The permanent impact of the 2007-08 crisis

Posted by on 28 January 2009

The economics profession spent the last few years debating and forecasting the unwinding of the global imbalance.

The supposedly unavoidable dollar crisis

There was almost unanimity, from the many masters of doom to the few and rare optimistic voices, that a dollar crisis was the unavoidable component of the unwind, and litres of ink were spilled calculating how much the dollar would have to fall, how big the losses on the Chinese reserves would be as a result, and how vulnerable the financial system was to a major currency crisis. At the end, it just did not happen.

We collectively missed the key dynamics of the unwinding of the biggest credit build-up in history.

A humbling experience

This is a very humbling experience, and should be the basis for a major therapy session for the economics profession. It shows that in this global and integrated economy it is dangerous to look at issues in isolation. For example, has a central bank accomplished its mission if it achieves internal balance – price stability and potential growth – but it has an unstable external situation?. It is risky to ignore the “one objective, one instrument” rule (as the “leaning against the wind” approach to monetary policy advocated). It is a mistake to ignore the structure of incentives of societies and policymakers (as those who accused emerging markets of mercantilism clearly did, not understanding that the key objective of a policy of reserve accumulation was to build a buffer against currency crisis, not to achieve an export oriented growth strategy).

Thousands of PhD theses to be written

This crisis has shattered many long standing views and practices, and its impact will be felt for decades – and will generate thousands of PhD theses which will try to integrate in macroeconomic models all the many features that are clearly missing.

The monetary policy will never be the same

The practice of monetary policy will never be the same. Not only will it take years to unwind all the many asset purchase facilities that are being established across the world – casting a cloud of doubt over the future independence of monetary policy, and complicating enormously the calibration and communication of the stance of policy – but also central bankers will be very wary of allowing a rapid increase in credit growth no matter the inflation outlook. This risks suppressing positive productivity shocks that may require a healthy dose of credit growth.

Supervision and regulation will never be the same

The practice of supervision and regulation will never be the same. There is now a clear understanding that the soundness of individual banks does not guarantee the soundness of the financial systems (see for example Brunnermeier et al 2009). Macro-prudential tools – whatever those may become, but likely to involve some mix of time-varying capital ratios and provisions, leverage limits and liquidity buffers – will be urgently needed. The result is likely to be a heavily constrained financial sector (wherever it is still in private hands).

More domestic national banking champions

In addition, the considerations of home/host country supervision will change drastically. The current experience – where Western banks suck credit out emerging economies through their branches and subsidiaries – will likely lead to the creation of domestic national banking champions in many countries.

Fiscal policy will never be the same

The practice of fiscal policy will never be the same. The anchors of fiscal stability – the Maastricht criteria of 3% deficit and 60% debt ratios had become the convergence points of fiscal stances, even if they were arbitrary – have been broken. A new debate will surface over the definition of fiscal soundness, the need or not to return to fiscal balances, and the interplay between fiscal and monetary policy (lest we forget, the Bank of Japan never discontinued the program of purchases of government bonds created during the quantitative easing regime).

Without IMF reform, expect more reserve accumulations

One aspect of policies, however, is likely to remain the same. Unless the G20 decides to reform the IMF in a way that can provide a credible system of insurance, emerging markets economies will very likely continue to adopt a policy of accumulation of reserves as buffers against crises.

Thus the G20 leaders have in their hands the possibility of shaping the future of the world economy via their decision on the reform of the IMF. If they chose to ignore the need for insurance, they will create the basis for an even bigger global imbalance for years to come, and lose all their credibility in their future demands for more flexible exchange rate regimes.

The chain of bubbles

It all started with a positive productivity shock, the IT revolution that led to the NASDAQ bubble; the technology shock migrated then to the financial sector and generated the subprime and structured credit bubbles.

The chain of bubbles will surely continue

Until the next one appears, the world is facing a rather complicated outlook, with plenty of policy risk in the pipeline and of opportunities for unintended consequences due to lack of coordination of policies and experimentation with new policy regimes.

Tudor Investment Corporation


Brunnermeier, Markus, Andrew Crockett, Charles Goodhart, Avinash Persaud and Hyun Shin (2009). “The Fundamental Principles of Financial Regulation,” CEPR-CIMB Ebook on