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NS3040 Fall Term 2017 Origins and Early Years of The Global Economic Crisis


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Title: NS3040 Fall Term 2017 Origins and Early Years of The Global Economic Crisis

NS3040 Fall Term 2017Origins and Early
Years of The Global Economic Crisis

Economic Crisis and Security Threats
  • The global recession is Americas primary
    near-term security concern.
  • Admiral Blair Director of National Intelligence
  • (February 2009)
  • The single biggest threat to national security
    is the national debt.
  • Admiral Mullen, Chairman of the Joint Chiefs of
  • (August 2010)
  • I have to confess, I paid no attention to this
    (economics) as a cadet and have done nothing to
    increase my awareness of economics issues between
    age 22 and 59. I should have paid attention.
  • General Dempsey, Chairman of the Joint Chiefs
    of Staff (October 2011)

The World Economic Crisis
  • The current crisis while severe, shares many
    characteristics and patterns associated with past
  • Its origins and underlying causes follow a
    familiar pattern --- with several unique twists

Characteristics of Financial Crisis
  • All financial crisis share the same core
  • Some type of shock
  • Its propagation (how it spreads contagion)
  • The broader impact
  • The Underlying Causes
  • Primarily microeconomic (e.g. bad banking)
  • Primarily macroeconomic (e.g. recession)
  • Primarily institutional (e,g. poor infrastructure
    or inadequate supervision)

Crisis Overview Vulnerabilities and Triggers
  • U.S. Vulnerabilities
  • Monetary and fiscal policies too loose to long
  • Innovation and regulatory failure
  • Excessive household debt and bank leverage
  • Global Vulnerabilities
  • Demand boom and inflationary pressures
  • Housing and asset price boom
  • Large and widening imbalances
  • Triggers
  • Subprime securities collapse
  • Lehman failure

Causes of the Current Crisis I
  • Over the years the stage being set for the
    current crisis. Four initial conditions critical.
  • 1. Assets were created, bought and sold that
    appeared much less risky than they truly were.
  • Early 2000s environment stable in most of world
    with sustained growth and low interest rates.
  • Investors expected housing prices to continue
    their rapid increase.
  • 2. Development of securitization led to complex
    assets on the balance sheets of financial
  • Major improvements in risk allocation,
  • But harder to assess values than the case of
    simple mortgages
  • Worries about the original mortgages translated
    into a large degree of uncertainty about the
    value of derived securities
  • The fact that the securities were held by a large
    set of financial institutions implied that this
    considerable uncertainty affected a large number
    of balance sheets in the economy.

Causes of the Current Crisis II
  • Initial conditions contd.
  • 3. Securitization and globalization led to
    increasing interconnection of financial
    institutions, both within and across countries.
  • Foreign claims by banks from the five major
    advanced economies increased from 6.3 trillion
    in 2000 to 22 trillion by June 2008
  • Claims by these banks on emerging market
    countries alone exceeded 4 trillion.
  • 4. Leverage increased within the financial system
  • Financial institutions increased their portfolios
    with less and less capital thus increasing the
    rate of return on that capital.
  • Optimism and the underestimation of risk key
  • Numerous regulatory holes
  • Implications if for any reason the value of the
    assets became lower and more uncertain, then the
    higher the leverage the higher the probability
    capital would be wiped out and the institutions
    would become insolvent exactly what happened.

Crisis Timetable
  • The economic crisis has evolved through several
  • Summer 2007 initial phase
  • Subprime mortgage crisis,
  • Beginning of collapse of stock exchange
  • Early 2008 growing stress in advanced countries
  • Systemic crisis of financial intuitions in US
  • Economic slowing down in U.S. EU and Japan, but
  • Overheating inmost emerging markets (high
    commodity prices, weak US dollar accelerating
  • Summer 2008 breaking point
  • Bursting commodity and other bubbles
  • Global crisis of financial institutions
    (bankruptcy of Lehman)
  • Recession in developed countries
  • Fall 2008 crisis hits emerging market
  • Effects of the crisis world-wide and more severe
    than in past modern recessions severe because
    of wide-spread financial institutions holding of
    bad paper.

Economic Growth Rates
Global Financial Crisis Potential Security
Four Early Economic/Security Scenarios
  • In late 2008, early 2009 four economic
    crisis/security scenarios were getting
    considerable attention
  • The Vulnerability Effect terrorists seeing the
    U.S. economy melting down calculate that a strike
    could have a force multiplier because of the
    already skittish stock market.
  • The China Syndrome Chinese own more than 500
    billion in US. Treasury bonds, and billions more
    in other U.S. debt. While they would not dump
    them on the market to disrupt the U.S. economy,
    they have leverage over U.S. decisions on
    interest rates, exchange rate decisions.
  • A Japanese Lost Decade U.S. economy flat in
    the water for a decade or so government runs up
    debt with no stimulating effect on the economy
  • The Alternative-Dollar Nightmare countries
    refuse to hold dollar reserves. Dollar crashes
    and U.S economy along with it.
  • None happened Lesson Much More Stability in
    Global System than Commonly Believed

Factors Contributing to Stability
  • Why didnt the global system collapse when many
    in late 2008 were predicting its immediate
  • Revival did not happen because markets managed to
    stabilize themselves on their own
  • Governments learning from the great depression
    responded quickly through central banks and
  • The extensive social safety nets across the
    industrialized world cushioned the pain
  • Global system is simply more resilient than we
    imagined three major reinforcing elements
    producing stability
  • Spread of great power peace relatively little
    friction between major nations rare in history
    true global economy
  • Relatively low rates of inflation can plan for
    the future
  • Technological connectivity information
    revolution crated a deeply connected global
    system most nations have benefitted greatly
    from the system cautious about appeals to
    nationalism or acts that would jeopardize the
    current system.

Crisis Potential U.S. Growth
  • The crisis will have a marked impact on U.S.
    potential growth
  • The recession, the rising U.S. debt levels and
    tighter financial conditions will hurt
    investment, keeping capital formation well below
    rates in pre-crisis years
  • Resulting high and more-persistent-than-usual
    unemployment will lower potential growth
  • IMF estimates that U..S. potential output will
    average about 1.5 over the next five years.
  • This compares with an estimated 2.0 percent
    anticipated average in the absence of the crisis
  • By 2014 the potential output expected to be abut
    6 percent below what it would have been in the
    absence of a crisis

Crisis Transmission and Responses
Crisis Response
  • Not much coordinated activity in responding to
    crisis, because of incompatible conceptual
    frameworks for understanding its root causes
  • U.S. policy makers believe that trade surplus
    countries pursued policies that created global
    imbalances excess savings in China fixed
    exchange rate
  • Europeans believed that the root cause of the
    crisis was excessively deregulated financial
  • China feels reserve status of dollar created the
    imbalances to develop to unsustainable levels
  • Therefore responses not coordinated
  • Fiscal stimulus in some countries
  • Expansive monetary policy, central bank asset
  • Support (IMF) to vulnerable countries
  • Attempts through WTO at preempting protectionism

Overview Divergent Growth Recovery
Crisis Recovery Type I Countries
Crisis Recovery Type II Countries
Crisis Recovery Type III Countries
Crisis Assessment October 2010
  • Despite encouraging signs, still much uncertainty
    in the world economy
  • Currently, the global recovery is looking like a
    U but that could change quickly several
    distinctive recovery patterns
  • Economic repair is still incomplete and
    fragilities remain.
  • Will private sector demand be strong when
    stimulus over?
  • Will exit from stimulus policies be well timed
    and orderly?
  • Premature retreat can kill the recovery delayed
    retreat can raise inflationary likelihood
  • Medium term growth for the world might be subdued
  • Fiscal viability of the rich economies in in
  • Financial systems in rich countries are still
  • A slow expansion of world trade is likely in the
    context of rebalancing
  • Possible adverse impact on developed country
    investment due to regulatory uncertainty.

  • Martin Wolf Assessment

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Crisis Impacts I
  • International Relations
  • Potential effects on the U.S. leadership position
    in the world
  • Enhanced role for the International Monetary
    Fund, and Multilateral Development Banks
    decline in U.S. influence in IMF policy.
  • The rise of China as a player in international
    financial issues and the co-mingling of U.S. and
    Chinese financial interests
  • Additional pressures on European unity and policy
    discord between the United States and
  • Possible economic and political crisis in Eastern
    Europe and a tug-of-war for influence there
    between Russia and the EU/US.

Crisis Impacts II
  • Fundamental Philosophies
  • Rise of state capitalism and a questioning of the
    Western economic model of deregulated,
    market-based decision-making
  • Risk of rising trade protectionism and
    intensified anti-globalization efforts.
  • Potential for more authoritarianism in countries
    such as China and Russia and or rise in
    authoritarian models of governance in the
    developing world.
  • Security
  • Rising poverty and potential political
    instability in developing countries fertile
    ground for recruits for extremism
  • Budgetary pressures in Western nations could
    constrain international security and diplomatic
  • More instability in poor countries -- Estimates
    are that the risk of conflict goes up 1
    percentage point for each percentage-point
    decline in economic growth rates.

Crisis Impacts III
  • Financial and Economic Fallout
  • Possible reduced U.S. financial primacy in the
    world and importance of dollar as a reserve
  • Diminished flows of economic assistance, capital
    and remittances to developing nations
  • For developing nations, declines in export
    earnings from low prices for commodities and from
    shrinking world trade.
  • Increased likelihood of espionage against both
    private corporations and U.S. government agencies
    increased employee vulnerability

Roubini Q3 2010 Assessment
  • Going into Q3 2010 global recovery remains in
    grip of extreme economic uncertainty and
    unprecedented financial volatility. Four main
  • V-Shaped global recovery (4 probability)
    imbalances increase as both surplus and deficit
    G10 and EM countries get back to business as
  • W-Shaped double dip (35) with collapsing
    financing of imbalances precipitating cascading
    defaults around the world damaging both creditor
    and net debtor economies.
  • U-Shaped anemic G10 and semi V-shaped EM recovery
    (52) in which protracted balance sheet repair
    allows for gradual rebalancing/reduction of
    global macro imbalances.
  • L-Shaped stagnation (9) in advanced economies
    and U-shaped below potential EM growth due to a
    lack of adjustment among both debtor and creditor

IMF Scenarios I
  • Scenario 1 Global Cooperation to Rebalance World
    Output and Demand Not much evidence of this
  • Refocus of citizens and governments on
    sustainable domestic production and consumption
  • Sustainability refers to patterns of work,
    investment and spending that do not rely on
    persistent, large international transfers of
    economic and financial resources.
  • At the international level it means that
    international trade and financial balances should
    not be far from zero in either direction over
    long periods of time
  • Scenario 2 Lack of Coordinated policy
    Adjustments Global Imbalances Return Seems to
    be playing out now
  • Continuation of export led growth, especially in
    Asia could frustrate attempts by US to shift its
    economy away from excessive consumer and
    government borrowing and spending toward business
    investment and exports
  • If we attempted this sift and the surplus
    countries continued export-led growth U.S.
    would have at best a weak recovery

IMF Scenarios II
  • Scenario 3 No Policy Adjustments and Premature
    Withdrawal of Macroeconomic Support Global Slump
    Returns not widespread Eurozone?
  • Assumes no progress toward economic restructuring
    while policymakers misjudge the strength of
    economic recovery
  • If government policies that have resulted in
    large budget deficits and near-zero short-term
    interest rates which probably kept the global
    economy out of a depression are reversed and if
    private sector spending slows unexpectedly,
    economies could fall back into a slump as bad as
  • Result in a double-dip global recession with
    policy responses even more drastic than the first
  • Further long-lasting economic damage in form of
    long term unemployment and financial defaults
    would occur.

Global Recovery Consensus
  • Despite diverging interpretations over the
    pattern of recovery, most analysts agree that
  • The global economy has been significantly
    affected by the financial crisis
  • Emerging economies will outpace growth of the
    advanced economies. This disparity in growth has
    only been exacerbated by the financial crisis.
  • Commodity prices are also set to rise, which
    could further frustrate gains in GDP as well as
    affect security.
  • Debt will rise and revenues will fall for the
    governments of the advanced economies, while
    emerging economies will be more financially

Crisis Impact on Defense Spending
  • Global financial crisis and the subsequent
    recession in most European countries has created
    a new dynamic for defense spending
  • Even before the crisis punishing demands of
    operations on armed forces revealed shortfalls in
  • In addition the cost of new equipment was rising
    at a rate of 5-10 per year.
  • As both trends continue, European governments now
    struggling to control public deficits have
    launched a series of austerity measures across
    the board.
  • In the overall scheme of government priorities,
    defense spending has become discretionary and
    many defense ministers have already been asked to
    make do with less money
  • Two basic options in light of these developments
  • Accept that reduced financial resources will lead
    to reduced capabilities
  • Use the budget crunch as an opportunity to do
    things differently

Defense and Austerity
  • Most elements of defense policy are likely to
    experience major changes.
  • UK government has suggested defense expenditures
    might be cut between 10 and 25 over the next
    few years
  • France is considering cuts of 2.6-6.6 billion
    over the next three years.
  • Germany Finance Ministry has demanded
    reductions totaling 4.3 billion Euros for the
    period 2011-14.
  • Italy and Span have slashed budgets as have a
    range of smaller EU member states.
  • So far these cuts have not been coordinated on
    the European level which increases the likelihood
    that an overall reduction of European capability
    will be the result
  • In late July 2010 France and Germany were first
    countries to announce coordinated discussions
    about cuts.

Patterns of Military Expenditures
Projected Changes in Defense Budgets 2010-2015
Spending Cuts Hit Foreign Aid
CBO Defense Budget Estimates
Is Health Care the Worst Threat to U.S. National
Implications for U.S. Security
  • One key outcome of the Crisis Lower Growth and
    Higher debt Greater Threat to Security than
    Concerns at Start of Crisis
  • Financial constraints will play a considerable
    role in structuring U.S. policy in the
    foreseeable future
  • When debt levels reach 90 or more of GDP, the
    U.S. may find that its rate of growth slows by 1
    per year (ring of fire diagram)
  • The fiscal squeeze that the U.S. and other
    advanced economies may experience can have the
    ability to crowd out discretionary spending
    defense budgets under considerable stress.
  • As a result the ability for advanced countries
    such as the U.S. to spend increasing shares of
    GDP on defense and security may ---- even to
    respond to threats may be extremely limited.
  • In the longer term the U.S. is likely to find
    that its traditional allies are declining in
    relative economic and military strength.
  • Similarly, the U.S. will find it has to deal more
    and more with countries that it traditionally has
    not had shared common interests

Summing Up
  • Key Points
  • The global economy has been significantly
    affected by the financial crisis
  • Emerging economies will outpace the growth of the
    advanced economies. This disparity in growth has
    only been exacerbated by the financial crisis
  • If commodity prices increase over the next
    several years it would further reduce slow DMs
    and perhaps some EMs
  • Debt will rise and revenues will fall for the
    governments of advanced economies while emerging
    economies will be more fiscally sound
  • U.S. and other DM countries will most likely
    experience a lower rate economic growth than it
    has in the past creating greater fiscal stresses
  • The fiscal stress in the advanced economies may
    significantly reduce defense expenditures and
    other discretionary items.
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