The financial crisis that started in August 2008 has reached a climax in the autumn of 2008 with a wave of bank nationalisations across North America and Europe. Although banking crises are not uncommon, this is the largest since 1929–33. This paper discusses the build-up to the crisis, looking at the role of low real interest rates in stimulating an asset price bubble. That bubble was stocked by financial innovation and increases in lending. New financial products were not stress tested and have failed in the downturn. After discussing the bubbles we look at the collapse of the complex asset structure, and then put the crisis in the context of the literature. The paper concludes with a discussion of policy implications of the crisis, and advocates a significant improvement in the regulatory structure.

The 2007–8 banking crisis in the advanced economies has exposed deficiencies in risk management and prudential regulation approaches that rely too heavily on mechanical, albeit sophisticated, risk management models. These have aggravated private and economic losses. While fiscal costs were at first limited, it remains to be seen to what extent the taxpayer will be protected. Policymakers and bankers need to recognise the limitations of rules-based regulation and restore a more discretionary and holistic approach to risk management.

Recent events have highlighted the importance of asset prices to central bank decisions. We argue that, in response to asset price bubbles, central banks should ‘lean against the wind’ (LATW hereafter). Even if the bubbles themselves are not significantly affected by LATW, macroeconomic performance can be improved if monetary policy reacts to asset price misalignments over and above the reaction to fixed horizon inflation forecasts. In addition, it might reduce the probability of bubbles arising at all. This article restates the case for LATW, and reviews the debate. In particular I respond to various criticisms that have been made against LATW and briefly consider alternative policies designed to make the financial system less cyclical.

One of the features of the sub-prime crisis, that began in August 2007, was its unexpected nature. It came as a surprise not only to most financial market participants but also in some degree to the policy community. In this context, we seek to assess whether early warning systems based on the logit and binomial tree approaches on the UK and US economies could have helped to warn about the crisis. We also consider a ‘check list approach’ of indicators based on history. Although not all of the complementary approaches are successful, we contend that our work suggests that a broadening of approaches to macroprudential analysis is appropriate.

The current financial crisis has raised queries about the adequacy of the present regulatory regime. Whilst the immediate priority may be to plug the obvious holes in the system, there are some long-term generic problems with almost any system of financial regulation. This paper explores one such concern, i.e. the boundary problem. This arises because effective regulation, one that actually bites, is likely to penalise those within the regulated sector, relative to those just outside, causing substitution flows towards the unregulated. This boundary problem impacts on many proposals, such as ‘narrow banking’ and my own, with Avinash Persaud, for state and time-varying capital adequacy requirements. The question of how and where to set the boundary is considered. Such boundaries will always be criticised as leading to disintermediation, competitive inequality (no level-playing-field), inefficiency and higher spreads and borrowing rates; and such criticisms will be valid up to a point. The paper ends by discussing how best to respond.

The paper discusses the effects on growth of a systemic banking crisis as a result of debt defaults. These effects will come from the impact of credit rationing on consumption and credit and from the impacts of a significant rise in the spread between lending and borrowing rates for both producers and consumers. The analysis uses the dynamic stochastic general equilibrium version of the National Institute global model. The paper also investigates the impact on output of a permanent, regulation induced, rise in margins in the financial sector, taking into account the impacts of regulation on equity market valuations.

The Government, when it came to power in 1997, adopted a monetary and fiscal policy framework which was intended to deliver low and stable inflation, high and stable economic growth and fiscal balance as a basis for fairness between generations. It is abundantly clear from the chaos of the past few weeks that the policy has failed. Given that the policy goals are unlikely to be criticised, the question addressed here is which parts of the policy need replacing or augmenting.

Over the past few weeks, the global financial system has appeared on the brink of collapse, as mounting bank losses and a lack of banking liquidity have resulted in a wave of collapsing financial institutions across Europe and the US. While the immediate threat to the financial system appears to have been averted, the continuing deleveraging process, declining asset prices and heightened uncertainty regarding the viability of financial institutions have sharply reduced the willingness and ability of banks to lend to each other and to other borrowers, and at the same time reduced the willingness of borrowers to increase their levels of debt. As the events of recent weeks have unfolded, it has become increasingly clear that the fallout from the financial market crisis will continue to restrict bank lending severely for at least the next several months, pushing the world's major economies into recession. As a consequence, growth in the OECD economies next year is projected to be the weakest since 1982, with output forecast to rise by just 0.4 per cent.

The US dollar has strengthened in recent months against most major currencies, with the exception of the yen. It has also gained strength against emerging market currencies, and the US effective exchange rate has appreciated by just over 7 per cent in the past three months. Emerging market declines have been exacerbated in recent weeks by the turbulence on financial markets that has forced stock markets to interrupt trading on several occasions. Figure 13 shows effective exchange rates for the US, Canada, Mexico and Brazil. Central banks in Mexico and Brazil have intervened in currency markets in recent weeks to stem the decline of their currencies, which have dropped against the dollar by nearly 20 per cent in the case of Mexico and 40 per cent in Brazil since the beginning of September. If stock market trading stabilises, much of these losses should prove temporary. Our forecast assumes that a depreciation of 10 per cent in effective terms in the Brazilian real and 5 per cent in the Mexican peso is sustained. While this raises the inflationary outlook for these economies, gains in competitiveness will help moderate the impact of the global recession on Latin American economies. However, a more sustained depreciation will put the banking systems in these countries at risk as it becomes increasingly difficult to service debt in foreign currency.

We are forecasting what might be called a global recession in 2009, since this is commonly defined as world growth (calculated at purchasing power parity weights) of less than 3 per cent per annum. However, relative to previous global downturns, a global expansion of 2.8 per cent in 2009 appears mild compared to growth of just 2.2 per cent in 2001, 1.5 per cent in 1991 and 0.9 per cent in 1982. The global figures are somewhat distorted by the increasing importance of the fast growing economies of China and India in the world aggregate. In 1982, these two economies accounted for just 4.6 per cent of world output, while this weight rose to 6.7 per cent in 1991, 11.4 per cent in 2001 and is expected to be about 17 per cent in 2009. Indeed, as we can see from figure 16, in our current forecast we expect China to become the world's largest economy in 2020, overtaking the US in size, measured in purchasing power parity terms. Excluding China and India, the world is expected to grow by just 1.7 per cent next year, as it did in the recession of 2001.

This year should see a sharp downturn in the Euro Area's economic growth. After peaking at 2.6 per cent in 2007, real GDP growth is projected to slow down to around 1¼ per cent this year and fall to about ¼ per cent in 2009. We expect GDP growth in the Euro Area to remain just below 1 per cent in 2010, before returning to trend in the medium term. In 2008 the Euro Area is forecast to experience two consecutive quarters of falling output, due to declining external demand and the severe disruption of the banking sector and financial markets. Although the worst of the crisis appears to be over following concerted intervention by European governments (See Box A), the Euro Area is likely to go through a period of sustained economic weakness in the short run.

The production of this forecast is supported by the Institute's Corporate Members: Abbey plc, Bank of England, Barclays Bank plc, HM Treasury, Nomura Research Institute Europe Ltd, and the Office for National Statistics.