Great Recession


 * ...the world economy is expected to have contracted ... in 2009 from the year before - the first annual decline in world output in more than half a century.
 * (Economic Report of the President, 2010)

In their report, the Economic Advisors to the President referred  to  the events of 2008 and 2009 as the Great Recession, suggesting a parallel with the Great Depression of the 1930s. Like the Great Depression - and unlike other recessions - it had a simultaneous impact on most of the world's economies. But in other respects it was unique. There had been no precedent for such extensive damage to the world's financial system, nor for the coordinated measures that were taken to avert what was feared to be its imminent collapse. Its economic cost may amount to as much as a whole year's ouput of every country in the world.

Overview
During the 1980s there was a re-appraisal of the financial regulations that had been introduced in response to the events of the Great Depression. A consensus emerged, particularly in the United States, that  regulations  were imposing  unnecessary restrictions upon economic activity, and that the tools of monetary policy would be well able to respond to any further signs of instability; and ongoing programmes of deregulation were extended to include banking. After the mid-1980s came a twenty-year  period that has been termed the "Great Moderation", during which recessions had been less frequent and less severe than in previous periods, and during which there  been  a great deal of successful  financial innovation. In the United States that period was characterised by the large-scale granting of credit to households, and by  2007 personal savings rates dropped to 2 per cent of disposable income from their previous average of 9 per cent and there was a house price boom  that has since been categorised as a bubble.

The bursting of that bubble in 2007, and the downgrading by the credit rating agencies of large numbers of internationally-held financial assets created what came to be known as the subprime mortgage crisis, which led, in turn,  to the  financial crash of 2008 and the failure of several of the world's largest banks. The loss of investors' confidence caused by failure of the Lehman Brothers investment bank in September 2008,  resulted in a credit crunch which   struck the major economies at a time when they were suffering from the impact of a supply shock in which  a surge in commodity prices was causing households to reduce their spending, and as a result of which economic forecasters were expecting a mild downturn. The immediate outcome was the global downturn in economic activity that has come to be known as the Great Recession.

Although the trigger that set the recession  off had been  the malfunction of a part of  the  United States  housing market, it soon emerged that a more fundamental problem had been  the fact  that  the financial innovations that had been  richly rewarding traders in the world's financial markets,  had also  been threatening their collective survival. The crucial nature of that threat for the stability of the world economy  arose from the fact that it had become  dependent upon the services of a well-functioning international financial system.

What was generally considered to be the impending collapse of that system was averted towards the end of 2008 by widespread governmental guarantees of unlimited financial support to their countries' banks. The consensus view among economists was that the combination of monetary and fiscal expansion that was then undertaken by policy-makers was nevertheless  necessary to avoid  a  greatly intensified global recession, possibly  on the scale of the Great Depression of the 1930s - although there was  a body of opinion at the  time that considered a fiscal stimulus to be unnecessary, ineffective and potentially damaging. Before those policy actions could take effect, there were sharp reductions in  the levels of activity in most of the world's developed economies, mainly because of the discovery  by banks and households that they had been  overestimating the value of their assets. That discovery prompted banks to reduce their lending, at first because of doubts about the reliability of the collateral offered by prospective borrowers and later, when those doubts receded, in order to avoid losing the confidence of their depositors by holding proportionately excessive amounts of debt. The practice of  debt reduction (known as deleveraging) was also adopted by those households that had acquired historically high levels of indebtedness, many of whom were experiencing unaccustomed falls in the market value of their houses. The effect of deleveraging by banks and by households was, in different ways, to increase the severity of the developing recession.

By the spring of 2009, the recession had involved most of the world's developed and developing economies,  and although the world's economic growth had resumed by end of 2009, pre-crisis levels were not restored except among emerging and developing economies. Growth among the developed economies was generally held back by the lasting damage that had been done to their financial sectors, and by the expenditure effects of reductions in household debt. Consequently there was continued underutilisation of productive capacity and unemployment continued to rise. Many governments had been forced to borrow money by issuing bonds, to offset the fiscal consequences of their  automatic stabilisers, as a result of which there had been major increases in national debt. In late 2009 and early 2010, the bond markets  added substantial risk premiums  to the interest rates to be paid on the bond issues of several European governments to compensate for fears of  default on their repayment.

By the middle of 2010 the effects of fiscal stimuluses had peaked in most of the developed economies. Despite the persistence of unused capacity, their governments were generally reluctant to provide further fiscal support for fear of adverse market reactions to the bond issues that would be required. In response to that fear, plans were made to reduce public expenditure and increase taxation, most of which would begin to take significant effect in early 2011. The possibility of a double-dip recession came to influence the financial markets and unused capacity was expected to persist in some countries (including most Eurozone countries) through 2011.

Domestic stability
For about twenty years before the onset of the Great Recession, all of the major market economies except Japan's had been experiencing a hitherto unaccustomed stability, following a sudden reduction of their output volatility in the mid-1980s to about a third of its previous level. It was not clear at the time whether the "Great Stability", as it came to be called, should be attributed to to luck or to judgement, but the US Federal Reserve's Ben Bernanke has been inclined to attribute it to the adoption of an economic policy ,  referred  to by others in America as  the "Greenspan effect" ,  and Charles Bean (the  Deputy Governor of the Bank of England) has described the transition from  what had been thought of as the Keynesian use of fiscal policy -  through the unsuccessful monetarist attempts  to target the money supply,  to what he refers to as  "the neo-classical synthesis" or as "new  Keynesian" , under which monetary policy was targetted on the output gap using an empirical relationship such as the Taylor rule.

International volatility
There was a contrasting increase in the volatility of the international financial system - which experienced 139 financial crises during the 24 years from 1973 to 1997, compared with 38 during the previous 26 years. Many of those crises were associated with the development of globalisation and its accompanying large and volatile international capital flows. At first the predominant direction of flow was from the developing countries to the developing countries, but that changed toward the end of the 20th century with the development of very large global imbalances. The oil-exporting countries as well as Japan, China, and some other east Asian emerging developing nations accumulated large current account surpluses, and correspondingly  large current account deficits  developed elsewhere, especially   in the United States, the United Kingdom, Ireland and Spain. Flows of capital into the advanced countries rose from about 8 per cent of world GDP in 2002 to about 16 per cent in 2007 .                     Nearly all of the corresponding investments of the surplus countries  were in the government bonds  or government-guaranteed bonds of the deficit countries and the increased demand for those bonds enabled their issuers to reduce their yields - typically from a real (ie inflation-adjusted)  yield of 3 per cent in 1990 to less than 2 per cent in the early 21st century.

Housing booms
The increased availability of credit at low interest rates prompted large household debt increases in the United States and Europe, much of which was used to finance expenditure on housing. In response to the increase in demand there were almost unprecedented increases in house prices in several countries. In the United States real (inflation-corrected) prices rose by nearly 85 percent between 1997 and 2006, in the United Kingdom there was an (uncorrected) rise of 180 per cent , in Spain they nearly trebled , and in Ireland they more than quadrupled. By 2005, some economists in the United States had become convinced that an asset price bubble had developed, but Ben Bernanke (then Chairman of the President's Council of Economic Advisers) reported that "... although speculative activity has increased in some areas, at a national level these price increases largely reflect strong economic fundamentals" and that "a moderate cooling in the housing market, should one occur, would not be inconsistent with the economy continuing to grow at or near its potential next year". In the event, price increases grew more rapidly over  the following  year and a half.

Deregulation
American attitudes about regulation changed substantially during the final three decades of the 20th century. Beginning in the 1970s, policy-makers grew increasingly concerned that economic regulation protected inefficient companies at the expense of consumers . Deregulation of the banks began in the 1980s and involved a combination of changes in federal and state statutes and changes in regulatory and judicial interpretations of existing laws, culminating in the passage of the Banking Act of 1999, and there were similar developments in other developed countries. Until the 1980s, investment banks were not normally permitted to undertake non-financial activities, nor other financial activities such as branch banking, insurance or mortgage lending. In the 1980s, however, there was extensive deregulation of the banks with the intention of increasing competition and improving efficiency. Reserve requirements were relaxed and restrictions upon the range of their financial activities were generally relaxed or removed.

Financial innovation
The reduction that took place in the yields on government bonds prompted investors to seek higher-yielding alternatives, and the finance industry employed a great deal of high-powered ingenuity to meet that demand. They were helped in that endeavour by a series of Nobel-prize-winning advances in financial economics that had been made in the 1970s and early 1980s; by the deregulations of the 1980s, and the work of a group of brilliant mathematicians that came to be known as the "quants". The economists had developed a succession of theories based upon adaptations of the the efficient market hypothesis, including portfolio theory and the capital asset pricing model; on the basis of which the quants developed and operated a range of computer packages that could provide precise estimates of an investor's "value at risk" derived from probability analysis of previous experience. Armed with more sophisticated methods of assessing risk, the banks and other financial intermediaries increased their capacity to provide credit to producers and consumers by distributing the risks and rewards involved more widely among those most willing to accept them. The devices adopted for that purpose included a vastly extended application of the techniques of securitisation, involving the conversion of their loans into packages of bonds that were graded according to the  credit risk ratings provided by the credit rating agencies. The traditional banking practice of holding loans on their balance sheets until they were repaid, gave way to  the strategy known as originate and distribute, under which  those packages of  bonds were sold  to pension funds, insurance companies and other banks. That procedure removed the loans from the balance sheets of the banks, and the institutions of the growing shadow banking system, thus enabling them to increase activity without breaching the reserve ratio requirements of the financial regulators.

Financial crisis (2007 - 2008)
What came to be known as the subprime mortgage crisis had its origin in repayment defaults by some Americans with low credit ratings who had borrowed money to help pay for house purchases. When house prices were rising, many of them had been able to get the money needed for repayments by further borrowing (because of the increased collateral that the price increases enabled them to offer). But the sharp fall in the market value of their houses that occurred in  2007 deprived them of that option, and left many of them owing more than their houses were worth  - making default a rational, and sometimes unavoidable, recourse.

The financial crisis began in early June 2007, when surge in defaults  led the credit rating agencies to downgrade their ratings of securities based upon those mortgages, and banks holding such securities found themselves unable to use them as collateral for their borrowing needs. This created financial problems that started with Fannie Mae and Freddie Mac and then shifted to the major banks. In that month, hedge funds guaranteed by the American Bear Stearns bank ran into difficulties, and mortgage  defaults led subsequently to the collapse and a government rescue from bankruptcy of Fannie Mae and Freddie Mac. Uncertainty about the quality of banking assets made banks reluctant to lend to each other and the important interbank market vitually ceased to operate, triggering a growing credit shortage.

The events of 9th August 2007 marked first upsurge in  the intensity  of the crisis. The French bank BNP Paribas announced  that it had suspended withdrawals from three of its hedge funds on the grounds that it had become impossible to value their mortgage-backed assets. On the same day it became apparent that European banks were experiencing serious liquidity shortages when it was learned that they had sought help from the European Central Bank. Other banks throughout the world cut back on their lending in an attempt to offset the increase in their leverage brought about by the downgrading of their mortgage-based assets. The fear of default fed on itself as a result of  more and more   major bank failures in 2007 and 2008 as well as many failures of other businesses - often because they found themselves unable to roll-over their debts. In March 2008 the United States authorities organised the rescue of the Bear Stearns (the world's fifth largest investment bank)].

The second upsurge of financial panic started in September 2008. The collapse of the Lehman Brothers investment bank on September 15 created a near total loss of mutual confidence throughout the world's financial system. The LIBOR-OIS spread which is the conventional measure of the banks' willingness to lend, which had already risen to 0.9 per cent from its normal level of around 0.1 per cent, surged to an unprecedented 3.6 per cent. Fears of default spread through the financial system  with the crippling consequences that came to be known as the credit crunch. Banks and other businesses found that they could not borrow for longer than overnight,  and by early October even overnight credit became  scarce. It become apparent that a collapse of the entire  financial system had become a distinct possibility, and the Governor of the Bank of England warned that "Not since the beginning of the First World War has our banking system been so close to collapse".

The International Monetary Fund's economists estimated in October 2009 that the global writedowns of the value of financial assets resulting from the crisis to have totalled $3.4 trillion.

Financial policy
In the course of the first two weeks of October 2008 a series of banking systems rescue plans had been launched. The UK had announced large scale plans to inject capital into its banks and to offer unlimited guarantees on the debts of all of its banks, and similar action had shortly after been agreed by European leaders and by the President of the United States. The national rescue systems that were actually adopted by the principal banking countries differed only in detail from those initial proposals. It was recognised that those actions were temporary treatments, not remedies, and remedial measures were also set in motion in the course of 2009, as described in the paragraph below on diagnosis and remedies.

Monetary policy
The Federal Reserve Bank, the Bank of Japan and the Bank of England made a series of [[discount rate reductions  to near zero levels in the 4th quarter of 2008 and the 1st quarter of 2009 (and the European Central Bank made a series of reductions to reach 1 per cent in the 2nd quarter. When it became clear that those moves had not achieved the intended easing of the credit crunch it was decided to adopt the controversial and largely untried  policy of quantitative easing.

Fiscal policy
In a significant departure from the accepted practice of relying solely upon monetary policy to stabilise their economies, most industrialised countries adopted  fiscal stimulus packages to augment the  already substantial expansionary influence of the automatic stabilisers. Those moves  frequently involved departures from recently adopted deficit-limiting rules, including The European Union's Stability and Growth Pact, and the United Kingdom's Code for Fiscal Stability and  levels of  national debt ranging  from the UK's 44 per cent of GDP to Japan's 188 per cent were forecast to rise to at least  double their existing proportions  of GDP.

Economic downturn (2007 - 2009)
The economic downturn started in the United States in the first quarter of 2007, where a combination of rising oil prices, falling house prices and credit shortages was having a depressing effect on household spending and business investment. The downturn continued during the next three quarters, and its depressing effects were being felt by the economies of many of  the other advanced economies. The financial problems created by the subprime mortgage crisis had a further depressing effect, and the financial panic that followed the demise of the Lehman Brothers investment bank in September 2008 created  further - and much more serious - obstacles to economic activity and to trade. By the fourth quarter of 2008 recessionary pressures were being felt in all of the world's economies. There were massive reductions in world trade during that quarter and in the first quarter of 2009. Also during the first quarter of 2009, the price of crude oil fell sharply to reach 25 per cent of its 2008 peak, and there were substantial downturns in the housing markets of several advanced economies (including Canada, Denmark, Ireland, Spain and the United Kingdom), and - for the first time since the Great Depression, there were simultaneous reductions in the growth of nearly all of the world's economies.

Regional impacts varied widely, however. There was little change to the economies of Southern Asia; those of East Asia  were less adversely affected  than most; the economies of China and India  experienced  significant growth rate reductions; and all the high-income economies of the United States, Europe and Japan, together with most of the other developing countries, went into recession. Economies with relatively large financial sectors - such as those of Britain and Iceland - suffered directly from the banking crisis. Economies with relatively large export sectors - such as those of Japan and Germany and many developing countries - suffered indirectly from the collapse in world trade that occurred at the end of 2008. Commodity-exporting developing countries were affected by the fall in commodity prices hit the economies of the, and the international credit crunch created financial problems for developing countries who found themselves unable to roll-over maturing short-term debt. There were widespread increases in unemployment.The severest effects were upon the economies of Russia, the Baltic States, Iceland and Ireland. In several countries, (including the United States, the United Kingdom and Ireland ) the recession had the historically rare characteristics of a balance sheet recession, which they suffered as a  result of the downgrading of their assets that occurred in the course of the American subprime mortgage crisis. In the United States, Japan and the United Kingdom, the effect of deleveraging by the banks was accentuated by attempts by businesses and households to reduce their inflated levels of debt. Thus the recession  struck widely for reasons that often had  nothing in common with the events that set it off.

Recovery (2009-2010)
Early in 2009 there were signs of a  gradual return of confidence in operation of the financial system. By February, LIBOR-OIS spreads had fallen from their 3½ per cent peak to around 1 percent, and by August they had return to the relatively normal level of 0.25 per cent. There was no longer a prospect of the collapse of the financial system, but nor was there an immediate prospect of a return to normal. Bank executives were by then accutely aware of the need to reduce leverage and were devoting available funds to that purpose rather than to lending. As a result there was no more than a gradual reduction in the severity of the credit crunch

By the middle of 2009 there were also signs of a return to the growth of economic activity. World output rose at 3¼ per cent per annum in the second quarter of 2009, and at 4½ per cent in the second half as a whole. Most of the growth occurred in the emerging economies. In the developed economies, the pace of recovery was slow, and activity remained far below precrisis levels. Growth was led by a rebound in manufacturing and the rebuilding of depleted stocks. Estimates of output gaps   indicated the presence in most developed countries of very substantial amounts of unused resources suggesting that without a high degree of  labour market price flexibility, high levels of unemployment would probably  persist into  2010 and beyond. By the middle of 2009 the world trade statistics were also showing signs of a recovery, and  growth  continued through the second half of 2009 and into the first quarter of 2010, although the volume of trade remained substantially below pre-recession levels.

By the end of 2009, most economies had returned to economic growth, but there were numerous exceptions. Iceland's economy was not expected to recover from its exceptionally deep recession until 2011 and contractionary fiscal policies were expected to delay economic recovery in Ireland and Greece.

Policy-makers were faced by the fiscal dilemma, that arose from the conflict been the wish to reduce national debt and the wish to avoid creating another downturn. In October 2009, the International Monetary Fund advised that, notwithstanding rising public debt in many countries, fiscal stimulus needed to be sustained until the recovery is on a firmer footing and may even need to be extended,but that it could lose its effectiveness in the absence of convincing reassurances to investors  that government  debt will eventually be rolled back.

Aftermath (2010 - )
During the early months of 2010, national authorities in most of the developed countries were concerned both with the danger of a renewed downturn, and with the need to maintain investors' confidence in their ability to service their bonds. On the one hand, there was an awareness that the contribution to  the recovery  that had been due to the replacement of depleted stocks would not continue,  and that the  deleveraging of  high pre-recession levels of household and commercial debt might continue to hamper growth. On the other hand there was awareness that increased borrowing that had occurred during the recession - mainly to compensate for the reduction or tax revenues - had  increased their national debt,  often to  higher levels than had  previously been reached in peacetime. That gave rise to concerns that it might become necessary to add a risk premium to the normal interest rate in order to maintain investors' willingness to buy their bonds. In extreme cases, rumours of of impending sovereign default could generate a herding response,   leading  to a progressive  escalation of their risk premium  and to a self-fulfilling threat  to a country's fiscal sustainability. It turns out, however, that the need to pay a risk premium on the interest rates on a government's bonds depends less upon the level of national debt than upon the attitude of the market to that government. The fact that the bond market imposed higher risk premia on the bonds of the Eurozone's PIIG (Portugal, Ireland, Italy and Greece} governments  than upon the bonds of more deeply-indebted governments such as Japan's, has been attributed to an attitude toward them of debt intolerance . It has been suggested that the bond market took account of the necessary absence of offsetting exchange rate movements,  and were sceptical about compensating offers of support from  other Eurozone governments. In the case of the  2010 Greek debt crisis, it has been suggested that the country's deceptive conduct  and its default record were contributory factors.

The cost of the recession
The problem of estimating the cost of the recession is immensely difficult, requiring a comparison between its actual outcome and the outcome that would have eventuated in its absence. Even to estimate its actual output presents difficulties that may not be confidently resolved for many years. An attempt has nevertheless been considered necessary in order to provide a datum against which to relate  the costs of prevention. An estimate by Bank of England has put the present value of the cost of the output that has been lost at 3½ times world GDP, on the basis of which their Andrew Haldane has suggested that if only 25 percent of that loss were permanent, the present value of its global cost could amount to 90 per cent of the value of a year's output .

Causes
Even before the banking meltdown had been averted, attention was being given to the problem of identifying its causes with a view to avoiding another financial crisis (or, failing that, of limiting its severity). Many explanations were put forward. Some were concerned with the conduct of those involved, including the shortcomings of bank executives and their advisors, the laxity of their regulators, the indifference of the central banks, the  incompetence of the credit rating agencies, and the inaction of governments. Some were concerned with institutional factors including, the inadequacy of financial regulation, and the lack of coordination between monetary policy and financial regulation. The concern felt by many people that a global disaster had been sprung on them without warning was expressed by the Queen of England when, on a royal visit to the London School of Economics, she asked "Why did no-one see it coming". The School's Director assured her that economists had issued warnings, and a follow-up letter attributed their lack of influence among decision-takers to "wishful thinking combined with hubris". {The warnings included those of Paul Volcker, and William White .). But a group of eminent economists believe that the economics profession cannot escape responsibility for the crisis.  Positions of influence had in their view been occupied by  economists who had a mistaken view of how the economy works. Among that group, George Akerlov and Joseph Stiglitz argue that a major cause of the crash of 2008 had been the use of models embodying the efficient markets hypothesis and, more generally, to the belief that financial markets are inherently stable . The economist Paul Krugman claims that those responsible for economic management had acted either on the belief that  free-market economies never go astray, or the belief that deviations could readily be corrected by the central banks,  and that economists' preoccupation with elegant mathematical models had led them to "mistake beauty for truth". A contrary view is taken by Nobel prizewinner Myron Scholes (joint creator of theBlack-Scholes model which embodies the efficient markets hypothesis), who defends the use of models and attributes any adverse consequences to their misuse, saying "you can build a wonderful car such as a Porsche or a Lamborghini and turn it over to someone to drive it who has no skills and causes it to crash".

Prescriptions
In a reversal of the previous consensus, there was general agreement by 2009 that further regulation of the financial industry is necessary. It was also accepted that the new regulations should not be concerned solely with the stability of individual firms. A paper by the United States Department of the Treasury makes the point that "a narrow micro-prudential concern for the solvency of individual firms, while necessary, is by itself insufficient to guard against financial instability. In fact, actions taken to preserve one or a few individual banking firms may destabilize the rest of the financial system". The term "macroprudential" came into general use to denote concern with the integrity of the financial system as a a whole. There was also seen to be need for international agreement, if only in order to avoid a situation in which financial firms migrate toward the least-regulated administration.

The Deputy General Manager of the Bank for International Settlements has set out a broad agenda for the reform of the international economy that included: Work was already in hand to develop the first of those proposals. In December 2009, the Basel Committee on Banking Supervision had issued consultative proposals, introducing a leverage ratio requirement, a liquidity requirement, and a range of countercyclical measures that came to be known as "Basel III", and a range of national legislation had already been enacted. There had been discussions about banking regulation at Heads of State meetings and Finance Ministers meetings of the Group of Twenty leading economies. International agreement on specifics was elusive, however, and the situation at April 2010 was summed up by the Governors of the International Monetary Fund as "Strengthening financial regulation, supervision, and resilience remains a critical but as yet incomplete task." , and Andrew Haldane of the Bank of England commented that "although several packages of remedial measures have been enacted,  the "great debate" on the future structure of finance has only just begun".
 * expansion of the scope financial regulation to priority to macroprudential provisions as well as strengthening its  existing microprudential provisions ;
 * expansion of the scope of monetary policy to restrain any tendency to develop asset price bubbles as well as restraining inflation;
 * expansion of exchange rate policy to reduce global imbalances as well as promoting exchange rate stability; and,
 * adoption of a countercyclical fiscal policy by maintaining a positive budget balance during periods of economic growth that will be large to enable an effective response to future economic downturns.

International agreement of the second BIS proposal - that monetary policy should "lean against" asset price booms - seems unlikely because it has been opposed by the Chairman of the Federal Reserve Board and the President of the European Central Bank. In the communiqué issued after the 2009 Pittsburgh summit the world leaders reiterated the need to manage global imbalances , - a topic that had been regularly discussed at summits over the previous decade - but did not propose any means of doing so. There seems little chance of G20 agreement on Heribert Dieter's proposal to levy a penalty on surplus countries , nor on the alternative of penalising deficit countries. More attention is likely to be given to the virtues of countercyclical fiscal policy as a result of the recession, but there would seem to be limited scope for a binding  international agreement on the matter.