Arcillas, Rachel Chris G.

BSMA-III / Fin211-A
April 28, 2017

In 2008 the world economy faced its most dangerous crisis since the Great Depression of
the 1930s. The contagion, which began in 2007 when sky-high home prices in the United States
finally turned decisively downward, spread quickly, first to the entire U.S. financial sector and
then to financial markets overseas. The casualties in the United States included a) the entire
investment banking industry, b) the biggest insurance company, c) the two enterprises chartered
by the government to facilitate mortgage lending, d) the largest mortgage lender, e) the largest
savings and loan, and f) two of the largest commercial banks. The carnage was not limited to the
financial sector, however, as companies that normally rely on credit suffered heavily. The
American auto industry, which pleaded for a federal bailout, found itself at the edge of an abyss.
Still more ominously, banks, trusting no one to pay them back, simply stopped making the loans
that most businesses need to regulate their cash flows and without which they cannot do
business. Share prices plunged throughout the worldthe Dow Jones Industrial Average in the
U.S. lost 33.8% of its value in 2008and by the end of the year, a deep recession had enveloped
most of the globe. In December the National Bureau of Economic Research, the private group
recognized as the official arbiter of such things, determined that a recession had begun in the
United States in December 2007, which made this already the third longest recession in the U.S.
since World War II.

Another study stated that apart from apportioning blame to greedy and in some cases,
fraudulent bankers, most analyses focus on proximate causes within the financial sector,
especially in the United States. These mainly relate to four forms of market failure and three
types of state failure. Market failures, state failures and ongoing debate.

Market failures
Speculative asset price inflation can be considered one type of market failure, which can
induce large-scale misallocation of capital and huge collateral damages after the bursting
 of a bubble. In this respect, the inefficiency of financial markets may be viewed as a
market failure, in addition to traditional typologies of market failure in microeconomics.
Also, oligopolistic rating agencies which collude with their clients are likely to be biased, and if
they suffer from information asymmetry, they may tend to spread false information with highly
negative external effects.

State Failure
If market failures exist, they should be cured or mitigated by government regulations,
specifically in the financial sector. One type of state failures, including false policies, are
under discussion. That is, many observers believe that monetary policy was too
expansionary after the terrorist attacks in New York in September 2001 and the bursting
of the dot-com bubble. Too much money in circulation had fuelled asset price increases,
and not inflation, which was checked by global competition (Taylor, 2009). Implicitly it
is held that the Federal Reserve, or central banks in general, can avoid both inflation and
asset price bubbles if they strictly follow the Taylor rule. However, if this proposition
does not hold, and if neither the Federal Reserve nor the government cares about asset
inflation, and if the central bank narrowly focuses on inflation-targeting (i.e. consumer
prices), there would be no instrument to counter speculative bubbles, although these can
have a severe macroeconomic impact. In the case of the Federal Reserve, its former
chairman, Alan Greenspan, and his successor, Bernanke (and many others), believed that
monetary policy should target only inflation, and that burst bubbles could be dealt with
by a proactive monetary policy of low interest rates, as in 20012002, sometimes referred
to as the Jackson Hole doctrine. This doctrine believes in the omnipotence of monetary
policy, categorically ruling out such problems as liquidity traps, credit crunches and
systemic financial instability. In short, modern central banking claims that it cannot
happen again.

Ongoing Debate
one area of ongoing debate is about the proximate causes. This area concerns the massive
bonus payments. There can be no question that short-term incentives for bankers
contributed to risk taking and speculative behaviour, although the incentives were
 designed to prevent this and to make bankers accountable for misbehaviour. The
underlying questions relate to the corporate governance of financial institutions why
shareholders did not voice concern and the enormous profits made by them, with much
higher returns on equity than elsewhere in the economy. The latter can, in principle, be
due to their incurring higher risks, to monopoly power (including rent seeking), windfall
profits based on extraordinarily high demand for financial services, technical progress
(due to innovations) and/or creative accounting practice, apart from fraud. All of them
may have contributed to the crisis, and should have been a matter of concern for
regulators and governments, but were not. However, fixed salaries and small bonuses
would not have prevented the crisis.

Western Europe is being hit by major shocks that are weakening economic activity,
notably extraordinary financial stress. Real GDP growth has stalled in the euro, following a first-
quarter rebound. Growth was already noticeably weaker elsewhere during the first quarter,
including in the United Kingdom and most Nordic countries, and conjunctural indicators now
suggest that many countries are moving close to or into recession. At the same time, high oil and
food prices are still keeping inflation at elevated levels. Economic growth is being slowed by a
number of factors, initially mainly by rising oil prices but now increasingly by tightening
financial conditions. Relative to 2007, oil prices are some 40 percent higher in euro terms and,
together with surging food prices, have squeezed already sluggish consumption growth. All other
things equal, standard rules of thumb would imply output losses from such a shock in a broad
range up to about 2/3 percent of GDP for the euro arealess for oil producers such as the United
Kingdom and Norway. Although oil prices increased sevenfold over 19992008, the response of
wages has remained generally subdued, unlike during the 1970s, reflecting structural reforms and
improved policy frameworks. Together with rapidly cooling activity and rising unemployment
fears, these factors should help contain wages over the coming year (Figure 2.2). Thus, while
headline inflation has recently been running in the 34 percent range in many countries, core
inflation (excluding all food and energy) has generally been below 2 percent in the euro area and
the United Kingdom.3 Inflation expectations have generally remained well anchored, although
somewhat less so in the United Kingdom than in the euro area. While oil and food price hikes are
undercutting real disposable incomes, financial conditions are tightening quickly. European
banks are struggling with a confluence of adverse shocks. They have been exposed to losses on
their holdings of U.S.-mortgage-related assets and deteriorating overall credit quality since 2007.
Concerns that initially focused on liquidity are also affecting solvency. Confidence in the sector
has weakened and highly leveraged banks are struggling to maintain funding in the face of rising
creditor concerns about balance-sheet risk. Equity-to-asset ratios will need to be boosted, which,
to a large extent, will have to be achieved by cutting back on lending because bank stock prices
have declined.

The process of deleveraging, including market exit by some institutions, will likely be
long and arduous and banks have already tightened lending standards to far above pre-turmoil
levels. Households and firms operating in real estate are struggling under growing debt burdens,
particularly in countries such as Ireland, Spain, and the United Kingdom, where floating-rate
mortages indexed to short-term interest rates are common. In real terms, residential property
prices are falling in these and some other countries, while slowing quickly elsewhere (see Box
1.2). While there is a risk of an outright housing-related credit crunch, some factors would
mitigate pernicious feedback loops between the financial and real sectors (Chapter 4). Although
residential real estate generally accounts for a larger share of activity in western Europe than the
United States, the recent expansion of residential investment was generally less pronounced,
except in Finland, Greece, Ireland, Spain, and the United Kingdom. Furthermore, these countries
are less likely to suffer from the financial vulnerabilities exposed in the United States: household
savings are generally higher and debt lower, non-prime lending is much less widespread, loan-to-
value ratios are more conservative, and opportunities for equity withdrawal are much more
limited. However, even in the absence of an outright credit crunch, the downturn in residential
real estate will have an appreciable short-run impact in some countries (for example, Ireland,
Spain, and the United Kingdom) and, with the exception of a few countries (for example,
Austria, Germany, and Switzerland), produce noticeable medium-term headwinds.