The Global Financial Crisis and the Great Recession: Causes, Effects, Measures and Consequences for Economic Analysis and Policy Claes Berg1 Advisor to the Governor of Sveriges Riksbank May 23, 2011 Presented at a Workshop on Monetary Policy, Macroprudential Policy and Fiscal policy at the Centre for Central Banking Studies of Bank of England 17 May-19 May 2011
In 2007 a financial crisis started in the US housing market that spread to more countries and developed into the deepest international recession since the Great Depression. The financial crisis that created the great recession took place against the backdrop of several macroeconomic imbalances and deficiencies in the financial regulatory framework of the global economy.
The crisis contributed to rising interest rates and severe disruptions in the function of the financial system, which slowed down demand and supply of goods and services in the economy. The quality of financial information fell drastically and impaired relations between players in the financial system. Several financial institutions failed or were taken over by government authorities. Domestic demand fell in country after country, contributing to the collapse of exports to other countries as well. The global economy went into a downward spiral.
Extensive central bank and government measures became necessary to reduce the rise in interest rates and restore financial systems. International cooperation between central banks was substantially extended when they supplied liquidity in domestic and foreign currency to financial institutions. In several countries governments were obliged to provide capital to prevent a collapse of the financial system. All this contributed to an intensive debate on how central banks’ monetary policy should be 1
I am grateful for comments from colleagues at Sveriges Riksbank. The views expressed are my own and cannot be regarded as an expression of the Riksbank’s view on these issues.
drawn up to stabilise the economy, on how new and better financial regulatory frameworks should be designed, and on the need for consolidation of public finances in countries with large deficits and growing debts.
This paper first briefly describes the most central events in the process. It then goes on to discuss the reasons for the global crisis and the measures taken to counteract it, and discusses the consequences of the crisis for economic policy and analysis. Do we need a paradigmatic shift in the science of economics? What are the lessons to be learned for economists’ macro models? How is monetary policy affected? What role should financial stability policy play? What methods can be used to identify financial systemic risks? The essay has an appendix showing how the crisis can be explained using a simple but modern macro model that can be used in teaching basic economics.
The course of the financial crisis can be divided into four phases.
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. The financial institutions’ liquidity problems grew, interbank market rates increased, see Figure 1, and in March 2008 a large USA investment bank, Bear Sterns, collapsed. Credit rating agencies downgraded several financial institutions. In the USA the government was obliged to take over two large mortgage institutions, Fannie Mae and Freddie Mac. The central banks started to cut policy rates and supply liquidity to financial institutions at longer maturities than normal.