Archive for July, 2009
Remarks at the Eighteenth Cycle of Economics Lectures, Banco de Guatemala June 16, 2009 Almost two years ago, the global economy and financial system entered a severe crisis. The incidence and ramifications of the crisis were obscure. Even now, the full dimensions and consequences are not known, but almost certainly this crisis will prove to be the most severe in the extent and severity of its global impact and depth since the end of World War II. Because the crisis is not yet over, among other reasons, we lack the perspective to develop a full catalog of the lessons from the crisis, either in general or for developing countries in particular. However, I thank the Banco de Guatemala for inviting me to share my thoughts on this important and complex subject from the vantage point of June 2009.
In these remarks, I first offer my perspective on the causes of this crisis and how this crisis differs from previous global financial crises. This is a necessary precondition to learning the appropriate lessons from the crisis. Otherwise our lessons will be off-target or incomplete. Second, I offer some key relevant lessons under five headings: too good to be true is probably false; be better prepared; the myth of self-insurance; the role of the International Monetary Fund (IMF); and the future of globalization.
Causes of the Crisis
I concluded six months ago (Truman 2008) that there was no shared diagnosis of the origins of this crisis. Nothing that I have heard or read since then has convinced me otherwise. If anything, disagreements have become more intense, in the meantime. This fact hampers our ability to learn the proper lessons from this crisis. This fact also means that it is useful for me to declare my own biases in advance. Conventionally, causes of this financial crisis include some or all of the four following elements: macroeconomic policies, financial-sector supervision and regulation, financial engineering, and the global activities of large private financial institutions. The context for each element is the United States or other similarly advanced countries.
In my view, macroeconomic policies in the United States and the rest of the fully developed world were jointly responsible for the crisis we are now experiencing to a substantial degree. In the United States, fiscal policy contributed to a decline in the US saving rate, and monetary policy was too easy for too long. In Japan the mix of monetary and fiscal policies distorted the global economy and financial system. Finally, many other countries also had very easy monetary policies in recent years, including other Asian countries, energy and commodity exporters, and, in effective terms, a number of countries within the euro area. The impressive accumulation of foreign exchange reserves by many countries also distorted the international adjustment process, including but not limited to taking some of the pressure off of the macroeconomic policies of the United States and other countries.
The result was not just a housing boom in the United States, but also housing booms in many other countries, some to a greater extent than in the United States.1 However, in addition to housing booms, there was a global credit boom fueling increases in the prices of equities and other manifestations of financial excess.2
Financial-sector supervision and regulation, or the lack thereof, over several decades also played a role. However, without the benign economic and financial conditions that prevailed in the wake of the dot-com boom and the associated belief that “this time it is different,” this crisis would have taken a different form.
Benign conditions lead to lax lending standards, just as the night follows the day. In principle, financial-sector supervision could have helped to curb the excesses, but it did not do so in the United States or in many other countries around the world.
In some cases, including importantly the United States in this regard but again elsewhere, regulation and supervision were incomplete. The rise of what is now known as the shadow financial system had been going on for decades in many countries: money market mutual funds, special purpose investment vehicles, hedge funds, private equity firms, etc. In many cases, these entities were highly leveraged and/or used short-term funding to finance longer-term investments. We saw a gradual shift over several decades in financial intermediation from traditional banks to other types of financial institutions that were less well capitalized and subject to less close supervision. Traditional banks themselves gradually, but radically, transformed their business models in order to compete with the less-regulated institutions. The global financial system became overleveraged, particularly in the United States, but also to varying degrees in other countries. When confidence waned, funding dried up and structures collapsed.
Part of the overall picture was new forms of financial engineering, but innovations have been a feature of domestic and international finance for decades. In many cases, the associated innovations were poorly understood, resulting in a failure of risk recognition, which is a necessary precondition for good risk management. Financial engineering contributed to the market dynamics once the crisis got underway, but it was not “the cause” of the crisis.
Finally, some argue that the lack of comprehensive supervision of about 50 large private financial institutions with operations around the world caused the problems faced by the global economy today. In this view, no single national financial supervisor or regulator could possibly understand the full scope of the operations of these institutions. True, some major financial institutions have failed, or the authorities have decided to rescue them, which is tantamount to failure from a market perspective. However, they did not fail because they had multiple national supervisors and thus escaped appropriate supervision. Size has been a problem, and complexity has led to some decisions to rescue particular institutions in whole or in part, but the global scope of the operations of these institutions was not a major contributing factor to the crisis per se.
Thus, in my view the two major causes of the global financial crisis of 2007–09 were failures in macroeconomic policies and in financial supervision and regulation. I would assign principal blame to failures in macroeconomic policies by a small margin. I do not see this as inconsistent with the view that there are structural flaws in national and global financial regulatory and supervisory systems, which had been building for years and should be addressed in the wake of the crisis. It may well be that a crisis of this magnitude was necessary to uncover those flaws. Whether they would have been revealed without the macroeconomic failures is at least a debatable question.
Whatever the fundamental or proximate causes of this crisis, three features distinguish it from many other international financial crises in recent decades.
First, the proximate origins of the crisis were in the United States to a greater degree than with other crises. Regardless of the amount of blame for the crisis one places on US macroeconomic policies on the one hand, or US financial regulatory policies on the other, the fact is that the United States led the way into the crisis. Activity in the US residential construction sector peaked in the fourth quarter of 2005. The actions of US financial institutions were central to the unwinding of financial positions that began in the summer of 2007. Activity in the US economy peaked in the fourth quarter of 2007. For the rest of the world, all this meant that the US economic and financial engine eventually went into reverse.
Second, if the largest economy in the world, whose currency and institutions are at the core of the global financial system, stops functioning, the fact that the resulting crisis becomes global should not be surprising. However, many observers and policymakers were surprised. At the beginning of the crisis, “decoupling” was in fashion. In particular, the emerging-market economies in Asia and elsewhere were going to rescue the United States from recession.3 In fact, globalization has linked all financial systems and economies, but the extent of that linkage was poorly understood prior to the crisis. As a result, comprehensive global solutions have been slow to emerge.
What we have learned is that deleveraging is a process that does not discriminate even among economies and financial systems that are less leveraged than others. Similarly, at the start of the crisis, trade links were stronger than they had been for a century. The US economy drove much of the recent expansion in trade with its external deficits, and that process has reversed. According to IMF projections (2009b), world trade in goods will decline this year by 11.5 percent in volume and by 25 percent in value. Therefore, we should not be surprised that only 17 of the 182 economies that the IMF follows are expected to grow faster this year than they did last year, or that 71 of them are projected to shrink, including 30 of the 34 advanced countries. In this crisis, the citizens and authorities of a country can run, but they cannot hide.
Third, it is not unusual for a crisis to begin in the financial sector, spread to the real economy, cycle back to further weaken the financial sector, and thereby further weaken the real economy. However, this sequence is debatable if one wants to say the United States was the epicenter of the crisis and trace the trigger of this sequence exclusively to the US financial sector. If the proximate cause of the financial crisis was the US housing boom, housing is a feature of the real economy. Subprime mortgages were a manifestation of financial excess or worse, but they were not the principal cause of the housing boom, which was easy credit and low interest rates. What is real and what is financial? In this case, we really can not say.
What we do know is that the US financial sector motored on for some time after the housing sector turned down. We also know that once the US financial system began to implode in the summer of 2007, it took more than a year for the financial crisis to reach its climax in the fall of 2008 and for the real economy to enter its nosedive. The full extent of the crisis took a while to unfold.
Diagnosis of the economic and financial situation was even more complicated in the rest of the world. During much of 2008, economic growth appeared to be holding up in general, and inflation, particularly in commodity prices, was still rising. In April 2008, eight months into the global crisis if we date its start as August 2007, the IMF (2008) was forecasting only a mild slowdown in global growth in 2008 and 2009 to 3.7 and 3.8 percent, respectively, from the 4.9 percent that then was estimated for 2007.4 Median consumer price inflation in the advanced countries was projected to rise to 2.9 percent in 2008 from 2.1 percent in 2007. In fact, median inflation rose to 3.2 percent. Recall that the European Central Bank (ECB) raised the target for its key refinancing rate on July 3, 2008, and the ECB was not alone in its inflation concerns at that time.
It is possible to have a mild economic downturn without an associated financial crisis. It is also possible to have a financial disruption without an associated economic downturn. What is rare, but not impossible, is a significant economic downturn without a severe financial crisis, affecting a broad set of asset prices and credit markets, or vice versa. Policymakers were slow to learn that they were dealing with dual severe crises on a global scale.
As a participant in debates in the 1990s about the Japanese economy and financial system, I was struck at that time by the lack of consensus about this chicken-or-egg question: What should be addressed first, economic recovery or financial repair? I finally decided that the best answer was both! That lesson was not widely agreed then, and it is not agreed now.
Nobel Laureate economist Paul Krugman has stated that “Latvia is just another Argentina” that has to devalue its currency to escape from its financial crisis. Similarly, the Russian financial crisis in 1998 points to devaluation as a suitable solution. But Latvia’s situation is very different. The common feature in these three crises was the pegged […]