The global financial crisis: a selective review of recent research in the International Finance and Macroeconomics program.

• Author: Frankel, Jeffrey A.
• Position: Program Report

In recent months, many members of the NBER's International Finance and Macroeconomics (IFM) program have turned their attention to the financial crisis that erupted in the United States in 2007 and spread to the global economy in 2008 and 2009. Since my last program review, in 2004, IFM program members have produced nearly one hundred working papers per year on a wide variety of topics. It would be impossible to summarize that enormous body of work in just a few pages. Instead of trying to touch on all of the topics studied by IFM researchers, this survey presents a focused summary of research from the past year that is relevant to the global financial crisis. All of the working papers in the IFM program can be found on the NBER's publications webpage using the "working papers by program" feature.

Origins of the U.S. Financial Crisis

Markus K. Brunnermeier (1); Douglas W. Diamond and Raghuram Rajan (2); and John B. Taylor have offered useful overviews of the origins and progress of the crisis. (3)

One view is that the bubble-like conditions that set the stage for the sub-prime mortgage crisis of 2007 were created by low U.S. interest rates during 2003-6--whether because of easy monetary policy by the Fed, a savings glut among foreigners, or under-perceptions of risk by investors in general. The resulting "search for yield" during this period sent waves of money into alternative assets, including high-interest foreign currencies, (4) commodities, (5) and especially housing. (6)

Various analytical tools, ranging from Dynamic Stochastic General Equilibrium models to Irving Fisher's debt deflation theory, have been brought to bear on the crisis that erupted in 2007. (7) Hui Tong and Shang-Jin Wei develop a methodology to study whether and how a financial-sector crisis can spill over to the real economy and apply it to the case of the subprime mortgage crisis. (8) Kimie Harada and Takatoshi Ito look back at the experience of Japan at the end of the 1990s to shed light on whether the motivation for bank mergers was gains in efficiency or exploitation of too-big-to-fail bailouts. (9)

Consequences for the Real Economy

Robert J. Barro and Jose Ursua study the relationship between sharp declines in stock market values and economic activity using a sample of 25 nations for the period since World War I. They conclude that conditional on a non-wartime stock market decline of more than 25 percent, which the United States experienced in 2008 and early 2009, the probability of a 10 percent decline in real economic activity is 20 percent, and the probability of a 25 percent decline in real activity is 3 percent. (10) In a series of influential papers, Carmen Reinhart and Kenneth S. Rogoff have studied the historical record of countries experiencing severe financial crises. They report that real housing price declines average 35 percent stretched out over six years from peak to trough, while equity price collapses average 55 percent over a downturn of about three and a half years. The unemployment rate rises by an average of 7 percentage points over the down phase of the cycle and output falls by an average of over 9 percent. The real value of government debt tends to explode, rising an average 86 percent, because of lost tax revenues. (11) Reinhart and Rogoff also find that the historical patterns of banking crises in middle-to-low-income countries have been similar to those in rich countries. (12)

Spread of the Crisis throughout the Global Banking System

Initially it was hoped that the rest of the world, or at least newly robust emerging markets, would be "decoupled" from the crisis in the Anglo-American economies. (13) But in 2008 the crisis spread worldwide, in part via the banking system. Nicola Cetorelli and Linda S. Goldberg study the globalization of U.S. banks and the international propagation of domestic liquidity shocks to lending by affiliated banks abroad. (14) An analysis of market-judged creditworthiness of banks by Barry Eichengreen, Ashoka Mody, Milan Nedeljkovic, and Lucio Sarno shows that international interdependence rose from the outbreak of the Subprime Crisis in 2007 through the rescue of Bear Stearns, and that it attained a new high with the failure of Lehman Brothers in the Fall of 2008. (15)

What Determines Which Countries Are Worst Hit by the Crisis?

What policies can countries adopt ahead of time to make themselves less vulnerable to crises? Ethan Ilzetzki and Carlos Vegh confirm the longstanding view that fiscal policy in developing countries tends to be procyclical, thereby exacerbating macroeconomic swings. (16) Much research shows the danger of incurring liabilities that are denominated in foreign currency. (17) Some emerging market countries learned the currency mismatch lesson after the crises of 1994-2002, but some others in Central and Eastern Europe borrowed in foreign currency during the subsequent cycle. (18)

A short time ago, it appeared that many countries, especially Asians and oil exporters, were holding a puzzlingly high level of reserves. (19) But Joshua Aizenman concludes that now the global liquidity crisis has illustrated that foreign exchange reserves provide important self insurance. (20) Reserve accumulation is a way of saving windfall gains in export revenue for a rainy day. Sovereign wealth funds also can play this role. (21) Similarly, Maurice Obstfeld, Jay Shambaugh, and Alan M. Taylor conclude that countries that built up large precautionary holdings of reserves after the East Asia crisis of the late 1990s were less likely to experience large depreciations in the "Panic of 2008." (22) Swap lines also can substitute for reserves to some extent...