The Financial and Economic Crisis

Lecture Two: How the crisis affected the US and world economies

Mike Kennedy

The epicentre of the storm, the US economy

What happened in some individual OECD economies…

19851986

19871988

19891990

19911992

19931994

19951996

19971998

19992000

20012002

20032004

20052006

20072008

20092010

20112012

20132014

20152016

-10

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-8

-7

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-3

-2

-1

0

1

2

3

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6

7

8

Output gaps

Great recession Canada

Japan United Kingdom

United States Euro area (15 countries)

OECD - Total

Source: OECD Economic Outlook database and IMF (for UK)

… and in the euro area

19851986

19871988

19891990

19911992

19931994

19951996

19971998

19992000

20012002

20032004

20052006

20072008

20092010

20112012

20132014

20152016

-10

-9

-8

-7

-6

-5

-4

-3

-2

-1

0

1

2

3

4

5

6

7

8

Output gaps

Great recession Austria BelgiumDenmark Finland FranceGermany Italy NetherlandsPortugal Spain

Source: OECD Economic Outlook database

Risk aversion spiked during the crisis

Credit conditions were affected by the spike in risk…

… as was the outlook for activity

A driving factor were house prices (nominal) which fell (almost) everywhere

1990:1

1990:4

1991:3

1992:2

1993:1

1993:4

1994:3

1995:2

1996:1

1996:4

1997:3

1998:2

1999:1

1999:4

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2001:2

2002:1

2002:4

2003:3

2004:2

2005:1

2005:4

2006:3

2007:2

2008:1

2008:4

2009:3

2010:2

2011:1

2011:4

2012:3

2013:2

2014:10

1

2

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6

USAJPNDEUFRAITAGBRCANAUSGRCIRLKORNLDESPSWECHE

One offshoot of the housing boom: the US economy (and others) became unbalanced, with the share of

construction rising in importance

But this wasn’t just a US phenomenon – Spain, Greece and Ireland stand out as seeing a rise in the importance of housing in their economies

Another look at housing investment in the OECD

Based on past experience, a decline in house prices would have negative effects

• A house price downturn, when it occurs, or even just a stabilization of prices, could: – affect consumption through reduced housing equity

withdrawal and effects on perceived wealth, – be exacerbated by ratios of household debt to income which

are at historical highs in several countries. • The historical record suggests that in the case of a major

housing downturn, spill-over effects may be large, with consumption and GDP growth on average falling from around 4% prior to a housing peak to practically nil after it.

• As well, with low inflation, a correction in “real” house prices would be long and slow.

A look at housing investment

20002001

20022003

20042005

20062007

20082009

20102011

20122013

20142015

2016

-50

-40

-30

-20

-10

0

10

20

30

40

GreeceIreland

AustraliaCanadaFranceGermanyGreeceIrelandItalyJapanKoreaNetherlandsSpainSwedenSwitzerlandUnited KingdomUnited States

Business confidence plunged …

Dec-2004

Apr-2005

Aug-2005

Dec-2005

Apr-2006

Aug-2006

Dec-2006

Apr-2007

Aug-2007

Dec-2007

Apr-2008

Aug-2008

Dec-2008

Apr-2009

Aug-2009

Dec-2009

Apr-2010

Aug-2010

Dec-2010

Apr-2011

Aug-2011

Dec-2011

Apr-2012

Aug-2012

Dec-2012

Apr-2013

Aug-2013

Dec-2013

Apr-2014

Aug-2014

95

96

97

98

99

100

101

102

103

RecessionAustraliaJapanUnited KingdomUnited StatesEuro area (18 countries)

… and non-residential investment also declined but nowhere to the extent of residential

structures

20002001

20022003

20042005

20062007

20082009

20102011

20122013

20142015

2016

-50

-40

-30

-20

-10

0

10

20

30

AustraliaCanadaFranceGermanyJapanNetherlandsSwedenSwitzerlandUnited KingdomUnited States

Real consumption also fell but not like housing

19901991

19921993

19941995

19961997

19981999

20002001

20022003

20042005

20062007

20082009

20102011

20122013

20142015

2016-10

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0

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15

AustraliaCanadaFranceGermanyGreeceIrelandItalyJapanKoreaNetherlandsSpainSwedenSwitzerlandUnited KingdomUnited States

The outlook for family incomes played a role in the US

Household balance sheets were weakened…

y-2002 y-2003 y-2004 y-2005 y-2006 y-2007 y-2008 y-2009 y-2010 y-2011 y-2012-25

-20

-15

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0

5

10

15Net wealth

RecessionCanadaFranceGermanyItalyJapanUnited KingdomUnited States

Per c

ent c

hang

e

… in part by a fall in housing wealth

y-2002

y-2003

y-2004

y-2005

y-2006

y-2007

y-2008

y-2009

y-2010

y-2011

y-2012

-20

-15

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0

5

10

15

20

Non-financial wealth

RecessionCanadaFranceGermanyItalyJapanUnited KingdomUnited States

Per c

ent c

hang

e

World trade collapsed…

19901991

19921993

19941995

19961997

19981999

20002001

20022003

20042005

20062007

20082009

20102011

20122013

20142015

201630

30.2

30.4

30.6

30.8

31

31.2

31.4

31.6

Recession

ln(Total trade volume)

The volume of world trade (total exports and imports) fell by 11% during the recession

… with both exports and imports hit hard

19911992

19931994

19951996

19971998

19992000

20012002

20032004

20052006

20072008

20092010

20112012

20132014

20152016

-15

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0

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15

Recession

∆ln(Total exports)

∆ln(Total imports)

Intentions to hire driven by the outlook for sales

Unemployment rates rose virtually everywhere…

19901991

19921993

19941995

19961997

19981999

20002001

20022003

20042005

20062007

20082009

20102011

20122013

20142015

20160

5

10

15

Unemployment rates

RecessionAustraliaCanadaJapanKoreaUnited KingdomUnited StatesEuro area (15 countries)OECD - Total

… but especially in the euro area

19901991

19921993

19941995

19961997

19981999

20002001

20022003

20042005

20062007

20082009

20102011

20122013

20142015

20160

5

10

15

20

25

30

Greece

Ireland

Spain

Unemployment rates in the euro area

RecessionFranceGermanyGreeceIrelandItalyNetherlandsSpainEuro area (15 countries)OECD - Total

Not much of the problem was structural …

19901991

19921993

19941995

19961997

19981999

20002001

20022003

20042005

20062007

20082009

20102011

20122013

20142015

20160

2

4

6

8

10

12

14

16

18

20

NAIRU

RecessionAustraliaCanadaJapanKoreaUnited KingdomUnited StatesEuro area (15 countries)

… except in certain parts of the euro area and only later

19901991

19921993

19941995

19961997

19981999

20002001

20022003

20042005

20062007

20082009

20102011

20122013

20142015

20160

2

4

6

8

10

12

14

16

18

20

Greece

Ireland

Spain

NAIRU

RecessionFranceGermanyGreeceIrelandItalyNetherlandsSpainEuro area (15 countries)

Cyclical unemployment rose during the recession in non-euro area economies

19901991

19921993

19941995

19961997

19981999

20002001

20022003

20042005

20062007

20082009

20102011

20122013

20142015

2016-8

-6

-4

-2

0

2

4

6

8

10

12

Cyclical unemployment

RecessionAustraliaCanadaJapanKoreaUnited KingdomUnited StatesEuro area (15 countries)

Cyclical unemployment also rose in the euro area but after the recession!

19901991

19921993

19941995

19961997

19981999

20002001

20022003

20042005

20062007

20082009

20102011

20122013

20142015

2016-8

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0

2

4

6

8

10

12

Greece

Ireland

Spain

Cyclical unemployment

RecessionFranceGermanyGreeceIrelandItalyNetherlandsSpainEuro area (15 countries)

Did unusually high house prices foreshadow sharp drops in those prices? Not that well this time

Did the high real house prices foreshadow the depth of the recessions? Not really. We need to look elsewhere for that –

to a banking system that was being transformed

Mortgages became an increasing share of total bank loans in the US …

… with subprime mortgages growing in importance…

… but mortgage delinquency rates were low up until 2007

Euro debt markets were affected

Credit restraint also affected euro area government bond rates but uncertainty was likely more important

Euro area is still in crisis

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Greece

Ireland

Portugal

Spain

Differential with Germany(long-term interest rates) Recession

Austria

Belgium

Czech Republic

Denmark

Finland

France

Greece

Ireland

Italy

Netherlands

Portugal

Slovak Republic

Spain

Was being a member of the euro a problem: Swedish (red line) and Finnish (blue) long-term interest rates

Jan-2005

Apr-2005

Jul-2005

Oct-2005

Jan-2006

Apr-2006

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Jan-2012

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Apr-2013

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Apr-2014

Jul-2014

Oct-2014

0

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RecessionFinlandSweden

Emerging markets get hit through the financial channel

Sep-01

Dec-01

Mar-02

Jun-02

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Dec-03

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Response of Some Emerging Market Bond Spreads During the Crisis

BRA BUL COL INDMEX PAN PER PHLRUS SAF TUR

Key emerging market GDPs were affected, with some seeing large negative growth

20002001

20022003

20042005

20062007

20082009

20102011

20122013

20142015

2016-15

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-5

0

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10

15Recession

Brazil

China (People's Republic of)

Colombia

India

Indonesia

Latvia

Russia

South Africa

Dynamic Asian Economies

Other oil producers

A typical economic time series

Some scary stuff: An error correction mechanism

€

yt = μ +λyt−1 +γ1xt +γ2 xt−1

y t = α −βxt

α =μ

1−λ; β =

γ1 +γ 2

1−λyt − yt−1 = μ − yt−1 +λyt−1 +γ1xt +γ 2xt−1 +γ2 xt −γ 2xt

Δyt = −(1−λ ) yt−1 −μ

1−λ−

γ1 +γ2

1−λxt

⎡

⎣ ⎢ ⎤

⎦ ⎥−γ 2Δxt

Δyt = −(1−λ )[yt−1 −α +βxt ]−γ 2Δxt