GLOBAL FINANCIAL CRISIS: Causes and Consequences

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1 GLOBAL FINANCIAL CRISIS: Causes and Consequences Hyeongwoo Kim Auburn University October 30, 2010 Prepared for the 4 th KSEA-AL Symposium on Automotive Technology

2 US Financial Crisis The collapse of the US sub-prime mortgage market in 2007 triggered a global financial crisis. The failure of Lehman Brothers resulted in a serious disruption in international financial markets. Stock prices (level, sd) Exchange rates (level, sd)

3 Global Recessions This US financial crisis triggered recessions not only in the US but also in the rest of the world. Real GDP growth rates (Fig) Unemployment rates (Fig) Still very high in the US (Unemployment durations ) Inflation rates (recessions) after initial increases (expansionary M policies) (Fig)

4 Policy Responses Policy makers tried to stop it, but less successful Expansionary monetary policies Interest rate cuts (short, long) Quantitative easing (US) Expansionary fiscal policies Stimulus checks Cash for clunkers Government spending vs. tax cuts Private sectors did not respond as expected Consumption (Fig) and Investment (Fig) barely responded. International trade shrank (Fig).

5 Causes and Consequences The profession seems to agree on that the crisis was triggered by the collapse of the US sub-prime mortgage market. Then, natural questions are, Why did it collapse? The value of the US sub-prime mortgage market is tiny (6.7% of total mortgage debt in 2009). Why did it spread to, Other financial industries? Other non-financial industries? Other countries?

6 Causes of the Crisis Why did it collapse? Housing price bubble Unsustainable (Fig) Bubble is supposed to burst. Some blame Greenspan unclear (Fig) Overall asset bubbles around 2000 (Fig) Securitization (financial innovations, loophole mining) Excessive leverage (off-balance sheet activities) Moral hazard (too big to fail)

7 Other Financial Sectors Financial activities are highly intertwined. The Glass-Steagall Act (Banking Act of 1933) were repealed, Depository Institutions Deregulation and Monetary Control Act of 1980 (Regulation Q) The Gramm Leach Bliley Act (November 12, 1999; Bank-holding company) Virtually no separation of banking from securities industry now Update: President Obama signed the Dodd-Frank financial regulation reform bill (July 21, 2010). The collapse of the sub-prime mortgage market quickly spread to other financial industries.

8 Non-Financial Real Sectors Spill-over effects to non-financial industries Caused by liquidity crunch Excess reserves (Fig) Money multiplier (Fig) Higher borrowing costs due to high degree uncertainty Risk premium (Fig) Credit default swap

9 Contagion to Other Countries Financial markets are highly integrated across countries (Financial channel) De-regulation (can be costly, Korea vs. China in 1997) Shares of foreign investors Mrs. Watanabe (Fig) Substantial increases in volumes of international trade (Real activities channel) (Fig) Supposed to be good (comparative advantage) May become vulnerable to foreign shocks Exchange rate shocks (highly volatile and persistent)

10 Contagion to Other Countries Highly integrated international economies may imply, Higher degree co-movement in 2000s Coupling phenomenon Static synchronization (Fig) Temporary dynamic correlations (Fig) Severer and more persistent adverse effects of a foreign shock in 2000s. Dynamic synchronization (Fig) 1% in the US stock price 0.5% and 2% in German stock prices in the 1970s and in the 2000s, respectively, in the long-run. More Significant adverse effects in the 2000s both quantitatively and qualitatively

11 Policy Implications Kim and Kim (2010a, 2010b) studied the recent US financial crisis and identified the channels of contagion in international financial markets. Contagion occurred abruptly and lasted for a short period of time.

12 Policy Implications Kim and Kim (2010a, 2010b) studied the recent US financial crisis and identified the channels of contagion in international financial markets. Substantial level effect Stock prices (level) Exchange rates (level)

13 Policy Implications Kim and Kim (2010a, 2010b) studied the recent US financial crisis and identified the channels of contagion in international financial markets. EWS, Currency Swap Agreements Strengthen the roles of domestic agents in financial markets

14 Thank you.

15 Stock Prices

16 Stock Returns Volatility

17 Foreign Exchange Rates

18 FX Depreciation Rates Volatility

19 Real GDP Growth Rates

20 Unemployment Rates

21 CPI-based Inflation Rates

22 Overnight Inter-bank Rates

23 10-Year Government Bond Yields

24 Real Consumption Growth

25 Real Investment Growth

26 Exports-Imports Growth

27 US Money Growth

28 Housing Price and Fundamentals t Rate Index or Interes Building Costs Home Prices Population Population in Millions Interest Rates Year Source: Irrational Exuberance (2 nd Edition), Robert J. Shiller

29 Interest Rates

30 Commodity Prices

31 Risk Premium

32 US Trade Openness

33 Mrs. Watanabe

34 Excess Reserves

35 Money Multiplier

36 Stock Market Synchronization

37 BEKK Conditional Correlations

38 Impulse-Response Analysis