Notes from the Vault
International Dimensions of the Financial Crisis of 2007 and 2008
Gerald P. Dwyer
Why were some countries seriously affected by the financial crisis while others, such as Canada, had no financial crisis to speak of? It's easy to come up with answers to a question like this in casual conversation. It's not so easy to come up with answers that have enough support to convince people who didn't believe in the answer already.
A related question is whether the United States was the source of the financial crisis not just internally but in other affected countries. Some explanations of the crisis suppose that the U.S. Federal Reserve and subprime mortgages in the United States, or both, were the source of the problems everywhere. Taken to the limits of logic, these explanations are extraordinarily implausible. There is no reason to think that the banking problems in Iceland—which erupted in September 2008—or the problems in Ireland with Irish bank loans to developers were the result of U.S. monetary policy or U.S. subprime loans.1
The Center for Financial Innovation and Stability cosponsored a conference in December 2010 to examine international aspects of the crisis. This conference was cosponsored with the Frank J. Petrilli Center for Research in International Finance at Fordham University and the Centre for Economic and International Studies at the University of Rome Tor Vergata. The proceedings will be published in the Journal of International Money and Finance later this year.
The purpose of the conference was to bring together some of the best research being done on international dimensions of the crisis to begin to get a handle on the answers to these questions. The conference examined the questions in two different ways. One set of papers focused on global aspects of the crisis. The other set of papers examined developments in detail in three countries—Ireland, Spain, and the United Kingdom—that had difficulties in the crisis.
While it might seem desirable to examine countries that did not have difficulties, such as Australia or Canada, the evidence from such case studies inevitably is limited, and what can be learned already has been convincingly demonstrated. In a presentation at a 2009 CenFIS conference, Renée Fry (2009) shows that Australia avoided having a financial crisis partly because its banking system is very concentrated, highly regulated, and not a very good banking system from the viewpoint of consumers; another part of the explanation is the rapid growth in exports of natural resource–based products from Australia.
Global aspects of the financial crisis
Does the worldwide spread of financial derivatives based on U.S. subprime mortgages explain much of the global aspects of the crisis? Laurie DeMarco presented her paper with Steven Kamin (Kamin and DeMarco 2010), which attempts to answer this question. They analyze detailed data on non-U.S. financial institutions' holdings of securities backed by U.S. mortgages. While they find evidence that these holdings contributed to the financial difficulties these institutions faced, they also find that even countries with negligible holdings of U.S. mortgage-backed countries experienced substantial distress. DeMarco and Kamin conclude that problems with U.S. mortgage-backed securities more plausibly were a wake-up call about banking problems around the world than a direct cause of those problems.
If not U.S. mortgage-backed securities, what does explain cross-country differences in the effects of the financial crisis? Gaston Gelos presented his paper (with colleagues at the International Monetary Fund Pelin Berkmen, Robert Rennhack, and James P. Walsh), which examines exactly that question. No doubt their paper is one of the first in a long series. Rather than attempt to answer this question for all countries, Gelos and his coauthors focus on more homogeneous subsets of all countries: developing countries and emerging markets.2 To measure the effects of the crisis, Gelos and his coauthors examine the effect of the financial crisis on the change in forecast output for 2009. Forecasts of 2009 output are available for the first half of 2008 and the first half of 2009; this interval between the forecasts spans the climax of the crisis. They use the forecast output growth in the first half of 2008 as a baseline to allow for country-specific differences in growth, such as the difference in underlying output growth in China and Russia. They use the forecast output in the first half of 2009 to measure the effect because reliable estimates of actual output in 2009 were not available when the current draft of the paper was written at the end of 2009.
The results of their analysis are quite striking. Faster growth of credit and higher leverage before the crisis are associated with larger decreases in projected output in 2009 both for developing countries and emerging markets. The exchange rate regime also matters, with a pegged exchange rate associated with larger decreases in projected output. For the emerging markets, trade also seems to matter as well as these variables. Exports of manufactured goods are associated with larger decreases in projected output, and exports of food are associated with smaller decreases. Many of the measured effects are large. For example, the regressions suggest that a reduction in leverage from the highest 25 percent of observations to the lowest 25 percent of observations would have decreased the growth revisions by 4 percentage points per year.
Monetary policy's role in the crisis has been controversial. One controversy concerns whether monetary policy was a contributor to the financial crisis, in the United States or abroad. Another controversy concerns the appropriateness of monetary policy since the crisis. James Lothian examines whether monetary policy in the United States, as measured by the stock of money, contributed to the mildness of the output effects of the crisis compared to the Great Depression. His analysis updates an earlier comparison of financial upheaval, if not financial crises, by Milton Friedman (2005) in (1) the Great Depression in the United States, (2) Japan in the 1980s and early 1990s, and (3) the United States in the 1990s and early 2000s. Friedman found that the dramatic decline in the money supply in the Depression and the resulting collapses of output and the stock market have been avoided in the other two instances. Lothian adds the recent financial crisis to these data and finds that monetary policy as measured by the money stock has accelerated since the crisis. As a result, Lothian concludes that monetary policy during and after the financial crisis in 2007 and 2008 has been helpful at least in this respect.
Developments in individual countries
The experiences of Ireland and Spain are the subjects of papers presented by Thomas Flavin and by Santiago Carbó Valverde and Francisco Rodríguez Fernández. Flavin and his coauthors (Connor, Flavin, and O'Kelly 2010) compare the U.S. crisis and the Irish crisis. They argue that the Irish crisis is primarily the result of large net borrowing by Irish banks from abroad, extraordinarily high property values—much higher relative to U.S. values—and very imprudent bank loans for property development. In a direct sense, developments in the United States had no role in creating the Irish problems other than possibly through general difficulties created in the interbank market for funds. Even so, the authors argue that both countries' problems have four common features: irrational exuberance, large capital inflows, regulatory failures, and moral hazard problems. The moral hazard problems are similar in one respect: performance pay was received by many people for deals that were successful for a time and ultimately were unsuccessful. There were differences, though, with securitization of mortgages important in the United States but not in Ireland, and Irish malefactors likely being immune to prosecution.
Santiago Carbó Valverde and Francisco Rodríguez Fernández, with their coauthor David Marqués Ibañez, examine securitization in Spain and the changes in the quality of the securities. Spain had a substantial increase and subsequent decrease in housing prices. Spain also had a substantial increase in securitizations, rising to 90 billion euro in 2006 from 5 billion euro in 1999. This securitization of bank credit was associated with a substantial increase in private sector debt, in particular mortgage debt. The authors present evidence that banks' characteristics such as solvency have substantial effects on securitized loans' ratings and that higher loan growth is associated with a higher fraction of loans that are nonperforming a couple of years later.
Tomasz Wieladek's presentation of preliminary results from his work with Andrew Sentence and Mark Taylor (Sentence, Taylor, and Wieladek 2010) echoed many themes of other papers. Before the crisis, U.K. housing prices increased substantially, quite a bit more than in the United States. In addition, the United Kingdom had substantial capital inflows associated with growth of private sector debt. Combined with a large financial sector exposed to foreign developments, these factors led many to expect a worse experience than has transpired. Indeed, the run on Northern Rock in the United Kingdom in September 2007 is one of the first major developments in the financial crisis (Dwyer and Tkac 2009). Wieladek and his coauthors attribute the economy's resilience to fiscal and monetary policy since the crisis, to greater flexibility in the labor market than even ten years ago, and to the United Kingdom's relatively low restrictions on business activity.
There is much to be learned from the international effects of the crisis. It is hard to attribute other countries' problems to subprime mortgages in the United States. Developments in Ireland or Spain or and even the United Kingdom seem to more closely mirror developments in the United States than to be a result of developments there. These mirrored developments, of course, are unlikely to be a coincidence. But placing the blame for all these international problems on one or a few factors in the United States seems unlikely to be correct. That said, there is still much to be learned.
Gerald Dwyer is the director of the Center for Financial Innovation and Stability at the Atlanta Fed. Scott Baier provided helpful comments on an earlier draft. The views expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System.
1 The cause of Icelandic banks' solvency problems was not clear in 2008 (IMF 2008) and is not clear even as of this writing.
2 Developing countries and emerging markets are listed in Table A.2 of the paper (Berkmen et al. 2010, 4). The definitions are those from two data sets. The set of ninety-three emerging markets includes all forty developing countries.
Berkmen, Pelin Gaston Gelos, Robert Rennhack, and James P. Walsh. 2010. The global financial crisis: Explaining cross-country differences in the output impact. International Monetary Fund, unpublished paper.
Carbó Valverde, Santiago, David Marqués Ibañez, and Francisco Rodríguez Fernández. 2010. Securitization, risk transferring, and financial instability: The case of Spain. University of Granada, unpublished paper.
Connor, Gregory, Thomas Flavin, and Brian O'Kelly. 2010. The U.S. and Irish credit crises: Their distinctive differences and common features. National University of Ireland, Maynooth, unpublished paper.
Dwyer, Gerald P., and Paula Tkac. 2009. The financial crisis of 2008 in fixed-income markets. Journal of International Money and Finance 28, no. 8:1293–1316.
Fry, Renée. Australia's resilience during the GFC. Presentation at the conference "Regulating Systemic Risk," hosted by the Center for Financial Innovation and Stability, Federal Reserve Bank of Atlanta, October 2009.
International Monetary Fund. 2008. Iceland: Financial system stability assessment—update.
Kamin, Steven B., and Laurie P. DeMarco. 2010. How did a domestic housing slump turn into a global financial crisis? Board of Governors of the Federal Reserve System, unpublished paper.
Lothian, James R. 2010. Money and credit in the recent financial crisis. Fordhman University, unpublished paper.
Sentence, Andrew, Mark P. Taylor, and Tomasz Wieladek. 2010. How the UK economy weathered the financial storm. Bank of England, paper in progress.