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4 The Global Macroeconomy and the 2007–2009 Crisis
Chapter 22: Topics in International Macroeconomics
The Global Financial Crisis of 2007–2009 and the
associated Great Recession constitute one of the most
significant global macroeconomic events of modern history.
The current recessions will not be forgotten quickly by our
generation of households, firms, banks, or governments, all
of whom have been affected by the downturn.
Macroeconomists have much to learn from the crisis. Some
key macro-financial and policy issues have been known
about since the early 1800s, but they had been ignored or
forgotten by many economists.
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Backdrop to the Crisis
Chapter 22: Topics in International Macroeconomics
Preconditions for the Crisis The global financial crisis was
primarily a story of investments turned bad, that is, of
savings unwisely allocated.
A large source of global saving in the ten years prior to the
crisis was the group of emerging market (EM) countries that
consistently ran surpluses on their current accounts, as their
investment rates (quite high) were consistently exceeded by
their saving rates (even higher).
Because the world as a whole has to have a current account
equal to zero, these EM surpluses had to be offset by equal
and opposite developed market (DM) current account
deficits, as shown in Figure 22-15.
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Chapter 22: Topics in International Macroeconomics
FIGURE 22-15
Global Imbalances
and Their
Composition Panel
(a) shows that the
chronic current
account deficits of
developed markets
were offset by
chronic surpluses in
emerging markets.
Looking just at the
emerging markets,
panel (b) shows that
the emerging
markets’ financial
accounts were in
deficit due to
massive official
foreign reserve
accumulation, offset
somewhat by private
capital flows.
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Chapter 22: Topics in International Macroeconomics
The unidirectional flow from EM to DM was referred to as
the problem of global imbalances; the high level of savings
in the Ems that was a part of it was referred to as the
savings glut.
On the EM side, countries (especially those in Asia) had
been very high saving societies for many, many years, and
much of this was private saving. However, the new twist was
the rapid increase in public (government) saving. This
increase in government saving necessarily sends the
current account toward more surplus.
EM countries knew that they would have to take
responsibility for their own financial security and, instead of
relying on access to borrowed funds, would have to build up
a war chest of liquid savings that could be drawn down in
the event of a crisis.
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Chapter 22: Topics in International Macroeconomics
The private sectors in EM countries also learned and made
some changes to their behavior after the 1990s crises: for
example, there was typically a shift toward less borrowing in
foreign currency to reduce the liability dollarization problem.
There was an increase in the purchase of official foreign
assets, which in balance of payments terms correspond to
large Current Account (CA) surpluses. In the last decade, on
net, capital was flowing uphill from poor to rich countries: a
reversal!
What impact did these flows have on the rich DM countries?
Buying a large amount of U.S. government debt bids down
the yield and also lowers yields on other forms of debt such
as corporate debt, loans, mortgages, and so on.
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Chapter 22: Topics in International Macroeconomics
This large flow of EM savings thus created a large wave of
liquid funds in global capital markets seeking profitable
investment opportunities, and allowing borrowers access to
capital on some of the most generous terms that had been
seen in a very long time.
If the financial systems of the world, and particularly those in
the DM economies, had been efficient in their allocation of
such capital flows, and if all projects by private or public
borrowers had been a wise use of funds, then all would
have been well.
In the 2000s an expansion of credit in developed economies
rose to a level not seen before in the entire recorded history
of financial capitalism, as revealed by the trends shown in
Figure 22-16.
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Chapter 22: Topics in International Macroeconomics
FIGURE 22-16
Developed Market Credit Trends over 140 Years This chart shows average data for
fourteen developed markets since 1870. The ratio of bank loans and total bank
assets to GDP was stable in the early twentieth century and fell during the 1930s
following the Great Depression. In the postwar period these ratios surpassed their
previous peaks around 1980 and kept on growing as modern economies built their
economic model around more and more debt.
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Exacerbating Policies and Distortions
Chapter 22: Topics in International Macroeconomics
■ Deliberately undervalued exchange rates in China and
other Asian economies promoted an overly rapid, exportled growth strategy highly dependent on the Western
(mainly U.S.) consumer being willing to go deeper into
debt to purchase a growing supply of manufactured goods.
■ Monetary policy makers in the DM economies, and
especially the too-easy monetary policy of the U.S.
Federal Reserve, kept interest rates too low for too long
and encouraged lending and facilitated bubbles. A similar
argument can be leveled at the European Central Bank,
which also pursued rates that were “too low” and ignited
similar bubbles.
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Chapter 22: Topics in International Macroeconomics
■ Others would argue that the problem was a failure of
regulation and supervision in that regulatory bodies and
lawmakers simply allowed the financial systems to run out
of control. Under the more stringent regulatory regimes
created after the 1930s disaster no developed country
witnessed any banking crises whatsoever from 1945 to
1970.
Regulations were outpaced by the scale of financial
innovation, which both allowed the system to take on
greater risks through new products (e.g., the securitization
of credit with a reliance on rating agencies and the use of
unregulated derivatives) and to expand so much as to
create large, complex, “too big to fail” (or in some
countries “too big to save”) banks.
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■ Some analysts believe that government failure is to
blame because governments distorted private incentives
in various ways.
Implicit backstops to many “too big to fail” banks
incentivizes people to take too much risk, knowing that
they will be bailed out of some or all losses, a problem
known as moral hazard.
■ Many other observers see widespread evidence of market
failure, in which irrational investors, herding, imperfect
information, and asymmetric information all created
serious inefficiencies in financial systems. An oscillation
between greed and fear with no real connection to market
fundamentals created an unnecessary and unwelcome
volatility in the economy.
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Chapter 22: Topics in International Macroeconomics
FIGURE 22-17
Banking Crises in History This chart tracks the frequency of banking crises each
year in both developed (high-income) and emerging (middle- to low-income)
economies.
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Panic and the Great Recession
Chapter 22: Topics in International Macroeconomics
In 2007 the Global Financial Crisis started to unfold quickly
from a latent set of risks into a massive catastrophe that
would wreak havoc on the global economy for the next
several years (see the timeline in Table 22-2).
The event that triggered a flight from risk to safety in capital
markets was a deterioration in the perceived quality of U.S.
residential mortgages.
As house price appreciation stalled and delinquencies rose
in 2006 and 2007, problems quickly became evident in the
risky subprime sector. Similar stresses also erupted in other
countries such as the United Kingdom and Ireland.
The losses were centered on major financial institutions in
the United States and overseas.
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TABLE 22-2 (1 of 2)
Chapter 22: Topics in International Macroeconomics
Timeline for the Global Financial Crisis This table highlights key events in the 2007–
2010 period.
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TABLE 22-2 (2 of 2)
Chapter 22: Topics in International Macroeconomics
Timeline for the Global Financial Crisis This table highlights key events in the 2007–
2010 period.
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Chapter 22: Topics in International Macroeconomics
A Very Modern Bank Run In today’s economy banks fund
themselves by short-term loans, and it was these funding
facilities that shrank in size, or became prohibitively
expensive, when the creditworthiness of banks came into
question.
Unable to borrow, banks had to shrink their balance sheets
and scramble for liquid funds to fill the funding gap. To free
up and conserve cash, they had to stop making new loans
and/or allow old loans to “roll off” their books. They also had
to sell their liquid and illiquid assets (such as hard-to-value
mortgages and derivatives) into collapsing markets.
In September 2008 it would be fair to say that the financial
systems in the United States and all over the world were
plagued with a banking panic of a magnitude not seen since
the early 1930s.
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Chapter 22: Topics in International Macroeconomics
Financial Decelerators The financial crisis had the effect of
depressing real economic activity, through the so-called
financial accelerator mechanism (or decelerator).
When wealth is destroyed by a panic, the impaired
households and firms tend to rebuild their wealth by saving
to pay off liabilities or accumulate assets, thus dampening
the demand for goods and services.
A side effect of the crisis was the effect on the dollar and the
unusually high spread between U.S. government interest
rates and private sector interest rates: at the height of panic,
investors sought out U.S. dollar assets as a safe haven (a
typical experience for a reserve currency). This caused the
dollar to appreciate markedly and the yields on U.S.
government bills to approach zero.
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Chapter 22: Topics in International Macroeconomics
The End of the World Was Nigh It took until March 2009
for the collapse of U.S. stock markets to end (the S&P 500
Index hit a low point of 666).
Investment banks had failed or been taken over and a $700
billion bank recapitalization scheme had been created by the
U.S. Treasury. Bank recapitalization projects took shape in
other countries, too.
During the April 2009 G-20 summit in London, global leaders
pledged greater support and cooperation. Fiscal policy
makers had by then stepped in with large-scale stimulus
plans in most countries (see Table 22-3) and monetary
policy had been eased everywhere, in many countries all the
way down to zero interest rates. Credit was still tight, but for
those who could get it, costs had fallen.
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TABLE 22-3
Chapter 22: Topics in International Macroeconomics
Discretionary Fiscal Policies in the Great Recession After the crisis, as output
growth slowed or turned negative, many countries increased government spending
or cut taxes to try to provide additional macroeconomic stimulus.
The table shows data on discretionary fiscal stimulus measures for the G-20 taken
in 2008–2010 relative to a 2007 baseline, as a percent of GDP.
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Chapter 22: Topics in International Macroeconomics
Despite fears of a return to 1930s-style protectionism, world
trade policies stayed open, thanks in part to countries’
commitments to and oversight by the WTO, and trade
volumes started to pick up.
As these efforts took hold, the free-fall of the world economy
halted, and trends in GDP and trade, which had been diving
along trajectories eerily similar to those seen after 1929, hit
bottom. But by now the economic costs of the financial
meltdown had reached unfathomable heights (see Figure
22-18 for U.S. evidence).
The main problem would be that in the United States and
elsewhere output was 5% or more below capacity and
unemployment near to or above 10%, conditions that were
likely to persist for years.
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Chapter 22: Topics in International Macroeconomics
FIGURE 22-18 (1 of 3)
The Crisis and Recession in the United States These charts show key U.S. economic
trends from 2003 through 2010.
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Chapter 22: Topics in International Macroeconomics
FIGURE 22-18 (2 of 3)
The Crisis and Recession in the United States These charts show key U.S. economic
trends from 2003 through 2010.
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Chapter 22: Topics in International Macroeconomics
FIGURE 22-18 (3 of 3)
The Crisis and Recession in the United States These charts show key U.S. economic
trends from 2003 through 2010.
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Chapter 22: Topics in International Macroeconomics
Europe Policy responses varied in different countries. The
core countries of the Eurozone managed to escape, even
though their banking systems had been infected by U.S.
toxic assets. Deep trouble was brewing on the periphery of
Europe, however (see Figure 22-19).
In Ireland a large property boom went bust and the banking
system was at risk of collapse. Ireland’s risk of default was
elevated.
The Baltic states, Greece, Spain Portugal, and Spain were
also exposed to the global crisis.
Portugal and Greece were lumped together with Ireland and
Spain in the uncharitably named “PIGS” group, and given
low (near-junk) credit ratings.
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Chapter 22: Topics in International Macroeconomics
FIGURE 22-19 (1 of 2)
The Crisis and Recession in the Eurozone These charts show key Eurozone
economic trends from 2003 through 2010, with an emphasis on the four peripheral
countries: Portugal, Ireland, Greece, and Spain.
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Chapter 22: Topics in International Macroeconomics
FIGURE 22-19 (2 of 2)
The Crisis and Recession in the Eurozone These charts show key Eurozone
economic trends from 2003 through 2010, with an emphasis on the four peripheral
countries: Portugal, Ireland, Greece, and Spain.
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The crisis exposed profound questions about the long-term
viability of the euro project:
Chapter 22: Topics in International Macroeconomics
Should Eurozone fiscal policy rules be modified after the
spectacular failure of previous efforts?
Can such disparate economies to be safely put into a
common currency given the asymmetric shocks they face?
Can a way be found for European cross-border banks to
operate safely?
Can the restrained countries coexist with credit-bubble, and
crisis-prone low-saving peripheral countries?
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Chapter 22: Topics in International Macroeconomics
The Rest of the World Outside of the United States and the
Eurozone, the impacts were less catastrophic. Japan’s
economy had already been in a slump and collapse of its
banking system.
In the emerging market world, rapid growth quickly resumed.
These countries had strong precrisis economic growth and
were not exposed so much to financial sector risk. Some
spent their reserves to support fiscal policy expansions that
buffered their economies from the global shock.
A “two-track” economic recovery started to take shape in
2009 and continued into 2010 (see Figure 22-20).
The world had gone through its greatest synchronized global
financial crisis ever and not a single EM country had
experienced a banking, currency, or sovereign default crisis!
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Chapter 22: Topics in International Macroeconomics
FIGURE 22-20
The “Two-Track”
Global Recovery
Using data on
industrial
production, these
two charts
contrast the
sluggish recovery
in developed
markets (panel a)
with the rapid
resumption of
growth in
emerging markets
(panel b).
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The Road to Recovery As of late 2010, the global recovery
was not guaranteed to continue in a sustained and
uninterrupted fashion. Several risks remain:
Chapter 22: Topics in International Macroeconomics
■ “Austerity” programs might tip economies back into
recession, in which case public debts would get worse still.
■ There is no further room for easing using conventional
tools of monetary policy.
■ The transmission mechanisms of monetary policy
remained impaired as many banks continued to struggle
with damaged balance sheets, and many households held
zero or negative equity in their homes.
■ The Fed had instituted unconventional measures such as
quantitative easing (QE), causing its balance sheet to
expand.
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Chapter 22: Topics in International Macroeconomics
■ How the Fed or Bank of England or Bank of Japan would
exit from QE-type measures and how the ECB would pull
back its special liquidity support and (sterilized) bond
purchase programs were future problems still to be
resolved. It is hard to find precedents for these unusual
monetary experiments.
■ As of late 2010, the Eurozone remained in a fragile state:
the peripheral countries still had weak banks and fiscal
positions.
■ It remains unclear whether the global economic engine
can continue to function satisfactorily when three out of
four main cylinders are not working properly (the United
States, Japan, and Eurozone), and only the EM part of the
world is experiencing robust growth. Here again, we are in
uncharted waters.
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Chapter 22: Topics in International Macroeconomics
Conclusion: Lessons for Macroeconomics
The crisis is profoundly changing our thinking with respect to
the way that macroeconomists do their research and
teaching.
Many defects of existing, standard macroeconomic models
need to be remedied. It is not enough to model the real side
of the economy and ignore the financial sector.
Deeper thinking will be needed to integrate finance and
macroeconomics.
Economists will need to think carefully about what drives the
demand for money and other safe assets when markets fail,
and how to understand and incorporate rival views of crises,
such as irrational herding, limits to arbitrage, imperfect
information, moral hazard, and so forth.
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Can authorities develop sufficient instruments to meet their
targets of not just price stability and, possibly, maximal
employment, but also financial stability?
Chapter 22: Topics in International Macroeconomics
A narrow focus on interest rate policy will be joined by a
broader investigation of what a sensible macroprudential
policy for the financial sector might look like.
Lastly, the challenges will require new evidence to guide
theory and refute or confirm hypotheses. Financial shocks of
the kind we have just witnessed are rare events.
In the end, economists and policy makers face the task of
better linking aggregate economic outcomes to financial
conditions, a task that will surely take economic research
down some new and interesting paths. There is much work
to do.
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