The Great Recession: A Self-Fulfilling Global Panic

While the 2008-2009 financial crisis originated in the United States, we witnessed steep declines in output, consumption and investment of similar magnitude around the globe. This synchronicity is surprising in the context of both existing theory and past business cycle experience. Theory implies that perfect co-movement can only happen when countries are perfectly integrated, in sharp contrast to the observed home bias in goods and financial markets. We develop a two-country model that allows for self-fulfilling business cycle panics and is consistent with high internationl co-movements and the worldwide increase in perceived uncertainty. We show that limited integration of goods and financial markets is sufficient for business cycle panics to be perfectly synchronized across countries. Moreover, a panic is more likely with tight credit, low interest rates, and unresponsive fiscal policy. We argue that the world was particularly vulnerable to such global panics in 2008.