GREAT RECESSION: how was the financial crisis of 2007-09 transmitted?

The trade channel was twice as important as the financial channel in the transmission of the financial crisis of 2007-2009 from the US to Germany, while to the UK, with its large and internationally connected financial sector, the proportions were the opposite: the financial channel dominated the trade channel.

These are the findings of new research by Zeno Enders and Alexandra Born, published in the October 2019 issue of The Economic Journal, which uses a model to study how the financial crisis of 2007-09 spread from the US to the rest of the world.

The global financial crisis differed from earlier crises as it spread rapidly from a small segment of the US financial market to other sectors and countries. Within a short period of time, it was transmitted internationally and dragged down national income in previously healthy economies, such as the UK and Germany, the subjects of this study.

How this transmission took place differed considerably among countries. After decades of rising financial globalisation, the international banking system took centre stage in the international transmission of the crisis. Though this notion of a finance-transmitted crisis is commonplace, the exact contribution of the international `financial channel´ (as opposed to the more traditional transmission channel of trade) to the observed recessions in infected countries remains unclear.

To study the contributions of these channels to the transmission of the crisis, the authors developed a theoretical model – a mathematical representation of the main characteristics – of a typical country on the receiving side of the international transmission of a crisis. They fit their model to the UK and the German economies. Given that the model features the trade and the financial channels in detail, they were able to investigate the relative contribution of each channel by turning on each channel separately.

In reality, of course, both channels were active simultaneously. By separating the two channels, the authors were able to study the channels individually and obtain clearer results. They also discovered that the financial channel has had much longer-lasting negative consequences for GDP in both countries, even though on impact the trade channel had a more severe effect for Germany (the financial crisis is thus crucial in accounting for the fact that German output in the last quarter of 2010 was still below its level two years before, and even more so in the UK).

In addition, the development of the model allows the authors to conduct counterfactual simulations. In these simulations, they investigate the effects of stricter banking regulation in the form of either higher costs for violating the capital requirement or introducing a higher capital requirement.

The former policy appeared to frontload the recession, meaning the GDP drop would have been simultaneously deeper and shorter. The same is true for higher capital requirements, if banks leave the size of their balance sheets unchanged. With required bank capital twice the size of its historical value, the initial GDP drop due to the combined trade and financial channels would have been around a quarter percentage point larger, but the pre-crisis level of GDP would have been reached half a year earlier in both countries. If banks react to higher capital requirements by shrinking the balance sheet, the recession would have been shorter and flatter. The GDP reduction would have been around a quarter percentage point lower on impact, but from a 1.7% lower level of GDP that would prevail in normal times.

Global Banking, Trade, and the International Transmission of the Great Recession by Zeno Enders and Alexandra Born is published in the October 2019 issue of The Economic Journal.

Zeno Enders

Professor of Economics at Heidelberg University

Alexandra Born

Financial Stability Expert at European Central Bank