Sources of Spillovers

In Chapter 5 "Globalization and Competitiveness", we explained how countries are linked through the flows across national borders of goods, services, labor, financial capital, and information. Countries do not exist in isolation, and these linkages imply that problems in one country can be transmitted to others. In the crisis of 2008, we can point to three broad channels of spillover from the United States to the rest of the world:

1. Within financial markets across borders (integrated financial markets)
2. From financial markets into real markets in the United States, followed by real spillovers across countries
3. Contagion effects through market psychology

The first two linkages can be seen in the circular flow of income in Figure 15.2 "The Foreign Sector in the Circular Flow". In this version of the circular flow, we highlight the interactions between a single country and the rest of the world. These interactions operate through the flows of goods and services and financial assets. During good times, they are a key part of the workings of the world economy. But during bad times, such as a financial crisis, these same links create channels for the sharing of financial crises.

Figure 15.2 The Foreign Sector in the Circular Flow

Households purchase goods from other countries; these are called imports. Citizens of other countries purchase our products; these are called exports. A trade deficit requires borrowing from the rest of the world.

There are three international flows in Figure 15.2 "The Foreign Sector in the Circular Flow":

1. Exports. Households, firms, and the government in the rest of the world purchase goods and services produced in the home country.
2. Imports. Households (and also firms and the government) purchase goods and services produced in the rest of the world.
3. Financial flows. Financial intermediaries in the home country buy and sell financial assets flows from/to the rest of the world. The net flow can go in either direction; Figure 15.2 "The Foreign Sector in the Circular Flow" shows the case where there is a net flow of money into the home country.

International Spillovers in Financial Markets

One channel through which the crisis of 2008 spread was the holding of US financial assets by governments, financial institutions, and banks in other countries. Take, for example, mortgages that were marketed and issued in the United States. These mortgages were usually not ultimately held by the banks that issued them to homeowners. Instead they were bundled together with other mortgages and then resold.

These “mortgage-backed securities” were marketed and sold all over the world, not just in the United States. This means that any risk associated with these assets was shared across investors in different countries. The spread of this risk across world markets also provided a way for the crisis to propagate across countries. When it became clear that these assets were less valuable than investors had previously thought, the reduction in their price reduced the wealth of investors all over the globe. Moreover, the various financial institutions in the United States that were either bought out or went bankrupt were partly owned by investors in other countries. Thus financial links across the world economy provided one avenue for the spread of the crisis.

Second, the financial flows across countries played a significant role in the spread of the crisis. Since the early 1970s, the United States has run current account deficits each year. One consequence of this is that it has been borrowing from abroad to finance these deficits. In other words, foreigners hold substantial amounts of US assets. These assets include US government debt and, in many cases, large amounts of mortgage-backed securities.

One way to see the extent of these financial interactions is to look at the behavior of stock markets around the globe. Figure 15.3 "Stock Markets around the World Crashed Together" shows the values for six indices around the world: the Dow Jones Industrial Average (United States), CAC (France), FTSE (United Kingdom), Hang Seng (China), Nikkei (Japan), and Merval (Argentina). The figure shows that the last six months of 2008 were problematic for stock markets across many countries.

Figure 15.3 Stock Markets around the World Crashed Together

The Crisis in the EMU

When the crisis hit in the United States, the secretary of the Treasury and the chairman of the Board of Governors of the Federal Reserve System held a joint press conference. By so doing, they made it clear that, in the United States, monetary and fiscal policy were being used jointly to resolve the financial crisis. In Europe, the picture was very different. As we have explained, countries within the EMU have a common central bank but do not have a common fiscal policy. Fiscal policy is decided at the country level, while the ECB is supposed to target the overall European inflation rate (as discussed in Chapter 10 "Understanding the Fed") and is not supposed to play any role in bailing out individual governments.

This system may work in normal times. The events of the crisis of 2008 revealed that it did not work so well in abnormal times; this in turn led to some calls for change.

President Sarkozy’s concern was that there is no centralized entity in the EU that can play the same role as the Treasury in the United States. Member governments devise their own fiscal policies to deal with their own country’s problems and do not take account of the effects of their actions on others in the European Union. This matters because the EU countries are so closely linked through trade and capital flows.

Governments within the EU did indeed act unilaterally to preserve their individual banking systems. The French government agreed to a 360 billion euro package of support for the French banking system and made a statement that no banks would collapse. Other countries took similar measures to restore confidence in their banking systems. Such measures sound similar to those taken in the United States, but there is an important difference. For the United States, such spending could be financed by taxes, government borrowing, or monetary expansion. But for, say, France, the equation is different. If the rescue package is not financed by increased taxes, then the French will have to issue more debt. They no longer control their money supply, so they cannot print currency to finance these bailouts.

Moreover, the Stability and Growth Pact, as we explained, places restrictions on the permissible magnitude of deficits by member governments. The reason for these restrictions is that, if many countries in the EMU were to run large deficits, there would be pressure on the ECB to finance some of this spending through additional money creation. In the aftermath of the crisis, many countries violated the fiscal restrictions, and how the monetary and fiscal authorities will ultimately respond to such pressure remains an open question.

One part of the response has been the establishment of additional facilities within Europe to pool resources to provide assistance to member states. Countries within Europe have been fulfilling a similar role to that played by the International Monetary Fund (IMF). In particular, the crisis in Greece, and related debt problems in Ireland and Portugal, led to the creation in May 2010 of the European Financial Stability Facility (http://www.efsf.europa.eu/about/index.htm) to provide for the stabilization of countries undergoing financial and debt problems. A June 2011 press release discusses the provision of funds for Ireland and Portugal under this stabilization fund (http://www.efsf.europa.eu/mediacentre/news/2011/2011-006-eu-and-efsf-funding-plans-to-provide-financial-assistance-for-portugal-and-ireland.htm). The funds for Greece are coming from the EU member states directly.

Within the ECB, the discussion by President Trichet (http://www.ecb.int/press/key/date/2009/html/sp090427.en.html) summarized the perspective and policy choices of the central bank, including the provision of liquidity. Given that the ECB maintains an inflation target, how is this provision of liquidity consistent with that goal? One answer often given is that without this liquidity, the European economies might have fallen into deeper recessions and thus opened up the possibility of deflationary periods, as witnessed in the Great Depression years in the United States and in Japan during the 1990s.

The Crisis in the United Kingdom

So far we have looked at two large economies: the United States and the euro area. We now turn to the experience of some smaller economies, beginning with the United Kingdom. The United Kingdom is part of the EU but it is not in the euro area. It retained its own currency (the pound sterling) rather than adopting the euro. This meant, of course, that it also retained its own central bank. The Bank of England is known as a very independent monetary authority, and operates under very strict rules of inflation targeting. Yet it, too, responded to the crisis.

The United Kingdom was one of the first countries to face serious implications of the financial crisis when, in September 2007, there was a run on a lending institution called Northern Rock. The Bank of England evidently could have—but chose not to—take action early in the crisis to avoid the run on Northern Rock. Once the run commenced, however, the Bank of England injected liquidity into the system.

In October 2008, the Bank of England was, along with other central banks, cutting interest rates. However, the cuts it enacted were modest relative to the action taken in the United States and other countries. More significantly, the United Kingdom partially nationalized some of its banks over this period under a 400-billion-pound bailout plan. Just as in the US plan, the aim was to provide liquidity directly to these banks and thus open up the market for loans among banks. But, according to contemporary reports, UK banks were still not making new commitments weeks after this bailout plan was enacted.

The Crisis in Iceland

Iceland is a relatively small, very open economy. It has close links to the EU but retains its own currency: the krona. It was particularly hard hit by the financial crisis, in part because Icelandic banks had been borrowing extensively from abroad in the years prior to the financial crisis. According to one estimate, banks held foreign assets and liabilities worth about 10 times Iceland’s entire GDP.This is partly based on a BBC article about Iceland: Jon Danielsson, “Why Raising Interest Rates Won’t Work,” BBC News, October 28, 2008, accessed July 26, 2011, http://news.bbc.co.uk/2/hi/business/7658908.stm.

The sheer size of asset holdings meant that if there was a substantial decrease in asset values, it was simply not possible for the Icelandic central bank or fiscal authorities to bail out domestic banks. Any attempt to bail out the banks would simply have bankrupted the government. You also might wonder why, as a last resort, Iceland could not generate print money to get itself out of trouble, financing a bailout through an inflation taxA tax occurring when the government prints money to finance its deficit.. We explained earlier that this would be a possibility in the United States, for example. The difference is that most of the liabilities of US financial institutions are denominated in US dollars, so inflation would reduce the real value of these liabilities. But much of the debt of Icelandic banks was not denominated in krona; it was denominated in euros, US dollars, or other currencies. Inflation in Iceland would simply lead to a depreciation of the currency and would not reduce the real value of the debt.

Based on estimates from the IMF, the financial and exchange rate problems of Iceland led to a contraction in real GDP of around 3 percent in 2009. In late October 2008, Iceland negotiated a $2.1 billion dollar loan from the IMF (http://www.imf.org/external/np/sec/pr/2008/pr08256.htm) for emergency funding to help stabilize its economy. To put this in perspective, Iceland’s GDP is only $12 billion, and the loan was equivalent to almost $7,000 per person. Meanwhile, there was a precipitous decline in the value of the krona: between January and October 2008, the krona lost nearly half of its value.

Iceland’s banking system was effectively nationalized in 2008. The government took over three of the biggest banks. During late October, the government tried to peg the krona at about 131 per euro. Their attempt failed, and the government was forced to allow the krona to decrease in response to market forces. There was a report of a trade at 340 krona per euro, far from the government’s attempted peg.See Bo Nielsen, “Iceland’s Krona Currency Trading Halts as Kaupthing Taken Over,” October 9, 2008, accessed July 26, 2011, http://www.bloomberg.com/apps/news?pid=20601085&refer=europe&sid=aiz5QIq94nrw. One way to think about the decline in the value of the krona is through the government budget constraint. Once the government took over the banks, what had been a private liability became a government liability to depositors. One way to meet this obligation is through higher taxes; another is through the creation of more currency. The rapid depreciation of the krona indicates that market participants were anticipating more inflation in Iceland, so the value of the currency decreased.

Iceland was merely the first country that ran into considerable distress as a result of the crisis of 2008. It was followed a few days later by Ukraine, which agreed to a $16.5 billion loan from the IMF. Countries such as Greece and Spain also faced problems as investors started to worry that their governments might default on their debt.

The Crisis in China

The financial crisis had an impact on China largely through trade linkages. China exports a lot of goods to western economies. As the level of economic activity in these economies slowed, the demand for goods and services produced in China decreased as well. This led to lower real GDP in China. As shown in the circular flow of income (Figure 15.2 "The Foreign Sector in the Circular Flow"), the reduction in exports by China led to reduced output from Chinese firms, reduced income for Chinese households, and lower spending through the multiplier process.

Even though China owned many US assets, most were not directly linked to mortgage-backed securities. Instead, the Chinese were holding about $900 billion of US Treasury securities.Data on foreign holdings of US government securities is available at “Major Foreign Holders of Treasury Securities, ” US Department of the Treasury, September 16, 2011, accessed September 20, 2011, http://www.ustreas.gov/tic/mfh.txt. Although the value of these securities changed with the financial situation, this simply led to changes in the value of portfolios and did not lead to bankruptcy of financial institutions.

China differs from the United States and Europe because many of the banks operating in China are owned by the government. The top four state-owned banks had about 66 percent of China’s deposit market in 2007. So if the assets of those banks decrease in value, this loss is ultimately reflected in the budget of the government. Whereas the governments of England, the United States, and other countries attacked the crisis of 2008 by partial nationalization—that is, the purchase of bank shares by the government—this was unnecessary in China because the government already had a substantial ownership share in the banks.

Deposit insurance is also rather different in China. In the case of publicly owned banks, the government directly guarantees deposits so banks will not go bankrupt. There is no explicit deposit insurance for private banks, but the lack of explicit deposit insurance does not mean the Chinese government would not bail out a bank that was under attack. The Law of the People’s Republic of China on Commercial Banks Article 64 reads as follows:

The Crisis in Argentina

What about the experience in Latin America during the crisis of 2008? Many countries, notably Argentina, Brazil, and Mexico, experienced their own financial and currency crises in recent decades. Those crises were “homegrown” because they were largely caused by domestic economic policies.

But the upheavals of recent years were not created in these countries. The linkages we explained earlier also caused these countries to be affected by the financial events that afflicted the United States and Europe. Figure 15.3 "Stock Markets around the World Crashed Together" shows that the stock market in Argentina had similar volatility and losses to those experienced in other countries. This volatility, along with other financial upheavals, created an interesting response within Argentina: the government announced the nationalization of private pension plans.

What is the connection here? The government announced it was taking over private pensions to protect households who faced added financial risks. Instead of facing the risks of private asset markets, households were now shielded from that risk through a national pension system. Skeptics have argued that this was simply an opportunity for the government of Argentina to obtain some additional resources. Promises of future compensation for the lost pensions were not viewed as credible.

The Crisis in Australia

Finally, not every country in the world was badly hit by the crisis of 2008. Australia, for example, saw a significant stock market decrease but otherwise went through the crisis years with little more than a minor slowdown in economic growth. There are several reasons for this. Australia, like other countries, used both monetary and fiscal policy to stimulate the economy. On the fiscal side, it cut taxes and increased government purchases; on the monetary side, the Reserve Bank of Australia decreased interest rates (although not by as much as many other countries). Australia has historically kept its government debt very close to zero, so there were no concerns about default on Australian debt.

Australia made a very well-publicized cash transfer of about $1,000 to about half the population. Even though much of those transfers were probably saved rather than spent, they are credited with helping to support confidence and limit contagion effects in Australia. Finally, Australia has benefitted from a major resources boom, so demand for net exports was a robust component of aggregate expenditures during the crisis period.