How financial crisis affect economy

how financial crisis affect economy

Financial crisis and the economy

Klaus Schmidt-Hebbel ©DR

What are the main impacts of the financial crisis on the real economy, and what lessons might we draw from the crisis for the future? The next OECD Economic Outlook due on 25 November will provide some answers. We asked the new OECD Chief Economist Klaus Schmidt-Hebbel for some early insights.

OECD Observer. In its September update, the OECD painted a rather sombre outlook for the G7. What issues are you focusing on now in light of the financial crisis and can you provide some indications of your thinking ahead of the forthcoming OECD Economic Outlook ?

Klaus Schmidt-Hebbel: Our last assessment of the economy in September came just before the financial turmoil turned into a full-blown financial crisis. That assessment was still concerned with the effects of three factors that had developed since mid-2007, namely rising commodity prices, a housing market contraction in several OECD economies and, yes, financial turmoil. But now that turmoil has turned into a systemic crisis of world financial markets, and this looms over everything else.

Since mid-September of this year, mutual trust between financial market participants has quite simply evaporated, with a breakdown of short-term financial transactions in major OECD economies and a global meltdown in stock markets. When inter-bank lending, commercial-paper lending, and money markets come to a standstill, lending to corporations and households freezes. Spending, production, and employment could potentially collapse.

Governments and central banks are very aware of these huge risks to the world economy as proven by their quite radical policy actions over recent weeks. These measures aim at rescuing the global financial system by restoring trust and re-building financial institutions’ balance sheets. They were unprecedented in their scale, their use of new policy tools, and their international coordination across the major OECD economies.

Now we have to see how fast and effective these actions turn out to be.

What are the implications for the economy?

We in the Economics Department of the OECD are in the process of preparing our 2009-2010 projections for 30 OECD and 10 non-OECD economies, which will be issued in the Economic Outlook on 25 November. Our view will clearly be shaped by the most recent available data and how we see the effects of the financial crisis unfolding.

Our base scenario is built on the premise that the current freeze in short-term financial markets will be resolved in a relatively short time span, but that bank deleveraging and recapitalisation, as well as re-building of trust in the markets, will take much more time. This would mean a more protracted period of restrictive financial conditions and would affect loans and the access to funding generally. At the same time demand for loans is shrinking anyway as slumps in asset prices and a general feeling of uncertainty cause households and firms to rein in their spending plans.

So, we expect a significant weakening in the world economy, with many OECD economies slipping into recession sooner or later. The question is for how long. It is likely that recovery will be slower than in recent economic downturns, but the actual pace of recovery will depend largely on how quickly financial markets resume transactions and lending, even if that lending remains relatively restricted, at least compared with 2002-2007.

But beyond financial market interventions, let’s not forget that macroeconomic policy should also play an important role in cushioning the recessionary impact of the financial crisis. In other words, as economies quickly weaken and inflation recedes, there will be room for interest cuts in some OECD economies, not to mention timely, temporary, and targeted fiscal stimulus as well.

Which are the main risks in your scenario?

There are two major, related risks to the downside. On the one hand, the current freeze in financial markets and lending could take more time to thaw out, with more severe effects on spending, output and employment. This would lead to a deeper and more persistent recession.

The other downside risk we see comes from the as yet unknown budgetary costs of governments’ rescue plans. When the financial crisis and recessions are behind us, fiscal adjustment will be called for to maintain confidence in public debt and currencies, particularly in those countries that have had to foot high costs in bailing out their banks.

But there is also a favourable prospect to bear in mind, and that is the easing in oil, food and other commodity prices caused by a weaker world economy. If the downward trend proves larger than we currently envisage, this would bring still lower inflation and gains in real incomes for commodity importers, as well as providing more room for further monetary policy easing.

Are public fears of a global depression justified?

A depression is an ambiguous concept, some think of it as a very deep and drawn out recession. I think that we are certainly not there. Of course, this is the worst financial crisis in decades, but a repeat of the 1930s Great Depression is highly unlikely, thanks in large part to those massive rescue plans now in place.

Did you foresee the crisis?

Most professional economists know that business cycles are alive and kicking, and expected the particularly intense 2002-2007 credit boom and economic expansion to turn downwards at some point. Yet the precise timing and intensity of future recessions are impossible to predict. In this particular case, neither economists nor market participants, nor indeed governments foresaw a financial crisis of the type and magnitude we have now. The collapse of trust and subsequent credit freeze in the wake of the Lehman Brothers collapse was a shock not only to the system but to most economists and market participants as well.

What policy lessons can we learn?

It is still early in the game, but I nevertheless see lessons to be

drawn in four areas. First, remember that it started as a subprime mortgage lending crisis in the US, but gradually spread into other markets and countries through a combination of market failures and regulatory weaknesses. Where markets failed was in poor governance and the structures of executive incentives that were inappropriate for the stability of financial firms. They failed in the opacity of financial instruments and their trading, and a lack of public information about balance sheets of financial institutions and their off-balance sheet vehicles.

At the same time, regulatory omissions and failures were rife. Many countries lacked comprehensive and unified regulation of financial conglomerates and their market instruments, while capital regulation and accounting rules exacerbated pro-cyclical bank leveraging and lending. Weak oversight of the rating agencies did not help either.

Future regulatory reform will clearly aim to improve business models, transparency, disclosure, and oversight of financial institutions. At the same time, financial market participants must never assume bailouts are the norm, and reforms must therefore minimise the risk of “moral hazard” affecting future financial market behaviour. Also, while major regulatory changes of financial and capital markets will be required, both nationally and across countries, there is a clear and present trap to avoid, and that is the risk of a regulatory over-reaction. Excessive regulation can do damage too, by inhibiting future financial innovations, market integration and growth. We require better regulation, not just more regulation.

The second lesson is that we really have to work harder at strengthening the countercyclical features of fiscal, monetary, and financial policies, both to reduce the intensity of future business cycles and lower the likelihood of a global crisis like the current one happening again.

Third, much better contingency planning and crisis management will be needed. After all, this crisis was managed in a pretty haphazard way. Governments moved very late on from ad hoc and selective emergency bailouts to a comprehensive rescue operation of their financial systems. And only very late on did they shift their focus from removing toxic assets to providing comprehensive support to different components of balance sheets, by providing guarantees on deposits and interbank loans, acquiring bad assets of banks and non-banks, and providing new capital. The approach got better only at the very end.

Last but not least, we require rethinking of our current international financial architecture. This includes international co-operation in regulatory reform of financial and capital markets, accounting standards, and treatment of international financial transactions. The aim is to strengthen both integration and stability of world capital markets. In addition, we have to rethink the way international financial institutions provide support to countries facing capital and external-payments crises, like Iceland, Hungary, and the Ukraine are today.

These are just some key lessons, there may be others. OECD can play a major role in addressing them.

You have just joined the OECD after several years at the Central Bank of Chile, which is a candidate country for OECD membership. What added perspective do you think your background can bring to the job?

You are right, I spent the last 12 years of my career at the Central Bank of Chile, and eight years before that at the World Bank. I am a citizen of both Germany and Chile, my children were born in the US, my wife is Chilean-German-Costa Rican, I lived during some of my teenage years in Brazil, and I love France. I truly feel more like a world citizen than a national of any individual country, which provides a strong motivation for joining the OECD. My professional life combines academic experience–I am a full professor at the Catholic University of Chile, associate professor at the University of Chile, and just resigned as President of the Chilean Economic Association– research and policy advice at both the World Bank and the Central Bank of Chile. I also worked as a consultant with some 25 industrial and emerging-market economies and many international organisations.

My specialities include growth and structural reforms, macroeconomics and related policies, international economics and development, and financial markets and pension systems. I have worked both on and in developing, emerging-market, and industrial economies. So I have not only watched how the global economy has shifted, I understand the pressures countries face, whether rich or poor.

With the crisis, I certainly could not have come to the OECD at a more testing time, both for our member countries and for me, personally. But it is an intellectual challenge I am ready for.

From my perspective, the stakes are high but straightforward. Our first task is to work intensively to get past this crisis, and to minimise the strain and suffering of the people most hurt by it. Beyond that, we have to work even harder in evaluating the policy options and recommending the structural reforms that member countries require in order to achieve higher, more stable, growth and more welfare for their people. Finally, as the influence of emerging economies on the global economy will continue to increase, we will have to work on the integration of emerging economies into the world economy and their increasing engagement with our member countries. For this reason, the OECD’s new global focus led by Angel Gurrнa must be fully supported.

Finally, let me mention that I am both happy and proud to join this exceptional organisation, with its teams of outstanding professionals both in economics and beyond. We are all committed to provide the best services to our member countries, and to help them return our economies to good health and robust long-term growth.

  • OECD Economic Outlook No 84 will be released on 25 November 2008.
  • OECD (2008), OECD Economic Outlook No 83 . June, Paris
  • “What is the economic outlook for OECD countries? An interim assessment”, September, Paris. See www.oecd.org/dataoecd/0/51/41229145.pdf
©OECD Observer No 269 October 2008

Printer friendly version

Source: www.oecdobserver.org

Category: Personal Finance

Similar articles: