Question and Answer: Evaluating Demand-Side Reactions

Volume 35, Number 1, September 2017

Answers

Question and answer: Evaluating demand-side reactions

Stuart Luker

This resource provides context to the question set in the column on demand-side policy responses to the global financial crisis of 2008, on pp. 22–5 of the September 2017 issue of Economic Review.

What was the global financial crisis?

This is not a simple question to answer. The immediate trigger for the crisis is generally accepted to be the collapse of the sub-prime mortgage market in the USA, but the roots of the crisis go much deeper than that. Explanations include:

• the deregulation of financial markets that began in the 1980s
• financial innovation that resulted in overly complex financial instruments
• speculation and excessive risk-taking after a long period of relative economic stability, known as the Great Moderation
• the growth of large, diversified banks, some of which were judged ‘too big to fail’
• irresponsible banking practices accompanied by inadequate capital and liquidity
• too-lax monetary policy leading to unsustainable levels of debt
• globalisation and the interconnectedness of financial markets, which meant that problems in one part of the world spread around the globe

And, these are just some of the causes that have been identified.

The crisis led to the collapse of some major banks, e.g. Northern Rock and RBS in the UK, and Lehman Brothers in the USA, and a severe restriction in the supply of credit to other economic agents, including households and firms. In the short run at least, interest rates also rose markedly. Unprecedented intervention by central banks and governments was required to prevent a complete breakdown of the global financial system.

Wall Street and ‘Main Street’

Major problems in financial markets are almost certain to have significant effects on the real economy. In the USA, this was known as ‘Wall Street affecting Main Street’. Expansionary demand-side policies are an important way in which the authorities can try to offset the unavoidable impact of a financial crisis on ‘Main Street’.

Why do problems in financial markets affect the real economy?

When a bank fails, it is possible that depositors will lose their money, although, in recent times, many governments have guaranteed that most people will not lose their deposits. In the UK, at the time of writing, deposits up to £85,000 are protected. However, large depositors and other investors, including shareholders, will probably lose out. There is likely to be a negative wealth effect, which reduces aggregate demand.

A financial crisis leads to credit drying up and the cost of credit — the rate of interest — increasing. A modern economy runs on credit — a credit crunch is invariably accompanied by business failures, falling investment and a reduction in spending by households.

Problems in financial markets also dent confidence and lead economic agents to speculate that a recession is coming. As discussed in the article by Paul Rapley on pp. 2–4 in Economic Review Vol. 35, No. 1, animal spirits and herding behaviour have a powerful influence on the economy — expectations can become self-fulfilling. Again, firms shelve investment projects and households rein in spending, fearing that incomes may fall. The fall in confidence and speculation is also likely to affect asset prices, share prices fall and property prices may take a hit.

The net effect is a sizeable fall in aggregate demand, which is magnified by downward multiplier and accelerator effects. At best, economic growth slows and if the financial crisis is severe and prolonged, a period of negative growth and rapidly rising unemployment will follow. After the 2008 global financial crisis, these effects were experienced by many countries.

What has happened to the real economy in the UK?

Between the first quarter of 2008 and the second quarter of 2009, real GDP in the UK fell by over 6%. From then until 2013, growth in the UK was erratic and slow. Real GDP didn’t recover to reach its previous peak until the third quarter of 2013. By the end of 2016, real GDP in the UK was 8.6% above its value in the first quarter of 2008, but real GDP per head was only 1.8% higher. Although the UK economy has grown steadily since the first quarter of 2013, the overall pace of the recovery since the global financial crisis has been slow by historical standards. The latest estimates of the annual growth rate for the last 4 years are as follows:

2013 / 2.0%
2014 / 3.0%
2015 / 2.2%
2016 / 1.8%

At the start of 2008, unemployment in the UK was 5.2%, as measured by the Labour Force Survey, it peaked at 8.5% in 2011 but by the beginning of 2017 it had fallen to 4.7%. The last time the unemployment rate was below 4.7% was in the mid-1970s.

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