Severity of the Current Financial Crisis

Banking and financial crises have been a regular feature of modern economic history. According to one estimate, there have been 86 banking crises since the Great Depression that have spread beyond national borders. According to a World Bank study in 2001,² the world has witnessed as many as 112 systemic banking crises from the late 1970s to early 2001. Most crises, including the current one, share some common features. Some general examples include a search for increasingly higher yields in financial markets, a lax regulatory regime, a mismatch in appetite for risk and the capacity for bearing it, and the consequent build up of asset bubbles, usually in the real estate sector, which for various reasons is overlooked by the regulators. The recent financial sector crisis shares most, if not all, of these features. However, what makes the current crisis exceptional is that it emerged at the very epicentre of global capitalism, the US, and its contagion spread very quickly to the entire global economy, unlike previous crises that were usually confined to a region or a small number of countries. Economies like India and the People's Republic of China (PRC), where the financial sectors were not as integrated with the global financial system, were spared the first round adverse effects of the current crisis and their banks were left mostly unaffected. However, these giant economies and their Asian neighbors could not escape the second round effects that severely impacted their trade flows due to the collapse of output and trade in advanced economies.

The severity of the current crisis can be gauged by the steep decline in the equity markets of advanced economies. The bursting of the sub-prime housing bubble caused Wall Street to lose a staggering US$8 trillion in market capitalization in a very short time (Brunnermier 2009). Interestingly, the loss in market capitalization and crash in equity prices has been significantly higher in periphery economies as compared to US markets (Table 1 [ PDF 49.5KB | 1 page ]). According to Eichengreen and O'Rourke (2009) global stock markets fell faster during the current crisis than in 1929.

The financial crisis soon morphed in to a full-fledged global economic downturn as credits markets froze, aggregate demand in all advanced economies fell, and commodity prices crashed, forcing exporters to shelve expenditure and lay off workers in large numbers. Consequently, industrial production collapsed worldwide. In the last quarter of the calendar year 2008, advanced economies and large economies like India and the PRC witnessed a contraction in their industrial production. In some of the major export-oriented countries like Japan, Germany, and Brazil, industrial output contracted more than 10% during the third and fourth quarters of fiscal year (FY) 2008. The decline in industrial output made labor retrenchment and surging unemployment almost inevitable. According to the International Labour Organisation's (2009) Global Employment Trends Report more than 50 million people are expected to lose their jobs due to the crisis.

The severity and suddenness of the crisis can also be judged from the IMF's forecast for the global economy. During the last 10 months (July 2008 to April 2009), the IMF revised its forecasts four times, all in the negative direction. In July 2008, it projected a growth rate of 3.9% for the world economy for 2009. However, this figure was reduced to 2.2% in November 2008 and further to 0.5% in January 2009. Finally in April 2009, for the first time in 60 years, the IMF predicted a global recession with negative growth of 1.3% for world GDP in 2009. Comparisons with the Japanese experience since the bursting of its own real estate bubble in the late 1980s and the consequent stagnation over the 1990s have been drawn to suggest a possible long period of weak economic activity in advanced economies. Initially the IMF projected a positive growth rate of 1.8% for 2010 indicating a somewhat weak V-shape recovery. But by July 2009 this had changed and the possible recovery in 2010 was forecast to be much stronger. Because the recession in developed countries is expected to continue, developing countries are anticipated to lead the global turnaround.

Table 2: IMF Growth Projections [ PDF 74.3KB | 1 page ]

The fear is that the rather grim economic outlook, as reflected in the IMF forecasts, may induce many countries to turn to protectionism to ensure sufficient demand for their domestic industry and prevent a further rise in unemployment. In a recent study, Gamberoni and Newfarmer (2009) found that since the onset of the current global crisis, 17 of the 23 members of the informal G-20 grouping that met at the Washington Summit in November 2008 have invoked protectionism in one form or another despite agreeing to not take any new protectionist measures. This is indeed worrisome because it will further exacerbate the decline in global trade, which already has seen a historical collapse since the crisis began in October 2008. Given the sharp export contraction in the world's major exporting economies like Germany, Japan, and the PRC,³ the growth rate of global trade fell from 6% in 2007 to 2% in 2008 (Figure 1 [ PDF 81.9KB | 1 page ]). Furthermore, according to the World Trade Organization (WTO), world trade is expected decline by as much as 9% in FY2009–2010, which would make it the biggest contraction in global trade since World War II.

Essentially, the current crisis is truly global in nature and could be referred to as the worst crisis since the Great Depression. Fortunately, in sharp contrast to the experience during the Great Depression, the severity of the crisis was recognized early on and, even more important, governments in both advanced and emerging economies have coordinated their policy responses. Governments across the globe have announced various fiscal stimulus packages and huge amounts of liquidity have been injected into the system by central banks. Some countries like South Africa and the PRC have announced mega-stimulus packages that account for around 24.0% and 8% of their respective GDPs.⁴ In absolute terms, the US has announced a bailout-cum-stimulus package of worth US$8.1 trillion. As shown in Table 3 [ PDF 50.1KB | 1 page ], if we add up the stimulus packages of nine selected countries,⁵ the combined total comes to around US$10 trillion, which is roughly 20% of total world GDP. Given these initiatives, it is expected that the global economy will soon turn the corner and the recession will not be as prolonged as it was in 1929.

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