swing in commodity prices from 2003 but most noticeable
during 2006 and 2007 led to concerns about inflation leading to the sharp
reversal in monetary policy in the US. This tightening in US policy also implied
a tightening of monetary policy in economies that pegged to the US dollar. It
was the sharpness of this reversal as much as the fall in US house prices and
the failures of financial regulation that led to the financial problems for 2008.
Lehman Brothers’ failure was primarily due to the large losses they sustained
on the US subprime mortgage market. Lehman’s held large positions in the
subprime and other lower rated mortgage markets. But mortgage
delinquencies rose after the US housing price bubble burst in 2006-07. In the
second fiscal quarter 2008, Lehman reported losses of $2.8 billion. It was
forced to sell off $6 billion in assets.

Outlook from the Global Financial Crisis without Fiscal Stimulus

When all economies are affected by the global financial crisis through global
changes in risk premia and loss of consumer confidence, other countries like China
are adversely affected. When other economies are also adversely affected by the
reappraisal of risk, the cost of capital for them also rises and, in effect, causes the
existing capital stock to be too large. Investment plummets, but not everywhere
because it is relative effects that matter. Whereas Chinese investment rose when
just the United States was assumed to be affected by the crisis, now Chinese
investment falls to a low of over 10 percent below baseline in 2010 under the
permanent risk shock. Under the assumptions of the smaller rise in risk premia
across the rest of Asia, Latin America and LDCs, these regions gain relatively from
the global reallocation of investment. Investment in other Asia could be 2 to 4
percent higher over baseline in 2009 and 2010. India, China, Australia, other Asia,
Latin America and other LDCs do not go into recession as a result of the global
financial crisis as represented by the three shocks used in this module. While some
Latin American economies such as Argentina are not faring well at the moment,
there are other forces at work such as drought and the impact of taxes on their
exports. In most regions exports are variously 8 to 14 percent below baseline in
2009 with exports from Australia and India 20 to 25 percent down over the full year
and continue to remain low in the case of the permanent scenario. There is a

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substantially larger contraction in exports relative to the contraction in GDP in all

economies. This massive shift in the relationship between trade and GDP is not the
result of an assumption about the income elasticity of imports.
It reflects some key characteristics of the model. First, imports are modeled on a
bilateral basis between countries where imports are partly for final demand by
households and government and partly for intermediate inputs across the six
sectors. In addition, investment is undertaken by a capital sector that uses domestic
and imported goods from domestic production and imported sources. As
consumption and investment collapse more than GDP, imports will contract more
than GDP. One country’s imports are another country’s exports thus exports will
contract more than GDP unless there is a change in the trade position of a particular
country. The assumption that all-risk premia rise and the results that all real
interest rates falls everywhere implies small changes in trade balances.

Outcomes for Permanent versus Temporary Risk Scenarios

There are large differences depending on whether the shock to equity risk and
household risk is permanent or temporary. The first observation is that, as expected,
the impacts on the stock market, investment and exports is much greater and longer
lasting when the shock is permanent than when it is temporary. Whereas the
decline in stock markets is up to 20 or even 25 percent below baseline in 2009
under the permanent scenario, under the temporary scenario the decline is around
5 percent. That is, even though initial shock to risk premia under the permanent and
temporary scenarios is the same in 2009, in many cases the effect can be three to
five times greater, and longer lasting, when the shock is expected to be permanent,
compared to outcomes when the shock is expected to be temporary. The reason is
expectations.
As described earlier, because this is a fully specified dynamic intertemporal general
equilibrium model, forward looking behavior by some agents in the model has to be
allowed for. Under the temporary scenario, households and businesses expect risk
premiums to come down and behave accordingly. These groups of forward looking
households and firms partly see through the shock. Hence the stock market does not
fall as much, the collapse in investment is less and the impact on trade is less. Two
areas where there is less initial difference between the permanent and temporary
scenarios is outcomes for real GDP and real interest rates. In 2009, the differences in
real GDP outcomes as between the two scenarios are mainly confined to the United
States and the United Kingdom. The reasons are mainly due to the differences in the
assumed household risk shocks in the case of Japan and Germany and to the smaller
investment effects for the others for the reasons noted above. In subsequent years
the differences in real GDP outcomes between the two scenarios for all regions can
be substantial. The reason is that under the permanent increase in risk premiums
the stock of capital shrinks permanently and so does real GDP.

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For real interest rates there is an initial fall everywhere. Initially the fall in interest
rates is by around 400 basis points both reflecting a long run decline in the marginal
product of capital but also reflecting a response of monetary authorities in lowering
nominal interest rates. But there is a difference in real interest rate outcomes
between the permanent and temporary scenarios in subsequent years. Under the
temporary shock, real interest rates have recovered back to baseline or even slightly
above by 2011 due to the expected return to “normal” risk premiums.
The differences in results between permanent and temporary risk premiums pose a
dilemma for representing the global financial crisis in a model such as the one used
here. Initial outcomes around the world are indicative of the permanent rise in risk
premiums. But subsequent developments in financial markets show that the
temporary risk premium scenario is more likely to unfold.

Growing Imbalances that Starts the Crisis

For many years, a number of countries had been running large current account
deficits. This situation worsened during the 2000s. At the same time oil exporting
countries and some emerging countries, especially China, have been running large
and rising current account surpluses. A large proportion of these current account
surpluses were invested in developed countries. The increased demand resulted in
higher prices and lower government bond yields and low returns on fixed income
financial assets across all advanced economies. Thus, apart from all the positive
effects of low inflation and low interest rates, a side effect was a rapid accumulation
of debt among households in the Western world.
Moreover, the financial system became loaded with risk although its participants
were largely unaware of this.Many central banks, in particular the US Federal
Reserve, considered that they should not respond to the rapid rise in credit and
asset prices. Instead they should (aggressively) drop the interest rate if asset prices
fell sharply and led to an economic downturn. This approach was based on the
notion that they could not identify an asset price bubble and if they could it would
be dangerous to try to deflate it – but they could mitigate the deflationary effects on
the economy of a fall in asset prices. In countries where central banks had this
approach, the responsibility to address financial cycles implicit rested with the
government and, to some extent, with supervisors. However, supervisors mainly
address issues that affect individual firms and surveying systematic risks have
seldom been part of their assignment. In the end, it has not always been very clear
who was responsible for the financial cycle. In many cases the rapid credit
expansion and increased leverage was left without action.The crisis occurred in a
situation with high and stable growth but also with growing macroeconomic
imbalances, low interest rates and ample liquidity. However, a well-governed and
resilient financial sector should perhaps be able to function in such an environment,
without creating the excesses seen over the past decade. It was after all not the first
time when interest rates were low and asset prices were booming. Thus it can be

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argued that the crisis in many ways was a result of inherent weaknesses in the
financial markets, which allowed a large but underestimated buildup of risk.
The financial markets and its institutions have grown markedly over the past
decades. In the developed world, deregulation of financial markets since the 1970s
combined with globalization has led to the formation of large and very complex
cross-border financial institutions. Global markets have also become increasingly
integrated, with large capital flows across borders and emerging economies gaining
an increasing share of international trade. Financial innovations over recent years
have increased the complexity and scale of the network of inter-relationships
between financial institutions. These innovations were made possible by both
advancements in financial theory as well as in the technical infrastructure of the
financial markets. One example is the rapid increase in financial innovation, such as
securitization and over-the-counter derivatives (OTC derivatives). They were
thought to achieve high nominal returns without any significant increase of risk. As
later became evident, the risks inherent in these new products were not fully
understood by banks themselves or by the regulators and supervisors.
The growth of securitization was lauded by most financial industry commentators
as a means to reduce banking system risks. The purpose of securitization is to
repackage and sell assets to investors better able to manage them. The consensus
before the financial crisis was that it originate and distribute model of banking
resulted in risk being diversified and distributed more widely across the global
financial system.But when the crisis broke out it became apparent that
diversification of risk had not actually been achieved. Some of the holdings of the
securitized credit were not in the books of end investors intending to hold the assets
to maturity but on the books of highly leveraged bank-like institutions (so called
Special Purpose Vehicles or SPVs). The increasing use of the originate and distribute
model of lending also meant that lenders have had less incentive to apply strict
credit controls since the loans were expected to only stay on lenders’ balance sheets
for a short time.

The Global Economic Crisis