This autumn's banking panic will take a severe toll on world growth especially in developed economies. GDP growth in the OECD group of mainly rich countries will slow to 0.4 per cent in 2009, the weakest since 1982. Among the G7, the American and British economies will contract next year and the best performer among the other five countries will be Canada, with GDP growth of just 0.5 per cent. The key downside risk is that the bailout packages may not succeed, in which case financial turmoil will persist and the recession will be deeper and more prolonged than we are forecasting.
The financial shock will pull down growth through three main channels. First, credit will become scarcer for both businesses and households. Second, firms and consumers have become more cautious, which will also make them cut back. Third, lower equity prices will reduce consumption and bear down on business investment by making it harder for companies to raise capital.
The world economy
- Global growth will weaken from 4.0 per cent this year to 2.8 per cent in 2009, the slowest since 2002.
- National output will fall in the United States by 0.5 per cent in 2009, the first full-year decline since 1991 and the largest since 1982.
- The Euro Area and Japan will each grow by only 0.3 per cent next year.
- China will act as a growth counterpole as its economy slows only modestly, from 9.9 per cent this year to 8.6 per cent in 2009.
The crisis in the financial sector will thus spread out to the wider economy mainly by curbing consumer spending and private investment, both of which will fall next year in all the G7 economies except for Japan. Personal consumption will decline by 1.8 per cent in the US and by 0.5 per cent in the Euro Area. American business investment will decline by 3.3 per cent while housing investment will fall by 18.8 per cent, only a little less than this year. Private investment will contract by 5.5 per cent in the Euro Area.
The forecast incorporates the coordinated half-point cut in interest rates on 8 October by several central banks and assumes that the resulting rates are held until mid-2009, apart from a further half-point reduction in the UK at the turn of this year. If central banks were to deliver a further coordinated cut of 2.5 percentage points, this would raise annual output growth by a quarter of a percentage point over the next two years in the US and UK, and a little less in the Euro Area. The scope for alleviating the economic reverse through fiscal policy is relatively limited, but it may become the only effective tool available for economies like the US whose policy rates are already very low.
The causes of and lessons from the financial crisis are examined in six special articles in the Review. The main message is that while monetary policy should 'lean against the wind' when asset bubbles are developing, the crucial fault was a lack of macroprudential regulation, partly because of an institutional silo mentality. Central banks and the BIS had given warning about risks, but the remedies often lay with separate financial regulators, who did not respond adequately to these worries. Reforms will require those responsible to take a synoptic view of the financial system and should focus on higher capital requirements for banks. Those expanding their loan book rapidly should have to increase their capital ratios. Capital reserves should also be linked to reliance on wholesale funding markets. And complex new products should also require more capital. Regulators will have to remain vigilant to new developments as these changes to rules are 'fighting the last war'.
The UK economy
- The economy will contract in the second half of 2008 and GDP will fall by 0.9 per cent in 2009, the first full-year recession since 1991.
- Consumer spending will decline by 3.4 per cent next year.
- The other main factor dragging the economy down next year is a big fall in housing and business investment.
- Public sector net borrowing will increase from 2.5 per cent of GDP in 2007 to 4.5 per cent this year and 5.3 per cent in 2009-10.
The British economy will suffer next year as it experiences the worst setback among the G7 countries. This reflects an especially pronounced reverse to consumer spending, which will fall by 3.4 per cent in 2009, easily the biggest decline among the G7. The economy will also be dragged down by the collapse in private housing investment, which will fall by 17.1 per cent, and lower business investment, which will decline by 3.8 per cent. A sizeable contribution from net trade (mainly reflecting lower imports) is not sufficient to stave off recession in 2009.
The forecast assumes a further half-point cut in interest rates in early 2009, reducing the Bank rate to 4.0 per cent. The Bank of England has more scope to cut rates now that consumer-price inflation has probably peaked, although it will still be above the 2 per cent target until the end of 2009. However, it takes time for rate cuts to stimulate activity in normal times. And in current conditions the effectiveness of monetary policy is limited by credit rationing by banks and falling demand for loans. Even a very big cut in the Bank rate would not be sufficient to avoid a recession in the UK.
The UK is especially vulnerable to the credit crisis because of imbalances that had developed in recent years. The current account balance worsened to 3.8 per cent of GDP in 2007. Household debt rose to 170 per cent of income by the end of 2007 and the household saving ratio fell to negligible levels. The sharp fall in consumer spending next year will occur as the saving ratio rises from 0.7 per cent of disposable income in 2008 to 4.4 per cent in 2009 at a time when real income growth remains paltry.
The outlook for the public finances is poor. Public sector net borrowing will rise to 4.5 per cent of GDP in 2008-09, and then climb further to 5.3 per cent next year and 6.1 per cent in 2010-11. Public sector net debt will rise to 50.5 per cent of GDP in 2008-9. The deterioration in public sector net borrowing reflects the impact of the recession, together with weaker receipts from the financial and property sectors.
National Institute Economic Review No. 206 October 2008 is published today (Wednesday 22 October) and can be acccessed online at http://ner.sagepub.com/
Introduction: The Great Crash of 2008
THE EVOLUTION OF THE FINANCIAL CRISIS OF 2007-2008
Ray Barrell and E. Philip DavisThe financial crisis that started in August 2008 has reached a climax in the autumn of 2008 with a wave of bank nationalisations across North America and Europe. Although banking crises are not uncommon, this is the largest since 1929-33. This paper discusses the build-up to the crisis, looking at the role of low real interest rates in stimulating an asset price bubble. That bubble was stocked by financial innovation and increases in lending. New financial products were not stress tested and have failed in the downturn. After discussing the bubbles we look at the collapse of the complex asset structure, and then put the crisis in the context of the literature. The paper concludes with a discussion of policy implications of the crisis, and advocates a significant improvement in the regulatory structure.
RISK MANAGEMENT AND THE COSTS OF THE BANKING CRISIS
The 2007-08 banking crisis in the advanced economies has exposed deficiencies in risk management and prudential regulation approaches that rely too heavily on mechanical, albeit sophisticated, risk management models. These have aggravated private and economic losses. While fiscal costs were at first limited, it remains to be seen to what extent the taxpayer will be protected. Policymakers and bankers need to recognise the limitations of rules-based regulation and restore a more discretionary and holistic approach to risk management.
SHOULD MONETARY POLICY RESPOND TO ASSET PRICE BUBBLES? REVISITING THE DEBATE
Recent events have highlighted the importance of asset prices to central bank decisions. We argue that, in response to asset price bubbles, central banks should 'lean against the wind' (LATW hereafter). Even if the bubbles themselves are not significantly affected by LATW, macroeconomic performance can be improved if monetary policy reacts to asset price misalignments over and above the reaction to fixed horizon inflation forecasts. In addition, it might reduce the probability of bubbles arising at all. This article restates the case for LATW, and reviews the debate. In particular I respond to various criticisms that have been made against LATW and briefly consider alternative policies designed to make the financial system less cyclical.
COULD EARLY WARNING SYSTEMS HAVE HELPED TO PREDICT THE SUB-PRIME CRISIS?
E. Philip Davis and Dilruba Karim
One of the features of the sub-prime crisis, that began in August 2007, was its unexpected nature. It came as a surprise not only to most financial market participants but also in some degree to the policy community. In this context, we seek to assess whether early warning systems based on the logit and binomial tree approaches on the UK and US economies could have helped to warn about the crisis. We also consider a 'check list approach' of indicators based on history. Although not all of the complementary approaches are successful, we contend that our work suggests that a broadening of approaches to macroprudential analysis is appropriate.
THE BOUNDARY PROBLEM IN FINANCIAL REGULATION
The current financial crisis has raised queries about the adequacy of the present regulatory regime. Whilst the immediate priority may be to plug the obvious holes in the system, there are some long-term generic problems with almost any system of financial regulation. This paper explores one such concern, i.e. the boundary problem. This arises because effective regulation, one that actually bites, is likely to penalise those within the regulated sector, relative to those just outside, causing substitution flows towards the unregulated. This boundary problem impacts on many proposals, such as 'narrow banking' and my own, with Avinash Persaud, for state and time-varying capital adequacy requirements. The question of how and where to set the boundary is considered. Such boundaries will always be criticised as leading to disintermediation, competitive inequality (no level-playing-field), inefficiency and higher spreads and borrowing rates; and such criticisms will be valid up to a point. The paper ends by discussing how best to respond.
FINANCIAL CRISES, REGULATION AND GROWTH
Ray Barrell, Ian Hurst and Simon Kirby
The paper discusses the effects on growth of a systemic banking crisis as a result of debt defaults. These effects will come from the impact of credit rationing on consumption and credit and from the impacts of a significant rise in the spread between lending and borrowing rates for both producers and consumers. The analysis uses the dynamic stochastic general equilibrium version of the National Institute global model. The paper also investigates the impact on output of a permanent, regulation induced, rise in margins in the financial sector, taking into account the impacts of regulation on equity market valuations.