Three Lessons from the Financial Crisis
John Makin's September 2009 <em>Economic Outlook</em>

Media inquiries: Véronique Rodman
202.862.4870 (vrodman@aei.org)

FOR IMMEDIATE RELEASE: September 10, 2009

Two years since the U.S. housing bubble burst, and a year after the collapse of Lehman Brothers brought wrenching dislocations to financial markets, AEI scholar John Makin provides, in his latest Economic Outlook, three lessons to be learned from these events to enable a quicker policy response to future crises.

The following are excerpts from John Makin's latest Outlook:

  • Financial crises produce very powerful effects on the real economy

"The immense power of a financial sector disruption--such as the collapse of the housing bubble--to depress the real economy in a way that neither central banks nor financial markets anticipate was illustrated by the events following the September collapse of Lehman Brothers."

"The inability of the Federal Reserve to save Lehman was an indication of the fact that the financial crisis had reached a stage that could not be contained; saving Lehman would not have saved the system. If the Lehman Brothers failure had not triggered the panic phase of the cycle, some other institutional failure would have done so."

"The fourth quarter of 2008 and the first quarter of 2009 were among the most severe quarters of contraction seen in the United States during the postwar period. Both consumers and businesses froze spending. . . . The nonlinear, negative response to the onset of the acute phase of the financial crisis was global. . . . By the first quarter of 2009, the Japanese economy contracted at an extraordinary annual rate . . . Germany contracted at a similar pace. . . . Capital flows to most emerging markets dried up, and growth fell sharply in those markets as well. The sharpness of the contraction was unprecedented and left policymakers scrambling to avoid a full-scale panic."

  • Central banks tend to be slow to react, but possess great power to contain a financial crisis

"A financial crisis causes such a quick and powerful negative shock to the economy, raising the risk of further damage to the financial sector, that an extemporaneous response by the central bank--backed by fiscal authorities of the government--is the only viable option."

"There are additional reasons for the stabilization of investor attitudes that appeared by March 2009, tied largely to actions taken by the Fed. Wisely, the Fed moved aggressively to assure that there were no runs on banks and that no depositors at federally insured institutions lost any money, unlike during the Great Depression."

  • China has become an even bigger global player and can perform an important role in helping to stabilize the global economy and financial markets

"This year may be the first in which China's economy has played a substantial role in determining the path of the global economy. . . . [Chinese policymakers'] response was among the quickest. In November they announced their massive public works program that would, over a period of about two years, be the equivalent of 14 percent of GDP--an extraordinary amount by any measure. . . . The Chinese stimulus program produced immediate results. . . . While there may be concern about bubbles in the Chinese property and equity markets emerging late in the summer of 2009, no one can still doubt the power of Chinese policy measures to boost the economy and financial markets of China, Asia, and the G7 economies."

Makin concludes that "The global economy is at an important juncture. The story of the year to date has been, first, the substantial power flowing from collapsing markets to a collapsing real economy in the fall of 2008 and a reversal of that process in the spring of 2009. With financial markets likely to be playing a smaller role in determining the path of the real economy, it is prudent to consider how the feedback loop may run from the real economy back to financial markets. If growth resumes on a sustainable basis (as the consensus currently believes), financial markets will rise further, thereby providing additional reinforcement to positive growth in the real economy. Conversely, if aggregate demand fails to pick up and the real economy falters, financial markets will have a difficult time sustaining current levels and may even come to pose further downside risks to global economic activity."

Click here for the full text of "Three Lessons from the Financial Crisis."

John Makin is available for interviews and can be contacted at jmakin@aei.org or through Denise Linden at dlinden@caxton.com (212.303.6151). For all other media inquiries, please contact Véronique Rodman at vrodman@aei.org (202.862.4871) or Sara Huneke at sara.huneke@aei.org (202.862.4870).

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