The Global
Financial Crisis
and the Great
Recession: Causes
and
Consequences
Claes Berg
Advisor to the Governor
Outline




What happened?
What are the reasons?
Macroeconomic factors
Microeconomic factors

What are the consequences?
Economic Theory
Monetary Policy

Inflation Targeting and Financial Stability

Financial Stability Policy

New Systemic Risk Measures

Conclusions


Phase 1

Outbreak. The acute crisis related to the housing market
in the USA broke out in earnest in June 2007 and the
first phase lasted until September 2008. Many borrowers
with low credit ratings (”sub prime”) had been allowed
for a period to take out mortgages as a result of a
weakened regulatory framework and unreliable
assessments on the part of the lenders. When house
prices started to fall in the USA these house owners were
the first to have problems, but the crisis spread to the
entire mortgage market.
Phase 2

Systemic crisis and countermeasures. When the
Lehman Brothers investment bank failed on 15
September 2008 it triggered a period marked by panic
and collapse of confidence, since the bank had
counterparties throughout the world and interbank rates
rose dramatically. A very deep and globally synchronised
downturn started, which lasted until the end of the first
quarter of 2009
Phase 3

The measures start to have an effect. A slow recovery
in the global economy started between the second and
fourth quarters of 2009. Fiscal policy became
increasingly expansive as a result of automatic stabilisers
and stimulus measures. The economy made the clearest
recovery in Asia, partly as a consequence of demand in
China being maintained by central government stimulus
measures.
Phase 4

Recovery but government finances unsustainable in
the long-term. From early 2010 world economic
recovery stabilised, the situation on the global financial
markets calmed down and crisis measures started to be
withdrawn. The two track global recovery continued –
with advanced countries growing more slowly than
emerging economies. Focus increased on large budget
deficits and national debt in several countries.
Difference between interbank rates and expected
monetary policy (Basis spread)
Basis points
400
350
400
350
Sweden
Euro area
300
250
300
USA
United Kingdom
250
200
200
150
150
100
100
50
50
0
Jan-07
0
Jul-07
Jan-08
Jul-08
Jan-09
Jul-09
Jan-10
Jul-10
Note. The spread is calculated as the difference between the three-month interbank rate and the three-month overnight index swap.
Sources: Reuters EcoWin and the Riksbank
Global GDP Growth
Fiscal Balances
What Are the Reasons?





Macroeconomic factors
The Great Moderation
and low inflation
Low global interest rates
Low federal funds rate in
the USA
Global imbalances: High
level of savings in other
countries invested in the
USA





Microeconomic factors
Weak regulatory
framework for financial
supervision
Incorrect credit
evaluation
A shadow banking system
without financial
supervision
Financial leverage
Real House Prices and Growth Rate of
Nominal Credit
Real Federal Funds Rate
Savings and Investment
Percent of GDP
Savings
I nvestment
Countries
2001
2008
2001
2008
USA
16,4
11,9
19,1
17,5
UK
15,4
15,1
17,4
16,8
China
37,6
59
36,3
49
Emerging economies in
27,6
32,1
24,2
30,1
Japan
26,9
26,7
24,8
23,5
Germany
19,5
25,7
19,5
19,3
Oil exporting countries
33,3
50,8
24,8
26,7
World
21,4
24,2
21,5
23,9
Asia
Global Imbalances (Current Account)
CDS-spreads for Financial Institutions
Balance Sheet Effects
Upward spiral
Downward spiral
Increased
positions
Profits
Increased
leverage
Reduced
positions
Price increases
Lower
margins
Increased
profits
p
Losses
Funding
problems
Price falls
Higher
margins
Losses
World trade volume
World Trade Monitor index, 2000 = 100, seasonally adjusted data
250
250
World trade total
Emerging economies
Advanced economies
200
200
150
150
100
100
50
50
0
0
91
93
95
97
99
01
03
05
07
09
Source: Netherlands Bureau for Economic Policy Analysis
Average Change in Growth Rates
Average change in growth rates
(2008-2009 minus 2005-2007)
GDP Consumption
Investment Exports
Eastern Europe
-7,8
-8,7
-25,6
-13
CIS
-7,3
-6,6
-25,2
-6,8
Industrial
-4,6
-3,4
-15,3
-10,8
-3,7
-4,3
-11,8
-7,5
Emerging Asia
-3,1
-1
-11,8
-7,6
Africa
-1,9
1,8
0,9
-4,1
Middle East
-1,4
-0,7
-2,7
-8,2
countries
Western
Hemisphere
Central Bank Policy Rates
percent
Central Bank´s Balance Sheets
percent of GDP
General Governement Fiscal Balance
percent of GDP
General Government Gross Debt
Percent of GDP
Swedish Policy Action in the Financial
Crisis

Central bank






Longer term loans to banks
Relaxed collateral requirements
Lending in domestic currency and USD
Swap lines with the Federal Reserve
Emergency liquidity assistance to banks
Interest rate cuts

Government

Increased deposit insurance
Borrowing Guarentees to banks
Capital injections
Public administration of failed banks



What are the Consequences for
Economic Theory?
No: Multiplier effects are
uncertain!

 No: not related to
financial stability

 Yes: with financial
frictions
 Yes
 Develop new models!
 Complementary channels!  Yes
 Yes
 Several interest rates!
 Yes
 Allow expert judgement!

Return to old Keynesian
models!
Efficient markets
hypothesis is wrong!
New Keynesian models!

What are the Consequences for
Monetary Policy?





Before the crisis
Objectives: Stable
inflation and stable real
economy
Financial variables
indicator variables
Not possible to identify
asset price bubbles in
advance
Dichotomy between
monetary policy and
financial stability policy





After the crisis
Objectives: Stable
inflation and stable real
economy
An additional objective
may also be to reduce the
risk of financial crisis
Forecast based monetary
policy: financial frictions
taken into account
More coordination
between mp and fsp
Flexible Inflation Targeting
Forward looking procedure
 Use all available information (incl. judgement)
when setting interest rates
 Projections for inflation and the output gap
should satisfy a sequence of target criteria (not a
point-in-time criterion)

Inflation Targeting and Financial
Stability
Woodford (2010, 2011) discuss two aspects of
this question:
 (1) the appropriate monetary policy response to
financial crisis, after one occurs
 (2) whether monetary policy can reduce the
likelihood of occurrence of a crisis, before the
next crisis occurs

Monetary policy response to a
financial crisis after it occurs
Cúrdia & Woodford (2009, 2010)
Time-varying financial frictions (”credit spreads”)
affect both the IS relation and the AS relation
 Affecting the expected future path of short-run
real rates is still the primary tool of the central
bank (rather than the current short rate as such)
 Projections for output and inflation should still
satisfy a target criterion
 The average interest rate rather than the policy
rate determines how the target criterion is
satisfied


Monetary policy response to a
financial crisis after it occurs
Flexible inflation targeting is better than a
spread adjusted Taylor rule
 The optimal degree of response to changes in
the credit spread depends on the degree of
anticipated persistence of the disturbance
 A forecast-targeting central bank will take into
account many credit spreads, their expected
persistence and other judgemental factors

The crisis in a
simplified model
Aggregate demand/inflation








Inflation target = 2
Equilibrium real interest rate = 2
Monetary Policy Rule:
Real interest rate = 2 + a•(Inflation – 2) +
b•Resource utilisation
Resource utilisation = c – d•Real interest rate
Substitute the interest rate from MPR into the
equation above =>
Aggregate demand/inflation:
Resource utilisation= e - f•(Inflation – 2)
Aggregate supply/inflation





Firms´ price setting behaviour
Adaptive expectations:
Inflationt = Inflationt-1 + g•Resource utilisation + Supply
shock
Rational expectations:
Inflationt = InflationE + g•Resource utilisation + Supply
shock
A rising credit spread between interbank rates and
expected policy rates (Basis spread)
400
400
Sweden
350
Euro area
350
300
USA
300
250
United Kingdom
250
200
200
150
150
100
100
50
50
0
0
jan07
apr07
jul07
okt07
jan08
apr08
jul08
okt08
jan09
apr09
jul09
okt09
Sources: Reuters EcoWin and the Riksbank
The crisis in a simplified model






Real interest rate = Real policy rate + Credit
spread
Resource utilisation = c – d•(Real policy rate +
Credit spread)
Monetary Policy Rule:
Real interest rate = 2 + a•(Inflation – 2) +
b•Resource utilisation
New Aggregate demand/inflation:
Resource utilisation= e - f•Credit spread f•(Inflation – 2)
Transmission of the crisis
Aggregate demand/inflation shifts down to the
left:
 The Credit spread increases the real interest rate
 Investment and consumption are dampened by
falling asset prices and weaker balance sheets
 Exports is weakened during a international crisis:



Lower international demand
Financial crisis reduces firms´ access to trade credit
The crisis in a simplified model
Aggregate demand before
the crisis
Aggregate supply before
the crisis
A
Inflation (%)
2
Aggregate demand
during the crisis
Aggregate supply during
the crisis
B
D
1
C
0
Low
Normal
Resource utilisation
High
Can monetary policy can reduce the
likelihood of a crisis?
Woodford (2010, 2011)
 Loosening monetary policy increases leverage of
intermediaries: easier for an unexpected shock
to trigger crisis
 Monetary policy affects risk of financial crisis and
should not be the complete solution:
macroprudential tools also needed
 A financial stability objective is introduced in the
flexible IT framework

Can monetary policy can reduce the
likelihood of a crisis?






Credit frictions introduced in the intertemporal
IS relation
Measures distortion in allocation of expenditure
due to credit frictions
Corresponds also to a credit spread between
long-term bond yields
Two-state Markov-switching model:
low-credit-spread (normal) state
high-credit-spread (crisis) state
Can monetary policy reduce the
likelihood of a crisis?
Loss function: inflation, output (gap) + loss from
inefficient composition of expenditure due to
credit frictions
 The target criterion: inflation and output + the
rate at which the expected loss from financial
crisis increases per unit increase in leverage
 What matters for the target criterion is leverage
of intermediaries and marginal crisis risk, not
credit as such

What are the Consequences for
Financial Stability Policy?




Prudential policy instruments can be used to offset the
emergence of financial imbalances, such as instruments
that directly affect the banks’ lending.
New methods for analysing how risks arise and be used
to calculate the banks' fees for government support
measures.
The Basel Committee has agreed to raise banks’ capital
and liquidity requirements to increase their resilience in
crises.
In Europe a new body, the European Systemic Risk Board
(ESRB), is being set up to play a system-focused macro
role.
Core Concept of Contingent Claims
Analysis (CCA): Merton Model
Assets
Equity
or Jr
Claims
Risky
Debt



Assets
• Value of liabilities
derived from value of
assets.
• Liabilities have different
seniority.
• Randomness in asset
value.
=
Equity
+
Risky Debt
=
Equity
+
Default-Free Debt – Expected Loss
= Implicit Call Option + Default-Free Debt – Implicit Put Option
Source: Gray, D and S Malone
(2008)
44
The Government Borrowing
Guarantee in Sweden
Broad category of liabalities from 3 months to 5 years
 For liabilities less than one year: a uniform fixed fee set
at 0.5 per cent of the guaranteed amount
 For liabilities with maturities greater than one year the
fee will be risk-based
 Based on CDS spreads 1/01 2007 – 31/08 2008 plus 0.5
percentage points

The CCA Price of the Insurance



Contingent claims analysis can be applied to set the
price of the fee.
The implicit put option associated with the debt of the
banks gives the value of the insurance.
The value can be converted to a spread which gives the
risk-based premium expected to cover the cost of the
guarantee for a given horizon.
Guarantee Fees, Swedish Banks,
contingent claims analysis,
Basis Points
Source: IMF (2010), Sweden – Staff Report for the
2010 Article IV Consultation.
Conclusions




The crisis will lead to more focus on the interconnections
between the real economy and the financial system and
the balance sheets of households, firms, banks and the
sovereign.
Contingent Claims Analysis can provide guidance for
decision-makers, both in the financial sector and the
political system.
Monetary policy can probably to some extent counteract
future crises, but a more effective strategy must come
from a new macro-prudential framework.
More work on inflation targeting and financial stability is
needed.
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