The Global Financial Crisis

The intensification of the global financial crisis, following the bankruptcy of

Lehman Brothers in September 2008, made the economic and financial environment very
difficult for the world economy, the global financial system and for central banks. The fall
out of the current global financial crisis could be an epoch changing one for central banks
and financial regulatory systems. It is, therefore, very important that we identify the causes
of the current crisis accurately so that we can then find, first, appropriate immediate crisis
resolution measures and mechanisms; second, understand the differences among countries
on how they are being impacted; and, finally, think of the longer term implications for
monetary policy and financial regulatory mechanisms.
These are all large subjects and one cannot hope to do full justice to them in one
paper. A legion of both policymakers and scholars are at work analysing the causes of the
crisis and trying to find both immediate and longer term solutions (for example, the de
Larosiere Report (2009), the Turner Review (2009), the Geneva Report (2009), the Group
of Thirty Report (2008), the IMF Lessons paper (2009b) and the United Nations Report
(2009)). I can only attempt some conjectures, raise issues and identify some possible
directions in which we should move.
Global Financial Crisis
Genesis of Global Financial Crisis
The proximate cause of the current financial turbulence is attributed to the sub-
prime mortgage sector in the USA. At a fundamental level, however, the crisis could be
ascribed to the persistence of large global imbalances, which, in turn, were the outcome
of long periods of excessively loose monetary policy in the major advanced economies
during the early part of this decade (Mohan, 2007, Taylor, 2008).
Global imbalances have been manifested through a substantial increase in the
current account deficit of the US mirrored by the substantial surplus in Asia, particularly in
China, and in oil exporting countries in the Middle East and Russia (Lane, 2009). These
imbalances in the current account are often seen as the consequence of the relative
inflexibility of the currency regimes in China and some other EMEs. According to Portes
(2009), global macroeconomic imbalances were the major underlying cause of the crisis.
These savinginvestment imbalances and consequent huge cross-border financial flows put
great stress on the financial intermediation process. The global imbalances interacted with
the flaws in financial markets to generate the specific features of the crisis.
The emergence of dysfunctional global imbalances is essentially a post 2000
phenomenon and which got accentuated from 2004 onwards. The surpluses of East Asian
exporters, particularly China, rose significantly from 2004 onwards, as did those of the oil
exporters. In fact, Taylor argues that the sharp hikes in oil and other commodity prices in
early 2008 were also related to the very sharp policy rate cut in late 2007 after the
subprime crisis emerged.
It would be interesting to explore the outcome had the exchange rate policies in
China and other EMEs been more flexible. The availability of low - priced consumer
goods and services from EMEs was worldwide. Yet, it can be observed that the Euro area
as a whole did not exhibit large current account deficits throughout the current decade. In
fact, it exhibited a surplus except for a minor deficit in 2008.
Thus, it is difficult to argue that the US large current account deficit was caused by
China’s exchange rate policy. The existence of excess demand for an extended period in
the U.S. was more influenced by its own macroeconomic and monetary policies, and may
have continued even with more flexible exchange rate policies in China.
In the event of a more flexible exchange rate policy in China, the sources of
imports for the US would have been some countries other than China. Thus, it is most
likely that the US current account deficit would have been as large as it was – only the
surplus counterpart countries might have been somewhat different. The perceived lack of
exchange rate flexibility in the Asian EMEs cannot, therefore, fully explain the large and
growing current account deficits in the US. The fact that many continental European
countries continue to exhibit surpluses or modest deficits reinforces this point.
Components of the Crisis
Most of the crises over the past few decades have had their roots in developing and
emerging countries, often resulting from abrupt reversals in capital flows, and from loose
domestic monetary and fiscal policies. In contrast, the current ongoing global financial
crisis has had its roots in the US. The sustained rise in asset prices, particularly house
prices, on the back of excessively accommodative monetary policy and lax lending
standards during 2002-2006 coupled with financial innovations resulted in a large rise in
mortgage credit to households, particularly low credit quality households. Most of these
loans were with low margin money and with initial low teaser payments. Due to the
‘originate and distribute’ model, most of these mortgages had been securitized. In
combination with strong growth in complex credit derivatives and the use of credit ratings,
the mortgages, inherently sub-prime, were bundled into a variety of tranches, including
AAA tranches, and sold to a range of financial investors.
As inflation started creeping up beginning 2004, the US Federal Reserve started to
withdraw monetary accommodation. With interest rates beginning to edge up, mortgage
payments also started rising. Tight monetary policy contained aggregate demand and
output, depressing housing prices. With low/negligible margin financing, there were
greater incentives to default by the sub-prime borrowers. Defaults by such borrowers led to
losses by financial institutions and investors alike. Although the loans were supposedly
securitized and sold to the off balance sheet special institutional vehicles (SIVs), the losses
were ultimately borne by the banks and the financial institutions wiping off a significant
fraction of their capital. The theory and expectation behind the practice of securitisation
and use of derivatives was the associated dispersal of risk to those who can best bear them.
What happened in practice was that risk was parcelled out increasingly among banks and
financial institutions, and got effectively even more concentrated. It is interesting to note
that the various stress tests conducted by the major banks and financial institutions prior to
the crisis period had revealed that banks were well-capitalised to deal with any shocks.
Such stress tests, as it appears, were based on the very benign data of the period of the
Great Moderation and did not properly capture and reflect the reality (Haldane, 2009).
The excessive leverage on the part of banks and the financial institutions (among
themselves), the opacity of these transactions, the mounting losses and the dwindling net
worth of major banks and financial institutions led to a breakdown of trust among banks.
Given the growing financial globalization, banks and financial institutions in other major
advanced economies, especially Europe, have also been adversely affected by losses and
capital write-offs. Inter-bank money markets nearly froze and this was reflected in very
high spreads in money markets. There was aggressive search for safety, which has been
mirrored in very low yields on Treasury bills and bonds. These developments were
significantly accentuated following the failure of Lehman Brothers in September 2008 and
there was a complete loss of confidence.
The deep and lingering crisis in global financial markets, the extreme level of risk
aversion, the mounting losses of banks and financial institutions, the elevated level of
commodity prices (until the third quarter of 2008) and their subsequent collapse, and the
sharp correction in a range of asset prices, all combined, suddenly led to a sharp slowdown
in growth momentum in the major advanced economies, especially since the Lehman
failure. The global economy, which was seen to grow in 2009 by a healthy 3.8 per cent in
April 2008, is now expected to contract by 1.1 per cent (IMF, 2009c) (Table 2). Major
advanced economies are in recession and the EMEs - which in the earlier part of 2008
were widely viewed as being decoupled from the major advanced economies – have also
been engulfed by the financial crisis-led slowdown. Global trade volume (goods and
services) is also expected to contract by 12 per cent during 2009 as against the robust
growth of 8.2 per cent during 20062007. Private capital inflows (net) to the EMEs fell
from the peak of US $ 697 billion in 2007 to US $ 130 billion in 2008 and are projected as
of October 2009 to record net outflows of US $ 52 billion in 2009. This is in contrast to
expectations in April 2009 of net outflows of US $ 190 billion, demonstrating the level of
uncertainty caused by the financial crisis. The sharp decline in capital flows in 2009 will
be mainly on account of outflows under bank lending and portfolio flows. Thus, both the
slowdown in external demand and the lack of external financing have dampened growth
prospects for the EMEs much more than that was anticipated a year ago.
Conclusions and Lessons
The global financial crisis of the past couple of years can be largely attributed to
extended periods of excessively loose monetary policy in the US over the period 2002-04.
Very low interest rates during this period encouraged an aggressive search for yield and a
substantial compression of risk-premia globally. Abundant liquidity in the advanced
economies generated by the loose monetary policy found its way in the form of large
capital flows to the emerging market economies. All these factors boosted asset and
commodity prices, including oil, across the spectrum providing a boost to consumption
and investment. Global imbalances were a manifestation of such an accommodative
monetary policy and the concomitant boost in aggregate demand in the US outstripping
domestic aggregate supply in the US. This period coincided with lax lending standards,
inappropriate use of derivatives, credit ratings and financial engineering, and excessive
leverage. As inflation began to edge up reaching the highest levels since the 1970s, this
necessitated monetary policy tightening. The housing prices started to witness some
correction. Lax lending standards, excessive leverage and weaknesses of banks’ risk
models/stress testing were exposed and bank losses mounted wiping off capital of major
financial institutions. The ongoing deleveraging in the advanced economies and the
plunging consumer and business confidence have led to recession in the major advanced
economies and large outflows of capital from the EMEs; both of these channels are now
slowing down growth in the EMEs.
Monetary Policy and Asset Prices
The conventional wisdom is that, even if the monetary authority can exante identify an
asset bubble, the typical monetary policy actions – changes of 25 or 50 basis points –
would be insufficient to stop the bubble. It has been argued that only substantial hikes in
policy rates could prick the bubble but this would be at a substantial cost to the real
economy. The influence of interest rates on the speculative component of asset prices is
unclear from both a theoretical and empirical perspective (Kohn, 2008). In the context of
the current global financial crisis, with deleterious impact on growth and employment and
significant fiscal costs, the issue of relationship between monetary policy and asset prices
needs to be revisited. It can be argued that the output losses of a pre-emptive monetary
action might have been lower than the costs that have materialised from a non-responsive
monetary policy. At least, a tighter monetary policy could have thrown sand in the wheels
and could have reduced the amplitude of asst price movements. As asset price bubbles are
typically associated with strong growth in bank credit to certain sectors such as real estate
and stock markets, pre-emptive monetary actions could be reinforced by raising risk
weights and provisioning norms for sectors witnessing very high credit growth. For both
monetary and regulatory actions to be taken in tandem, it is important that both the
functions rest with the central banks. In this context, the recent trend of bifurcation of
monetary policy responsibility from regulatory responsibility appears to be unhelpful
(Mohan, 2006b). On balance, it appears that pre-emptive and calibrated monetary and
regulatory measures would be better than an inertial monetary policy response. Such an
approach can help in mitigating the amplitude of the bubble in both the upswing and the
downswing of the cycle and contribute to both macroeconomic and financial stability. This
view seems to be gaining ground. As the IMF in its assessment noted: “Central banks
should adopt a broader macro-prudential view, taking into account in their decisions asset
price movements, credit booms, leverage, and the build up of systemic risk. The timing
and nature of pre-emptive policy responses to large imbalances and large capital flows
needs to be re-examined” (IMF, 2009b).
It thus appears that the sharp swings in monetary policy, especially periods of
prolonged accommodation, in the advanced economies are the underlying causes of the
ongoing global financial crisis. While until recently, the ‘Great Moderation’ since the early
1990s – reduction in inflation and reduction in growth volatility - had been attributed, in
part, to the rule-based monetary policy, it now appears that that volatility in monetary
policy can also have the side-effect of creating too much volatility in financial markets and
financial prices, which can then potentially feed into the real economy with dangerous
consequences, as indicated by the ongoing global financial crisis.