Ten years on, in uncharted waters

The crises in emerging economies show how vulnerable they remain to the vagaries of U.S. economic policy
Economists thrive on crises. The East Asian crisis of 1997 caused a rethink on full capital account convertibility and fixed exchange rates. The Internet bubble and bust of the early 2000s led many to question the impact of new technology on long-term productivity growth. The scandals in the corporate world through the 2000s in the U.S. provided grist for a fresh debate on corporate governance. None of these was any match for the opportunities for cerebration created by the financial crisis of 2007. The crisis, which peaked in early September 2008, occasioned an enormous outpouring of scholarly papers, articles and books on the causes of the crisis and the lessons to be learnt. Have these made the world any safer? Unlikely, as we shall see later.
Centred in regulation failure
The crisis of 2007 had multiple causes. Global macroeconomic imbalances, a loose monetary policy in the U.S., the housing bubble in the U.S. again and elsewhere, a bloated financial sector, a flawed belief in efficient markets, greedy bankers, incompetent rating agencies — these and others have been identified as among the villains of the crisis. All of them undoubtedly contributed their part. But each has happened before without on its own bringing on a global economic crisis. Most of the blame for the implosion of the financial sector in 2007-08 lies elsewhere — in a failure of regulation. This failure manifested itself in several ways. One, banks were allowed extraordinarily high levels of debt in relation to equity capital. Two, banks in the advanced economies moved away from the business of making loans to investing their funds instead in complex assets called “securitised” assets. The securitised assets consisted of bundles of securities derived from sub-prime loans, that is, housing loans of relatively higher risk.
Core issues
That is because three issues remain significantly unaddressed. First, the ‘too big to fail problem’ — some banks being so large that they cannot be allowed to fail. Some of the biggest banks in the world have grown even bigger after the crisis. Concentration in banking has increased. Second, the size of debt in various forms in the world economy. A crucial aspect of the financial crisis was the build-up of private debt, that is, the debt of households and non-financial firms. Two Chicago economists, Atif Mian and Amir Sufi, argued in a well-received book, House of Debt , that the expression ‘financial crisis’ was something of a misnomer. The key driver of the recession in the U.S. was the rise in household debt and the consequent drop in household consumption. This does not negate the view that regulatory failure was the principal cause. It only means that regulation must address growth in credit as well as the flow of credit into sectors such as real estate. In the years following the crisis, private debt has fallen but government debt and corporate debt have risen. The former head of the U.K.’s Financial Services Authority, Adair Turner, says that total debt — government, corporate, and household — as a percentage of GDP is higher than ever before ( Financial Times , September 11). For the global economy as a whole, the overhang of debt poses serious challenges.
Third, financial globalisation makes the world vulnerable to U.S. monetary and fiscal policy. From time to time, the U.S. unleashes a flood of dollars at low rates. The world laps up the cheap finance. Then, the U.S. raises interest rates. Other economies find themselves staring at huge debt repayments. Further, the dollar remains the reserve currency of the world. The U.S. can borrow to the hilt but the dollar will not depreciate, it may even appreciate! The present crisis in emerging economies highlights how vulnerable emerging markets are to the vagaries of American economic policy. The world needs to be weaned away from its dependence on the dollar. Alas, an alternative global financial architecture is nowhere in sight. Economists are free to draw their lessons from financial crises but the world is ultimately shaped by political and business interests, not by economists.
T.T. Ram Mohan is a professor at IIM Ahmedabad. E-mail: ttr@iima.ac.in

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