1/18Nicola Viegi The Economics of the Crisis

Nicola ViegiUniversity of Cape Town and ERSA

TIPS May 2009

The Economics of Global CrisesThe Economics of Global Crises

Tips

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The Financial Origin of The Crisis

The Economics of The Crisis

On Prudence

Outline

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The financial origin of the crisis

• Leverage + Financial innovation + Easy Money =

• Financial Crisis

– Originate and distribute banking model

– Increased leverage/maturity mismatch (on/off balance sheet)

– Lax lending standards

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Macroeconomic Consequences

• Credit Crunch

• Collapse in Demand

• Collapse in production and employment

• Collapse of international trade

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World industrial production

60

65

70

75

80

85

90

95

100

5 10 15 20 25 30 35 40 45 50

June 1929=100 April 2008=100

5

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World stock market index (GFD)

30

40

50

60

70

80

90

100

110

5 10 15 20 25 30 35 40 45 50

June 1929=100 April 2008=100

6

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World trade

60

70

80

90

100

110

5 10 15 20 25 30 35 40 45 50

August 1929=100 April 2008=100

7

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Capital Flows

8

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Policy Response Expansionary Monetary and Fiscal Policy everywhere

9

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Different Policy Response Expansionary Monetary and Fiscal Policy everywhere

10

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Will it Work? Signs of Recovery

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Will it Work? Signs of Recovery

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Will it Work? It will take time

• Slow Response of the Economy

– Banking Sector is not working (no supply of credit)

– Private sector is not working (no demand of credit – no investment or consumption)

• Explanation?

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Flow-Stock deflation spirals

• Keynesian Saving Paradox

• Fisher’s Debt Deflation

• Cost Cutting Deflation

• Bank Credit Deflation

• Coordination Failures

• What else can go wrong? Protectionism

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Solutions? Public Policy

• Externality is solved by public intervention

– Solve stock problems first (clean balance sheet of banking system – nationalise banking)

– Only than monetary and fiscal policy (to solve the flow problem) will be effective

How Does This Affect Our Understanding of Economic Policy?

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On Prudence

• Two Principles of Economics Under Uncertainty

– Act Conservatively, be prudent– Build Up Insurance against unknowns

The Crisis is a direct result of disregarding inter-temporal stability conditions – too

much debt, too easy money.

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An Example: Chile

Very Smooth Response to the Crisis

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An Example: Chile

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An Example: Chile

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An Example: ChileFoundation: Fiscal Surpluses In Good Time

(If the private sector don’t save, the government should)

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Conclusions

Origin of the Crisis – unsustainable private sector debt

Strong policy response but slow exit

Prudent economic policy is an insurance in good time to deal with bad ones

Private sector and public sector stability rules not different – do not live beyond your means