Why did the world economy plunge into the worst recession since the Great Depression? This column argues that economic fundamentals do not explain the global crisis. But they did play a role. Events such as the fall of Lehman Brothers can become focal points for investors’ risk perceptions, changing the way the fundamentals are interpreted. This can lead to “risk panics” – self-fulfilling spikes in risk and a collapse in asset prices.
The economy’s performance in recent years raises questions.
- Why did the world economy plunge into the worst recession since the Great Depression in the wake of the Lehman Brothers failure?
- Why did fiscal problems in a small open economy such as Greece trigger a sharp drop in global stock markets?
Changes in economic fundamentals do not offer a satisfactory explanation. This is not to say that the crises entailed no fundamental elements. For instance, the fall of Lehman Brothers revealed the true depth of the subprime problems – even though a full year had then elapsed since the beginning of the crisis. Yet it is hard to attribute the massive reaction in global markets to fundamentals, even if we allow for the types of feedback loops stressed by Brunnermeier and Pedersen (2009). In addition, the international transmission of the crisis does not square well with countries’ exposure to losses on US mortgage securities (Kamin and Pounder 2010)...
In recent research, we offer an explanation for such movements that focuses on shifts in risk perceptions (Bacchetta et al. 2010). Risk clearly plays a central role, as illustrated in Figure 1 which shows US stock prices and the VIX index measuring risk. We clearly see that large declines in asset prices are associated with surges in risk. In addition, the risk measure itself becomes more volatile at times of crisis. Time-varying risk is clearly a major feature of the crisis..
Finance Focus
voxEU.org
June 28 - 30, 2010