Cracks in the System

• Author: Olivier Blanchard
• Position: Economic Counsellor and Chief Economist of the IMF
• Pages: 8-10

Repairing the damaged global economy

Page 8

The global economy is facing its worst crisis in 60 years. In the first half of the 2000s, a benign environment led investors, firms, and consumers to expect a permanently bright future and to underestimate risk. housing and other asset prices shot up, risky assets were created and sold as being nearly riskless, and leverage increased. So when housing prices turned around, and subprime mortgages and the securities based on them turned sour, the stage was set for the crisis. In the context of rapid global integration and deep and complex interconnections between financial institutions, the crisis quickly moved across assets, markets, and economies. The rest is history, or, more precisely, history in the making.

Looking at where we are today, the good news, if any, is that we have probably stepped back from the brink of financial catastrophe. In October, faced with what looked like an imminent implosion of the financial system, major advanced economies announced a coherent set of measures to deal with the problem.

In addition to continuing the provision of liquidity, governments initiated programs to buy bad assets, recapitalize financial institutions, and provide comprehensive guarantees.

To be sure, these are extremely complex measures to implement, and implementation has been far from perfect, with governments feeling their way through the right combination of measures as they go along. The message from the financial markets at this point is that progress has been made, but it is much too early to declare victory. Indeed, while the financial crisis has moderated somewhat in advanced economies, it has increasingly engulfed emerging economies. Through no fault of their own, many countries are facing sudden stops, pressure on the exchange rate, and the danger of financial disruptions.

The bad news, however, is that, as policymakers in advanced economies were adopting appropriate measures on the financial front, the financial crisis began to have a sharper and deeper impact on the real economy.

Deleveraging by financial institutions has now translated into more expensive credit for households and firms, and difficulties in financing even normal business operations.

And, more importantly (at least in terms of its quantitative effects), consumers and firms across the globe have lost confidence. Fears of a long and deep recession, similar to the experience of the 1930s, have triggered worries about job security, savings, and credit.

As a result, consumer spending has slumped, business...