5 - The financial crisis of 2007/08

Summary

In understanding how to deal with the financial crisis and how to analyse it, there inevitably is a challenge in that it obviously has complex financial roots, and indeed, one of the issues that arose was precisely the fact that institutions had signed up to financial contracts that were so complex that they themselves could not understand them fully. This was so true that, when the crisis struck, it was difficult to unravel who it was that was eventually liable to pay for these contracts. This complexity, this alphabet soup of derivatives with credit default swaps or collateralized debt obligations, is too cumbersome to be analysed in detail, and accounts of some of these contracts have been written elsewhere, Skidelsky (2018) being one such example but there also are two chapters in Carlin and Soskice (2014) dealing with these details. What is going to be covered here is instead the challenges that the financial crisis posed in terms of macroeconomic policy choices in the first instance, and macroeconomic modelling in the second instance. One of the points that will be returned to at several stages is the extent to which financial considerations had been assumed away as largely irrelevant in most of the models that preceded the financial crisis. The question of finance basically was left as a black box that did not matter much, as largely confined with its own selfreferential dealings, but as far as the macroeconomic modelling was concerned, it was not a primary concern. That obviously became patently false and a major drawback of all models once the crisis struck.

Obviously, the policy challenges also need to be examined once a suitable model to analyse them is put together. But one of these challenges can be looked at without any changes to the existing model, and it is the problem of deflation. The first question to be looked at is, why is it that deflation is such a problem? The second one, related to it, is the fact that there is a zero lower bound to the level of the (nominal) interest rate that central banks can set.

Two further questions will need addressing later on in the chapter: how can the mechanics of the banking sector not be ignored? How can the unconventional policies that have been adopted to deal with the crisis in its aftermath be understood?