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Working Paper No. 407
Global Financial Crisis: Causes, Impact, Policy
Responses and Lessons
by
Rakesh Mohan
December 2009
Stanford University
579 Serra Mall @ Galvez, Landau Economics Building, Room 153
Stanford, CA 94305-6015
GLOBAL FINANCIAL CRISIS: CAUSES, IMPACT, POLICY RESPONSES AND LESSONS*
Rakesh Mohan
December 2009
Abstract
Although the global financial crisis is still ongoing, there has been a tremendous effort to research
and analyze its causes. Though the crisis started with the subprime mortgage sector in the US, its genesis
can be traced to excessively loose monetary policy in the US during 2002-04. Low interest rates
encouraged the search for higher yield and consequently created large global imbalances. Coupling this
environment with other factors such as lax lending standards, excessive leverage and underpricing of risk
led to a crisis that quickly spread to global financial markets.
In the case of India, there was no direct impact from the crisis as India had little exposure to toxic
assets that afflicted Western countries’ financial institutions and foreign banks’ presence in India is
circumscribed. However, following the Lehman failure, there was a dramatic change in the external
environment, which caused capital outflows from India in late 2008 requiring urgent fiscal and monetary
policy responses.
India has weathered the storm relatively well compared to other countries. It is therefore
important to understand why this was the case. Dynamic provisioning by the banking system provided
buffers against negative shocks and strong balance sheets with transparency in bank operations prevented
any crisis in inter-bank money markets or the banking system as a whole. Additionally, India’s approach
to a gradual opening of the capital account and financial sector proved to be beneficial in shielding the
financial system from drastic external shocks. The Reserve Bank of India has therefore taken both
monetary and regulatory actions to prevent and contain the impact of the global financial crisis. As the
debate now turns towards designing regulation of the financial system to maintain financial stability, we
should also consider what can be learned from India’s approach of preemptive policy towards large
volatility in capital flows and imbalances and in financial regulation.
Keywords: Financial crisis; Fiscal policy; Monetary Policy; India.
JEL Classification No.: E63, E65.
* Based on remarks delivered at the RBI-BIS Seminar on “Mitigating Spillovers and Contagion – Lessons from the
Global Financial Crisis” at Hyderabad on December 4, 2008, at the International Chambers of Commerce at New
Delhi on January 16, 2009, at the Yale School of Management, Yale University on April 3, 2009, at the 7th Annual
India Business Forum Conference at London Business School, London on April 23, 2009, and at the Money and
Banking Conference organized by the Central Bank of Argentina on August 31 - September 1, 2009. Assistance of
Muneesh Kapur in preparing the speech is gratefully acknowledged.
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.
What I attempt to do here is to provide my interpretation of the unfolding
of the present global financial crisis; how it is affecting us; why the Indian
financial sector has been able to weather the crisis relatively well; the analytics
of our policy response; and, finally, some implications of its longer lasting
effects.
I. 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,
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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 saving-
investment 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. Such a view, however, offers only a partial analysis of the recent
global economic environment. The role of monetary policy in the major
advanced economies, particularly that in the United States, over the same time
period needs to be analysed for arriving at a more balanced view.
Following the dot com bubble burst in the US around the turn of the
decade, monetary policy in the US and other advanced economies was eased
aggressively. Policy rates in the US reached one per cent in June 2003 and
were held around these levels for an extended period (up to June 2004) (Chart
1). In the subsequent period, the withdrawal of monetary accommodation was
quite gradual. An empirical assessment of the US monetary policy also
indicates that the actual policy during the period 2002-06, especially during
2002-04, was substantially looser than what a simple Taylor rule would have
required (Chart 2). “This was an unusually big deviation from the Taylor Rule.
There was no greater or more persistent deviation of actual Fed policy since the
turbulent days of the 1970s. So there is clearly evidence that there were
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monetary excesses during the period leading up to the housing boom” (Taylor,
op.cit.). Taylor also finds some evidence (though not conclusive) that rate
decisions of the European Central Bank (ECB) were also affected by the US
Fed monetary policy decisions, though they did not go as far down the policy
rate curve as the US Fed did.
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Excessively loose monetary policy in the post dot com period boosted
consumption and investment in the US and, as Taylor argues, it was made with
purposeful and careful consideration by monetary policy makers. Accommodative
monetary policy and the corresponding existence of low interest rates for an extended
period encouraged the active search for higher yields by a host of market participants.
Thus capital flows to Emerging Market Economies (EMEs) surged in search of higher
yields, but could not be absorbed by these economies in the presence of either large
current account surpluses or only small deficits, largely ending up as official reserves.
These reserves were recycled into US government securities and those of the
government sponsored mortgage entities such as Fannie Mae and Freddie Mac. Thus,
while accommodative monetary policy kept short term interest rates low, the recycled
reserves contributed to the lowering of long term interest rates in the advanced
economies, particularly the United States. Such low long term interest rates
contributed to the growth of mortgage finance.
As might be expected, with such low nominal and real interest rates,
asset prices recorded strong gains, particularly in housing and real estate,
providing further impetus to consumption and investment through wealth
effects. Thus, aggregate demand consistently exceeded domestic output in the
US and, given the macroeconomic identity, this was mirrored in large and
growing current account deficits in the US over the period (Table 1). The large
domestic demand of the US was met by the rest of the world, especially China
and other East Asian economies, which provided goods and services at
relatively low costs leading to growing surpluses in these countries. Sustained
current account surpluses in some of these EMEs also reflected the lessons
learnt from the Asian financial crisis. Furthermore, the availability of relatively
cheaper goods and services from China and other EMEs also helped to
maintain price stability in the US and elsewhere, which might have not been
possible otherwise. Thus measured inflation in the advanced economies
remained low, contributing to the persistence of accommodative monetary
policy.
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Table 1: Current Account Balance (per cent to GDP)
Country 1990‐94 1995‐99 2000‐04 2005 2006 2007 2008
China 1.4 1.9 2.4 7.2 9.5 11.0 9.8
France 0.0 2.2 1.2 ‐0.4 ‐0.5 ‐1.0 ‐2.3
Germany ‐0.4 ‐0.8 1.4 5.1 6.1 7.5 6.4
India ‐1.3 ‐1.3 0.5 ‐1.3 ‐1.1 ‐1.0 ‐2.2
Japan 2.4 2.3 2.9 3.6 3.9 4.8 3.2
Korea ‐1.0 1.9 2.1 1.8 0.6 0.6 ‐0.7
Malaysia ‐5.2 1.8 9.8 15.0 16.0 15.4 17.9
Philippines ‐4.0 ‐2.8 ‐0.7 2.0 4.5 4.9 2.5
Russia 0.9 3.5 11.2 11.0 9.5 6.0 6.1
Saudi Arabia ‐11.7 ‐2.4 10.6 28.5 27.8 24.3 28.6
South Africa 1.2 ‐1.3 ‐0.7 ‐4.0 ‐6.3 ‐7.3 ‐7.4
Switzerland 5.7 8.8 10.8 13.6 14.4 9.9 2.4
Thailand ‐6.4 1.0 4.2 ‐4.3 1.1 5.7 ‐0.1
Turkey ‐0.9 ‐0.8 ‐1.6 ‐4.6 ‐6.0 ‐5.8 ‐5.7
United Arab Emirates 8.3 4.6 9.9 18.0 22.6 16.1 15.7
United Kingdom ‐2.1 ‐1.0 ‐2.0 ‐2.6 ‐3.3 ‐2.7 ‐1.7
United States ‐1.0 ‐2.1 ‐4.5 ‐5.9 ‐6.0 ‐5.2 ‐4.9
Memo:
Euro area n.a. 0.9@ 0.4 0.5 0.4 0.3 ‐0.7
Middle East ‐5.1 1.0 8.3 19.3 20.9 18.2 18.3
Source: World Economic Outlook Database, October 2009, International Monetary Fund (2009c).
Note: (‐) indicates deficit. @: 1997‐99
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 (Table 1). In fact, Taylor (op.
cit.) 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 sub-
prime 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
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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.
Apart from creating large global imbalances, accommodative monetary
policy and the existence of very low interest rates for an extended period
encouraged the search for yield, and relaxation of lending standards. Even as
financial imbalances were building up, macroeconomic stability was maintained.
Relatively stable growth and low inflation have been witnessed in the major
advanced economies since the early 1990s and the period has been dubbed as
the Great Moderation. The stable macroeconomic environment encouraged
underpricing of risks. It may be ironic that the perceived success of central
banks and increased credibility of monetary policy, giving rise to enhanced
expectations with regard to stability in both inflation and interest rates, could
have led to the mispricing of risk and hence enhanced risk taking. Easy
monetary policy itself may have generated a search for yields that resulted in a
dilution of standards in assessing credit risk leading to erosion of sound
practices (Mohan, 2007). Lower yields encouraged excessive leverage as
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banks and financial institutions attempted to maintain their profitability.
Lacunae in financial regulation and supervision allowed this excessive leverage
in the financial system. Assets were either taken off banks’ balance sheets to
off-balance sheet vehicles that were effectively unregulated; or financial
innovation synthetically reduced the perceived risks on balance sheets.
Financial innovations, regulatory arbitrage, lending malpractices, excessive use
of the originate and distribute model, securitisation of sub-prime loans and their
bundling into AAA tranches on the back of ratings, all combined to result in the
observed excessive leverage of financial market entities.
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
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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
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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 2006-
2007. 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.
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Table 2: Global Economic Outlook for 2009 (per cent)
Item 2008 IMF’s Forecast and Month of Forecast for 2009
April
2008
July
2008
October
2008
January
2009
April
2009
July
2009
October
2009
1 2 3 4 5 6 7 8 9
1. Global Growth 3.0 3.8 3.9 3.0 0.5 - 1.3 -1.4 -1.1
AEs 0.6 1.3 1.4 0.5 -2.0 - 3.8 -3.8 -3.4
EDEs 6.0 6.6 6.7 6.1 3.3 1.6 1.5 1.7
2. World Trade @ 3.0 3.8 3.9 3.0 -2.8 - 11.0 -12.2 -11.9
3. Consumer Price Inflation
AEs 3.4 2.0 2.3 2.0 0.3 - 0.2 0.1 0.1
EMEs 9.3 5.7 7.4 7.8 5.8 5.7 5.3 5.5
AEs: Advanced Economies.
EDEs: Emerging and Developing Economies
@: Volume growth in goods and services.
Source: World Economic Outlook, various issues, International Monetary Fund.
To summarise, excessively accommodative monetary policy for an
extended period in the major advanced economies in the post dot com crash
period sowed the seeds of the current global financial and economic crisis. Too
low policy interest rates, especially the US, during the period 2002-04 boosted
consumption and asset prices, and resulted in aggregate demand exceeding
output, which was manifested in growing global imbalances. Too low short-term
rates also encouraged aggressive search for yield, both domestically and
globally, encouraged by financial engineering, heavy recourse to securitisation
and lax regulation and supervision. The global search for yield was reflected in
record high volume of capital flows to the EMEs; since such flows were well in
excess of their financing requirements, the excess was recycled back to the
advanced economies, leading to depressed long-term interest rates. The Great
Moderation over the preceding two decades led to under-pricing of risks and the
new financial and economic regime was considered as sustainable. The
combined effect of these developments was excessive indebtedness of
households, credit booms, asset price booms and excessive leverage in the
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major advanced economies, but also in emerging market economies. While
forces of globalisation were able to keep goods and services inflation contained
for some time, the aggregate demand pressures of the accommodative
monetary started getting...