As a result, at times, such as during the “Little Panic” of August 2007, as well as the “Great Panic” of September-October 2008, the markets for a whole range of asset-backed securities closed completely and investors sought safety in liquid government assets. These pressures are reflected in the spread between measures of bank funding costs and equivalent maturity government debt (Fig. 13). Even when confidence has appeared to be improving, the markets for asset-backed securities have remained dysfunctional. Amplification and propagation While these incentive distortions and information problems help to explain why the crisis happened, they don’t explain why its impact has been so great. Back in 2007, the US Federal Reserve estimated the unexpected losses associated with the sub-prime mortgage market would be of the order of $ billion 7 . Since then, the IMF have progressively raised their estimate of the write-downs on US-originated assets to $ trillion (see Fig. 14), while their current estimate for write-downs across the United States, Europe and Japan stands at $ trillion. Alongside that we are witnessing a sharp and internationally synchronised slowdown in global growth that will probably turn out to have been the sharpest in the postwar period, together with an unprecedented contraction in world trade (Fig. 15). The shortfall in advanced country GDP, relative to potential, alone is projected by the Fund to reach around $ trillion by 2010. How could this come about?
18 documents some similar results from a recent IMF (2008) exercise, showing that the cumulative output loss in outright recessions, as well as in milder slowdowns, on average tends to be almost twice as much if preceded by a financial crisis. The results of Furceri and Mourougane (2009) suggest, moreover, that part of this output loss is permanent; they find that the typical OECD financial crisis knocks around 2% off potential output, which rises to 4% for deep crises. These findings suggest that financial crises can have a material impact on both the dynamics of the business cycle and on the underlying equilibrium growth path. The literature on the “broad credit channel” and the “financial accelerator” points to an amplifying effect of changes in firms’ financial health on their cost of capital. In particular, when borrowers have less collateral they face a higher external finance premium to compensate lenders for the increased monitoring costs (see e.g. Bernanke, Gertler and Gilchrist, 1999). But the quantitative magnitude of the effect in this type of model is usually relatively modest. And the banks in this class of model are simple or non-existent, and any incentive or information problems relate to the borrower, rather than the financial intermediary. Instead, it seems likely that the adequacy of bank capital and the associated phenomenon of financial sector de-leveraging are likely to play a central role. Capital is essential because it is the means by which intermediaries persuade creditors that they will almost surely get their money back.