Evaluating Policy Reactions to the Financial Crisis

Extract

The current financial crisis has evolved slowly over the past eighteen months, and policy reactions have responded to events. In August 2007 it became clear that a number of banks had lost some of their capital base as a result of defaults on home loans in the US. The impacts of these defaults had been spread across the Atlantic as they were contained within bundles of assets that had been constructed into securities and sold to European banks. By the autumn of 2007 it was clear that there was a strong risk of a banking crisis, as discussed by Barrell and Holland (2007) in the October 2007 Review. We considered that this was a risk, but that the costs were so obviously large that policymakers would strive to avoid it, and hence it was not our main scenario. We were wrong on both counts, and a crisis at least as large as that we discussed emerged after the US authorities let Lehman Brothers fail in September 2008. We argued that a crisis would lead to a reduction in growth of a cumulated 3 per cent in the US and a cumulated loss of about 2 ½ per cent in the UK and the Euro Area. If a crisis burst, we expected US interest rates to reach zero in 2009 with deflation toward the end of the year.