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The financial crisis and its consequences for the real economy IBFP- 27.11.2009 Henri Bogaert. Outline. Origins of the crisis Where do we stand now? The near future. Origins of the crisis. Four joint driving forces combining macro and micro policy errors.
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The financial crisis and its consequences for the real economyIBFP- 27.11.2009Henri Bogaert
Outline • Origins of the crisis • Where do we stand now? • The near future
Four joint driving forces combining macro and micro policy errors
Transmission channels of monetary policy Accommodating monetary policy Low interest rate Impact on real economy Channel n° 2 Reduced mortgage and credit costs Increase of housing investment and durables Channel n° 1 Reduced cost of capital Increase of Investment Growth of GDP Inflation Tightening of monetary policy
What went wrong? Accommodating monetary policy from 2001 to 2006 Development of asset price bubbles Impact on real economy Channel n° 2 Wealth effect and indebtedness Increase of housing investment and durables Channel n° 1 Reduced cost of capital Increase of Investment Growth of GDP: no boom No Inflation No Tightening of monetary policy
US monetary policy • Following the bursting of the technology bubble, rates were slashed to fight deflation • Real fedfundsrate close to 0% or even negative for 5 years • Making credit very cheap • Increased risk taking, resulting in historically low risk spreads • Pushing up asset prices (financial & houses)
When expectation of price increase is based on past increase
US stock market • Stock indices rose by almost 100% in the 5 years to mid 2007
US house prices • House prices rose by almost 90% between early 2001 and mid 2006 • The belief in ever increasing house prices was a major cause for the current crisis • From mid 2006 onwards, house prices start to decline • This resulted in a plunge of the prices of mortgage related financial products
Very high asset price inflation did not lead to high growth and consumer price inflation ! • Increasing share of durable goods has been produced in emerging countries, especially China • At low wage cost • And at undervalued exchange rates, large imbalances and sterilization in emerging countries • But internal factors have also played a role: • Credibility of Central Banks • Increasing competition • Reduction of taxes
Consequences of the crisis for the real economy and where do we stand now?
When the bubbles burst… Tightening of monetary policy from 2007 onwards Burst of asset price bubbles + collapse of global banking system Impact on real economy Channel n° 2 Deleveraging and increase of saving ratio Drop of housing investment and consumption Channel n° 1 Interest rates increase and credit conditions tightened Drop of Investment Recession Fear of deflation Massive monetary and fiscal support
Massive interventions stabilized financial markets US interbank rate Spread between interbank and official rates soared during the crisis This spread has disappeared in the US, the euro area and elsewhere
But also massive support from the budget • Increased government spending (stimulus plans), lower tax receipts resulted in large budget deficits • Which will result in rapid increases in debt levels • Risk of higher long term interest rates • Stimulus can not last for very long
Cost of capital: Corporate bond spreads have normalized Corporate bond market spreads have diminished, but will probably remain more elevated than in 2005-2007
Wealth effects: equity and house prices are rising Stock indices have soared by 50% or more since low early March House prices are again starting to rise in the US, the UK Most asset prices are rising
The global recession has ended • Near term optimism caused by a combination of temporary factors : • fiscal stimulus • inventory rebuilding • rather than by solid private consumption and investment growth
Danger of early exit, exhibit 1:Greece Source: FT, Barclays, OECD
Banks’ health still fragile • S&P’s risk-adjusted capital (RAC) ratios study of 45 world’s leading banks • RAC reflects leverage • Resembles new capital ratio regime expected to be set by the Base committee early next year • Completely different picture of banks’ strength to that under current Basel II rules (Tier1) • Especially German & Japanese banks fair badly • Only 9 of 45 banks RAC of above 8%, minimum level to cover forecast levels of stress • Implication: Banks will need to raise billions of capital
And the fiscal challenge in 2011 will be difficult to manage Deficits and debts are unsustainable Fiscal consolidation is necessary worldwide But would slow the economic growth during several years Timing of consolidation controversial
Two rebalancing acts needed • That would lead to a sustainable recovery : • From public to private spending: otherwise debts would continue to rise and risk pushing interest rates higher • Shift from domestic to foreign demand in the US & shift from foreign to domestic demand in Germany, China and the rest of Asia Will take time
Outcome? Three scenarios • Pessimistic: • Fiscal and monetary exit strategy happens too soon • Private demand does not take over role of government spending, while banks tighten credit standards & prices • Economic activity nosedives • New problems surface in the financial sector • Towards the next bubble: • Monetary and fiscal too loose for too long • Asset prices are boosted by the lenghty surge in liquidity • Governments, central banks allow more inflation to erode debt • Bubble collapses bringing us back to the situation of late 2008, but starting with much higher debt rates • Global rebalancing: • Timing of monetary and fiscal exit is just ‘right’ • Chinese domestic demand become drivers of world economy (Germany?) • US households repair balance sheet (deleveraging, saving more), US growth more driven by external sector
