Five years after the 2008 financial crisis, the global economy is finally beginning to behave in a more normal fashion. What did we learn from this painful experience? We learned that timely and co-ordinated policy intervention can make a huge contribution to economic recovery; but the agenda for lasting policy reform is far from finished.
The global financial system was pitched into crisis beginning Sept. 15, 2008, with the bankruptcy of the Wall Street investment banking firm Lehman Brothers. Fear rippled through financial institutions around the global and quickly spilled into the real economy. Financial markets essentially shut down, equity prices and private investment collapsed, and most industrial countries were dragged into recession. It took the combined efforts of central banks, treasuries and legislatures to stop the financial bleeding and restore confidence in financial and other markets.
On the five-year anniversary of the crisis, four lessons can be drawn from this experience.
Lesson one: Targeted and timely fiscal and monetary policy intervention can shore up consumer demand, re-build private sector confidence that is critical to investment and kick-start economic growth. The financial crisis quickly had a serious impact on the economy – deep cuts to GDP, private investment and jobs. In response, the Bank of Canada slashed short-term interest rates and intervened in specific financial market segments. Canadian governments introduced active fiscal stimulus through targeted tax relief and added spending on infrastructure and other programs that could be quickly implemented. It worked – Canadian growth was restored by mid-2009.
Lesson two: Co-ordinated action among the major countries is needed to deal with a global financial and economic crisis. Beginning in early October, 2008, a series of co-ordinated discussions and actions took place among major industrial countries. For the first time, key emerging markets like China, India and Brazil were also brought into the discussion. The IMF recommended countries immediately inject fiscal stimulus of 2 per cent of GDP. Central banks co-ordinated their efforts to inject liquidity. Again, the plan worked; most affected countries had clawed their way back to growth by late 2009.
Lesson three: The financial sector requires exceptional regulatory oversight – since a well-functioning financial system is critical to the performance of every other sector in the economy. The crisis was precipitated by a housing bubble in the U.S. and parts of Europe that was allowed to grow and then burst. The pain was spread globally through financial innovation like mortgage-backed securities, enabled by regulation that did not keep pace with the evolution of the financial sector over the previous decade and was neither effective nor efficient. Some progress has been made in developing more effective global regulation of the financial sector – but the process is unfinished and the application of that regulation remains very inconsistent.
Lesson four: When firms are “too big to fail”, they can threaten the entire economic system. This was a key reason why certain major banks and auto companies were bailed out by governments in 2008-09. Unfortunately, there has been little subsequent action to reduce what economists call “systemic risk” by addressing the overall size of firms. So, a major bank or auto company that fails today would still likely end up being bailed out by government.
In 2008, we learned how to respond to a crisis – apply selective monetary and fiscal stimulus when required, and organize a globally co-ordinated effort. However, the lessons have not been learned when it comes to preventing a crisis. Five years after the 2008 financial crisis, the world economy is in much better shape, but it remains exposed to key risk factors – regulation of the financial sector globally and very large firms in financial trouble. Here, more serious policy action is still required.
Glen Hodgson is senior vice-president and chief economist at The Conference Board of Canada.