The Global Roots of the Current Financial Crisis and Its Implications for Regulation

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The Global Roots of the Current Financial Crisis and its Implications for Regulation
Anil Kashyap (University of Chicago) Raghuram Rajan (University of Chicago) Jeremy Stein (Harvard University)

Where did the current financial crisis come from? Who or what is to blame? How will it be resolved? How do we undertake reforms for the future? These are the questions this paper will seek to answer. The analysis will have three parts. The first is a rough and ready sketch of the global roots of this crisis. Second, we will focus in a more detailed way on why it hit the financial sector, especially banks. Finally, we will end with some suggestions for future regulation, especially capital regulation.

I. A Rough Sketch.
It is always useful to start with the macroeconomic environment. In a sense, this is a crisis borne out of previous crises. An important difference between the recent period of sustained growth and previous periods is the low level of long term real interest rates over the last 5 years, certainly relative to the last two decades. Long rates fell following the collapse in investment in both emerging markets and developed countries after the crises in 1998 and the ICT bubble in 2001. Emerging market governments became more circumspect and increased budgetary surpluses, even while cutting back on public investment. For instance, in Philippines, investment fell from 24% of GDP in 1996 to 17% in 2006, while its savings rose from 14% to 20%. From borrowing 10% of its GDP, it now pumps out 2.5 percent as a current account surplus. Moreover, as industrial economies recovered, corporate investment did not pick up, at least not to the extent warranted by the growth. As a result, the worldwide excess of desired savings over actual investment – the so-called savings glut (Bernanke (2005)) -- pushed its way into the main markets that were open to investment,…...

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