The 2007–08 financial crisis began with problems in the subprime mortgage market in the United States but quickly turned into a global financial crisis. The crisis resulted in a wide range of adverse effects on the real economy, as nonfinancial firms around the world appeared to spiral downward. A key potential contributor to the plight of the nonfinancial firms was the financial crisis itself in the form of a negative shock to the supply of their external financing needs. This article briefly surveys recent IMF research on the real effects of the crisis.

The financial crisis that started with problems in the U.S. subprime mortgage market in early 2007 extended to financial institutions and money markets in the summer of 2007, to corporate credit markets at the end of 2007, and eventually to other countries in the fall of 2008. The effects of the crisis on real activity had appeared to be limited at first, but this did not last. Gradual declines in housing and equity prices started to take their toll in the second half of 2007. In the fall of 2008, the effect suddenly became much more pronounced. The worry that the crisis might lead to another episode like the Great Depression led to sharp declines in equity markets along with deterioration in consumer and business confidence around the world (Blanchard, 2008).

Recent research at the IMF has studied how the financial crisis affects the real economy considering various angles: the general mechanisms through which financial crisis spillovers to the real economy; empirical evidence about the existence of credit constraints; the unique features of the current episode; and global spillovers through real and financial channels.

A financial crisis affects the balance sheets of financial institutions, corporates, and households, and thereby influences the availability of credit, and thus the performance of the real economy. Claessens, Kose, and Terrones (2008) study the linkages between macroeconomic and financial variables around business and financial cycles in a large set of Organization for Economic Cooperation and Development countries from 1960–2007. In particular, they consider the implications of recessions when they coincide with financial market difficulties, including credit crunches, house price busts, and equity price busts.

They find that interactions between macroeconomic and financial variables play major roles in determining the severity of recessions. While most macroeconomic and financial variables exhibit procyclical behavior during recessions, recessions often coincide with episodes of contractions in domestic credit and declines in asset prices. The authors report that recessions associated with credit crunches and house price busts tend to be deeper and longer than other recessions. These findings suggest that the strength of linkages between the financial sector and the real economy can aggravate output losses during recessions. Hence, recessions following the current crisis are expected to be more costly than other recessions because they take place alongside simultaneous credit crunches and asset price busts.

It is not self-evident, however, that the real economy is suffering from a liquidity crunch during this current financial turmoil. The fall in the stock prices of nonfinancial firms could be explained by a decline in the demand for their output. Moreover, as Bates, Kahle, and Stulz (2007) document, nonfinancial firms held an abundance of cash prior to the crisis and could have paid off their debt with their cash holdings. This suggests the possibility of limited tightening of liquidity outside the financial sector. Finally, as recently as in mid-October 2008, Chari, Christiano, and Kehoe (2008) reported that the data do not support the view that the supply of financing to nonfinancial firms had declined significantly in terms of either aggregated bank lending or issuance of commercial papers.

Disentangling the finance and demand shocks is difficult in the aggregate, as they are observationally equivalent. They also feed off each other as a crisis unfolds. To make progress, Tong and Wei (2008) propose a framework that explores heterogeneity across nonfinancial firms based on their differential ex ante vulnerability to each of these shocks. If there is a supply-of-finance shock, the effect is likely to be more damaging to those firms that are relatively more financially constrained to start with. Similarly, if there is an aggregate demand shock, it is likely to affect more those firms that are intrinsically more sensitive to a demand contraction. Exploring variations across firms may thus open a window into the respective roles of the two shocks in the fortune of nonfinancial firms.

To determine cross-firm heterogeneity in the sensitivity to an aggregate demand contraction, Tong and Wei (2008) propose a measure of sector-level sensitivity to a demand shock, based on the stock price response to the 9/11 terrorist attack. To analyze cross-firm vulnerability to a supply-of-finance shock, they construct firm-level indexes on the degree of ex ante financial constraint, following Rajan and Zingales (1998) and Whited and Wu (2006). They then check whether these ex ante classifications of firms prior to the subprime mortgage crisis help to predict the ex post magnitude of their stock price changes since August 2007. Tong and Wei find that both channels are at work in the current crisis, but that a tightened liquidity squeeze appears to be economically more important than aggregate demand contraction in explaining cross-firm differences in stock price declines.

The current credit squeeze appears to be the result of insolvency problems in financial institutions that have been aggravated by the augmented interconnectedness of large banks and sharply increased market and funding illiquidity since the 2007 subprime crisis (Frank, González-Hermosillo, and Hesse, 2008). As the banking system is a key element allowing credit constraints to be relaxed, a sudden loss of these intermediaries may hurt economic growth. Historically, sectors more dependent on external finance tend to suffer larger contractions during banking crises (Dell'Ariccia, Detragiache, and Rajan, 2006). Also, during a banking crisis, sectors highly dependent on external finance tend to experience a greater contraction of value-added in countries with deeper financial systems (Kroszner, Laeven, and Klingebiel, 2007). Industries that rely more on external finance recover more slowly following episodes of financial crises (Prakash, 2009).

Bank crises could have larger negative effects on output if one allows for the full credit cycle among banks' capital/ asset ratio, credit availability, and spending, as documented by Bayoumi and Melander (2008). Moreover, these effects of banking crises might be more severe if the separate effects of systemic bank shocks and government responses are disentangled (De Nicoló, 2009). Dell'Ariccia, Igan, and Laeven (2008) report that the credit boom in the United States before the 2007 crisis is associated with a decrease in lending standards that is unrelated to improvements in underlying economic fundamentals. To the extent that bankers may over-tighten the lending standards during the bust more than is justified by economic fundamentals, the findings also suggest a possible overshoot of credit decline and hence output contraction.

The current crisis has been felt around the world through financial and trade channels. The nature of the spillovers to a particular country can be shaped by many factors, including the pre-crisis financial health of its firms, banks, and households, and policy measures to mitigate the crisis. Tong and Wei (2009) study the global effects of the current crisis on the real economy. They propose a framework to (1) quantify the importance of the finance shock to nonfinancial firms in 44 countries by exploring cross-firm heterogeneity in dependence on external finance for working capital and long-term capital investment; and (2) study whether and how country features, such as financial integration and the magnitude of pre-crisis credit expansion, affect the global transmission of the finance shocks.

Tong and Wei find that from July 2007 to December 2008, the decline of stock price was more severe for firms with larger ex ante sensitivity to external finance. This finding thus provides evidence that nonfinancial firms have indeed suffered from a negative supply-of-finance shock. Moreover, this pattern is stronger for countries with pre-crisis credit expansion from 2000 to 2006, in line with the literature that a credit boom tends to precede a financial crisis (see Mendoza and Terrones, 2008; and Barajas, Dell'Ariccia, and Levchenko, 2009). Finally, the financial shock is more severe for emerging economies that have higher pre-crisis exposure to foreign portfolio investments and foreign loans, but less severe for countries that have higher pre-crisis exposure to foreign direct investments.