The deleveraging of the global financial system and the U.S. economy's current severe recession raise key long-term questions.
The global economy is grappling with the most severe financial shock since the Great Depression. Financial market volatility is at or near unprecedented levels; yields on corporate, sovereign, and high-yield bonds have spiked; and global equity and commodity prices have plummeted. As illustrated in Figure 1, financial markets around the world are under considerable stress. Figure 1 clearly indicates not only the magnitude of this extraordinary financial shock, but also how integrated international financial markets have become.
Policymakers around the world have taken unprecedented and coordinated action to address the financial panic. In the United States, the Federal Reserve Board has slashed short-term interest rates aggressively, has created an array of novel liquidity facilities, and has drastically expanded its balance sheet to provide an unprecedented amount of liquidity to the impaired financial system. At the same time, the U.S. Treasury has used public funds to implement a number of extraordinary steps, including the injection of capital into certain financial institutions.
Despite these policy actions, the U.S. economy is expected to contract significantly at the end of 2008 and well into 2009 as a result of the financial crisis. The extreme financial shock has significantly tightened the supply and increased the costs of credit for consumers, businesses, and other institutions. According to the Vanguard Economic Strategy Group, the duration of the current U.S. recession will likely be the longest of the post-World War II era (see Figure 2).
With the global financial system deleveraging and the U.S. economy facing a severe recession, the global economy is decelerating quickly after years of heady growth. These profound recent developments raise important questions about the world economy and global financial markets.
