Global Banking, Trade, and the International Transmission of the Great Recession

By Zeno Enders and Alexandra Peter

http://d.repec.org/n?u=RePEc:zbw:vfsc15:113022&r=dge

The global financial crisis of 2007-2009 spread through different channels from its origin in the United States to large parts of the world. In this paper we explore the financial and the trade channels in a unified framework and quantify their relative importance for this transmission. Specifically, we employ a DSGE model of an open economy with an internationally operating banking sector. We investigate the transmission of the crisis via the collapse of export demand and through losses in the value of cross-border asset holdings. Calibrated to German and UK data, the model attributes around half of the observed maximum output decline in Germany to these channels, and 87% for the UK. While the trade channel explains 30% of the empirical output decline in both countries, the financial channel plays a much larger role in the UK than in Germany. The UK’s larger vulnerability to financial shocks is due to higher foreign-asset holdings, which simultaneously serve as an automatic stabilizer in case of plummeting foreign demand. The transmission via the financial channel triggers a much longer-lasting recession relative to the trade channel, resulting in larger cumulated output losses and a prolonged crisis particularly in the UK. Stricter bank capital regulations would have deepened the initial slump while simultaneously speeding up the recovery.

Opening an economy and diversifying internationally an asset portfolio are almost always considered as the best thing to do. One has to keep in mind that this exposes oneself to foreign shocks, and the last recession in Europe is a prime example of that. This paper nicely decomposes the effects and shows how the UK and Germany were differentially hurt. The reaction, however, should not be to close the borders. Indeed, the international diversification also allows to smooth out domestic shocks, and usually more so than foreign shocks hurt. And there is also a positive level effect from diversification.

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