The Current Financial Crisis: Causes and Policy

Abstract

The driver of the current crisis is the collapse in domestic aggregate demand, originating from international factors. It is important, therefore, to consider potential areas where aggregate demand can be expected to increase in order to understand the possibility of recovery. The current crisis was preceded by an unprecedented increase in the level of household debt, which will hinder the recovery of consumer expenditure. Consumption is also being affected by uncertainty with respect to both income and employment. Similarly, the outlooks for investment and net exports suggest that they are unlikely to contribute to the initial phase of recovery. This leaves the important area of government expenditure. It is argued that government expenditure, particularly in infrastructure and capital, is particularly important as in the short run it contributes directly to demand, while, in the longer run it boosts growth and productivity. Finally, approaches to financing the implications of increased government expenditure are examined.