The Real Effects of the 2007-08 Financial Crisis

• Author: Hui Tong
• Pages: 1-5

Page 1

The financial crisis that started with problems in the U.S. subprime mortgage market in early 2007 extended to financial institutions and money markets in the summer of 2007, to corporate credit markets at the end of 2007, and eventually to other countries in the fall of 2008. The effects of the crisis on real activity had appeared to be limited at first, but this did not last. Gradual declines in housing and equity prices started to take their toll in the second half of 2007. In the fall of 2008, the effect suddenly became much more pronounced. The worry that the crisis might lead to another episode like the GreatPage 4 Depression led to sharp declines in equity markets along with deterioration in consumer and business confi dence around the world (Blanchard, 2008).

Recent research at the IMF has studied how the financial crisis affects the real economy considering various angles: the general mechanisms through which financial crisis spillovers to the real economy; empirical evidence about the existence of credit constraints; the unique features of the current episode; and global spillovers through real and financial channels.

A financial crisis affects the balance sheets of financial institutions, corporates, and households, and thereby infl uences the availability of credit, and thus the performance of the real economy. Claessens, Kose, and Terrones (2008) study the linkages between macroeconomic and financial variables around business and financial cycles in a large set of Organization for Economic Cooperation and Development countries from 1960-2007. In particular, they consider the implications of recessions when they coincide with financial market diffi culties, including credit crunches, house price busts, and equity price busts.

They find that interactions between macroeconomic and financial variables play major roles in determining the severity of recessions. While most macroeconomic and financial variables exhibit procyclical behavior during recessions, recessions often coincide with episodes of contractions in domestic credit and declines in asset prices.

The authors report that recessions associated with credit crunches and house price busts tend to be deeper and longer than other recessions. These findings suggest that the strength of linkages between the financial sector and the real economy can aggravate output losses during recessions.

Hence, recessions following the current crisis are expected to be more costly than other...