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A global crisis calls for a global answer

10/31/2008

Author : Madariaga College of Europe Foundation

Introductory remarks by Pierre DEFRAIGNE

A financial crisis like the present one should never have come as a surprise because such crises are inherent to market capitalism.
Market capitalism has indeed four features: it is efficient because it is innovative; unstable because it is subject to supply or demand shocks and to financial and real estate bubbles; unfair because it aggravates starting inequalities in resources endowment although allowing for social mobility; unsustainable because it does not properly price natural resources.
Regulation through public policy can make market capitalism more or less efficient, more or less unstable, more or less unfair, or more or less sustainable, depending on the orientation and on the quality of policies. Market failures can indeed be either aggravated or corrected by policy failure or policy success. Picking the right policy and gathering consensus to make it effective is very difficult. It calls for the right institutions, the right expertise and very effective leadership so as to achieve social consensus: economic policies work as long as households and economic operators play along and not against.
Western European countries have probably best regulated market capitalism through social negotiation, Welfare State and Keynesian policies during the ‘Glorious Thirties’. The mould got its first crack with the first oil shock and received another blow from globalisation. Yet it survived although badly in need of modernisation.

Globalisation has indeed reinforced market capitalism’s four main features as it has allowed it to escape from national regulation regimes:

- The global output chain has increased its efficiency through better international division of labour and competition, in particular through the integration of Asia- mainly China- into the world economy as a source of cheap manufacturing. Trade and FDI have been the main vehicles for enhancing global productivity, supporting world growth and raising welfare in emerging economies. But as evidenced by the example of China, the quality of domestic policies proved also critical in turning globalisation into an economic miracle;

- But globalisation has also eased the ‘hyper financialisation of the economy: the switch to direct finance – from bank to stock exchange-, the securitization and the rise of global financial markets have exerted enormous pressure on both governments and real business for higher after tax returns on investment. Global finance has contributed to efficiency gains, but it has done so at growing costs in terms of increased instability (see the number of financial crises since Mexico 1982) and of uneven distribution of the globalisation benefits , particularly between capital and labour worldwide, while an oversized and overpaid financial industry has taken too large a share of the value added.

- Globalisation has aggravated the pressure on the environment, particularly with regard to climate and biodiversity, including through maritime and air transport which currently undervalues the cost of carbon emissions.

Globalisation has allowed an emancipation of market capitalism (global firms and financial markets) from national regulation regimes, whilst we still lack serious regulation at a global level, barring WTO rules and disciplines with respect to trade, hence the global governance deficit. Deregulation, particularly of finance, has benefited first savings holders everywhere -leading to a formidable concentration of wealth in some countries-, then the USA because of the privilege of the dollar and last but not least the emerging economies, which are the main destination of FDI after the advanced economies. But unregulated financial globalisation has irresistibly drifted towards predatory behaviour and speculation, bringing eventually the whole Western financial system into an unprecedented crisis.

Dealing with the global capitalism crisis calls for action but questions arise: what’s the right level of regulation? National or global? How do we ensure the consistency of national policies? Is policy-convergence and coordination among national policy-makers –e.g cooperation within the G 7/8 or G20- preferable to autonomous action? Does the latter make sense with the risk of negative externalities and spill-overs and subsequent losses of global welfare?
These might look like theoretical questions, but they are the questions raised today to the four main global economies – EU, US, China, Japan – both about the handling of the financial crisis and about the response to the looming recession. The real issue is eventually: shall we succeed or hang together or shall we be hanged separately? There is no alternative to cooperation but competition with the risk of confrontation among economic systems and among continents. Multilateralism is the most advantageous way out. But it calls for a fair sharing of responsibilities and benefits, particularly between advanced, emerging and developing economies. The real test of the new multilateral system will be to enhance the ability of China to achieve sufficient growth in order to meet its development needs while ensuring its environmental sustainability.
But let’s go back to the starting point.

1. The origins of the financial crisis

It’s important to realize that the dynamics of the financial crisis originate in the collective preference for household and government indebtedness and for high leveraged and low regulated finance in the USA, the largest single economy in the world. This results from three factors: the combination of tax cuts for the rich and of huge military expenditures (the waging of two wars) have lead to a structural budget deficit; the huge inequalities combined with consumerist culture have pushed the middle-class and the poor into debt (both through mortgages and plastic cards ) ; last but not least the ‘dollar privilege’ has allowed the USA to pile up an external debt of the size of the rest of the world’s debt, but denominated in its own currency. As long as foreigners have been willing to buy US T-bonds because they trust America’s resilience and innovative capacity, the debt was deemed to be sustainable.

But this combination of factors makes the US economy very vulnerable to a major shock. The shock came from within the US financial system itself with the subprime crisis, which has its roots in two factors:

- on the one hand the cheap and abundant liquidity secured for the last decade by the FED in a non-inflationary environment thanks to cheap oil and low cost imports of manufactured goods from China, has pushed private households into negative savings, and part of the business, particularly finance and the hedge funds, into high debt leverage with the view of increasing their ROI. Incidentally oversupply of liquidity has been also fuelling first financial and then housing bubbles.

- on the other hand, the explosion of inequalities in the USA had a particular bearing on the housing market . Nobel Prize Paul Krugman has repeatedly pointed at blue collar workers’ real hourly wages stagnation for 30 years in stark contrast to the top 1% who have captured half of the US’s GDP growth whilst enjoying tax cuts. He highlighted that America went back to a pre-New Deal 1926 distribution of income. In that social context, indebtedness has become the only way to support consumption. The housing market boom has made the trick. Nurtured by the bad mortgage loans to poor households –the subprimes- the housing market allowed them to get into debt through a perverse mechanism: no initial instalment, extended grace period, progressive and variable interest rates and long maturity. Real estate agents get a fee and pass the buck to the bank which grants the loan, but then write it off immediately from its own balance sheet as a poisonous asset. Securitization of the loan disconnects lenders from borrowers and disseminates the risk into the system. Banks eventually act just as fees’ collectors. The packaging of bad and good assets in vehicles granted the AAA by complacent rating agencies (subject to conflicts of interests and oligopoly) hide the systemic risk and allow its propagation abroad. US subprime assets have indeed been exported to Europe where local bankers’ greed and incompetence as well as supervision failures made them infect banks’ portfolios. Whereas the euro was supposed to have sheltered the Eurozone from external shocks, including financial ones, the financial deregulation opened up the window to instability imported from America.

As the housing market boom fuelled by subprime loans came to a slow landing by the end of 2006, this was enough for triggering off a domino effect and for creating a vicious spiral of defaults and falling house prices. The magnitude of the price reversal beyond the expected range made the underlying econometric models irrelevant. Because of the sheer size of the operations, the whole of the American and European financial systems became contaminated and the crisis spread across the rich-world like a forest fire.
So far the damage has stopped here. A flight from the dollar on top of the banking crisis would have precipitated America into a collapse of its economy with unpredictable political consequences. An incredible end indeed to an eight-year neo-conservative Presidency whose purpose was precisely to shape some form of new world order!
Neither Asians nor Europeans should indulge in Schadenfreude though!
in The interests of the whole world, including Asia, lies in ‘Saving Private US economy’!

2. The narrative of the crisis’ handling

- The crisis is quintessentially financial, no doubt about that! It is an overall, deep and brutal crisis; it bears both on the liquidity and the solvency of the financial system. It is the “biggest asset and credit bubble in history” (the Economist 13/10/2008) and this is the first modern financial crisis whose epicentre is in the West.
- Freezing the toxic assets until their maturity and re-establishing both banks’ liquidity and savers’ confidence are the priority. It’s a huge and tough job which has just started.
- It has been done in two steps: first through an unprecedented cooperation among the major central banks -Fed, ECB, Bank of England and incidentally the Bank of China which on October 8th have decided to provide the necessary liquidity through money supply, interest rate cuts and swaps between the Fed and the ECB. Then the solvency issue was dealt with through the ‘correlation’ of national governments actions: bail outs (banks recapitalisation through nationalisations), confidence restoring measures (guarantees to inter-bank lending and to savers and depositors, at least within the EU).

- What was interesting and remarkable is the momentum of the action :
- at the very start of the crisis early this summer, in the sheer absence of information from the banks about their exposure to bad debts, there has been a reluctance from the authorities to recognize the real extent of a potential crisis . See the tentative statement from an OECD official in June : ‘the worst is probably behind us’.
- second, reactions were on a case by case basis ( Bear Stern’s take over with the help of the Fed, nationalisation of Northern Rock, Lehman Brothers’ bankruptcy) . The concern from the US side was to find a balance between damage control and moral hazard. But the Lehman Brothers’ bankruptcy has in fact contributed to a further loss of confidence among bankers and depositors and therefore was close to causing a credit crunch;
- then, eventually, came a two step global answer: first the $700 billion Paulson Plan aiming at purchasing toxic assets from banks with the view of creating a liquid secondary market; then the $2,5 trillion EU plan triggered off in Europe by an unlikely alliance between Sarkozy , as chair of the EU and Gordon Brown , not a eurozone member though, yet the source of inspiration for the correlated three-pronged answer between EU and US. Remarkably enough the G7 response was mainly the EU making: the leadership vacuum in the USA stemmed from a doctrinal inhibition among the US government dominated by the neo-lib thinking and from Bush being a lame duck President. Not surprisingly since it lost its credibility during the Asian crisis the IMF sat on the sidelines. The G7 plan integrated nationalisations , interbank liquidity , guarantees to depositors and savers up to 100.000 Euros in the EU.

The financial crisis is not over yet : it will dwell on as long as rotten assets stay in the banks’ and other institutional investors’ portfolios and as long as a major restructuring –including a drastic downsizing of the financial sector- has not taken place. Nationalisations might even complicate the restructuring in Europe while putting the unity of the financial Single Market at risk. The borrowing needs of some of the EU States for bailing out their banks might force them into exceeding the 3% GDP limit to public deficit set up by the Stability and Growth Pact within the Eurozone with the underlying potential risk of inflation or of Euro depreciation.
Yet the key issue is from now on the impact of the financial crisis on the real economy: will the recession be circumscribed to the OECD countries? Will the recession turn into a depression because of the deflationary nature of ‘deleveraging’ in America? What will be the impact on the emerging economies through financial channels (interest rates, exchange rates, stock exchange busts) and through trade and FDI flows?

But in order to take the appropriate remedy it is first and foremost important to understand why global market capitalism has been exposed to a crisis of this type whose final impact if unpredictable, could be devastating.

3. the financial crisis as a amplifying factor of a real crisis

What makes the post financial crisis recovery uncertain lies in the coincidence of the financial crisis with a real slowdown in the world economy.

Real business cycles have been smoothed over the last three decades by a combination of several factors:

- business and consumer confidence have been fed by stable world growth and have nurtured positive self-fulfilling predictions while blurring the risk perception;
- recurrent technological innovation waves have become the hallmark of global capitalism: economies of scale, competition and innovative finance, i.e. venture capital have enhanced the ongoing technology revolution leading to further productivity gains and goods variety.
- the integration of the Asian labour force into the global economy has brought about huge productivity gains whose benefits have also accrued to the West through corporate profits and cheap imports.
- cheap money was secured by the Fed
- cheap oil as long as it lasted
- structural imbalances as long as they were sustainable : both domestic (household indebtedness as a counterpart to real wage stagnation) and external indebtedness in America whose deficit , financed by Asian savings, has been one of the major drivers of world growth , are now proving now a major source of instability

Things are changing dramatically:
- first the other side of the ‘Chinese factor’ cropped up through last year’s steep rise in oil, raw materials and food; the resulting bout of inflation bent down the growth trend , while dollar surpluses in commodity exporting countries did not translate into development due to poor absorption capacity (Africa, Middle East, Latin America). The end result was a fall in global demand which over the last quarter translated into the plummeting of the oil price.
- second, the US twin imbalance proved eventually unsustainable with the breaking-out of the subprime crisis. The need for deleveraging (i.e. cutting on debt) will exert a deflationary effect on the world economy;

4. What the global response should be

One should realize that, beyond the financial crisis whose impact can dwell on for a long time, the real issue is the possibility of a rich-world recession. But the changes will be yet more far reaching as it is getting clearer that the crisis is a systemic one because

- a loss of confidence in the financial system in the West will discredit ‘hyper finance’ for one generation
- the resulting aversion to risk might hamper innovation, which is the main key to productivity gains and therefore to growth in ageing economies
- the shift of the economic weight from West to East will gather a new momentum , making it necessary to rebalance multilateral governance and to share the responsibility of remedies
- the US market capitalism model will not be anymore seen as a benchmark for emerging economies after the Wall Street financial meltdown;
- the Anglo-Saxon leadership in economic policy thinking - the Reaganomics and the self-regulation school - has received a serious blow and the pendulum is swinging from market to policy, with the inherent risk of policy conflict though, which is not a minor concern;
- a stabilisation of globalisation at its present level because of long term rising energy, logistical and environmental costs of transport and because of a shift from an export-driven to a consumption-driven development in China.

A new political economy doctrine must be devised. It is the stimulating dimension of the upcoming crisis. The thinking will not come just from the West anymore: America, Asia and Europe will have to work out a new policy consensus beyond the rich-world countries’ thinking. China has obviously a key role to play.

The answer must be comprehensive and global, i.e. including all the main actors disregarding the responsibilities in the crisis:

a) Emergency measures : the rescue package is now in progress and hopefully will pre-empt a credit contraction though the bailing out of banks (recapitalisation) , restoring interbank lending and guaranteeing savers and depositors’ safety;

b) Financial regulation -both national and transnational - must be strengthened:
- Reviewing accounting norms (mark to market vs historical costs) because of their pro-cyclical impact
- Disciplining rating agencies
- Strengthening Basel capital requirements ( dealing with off balance sheet assets) and extending them to other financial institutions
- Retaining part of securitized loans in the books of the initial lender
- Rebalancing corporate governance from share-holders to stake-holders (stock options, golden parachutes , remunerations ratios)
- Levying a tax on transactions for bailing-out funds

c) Tax havens : imposing on them minimum regulatory standards (hedge funds ) and tax cooperation policy (exchange of information) wherever they are located, under the threat of restrictions on capital movements for the non-cooperative ones.

d) The most serious challenge of combining short term expansionary measures (fiscal stimulus package) and long term structural reforms aimed at environmental sustainability (energy and climate change) and social cohesion :
- The US answer: a stimulus package for compensating households’ return to savings, ; plus a resistance to all forms of protectionism;
- The EU answer: a public indebtedness constraint for several Member-states, a challenge for unity, whilst paving the way for a global energy/climate deal (20/20/20 plan for 2020); keeping markets open to trade and FDI (including Sovereign Wealth Funds)
- The Chinese answer: changing gears from export- to consumption- and environmental investment-driven growth ; resisting the temptation of going back on economic reforms and openness and enshrining Asian regionalism into buttressed multilateralism

e) The reform of the Bretton Woods System: giving the IMF a new legitimacy after the Asian crisis (1997-1998)
- Convertibility
- Free movement of capital ( control of hot money)
- Stability of exchange rates through respect of fundamentals
- Rebalancing the IMF’s governance ( capital, reserve assets, voting rights and board membership) : rise of emerging economies, including China; substituting the Eurozone for individual EU Member-countries;
- Bringing the new IMF back to the centre stage with an overall mission of surveillance addressing all structural imbalances- i.e. including the anchor currency country, namely the USA- and of last resort lender with a revisited conditionality ( allowing for policy space and diversity of market capitalism models)
- Considering alternatives for anchoring the currency system
- Pooling part of the reserve assets of the surplus countries and making the IML act as a powerful stabiliser
- Coordinating the revision of the aggiornamento of the financial regulation (see above)

f) the conclusion of the Doha Round and the implementation of Kyoto targets whose impact on the real economy will be very positive over the long run

g) turning the G8 into a G something with US, EU, China, Japan on board, as a coordination body for the three pillars of the multilateral system (trade, finance and norms).

5. Conclusion

China’s emerging and still fragile economy is being hit by a financial crisis started and caused by excessive deregulation in the USA and extended to Europe via a supervisory default. As a growing trade player and the most important holder of foreign reserves, China has a central role to play in the reshaping of the post financial meltdown order. China’s potentially huge domestic market secures the possibility of a robust endogenous growth: internal demand can offset a likely fall in external demand and maintain the high rate of growth needed for creating jobs for migrant workers. By championing sustainable development at home and punching its full weight as a global player in the multilateral economic governance, China can overcome the difficulties ahead and contribute to a faster world economic recovery.

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