Difficulties in them management of the global financial crisis: academic and economic policy lessons

In this paper, we examine the causes and economic policy lessons of the fact that – compared to previous recessions – the global economic crisis which started in 2007 and intensified in 2008 appears to be deeper and more lasting, and the recovery is taking longer. We demonstrate that the financial crisis may be regarded as a special balance sheet recession accompanied by portfolio imbalances, which alone explains why the present downturn results in higher macroeconomic costs than a recession taking place in the traditional business cycles. The current fragile recovery is also explained by the incorrect diagnosis and management of the nature of the crisis, and the effect of misconceived economic theories and policies which were widespread before the crisis can also be demonstrated in this regard. One of the economic policy lessons learnt from the balance sheet recession and the rather unsuccessful European crisis management is that there is a need for countercyclical fiscal policy, which during times of downturn provides sufficient leeway for the management of a balance sheet recession and, by increasing the deficit, may support balance sheet adjustment by actors in the private sector. The present financial crisis also highlighted the fact that without proper prudential regulation the self-regulation capacity of the market is limited under the modern financial system and is inefficient in preventing the build-up of financial instabilities. Regulation must be transformed so that it takes the macroeconomic nature of the financial instabilities into consideration. In accordance with this, the monetary policy strategy must be also reconsidered to ensure that the financial processes and the financial stability risks receive increased attention, in addition to real economic considerations. All in all, the individual economic policies should support the recovery of the real economy without building up excessive financial imbalances. If no proper economic policy response is given bearing these principles in mind, the balance sheet recession may continue over the long run or become a recurring phenomenon.