Monday, December 9, 2013

Why did the panic of 2008 spread abroad?

Why did the Great Recession spread outside the United States? In particular, why did almost all Western industrial countries enter a deep and pronounced recession together? The failure of Lehman Brothers sent ripples throughout international financial markets, plus European banks were heavily involved in the US subprime mortgage market. Yet, financial and goods markets are not perfectly integrated and this should not have lead to such perfectly coordinated business cycles.

Philippe Bacchetta and Eric van Wincoop show that you do not need complete market integration to get there, only partial. All you need is that market integration be sufficiently high. In addition, tight credit, very low interest rates and inactive fiscal policy "help" tremendously with creating a panic, and we certainly were in such a situation at the time. And this panic is what makes it different from "normal" recessions, where synchronization is not perfect. The model hinges on the fact that there are possibly multiple equilibria and a global panic is the optimal coordination on a bad one. Crucial to the model are a couple of rather strange assumptions, though: prices are preset while wages are fully flexible, I would have thought wages to be less flexible than prices; and there are two periods in the model, meaning that the panic state must be permanent. As a consequence, am not quite sure what to make of this paper.

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