Global Economic Slowdown

How it happened

The origins of the crisis are numerous and global.

Governments pursuing domestic goals did not take full account of the global consequences, resulting in a build-up of global imbalances.

This led to low interest rates, which encouraged financial institutions to seek more risk by investing in new highly complex products.

With hindsight it is now clear that there was insufficient understanding and monitoring across the world of the resulting risks:

internally in private sector financial institutions - such as banks

in credit rating agencies - organisations that set the criteria of the ability to

pay back debt

by regulators - independent bodies that set and enforce rules in the financial system  More broadly there was a failure by policy makers to:

fully appreciate the level of fragility in the financial sector, and

understand the interactions between financial market developments. For example, between the creation of new types of financial products, and the macroeconomy - the performance, structure, and behaviour of our economies as a whole.

Where it started

 The trigger for the instability was the downturn in the US housing market.

Rising defaults on US sub prime mortgages undermined the confidence in structured credit purchases. This led to a reduction in the price of financial assets and funding difficulties for financial institutions.

Financial innovation provided prospective homeowners with access to greater sources of funding, at attractive short-term fixed interest rates or to borrowers with weak credit history.

This resulted in a housing price boom.

The subsequent 'teaser' interest rates led to a fall in house prices resulting in defaults on sub prime loans.

As the extent of the deterioration in credit standards was revealed, securitisation markets broke down.

There was also an increase in valuation uncertainty for complex products where informational problems were most acute due to a loss of confidence by investors in credit rating agencies.

This led to a sharp increase in actual counterparty risk, resulting in liquidity pressures.

Opacity in the distribution of exposures across institutions added to the perceptions of heightened counterparty credit risk in inter-bank markets. This exposed the vulnerabilities in the banking system.

These losses spilled over across global financial markets, reversing the previous cycle of rising asset prices and credit quality.

The instability grew steadily, escalating in the weeks following the collapse of US investment bank Lehman Brothers, in September 2008.

Hugely exposed to unsecured mortgages and the bad debts that devalued the US housing market, confidence in Lehman Brothers collapsed and its share price fell by 95%.

With private sector investors and the US Treasury unwilling to guarantee for its trading obligations, Lehman Brothers filed for bankruptcy.

This sent shockwaves through the financial markets, with repercussions for the global economy.

To find out more about the effects on the global economy go to:

 Tackling the effects

 Our governments are now dealing with the deepest and most synchronized global recession in many decades.

Measures are being put in place to respond to the immediate crisis.

But the international community must also address the root causes - an unsustainable build up of global imbalances and regulatory failures - to establish a medium-term recovery path.

The international community has repeatedly failed to address the long-term question of global imbalances. Previous attempts, such as the International Monetary Fund's multilateral consultation process, have failed to produce the necessary macroeconomic cooperation.

Since the fall of Lehmans, the intensification of the crisis and the collapse in confidence has reinforced the need for a coordinated macro response to stabilise the global economy and promote an orderly unwinding of imbalances.

 How do we do this?

 Many measures have already been taken to stabilise financial markets and stimulate demand. But there is as yet little real time analysis of the impact of many of these measures and there is considerable uncertainty around the effectiveness of different responses.

Analysts are divided on the next steps.

Some argue that, since policy affects the economy with a lag and governments need to consider medium-term sustainability, governments should pause before pursuing further measures.

Others argue that the risk of inaction is so great - for example, from a deflationary spiral - further demand-stimulating measures are essential.

In taking further measures, governments need to recognise that falling demand in certain parts of the world are symptomatic of the need to correct the imbalances, and this should not be resisted.

The role of policy must be to avoid overshooting. However it is not clear where the dividing line is.

Taken together this makes the policy-making highly complex and risky.

What is clear is that international cooperation offers the most effective way of managing this crisis. And policymakers will need to continue to respond as new information arrives concerning the extent to which measures that have already been taken are sufficient to stabilise our economies.(internet)

Penulis : Drs.Simon Arnpld Julian Jacob