December 29, 2008
Abstract: In 2008, the general consensus was that the global economy would not easily recover from the collapse of Lehmann Brothers. Analysts were extrapolating the recent meltdown to make very pessimistic forecasts for 2009. The author takes a contrarian position. The decision by global central banks to fixate on rising inflation driven by sharp increase in oil prices and other commodities (a supply shock) led them to hike interest rates and curb liquidity in the first half of 2008. It is this policy blunder (tightening to dampen supply-side inflation), not the collapse of Lehmann, that explains the economic slump in the fourth quarter of 2008. Since monetary policy acts with a lag, easing policy and infusing liquidity in the second half of 2008 created conditions to break the negative confluence of factors, leading to a turnaround in the global economy in 2009.
Keywords: financial risk and risk management; financial crisis; central banks and their policies; fiscal and monetary policy; crisis management; policy blunder