The Crisis Basic Mechanism

The Crisis: Basic Mechanisms, and
Appropriate Policies
Olivier Blanchard
WP/09/80

© 2009 International Monetary Fund WP/09/80
IMF Working Paper
Research Department
The Crisis: Basic Mechanisms, and Appropriate Policies1
Prepared by Olivier Blanchard2
Authorized for distribution by Olivier Blanchard
April 2009
Abstract
This Working Paper should not be reported as representing theviews of the IMF.
The views expressed in this Working Paper are those of the author(s) and do not necessarily represent
those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are
published to elicit comments and to further debate.
The purpose of this lecture is to look beyond the complex events that characterize the global
financial and economiccrisis, identify the basic mechanisms, and infer the policies needed to
resolve the current crisis, as well as the policies needed to reduce the probability of similar
events in the future.
JEL Classification Numbers: E32, E44
Keywords: Financial Crisis, Credit, Liquidity, Spending, Leverage
Author’s E-Mail Address: oblanchard@imf.org
1 “Munich lecture,” delivered on Nov. 18, 2008. Ithank Stijn Claessens, Giovanni Dell’Ariccia, Gianni de
Nicolo, Hamid Faruqee, Luc Laeven, Krishna Srinivasan, and many others in the IMF Research Department for
discussions and help. I thank Ricardo Caballero, Charles Calomiris, Steve Cecchetti , Francesco Giavazzi, Anil
Kashyap, Arvind Krishnamurthy, Andrei Shleifer, and Nancy Zimmerman, for discussions along the way. I
thank IoannisTokatlidis for research assistance.
2 MIT, NBER, and IMF.
2
CONTENTS PAGE
I. Introduction ............................................................................................................................3
II. Initial Conditions...................................................................................................................5
III. AmplificationMechanisms..................................................................................................9
IV. Dynamics in Real Time .....................................................................................................11
V. Policies for the Short Run ...................................................................................................16
VI. Policies to Avoid aRepeat.................................................................................................20
VII. Conclusions ......................................................................................................................21
Figures
Figure 1. Initial Subprime Losses and Declines in World GDP and World
Stock Market Capitalization.......................................................................................3
Figure 2. A Visual Sense of the Complexity: From Mortgages to Securities............................6
Figure 3. Connectedness Across Countries: Advanced Economies Banks’
Claims on the Rest of the World.................................................................................8
Figure 4. Contagion Across Assets, Institutions, andCountries..............................................12
Figure 5. Counterparty Risk in the Advanced Economies.......................................................12
Figure 6. Bank Lending Standards in the U.S. and the Euro Area ..........................................13
Figure 7. Emerging Market Sovereign Spreads.......................................................................14
Figure 8a. Decrease inStock Prices.........................................................................................15
Figure 8b. Decrease in Business and Consumer Confidence ..................................................15
Figure 9. Growth Forecasts for 2009. ......................................................................................16
Figure 10. Counterparty Risk Since September...