Notes on International Finance: Global Financial Crisis

Background to the Crisis

  • The Financial Crisis succeeded a period of global economic stability known as the Great Moderation.
  • Backus and Kehoe's 1992 AER study discussed historical business cycles:
    • Analyzed three periods: pre-war, inter-war, and post-war.
    • Found economies were more volatile in pre-war and inter-war periods, with post-war volatility reduced except in Japan.

Properties of Output Fluctuations

  • Analysis of output fluctuations showed varied volatility:
    • Australia: Pre-war (6.30), Inter-war (4.85), Post-war (0.72)
    • United States: Pre-war (4.28), Inter-war (9.33), Post-war (2.26)
  • Volatility measured via standard deviations with computed sample moments from Hodrick-Prescott filtered logarithms.

Great Moderation

  • Starting in the Mid-1980s, known as the "Vanishing of the Business Cycle":
    • Changes attributed to:
    1. Output Composition: Shift toward services, which are less volatile.
    2. Policy Improvements: Governments became more effective at stabilizing the economy.
    3. Size of Shocks: Smaller shocks with decreased variance contributing to output stability.
    • Bernanke (2004) noted a substantial decline in macroeconomic volatility, benefiting inflation, employment, and economic planning.

Phases of the Financial Crisis

  • The crisis had two phases:
    • Phase I (July 07 – Sep 08): Housing bubble burst; company failures in mortgage-backed securities led to credit crunch.
    • Phase II (Sep 08 onwards): Total collapse of confidence, rise in credit spreads, and diminished bank lending due to perceived risks.

Global Consequences of the Crisis

  • The crisis, originating in the U.S., quickly affected global economies due to:
    • Financial globalization: ownership of financial assets across countries.
    • Trade channels transmitting economic shocks.
  • Resulted in increasing government debt and difficulties in fiscal management in affected nations.

Causes of the Financial Crisis

  1. Global Imbalances: Rising US current account deficit fueled by surpluses in emerging economies like China.
  2. Monetary Policy: Low interest rates encouraged risk-taking behavior in financial assets.
  3. Ineffective Regulation: Lack of rules for risky financial instruments led to miscalculations of risks by investors.
  4. Mispricing of Risk: Overestimation of housing market stability caused higher default rates due to unsound lending practices.

Policy Implications of the Financial Crisis

  • Monetary policy: Should include financial stability alongside price stability, emphasizing macroprudential regulation (e.g., capital requirements).
  • Fiscal policy: Should maintain capabilities to respond to crises; emphasis on managing debt levels for future safety.
  • The IMF may need to reassess its stance on encouraging savings to prevent sudden stops.

International Coordination

  • Global rebalancing necessitates international cooperation on banking standards and monetary policies to mitigate financial risks.
  • Key events include coordinated interest rate cuts by multiple central banks during the crisis, highlighting the need for synchronized action in response to global financial issues.