Banking crisis → Trade balance: chain of analysis

ChainWhat it assumes · how to break it

Start

Banks suffer large losses on mortgage-related loans and securities as house prices fall, as in the 2007–08 global financial crisis, and begin to doubt each other's solvency.

As a result, banks stop lending to each other in the interbank market because they cannot tell which banks hold the bad assets, so funding costs rise and credit dries up.
credit crunch · asymmetric information

Assumes: Banks cannot judge each other's exposure to bad loans.

But: If the central bank acts as lender of last resort and supplies liquidity freely, banks can fund themselves without relying on each other.

This means banks with depleted capital tighten lending to firms and households, charging higher rates and demanding larger deposits on mortgages.
credit rationing · capital adequacy

Assumes: Banks rebuild capital by shrinking their lending.

But: If the government injects capital, as the UK did with RBS and Lloyds in 2008, banks need not cut lending as much to restore their capital ratios.

Consequently, investment falls because firms cannot finance projects, and consumption falls as households lose access to credit and house prices fall.
investment · consumption · negative wealth effect

Assumes: Firms and households depend on bank credit to spend.

But: Large firms can borrow directly through bond markets or use retained profits, and many households have little debt, so much spending does not depend on bank credit.

Therefore, national income falls, and because spending on imports depends on income, imports fall.
marginal propensity to import

Best link to attack
Assumes: The recession is deeper at home than in trading partners.

But: In a global crisis, trading partners' incomes fall too, so exports fall alongside imports and the balance may barely change.

At the same time, the central bank cuts interest rates and investors move funds out of the country's banks, so the currency depreciates.
hot money · depreciation

Assumes: The crisis makes the currency look riskier than others.

But: In a global crisis, investors often buy the safest currencies; the US dollar rose in late 2008 even though the crisis began in the US.

As a result, exports become more price competitive and imports dearer, so the current account deficit narrows.
Marshall–Lerner condition · current account

Assumes: Demand for exports and imports is price elastic.

But: Demand is often price inelastic in the short run, so the balance can worsen first (the J-curve), and export markets shrink in a global recession.

End

Imports fall with income and the currency may depreciate, so the trade deficit narrows, at least while the recession lasts.

Evaluation chainattacks link 4 · Assumptions

E1However, the improvement in the trade balance depends on the recession being deeper at home than in trading partners.
E2Because the 2007–08 crisis spread to most advanced economies, demand for exports fell at the same time as demand for imports.
E3As a result, world trade fell sharply in 2009 and exports fell alongside imports.
E4So the trade balance may improve only a little, and the improvement reverses once domestic demand recovers and imports rise again.

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Questions this answers

Assess the likely impact of a financial crisis on a country's current account.
Evaluate whether a recession improves the trade balance.
Discuss the impact of a depreciation following a banking crisis on the current account.

Diagram

No standard diagram for the income effect. For the exchange rate, use a currency market diagram with supply of the currency shifting right and the exchange rate falling.

Reverse and related

Recovery from the crisis → incomes and imports rise and the trade deficit widens again.

Questions this answers

Diagram

Reverse and related

GCSE version