A Tour of The World:From Great Expectations to the Economic

Downturn

Based on • Olivier BlanchardMacroeconomics, 5/e Prentice Hall •

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The United States

Figure 1 - 1

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1-1 The United States

Table 1-1 Growth, Unemployment, and Inflation in the United States Since 1970

1970–2006

(average)

1996–2006

(average) 2006 2007 2008

Output growth rate 3.1% 3.4% 3.3% 2.1% 2.5%

Unemployment rate 6.2 5.0 4.6 4.6 4.8

Inflation rate 4.0 2.0 2.9 2.6 2.2

Output growth rate: annual rate of growth of output (GDP). Unemployment rate: average over the year. Inflation rate: annual rate of change of the price level (GDP deflator).

The period 1996-2006 was one of the best decades in recent memory:

The average rate of growth was 3.4% per year.

The average unemployment rate was 5.0%.

The average inflation rate was 2.0%.

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The average rate of growth of output per hour appears to have increased again since the mid-1990s.

1-1 The United States before 2007

Rate of Growth of Output per Hour in the United States Since 1960.

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1-1 The United States

The U.S. Trade Deficit?

The trade deficit increased from about 1% of output in 1990 to about 6% of output in 2006.

The U.S.Trade Deficit Since 1990

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1-2 The European Union

The European Union

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Table 1-2 Growth, Unemployment, and Inflation in the Five Major European Countries Since 1970

1970–2006

(average)

1996–2006

(average) 2006 2007 2008

Output growth rate 2.3% 2.0% 2.7% 2.6% 2.2%

Unemployment rate 7.4 8.7 7.6 7.0 6.7

Inflation rate 5.4 1.8 1.7 1.8 2.2

Output growth rate: annual rate of growth of output (GDP). Unemployment rate: average over the year. Inflation rate: annual rate of change of the price level (GDP deflator).

1-2 The European Union

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The economic performance of the five countries in Table 1-2 has been far less impressive than that of the United States over the same period:

Average annual output growth from 1996 to 2006 was only 2.0%.

Low-output growth was accompanied by persistently high unemployment.

The only good news was about inflation. Average annual inflation for these countries was 1.8%, much lower than the 5.4% average over the period 1970 to 2006.

1-2 The European Union

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1-2 The European Union

The unemployment rate in the four largest continental European countries has gone from being much lower than the U.S. unemployment rate to being much higher.

Unemployment Rates: Continental Europe Versus the United States Since 1970

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There is still disagreement about the causes of high European unemployment:

Politicians often blame macroeconomic policy.

Most economists believe, however, that the source of the problem is labor market institutions.

Some economists point to what they call labor market rigidities.

Other economists point to the fact that unemployment is not high everywhere in Europe.

1-2 The European Union

How Can European Unemployment Be Reduced?

1-3 China

China

Figure 1 - 6

Since 1980, Chinese output has grown at close to 10% per year, and the forecasts were for more of the same.

This is a truly astonishing number: Compare it to the 3.1% number achieved by the U.S. economy over the same period. At that rate, output doubles every 7 years.

Table 1-3 Growth and Inflation in China Since 1980

1980–2006 1996–2006 2006 2007 2008

Output growth rate 9.3% 8.8% 10.7% 10.0% 9.5%

Inflation rate 5.4 3.3 1.5 2.5 2.2

Output growth rate: annual rate of growth of output (GDP). Inflation rate: annual rate of change of the price level (GDP deflator).

1-3 China

4. All this have changed in 2007

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World GDP Growth

Advanced economies Emerging and developing economies World

World growth is projected to fall to ½ percent in 2009, its lowest rate since World War II. Despite wide-ranging policy actions, financial strains remain acute, pulling down the real economy.

Inflation is not an issue

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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Inflation

World Advanced economies Emerging and developing economies

Sluggish real activity and lower commodity prices have dampened inflation pressures . In the advanced economies, headline inflation is expected to decline from 3½ percent in 2008 to a record low ¼ percent in 2009, Moreover, some advanced economies are expected to experience a period of very low (or even negative) consumer price increases. In emerging and developing economies, inflation is also expected to subside to 5¾ percent in 2009 and 5 percent in 2010, down from 9½ percent in 2008.

Global monetary and fiscal policies are providing substantial support.

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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

General Governement Fiscal Balances (Percent of GDP)

Advanced economies Emerging and developing economies World

Central banks in the advanced economies have taken strong actions to cut policy rates and improve credit provision..To combat the downturn, many governments have announced fiscal packages to boost their economies. Deficits are also expected to be boosted by the operation of automatic stabilizers and the impact on revenues of sharp asset price declines, as well as the costs of financial sector rescues.

How we got here?

Let us see the sequence of events in the American Economy:

FROM ONE MARKET TO THE OTHER.

1. Housing Boom Burst (mid 2007).

2. Investment banks caught holding toxic assets bought with lots of borrowed money.

3. Generalized uncertainty, confidence at its lowest point. Recession in the real economy.

VICIOUS CIRCLES AND FROM AMERICA TO THE WORLD ECONOMY

The Housing Market Bubble

The dream of a homeowners society (NINJA MORTGAGES).

Interest rates: too low for too long.

An era of hyper confidence and big expectations.

GOLDEN AGE OF FINANCE

Financial innovation: Mortgages packed in CDO (Subprime USA) High leveraged baank balance sheets.

Limited regulation (Assets/Liabilities; short term funding)

Great business while it lasted

The Financial turndown

Excess vulnerability due to toxic assets holding and short term funding.

Most financial transactions occur in the shadow.

No transparency in the bank system. Sistemic Risk and great uncertainty: THE CREDIT CRUNCH

Slow moving crisis (a soap opera) but in essence the entire collapsing of the shadow financial system.

The Road to depression

Uncertainty over the future leads to high savings and the postponement of consumption decisions.

Reduced demand translates into excess supply and unemployment.

Fiscal effort today increases risk of a long recession.

Recession increases financial crises, reinforces the credit crunch and creates a vicious circle.

The Road Ahead:

How to bring the financial system back to health?.

How to smooth the depression and restore market confidence?

What role for the financial and monetary policy?

What role for fiscal policy?