Ignazio Visco: The global crisis - the role of policies and the
international monetary system
Paper by Mr Ignazio Visco, Deputy Director General of the Bank of Italy, to the G20
Workshop on the Global Economy - Macroeconomic causes of the crisis: key lessons -
Session 2: Did the international monetary system contribute to the crisis?, Mumbai, 24-26
May 2009.
While I retain full responsibility for the theses presented in this paper, it owes much to exchanges and joint work
with Pietro Catte, Pietro Cova, Giorgio Gomel and Patrizio Pagano. For a wider and deeper discussion of the
topic, see Catte et al. (2009).
* * *
1. Introduction: A macro view
If the outbreak of the financial crisis surprised many economists, this was in part because
most of them saw the risk of a hard landing for the US economy as originating elsewhere,
namely in the unsustainable US current account imbalance, which might have eventually
been corrected through a disorderly dollar depreciation. As it turned out, another time bomb,
located in the financial system and less visible to most observers, exploded first. But does
this imply that the fundamental sources of vulnerability for the world economy had been
wrongly identified? Was the time bomb that did explode entirely unconnected to the one that
did not? Not only, I think, the answer to both questions is in the negative, but it is worth giving
proper consideration to the idea that had the forces that led to global imbalances been
removed, the financial turmoil would have had lesser global consequences. A proper
counterfactual analysis is beyond the objectives of this short paper, but I believe that the
evidence presented here clearly supports such proposition.
Both the trigger of the global financial turmoil that started in the summer of 2007 and its
proximate causes were essentially financial in nature, and originated in a specific segment of
US financial markets. However, when we look at how the crisis spread rapidly across
markets and then progressively affected the real economy, not just in the industrialised world
but globally, it is immediately clear that only a much broader set of interrelated factors -
macroeconomic as well as financial - could have generated a crisis of these proportions.
In attempting to disentangle these factors, one should avoid the temptation to look for simple
reductionist approach, leading to mono-causal explanations. Distorted incentives, inadequate
risk management and lax supervision encouraged the financial sector to take increasingly
large, poorly understood risk exposures, financed through high leverage and a growing
reliance on wholesale short-term funding. However, it is unlikely that all this would have
developed to the same extent had the macroeconomic environment not been characterised
by low interest rates, rising asset prices and large saving-investment imbalances in the
United States and, with opposite sign, in Asia and the oil producing countries. All this was
reflected in growing worldwide external imbalances; while the role of other areas of the world
economy should not be ignored, their direct contribution to the imbalances is more difficult to
assess. These macroeconomic factors created enormous stress for a US and global financial
system in which financial innovation and regulatory failures had progressively introduced
serious structural flaws. Moreover, the complacency on the part of risk managers and
financial supervisors that allowed the resulting vulnerabilities to grow unchecked owed much
to the climate of general optimism that those macro conditions supported.
Out of this complex interaction, in this paper I will focus primarily on the role of policies and
on how they reacted to the various shocks to the global economy over the past 15-20 years:
geopolitical shocks such as the end of the Cold War and the emergence of terrorism;
technological shocks like the advent of new information and communications technologies;
economic shocks such as the integration of China in the world trading system and financial
globalisation.
Figure 1
United States: household sector net worth and saving rate
(in percent of disposable income)
800
700 14
600 12
500 10
400 8
300 6
200 4
100 2
0 0
-100 -2
-200 -4
'80 '81 '82 '83 '84 '85 '86 '87 '88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09
Financial assets other than equity Equity Real estate assets of households Other nonfinancial assets
Financial liabilities Saving rate (right axis) Net worth
Source : Federal Reserve (Flow of Funds) and Bureau of Economic Analysis.
Note : Other nonfinancial assets include tangible assets owned by non-profit organizations and consumer durables.
Macroeconomic policies and regulatory failures combined and reinforced one another. The
results were visible in a number of macro phenomena:
•
The dramatic fall in US households' saving rate, from around 7 percent in the
early 1990s to close to zero in 2005-2007. This decline in the propensity to save
closely matches the rise in household sector net worth (Figure 1), pushed up by
successive booms in asset prices. In the 1990s, US households "chose" to reap the
anticipated and real ("beyond the hype") - but partly illusory - benefits of the
productivity acceleration related to the New Economy, and incorporated in overblown
equity values, in advance, in the form of current consumption; after 2000, they did the
same with the rise in housing wealth, and financed their demand through a large
increase in indebtedness (Figure 2).
Figure 2
US household sector: selected balance sheet ratios
(percent; quarterly data)
175 23
Total debt, ratio to disposable income (1)
155 21
Net housing equity, ratio to disposable income (1) (2)
Leverage (3) (right scale)
135 19
115 17
95 15
75 13
55 11
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Source : Federal Reserve and Bureau of Economic Analysis.
Notes
: (1) disposable income is calculated as a 4-month moving average. (2) Net housing equity is calculated as the difference between real
estate wealth and home mortgages. (3) Total debt over total assets.
Figure 3
Global measures of liquidity (1)
(percent; annual data)
100 5
Ratio of broad money to GDP - left scale (2)
Ratio of bank credit to GDP - left scale (3)
Real long-term bond yield - right scale (4)
90 4
80 3
70 2
60 1
50 0
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Source : IMF, World Economic Outlook, October 2008.
Notes : (1) Aggregated using GDP weights at PPPs. (2) end of period; weighted average of China, Japan, Euro area, UK and USA. (3) end of period; weighted
average of Japan, Euro area, UK, USA and, starting in 1999, China. (4) averages; deflated with CPI inflation; weighetd average of Japan, Euro area, UK and
USA.
•
A very large increase in US and global liquidity (Figure 3). This was largely the
consequence of US monetary conditions, which were generally accommodating
throughout the 1990s - partly in response to actual or feared shocks to the financial
sector (the Asian crisis, LTCM, the millennium bug) - and then were eased
dramatically and maintained expansionary for an unusually long period of time
following the bursting of the dot.com bubble in the first half of the current decade. It is
noteworthy that fiscal conditions also became highly expansionary starting in 2001,
dramatically reversing the trend of the second half of the 1990s.
•
The widening of global imbalances, recognised as unsustainable already in the late
1990s. Starting in 1991, and with a sharp acceleration around 1996, the US current
BIS Review 87/2009
account deficit worsened steadily. Initially its main counterpart was surpluses in
Europe and Japan, but after 1997 the surpluses expanded mainly in Asia (in China
since 2001-02) and in the oil exporting countries (Figure 4). The US international
investment position deteriorated by less than the cumulated deficits would imply,
thanks to favourable valuation effects (Figure 5). But these temporary effects masked
a clearly unsustainable underlying trend.
Figure 4
Current account balances
(in percent of world GDP)
3
2
1
0
-1
-2
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
United States Euro area China Em. Asia excl. Japan and China Oil exporters Japan
Source : World Economic Outlook, April 2009.
Figure 5
Cumulated current account balances
(in percent of GDP)
60.00
Japan (1)
40.00
China (1)
Oil exporters (1), (2)
20.00
Em. Asia exc. China
Euro area (1)
0.00
-20.00
United States (3)
United States
-40.00
-60.00
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
Sources : IMF, World Economic Outlook, April 2009; Bureau of Economic Analysis.
Notes : (1) Calculated as the cumulated current account balances, starting in 1980. (2) Inludes only emerging and developing economies. (3) Actual net foreign
asset position (at market values).
Figure 6
Total reserves minus gold
(USD billions)
7000
6000
5000
4000
3000
2000
1000
0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Japan Advanced Economies excl. Japan China, P.R.: Mainland Oil exporters Other Emerging & Developing Economies
Source : IMF, International Financial Statistics.
•
An enormous increase in official reserves (Figure 6). Initially driven by a desire to
achieve greater resilience against capital outflows in the aftermath of the Asian crisis,
after 2002 the reserve accumulation grew far beyond any reasonable reserve needs.
It was largely concentrated in emerging Asia and the oil exporting countries, which
pegged their currencies to the US dollar or in any case resisted their appreciation.
Figure 7
United States: Fed funds target rate and 10-year Treasury bond yields
(percent; monthly data)
10
9
8
7
6
5
4
3
Federal funds target
2
10-year Government bond yield
1
0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Source : Thomson Reuters Datastream.
•
Very low levels of global long-term interest rates and asset price volatility after
2003. Long-term interest rates, which had fallen sharply after 2000, remained
unusually low even after US policy rates started to be gradually raised in mid-2004
(Figure 7). After the US economy came out of the 2001-2002 recession and the
effects of a number of other shocks subsided (Enron-like corporate scandals;
September 11 and the start of the global war on terror), credit risk spreads and
volatility declined to historically low levels in a broad range of markets (Figures 8 and
9).
Figure 8
Implied volatility of selected US financial asset prices
(percent; monthly data)
100
1-year interest rates (1)
90
10-year interest rates (2)
equities (VIX) (3)
80
70
60
50
40
30
20
10
0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Source : Thomson Reuters Datastream.
Notes : (1) Option-implied volatility on 1 year swap rates. (2) Option-implied volatility on 10 year swap rates. (3) CBOE S&P 500 Volatility Index.
Figure 9
Spreads on corporate and sovereign bonds
(basis points; daily data)
1,800
1,600 EMBI Global
US high-yield corporate
1,400
US high-grade corporate
1,200
1,000
800
600
400
200
0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Source
: Bloomberg.
•
A sequence of asset price bubbles, in the United States and globally (Figure 10).
The dot.com equity bubble of the late 1990s was essentially driven by overoptimistic
expectations, but it was also accommodated by monetary policy. Then, after 2000,
the combination of low interest rates, abundant liquidity and investors' search for yield
combined to create extremely easy financial conditions, not only in the United States
but globally, which supported and financed an unusually synchronised global housing
price boom; by 2007, equity markets too were again at or above earlier peak levels.
Figure 10
Global asset prices in real terms (1)
(indices 1990=100; quarterly data)
300 135
250 Equities - left scale (2) 125
Housing - right scale (3)
200 115
150 105
100 95
50 85
0 75
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
Sources : Datastream, IMF and OECD.
Notes : (1) Deflated with G7 CPI index. (2) MSCI index. (3) Total OECD.
The combination of these macroeconomic sources of tension interacted with the financial
system flaws to build up very significant, although at least partly hidden, financial fragilities,
which were then fully revealed by the outbreak of the crisis. A major role was played by
shortcomings in the assessment of risk, especially, but not only, on the part of "large and
complex financial institutions"; by the difficulty, if not impossibility, of valuing complex new
products of structured finance; by the laxity and gaps of financial regulation. The
consequences for the financial system and our market economies will certainly be very
substantial and long lasting. But the macroeconomic policy framework and the modus
operandi of the international monetary system that led to the imbalances not only
exacerbated the impact of the financial flaws but in fact transformed the severe financial
turmoil into a fully fledged global economic crisis.
2. The role of policies
In my view, then, the lack (beyond the declarations and press releases at G7 meetings and
the like) of sufficiently decisive policy reactions to the external imbalances that began to
expand rapidly from the second half of the 1990s was crucial. Essentially these disequilibria
reflected rapid and sustained growth in final demand, especially consumption demand, in the
leading economic region of the planet, financed by over-borrowing, primarily from abroad.
Growth, in short, has occurred without savings in the United States and with excess savings
in other major economies. If the United States has served as a sort of "consumer of last
resort," other large advanced and emerging economies have implicitly or explicitly followed
an export-led growth strategy, that is difficult to maintain indefinitely but also difficult to
abandon.
The discussion that follows deals chiefly with the inability to respond, in what has come to be
called the Bretton Woods II system, to the growing external imbalances. While the surplus
economies, in emerging Asia and elsewhere, have not been able to raise domestic demand,
a more difficult question concerns the response of the European Union, in particular that of
the euro area. For the latter, external positions on the whole have been balanced all
throughout its existence (since 1999), and monetary stability has been successfully
maintained. Economic growth has been relatively modest, however, and catching up to the
US in per capita income has basically halted. My interpretation is that domestic demand has
lagged behind not much because of excessive saving but because of limited potential output
expansion, the result perhaps of slow and timid structural adjustment. Within the area, the
largest economy's exceptional reliance on exports is also a fact.
To show that the role of policies has not been negligible, in what follows I argue that (i)
monetary policy in the US was overly expansionary for too long, (ii) exchange rates in
several emerging market economies have been too rigidly pegged to the US dollar, and (iii)
asset price and financial stability have not been considered a responsibility of the central
bank or at best have been assigned a secondary role. These are not original observations,
as they have been advanced in various occasions since the late 1990s. However, they have
not often been considered jointly and have generally played only a limited part in the policy
debate. With the benefit of hindsight, I would venture to say that they are now recognized as
most relevant factors in the process that has led to the current global crisis (some relevant
references are listed at the end of the paper).
To emphasize the role of policies in the onset of the global recession, I believe that it is
useful to propose a reconstruction of the sequence of events that have marked the last ten to
fifteen years, condensed in the following six statements:
•
Around the mid-1990s, the acceleration of US productivity and the increase in
household net worth determined a first upward shift in private sector
propensities to invest and to consume.
As the 1990s began, the Cold War was ending. For the previous half-century, America had
strengthened its defences and built global alliances to contain Soviet communism, an enemy
that now suddenly ceased to exist. My conjecture is that the peace dividend made possible
the sudden diffusion of a substantial backlog of originally defence-related technological
innovations (in materials, technologies, general know-how) to the civilian economy. In any
case, the revolution in the new information and communication technologies (ICT) definitely
reversed the trend of productivity in the United States, which returned to markedly high rates
of growth in the second half of the 1990s. A large fraction of the productivity pick-up in the
United States was due to the diffusion of ICT, which drove overall output growth both directly
- through the boost to total factor productivity in the ICT-producing industry itself - and
indirectly, via capital deepening in ICT equipment by other sectors (Figure 11).
Figure 11
United States: TFP growth by sector
(percent per year; period averages)
1.4%
IT-producing sectors
1.2%
IT-using sectors
1.0%
0.8%
0.6%
0.4%
0.2%
0.0%
1973-1995 1995-2000 2000-2006
Source : Oliner, Sichel, and Stiroh (2007).
Expectations of high future productivity and income gains were most likely a factor underlying
the decline in saving rates, which may be rationalized in terms of efficient consumption
smoothing: US households were simply taking advantage of borrowing opportunities,
fostered by financial deregulation, to consume part of their anticipated future income and
wealth gains immediately. However, private agents probably overestimated the effects of
productivity gains on permanent income and profits. The transmission of the shock to
consumption and investment occurred to a large extent via the rise in equity prices.
Reasoning in terms of a standard solved-out consumption function, the observed decline in
the saving rate is consistent with the hypothesis that consumers perceived the increase in
wealth as permanent. In fact, a back-of-the-envelope calculation shows that the decline in
the household sector saving rate (by about 6 percentage points from the end of 1992 to the
third quarter of 1999) only slightly exceeds what we obtain if we apply the standard
propensity to consume out of wealth incorporated in most macroeconometric models,
including the Fed's, to the actual change in household net worth, and compare it to a
counterfactual where net worth grew only in line with disposable income.
•
The US monetary policy stance generally accommodated the hype in the "new
economy" in the late 1990s; by historical standards it was particularly easy for
a prolonged period after the turn of the century.
Following the financial crises that hit the economies of South-East Asia and Russia
(199798) and the collapse of LTCM (autumn 1998), the Federal Reserve's policy remained
essentially accommodating; ample liquidity was also provided to counter the risks of the
socalled millennium bug. While the ex post fitting of a "Taylor rule" (Figure 12) does not
highlight monetary conditions much easier than those that would be implied by a policy
responding to output and inflation according to historical standards, it is a fact that they were
accommodating what many observers considered to be a bubble in equity prices. In the
aftermath of the Asian crisis the output gap reversed but monetary conditions still appeared
to be appropriate, as a result of inflation and inflation expectations being contained by a
number of supply (as well as external) factors and the credibility, at the time, of the monetary
policy regime. But there was some debate over whether the Fed should have started raising
rates before the early months of 1999. The rationale for monetary policy at the time was
provided by Alan Greenspan's famous statement at the Federal Reserve Bank of Kansas
City Symposium in Jackson Hole in August 1999: "... central banks do not respond to
gradually declining asset prices. We do not respond to gradually rising asset prices. We do
respond to sharply reduced asset prices, which will create a seizing up of liquidity in the
system. But you almost never have the type of 180-dgree version of the seizing up on the up
side. If, indeed, such an event occurred, I think that we would respond to it. The actuality is
that it almost never occurs, so it appears as though we are asymmetric when, indeed, we are
not. The markets are asymmetric; we are not". In the following months stock prices
skyrocketed, especially on Nasdaq, the Fed's policy moved to a tighter stance, and monetary
tightening ended up bursting, late, the dot-com bubble in 2000-01.
Figure 12
Actual US short-term interest rate and the Taylor rule
(percent; quarterly data)
8
7
6
5
4
3
2
US short-term interest rate
1
Taylor rule
0
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Source : OECD, Economic Outlook No 85; Federal Reserve Bank of Philadelphia and Federal Reserve Board.
Notes : Taylor rule formula: r* = 2.85 + π + 0.5•(π - 1.9) + 0.5•(GAP). For the output gap the latest (June 2009) OECD estimates are used. For inflation,
oneyear ahead expected CPI inflation from Philadelphia Fed's Survey of Professional Forecasters. The short-term rate is the effective Federal funds rate.
The recessionary effects of this were compounded by those of the severe shock of the
September 11 terrorist attacks. The Federal Reserve's response was then very rapid and
very accommodating. The drastic reduction in interest rates was accompanied by a strongly
expansionary budgetary policy, which remained in place also in relation to the military
operations in Afghanistan and Iraq. Monetary policy remained expansionary for a protracted
period, facilitating a return to sustained growth in household consumption, not countering the
trend towards a zero saving rate. It also gave free rein to financial innovation, in conditions of
-
abundant liquidity, especially with the repackaging in 2004-06 of mortgages in a context of
-
constantly rising house prices into structured products that opened up new investment
possibilities to banks.
The gap relative to historical standards, summarized in the Taylor rule, became very wide
and durable. A crucial element motivating this policy was the "deflation scare" of 2002-03,
when the Fed became highly concerned that monetary policy risked becoming ineffective in a
low-inflation environment. With hindsight, it can be argued that in that period, thanks to the
credit and housing channel, US monetary policy had become more powerful than before and
that, therefore, the federal funds rate was kept too low for too long. This conclusion would
apply a fortiori to the extent that policy should have reacted to rising equity and house prices
and to the associated risks to financial stability, given that these were not adequately being
offset by regulatory policies and macro-prudential supervision.
•
As the hype in the "new economy" and the expansionary monetary (and fiscal)
stance sustained US domestic demand, they contributed to an unsustainable
widening of the external imbalance, compensated by an imbalance of opposite
sign that progressively grew in the external positions of major emerging
economies.
-
The US current account deficit deteriorated from around 2 percent of GDP in mid-1996
-
close to its historical average over the previous twenty years to almost 6 percent in 2006.
For a while in the 1990s the expansion of private sector consumption and investment driven
by the "new economy" euphoria was partly offset by a tighter budgetary policy, so the effects
on domestic balance (overheating) and external balance (current account deficit) were
relatively contained (Figure 13). On the other hand, while fiscal policy turned very
expansionary after 2000, it largely offset the sharp increase in corporate net saving as the
investment boom ended. Households, which had already turned net borrowers in the late
1990s, ran increasingly larger saving deficits as the housing boom got under way.
Figure 13
USA: net lending (-) or borrowing (-) by sector
(in percent of GDP; quarterly data)
60
40
20
0
-20
-40
Government
-60
Corporates
Households
-80
Total
-100
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
Source : Federal Reserve, Flow of Funds Accounts.
The powerful expansion in US final demand and imports supported the increasingly rapid
growth of exports and output for the major emerging economies such as China and India,
which had previously lagged behind. The growing US current account deficit was
accompanied by ever-larger surpluses in emerging economies and in Japan, with a
significant build-up of official reserves, in a context of relatively sluggish growth in domestic
demand and, in China, saving rates higher even than the exceptional rates of fixed
investment (Figure 14). The oil-producing countries also recorded sharply higher trade
surpluses, reflecting the rise in oil prices due to the expansion of global demand.
Figure 14
National saving and investment of selected countries and country groups
(in percent of GDP)
Euro area
United States
22
24
20 23
18 22
16 21
14 20
12 19
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
National Saving National Investment
National Saving National Investment
Japan China
36
60
34
55
32
50
30
45
28
40
26
35
24
22
30
2006 2007 2008
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
National Saving National Investment National Saving National Investment
Oil exporters
Em. Asia exc. China
34
40
32
35
30
30
28
25
26
20
24
15
22
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
National Saving National Investment
National Saving National Investment
Source:
IMF, World economic outlook, April 2009.
BIS Review 87/2009
The unsustainability of these growing current account imbalances was already an issue in
the late 1990s; afterwards, only a succession of positive variations in the value of net
external financial assets contained the otherwise explosive deterioration of the US net debtor
position.
•
A number of countries that pegged their currencies to the US dollar
accumulated very substantial official reserves. The investment of these in US
Treasury paper contributed to lower long-term interest rates.
The financing of the growing US current account deficit did not pose particular problems. Up
to 2000 private capital flowed to the United States as returns on financial assets were
perceived as being higher than in other advanced countries, due also to faster economic
growth. As a result, a self-reinforcing effect set in. The capital inflows to the United States
boosted asset prices and returns, thus stimulating additional flows of capital. After the
bursting of the dot.com bubble, inflows of private capital diminished substantially, but they
were replaced by official flows, coming from countries with limited exchange rate flexibility.
The less-than-complete substitution led to a depreciation of the US dollar and of the
currencies pegged to it.
The accumulation of official reserves accelerated as China and other emerging countries
kept pegging their exchange rates to the dollar: of the total increase in foreign exchange
reserves between 1998 and 2007 almost 70 percent is to be ascribed to emerging Asian and
oil/exporting economies. The large volume of investment in US Treasury securities by foreign
official investors contributed to drive their yields lower. The consensus view seems to be that
the effect of foreign flows was to lower long-term US rates by slightly less than one
percentage point. Much of the fall in yields seems to have reflected a narrowing of term
spreads: long rates declined significantly more than the expected future profile of short rates
(Figure 15).
Figure 15
Long- term US Treasury bond yields and expected short-term rates
(percent; daily)
9
8
7
6
5
4
3
10-year constant maturity Treasury bond yield
2
Expected average 3-month T-bill rate over the next 10 years
1
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Sources
: Federal Reserve; Federal Reserve bank of Philadelphia, Survey of Professional Forecasters.
•
Low interest rates triggered a search for yield which, by squeezing risk
premiums, tended to make financial conditions even more favourable for a
broad range of borrowers. Low perceived risk, abundant liquidity and credit
expansion, as well as regulatory failures in some markets, helped feed the
house price bubble.
Ex-ante real interest rates on 10-year US government bonds fell below 2 percent in 2002,
and remained there for several years. One of the consequences was an increasing search by
-
investors including international banks, banks of other countries and financial vehicles they
controlled - for investments with higher risk-return profiles. This stimulated the supply of
structured financial instruments backed mainly, although not exclusively, by home mortgages
granted with loan-to-value ratios even exceeding 100 per cent, based on the false premise
that house prices could only increase. In this context, a crucial role was played by financial
regulation that was generally lax, and, in some market segments, non-existent.
In this environment, housing finance became cheap and attractive, especially variable rate
mortgages, and even more so those with teasers. For 30-year fixed-rate conventional
mortgages, rates declined to just above 5 percent in June 2003, with almost 3 percent annual
inflation. Housing starts jumped by the end of 2003 and the surge in housing demand
spurred housing prices. The increased ability of households to borrow against their home
equity was crucial in igniting the spiralling of housing demand and prices.
The global housing price rise started in the late 1990s and gradually accelerated after 2000,
despite the turn in the economic cycle, supported by lower interest rates. Between 1996 and
2007 real house prices in the OECD area approximately doubled. Although the extent of the
increase differed considerably across countries, and a few, such as Japan and Germany
were left out for particular reasons (respectively, the earlier experience of an extremely
severe boom-bust cycle and the consequences of the reunification process), the cycle was
remarkably synchronised for an asset market that is inherently local. The last part of the
house price upswing coincided with a new run-up in equity prices; in advanced countries
overall market indexes reached levels close to the 2000 peaks in real terms, and in emerging
economies exceeded them by far.
•
Eventually, global supply reached bottlenecks in the form of commodity supply
constraints, US monetary policy was gradually tightened, and house prices
peaked. At that point, the large risk exposures that had accumulated in the
financial system suddenly became apparent, precipitating the turmoil.
The strong expansion of global demand was accompanied by a rapid increase in the demand
for energy and other commodities, particularly in high-growth emerging economies. Over
time, this added to inflationary pressures, and monetary policy in the advanced economies
was gradually tightened. By late 2006 the rise in US interest rates had induced first a loss of
momentum and then a turnaround in house prices. This triggered a domino effect, starting
with the structured products based on subprime mortgages.
In the summer of 2007 the world economy entered a period of acute financial turmoil, which,
despite central banks' prompt and massive response, gradually turned into a global crisis
affecting whole industries and economies. The earlier rise in leverage and the various kinds
of pro-cyclicality that characterise the behaviour of financial systems amplified the rush
toward de-leveraging and exacerbated the resulting credit crunch.
At the root, however, remain the macroeconomic imbalances that the policies conducted by