What caused the global economic crisis?

(the Hindu Mar 16 2009)
The global economy remains mired in a deep crisis. Very recently the World Bank, in one of its bleakest assessments yet of the ongoing crisis, has said that the global economy and the volume of global trade would both contract this year, the first time since World War II.



The IMF, which in January had forecast the global economy to grow by just 0.5 per cent in 2009, now predicts a contraction. Developed countries will see their economies shrink while developing countries will grow but a much slower rate than what they have been used to. There is near unanimity that the world economy will not recover until the raging financial sector crisis is brought under control. However, despite committing several hundred billion dollars of public money, governments in the U.S and other developed countries have not been able to come to grips with the crisis. Extreme measures such as outright nationalisation of banks — to save them from the crisis — are being contemplated. In April, heads of G-20 countries will meet in London to discuss a number of proposals to reinvent the world financial order. The decision to call such a meeting was taken earlier, in November 2008, at the Washington summit. What are the factors behind the crisis? Ahead of the G-20 meeting the question assumes topical significance.


Global imbalance


Obviously identification of the causes would help in finding long lasting solutions or at least mitigating the immediate impact of the crisis. So far there has been no unanimity on the factors responsible for the crisis. There have been two different, but not mutually exclusive viewpoints on what is behind the crisis.


According to one view, shared among others by Nobel prize winner and New York Times columnist Paul Krugman, the financial sector debacle has its origins in the “global imbalance” — the phenomenon of large current account surpluses in China and a few other countries co-existing with large U.S. deficits. The global imbalance is reflected in large mismatches in the current account positions of some countries and its mirror image in the form of domestic savings — investment mismatches. Understanding such imbalance is not that difficult even for lay people. The U.S has been running huge deficits. Countries such as China and Japan needed an outlet to deploy their surpluses. It was mutual convenience, as it were, for the savings of Asian countries to find a haven in the U.S., which needed the money because it saved very little.


An important manifestation of the global imbalance has been the flood of money into the U.S. that kept interest rates low, inflated prices of real estate, shares and other assets. When the bubble burst the financial sector crisis surfaced. So an ‘orderly’ unwinding of imbalance alone will help mitigate the crisis. If this viewpoint is accepted, macro economic policies of countries need fine tuning.


The U.S government’s efforts to persuade China to revalue the yuan, making its exports less competitive arises from the belief that global imbalance is a primary cause for the current crisis. The U.S. has not been successful so far and similar efforts to influence other countries will not bear fruit unless there is a high degree of understanding and co-operation among nations. A consensus is highly doubtful at the forthcoming summit.


Poor regulation


A very different view has been presented by the IMF in a recent paper. Global imbalance is only an indirect cause. The main culprits were deficient financial regulation and the failure of market discipline resulting in a systematic flouting of rules and regulations by banks.


As the sub-prime crisis showed, practically all banks used their ingenuity to develop structures and products that were outside the normal regulatory confines of banking in order to satisfy their customers seeking high returns. In the process they created a large number of shadow banking institutions — investment banks, hedge funds and the like. These shadow institutions grew over time to be systemically important. Through securitisation and other means the banks convinced themselves that the risks were spread out.


The complex instruments presumed to minimise risks with the original issuer and guarantee a high return for those who bought them. In the end those who created them did not comprehend their risks.


The collapse of the housing market was followed by a great squeeze in the credit markets.


The IMF’s prescriptions (in one of the background papers to the G-20 summit) are to step up regulation, to bring ‘shadow banking’ within the ambit of regulation.


Obviously, both viewpoints have merit and at the forthcoming summit a judicious mix of the two — winding down global imbalance and enhanced regulation — will be agreed upon.


The Indian connection


While on the subject of global imbalance and global economic crisis it is worth recalling the prescient observations of former RBI Governor Y. V. Reddy. In an address at the Financing for Development (FFD) Office, United Nations, on May 11, 2006, he had this to say: “One wonders whether there is a dissonance between the perception of financial markets and that of policy makers in regard to global imbalances.


“The policy makers appear to give some signals of concern, but the response of the financial markets is often out of alignment with the signals. Interestingly, anecdotal evidence shows that analysts in financial intermediaries are sensitive to the downside risk of imbalances but the conduct of the participants does not reflect the awareness... If such dissonance is true, and persists, what would be the effectiveness of public policy?”


The speech was delivered 29 months before the collapse of Lehman Brothers and other institutions and the full impact of the crisis began to be felt around.