Introduction

Thefinancial crisis of 20072008, also known as theGlobal Financial Crisisand2008 financial crisis, is considered by many economists to have been the worstfinancial crisissince theGreat Depressionof the 1930s.It threatened the total collapse of large financial institutions, which was prevented by thebailoutof banks by national governments, but stock markets still dropped worldwide. In many areas, the housing market also suffered, resulting inevictions,foreclosuresand prolonged unemployment. The crisis played a significant role in the failure of key businesses, declines in consumer wealth estimated in trillions of U.S. dollars, and a downturn in economic activity leading to the20082012 global recessionand contributing to theEuropean sovereign-debt crisis.The active phase of the crisis, which manifested as aliquidity crisis, can be dated from August 9, 2007, whenBNP Paribasterminated withdrawals from three hedge funds citing "a complete evaporation of liquidity".The bursting of the U.S. (United States)housing bubble, which peaked in 2006,caused the values ofsecuritiestied to U.S.real estate pricingto plummet, damaging financial institutions globally.The financial crisis was triggered by a complex interplay of policies that encouraged home ownership, providing easier access to loans for(lending)borrowers, overvaluation of bundledsubprimemortgages based on the theory that housing prices would continue to escalate, questionable trading practices on behalf of both buyers and sellers, compensation structures that prioritize short-term deal flow over long-term value creation, and a lack of adequate capital holdings from banks and insurance companies to back the financial commitments they were making.Questions regarding banksolvency, declines in credit availability and damaged investor confidence had an impact on globalstock markets, where securities suffered large losses during 2008 and early 2009. Economies worldwide slowed during this period, as credit tightened and international trade declined.]Governments andcentral banksresponded with unprecedentedfiscal stimulus,monetary policyexpansion and institutional bailouts. In the U.S., Congress passed theAmerican Recovery and Reinvestment Act of 2009.Many causes for the financial crisis have been suggested, with varying weight assigned by experts.The U.S. Senate'sLevinCoburn Reportconcluded that the crisis was the result of "high risk, complex financial products; undisclosed conflicts of interest; the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street." TheFinancial Crisis Inquiry Commissionconcluded that the financial crisis was avoidable and was caused by "widespread failures infinancial regulationand supervision," "dramatic failures ofcorporate governanceandrisk managementat many systemically importantfinancial institutions," "a combination of excessive borrowing, risky investments, and lack of transparency" by financial institutions, ill preparation and inconsistent action by government that "added to the uncertainty and panic," a "systemic breakdown in accountability and ethics," "collapsing mortgage-lending standards and the mortgage securitization pipeline," deregulation ofover-the-counterderivatives, especiallycredit default swaps, and "the failures of credit rating agencies" to correctly price risk.The1999 repealof theGlass-Steagall Acteffectively removed the separation betweeninvestment banksand depository banks in the United States.[Critics argued thatcredit rating agenciesand investors failed to accurately price theriskinvolved withmortgage-related financial products, and that governments did not adjust their regulatory practices to address 21st-century financial markets.Research into the causes of the financial crisis has also focused on the role of interest rate spreads.In the immediate aftermath of the financial crisis palliative fiscal and monetary policies were adopted to lessen the shock to the economy.In July 2010, theDoddFrankregulatory reforms were enacted in the U.S. to lessen the chance of a recurrence

Thecollapseof Lehman Brothers in September2008, sent awaveof fear aroundworld financial markets. Banks virtually stoppedlendingtoeach other. Theriskpremium on interbankborrowingrosesharply to 5 percent, whereas typically it was closeto zero. Although authorities scrambledtoinject liquidity intofinancial markets, thedamage was done. Theriskpremium on corporatebonds shotupeven moreto over6per cent. Large CAPEXprojects wereshelved,thecorporate sector virtually stoppedborrowing, trade credit was hardto get and, with fallingdemand, particularly for investment goods and manufacturingdurables likecars,trade volumes collapsed. Theresult is that theglobal financial crisis has seen thelargest andsharpest dropin global economicactivity of themodern era. In 2009, mostmajor developedeconomies find themselves in adeeprecession. Thefallout for global trade, both for volumes andthepattern of trade has been dramatic. TheOECDpredicts worldtrade volumes couldshrinkby 13 percent in 2009from 2008levels.1 Governments haverespondedwith an easingof monetary andfiscal policy that in turn have their own effects on activity andfinancial andtradeflows. Thedownturn in activity is causingunemployment torisesharply and, with it, apolitical responsetoprotect domestic industries through various combinations of domesticsubsidies andborderprotection. Thereis potential for protectionism torisefurther. Theobjectiveof this paper is twofold:tomodel theglobal financial crisis andexplorethe differences between asharprisein global riskthat is permanent versus onethat expectedto betemporary andsecond, toshowtheimpact of thepolicy response, especially thefiscal response. To dothis, adynamic,intertemporal general equilibrium model that fully integrates thefinancial andreal sectors of theeconomy is usedto unravel andunderstandthe mechanisms at work. Themodel incorporates wealth effects, expectations andfinancial markets for bonds, equities andforeign exchangeas well as trade andfinancial flows. Itis a suitabletool toanalysetheimpact of thecrisis and policy responses on global trade and financial flows. Thepaper is organisedas follows. In thenext section, themain features of theGCubed model that is usedin this analysis aredescribedbriefly as themodel is documentedin full elsewhere. In section 3, thesimulations torepresent thefinancial crisis aredescribedandthejustification for thesize of theshocks chosen. It turns out fiveshocks areneeded:three for thecrisis itself andtwofor thesubsequent policy responses whichcovers monetary andfiscal stimulus 2. In section 4we exploretheimpact of thecrisis and unpicksomeof themechanisms at work by initially surmisingwhat wouldhavehappenedhadtheUnitedStates alonebeen affected by thecrisis. Wealso explorethecritical roleof thereappraisal of riskpremiums, in particularwhethertheshocks arepermanent or temporary3. Theeffects of themassivepolicy responseareaddressedin Section 5. Itturns outthat mostof themonetary easingis already capturedby theendogenous monetary policy ruleincorporated into themodel, but not so thefiscal stimulus deployedaroundtheworldso weconcentrate on this aspect in this section. Finally, in section 6, someof themain insights arehighlightedanddiscussed

TheGCubedmodel is an intertemporal general equilibrium model of theworldeconomy. Thetheoretical structureis outlinedin McKibbinandWilcoxen (1998)4 . A numberof studiessummarizedin McKibbin andVines (2000)showthattheGcubedmodelling approach has been useful inassessingarangeof issues across anumberof countries sincethe mid1980s.5 Someof theprincipal features of themodel areas follows: Themodel is basedon explicit intertemporal optimization by theagents (consumersand firms) in each economy6 . In contrastto staticCGEmodels, timeanddynamics areof fundamental importance in theGCubedmodel. TheMSGCubedmodel is known as a DSGE (DynamicStochasticGeneral Equilibrium) model inthemacroeconomics literature andaDynamicIntertemporal General Equilibrium(DIGE) model in thecomputable general equilibrium literature. In order to trackthemacro timeseries, thebehavior of agents is modifiedto allowfor shortrun deviations from optimal behavior eitherduetomyopiaor torestrictions on the ability of households andfirms to borrowattheriskfree bondrateon government debt. For both households andfirms, deviations from intertemporal optimizingbehavior take the form of rulesofthumb, which areconsistent with an optimizingagent that does not updatepredictions basedon newinformation aboutfutureevents. Theserulesofthumb arechosen togeneratethesamesteady statebehavior as optimizingagents sothat in the longrun thereis only asingleintertemporal optimizingequilibrium of themodel. In the shortrun, actual behavior is assumedtobeaweightedaverageof theoptimizingandthe ruleofthumb assumptions. Thus aggregateconsumption is aweightedaverageof consumption basedon wealth (current asset valuation andexpectedfutureaftertax labor income)andconsumption basedon current disposableincome.Similarly, aggregate investment is aweightedaverageof investment basedon Tobins q(amarket valuation of theexpectedfuturechangein themarginal productof capital relativetothecost) and investment basedon abackwardlookingversion of Q. Thereis an explicit treatment of theholdingof financial assets, includingmoney. Money is introducedintothemodel through arestriction that households requiremoney to purchasegoods. Themodel also allows for short run nominal wagerigidity (by different degrees in different countries) andthereforeallows for significant periods of unemployment dependingon thelabor market institutions in each country. This assumption, when taken togetherwith theexplicit rolefor money, is what gives themodel its macroeconomic characteristics. (Hereagain themodel's assumptions differfrom thestandardmarket clearingassumption in most CGE models.) Themodel distinguishes between thestickiness of physical capital within sectors and within countries andtheflexibility of financial capital, which immediately flows to where expectedreturns arehighest. This important distinction leads toacritical difference between thequantity of physical capital that is availableat any timeto produce goods and services, andthevaluation of that capital as aresultof decisions about theallocation of financial capital. As aresult of this structure, theGCubedmodel contains rich dynamicbehaviour, driven on theonehandby asset accumulation and, on theotherby wage adjustment toaneoclassical steady state. It embodies awiderangeof assumptions about individual behaviour and empirical regularities in ageneral equilibrium framework. Theinterdependencies aresolved outusingacomputeralgorithm that solves for therational expectations equilibrium of the global economy. It is importantto stress that theterm general equilibrium is usedtosignify thatas many interactions as possiblearecaptured, notthat all economies arein afull market clearingequilibrium at each point in time.Although it is assumedthat market forces eventually drivetheworldeconomy to neoclassical steady stategrowth equilibrium, unemployment does emergefor longperiods duetowage stickiness, toan extent thatdiffers between countries dueto differences in labor market institutions. In theversion of themodel usedherethereare6sectors (energy, mining, agriculture, manufacturingdurables, manufacturingnondurables andservices) and15countries/regions.

3. Simulatingtheeffects of thecrisis Eventsleadingupto thecrisis in2008 thebaseline Thefocus of this paper is on disentanglingthemany influences of thefinancial crisis on the global economy andin particularto see howwell themodel can explainthemacroeconomic andsectoral responses to thecrisis in confidence that wemodel through riskshocks. The crisis is definedhereas theburstingof thehousingmarket bubble in late2007, theensuing collapsein thesubprimemortgage market andrelatedfinancial markets andthesubsequent collapseof Lehman Brothers in 2008which resultedin asharpincreasein riskpremiaaround theworld. Theproblem inprecisely modellingthecrisis is that therearealready shocks in thebaseline thataffect subsequent global dynamics independently of thecrisis. Herewearefocussing only on theadditional shocks from thecrisis. Theproblem is thatsomeof theseeds of the financial crisis weresown in thedecadebeforethecrisis. Therewereaseries of largeglobal events, such as theburstingof thedotcom bubblein 2001andthe rapidgrowth of China,that werealready reshapingthepattern andlevel of worldtrade before the20072008financial crisis hit. Someof theseevents, likethelargedisparities between savings andinvestment in China(asurplus) andin theUnitedStates (a deficit) ledto largedifferences between exports andimports for each nation so that largecurrent account surpluses wereaccumulatingin Chinaandlargedeficits in America. Somepeople7attributethesegrowingglobal imbalances as contributingcauses of thecrisis, andthereis sometruth in that. But thefocus of this study is on theimpact of thecrisis itself on worldtrade andnoton tryingto disentanglethevarious contributingfactors to thecrisis, as important as that issueis. Therefore, besides population andproductivity trends shapingthebaselinefor theworld, someof thekey events overthelast decade influencingthebaselinewouldbe: First, therewas theAsian financial crisis of 199798, which sawAsian economies generatelargecurrent accountsurpluses that hadtobeinvestedoffshoreto keeptheir nominal exchangerates low. Capital flowedoutof AsiaintoUSdotcom stocks drivingup equity prices. Next was theburstingof thedotcom bubble, whichsaw theboomingNASDAQover 19982000burst in 2001. Fearingadownturn andpossibledeflation, theUS Federal Reserveeasedmonetary policy in 2001in aseries of steps to2004. Somearguethat they easedtoomuch for too long8 . But, with easy credit andarisinghousingmarket, aboom in houseprices followedanda periodof high growth in credit andleveragedloans. Riskpremiahit lowlevels and leverageddeals becamecommon as investors chasedyields in an environment of lax regulatory oversight. Risingdemands from China(and, tosomeextent, India), plus aboomingworldeconomy saw commodity prices riseacross oil, minerals and foodfrom late2004to late2007. The shockto theglobal economy from this commodity price boom was as bigas thefirst oil shockin the1970s9. Risingprices andinflation causedmonetary authorities totighten policy from mid2004to June2006

Each of thesemajor events set uptheir own dynamics for thecourseof theworldeconomy andhelpedshape theunderlyingbaseline.Someof theseevents such as theeasingand tighteningof monetary policy areendogenous tothemodel andalready incorporatedin the baseline. Itis important toappreciatethat theresults reportedhereare deviations from baselinefrom thefinancial crisis, as definedhere. What is importantis therelative contribution of different effects andtodisentangletheimpacts of thefinancial crisis on the global economy intheshort tomedium run. Thefive shocks torepresentthecrisis andthepolicy responses Theaboveevents haveledtothenowwell known global downturn. All official forecasting agencies, such as theIMF andOECD, havedescribedthis downturn andso will not be expandedhere. As theIMF notes Global GDPis estimatedtohave fallen by an unprecedented5percent in thefourth quarter (annualized), ledby advancedeconomies, which contracted by around7percent 10 . Japan has been particularly hardhit with afourth quarter GDP (2008) plummetingby 13percent. Demandfor durablegoods has been particularly hardhit. With thedownturn therehas been asharpupturn in savings by households (andcommensuratereduction in consumption), driven by areappraisal of riskby households andaloss of net worth with fallinghouseprices andequity prices. So shocks needtobedevisedto accountfor three things Theburstingof thehousingbubbleandloss in assetprices andhouseholdwealth with consumers cuttingbackon spendingandliftingsavings. A sharpreappraisal of riskwith aspikein bondspreads on corporateloans andinterbank lendingrates with thecostof credit, includingtradecredit, risingwith acommensurate collapseof stock markets aroundtheworld. Amassivepolicy responseincludingamonetary policy easing, bailouts of financial institutions andfiscal stimulus. Thesethree outcomes can berepresentedby fiveshocks three for thecrisis itself andtwo for thepolicy response. Three main shocks capture the onset of the global financial crisis: 1. Theburstingof thehousingbubblecausingareallocation of capital andaloss of householdwealth anddropin consumption. 2. A sharprisein theequity riskpremium (theriskpremium of equities overbonds) causing thecost of capital to rise,privateinvestment to fallanddemandfor durablegoods to collapse. 3. A reappraisal of riskby households causingthem todiscount their futurelabor incomeand increasesavings anddecreaseconsumption.

Shock 1: The burstingofthehousing bubble Fallinghouseprices has amajor effect on householdwealth, spendinganddefaults on loans heldby financial institutions. Events in theUnitedStates typify aglobal phenomenon. From 2000to 2006, houseprices in someareas doubledtosubsequently collapse(chart 3.1). These changes in someareas havegenerateddramaticnews headlines but, overall theUnitedStates index of houseprices has fallen by 6.2percent in real terms from the1stquarter 2008tothe samequarter in 200911 . Whilehouseprices wererisingso strongly, credit was suppliedliberally to meet thedemand as perceptions of riskfell. Therisingwealth boostedconfidence andspending. Thehousing bubblewas aglobal phenomenon centeredmainly on theAngloSaxon world.

Shock 2: Risingequityriskpremia Thesurpriseupswingin commodity prices from 2003but most noticeableduring2006and 2007ledtoconcerns aboutinflation leadingtothesharpreversal inmonetary policy in the US. This tighteningin USpolicy also impliedatighteningof monetary policy ineconomies thatpeggedto theUS dollar. Itwas thesharpness of this reversal as much as thefall in US houseprices andthefailures of financial regulation (for example, themortgage underwriters FannieMae andFreddieMac)thatledtothefinancial problems for 20080916 . Lehman Brothers failurewas primarily duetothelargelosses they sustainedon theUSsubprime mortgage market. Lehman's heldlargepositions in thesubprimeandotherlowerrated mortgage markets. Butmortgage delinquencies roseaftertheUShousingprice bubbleburst in 200607. In thesecondfiscal quarter2008, Lehman reportedlosses of $2.8billion. Itwas forcedto sell off $6billion in assets17 . Thefailureof Lehman Brothers in September2008 andeffect on riskpremiums across markets

Shock 3: A riseinhouseholdrisk Thereappraisal of riskby firms as aresult of thecrisis also applies to households. As households viewthefutureas beingmorerisky, so they discount their futureearnings and thataffects their savings andspendingdecisions. As with theprevious shock, wemodel two scenarios:onepermanent andtheothertemporary. Theincreasein householdriskin the UnitedStates is assumedtobe3percentage points in thepermanent scenario andreturningto zero by year three in thetemporary scenario.

Shock 4: Monetaryeasing Thereis an endogenous monetary responsein themodel for each economy whereeach economyfollows aHendersonMcKibbinTaylor rule as shown in equation (1) with different weights on inflation relativetotarget, outputgrowth relativetopotential andthe changein theexchangeraterelativeto target.) Theassumedparametervalues areset outin Table3.6. Note that Chinaandmost developing economies haveanon zeroweight on thechangein the$US exchangerate. Themonetary easingthat has occurredis closeto theendogenous monetary policy responsealready built into themodel so any extramonetary stimulus is notrequired. Of courseit is possiblethat authorities, beingfearful of raisinginterest rates tooearly andprickingthenascent recovery, couldendupeasingtoomuch for toolongandwouldbean interestingsimulation, especially if different countries chosedifferent amounts of overeasing which wouldset upcapital flowchanges andhence trade flowchanges.

Shock 5: Fiscaleasing Thereis an endogenous fiscal policy responsein themodel but theruleis atargetingof fiscal deficits as apercent of GDP. Theeasingof fiscal policy announcedby most economies has been an extraunprecedentedstimulus in themodern eraandexpansion of fiscal deficits and has to besimulated. Thediscretionary stimulus packages announcedbyeach country havemainly occurredover 2009and2010andis usefully summarisedby theOECD18 . For theUnitedStates the cumulativestimulus is nearly 5percent of GDPandfor Chinait is over11per cent of GDP. Itis unlikely that such astimulus will suddenly endin 2010for two reasons:it is hardto crankupgovernment spendingon things likeinfrastructure quickly andgovernments usually findit hardtoreign in spendingquickly once programs areannounced. Therefore, whilst assumingthesamecumulativefiscal responseas outlinedby theOECDandotherstudies, the fiscal responsehas been assumedtotaper off quickly after2010butfinishingin 2012.

4. Effects of crisis without a fiscalpolicyresponse Mechanisms atwork

Toappreciatethemechanisms at workfrom thethree shocks an illustrativescenariowhere permanentshocks affecttheUnitedStates alone is shown in chart4.1. Theburstingof the housingbubblehas thebiggest negativeimpact on real consumption, which beingroughly 70 percent of thedomesticeconomy, has thebiggest negativeimpact on real GDP. The permanent loss in wealth causes consumption tofall sharply andbecausethehousingshockis assumedtobepermanent, consumption is permanently lowerin all periods as shown on Chart 4.1. Thefinancial shockhas thelargest negativeimpact on stockmarket values from baselinein 2009andan equally largeimpact as theburstingof thehousingbubbleon investment. The equity riskshockcauses ashift outof equities into otherdomesticassets, such as housingand government bonds as well as toasset purchases overseas. Theshift into government bonds drives uptheir prices andpushes down real interestrates substantially. This surprisingly raises human wealth becauseexpectedfutureaftertax incomeis discountedat a much lower real interest rate. Thus in theUS, theequity shockaloneis positiveratherthan negativefor consumption in theshortrun. Investment on theotherhandfalls sharply. Theequity shockreduces USinvestment by about 20percent belowbaseline.Therisein equity riskimplies asharpselloff of shares dueto a largerisein therequiredrateof return to capital. Thehigherequity riskpremium implies that theexistingcapital stockis toohigh togeneratethemarginal productrequiredfrom the financial arbitrage condition andinvestment falls and, overtime,duetotheexistenceof adjustment costs, thecapital stockfalls andpotential output is permanently reduced. Underthis simulation wheretheUS aloneis assumedtobeaffectedby thecrisis, thereis a largeimpact on USexports (bottom left handpanel of chart 4.1) becausethereis alarge capital outflowfrom theUS as USsavers invest offshorein thehouseholdriskshock. TheUS trade balance improves by 4percentof GDPprimarily dueto asharpdepreciation of theUS dollar. Each of thethree shocks has anegativeeffect on theUnitedStates and, combined, has the effect of loweringreal GDPby 7percent belowbaselinein 2009andreal GDPdoes not return tobaselineuntil 2017, nearly adecadelater. That is sufficient toput theUS into recession in 2009(baselinegrowth is 3.4percent) but will allowpositivegrowth in 201019 . A key compositional effect also occurs when householddiscount rates riseandriskpremia generally rise.Theeffectis amuch sharperfall in thedemandfor durablegoods relativeto othergoods in theeconomy. Imports anddomestic production of durablegoods falls bymorethan non durablegoods. Thedifferences are substantial. Thehigh riskadjustedcostleads to a reduction in theflowof services from durables andthereforethedemandfor thesegoods drops sharply. This compositional effect is critical for thetrade outcomes. Countries that exportdurablegoods areparticularly affected by acrisis of thetypemodelled. Therecession in theUnitedStates has two main effects on theworldeconomy. Oneis the negativeknockon effect from theloss in activity with thoseeconomies most dependent on theUnitedStates market most affected.Thesecondeffect runs countertothefirst. As prospects dim in theUnitedStates, sothereturns on investment lookbetter elsewhere. Money flows out of theUnitedStates (or strictly inthecaseof theUS, less inflowthan otherwise) andinto othereconomies whereit stimulates investment andeconomicactivity. This is illustrated by theeffect on China. TheUnitedStates is alargeimporterfrom China. As USimports fall, Chinas exports fall , with a combinedeffect from thethree shocks of adrop in exports of 5percent belowbaselinein 2009. Chinas trade balanceworsens, but notehow small theeffect is:barely 1percent belowbaseline (as apercent of GDP). Notealso thenet small effecton Chinas real GDPeven though Chinas exports arealarge proportion of their GDP. When theUnitedStates aloneis affectedby thecrisis, thereis a small combinedeffect on Chinaof areduction in real GDPof 0.75percent belowbaselinein 2009andapositiveeffect from 2011onwards. Lookingat Chinas real investment provides theanswer. Becauseinvestment prospects in theUnitedStates arenow direunderthe combinedscenario, money flows elsewhere, onerecipient of whois China. Chinas real investment couldbe3.5percent abovebaselinein 2011and2012, in responsetothe relatively betterinvestment prospects. Chinagains at theUnitedStates expense.The favourablestimulus from extrainvestment largely offsets andeventually outweighs the negativeeffects from theloss of exports totheUnitedStates. Theconclusion is that thefinancial crisis which started in theUnitedStates, hadit been confinedto theUS alone,wouldnot havehaddireconsequences for theworldeconomy. Of coursethereal story is different. Contagion andrisingriskpremiums everywherehavecaused adifferent scenario. When everyoneis affectedtheconsequences for theUnitedStates also depends on who andhowothercountries areaffected.

When all economies areaffectedby theglobal financial crisis through global changes in risk premiaandloss of consumerconfidence,othercountries likeChinaareadversely affected. When othereconomies arealsoadversely affected by thereappraisal of risk, thecost of capital for them also rises and, in effect, causes theexistingcapital stock tobetoolarge. Equity markets plummet as shown in chart set 4.4. Investment plummets, but not everywhere becauseit is relativeeffects thatmatter. Theimpactoninvestment is shown in chart set4.5. Whereas Chineseinvestment rosewhen just theUnitedStates was assumedto beaffectedby thecrisis, nowChineseinvestment falls toalowof over10percent belowbaselinein 2010 underthepermanent riskshock Undertheassumptions of thesmallerrisein riskpremiaacross therestof Asia,Latin America andLDCs, theseregions gain relatively from theglobal reallocation of investment. Investment in OtherAsiacouldbe2to 4 percent higheroverbaselinein 2009and2010. India, China,Australia,otherAsia,Latin America andotherLDCs donot gointorecession (see chart set4.6) as aresult of theglobal financial crisis as representedby thethree shocks usedin this study. WhilesomeLatin American economies such as Argentinaarenotfaring well at themoment, thereare otherforces at work such as droughtandtheimpactof taxes on their exports. Theresults in chart set4.7 do show thatexports from all regions tobehit hard, however. Inmost regions exports arevariously 8to14percent belowbaselinein 2009with exports from AustraliaandIndia20to 25 percentdown overthefull yearandcontinueto remain lowin thecaseof thepermanent scenario. Oneof thekey features of thecrisis is reflectedin theresults in chart set4.6and4.7. Thereis asubstantially largercontraction in exports relativetothecontraction in GDPin all economies. This massiveshift in therelationshipbetween trade andGDPis not theresult of an assumption abouttheincomeelasticity of imports. Itreflects somekey characteristics of themodel. First, imports aremodelledon abilateral basis between countries whereimports arepartly for final demandby households andgovernment andpartly for intermediateinputs across thesix sectors. In addition, investment is undertaken by acapital sector that uses domesticandimportedgoods from domesticproduction andimportedsources. As consumption andinvestment collapsemorethan GDP, imports will contract morethan GDP. Onecountrys imports areanothercountrys exports thus exports will contractmorethan GDPunless thereis achangein thetrade position of aparticularcountry. Theassumption thatall riskpremiariseandtheresults thatall real interest rates falls everywhereimplies small changes in trade balances.

5. Effects of policyresponses Theresults so farhavebuilt in amonetary reactionfunction in theform of an Henderson McKibbinTaylor rulefor each economy with theshortterm nominal interest rateadjustingto avariety of factors in each economy. Therules assumedin themodel havegeneratedan endogenous monetary responsewhich is similartothatobservedso far. Theassumption of an unchangedfiscal deficit is very different towhat has been observed. In this section wefocus on announcedfiscal responses. Theassumedfiscalpolicy changes weregiven earlierin Table 3.7. Note that we do nothave infrastructurespendingin themodel so thatthefiscal responses hereareassumedtobespendingon goods andservices andnotgovernment investment in physical capital. Expenditureon infrastructure wouldlikely also stimulatemedium tolong run supply in themodel andthereforechangetheextent to which thereis crowdingoutover time. Howeverto theextent that even infrastructurespendingis ademandstimulus for the first few year beforetheprojects begin todelivermedium run supply responses, theinitial results in this study can beusedtounderstandtheshortrun impacts of thepackages.

Effects of the fiscalstimulus alone Tosee themechanisms at work, theeffects of thefiscal stimulus aloneareshown in chart set 5.1. Theseresults shouldbeaddedtothefinancial crisis results togetapictureof the financial crisis (eitherpermanent or temporary) with fiscal response. In discussingthese results we will talkaboutthem relativetobaselinewhich can also beinterpreted as relativeto what wouldbeseen postcrisis. Thefiscal stimulus gives aboostto real GDPabovebaselinefor all major economies and Chinain 2009, thefirst year of thefiscal packages. Theeffects areillustrated by referringto China. Chinas real GDPcouldbe1.6percent abovewhat otherwisewouldbethecasein 2009, butlittledifferent from baselinein 2010. Real GDPwouldbebelowbaselinein 2011in Chinaas theeffects of higherreal interest rates kickin. Real interest rates couldbeover3 percentage points abovebaselinein 2009and2010(see appendix charts) offsettingmuch of thedeclinein real interest rates from theglobal financial shockandmonetary policy responses. Real privateinvestmentis 9percent belowbaselinein 2010. Consideringthe massive11.4percent cumulativefiscal stimulus in China, theeffect of thefiscal stimulus aloneis quitesmall andtransitory. Theeffect on Australia,despitethesizeof thestimulus is amodest 1.1percent higherGDPthan otherwisein2009andGDPbelowbaselinein subsequent years. Notethatthefiscal stimulus in thefirst year raises GDPbut for all countries this effect only lasts for ayear andis much smallerthat many commentators argue. Indeedwhen addedto theresults for thefull GFC simulation this fiscal stimulus is not sufficient to completely neutralize thecrisis inits impact on GDP (except in Australiawheretheeconomy does not enterrecession overafull year). Themain reasonfor thelackof asustainedrisein GDPfrom thefiscal packages involves thereal interest rateimplications of thefiscal stimulus as shown inAppendix chart C.6. Theglobal natureof thestimulus implies aspikeupin real interest rates which partly offsetthespikedown in thefirst year of theshocks. Note howeverthat higherreal interest rates persist for up to 6 years after thestimulus. This suggests some serious problems tobefacedby policymakers duringtherecovery periodfrom 2010onwards. Thefiscal packages also havesignificant impacts on global trade. In themodel, theeffect of fiscal policy on trade comes in anumberof forms operatingboth through incomeandrelative price effects. If an economy increasedgovernment spending, privateconsumption tends to riseandshort term incomerises. Howevertheincreasedborrowingtends to increasereal interest rates, which reduces privateinvestment20 . Thesetwo responses haveopposite effects on trade. In particular, durablegoods consumption falls becauseof therisein real interest rates, whilenondurablegoods consumption rises dueto theincomeincrease. The effect is that imports of durablegoods fall andnondurables rise.In addition thehigherreal interest ratetends toattract foreign capital which appreciates thereal exchangerateandtends tocrowdoutexports andstimulates incomethrough relativeprice changes. A country acting alonehas asubstantial changein themix of thecomponents of final demand. Hence if there is aglobal fiscal stimulus, thereal exchangerate(or relativeprice) effects aremuted. Howeverbecauseall countries areactingthereal interest rateeffects areaccentuatedbecause thecall on global savings is much largerthan theoutcomeof any onecountry actingalone. Chartset5.1shows an interestingstory whereexports of theindustrial economies tendto fall as aresult of thefiscal package.This occurs for several reasons. Firstly, becausetheOECD economies haverelatively largerfiscal packages (apartfrom China), their real exchangerate will tendtoappreciaterelativetothenon OECDeconomies, crowdingoutexports. Secondly, theseeconomies tendto export moredurablegoods whosedemandis reducedby a risein global interest rates. This effect was also present in theglobal financial crisis simulation wheretheriskadjusteddiscount riserosesharply (even though real interest rates fell) andthedemandfor durablegoods collapsed.

Causes As with any large event in any field of human endeavour, it is never about just one thing. There were many causes of the financial crisis, some recent and some longstanding. I would like to focus on three of those causes today: the misperception and mismanagement of risk; the level of interest rates; and the regulation of the financial system. Perhaps the most basic underlying driver of the crisis was the inherent cycle of human psychology around risk perceptions. When times are good, perceptions of risk diminish. People start to convince themselves that the good times will go on forever. Then, when the cycle turns, risk aversion increases again, often far beyond normal levels, let alone those seen during the boom. We can see in Graph 1 how investors perception of risk changed in the years leading up to the crisis. Yields on emerging market bonds or US companies at the riskier end of the spectrum all narrowed relative to those on US government bonds and other securities that are seen as very safe. More recently, those spreads have widened out dramatically, as investors became more risk-averse, and the search for yield turned into a flight to safety. The effects of this boom-bust cycle of psychology are amplified when investors use leverage. Borrowing to purchase assets is lucrative when asset prices are rising, because all the upside beyond the interest costs goes to the investor, not the lender. But when times are bad and asset valuations are falling, investors losses are magnified by leverage. A second element that coincided with the perceptions of lower risk was the low level of interest rates in the early part of this decade. At the short end, policy interest rates in the major economies reached levels that were unusually low compared with history, as shown in Graph 2. At the longer end, bond yields in the major economies were also unusually low over this period. As Graph 3 shows, this remained the case even once policy rates started to rise in 2004. At the time, the low level of long rates was considered somewhat puzzling a conundrum, as former Fed chairman Greenspan put it. Over time, though, many observers have come to the view that unusually strong investor demand had pushed long rates down. Among those investors were central banks and other government agencies in emerging and industrialised economies, which were accumulating foreign reserves. Many observers were concerned about the way the low level of interest rates made higher leverage so attractive. Inflation pressures were quite subdued at that time, so the macroeconomic situation didnt necessarily warrant much higher interest rates. There has been plenty of debate, inside and outside central banks, on whether monetary policy should also respond to financial stability concerns. But there is also recognition in many quarters that low interest rates were not and shouldnt be enough to cause such a crisis on their own. A lack of appropriate financial regulation in some countries is widely regarded as one of the important causes of the crisis. Many shortcomings have been identified in this area. These include: the capital requirements on complex financial products such as collateralised debt obligations (CDOs); the use of ratings provided by the private-sector rating agencies in the regulation of banks; the way credit rating agencies have themselves been regulated; and the structure of remuneration arrangements and the risk-taking incentives they create. Perhaps most crucially, many internationally active banks failed to perceive, or appropriately manage, the risks involved in certain financial products and markets, and regulators did not make them do better on this front. One sector that took particular advantage of low long-term interest rates was the US mortgage market. American households traditionally took out fixed-rate mortgages, often guaranteed by the government-sponsored enterprises, Fannie Mae and Freddie Mac the GSEs. As rates fell, households refinanced in large numbers, but this extra origination business dried up once rates started to rise again. Rather than shrink their business, US mortgage lenders pursued riskier segments of the market that the GSEs did not insure, as Graph 4 shows. This included the sub-prime segment, but also so-called Alt-A and other nonstandard loans involving easier lending terms. At the time, this was considered a positive development, because it was thought that it allowed more people to become home owners. Products requiring low or no deposit, or with a low introductory interest rate were known as affordability products. They allowed households to pay the very high housing prices that their own stronger demand was generating. As the US housing boom wore on, lending standards eased further. As Graph 5 shows, up until 2006 the sub-prime market segment increasingly allowed mortgages with very high loan-to-valuation ratios: that is, borrowers did not need much deposit. Low-doc loans became more common across the board. Negative amortisation loans, sometimes called Pay-option ARMs, also became more common. These are mortgages where the borrower can pick a repayment level that is so low that the loan balance actually rises for a while something that is essentially unheard of in other countries. The result of all that mortgage borrowing was, as shown in Graph 6, an increase in leverage, defined to be the ratio of home mortgage debt to the value of the housing stock. This measure had been quite stable in the United States for a number of years. But it increased in those last couple of years of the boom, reaching around 45 per cent by the time prices peaked sometime in 2006. (The exact date depends on the price series used.) In Australia, the equivalent ratio is below 30 per cent. Since many home owners own their homes outright, the US figure implies that many Americans had very little equity in their homes by the time the boom peaked. And of course, this measure of leverage has increased a great deal since US housing prices started to fall. US households werent alone in gearing themselves up like this. Although corporate sectors around the world were by and large relatively restrained in their behaviour, there were some pockets where borrowing and gearing expanded a great deal. Some examples include the assetbacked commercial paper market, which is often used to finance entities that invest in other securities, and the leveraged loan market, often used to finance buyouts of companies. And as Graph 7 shows, leveraged buyout activity boomed, especially in North America and Europe. As with the mortgage market, the excesses built up most where the financing structures were most opaque, and the underestimation of the risks was greatest.Consequences When risk aversion rises like this, the macroeconomic consequences can be severe. Since at least Keynes day, it has been recognised that economies run in large part on confidence. When firms and consumers no longer feel confident, they pull back from spending. When banks and other financial institutions no longer feel confident, they pull back from lending. Projects that seemed likely to be profitable in the good times suddenly seem risky and less attractive. Bank regulation and behaviour might explain how a US mortgage crisis propagated into essentially a North Atlantic banking crisis. But trade and confidence effects explain why that North Atlantic banking crisis has escalated into a global problem. The intensification of the current crisis following the Lehman failure in September saw the deterioration of many macroeconomic indicators. Industrial output contracted sharply in much of the world. Commodity prices had been booming earlier in the year, but declined significantly towards the end of the year. There was a sudden contraction in the volume of world trade. In this environment, forecasters have had to scale down their forecasts for output growth repeatedly. As Graph 12 shows, the IMF is now forecasting that global output will contract in 2009. This would be the first annual contraction in output since at least the Second World War. The weak global macroeconomic outlook implies that borrowers have become riskier. Some are likely to face greater difficulty servicing their debts. Bad loans normally rise relative to total lending when economies turn down, and the current global downturn will be no exception to this pattern. In the current environment, this could weigh on the profitability of already weakened banking sectors in the major economies. Countermeasures At this stage, policy-makers around the world are focusing on solving the immediate problems in the banking system. Governments and central banks are also providing macroeconomicstimulus through fiscal and monetary policy easing. Restoring the global banking system to health is a precondition for a recovery in credit supply and economic activity. As such, it has to take priority over longer-term reforms. In this environment, the need for credible steps to restore the health of the financial system is crucial. Governments in the most-affected countries have provided substantial support to financial institutions and markets, especially since the Lehman failure. Most have ensured banks access to funding by guaranteeing wholesale debt issuance; some have injected capital into banks; and a few have helped banks to reduce the risk in their balance sheets. There are several ways of undertaking this de-risking of balance sheets. Governments can buy the assets outright and place them in an entity separate to the bank; they can insure assets remaining on banks balance sheets against losses; or they can invest in joint investment funds that buy the assets. Each of these approaches has been used in at least one country in the recent crisis. At this stage it is hard to say if there is one right way to deal with these issues. The important thing is that they are dealt with. Despite these considerable efforts, confidence in the financial system remains fragile. Some market-based indicators of confidence have nonetheless improved in recent weeks. Money market spreads have retraced much of the increase that occurred following the Lehman failure. Equity markets have also staged a partial recovery, especially after the US Government released further details about its own programs for de-risking bank balance sheets. On top of these efforts to deal with the immediate problems, there is also considerable focus on reforms to the financial system architecture, to prevent a similar crisis from occurring again. Policy initiatives under discussion include changes to the regulation of credit rating agencies, the pay incentives faced by financial institutions and their staff, and the regulation of bank capital and liquidity. Many of these initiatives have been developed under the auspices of international groupings of central banks and bank regulators, such as the Financial Stability Forum, now known as the Financial Stability Board, and the Basel Committee on Bank Supervision. Both groupings have expanded their memberships in the past few weeks, in particular to include major emerging economies. Australia was already represented on the Financial Stability Forum, and is one of the countries that have just joined the Basel Committee. Central banks and other authorities around the world are working together to deal with the crisis and finalise these initiatives. Some of the reforms being considered will take a couple of years to be introduced. The global financial system is therefore facing a period of change. The present financial crisis has followed a period in which the price of risk was unusually low and conducive to the build-up of excesses in credit markets. These easier conditions are unlikely to return any time soon. What happens over the next few years, at least, is highly uncertain. For the time being, credit conditions will probably still be tighter than had been the case a few years ago. There will probably be less financing available for asset acquisition. Among the important open questions are: how quickly the banking systems in major economies can repair their balance sheets; and how quickly confidence can be restored

Conclusion

This study has exploredtheimpact of three major shocks representingtheglobal financial crisis on theglobal economy. For thecrisis itself three shocks areneededtocapturethe observeddropin asset prices andreduction in demandandtrade. Itis necessary tosimulate theburstingof thehousingbubblecentredin theUnitedStates andEurope, but extending elsewhere, risingperceptions of riskby business as reflectedin theequity riskpremium over bonds andrisingperceptions of riskby households. Thepaper has also exploredthe differencebetween apermanent andatemporary loss of confidence. Thepolicy responsehas been dramatic. Sotheanalysis has includedamonetary easingacross theglobeandafiscal stimulus of varyingproportions across countries andregions. Simulatingtheeffect of thecrisis itself (that is ignoringthepolicy responses notalready built into themodel such as endogenous monetary policy rule)on theUnitedStates alone(the epicentre of thecrisis) shows several things. Hadtherenotbeen thecontagion across other countries in terms of riskreappraisal, theeffects wouldnot havebeen as dramatic. The adversetrade effects from theUnitedStates downturn wouldhavebeen offset tosomedegree by positiveeffects from aglobal reallocation of capital. WeretheUSaloneaffectedby the crisis, Chineseinvestmentcouldhaveactually risen. Theworldcouldhaveescapedrecession. When thereis areappraisal of riskeverywhereincludingChina, investment falls sharply in asensethereis nowherefor thecapital to goin aglobal crisis of confidence. Theimplication is that if markets, forecasters andpolicy makers misunderstandtheeffects of thecrisis and mechanisms at work, they caninadvertently fuel fearsof ameltdown andmake matters far worse. Theburstingof thehousingbubblehas abiggereffect on fallingconsumption andimports than does thereappraisal of risk, but thereappraisal of riskhas thebiggest effect on investment. Risingriskcauses several effects. Thecostof capital is nowhigherandleads to a contraction in thedesiredcapital stock. Hence thereis disinvestment by business andthis can goon for several years adeleveragingin thepopularbusiness media. Thehigherperception of riskby households causes them todiscount futurelabour incomes andleads to higher savings andless consumption, fuellingthedisinvestment process by business. When thereis aglobal reappraisal of riskthereis a largecontraction in outputandtrade the scaleof which depends on whetherthecrisis is believedtobepermanent or temporary. The longrun implications for growth andtheoutlookfor theworldeconomy aredramatically different dependingon thedegree of persistence of theshock. As expected, theeffects of the crisis aredeeperandlast longerwhen thereappraisal of riskby business andhouseholds is expectedto bepermanent versus whereit is expectedtobetemporary. This difference anda thirdscenario whereagents unexpectedly switch from onescenario to theotheris explored in McKibbin andStoeckel (2009b). Thedynamics for 2010arequitedifferent between the temporary scenario andtheexpectation revision scenario even though theshocks areidentical from 2010onwards.22