Topic 5: The Global Financial Crisis and the World Economy

Question 1

Main reasons for crisis

Answer 1

Global savings glut
(-> lowered r)
-> absorbed by US housing sector
Banks borrowed short term at low r, high profit
Structured finance -> ‘originate to distribute’
-> market value dropping, panic

Question 2

b) why did governments intervene? (2)

Answer 2

1) systemic risk to financial infrastructure

2) distributional consequences

Question 3

b) how did governments intervene?

Answer 3

1) Interest rate reductions (5.25 to 0.3% in UK)
2) Liquidity injections (to private entities)
3) QE
4) Fiscal stimulus (spending measures and tax cuts) $80bn UK, $800bn US

Question 4

c) financial crises and asset market (real estate and equity)

Answer 4

Real estate / housing
Average peak to trough decline of 35.5%
Average decline duration of 6 years

Equity markets
Average peak to trough decline of 55.9%
Average decline duration of 3.4 years

Question 5

c) financial crises and output/employment

Answer 5

Unemployment
Average increase of 7 percentage points over 4.8 years

Output
Average decline, 9.3% over 1.9 years

Question 6

c) financial crises and govt debt

Answer 6

Average increase in government debt 3 years after crisis (excluding current crisis) of 86.3%

Question 7

c) how recession became globalised

Answer 7

Integrated capital markets
Lower capital flows (FDI and portfolio investment)
Banking failures
Fall in export demand
High import content of exports

Question 8

c) summary of recession, possiblities for future

Answer 8

The global financial crisis pushed all major OECD economies into recession
Many emerging economies have slower or negative growth due to a collapse in export markets
There is uncertainty regarding the depth and duration of recession (in Europe)
There is a real possibility of deflation in some economies

Question 9

c) impact of recession on world trade

Answer 9

World trade slowed sharply in the final quarter of 2008
WTO estimates world trade declined by 12% in 2009, due to:
decline in capital flows (credit crunch)
decline in demand (recession)
High import content of exports (globalisation)

Question 10

d) key risk factors following the recession (6)

Answer 10

Unexpected ‘bad news’ (capacity to finance debt / political events)
Debt overhang higher than in 2007
Currency crises in emerging markets
Sovereign debt default
Loss of confidence in euro
Protracted deflation

Question 11

critical adjustment factors (6) RRRALM

Answer 11

Magnitude of asset devaluation and ownership of write-offs
Restoration of confidence in financial sector
Responsiveness to fiscal and monetary stimulus (especially in US)
Length and depth of recession
Adjustment in surplus countries
Recycling of ‘sovereign investment funds’

Question 12

c) ten ways the world will change

Answer 12

1) A jobs-light recovery
2) Reluctantly big government
3) A world of higher taxes
4) Slowing globalisation
5) Constrained consumers
6) Risk aversion versus creative destruction
7) Staying green
8) Suspicious of markets
9) Towards greater equality
10) Tilting faster to the east