Study Notes

Policy Responses to the Global Financial Crisis (Financial Economics)

Level:
A Level, IB
Board:
AQA, Edexcel, OCR, IB, Eduqas, WJEC

Last updated 21 Mar 2021

The credit crunch and the collapse of Lehman led to a steep fall in global real output and an even bigger decline in the volume of world trade. There were well-founded fears that the world economy was at risk of another depression similar to the 1930s.

Macroeconomic policy in many countries responded:

  1. Large conventional/unconventional monetary easing involving deep cuts in policy interest rates and quantitative easing
  2. Massive fiscal stimulus for a while – especially in China and (to a lesser extent) in the USA
  3. Backstop and bailout of the private sector (financial system, households, corporations) - including (in the UK) bail-outs and nationalisation of some banks

Side-Effects of the Macro Policy Response Post 2008

Ultra-low interest rates and quantitative easing:

  1. Surge in demand for assets – rising house prices (again)
  2. Increase in demand for commodities
  3. Limited reductions in private sector debt
  4. Continued survival of zombie businesses
  5. Issues about how and when to exit from QE and near-zero interest rates – dependency on low interest rates?

Big rise in fiscal deficits and national debt

  1. How and how fast to reduce fiscal deficits and debts that may be unsustainable?
  2. How to deal with the moral hazard that bailouts of the financial system may have induced?
  3. Decisions on when/whether to reverse nationalisation

Keynesian v Austrian Perspectives on Policy Response

Keynesian approach

  • Provide a strong monetary & fiscal stimulus – public sector spending needed when private sector demand is weak
  • Focus in particular on labour-intensive infrastructure projects with a potentially high fiscal multiplier effect
  • Bailout the private sector to prevent catastrophic job losses
  • Key is to support animal spirits and prevent a collapse in demand

Austrian approach

  • Avoid bail-outs as they lead to moral hazard and the survival of zombie businesses which ultimately constrains long run growth
  • Fast-forward structural economic / market reforms to promote competition and raise productivity
  • Against counter-cyclical macro stimulus - especially ultra-low interest rates as this "distorts" the allocation of capital

Strategies for Avoiding Future Financial Crises

  1. Floating exchange rates rather than fixed ones that could collapse
  2. Build up foreign currency reserves to avoid liquidity runs on banks
  3. Better regulated banks and financial systems
  4. Take steps to reduce public and private sector debt to reduce solvency risks
  5. Structural reforms to improve competitiveness of real economy

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