Great Recession

Supplements to this article include an annotated chronology of the main events of the recession; and accounts of the regional impact of the recession.

In their 2010 report, the Economic Advisors to the President referred the recent economic downturn as the Great Recession, suggesting a parallel with the Great Depression of the 1930s. Like the Great Depression - and unlike other recessions - it had a simultaneous impact on most of the world's economies. But in other respects it was unique. There had been no precedent for such extensive damage to the world's financial system, nor for the coordinated measures that were taken to avert what was feared to be its imminent collapse.

Although, according to the generally accepted definition of the term, the recession ended in most countries when economic growth resumed during 2009, its damaging effects upon the major economies are expected to persist beyond 2011, and its ultimate cost may amount to as much as a whole year's ouput of every country in the world.

The Great Recession has prompted a re-examination of beliefs concerning the functioning of markets comparable to that which followed the Great Depression.

Introduction

Explanations of the causes of the recession and accounts of contemporary debates concerning policy responses are available in the articles on the subprime mortgage crisis, the crash of 2008 and the recession of 2009, together with timelines linked to contemporary reports.

Overview

During the 1980s there was a widespread re-appraisal of the regulations that had been introduced in response to the financial instability that developed during the Great Depression. A consensus had already emerged that many regulations were economically harmful, as a result of which programmes of deregulation had been adopted. The reappraisal concluded that the financial regulations of the 1930s had become unnecessary because recently-developed monetary policy could be used to counter any further signs of instability. Ongoing programmes of banking deregulation that had prevented investment banks from engaging in branch banking, insurance or mortgage lending were dropped, and reserve requirements were relaxed or removed.

After the mid-1980s came a twenty-year period that has been termed the great moderation, during which recessions had been less frequent and less severe than in previous periods, and during which there been a great deal of successful financial innovation.

In the United States, that period was characterised by massive capital inflows and the large-scale availability of credit to households, and by 2007 personal savings rates dropped to 2 per cent of disposable income from their previous average of 9 per cent and there was a house price boom that has since been categorised as a bubble. The bursting of that bubble in 2007, and the downgrading by the credit rating agencies of large numbers of internationally-held financial assets created what came to be known as the subprime mortgage crisis, which led, in turn, to the financial crash of 2008 and the failure of several of the world's largest banks. The loss of investors' confidence caused by failure of the Lehman Brothers investment bank in September 2008, resulted in a credit crunch. The resulting fall in spending struck the major economies at a time when they were already suffering from the impact of a supply shock in which a surge in commodity prices was causing households to reduce their spending. Economic forecasters had been expecting a mild downturn: what actually happened was the global slump in ecomomic activity that has come to be known as the Great Recession.

Although the trigger that set the recession off had been the malfunction of a part of the United States housing market, it soon emerged that a more fundamental problem had been the fact that the financial innovations that had been richly rewarding traders in the world's financial markets, had also been threatening their collective survival. The crucial nature of that threat for the stability of the world economy arose from the fact that it had become dependent upon the services of a well-functioning international financial system.

What was generally considered to be the impending collapse of that system was averted towards the end of 2008 by governmental recapitalisation of the world's banks, backed up by guarantees of unlimited financial support. The consensus view among economists was that the combination of monetary and fiscal expansion that was then undertaken by policy-makers was nevertheless necessary to avoid a greatly intensified global recession, possibly on the scale of the Great Depression of the 1930s - although there was a body of opinion at the time that considered a fiscal stimulus to be unnecessary, ineffective and potentially damaging. Before those policy actions could take effect, there were sharp reductions in the levels of activity in most of the world's developed economies, mainly because of the discovery by banks and households that they had been overestimating the value of their assets. That discovery prompted banks to reduce their lending, at first because of doubts about the reliability of the collateral offered by prospective borrowers and later, when those doubts receded, in order to avoid losing the confidence of their depositors by holding proportionately excessive amounts of debt. The practice of debt reduction (known as deleveraging) was also adopted by those households that had acquired historically high levels of indebtedness, many of whom were experiencing unaccustomed falls in the market value of their houses. The effect of deleveraging by banks and by households was, in different ways, to increase the severity of the developing recession.

By the spring of 2009, the recession had involved most of the world's developed and developing economies, and although the world's economic growth had resumed by end of 2009, pre-crisis growth rates were not restored except among emerging and developing economies. Growth among the developed economies was generally held back by the lasting damage that had been done to their financial sectors, and by the expenditure effects of reductions in household debt. Consequently there was continued underutilisation of productive capacity and unemployment continued to rise. Many governments had been forced to borrow money by issuing bonds, to offset the fiscal consequences of their automatic stabilisers, as a result of which there had been major increases in national debt. In late 2009 and early 2010, the bond markets added substantial risk premiums to the interest rates to be paid on the bond issues of several European governments to compensate for fears of default on their repayment.

By the third quarter of 2010 the effects of fiscal stimuluses had peaked in most of the developed economies. Despite the persistence of unused capacity, European governments were generally reluctant to provide further fiscal support for fear of adverse market reactions to the bond issues that would be required. In response to that fear, European governments reduced their public expenditure plans and increased taxation. The Goverment of the United States, on the other hand, intensified its policy of fiscal and monetary expansion. A eurozone crisis developed as financial assistance to the governments of Greece and Ireland failed to reassure bond market investors.

The past month has certainly marked the worst period for the global economy since the grim days of late 2008. Equity markets have endured violent swings as investors have digested the implications of various unsettling developments. Political wrangling over the US debt ceiling led Standard & Poor's, a credit rating agency, to take the unprecedented step of cutting its AAA rating for the US government. Bond markets took this potentially grave news in their stride; trouble elsewhere seems, ironically, to have increased the safe-haven appeal of US Treasuries. The bigger concern is that Washington's political fixation on debt reduction all but precludes further stimulus, increasing the risk that US growth will remain weak. Meanwhile, on the other side of the Atlantic, there is rising alarm about the future of the euro zone, with the debt crisis now threatening to engulf Italy and Spain. The immediate challenge is to adopt convincing policies that will satisfy the market's solvency concerns and prevent government bond yields�the cost of issuing new debt�from rising further. But a long-term solution looks elusive, given euro members' continuing inability to agree on more concerted joint action.

Concerns about US growth and the tremors in the euro zone have substantially raised the risk of a contraction, or at least a stagnation, in global output. Governments have few policy tools to deal with a renewed downturn, compared with the massive fiscal and monetary stimulus they unleashed in 2008-09. Our core forecast does not, for now, envisage another recession, which we would broadly define as two or more quarters of contraction in US and euro zone GDP and overall global growth of 1.5% or less (at market exchange rates). However, we do think that a double-dip is becoming more likely, with at least a 40% chance of one occurring in the next two years. We also now think there is a very high risk�again, at least 40%�of the euro zone breaking up during the same period.

The latest problems are compounding the effects of other shocks to the global economy, including the political turmoil in the Arab world, the earthquake and tsunami in Japan, and rising inflation in many countries. Until recently, we thought that the global economy was in a temporary soft patch that would abate in the second half of this year as oil and other commodity prices eased, as Japan-related disruptions faded and as euro zone authorities came to grips with the debt crisis. -->

Background: the great moderation (1985 - 2007)

Domestic stability

The central problem of depression-prevention [has] been solved, for all practical purposes. Robert E. Lucas, Presidential Address to the American Economic Association, January 10, 2003.

For about twenty years before the onset of the Great Recession, all of the major market economies except Japan's had been experiencing a hitherto unaccustomed stability, following a sudden reduction of their output volatility in the mid-1980s to about a third of its previous level. It was not clear at the time whether the "Great Stability", as it came to be called, should be attributed to luck or to judgement, but the US Federal Reserve's Ben Bernanke has been inclined to attribute it to the adoption of an economic policy , referred to by others in America as the "Greenspan effect" , and Charles Bean (the Deputy Governor of the Bank of England) has described the transition from what had been thought of as the Keynesian use of fiscal policy - through the unsuccessful monetarist attempts to target the money supply, to what he refers to as "the neo-classical synthesis" or as "new Keynesian", under which monetary policy was targetted on the output gap using an empirical relationship such as the Taylor rule.

A general expectation of continued growth persisted until the recession struck: for example the International Monetary Fund's World Economic Outlook of April 2007 forecast that "world growth will continue to be strong".

International volatility

There was a contrasting increase in the volatility of the international financial system - which experienced 139 financial crises during the 24 years from 1973 to 1997, compared with 38 during the previous 26 years . Many of those crises were associated with the development of globalisation and its accompanying large and volatile international capital flows. At first the predominant direction of flow was from the developing countries to the developing countries, but that changed toward the end of the 20th century with the development of very large global imbalances . The oil-exporting countries as well as Japan, China, and some other east Asian emerging developing nations accumulated large current account surpluses, and correspondingly large current account deficits developed elsewhere, especially in the United States, the United Kingdom, Ireland and Spain. Flows of capital into the advanced countries rose from about 8 per cent of world GDP in 2002 to about 16 per cent in 2007 . Nearly all of the corresponding investments of the surplus countries were in the government bonds or government-guaranteed bonds of the deficit countries and the increased demand for those bonds enabled their issuers to reduce their yields - typically from a real (ie inflation-adjusted) yield of 3 per cent in 1990 to less than 2 per cent in the early 21st century.

Housing booms

The increased availability of credit at low interest rates prompted large household debt increases in the United States and Europe, much of which was used to finance expenditure on housing. In response to the increase in demand there were almost unprecedented increases in house prices in several countries. In the United States real (inflation-corrected) prices rose by nearly 85 percent between 1997 and 2006, in the United Kingdom there was an (uncorrected) rise of 180 per cent , in Spain they nearly trebled, and in Ireland they more than quadrupled . By 2005, some economists in the United States had become convinced that an asset price bubble had developed, but Ben Bernanke (then Chairman of the President's Council of Economic Advisers) reported that "... although speculative activity has increased in some areas, at a national level these price increases largely reflect strong economic fundamentals" and that "a moderate cooling in the housing market, should one occur, would not be inconsistent with the economy continuing to grow at or near its potential next year". In the event, price increases grew more rapidly over the following year and a half.

Deregulation

American attitudes about regulation changed substantially during the final three decades of the 20th century. Beginning in the 1970s, policy-makers grew increasingly concerned that economic regulation protected inefficient companies at the expense of consumers . Deregulation of the banks began in the 1980s and involved a combination of changes in federal and state statutes and changes in regulatory and judicial interpretations of existing laws, culminating in the passage of the Banking Act of 1999, and there were similar developments in other developed countries. Until the 1980s, investment banks were not normally permitted to undertake non-financial activities, nor other financial activities such as branch banking, insurance or mortgage lending. In the 1980s, however, there was extensive deregulation of the banks with the intention of increasing competition and improving efficiency. Reserve requirements were relaxed and restrictions upon the range of their financial activities were generally relaxed or removed.

Financial innovation

The reduction that took place in the yields on government bonds prompted investors to seek higher-yielding alternatives, and the finance industry employed a great deal of high-powered ingenuity to meet that demand. They were helped in that endeavour by a series of Nobel-prize-winning advances in financial economics that had been made in the 1970s and early 1980s; by the deregulations of the 1980s, and the work of a group of brilliant mathematicians that came to be known as the "quants". The economists had developed a succession of theories based upon adaptations of the the efficient market hypothesis, including portfolio theory and the capital asset pricing model; on the basis of which the quants developed and operated a range of computer packages that could provide precise estimates of an investor's "value at risk" derived from probability analysis of previous experience. Armed with more sophisticated methods of assessing risk, the banks and other financial intermediaries increased their capacity to provide credit to producers and consumers by distributing the risks and rewards involved more widely among those most willing to accept them. The devices adopted for that purpose included a vastly extended application of the techniques of securitisation, involving the conversion of their loans into packages of bonds that were graded according to the credit risk ratings provided by the credit rating agencies. The traditional banking practice of holding loans on their balance sheets until they were repaid, gave way to the strategy known as originate and distribute, under which those packages of bonds were sold to pension funds, insurance companies and other banks. That procedure removed the loans from the balance sheets of the banks, and the institutions of the growing shadow banking system, thus enabling them to increase activity without breaching the reserve ratio requirements of the financial regulators.

Financial crisis (2007 - 2008)

In recent decades, a vast risk management and pricing system has evolved combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. A Nobel prize was awarded for the discovery of the pricing model that underpins much of the advance in the derivatives markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year. (Testimony of Dr. Alan Greenspan before the Committee of Government Oversight and Reform October 23, 2008[3])

What came to be known as the subprime mortgage crisis had its origin in repayment defaults by some Americans with low credit ratings who had borrowed money to help pay for house purchases. When house prices were rising, many of them had been able to get the money needed for repayments by further borrowing (because of the increased collateral that the price increases enabled them to offer). But the sharp fall in the market value of their houses that occurred in 2007 deprived them of that option, and left many of them owing more than their houses were worth - making default a rational, and sometimes unavoidable, recourse.

The financial crisis began in early June 2007, when surge in defaults led the credit rating agencies to downgrade their ratings of securities based upon those mortgages, and banks holding such securities found themselves unable to use them as collateral for their borrowing needs. This created financial problems that started with Fannie Mae and Freddie Mac and then shifted to the major banks . In that month, hedge funds guaranteed by the American Bear Stearns bank ran into difficulties, and mortgage defaults led subsequently to the collapse - and a government rescue from bankruptcy - of the government-sponsored mortgage lenders Fannie Mae and Freddie Mac. Uncertainty about the quality of banking assets made banks reluctant to lend to each other and the important interbank market vitually ceased to operate, triggering a [[credit] (finance)|credit]] shortage.

The events of 9th August 2007 marked the first upsurge in the intensity of the crisis. The French bank BNP Paribas announced that it had suspended withdrawals from three of its hedge funds on the grounds that it had become impossible to value their mortgage-backed assets. On the same day it became apparent that European banks were experiencing serious liquidity shortages when it was learned that they had sought help from the European Central Bank. Other banks throughout the world cut back on their lending in an attempt to offset the increase in their leverage brought about by the downgrading of their mortgage-based assets. The fear of default fed on itself as a result of more and more major bank failures in 2007 and 2008 as well as many failures of other businesses - often because they found themselves unable to roll-over their debts. In March 2008 the United States authorities organised the rescue of the Bear Stearns (the world's fifth largest investment bank)].

The second upsurge of financial panic started in September 2008. The collapse of the Lehman Brothers investment bank on September 15 created a near total loss of mutual confidence throughout the world's financial system. The LIBOR-OIS spread which is the conventional measure of the banks' willingness to lend, which had already risen to 0.9 per cent from its normal level of around 0.1 per cent, surged to an unprecedented 3.6 per cent. Fears of default spread through the financial system with the crippling consequences that came to be known as the credit crunch. Banks and other businesses found that they could not borrow for longer than overnight, and by early October even overnight credit became scarce. It become apparent that a collapse of the entire financial system had become a distinct possibility, and the Governor of the Bank of England warned that "Not since the beginning of the First World War has our banking system been so close to collapse".

The International Monetary Fund's economists estimated in October 2009 that the global writedowns of the value of financial assets resulting from the crisis to have totalled $3.4 trillion.

Policy response (2008 - 2009)

Financial policy

In the course of the first two weeks of October 2008 a series of banking systems rescue plans had been launched. The UK had announced large scale plans to inject capital into its banks and to offer unlimited guarantees on the debts of all of its banks, and similar action had shortly after been agreed by European leaders and by the President of the United States. The national rescue systems that were actually adopted by the principal banking countries differed only in detail from those initial proposals. It was recognised that those actions were temporary treatments, not remedies, and remedial measures were also set in motion in the course of 2009, as described in the paragraph below on diagnosis and remedies.

Monetary policy

The Federal Reserve Bank, the Bank of Japan and the [[Bank of England made a series of discount rate reductions to near zero levels in the 4th quarter of 2008 and the 1st quarter of 2009 (and the European Central Bank made a series of reductions to reach 1 per cent in the 2nd quarter. When it became clear that those moves had not achieved the intended easing of the credit crunch it was decided to adopt the controversial and largely untried policy of quantitative easing.

Fiscal policy

In a significant departure from the accepted practice of relying solely upon monetary policy to stabilise their economies, most industrialised countries adopted fiscal stimulus packages to augment the already substantial expansionary influence of the automatic stabilisers. Those moves frequently involved departures from recently adopted deficit-limiting rules, including The European Union's Stability and Growth Pact, and the United Kingdom's Code for Fiscal Stability and levels of national debt ranging from the UK's 44 per cent of GDP to Japan's 188 per cent were forecast to rise to at least double their existing proportions of GDP .

Economic downturn (2007 - 2009)

(the country links in the following paragraphs are to the regional notes on the addendum subpage)

... the first annual decline in world output in more than half a century. (Economic Report of the President, 2010)

The economic downturn started in the United States in the first quarter of 2007, where a combination of rising oil prices, falling house prices and credit shortages was having a depressing effect on household spending and business investment. The downturn continued during the next three quarters, and its depressing effects were being felt by the economies of many of the other advanced economies. The financial problems created by the subprime mortgage crisis had a further depressing effect, and the financial panic that followed the demise of the Lehman Brothers investment bank in September 2008 created further - and much more serious - obstacles to economic activity and to trade. By the fourth quarter of 2008 recessionary pressures were being felt in all of the world's economies. There were massive reductions in world trade during that quarter and in the first quarter of 2009. Also during the first quarter of 2009, the oil price fell sharply to reach 25 per cent of its 2008 peak, and there were substantial downturns in the housing markets of several advanced economies (including Canada, Denmark, Ireland, Spain and the United Kingdom), and - for the first time since the Great Depression, there were simultaneous reductions in the growth of nearly all of the world's economies.

Regional impacts varied widely, however. There was little change to the economies of Southern Asia; those of East Asia were less adversely affected than most; the economies of China and India experienced significant growth rate reductions; and all the high-income economies of the United States, Europe and Japan, together with most of the other developing countries, went into recession. The severest effects were upon the economies of Russia, the Baltic States, Iceland and Ireland. There were widespread increases in unemployment.

The recession had struck widely for reasons that often had nothing in common with the events that set it off. Economies with relatively large financial sectors - such as those of Britain and Iceland - suffered directly from the banking crisis. Economies with relatively large export sectors - such as those of Japan and Germany and many developing countries - suffered indirectly from the collapse in world trade that occurred at the end of 2008. Commodity-exporting countries in Africa and Central and South America were affected by the fall in commodity prices, the fall in the oil price hit the oil- exporting countries such as Russia and Mexico, and the international credit crunch created financial problems for developing countries who found themselves unable to roll-over maturing short-term debt. In several countries, (including the United States, the United Kingdom and Ireland ) the recession had the historically rare characteristics of a balance sheet recession, which they suffered as a result of the acquisition of toxic debt from the American subprime mortgage crisis. In the United States, Japan and the United Kingdom, the effect of deleveraging by the banks was accentuated by attempts by businesses and households to reduce their inflated levels of debt.

Economic Recovery (2009-2011)

Early in 2009 there were signs of a gradual return of confidence in operation of the financial system. By February, LIBOR-OIS spreads had fallen from their 3½ per cent peak to around 1 percent, and by August they had return to the relatively normal level of 0.25 per cent. There was no longer a prospect of the collapse of the financial system, but nor was there an immediate prospect of a return to normal. Bank executives were by then accutely aware of the need to reduce leverage and were devoting available funds to that purpose rather than to lending. As a result there was no more than a gradual reduction in the severity of the credit crunch

There were also signs of a return to the growth of economic activity. World output rose at 3¼ per cent per annum in the second quarter of 2009, and at 4½ per cent in the second half as a whole. Most of the growth occurred in the emerging economies. In the developed economies, the pace of recovery was slow, and activity remained far below precrisis levels. Growth was led by a rebound in manufacturing and the rebuilding of depleted stocks. Estimates of output gaps indicated the presence in most developed countries of very substantial amounts of unused resources suggesting that without a high degree of labour market price flexibility, high levels of unemployment would probably persist into 2010 and beyond. By the middle of 2009 the world trade statistics were also showing signs of a recovery, and growth continued through the second half of 2009 and into the first quarter of 2010, although the volume of trade remained substantially below pre-recession levels.

By the end of 2009, most economies had returned to economic growth, but the recession continued into 2010 in the Baltic States, Ireland, Greece and Spain. Vigorous eofconomic growth returned to the emerging economies in the Far East, but growth of the mature economies remained well below trend through 2010 and into 2011, leaving substantial output gaps unclosed. By the middle of 2010, the world economy was experiencing vigorous growth, with the growth rates of many developing economies having returned to pre-recession levels. However the world economy had suffered an economic shock in the form of an exceptionally damaging earthquake and tsunami, and a political shock with expected economic consequences in the form of major Arab uprisings. A general loss of confidence (which it attributed to those events and to the US debt limit dispute and to the developing eurozone crisis) prompted the Economist Intelligence Unit in August 2011 to assign a 40 per cent probability to the occurence of a "double dip" within the following two years.. Of more immediate concern was the sharp increase in the 3-month LIBOR-OIS spread which started at the beginning of August. Although much smaller than that of 2008, it signalled an increase in the liquidity risk faced by the banks and the possibility that they might react by creating a credit crunch.

Fiscal aftermath (2010 - 12 )

As the recovery got under way, policy-makers were faced by the fiscal dilemma, that arose from the conflict been the wish to reduce their recession-inflated national debts and the wish to avoid creating another downturn. In October 2009, the International Monetary Fund had advised that, notwithstanding rising public debt in many countries, fiscal stimulus needed to be sustained until the recovery is on a firmer footing and may even need to be extended, but that it could lose its effectiveness in the absence of convincing reassurances to investors that government debt will eventually be rolled back. During the early months of 2010, national authorities in most of the developed countries became concerned that operators in the bond markets might demand the addition of substantial risk premiums to the normal rates of return on new issues of government bonds. In the event, the yields on the government bonds of the developed countries fell to record lows (except those of the PIIGS countries), substantially improving the sustainability of their debt. In Europe, a consensus nevertheless developed in favour of allowing the fiscal stimuluses of 2009 to lapse, and to adopt plans for the rapid reduction of budget deficits; and G20 leaders resolved to halve their deficits by 2013. A different view was taken by the United States government. Treasury Secretary Geithner argued that an immediate deficit reduction would inhibit economic recovery, and a budget programme was adopted that would increase the country's budget deficit to its highest proportion of GDP in its history.

During 2010, prospective investors became increasingly reluctant to buy the bonds isued by five PIIGS (Portugal, Ireland, Italy, Greece and Spain) governments at the offered interest rates, and the governments concerned had to make a succession of increases in those rates when they needed to roll-over existing debt. Two of those governments - Greece and Ireland - eventually decided that, without help, they would not be able to continue to finance their budget deficits, and they sought - and received - loans from other European governments. Those loans failed to reassure potential investors, and a eurozone crisis developed. In November investors demanded further increases in the interest rates on the government bonds of all five governments (including those of Portugal, Spain and Italy, because of fears of contagion from Greece and Ireland). By December 2010, there was widespread uncertainty about future prospects for the eurozone. There were doubts about the willingness of European governments to provide further financial support to the five "PIIGS" governments, and speculation that financing difficulties might spread to affect other governments.

The cost of the recession

The problem of estimating the cost of the recession is immensely difficult, requiring a comparison between its actual outcome and the outcome that would have eventuated in its absence. Even to estimate its actual output presents difficulties that may not be confidently resolved for many years. An attempt has nevertheless been considered necessary in order to provide a datum against which to relate the costs of prevention. An estimate by Bank of England has put the present value of the cost of the output that has been lost at 3½ times world GDP, on the basis of which their Andrew Haldane has suggested that if only 25 percent of that loss were permanent, the present value of its global cost could amount to 90 per cent of the value of a year's output .

Diagnoses and prescriptions

Causes

Even before the banking meltdown had been averted, attention was being given to the problem of identifying its causes with a view to avoiding another financial crisis (or, failing that, of limiting its severity). Many explanations were put forward. Some were concerned with the conduct of those involved, including the shortcomings of bank executives and their advisors, the laxity of their regulators, the indifference of the central banks, the incompetence of the credit rating agencies, and the inaction of governments. Some were concerned with institutional factors including, the inadequacy of financial regulation, and the lack of coordination between monetary policy and financial regulation. The concern felt by many people that a global disaster had been sprung on them without warning was expressed by the Queen of England when, on a royal visit to the London School of Economics, she asked "Why did no-one see it coming". The School's Director assured her that economists had issued warnings, and a follow-up letter attributed their lack of influence among decision-takers to "wishful thinking combined with hubris" . {The warnings included those of Paul Volcker, and William White .). But a group of eminent economists believe that the economics profession cannot escape responsibility for the crisis. Positions of influence had in their view been occupied by economists who had a mistaken view of how the economy works. Among that group, George Akerlov and Joseph Stiglitz argue that a major cause of the crash of 2008 had been the use of models embodying the efficient markets hypothesis and, more generally, to the belief that financial markets are inherently stable. The economist Paul Krugman claims that those responsible for economic management had acted either on the belief that free-market economies never go astray, or the belief that deviations could readily be corrected by the central banks, and that economists' preoccupation with elegant mathematical models had led them to "mistake beauty for truth". A contrary view is taken by Nobel prizewinner Myron Scholes (joint creator of theBlack-Scholes model which embodies the efficient markets hypothesis), who defends the use of models and attributes any adverse consequences to their misuse, saying "you can build a wonderful car such as a Porsche or a Lamborghini and turn it over to someone to drive it who has no skills and causes it to crash".

Prescriptions

In a reversal of the previous consensus, there was general agreement by 2009 that further regulation of the financial industry is necessary. It was also accepted that the new regulations should not be concerned solely with the stability of individual firms. A paper by the United States Department of the Treasury makes the point that "a narrow micro-prudential concern for the solvency of individual firms, while necessary, is by itself insufficient to guard against financial instability. In fact, actions taken to preserve one or a few individual banking firms may destabilize the rest of the financial system". The term "macroprudential" came into general use to denote concern with the integrity of the financial system as a a whole. There was also seen to be need for international agreement, if only in order to avoid a situation in which financial firms migrate toward the least-regulated administration.

The Deputy General Manager of the Bank for International Settlements has set out a broad agenda for the reform of the international economy that included:

• expansion of the scope financial regulation to priority to macroprudential provisions as well as strengthening its existing microprudential provisions ;
• expansion of the scope of monetary policy to restrain any tendency to develop asset price bubbles as well as restraining inflation;
• expansion of exchange rate policy to reduce global imbalances as well as promoting exchange rate stability; and,
• adoption of a countercyclical fiscal policy by maintaining a positive budget balance during periods of economic growth that will be large to enable an effective response to future economic downturns.

Work was already in hand to develop the first of those proposals. In December 2009, the Basel Committee on Banking Supervision had issued consultative proposals, introducing a leverage ratio requirement, a liquidity requirement, and a range of countercyclical measures that came to be known as "Basel III", and a range of national legislation had already been enacted. There had been discussions about banking regulation at Heads of State meetings and Finance Ministers meetings of the Group of Twenty leading economies. International agreement on specifics was elusive, however, and the situation at April 2010 was summed up by the Governors of the International Monetary Fund as "Strengthening financial regulation, supervision, and resilience remains a critical but as yet incomplete task.", and Andrew Haldane of the Bank of England commented that "although several packages of remedial measures have been enacted, the "great debate" on the future structure of finance has only just begun".

International agreement of the second BIS proposal - that monetary policy should "lean against" asset price booms - seems unlikely because it has been opposed by the Chairman of the Federal Reserve Board and the President of the European Central Bank.

In the communiqué issued after the 2009 Pittsburgh summit the world leaders reiterated the need to manage global imbalances , - a topic that had been regularly discussed at summits over the previous decade - but did not propose any means of doing so. There seems little chance of G20 agreement on Heribert Dieter's proposal to levy a penalty on surplus countries , nor on the alternative of penalising deficit countries. An alternative, proposed by Charles Goodhart and Dimitrios Tsomocos, would be taxes on capital flows.