Federal Planning Bureau Economic analyses and forecasts The financial crisis and its consequences...

FederalPlanning BureauEconomic analyses and forecasts

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

Macroeconomic policies

Financial market regulation

1. Speculative bubbles 3. Financial innovations and deregulation

2. “Organized” global imbalances

4. “Asymmetric information” leading to the collapse of the interbank market


Transmission channels of monetary policy

5

Accommodating monetary policy

Low interest rate

Impact on real economy

Channel n° 1Reduced cost of capital

Increase of Investment

Channel n° 2Reduced mortgage and credit

costs

Increase of housing investment and durables

Growth of GDP

Inflation

Tightening of monetary policy


What went wrong?

6

Accommodating monetary policy from 2001 to 2006

Development of asset price bubbles


Channel n° 1Reduced cost of capital

Increase of Investment

Channel n° 2Wealth effect and indebtedness

Increase of housing investment and durables

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)

Source: Thomson Reuters Datastream

1999 2000 2001 2002 2003 2004 2005 2006-4

-2

0

2

4

6

8

-4

-2

0

2

4

6

8

Federal Funds Target Rate Real FedFunds Rate (CPI corrected)


When expectation of price increase is based on past increase


US and euro area monetary policy


1999 2000 2001 2002 2003 2004 2005 2006-4

-2

0

2

4

6

8

-4

-2

0

2

4

6

8

Federal Funds Target Rate Real FedFunds Rate (CPI corrected) Real Refi Rate ECB


US stock market

• Stock indices rose by almost 100% in the 5 years to mid 2007


88 90 92 94 96 98 00 02 04 06 08200

400

600

800

1000

1200

1400

1600

200

400

600

800

1000

1200

1400

1600

S&P 500 COMPOSITE


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


88 90 92 94 96 98 00 02 04 06 0860

80

100

120

140

160

180

200

Case-Shiller house prices, index


US household indebtness (debt-to-income ratio)


1960 1970 1980 1990 20000.2

0.4

0.6

0.8

1.0

1.2

1.4

0.2

0.4

0.6

0.8

1.0

1.2

1.4

FINANCIAL LIABILITIES - HOUSEHOLDS & NONPROFITS (FOF) : United States/DISPOSABLE PERSONAL INCOME (QUAR…


US Private Consumption / GDP ratio


1950 1960 1970 1980 1990 20000.60

0.62

0.64

0.66

0.68

0.70

0.72

0.60

0.62

0.64

0.66

0.68

0.70

0.72

PERSONAL CONSUMPTION EXPENDITURES (AR) : United States/GDP (AR) : United States


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


Current account deficits & surpluses (2008, in bn USD)

Largest current account surpluses Largest current account deficits

OPEC 459,9 US -706,1

China 426,1 Spain -153,7

Germany 235,3 Italy -78,8

Japan 157,1 France -64,8

Russia 102,4 Greece -51,6

Norway 88,0 Australia -46,6

Netherlands 65,7 UK -46,5


Consequences of the crisis for the real economy and

where do we stand now?


When the bubbles burst…

17

Tightening of monetary policy from 2007 onwards

Burst of asset price bubbles + collapse of global banking system


Channel n° 1Interest rates increase and credit conditions tightened

Drop of Investment

Channel n° 2Deleveraging and increase of

saving ratio

Drop of housing investment and consumption

Recession

Fear of deflation

Massive monetary and fiscal support


The drop of world trade growth was comparable to 1929


World GDP growth since 1930


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


2008 20090

1

2

3

4

5

0

1

2

3

4

5

Fedfunds Rate 3M Interbank


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


Government financial balance in % of GDP (OECD)

92 94 96 98 00 02 04 06 08 10-12

-10

-8

-6

-4

-2

0

2

-12

-10

-8

-6

-4

-2

0

2

US Euro area


Cost of capital: Corporate bond spreads have normalized

• Corporate bond market spreads have diminished, but will probably remain more elevated than in 2005-2007


2001 2002 2003 2004 2005 2006 2007 2008 20090

1

2

3

4

5

6

7

0

1

2

3

4

5

6

7

AAA spread BAA spread


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


2007 2008 2009600

800

1000

1200

1400

1600

600

800

1000

1200

1400

1600

S&P 500 COMPOSITE


The global recession has ended


GDP qoq US, EA & Japan

2008 2009-4

-3

-2

-1

0

1

2

-4

-3

-2

-1

0

1

2

US GDP EA GDP Japan GDP

Near term optimism caused by a combination of temporary factors :

- fiscal stimulus

- inventory rebuilding

rather than by solid private consumption and investment growth


The near future


Growth will resume slowly...

2008 2009 2010 2011

US 0,4 -2,5 2,2 2

Japan -0,7 -5,9 1,1 0,4

Euro Area 0,6 -4 0,7 1,5

Belgium (BFP) 1,1 -3,1 0,4 1,9

Inflation 4,5 0 1,5 1,6

Employment Change 71,2 -35 -59 17,6

Unemployment Rate 7,0 8,2 9,4 9,6


But, unemployment will be unacceptably high


Danger of early exit, exhibit 1:Greece


Spread over Bund

2006 2007 2008 2009-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

Euro Area Belgium Greece Italy Ireland

Source: FT, Barclays, OECD

A B C D

Bank assets (in

bn €)

ECB funding (in

bn €)B/A

Debt/GDP in 2010

GR 481 38 7,9 111,8

IR 1650 98 5,9 80,3

BE 1163 40 3,4 106,4

GE 7519 221 2,9 84,1

ES 3427 84 2,5 68,2

NL 2208 40 1,8 76,6

LX 1150 19 1,7 n/a

FR 7707 101 1,3 94,2

IT 3730 30 0,8 127,3


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

RACTier

1

HSBC 9,2 8,3

Dexia 9 10,6

ING Bank 8,9 9,3

Goldman Sachs Group 8,3 13,8

Morgan Stanley 8,1 15,8

KBC Bank 7,7 9,7

BNP Paribas? 7,2 7,8

JPMorgan Chase 7 9,7

Deutsche Bank 6,1 10,1

UBS 2,2 13,2

Citigroup 2,1 12,7

Mizuho Financial Group 2 6,4

Global average of 45 6,1 9,7


And the fiscal challenge in 2011 will be difficult to manage

OECD area US Euro area

Fiscal balance -7.7 -9.7 -6.0

Debt 103.8 100.7 92.7

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

Federal Planning Bureau Economic analyses and forecasts The financial crisis and its consequences...

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