How The U.S. Government Engineered The Current Economic Crisis
237 Commentsby Michael Arrington on September 26, 2008
These people (the U.S. government) need to be stopped. Every time we get ourselves into an economic mess, there’s usually some milestone idiocy we can point back to as the government action that made the meltdown inevitable.
Take the current housing crisis that has now spread to the financial markets in general. The cause was too-easy credit that fueled a massive increase in housing prices as people bought houses they couldn’t afford with mortgages they weren’t able to pay off.
In 1999 there was roughly $5 trillion in total U.S. mortgage debt. That number ballooned to $12 trillion by 2007, and we know what happened from there (data is from the U.S. Office of Federal Housing Enterprise Oversight). To put this into perspective, total U.S. GDP is about $11 trillion annually, and U.S. government debt is around $9 trillion. If the housing market really falls apart (meaning more than conservative estimates of a 20% drop), there’s no way the government can simply cover these losses.
Why did it happen? Let’s go back to 1999, when Fannie Mae, the nation’s biggest underwriter of home mortgages, was under pressure by the Clinton administration to find a way to get more loans to “borrowers whose incomes, credit ratings and savings are not good enough to qualify for conventional loans.” A pilot program was launched, which soon became general policy. Money flowed to people who couldn’t afford to pay it back.
These new policies came on top of previous changes in the 90’s that let consumers get zero-down payment loans.
In a 1999 article that now looks absolutely insane, the New York Times reported on the easing of credit terms. Fannie Mae Chairman Franklin Raines, who’s quoted in the article, was all sunshine and roses as he threw away the financial future of millions of Americans. But at least one person. Peter Wallison, had a good idea of how this would all play out:
In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980’s.
”From the perspective of many people, including me, this is another thrift industry growing up around us,” said Peter Wallison a resident fellow at the American Enterprise Institute. ”If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.”
Too bad nobody listened to that guy.
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Comments Pages: [1] 2 3 » Show All
MarkSlindsey - September 26th, 2008 at 3:23 pm PDT
Mike, what’s your source for the graphic?
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Victor Caballero - September 26th, 2008 at 3:24 pm PDT
(data is from the U.S. Office of Federal Housing Enterprice Oversight)
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Steven Dole - September 26th, 2008 at 11:01 pm PDT
the true question is:
WHY BORROWERS BECAME SUDDENLY UNABLE TO PAY THEIR MORTGAGES 2-3 YEARS AGO?
The “poor” could pay their mortgage between 1999 to 2005 with no problem, so what happened?
I tell you what happened: unemployment. Yep, the rate rose from 4% to 6.1% in 8 years and will probably reach 6.5% by the end of the year. Thus it’s pretty easy to understand why it becomes difficult for those who loose their job to pay their mortgage.
And the so called “Economic Downturn” you’re talking about is due to the drastic change of political priorities since 2000 under the Bush Administration.
You want figures? I give you one: $600+ Billion. That’s the amount spent in Iraq so far (and counting), ironically getter every day closer to the Bush-Bailout’s amount. Funny, hu?
If we had spent this amount into our economy instead of this stupid war (investing in research and cut imports), the true victims of this mess wouldn’t have lost their job in the first place and wouldn’t have stopped paying their mortgages.
Access to ownership is a good thing, everyone deserve to own a house in our country. The problem is how good is the government at protecting you from loosing your job.
misleading graph - September 27th, 2008 at 12:20 am PDT
Graph does start from 0 trillion, hence it looks like it grew 10 times in 10 years, which is quite misleading.
Instead it grew from 5 trillion to 12 trillion, if inflation is taken into account it is less than double. If you normalize further wrt GDP, growth is further less.
Al Brown - September 27th, 2008 at 7:43 pm PDT
This did not happen because because people suddenly became unable to pay their mortgages 2 or 3 years ago.
This happened because the values of homes people purchased became less than what they owed. So they decided not to be suckers and stay in them.
The decline in value occurred because of homes were overvalued.
That happened for many reasons, most of which were government actions, either printing too much money, relaxing mortgage standards, eliminating capital gains on profits from many home sales.
A whole series of things happened that gave many the impression that houses would continue to appreciate faster than other assets.
But people knew it was happening. The real estate lobby knew but didn’t care. Congress knew but didn’t care. Ron Paul knew but didn’t…oops. Well, he actually did care and did speak out, but the media didn’t care.
Al Brown - September 27th, 2008 at 7:48 pm PDT
http://www.youtube.com/watch?v=raAtB1FONmg
Allen - September 28th, 2008 at 7:38 am PDT
Al Brown - hope that kool-aid tastes good. If you only didn’t have the luxury of living under the very freedom this country provides you - try moving to Iraq back in the Saddam era and tell me how it is. You wouldn’t even be able to type the sort of rhetoric you just did without being shunned (or killed) by a tyrant like Saddam. Hey - better yet, why don’t you move to Iran and speak of their government like you speak of ours - we’ll see how long you last. Why don’t you just thank those in leadership just once and allow them to do their jobs the best they can instead of just judging things after the fact.
P - September 28th, 2008 at 12:16 pm PDT
Allen - you are not refuting anything Al Brown has said. All you are saying is that he should shut up and be grateful. So under a Democratic president would you shut up?
Andy Wong - September 28th, 2008 at 11:34 pm PDT
Steven spotted on.
“And the so called “Economic Downturn” you’re talking about is due to the drastic change of political priorities since 2000 under the Bush Administration.
You want figures? I give you one: $600+ Billion. That’s the amount spent in Iraq so far (and counting), ironically getter every day closer to the Bush-Bailout’s amount. Funny, hu?”
If a country spent billions on something (Iraq war) without any return, the country lost fortune, and the currency lost credit.
The cause of credit crises is simply the country losing credit. Isn’t that simple?
You just don’t need fancy economic theory.
Anyway, after all, countries around the world will pay US after the green back will be getting de-valuated again.
Techcrunch40 Sponsor - AGORACOM - September 26th, 2008 at 5:55 pm PDT
From someone a lot smarter than you on this issue:
“@techcrunch your post on the causes of the current credit crisis is oversimplified to the point of absurdity. ”
http://twitter.com/pkedrosky/statuses/936380652
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Tom - September 27th, 2008 at 7:03 am PDT
And what exactly does Paul Kedrosky have a Ph.D. in? All bark, no bite.
David Litsky - September 28th, 2008 at 7:51 pm PDT
It should also be noted that consumers were encouraged to use their houses as a piggy bank, taking on home equity loans and home equity lines of credit to fund home improvements, automobile purchases and other consumer spending. These are loan products originally aimed towards customers that have repaid their original mortgage and want to withdrawal a nominal amount of equity (20-40%) from their homes. But as housing prices rose, consumers were allowed to withdrawal this new equity from their homes without true consideration as to why housing prices were rising so fast or their ability to repay two mortgages on their home. And now that housing prices are falling and unemployment is rising, consumers are learning a tough lesson in the true cost of money.
James Collier - September 29th, 2008 at 11:01 am PDT
David, I think you’ve actually identified the greater point of instability - it isn’t in the new homeowners who suddenly couldn’t pay their mortgage, it’s in the inflated value they paid because others cashed in on home equity loans.
Mitch Rosen - September 26th, 2008 at 10:39 pm PDT
I come to this site to get away from politics. Stay away from it.
You could potentially lose the admiration of half your readers if they think you’re on one side of the political spectrum, Mike, even if you didnt intentionally mean to alienate them.
Just a warning before it happens. A second political post will probably do some damage.
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Steven Dole - September 26th, 2008 at 11:04 pm PDT
Arrington has always claimed to be pro-Obama. By this article though, it becomes obvious he is anti-Clinton too.
Shilabula - September 27th, 2008 at 9:18 am PDT
Its not about politics, its about economics - crap macro economic management to be more specific.
Both parties are guilty, thus the true cause is deeper than the democratic veneer. Deep in the chipboard of the American power system.
Gebadia Smith - September 27th, 2008 at 9:28 am PDT
So this is what freedom of speech has become in the US. You make threats when someone writes something you don’t like? If you are against the war you are unamerican, if you are against spying on your own people, you are unamerican.
Seems to me the America we use to aspire to be does not exist and instead has become a Tom Clancy/Fahrenheit 451 novel without a hero. Poor education, poor health care, a christian enemy, better TV shows, video games and magic phones make for a world where governments can do whatever they want.
Even now when things go south Mr. Dole you want to play politics and make generalizations about Mike losing half his readership. Not everybody is a party drone. Some appreciate different view points.
Peter - September 27th, 2008 at 8:16 pm PDT
The largest economic meltdown since the 20s is a political post? Look at almost any industry magazine, site, newspaper, and what’s now the lead topic?
Government Bailing Out The Oil Market! - September 27th, 2008 at 5:58 pm PDT
Read how the government kept Oil and other commodities prices high for the consumer to protect Morgan Stanley and Goldman Sachs. if this hadn’t been done Oil prices could be $65 to $75 per barrel today. Gas at? $2.25 gal?
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Government Bailing Out The Oil Market! - September 27th, 2008 at 5:59 pm PDT
Here’s the link to the story at forbes: http://www.forbes.com/energy/2.....nergy.html
Don Wilson - October 3rd, 2008 at 7:06 pm PDT
The graph above is very misleading. It shows as if $3b is nothing compared to $9. The graph SHOULD start at $0 but it wouldn’t make the last 12 years more exciting in growth of debt.
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wolfsbayne - September 26th, 2008 at 3:23 pm PDT
here’s a ugc video that echoes some of that, mike.
sorry, it has pro mccain stuff in it.
http://is.gd/3b4v
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Korak - September 26th, 2008 at 3:24 pm PDT
Yep… There is a lot of blame being pointed at the “free markets” for this but the observation that it is governmental driven is a good one. And, while the Bush administration certainly deserves its share of the blame, it’s nice to see someone point out that Clinton’s administration played a role too. It did. They all suck.
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Patel - September 26th, 2008 at 4:33 pm PDT
While the economy is really bad, I think that some businesses can still make it…Even though the markets are not “free”
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Brian Sherwin @ Myartspace Blog - September 26th, 2008 at 9:12 pm PDT
I agree Korak. I keep reading blogs that blame one part or the other. Both played a role.
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dave g - September 26th, 2008 at 10:51 pm PDT
im not going to get too deep into this…but during my 4 years in the military, if something went wrong on my watch - it was my ass.
end-of-story.
i guess the lower pay grades are held to a higher standard.
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Cory - September 26th, 2008 at 3:24 pm PDT
Careful Michael… you have a lot of readers who are eager to blame this whole thing on Bush and Republicans, and you seem to be blaming this on Clinton-era policies. I can’t wait to see the ensuing comments.
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Pete - September 26th, 2008 at 3:50 pm PDT
“you seem to be blaming this on Clinton-era policies”
–Duh!!! It was the reptilian slick Willie plus the usual suspects: Christopher Dodd, Barney Frank, Chuck Schumer and others, such as Andrew Cuomo at HUD: all of these guys, and others, ARE responsible for this mess.
Greed, greed, greed… In the Washington DC area, over 22% of sub-prime, no-docs mortgages were taken by illegal aliens, underwritten by bastard, greedy mortgage brokers.
There is a lot more going on now, like this guy Henry Paulson: a leftist democrat with close ties to Obama and the bastards named above, coming up –out of thin air, with the 700B dollars.
It is a huge setup for Bush and McCain: Congress’ approval of this fraud will not happen and –if Obama is elected president, he will take credit for this, for “saving” the American people from the ‘failed’ policies of the Bush administration… while immediately raising taxes on everyone and everything.
I work on Capital Hill [not for long] and am familiar with so much s**t going on here. It is incredible, every idiot is rooting for the bumbling, ignorant and supremely misinformed empty suit. You know who…
By the wary Obama is not an “African-American” he is an “Arab-African” having been born in Kenya [no records to be found] and appearing in Hawaii four days later [again, no birth certificate or any other records proving that he is an American citizen. Hope that this is an 'October surprise']
Pete
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AhmedF - September 26th, 2008 at 3:54 pm PDT
Wtf Arab?
FactCheck.org and Snopes.com have thoroughly debunked his birth certificate - please, find some other lie to spread.
Pete - September 26th, 2008 at 4:03 pm PDT
To AhmedF — It is not a lie: my brother lived in South Africa and Kenya, representing a London newspaper; he actually interviewed people who remembered that in the early sixties a white American woman gave birth to a black baby in the area where Obama’s relatives still live. My brother could find only an abandoned small building, no more than a few rooms and a roof, that used to be a hospital. Could not find any records although he looked at transportation logs [cars, buses, airplanes] of companies carrying passengers our of the country.
Pete
aaron choi - September 26th, 2008 at 4:07 pm PDT
someone born in africa is arab?
Pete - September 26th, 2008 at 4:18 pm PDT
To aaron choi — Yes, for instance, does the name ‘Egypt’ mean anything to you?
Also, the name ‘Hussein’, Obama’s middle name is Muslim / Arab.
He is still Muslim. “Not that is anything wrong with that…”
Pete
Pete - September 26th, 2008 at 4:23 pm PDT
To aaron choi — Obama attended a ‘Madrassa’ in Indonesia. If you do not know this, these schools teach the Quran [the central religious text of Islam] in Arabic [NOT American English, by the way], along with a profound hatred of ‘infidels’ –of course, Americans.
There several very active Madrassas in the US, all sponsored by the Saudi government…
Pete
Charles - September 26th, 2008 at 4:48 pm PDT
Pete -
Of course you’re pointing fingers - which is all the republicans can do these days. Anything to try and divert focus away from the complete failures of their policies that all started with Reagan. Free Market and trickle down economics - do not work - especially in an economy this large. In addition, the lie that has been propagated about smaller government is just that. Every republican in office since Reagan has increased the federal budget deficit by increasing spending.
As George Carlin once said, “politicians are like diapers, they need be to changed often”, and McCain (26 + years in office) is full of sh*t.
mahalo bruddah - September 26th, 2008 at 5:22 pm PDT
Why don’t you look to find out where John McCain was born ….
Pete - September 26th, 2008 at 5:39 pm PDT
To mahalo bruddah - McCain was born in Panama, at an American military base: this means, he was born to American parents, in American territory: he IS an American citizen. –All American military bases around the world and also embassies and consulates ARE considered AMERICAN territory. Something you are not expected to know, coming from who knows where…
To Charles — I am a registered Democrat who is going to vote for McCain. Why? Because I want the BEST president possible for our country, no matter what skin color…
Most American citizens expect the most capable person as president, not one that is going to ‘learn on the job’, with no substantial experience of any kind, who is capable only of running his mouth [as any lawyer would do, I admit] spewing garbled pseudo-intellectual crap with no real meaning and no clear plans for anything.
Now, you are quoting George Carlin???? Pleeeeeeeeeeeease!!!!!
Pete
Ann - September 26th, 2008 at 5:48 pm PDT
Even if it is true. Kenya is not an Arab country. Get your geography right.
Laughing - September 26th, 2008 at 6:01 pm PDT
Pete, Is this your source
http://www.monkeyreview.co.uk/.....in-america
Peter Pan - September 27th, 2008 at 10:05 pm PDT
Yo Pete, get your G.E.D. and head out of the trailer.
ConspiracyLocator.com - September 26th, 2008 at 4:15 pm PDT
Organized Crime plain and simple. goes by the last name greed. Follow the money. its not hard to see who got it all. Modern Day Economic Terrorism
(AKA rape). Where is homeland security when you need them. They would rather surround the house of palins hacker instead of the people who conspired the greatest act of economic terrorism this country has ever seen. They “all knew” this was coming because they orchestrated this. Its easy to see the future when your creating it. Instead of giving a bailout to the people who dont need the money, why not give it to the consumers and let them save and spend it since they are the core driving force of this whole economy.
GovernmentLocator.com
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Abdalateef Taha - October 8th, 2008 at 5:30 am PDT
I thinc this economic crisis due to mismanagements
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Stephanie - September 26th, 2008 at 3:26 pm PDT
As I have been absolutely obsessed with and glued to CNBC since last Monday I really enjoyed your post!
A personal fave…
http://www.youtube.com/watch?v=SWksEJQEYVU
and another response.
http://www.youtube.com/watch?v=IG8uBhNEh7U
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ajadoniz - September 26th, 2008 at 3:27 pm PDT
I’m glad someone knows history from more than 5 years ago. I applaud you, Michael. People, nowadays, are always ready to pin everything on Bush and the GOP. Socialism doesn’t work in the long term. Social security, Fannie-Freddie, welfare, universal health care.
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AhmedF - September 26th, 2008 at 3:58 pm PDT
Except Fannie is not the cause of the overall market issue.
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TYPICAL_BAY_AREA_DEVELOPER - September 26th, 2008 at 3:27 pm PDT
Typical Bay Area Reply:
“It’s all the dot-commers fault for creating that excess wealth that pumped up house prices and demand!”
Yawn. Not very original.
Here’s a better question: how much of the mortgage debt is sub-prime? Home prices have definitely inflated over the past 10 years due to speculation, cash-rich folks, etc. Do they hold a larger of the debt pie than sub-primers who live Fontucky?
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Jim S. - September 26th, 2008 at 3:29 pm PDT
Take a look at this Times article from 2003: http://tinyurl.com/6lp5qu
The best quote is probably this one towards the end:
”These two entities — Fannie Mae and Freddie Mac — are not facing any kind of financial crisis,” said Representative Barney Frank of Massachusetts, the ranking Democrat on the Financial Services Committee. ”The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.”
Of course, the administration’s plan for reigning things in went no where because priorities were elsewhere and there was little political capital left to burn.
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RSS Reader - September 26th, 2008 at 3:30 pm PDT
Mike, c’mon, this is not a politics or a finance blog.
If I wanted that I’d go to DealBreaker or ClusterStock - you’re great at tech, not so great at politics and economics.
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Michael Arrington - September 26th, 2008 at 3:39 pm PDT
You are so right. What could this situation possibly have to do with the tech economy.
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jg - September 26th, 2008 at 3:58 pm PDT
I think it was a good post - go ahead and write about whatever the hell you want. As long as it’s well written and thoughtful, I’ll keep coming back.
Great points - concise and well written. I will fwd this around to a lot of people that aren’t in the tech world and don’t read TC. Thanks.
UMapper - September 26th, 2008 at 4:07 pm PDT
I agree, no matter what industry you are in, most likely, you are going to ‘feel’ the consequences… keep writing
mahalo bruddah - September 26th, 2008 at 5:24 pm PDT
What morons…. tech industry is next. All those PE and Hedge Fund players who are now temporarily barred from playing in the financial sandbox will divert their attention to tech.
Hang on to your shirts kids…
dave - September 28th, 2008 at 6:23 pm PDT
You are only marginally qualified to talk about tech; you are totally unqualified to talk about the broader market.
itchy - September 26th, 2008 at 3:32 pm PDT
“you get full points for telling me things BEFORE they happen”
-mike milken
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Your Daddy - September 26th, 2008 at 3:34 pm PDT
I blame the dot.com boom, bubble and Clinton for all this shit!
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Slick Willy - September 26th, 2008 at 3:49 pm PDT
Oh go smoke a cigar!
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Allan - September 26th, 2008 at 3:34 pm PDT
@Wolfsbayne - why does it matter if something is pro-McCain or pro-Obama when facts are involved? Why would you need to be apologetic about the truth? Whoever came up with this policy should be driven out of office - Democrat or Republican.
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wolfsbayne - September 26th, 2008 at 3:44 pm PDT
disclosure is good.
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sarabdeep singh - September 26th, 2008 at 3:37 pm PDT
Crux of the matter in any financial transaction is how you create a system where in people have some disincentive in not honoring the commitment , housing loans with zero dwnpayment basically reduces the incentive of the user to pay back , because if he defaults none of his funds will get stuck up , India has seen similar real estate bubble and now prices have cooled down but still there has been no major default because here most of the real asset properties have a book value which is much less than the market value , as a result the effective loan comes in the range of 50-60% of the asset value , as a result inspite of lowering of market prices there has not been huge defaults , because stakes for the borrowers are higher { not a legal way but effective }
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Victor Caballero - September 26th, 2008 at 3:38 pm PDT
I worked for a foreclosure aggregation service years ago and we saw this coming. Everyone in the office called it, the bubble burst and all these people riding the wave cashed out and who is left holding the bag, us, the people who have to pick up the pieces and pay for the mess. I am amazed that this took so long, some very powerful people kept our economy propped up and they just couldn’t do it any more.
Michael, I think there typo in the story, “(data is from the U.S. Office of Federal Housing Enterprice Oversight)” should be Enterprise.
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antje wilsch - September 26th, 2008 at 5:17 pm PDT
Enterprice is more appropriate
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Wille - September 26th, 2008 at 3:39 pm PDT
don’t forget loose monetary policy and low interest rates long into a boom.
Central banking is a bastion of socialism, if we don’t want our food supply centrally planned, why in the world would centrally planned money be a good idea?!
We need sound money backed by more than a hope and a prayer, and market based interest rates.
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Alex Eck - September 26th, 2008 at 3:41 pm PDT
Actually the problem is way more complicated. Throw in Investment Banks, cheap money, low food and oil prices, insane short-term bonuses, lack of understanding, the inevitable regulatory loopholes, standardized rating software. And you still haven’t captured the whole image.
Still you did get a point, Mike. And you got me commenting. So you’re article is great (because many, many more will follow me, and even more will read this populistic article).
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Mr. Recycle - September 27th, 2008 at 1:28 am PDT
ya, it was DEFINITELY the low food prices that got us in this mess.
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Stephen - September 26th, 2008 at 3:41 pm PDT
Sigh. This claim that it was Clinton and Fannie & Freddie has been repeatedly debunked, for quite a while now, too.
Here’s a good summary:
http://economistsview.typepad......-it-w.html
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Michael Arrington - September 26th, 2008 at 3:52 pm PDT
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Stephen - September 26th, 2008 at 4:16 pm PDT
Except for the share of the market held by F&F dropping off starting in 2002, replaced by asset backed securities lenders:
http://4.bp.blogspot.com/_nTCQ....._By_Holder(1)(1).jpg
Rebuttals back and forth are included in the original thread linked, also in this one:
http://economistsview.typepad......annie.html
delroy mckenize - September 26th, 2008 at 6:14 pm PDT
Stephen, you are perfectly correct, Mike has obviously joined the “talking heads” in trying to “blame” someone instead of understanding where we are now and finding solutions. According to this graph showed by Mike, that such a sharp increase in lending why didnt the market crash back in 2000 or 2001 or 2002 or 2003. The answer is simple, until the sharks on wallstreet entered into the market and started creative CDO and other asset back securities.
I would suggest you continue to focus on tech as your understanding of macro economics and its policies are either blurred by your political view or you simple dont get it.
Plain and simple, greed is why we are here now, plain and simple. As someone who as worked as an analyst for 4 year, i have seen first hand how greedy, they will sell their moms if they think she would net the right price.
Let me share with you a personal experience, while working at X IB firm, my group that was responsible for analyzing risk came across a few secrurties that was being push in the market place. A member of my team brought to our managers attention that we (X IB) was taking on far risker securities, his reponse was dont worry about it, we will just repackage it with a few other securities and offer a much higher return. Now clearly this was way above the risk level we should be have been taken, but you know what, we all got paid and everyone kept their mouth shut as long as the money was rolling in.
So i dont intend to attack you Mike, its just amusing to me, when i hear people talk about what caused the problem, when i have first hand experience in the system. Another thing to remember, Banks made bad decisions and lost confidence with investors. So if you want to point the blame at someone or something then we all have to share the responsibility.
And if you dont believe me, take a look at your mutual funds.
ICE - September 29th, 2008 at 12:37 pm PDT
Jamie G, and Franklin Raines, are the two people responsible, made possible by Clinton, duh,
Mike is basically right on the money.
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Righteous Marketing - September 26th, 2008 at 3:41 pm PDT
So wait, are you saying that when the government messed up the free market controls in order to help all those poor, working-class people get houses that it started this problem? Well I’ll be!
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Randall - September 26th, 2008 at 3:48 pm PDT
Wow, when I saw that Arrington was writing something about the economic crisis, I had my “STFU and talk about what you know about” post all queued up, and then he goes and posts something intelligent on the issue.
Though I’m sure your audience of SF socialists will take great umbrage at this argument.
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Doug - September 26th, 2008 at 3:48 pm PDT
Yeah Michael I’m not with you on this one. What is clearly a problem in this graph is that the debt increased very regularly over the years. But in this same time period we had the dot-com bust, 9-11, Afgan War, Iraq War, and ensuing recessions. Not to mention 2 Presidential elections and several Congressional elections. The problem, I think, was that lenders went too far on who they were granting credit too and in times when loose credit may not have been a good idea. I can’t blame the government in entirety for this. There’s plenty of blame to go around for all of this.
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Tom - September 26th, 2008 at 10:26 pm PDT
Doug, the lenders didn’t “go too far” - they were being ORDERED to. Take a look at Justice Dept. actions under both Clinton and Bush administrations, threatening banks that we’re meeting the guidelines under the CRA, as well as Fannie/Freddie pressures.
Not to be outdone, plenty of old-fashioned greed among the IBs and retail banks played into it with the creation of Mortgage Backed Securities and the derivatives. Add in Sarbanes/Oxley accounting requirements and then see what happens when a relatively small (at least manageable) percentage of the underlying mortgages go bad… POOF! Valuation evaporation across the board.
To those House Republicans who are trying to hold out on the bailout, while I admire your populism (and I don’t like being saddled with the bill as a taxpayer), I don’t see the alternative. The Gov’t created this mess and pushed this situation onto Wall Street, and thus bears responsibility for covering the losses it essentially mandated.
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JP - September 26th, 2008 at 3:50 pm PDT
THANK YOU TechCrunch! Everyone there’s still plenty of time to call / email your Congress members…they are getting flooded with messages now. Also, there were 251 Emergency Rallies held in 41 states this week.
CONTACT CONGRESS: http://www.visi.com/juan/congress/
JOIN FACEBOOK GROUP: http://tinyurl.com/482wv4 - This is Christopher Penn’s “Americans To Stop the Bank Bailout!” Facebook Group.
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pj - September 26th, 2008 at 3:52 pm PDT
Good article and valid point !
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TheChris - September 26th, 2008 at 3:53 pm PDT
Mr. Arrington have you read about the Gramm-Leach-Bliley Act? It repealed a piece of the Glass-Steagall Act.
It had a much larger role than Fannie Mae. That’s okay, you must have a little crush on Ann Coulter.
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Drew - September 26th, 2008 at 3:53 pm PDT
First post I ever sent my girlfriend, a very committed liberal and PHD in Poli Sci, from TechCrunch. She loves to rail against the free market but this was never a free market. Government protection and intervention distort markets and this is the outcome. Now we want to double down with $700,000,000,000 more and provide even more government oversight. In ten years we are going to have a much bigger mess.
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SteveR - September 26th, 2008 at 3:58 pm PDT
damn guvmint also blew up the WTC and faked the lunar landings.
Fannie and Freddie were woefully undercapitalized and mismanaged, but that wasn’t the root cause of the housing bubble.
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Aaron - September 26th, 2008 at 4:10 pm PDT
Yeah, I guess having Fannie and Freddie back every sub-prime mortgage did nothing to make it easier for people with no reputable credit to buy homes and I guess that having millions of previously unqualified people finally enter the housing market did nothing to drive up demand and housing prices.
/Sarcasm off
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Fact checker - September 26th, 2008 at 8:07 pm PDT
Fannie and Freddie definitely did not back every sub-prime mortgage.
Carla - September 26th, 2008 at 3:58 pm PDT
I feel the blame should ultimately be placed on the banks. I worked in housing during the boom years and bank were providing loans to individuals with 550 credit scores with little down payment. They also were providing loans for homes that were going up in value at 10% a month. (Vegas, Phoenix, Miami etc..). They understood that homes do not appreciate at this level but it’s hard to turn away money….. Yes, there were consumers made bad choices, idiotic investors who snatched up these sh*** mortgages, and a president who pushed home ownership, but if the banks had followed sound lending practices all of this would have been avoided.
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Thank you - September 26th, 2008 at 3:59 pm PDT
Thank you Michael Arrington for being brave enough to call out the true reason for this mess. People want to blame it on the free market while ignoring the true cause of this mess. Look up the CRA and ACORN’s involvement in this disaster.
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Ryan - September 26th, 2008 at 4:00 pm PDT
Here is video of Barney Frank in 2003 during a House Finance Committee meeting defending Fannie Mae. Its very damning. It gets good at about 4:40 into the video.
http://www.taxfoundation.org/blog/show/23617.html
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Pete - September 26th, 2008 at 4:12 pm PDT
Let’s not forget another type of ‘incestuous’ relationship: until a few months ago, Barney Frank was [truly] sleeping with one of the managers at Fannie Mae…
Pete
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damon - September 26th, 2008 at 4:04 pm PDT
US Annual Tax revenue - $3 trillion
US Total Debt - $9 trillion
If the government takes 10% of revenue each year to pay off the debt, it would take 30 years.
Of course, we typically pile on 10% each year, just digging the whole deeper.
Will a politician please stand up, call a spade a spade, and fix this, and stop with the endless pandering of how they will spend money to help every demographic if they would just for for ME.
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David - September 26th, 2008 at 6:56 pm PDT
yes. this is what has to happen. I’m a republican because it was our party who was supposed to do this. but obviously bush was a disaster with regard to spending. where is the real leadership? McCain nor obama will really fix the situation. We seem to be getting further away from reality with each passing day. No, 700 Billion isn’t a fix. No, we don’t need anymore spending.
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Tim - September 26th, 2008 at 4:05 pm PDT
Good to see your audience being used to get this thinking happening mike, there’s no way this was unexpected, all the data ha been pointing at it, and the graph you’ve shown, which is one of many is a simple look at an unsustainable metric that you’d hope one day we’ll not lose sight of.
We have rethink the debt driven approach to economic growth. ‘The money Masters’ video on google video sheds some good insight on how we’ve got here over a longer time horizon
http://video.google.com/videos.....&aq=f#
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Graham Langdon - September 26th, 2008 at 4:05 pm PDT
This is classic Mike Arrington -kicking ass and taking names. Yesterday it was Apple. Today it’s the US government and their mortgage company cohorts trying to plunger a trillion dollars from taxpayers.
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Alex G - September 26th, 2008 at 4:08 pm PDT
This is a royal misunderstanding of the issue to say the least. The reason why you seeing this nice little curve going up like that is because entire economy and monetary system is based on DEBT, also known to few as “fractional reserve banking”. This curve is a natural progression of banking where you need to have $1 of reserve to loan out $10. That $10 can be deposited at another bank which would allow them to loan out $100 and so on… as long as somebody is willing to borrow, DEBT will grow… and the only, the ONLY way to repay interest on this debt is to borrow some more because there’s no other way the money can possibly come from when all available money already comes from borrowed sources.
For as long as economy is control by a private bank (ie federal reserve) and is based on fractional reserve, you will continue seeing this. The next step to this nice little program is recession caused by contraction of available moneys through the fed. This has been done quite a few times before.
700B will accomplish only one thing. It will converts IOUs to actual money, therefore increasing banks’ reserves which will allow them to lend out more. This will depreciate and devalue US dollar even further.
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jg - September 26th, 2008 at 4:25 pm PDT
Debt is not evil. Debt is a source of capital and if it’s invested properly it leads to productivity gains and growth. You need to go pick up an econ book. I suggest reading up on Paul Romer and his ideas around technology as THE factor driving the productivity GDP growth equation.
http://en.wikipedia.org/wiki/Paul_Romer
Debt can be a good thing if the capital is invested properly. Credit is important to an economy and you have to ensure liquidity in the markets.
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Nick Savides - September 26th, 2008 at 4:12 pm PDT
Hey Mike,
Thanks for sharing. I actually like reading about how technology thinkers see the economy. After all, tech companies usually require lots of start-up capital, so the technologists have a vested interest in getting economics right.
Prior to reading this, I assumed that almost every west-coast technology guy thought the same way. I was surprised to learn about the Clinton initiative that accelerated the sub-prime mortgages, but I was even more surprised to see you writing about it.
The link from Wolfsbayne http://is.gd/3b4v was also informative.
Thanks again for venturing into this hot-button topic.
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Joe Bowers - September 26th, 2008 at 4:13 pm PDT
Michael Arrington, armchair economist.
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EL JEFE - September 26th, 2008 at 4:14 pm PDT
“Engineered” makes it sound like they intended to screw it up. Other than that you are spot on. Owning a house and even a second house almost became an inalienable right, despite a person’s income.
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Dan Isaac - September 26th, 2008 at 4:15 pm PDT
I put the blame on the millions of Americans who live beyond their means and pretend to be rich as well.
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tim - September 26th, 2008 at 5:30 pm PDT
finally, someone who gets it. if you’re in debt and can’t pay it back, you have no one to blame but yourself. when will americans be held accountable for their own actions?
i believe it is the false sense of entitlement most americans have that got us into this situation. if you make 100k a year, you shouldn’t live in a million dollar house.
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RJ - September 26th, 2008 at 10:33 pm PDT
I think the upcoming recession will make sure that “american’s are held accountable for their actions”
adam - September 26th, 2008 at 5:34 pm PDT
exactly. let’s not forget to place blame on the people who were stupid enough to buy homes they had no business buying. that banks allowed them to do it means they too deserve blame. But the most blame should fall directly on the millions who tried to live way beyond their means, even when they absolutely knew they couldn’t.
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dewde - September 26th, 2008 at 8:35 pm PDT
I agree!
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silicon valley dropout - September 26th, 2008 at 4:16 pm PDT
blame ruby on rails
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jay - September 27th, 2008 at 12:29 pm PDT
i tried to respond via twitter but they were down again…
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Matthew Flaschen - September 26th, 2008 at 4:24 pm PDT
Stopped reading when I saw your perfect exponential graph without a source in the caption. Don’t bother posting it now. You’ve already wasted your credibility.
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Joe Bowers - September 26th, 2008 at 4:26 pm PDT
hurr hurr
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Al Brown - September 26th, 2008 at 4:24 pm PDT
This is excellent information. The government is to blame for this mess.
The government has also inflated the dollar a great deal. With downward pressure on the rest of the economy due to globalization, the extra money had to go somewhere. It went into higher prices for housing.
And now the Federal Reserve has let the dollar deflate a bit recently, deflating the stock market and making people take money out of 401Ks, etc., creating pressure on banks involved with the mortgage mess.
After much exhaustive study, yes, it does seem that the use of force to distort economics has destructive effects. Who could have guessed?
Restore stability to the dollar and reality to decision making.
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Sylvia - September 26th, 2008 at 4:29 pm PDT
The real cause of the problem was not government policy implemented by Fannie Mae and Freddy Mac during the Clinton presidency.
The root cause of the problem started with the destruction of manufacturing in the U.S., and outsourcing jobs that only created bigger CEO bonuses instead of investment in R & D to create new jobs that replaced those outsourced or lost as the manufacturing sector disappeared.
Impatient shareholders are also to blame. Demands for quicker profits motivated CEOs and Boards to focus only on the next quarters results. This impatience combined with growing consumer demands for free and low cost products and services when reality is there are no free lunches, fueled unemployment.
The final straw was greed by the financial services sector by creating exotic MBS. As employment continued to drop and interest rates rose on creative financial mortgages, the meltdown began.
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Joe - September 26th, 2008 at 4:37 pm PDT
Where was your post before the collapse and did you Short AIG, Lehman and Wamu?
Monday morning quarterback.
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Andy McKenzie - September 26th, 2008 at 4:41 pm PDT
I agree with your point, but that is a highly deceptive graph. Truncating that y axis is a classic way to get people to see your point better. The data is already good, you didn’t need to embellish it.
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Mikael - September 26th, 2008 at 4:45 pm PDT
it boggles the mind how countries are run. everybody knows that you should not put yourself in debt or minimise debt but countries put themselves billions , or trillions in debt without a thought.
Its sad but true when they say ‘banks privatise profits but nationalise the risk’. i fully understand why tax payers are so against this.
If anyone wants to stay ahead of things check out this blog.
http://www.bbc.co.uk/blogs/the.....bertpeston
———–
liberta-togo.com
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ME - September 26th, 2008 at 4:46 pm PDT
Hmmm. Still wondering exactly how $700BB is gonna cover $12 trillion?
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Andrew - September 26th, 2008 at 5:28 pm PDT
Why? That’s only 18.5x leverage, almost half what an investment bank would do. That’s conservative for the governement.
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Raskin - September 26th, 2008 at 4:46 pm PDT
I think this topic is over the heads of most TC readers.
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Seth Wagoner - September 26th, 2008 at 5:03 pm PDT
No kidding.
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dewde - September 26th, 2008 at 8:38 pm PDT
Then perhaps this is just the sort of thing to help them realize the importance of getting a handle on it. I was encouraged to see the topic covered here.
peace|dewde
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ME - September 26th, 2008 at 4:47 pm PDT
Well, at least the $8 Trillion part that is the excessively leveraged position….
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Seth Wagoner - September 26th, 2008 at 4:49 pm PDT
If a policy decision back in 1999 actually did make this “inevitable” then that is a sign that the US political system is very, very broken, and needs fixing, badly. But we all knew that, right?
I don’t think you can blame Clinton. Most of the loans causing problems *now* weren’t written in 1999 or 2000, those ones sank or swam a long time ago. But you certainly could point a finger at the executives of Fannie and Freddy and their corporate lobbyists (most of which are now employed by the McCain campaign), who kept buying *ever more stupid* subprime loans as time went on. 1999 was just the start of it…
Most people simply weren’t paying attention to the fact that the housing market was propping up the US economy in an unsustainable way. Senior economists like Krugman and Roubini have been talking about it for years, but the banking sector was making money hand over fist and paying lobbyists to keep the gravy train going, and the politicians were eager to put of the recession if possible.
The pathetic thing is that all the extra money sloshing around was used so poorly. It paid for dodgy investments, more and more houses, vast numbers of SUVs, and of course, the war. At least the VCs have hoarded a fair bit of it and will have plenty of dry powder to work with over the next few years.
Also, the crisis engineering was *very* much a public-private partnership. The banking sector and their bizzare array of CDOs and CDSs managed to hide the build up of risk and spread it like poison through the whole financial system in a way that was never before possible, and the government really had nothing to do with that. The whole 62 trillion dollar Credit Default Swap market is completely unregulated, and under the guise of spreading risk around it actually set the banking sector up for a great big round of systemic failure.
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Pete - September 26th, 2008 at 5:45 pm PDT
It is really amazing how ignorant you are and the extent your misinformation reaches: the Fannie Mae CEO, who was paid 90M in about five years of sloppy work is now the closest financial advisor to, you know who?, well, none other than Barak Hussein Obama. Check it out…
Pete
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Seth Wagoner - September 27th, 2008 at 5:29 am PDT
Oh please. Are people really so dumb that they believe this sort of thing without looking it up? The guy said in an interview that he had one or two phone conversations with someone on Obama’s team about housing. This somehow makes him Obama’s closest financial advisor? Get real.
http://www.washingtonpost.com/.....03604.html
click - September 26th, 2008 at 5:04 pm PDT
So, if Democrats are always broadbrushed as big government, yet Clinton reduced government oversight in this, which would seem more of a Republican stannce.
So this was started by the open market, hands off gov’t approach that let the free will of greedy opportunists to market. Go on any school playground, there are bullys, dorks and peddlers.
So, if government intervention is the solution, being driven by a Republican administration, isnt’ that more of a stereotyped Democrat stance?
The ironies of all this are astounding.
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RJ - September 26th, 2008 at 10:36 pm PDT
I’m pretty sure you didn’t actually read the post. Clinton was pushing “affordable housing” which is INCREASED gov’t. Also I think affordable housing is another way of saying, getting people into homes they can’t afford.
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johnny - September 26th, 2008 at 11:00 pm PDT
You have a fundamental misunderstanding. The Clinton administration increased government intervention by forcing financial institutions to do something they did not want to. The gov’t forced the financial institutions to lend money to people they didn’t think financially deserved it.
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Larry Freeman - September 26th, 2008 at 5:05 pm PDT
In my view, we can blame both the current administration and the previous administrations.
Anyone who doesn’t see this is way too caught up in the political horse race.
Clinton should not have pushed for loans that people couldn’t afford without specifying a cap on the number allowed (the number that is affordable).
Bush should have stopped it. He stopped plenty of Clinton initiatives he didn’t agree. He could have stopped this one too.
I found this article very informative. Data to think about.
Thanks, Michael!
-Larry
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dewde - September 26th, 2008 at 8:44 pm PDT
According to the NY Times, Bush did try. But he sure as hell didn’t try hard enough if you ask me.
http://tinyurl.com/6lp5qu
peace|dewde
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dewde - September 26th, 2008 at 8:46 pm PDT
Oh yeah, and I agree both administrations are to blame.
I vehemently disagree with Obama’s press conference last night in which he said, “This didn’t happen on our watch.”
peace|dewde
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travis - September 26th, 2008 at 5:15 pm PDT
wow…just fuckin’ wow…
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Jerome Silverstone - September 29th, 2008 at 4:52 am PDT
Looks like you yankees have not revised your economic and political policies. You believe in the cut throat capitalism of survival for the fitest. Thats why you do not mind the homeless in your streets. Its also why you had no problems with slavery. The point is, you cannot make a man remain down, without remaining down with him. The current problems you have is because by embracing capitalism in its most brutish style, greed made wall street goons giddy with grutony. They became careless, and heartless. Now, the whole house of cards is coming crashing down. Why dont you guys ask the Sweds, the Fins, The Brits, an the Swizs how they do it? Make you system more humane. Otherwise the China man will come calling back his debt. Then we shall see where you will all be. Down with all the homeless you so despise!!!!!
Monday, February 2, 2009
Everyone should look for "exit strategies", says BIS
Everyone should look for "exit strategies", says BIS
by Chakravarthi Raghavan
--------------------------------------------------------------------------------
Geneva, 7 June -- The worst of the crisis in emerging and financial markets seems to be over, further turmoil cannot be ruled out, warns the Bank of International Settlements (BIS), in its Annual Report published Monday.
In recent episodes of turmoil, the world has benefited materially from the continued strength of the US economy.
"However, exit strategies should now be the preoccupation for all prudent policy-makers, including those in the United States," the BIS says in a cryptic, 'read-between-the-lines" comment.
The recent dramatic events in many parts of the emerging world have made it clear that macroeconomic variables can be subject to extreme outcomes, and one should not suppose that advanced industrial economies are immune to such problems. The current difficulties remain deeply rooted in excessive capital formation and credit expansion, and significant imbalances remain within the global economy. And recent experiences show there can be "a darker side to the operation of a market economy, particularly when financial markets are highly liberalized and expectations are prone to recurrent cycles of optimism and pessimism."
While this should not blind one to the overwhelming merits of the system and absence of a plausible alternative, "the real task is to improve the system before suggested alternatives look more attractive than they really are."
But there is no single or simple answer to current economic problems. It is not so straightforward or easy, in practice, to distinguish policies directed to macroeconomic stability from those related to financial stability. Lack of stability in one area often contributes to instability in the other - as the experience of the industrial economies in the 1970s and 1980s, and more recently that of Japan, Mexico and South-East Asia show.
Hence for sustained improvement in living standards, policy initiatives need to be undertaken on a wide front. But different policies to support macroeconomic and financial stability share a number of underlying characteristics.
Transparency in conduct of monetary and fiscal policies is needed to provide an anchor for expectations. But transparency is also needed on part of participants in the financial system if market discipline is to contribute to prudent behaviour. And policies in both areas must avoid solving today's problems at the cost of making tomorrow's problems worse.
What happened in the financial markets, between August and October 1998, showed that probability distributions characterizing asset price movements may have fat tails - at least on the downside (meaning that frequency distributions should allow for a relatively high probability of large down-wide price movements).
Interactions between various forms of risk, previously assumed to be separable, led to massive price movements that threatened the health of financial institutions and even the functioning of markets themselves.
While most forecasters expect continued and indeed accelerating growth, there are many specific uncertainties which imply a wide margin of error, nor is it obvious that balance of current risks is symmetrical.
A generalized resurgence of inflation seems less likely than further disinflation or even deflation. Uncertainty in itself erodes confidence and leads to lower spending. Imbalances work in the same direction. When they are eventually resolved, those who gain may not adjust spending upwards, while those who lose have little alternative but to retrench.
And the imbalances in the world economy also imply some downside risks to the forecasts.
The overhang of productive capacity in traded goods worldwide is already putting downward pressure on prices in advanced industrial countries, even though export volumes from Asia have not yet fully responded to earlier depreciations.
In the US, protectionist pressures are on the rise even as the unemployment rate keeps falling from one low to another. And intensification of price competition makes firms vulnerable to any significant acceleration of costs. Should profits come under further pressure, the effect on equity prices could be significant and could in turn have an impact on consumption.
And the record trade imbalances, at some point, must imply a lower dollar and an appreciation of the yen and the euro. "Should this happen before the economies of Japan and continental Europe are growing healthily again, the downside potential for the global economy is obvious."
Conscious of these concerns, policy-makers have acted to sharply lower interest rates throughout the industrial world and in many emerging economies. While this was consistent with the desire to help calm market turbulence through a further injection of liquidity, monetary policy would work less effectively if prices actually fall in a generalized way, largely, but not solely because nominal interest rates cannot fall below zero.
But it would be a mistake to conclude that the answer to current global economic problems is simply to ease monetary policy further. Greater attention needs also to be paid to difficult issues concerning exchange rate regimes, fiscal policy and labour market reform.
In the area of financial stability, urgent action is required in many countries to restructure banking systems, and the corporate sector as well, and to ensure that once financial systems are made healthy, they stay that way for the foreseeable future.
In some important respects, the uncertainties and trade-offs faced by the US Federal Reserve are not normal. Inflation forecasts in the conduct of monetary policy for domestic price stability, is usually based on some notion of amount of excess capacity. But there is a great deal of uncertainty surrounding these in the US: estimates of capacity levels based on labour market data are completely different from those based on capital stock data. And, there exists to date "no conclusive evidence" for or against the US economy having entered a 'new era' of enhanced productivity growth.
Asset price movements have also imposed severe side conditions on the normal conduct of US monetary policy. The global financial turbulence last autumn contributed to the decision to lower interest rates, while the runup in equity prices along with the robust growth of credit might have suggested that higher interest rates were called for. A similar conclusion is suggested by the recent rebound in stock prices to record levels and the associated impact on consumer spending.
One great danger to the continued expansion of the global economy is that the US economy will overheat and fears of subsequent recession will undermine the stock market, reduce wealth and cut spending. And if the dollar were to fall simultaneously under the weight of capital outflows and a large trade deficit, a period of stagflation would not be an impossibility.
With global financial markets now calmer, the need to avoid such a combination of events should be an important consideration in formulating monetary policy in the period ahead.
In Europe, while the advent of the euro has been "executed masterfully," the challenge is how to conduct monetary policy in not just a new economic environment as one that by design is supposed to be changing rapidly under the impact of the euro itself.
Further complications arise from the fluctuations in the value of euro and both how to interpret them and respond to them. But with the European Central Bank's clear objective of price stability, "the dangers of undershooting now seem to be at least as great as those of overshooting"
In Japan, monetary policy is being conducted in a highly unusual environment - one of falling prices. While the outcome is not certain, the ingredients seem to be in place for a continuation of such deflationary pressures. The burden of real debt of corporations continue to rise, impeding investment. Unit labour costs are increasing and restructuring will add to unemployment - further depressing confidence and consumer spending.
"While purchases do not yet appear to have been deferred in expectation of further price decline, as is happening in China, the potential for this cannot be ruled out."
The Bank of Japan has responded by lowering interest rates to virtually zero, increasing liquidity in the banking system, and purchasing large quantities of private sector paper.
But to-date the effect has been essentially that of "pushing on a string" - raising the issue of what more, if anything, might be done.
The Japanese experience illustrates the limitations of monetary policy when nominal rates are already very low and excess capacity is very high, and provides some indication of both the benefits and limitations of making clear statements about objectives of public policy. But, "at the least, it should be clearly stated that the goal of ending Japanese recession and avoiding development of a deflationary psychology must, for the time being, take priority over concerns about trade account."
While the sharp fluctuations in the value of the yen and the introduction of the euro led to suggestions for better ways to cooperatively manage a tripolar global exchange rate system, no political agreements seem likely to alter significantly the current regime in which domestic monetary policy is directed primarily to domestic needs.
And an underlying problem is the continuing propensity of investors to borrow in low and lend in high interest rate centres, without considering the full potential for having to pay back in appreciated currency. "The destabilising aspects of market failures of this sort need further investigation."
In many emerging economies, new questions about exchange rates arose, and the principal lesson was countries should eschew variable peg regimes in favour of either something harder or voluntary adoption of managed floating. In terms of harder alternatives, Hong Kong and Argentina successfully defended their currency board regimes, but in both cases "uncomfortably high interest rates had to be accepted."
Others like Brazil did not choose to follow this path, but were forced to float the currency in an environment of crisis, with generally unsatisfactory outcomes. Brazil also chose let high interest rates make a contribution. To date, aided by a sharp improvement in primary surplus and unexpectedly good inflation performance, "the bet seems to have paid off."
But the challenge for Brazil and other countries with newly floating exchange rates is to find some other nominal anchor to guide domestic monetary policy over the longer term. This will not be easy, given the lack of an anti-inflationary history, poor data on credit and monetary aggregates and absence of reliable procedures to forecast inflation.
On fiscal policy, there has been little debate; but it is commonly asserted that fiscal stimulus in Japan has played a useful role, that fiscal consolidation is thought to be desirable in Europe and, that in the US fiscal position has greatly improved and no tightening seems required at this time.
"While these assertions have a large measure of validity, they all need to be qualified in the light of circumstances," comments BIS.
In Japan, the impact of fiscal stimulus packages have been diminished by rising consumer saving - reflecting growing uncertainty over job security, inadequate pension provisions and fear of rise in taxes in future to service accumulating debts.
In Europe, the benefits of medium-term consolidation cannot be questioned, but it should be remembered that one of the benefits of a strong fiscal position is the scope it affords for allowing automatic stabilizers to operate.
"One cannot rule out the possibility of a situation arising in Europe in which fiscal stimulus may again be an appropriate policy response."
In the US, textbook economics would suggest a tightening of fiscal policy would reduce domestic overheating and risk of a disorderly rise and subsequent sharp fall in the dollar. But this would make it all the more important, though politically unlikely, to encourage expansion of aggregate demand elsewhere.
And it is not clear that fiscal restraint is always useful when exchanges in emerging market economies come under pressure. In emerging markets, it is thought, that fiscal restraint may both strengthen exchange rates and bring down initially higher interest rates by reducing credit risk premium on foreign borrowing.
This argument seems logical in the case of Brazil, Russia and other countries with poor fiscal record.
"Whether it applies to countries in Asia and elsewhere whose fiscal history is sound seems less obvious." But recognizing how fickle markets can be in a crisis environment, it might still make sense in such cases to cut the deficit initially, but reverse the stance as soon as confidence is restored. "While the question of timing remains controversial, this is essentially what happened recently in the crisis-affected countries of Asia."
In view of the global conditions of excess capacity and high or rising unemployment in Europe, Japan and much of the emerging world, supply-side reforms are also urgently required. This may sound paradoxical, since such reforms will eventually further increase production potential. But changes in relative prices can also contribute materially to the resolution of economic disequilibria. Even with adequate restructuring of corporate and banking sectors current excess capacity in many industrial sectors mean that investments in these areas will weaken for years to come, with associated multiplier effects on jobs and income.
It is therefore essential that government restrictions and other profit-destroying impediments to investment in other sectors, particularly services, be removed. While this applies to emerging markets, many industrial countries too need to move in the direction of deregulation.
At the same time, to solve current problems, the overhang of excess industrial capacity in many countries and sectors have to be dealt with. Without an orderly reduction or take-up of excess capacity, rates of return on capital would continue to disappoint.
Closing down individual production plants in Asia is impeded by concerns about what traditional rivals might do. And given heavy sunk costs, it often makes sense to continue producing at a loss so long as variable costs are being covered. In this respect, low interest rates and continuing availability of finance through the banking system or from abroad can be important disincentives to restructuring. Declarations of bankruptcy and asset sales at low prices to generate profits for new owners may be another option. But this depends on adequacy of bankruptcy laws. Also concerns about social and political costs of laying off workers in the absence of an effective social safety net are further major obstacles to industrial rationalization throughout Asia. Another factor holding up corporate restructuring, not merely in Asia, but in many other parts of the world, is the suspect soundness of the banking system.
And while current problems in financial systems of emerging market countries were primarily generated domestically, international capital flows clearly exacerbated them. Even flows that are modest from the perspective of international capital markets can have highly disruptive effects on small economies.
"This suggests that such countries should dismantle controls on short-term inflows only very cautiously, particularly if there are doubts, and there normally will be, about the inherent stability of the domestic financial system. There should also be much less hesitation in using market-based prudential instruments, such as reserve requirements, to prevent banks from relying excessively on short-term borrowing in foreign currency. In association with a less tightly managed exchange rate regime, this could make a real difference.
Also, countries wishing to accommodate such capital inflows, for whatever reasons, should make greater efforts to prepare themselves for sudden outflows.
One way is to run trade surpluses, but such an approach would exemplify the fallacy of composition: "what kind of global imbalances will emerge, if all emerging market countries endeavour to do this?"
But part of the solution also lies in the functioning of international capital markets. Imprudent lending has been motivated by both shrinking returns on traditional businesses at home and the belief that various forms of safety nets would protect creditors. But recent losses suffered in Russia and China have made clear the potential for losses, and this seems to be having an effect on the behaviour of banks, even if purchasers of emerging market bonds have lost little of their enthusiasm. But this too will probably change - after recent suggestions that bondholders should normally share in any restructuring of a country's external debt.
However, the inference drawn from the rescue of the US Long-Term Capital Management Fund (that regulatory authorities and principal creditors considered a non-banking institution too complex to fail) might be worrisome for the message sent out to much bigger banks and dealing firms with their own large proprietary trading operations.
Advances in technology and deregulation have not only altered traditional banking behaviour, but also encouraged lending through securities markets, and the use of such markets by banks themselves, with implications for financial and economic stability.
The fact that liquidity may dry up as credit spreads widen, has the further implication that "in a market-driven system, the downswings may be more violent than upswings."
And with credit being provided by a multitude of investors in impersonal markets from which exit is easy, it is becoming increasingly difficult to organise concerted lending to sovereign borrowers in need of liquidity. "Akin to the attitudes of governments, banks ask why they should be bailing out others."
Through various channels, financial institutions including banks are becoming exposed to higher levels of market risk. And this is more highly correlated with credit than previously thought, since market exposures are built on leverage and credit risk is more highly correlated with liquidity risk than earlier realised. And it is now evident that risk models also offer a false sense of security - because they may lose their predictive powers in extreme market conditions, and their mechanical use may actually contribute to market turbulence.
In terms of public policy, it has become equally important to monitor markets closely and identify concentrations of risk.
In some countries where central banks have lost their responsibility for banking supervision, they have been given responsibility for overall financial stability. What this means in terms of support of markets needs to be better defined. "Whether central banks stripped of regulatory responsibilities will be able to obtain information they require when they need it, to use their emergency liquidity support powers wisely and effectively in a market-driven world remains a very open question. In continental Europe, the additional complication of a supranational central bank interacting with diverse national supervisors also need careful attention."
In an introduction, titled, "the darker side of the market processes", the BIS said of the events of last year that while financial markets in Asia had stabilised and the deep recession seen in many Asian economies had bottomed out, some potentially worrisome trends continued globally in both the real and financial sectors:
Divergences in economic growth both between and within country groups were remarkable. So too were trade imbalances. Real commodity prices hit 40-year lows and prices of many tradable goods fell as well. Credit growth in most industrial countries was surprisingly strong, though still weak in economies hampered by fragile banking systems. Equity prices continued to reach record high in many industrial countries and property prices began to move up. And the US dollar stayed generally firm, despite the increasing weight of external indebtedness, and the perception of the euro as a competing reserve currency. And due to past excesses and recent deregulations, financial restructuring continued apace.
Global disinflation under way for almost two decades quickened in 1998. But it would be unwise to extrapolate the experiences in industrial economies (of headline inflation falling to 1-1/2%), of unusual price stability in South-East Asia, exchange rate stability in China and Hong Kong SAR or domestic price falls in Latin America, and conclude that "global deflation is the principal policy concern."
There was an unusually high degree of divergence in economic performance between the advanced industrial and emerging economies, and significant differences among major industrial countries as well. Even within many industrial countries, the gaps between surveys for consumer confidence (high) and business confidence (low) were striking.
On various proposals for preventing future crisis, the BIS says that given how jealously nations guard their sovereignty, proposals for establishment of a global central bank, an international lender of last resort, a global super-regulator or an international bankruptcy court are unlikely to be acted on in the near future.
Given the scale of private capital flows, the private sector will inevitably have to become more fully and directly involved in crisis management and resolution. Many of the recommendations in this regard of the G-10 deputies, made after the Mexican crises, have been recently reiterated, "although they have not been acted upon to date."
Having suffered heavier losses in 1998 than at any time since the 1980s debt crisis, creditor have become much more aware of their risk exposure. But welcome as these might be in terms of reducing future excessive capital inflows into emerging markets, "they may have increased the tendency for private sector capital that is already there to be withdrawn pre-emptively."
The sharp drop in bank credits to Brazil in the third quarter of 1998 has indeed been interpreted by some as a pre-emptive move by banks fearing they would otherwise be forced into rolling over existing credits or providing new ones, within the context of the anticipated IMF-adjustment programme.
The Malaysian recourse to capital controls, as a response to the crisis, has given further impetus to the debate on whether full- scale capital account liberalisation is premature for most emerging market economies.
In particular, support has grown in recent years for measures to slow the inflow of short-term capital until markets, institutions and regulatory frameworks have been sufficiently strengthened. Measures to contain capital flows, when implemented through market-based instruments, such as reserve requirements that tax shorter-term inflows more heavily, can be useful, and if carefully devised, can avoid a domestic credit boom and asset price bubble, while maintaining a liberal attitude towards longer-term flows.
But there has been much less acceptance for imposition of controls on outflows, in particular where a liberal regime was already in place. While such controls may give authorities necessary room to formulate and implement adjustment programmes to restore investor confidence, controls could also be abused either to maintain an inappropriate policy far too long or delay restructuring a weak financial sector. The effectiveness of controls also decline as loop-holes are found and exploited, and the process set in motion to plug them become ever more complex.
As for monetary policy in industrial economies, with inflation approaching zero in some countries and prices even declining in others, issues regarding appropriate conduct of monetary policy in conditions of near price stability took on new importance in major industrial countries. An inflation rate close to zero suggests central banks may experience brief episodes of declining prices more frequently in the future.
A potential concern is that nominal wages may be rigid downwards, and this means that with price falls real wages may be raised, depressing employment and economic activity. A second concern is that nominal interest rates cannot be made negative, and if a contractionary demand shock occurs and prices start to fall, real interest rates will rise and could reduce aggregate demand further. (SUNS4450)
The above article first appeared in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.
[c] 1999, SUNS - All rights reserved. May not be reproduced, reprinted or posted to any system or service without specific permission from SUNS. This limitation includes incorporation into a database, distribution via Usenet News, bulletin board systems, mailing lists, print media or broadcast. For information about reproduction or multi-user subscriptions please contact < suns@igc.org >
by Chakravarthi Raghavan
--------------------------------------------------------------------------------
Geneva, 7 June -- The worst of the crisis in emerging and financial markets seems to be over, further turmoil cannot be ruled out, warns the Bank of International Settlements (BIS), in its Annual Report published Monday.
In recent episodes of turmoil, the world has benefited materially from the continued strength of the US economy.
"However, exit strategies should now be the preoccupation for all prudent policy-makers, including those in the United States," the BIS says in a cryptic, 'read-between-the-lines" comment.
The recent dramatic events in many parts of the emerging world have made it clear that macroeconomic variables can be subject to extreme outcomes, and one should not suppose that advanced industrial economies are immune to such problems. The current difficulties remain deeply rooted in excessive capital formation and credit expansion, and significant imbalances remain within the global economy. And recent experiences show there can be "a darker side to the operation of a market economy, particularly when financial markets are highly liberalized and expectations are prone to recurrent cycles of optimism and pessimism."
While this should not blind one to the overwhelming merits of the system and absence of a plausible alternative, "the real task is to improve the system before suggested alternatives look more attractive than they really are."
But there is no single or simple answer to current economic problems. It is not so straightforward or easy, in practice, to distinguish policies directed to macroeconomic stability from those related to financial stability. Lack of stability in one area often contributes to instability in the other - as the experience of the industrial economies in the 1970s and 1980s, and more recently that of Japan, Mexico and South-East Asia show.
Hence for sustained improvement in living standards, policy initiatives need to be undertaken on a wide front. But different policies to support macroeconomic and financial stability share a number of underlying characteristics.
Transparency in conduct of monetary and fiscal policies is needed to provide an anchor for expectations. But transparency is also needed on part of participants in the financial system if market discipline is to contribute to prudent behaviour. And policies in both areas must avoid solving today's problems at the cost of making tomorrow's problems worse.
What happened in the financial markets, between August and October 1998, showed that probability distributions characterizing asset price movements may have fat tails - at least on the downside (meaning that frequency distributions should allow for a relatively high probability of large down-wide price movements).
Interactions between various forms of risk, previously assumed to be separable, led to massive price movements that threatened the health of financial institutions and even the functioning of markets themselves.
While most forecasters expect continued and indeed accelerating growth, there are many specific uncertainties which imply a wide margin of error, nor is it obvious that balance of current risks is symmetrical.
A generalized resurgence of inflation seems less likely than further disinflation or even deflation. Uncertainty in itself erodes confidence and leads to lower spending. Imbalances work in the same direction. When they are eventually resolved, those who gain may not adjust spending upwards, while those who lose have little alternative but to retrench.
And the imbalances in the world economy also imply some downside risks to the forecasts.
The overhang of productive capacity in traded goods worldwide is already putting downward pressure on prices in advanced industrial countries, even though export volumes from Asia have not yet fully responded to earlier depreciations.
In the US, protectionist pressures are on the rise even as the unemployment rate keeps falling from one low to another. And intensification of price competition makes firms vulnerable to any significant acceleration of costs. Should profits come under further pressure, the effect on equity prices could be significant and could in turn have an impact on consumption.
And the record trade imbalances, at some point, must imply a lower dollar and an appreciation of the yen and the euro. "Should this happen before the economies of Japan and continental Europe are growing healthily again, the downside potential for the global economy is obvious."
Conscious of these concerns, policy-makers have acted to sharply lower interest rates throughout the industrial world and in many emerging economies. While this was consistent with the desire to help calm market turbulence through a further injection of liquidity, monetary policy would work less effectively if prices actually fall in a generalized way, largely, but not solely because nominal interest rates cannot fall below zero.
But it would be a mistake to conclude that the answer to current global economic problems is simply to ease monetary policy further. Greater attention needs also to be paid to difficult issues concerning exchange rate regimes, fiscal policy and labour market reform.
In the area of financial stability, urgent action is required in many countries to restructure banking systems, and the corporate sector as well, and to ensure that once financial systems are made healthy, they stay that way for the foreseeable future.
In some important respects, the uncertainties and trade-offs faced by the US Federal Reserve are not normal. Inflation forecasts in the conduct of monetary policy for domestic price stability, is usually based on some notion of amount of excess capacity. But there is a great deal of uncertainty surrounding these in the US: estimates of capacity levels based on labour market data are completely different from those based on capital stock data. And, there exists to date "no conclusive evidence" for or against the US economy having entered a 'new era' of enhanced productivity growth.
Asset price movements have also imposed severe side conditions on the normal conduct of US monetary policy. The global financial turbulence last autumn contributed to the decision to lower interest rates, while the runup in equity prices along with the robust growth of credit might have suggested that higher interest rates were called for. A similar conclusion is suggested by the recent rebound in stock prices to record levels and the associated impact on consumer spending.
One great danger to the continued expansion of the global economy is that the US economy will overheat and fears of subsequent recession will undermine the stock market, reduce wealth and cut spending. And if the dollar were to fall simultaneously under the weight of capital outflows and a large trade deficit, a period of stagflation would not be an impossibility.
With global financial markets now calmer, the need to avoid such a combination of events should be an important consideration in formulating monetary policy in the period ahead.
In Europe, while the advent of the euro has been "executed masterfully," the challenge is how to conduct monetary policy in not just a new economic environment as one that by design is supposed to be changing rapidly under the impact of the euro itself.
Further complications arise from the fluctuations in the value of euro and both how to interpret them and respond to them. But with the European Central Bank's clear objective of price stability, "the dangers of undershooting now seem to be at least as great as those of overshooting"
In Japan, monetary policy is being conducted in a highly unusual environment - one of falling prices. While the outcome is not certain, the ingredients seem to be in place for a continuation of such deflationary pressures. The burden of real debt of corporations continue to rise, impeding investment. Unit labour costs are increasing and restructuring will add to unemployment - further depressing confidence and consumer spending.
"While purchases do not yet appear to have been deferred in expectation of further price decline, as is happening in China, the potential for this cannot be ruled out."
The Bank of Japan has responded by lowering interest rates to virtually zero, increasing liquidity in the banking system, and purchasing large quantities of private sector paper.
But to-date the effect has been essentially that of "pushing on a string" - raising the issue of what more, if anything, might be done.
The Japanese experience illustrates the limitations of monetary policy when nominal rates are already very low and excess capacity is very high, and provides some indication of both the benefits and limitations of making clear statements about objectives of public policy. But, "at the least, it should be clearly stated that the goal of ending Japanese recession and avoiding development of a deflationary psychology must, for the time being, take priority over concerns about trade account."
While the sharp fluctuations in the value of the yen and the introduction of the euro led to suggestions for better ways to cooperatively manage a tripolar global exchange rate system, no political agreements seem likely to alter significantly the current regime in which domestic monetary policy is directed primarily to domestic needs.
And an underlying problem is the continuing propensity of investors to borrow in low and lend in high interest rate centres, without considering the full potential for having to pay back in appreciated currency. "The destabilising aspects of market failures of this sort need further investigation."
In many emerging economies, new questions about exchange rates arose, and the principal lesson was countries should eschew variable peg regimes in favour of either something harder or voluntary adoption of managed floating. In terms of harder alternatives, Hong Kong and Argentina successfully defended their currency board regimes, but in both cases "uncomfortably high interest rates had to be accepted."
Others like Brazil did not choose to follow this path, but were forced to float the currency in an environment of crisis, with generally unsatisfactory outcomes. Brazil also chose let high interest rates make a contribution. To date, aided by a sharp improvement in primary surplus and unexpectedly good inflation performance, "the bet seems to have paid off."
But the challenge for Brazil and other countries with newly floating exchange rates is to find some other nominal anchor to guide domestic monetary policy over the longer term. This will not be easy, given the lack of an anti-inflationary history, poor data on credit and monetary aggregates and absence of reliable procedures to forecast inflation.
On fiscal policy, there has been little debate; but it is commonly asserted that fiscal stimulus in Japan has played a useful role, that fiscal consolidation is thought to be desirable in Europe and, that in the US fiscal position has greatly improved and no tightening seems required at this time.
"While these assertions have a large measure of validity, they all need to be qualified in the light of circumstances," comments BIS.
In Japan, the impact of fiscal stimulus packages have been diminished by rising consumer saving - reflecting growing uncertainty over job security, inadequate pension provisions and fear of rise in taxes in future to service accumulating debts.
In Europe, the benefits of medium-term consolidation cannot be questioned, but it should be remembered that one of the benefits of a strong fiscal position is the scope it affords for allowing automatic stabilizers to operate.
"One cannot rule out the possibility of a situation arising in Europe in which fiscal stimulus may again be an appropriate policy response."
In the US, textbook economics would suggest a tightening of fiscal policy would reduce domestic overheating and risk of a disorderly rise and subsequent sharp fall in the dollar. But this would make it all the more important, though politically unlikely, to encourage expansion of aggregate demand elsewhere.
And it is not clear that fiscal restraint is always useful when exchanges in emerging market economies come under pressure. In emerging markets, it is thought, that fiscal restraint may both strengthen exchange rates and bring down initially higher interest rates by reducing credit risk premium on foreign borrowing.
This argument seems logical in the case of Brazil, Russia and other countries with poor fiscal record.
"Whether it applies to countries in Asia and elsewhere whose fiscal history is sound seems less obvious." But recognizing how fickle markets can be in a crisis environment, it might still make sense in such cases to cut the deficit initially, but reverse the stance as soon as confidence is restored. "While the question of timing remains controversial, this is essentially what happened recently in the crisis-affected countries of Asia."
In view of the global conditions of excess capacity and high or rising unemployment in Europe, Japan and much of the emerging world, supply-side reforms are also urgently required. This may sound paradoxical, since such reforms will eventually further increase production potential. But changes in relative prices can also contribute materially to the resolution of economic disequilibria. Even with adequate restructuring of corporate and banking sectors current excess capacity in many industrial sectors mean that investments in these areas will weaken for years to come, with associated multiplier effects on jobs and income.
It is therefore essential that government restrictions and other profit-destroying impediments to investment in other sectors, particularly services, be removed. While this applies to emerging markets, many industrial countries too need to move in the direction of deregulation.
At the same time, to solve current problems, the overhang of excess industrial capacity in many countries and sectors have to be dealt with. Without an orderly reduction or take-up of excess capacity, rates of return on capital would continue to disappoint.
Closing down individual production plants in Asia is impeded by concerns about what traditional rivals might do. And given heavy sunk costs, it often makes sense to continue producing at a loss so long as variable costs are being covered. In this respect, low interest rates and continuing availability of finance through the banking system or from abroad can be important disincentives to restructuring. Declarations of bankruptcy and asset sales at low prices to generate profits for new owners may be another option. But this depends on adequacy of bankruptcy laws. Also concerns about social and political costs of laying off workers in the absence of an effective social safety net are further major obstacles to industrial rationalization throughout Asia. Another factor holding up corporate restructuring, not merely in Asia, but in many other parts of the world, is the suspect soundness of the banking system.
And while current problems in financial systems of emerging market countries were primarily generated domestically, international capital flows clearly exacerbated them. Even flows that are modest from the perspective of international capital markets can have highly disruptive effects on small economies.
"This suggests that such countries should dismantle controls on short-term inflows only very cautiously, particularly if there are doubts, and there normally will be, about the inherent stability of the domestic financial system. There should also be much less hesitation in using market-based prudential instruments, such as reserve requirements, to prevent banks from relying excessively on short-term borrowing in foreign currency. In association with a less tightly managed exchange rate regime, this could make a real difference.
Also, countries wishing to accommodate such capital inflows, for whatever reasons, should make greater efforts to prepare themselves for sudden outflows.
One way is to run trade surpluses, but such an approach would exemplify the fallacy of composition: "what kind of global imbalances will emerge, if all emerging market countries endeavour to do this?"
But part of the solution also lies in the functioning of international capital markets. Imprudent lending has been motivated by both shrinking returns on traditional businesses at home and the belief that various forms of safety nets would protect creditors. But recent losses suffered in Russia and China have made clear the potential for losses, and this seems to be having an effect on the behaviour of banks, even if purchasers of emerging market bonds have lost little of their enthusiasm. But this too will probably change - after recent suggestions that bondholders should normally share in any restructuring of a country's external debt.
However, the inference drawn from the rescue of the US Long-Term Capital Management Fund (that regulatory authorities and principal creditors considered a non-banking institution too complex to fail) might be worrisome for the message sent out to much bigger banks and dealing firms with their own large proprietary trading operations.
Advances in technology and deregulation have not only altered traditional banking behaviour, but also encouraged lending through securities markets, and the use of such markets by banks themselves, with implications for financial and economic stability.
The fact that liquidity may dry up as credit spreads widen, has the further implication that "in a market-driven system, the downswings may be more violent than upswings."
And with credit being provided by a multitude of investors in impersonal markets from which exit is easy, it is becoming increasingly difficult to organise concerted lending to sovereign borrowers in need of liquidity. "Akin to the attitudes of governments, banks ask why they should be bailing out others."
Through various channels, financial institutions including banks are becoming exposed to higher levels of market risk. And this is more highly correlated with credit than previously thought, since market exposures are built on leverage and credit risk is more highly correlated with liquidity risk than earlier realised. And it is now evident that risk models also offer a false sense of security - because they may lose their predictive powers in extreme market conditions, and their mechanical use may actually contribute to market turbulence.
In terms of public policy, it has become equally important to monitor markets closely and identify concentrations of risk.
In some countries where central banks have lost their responsibility for banking supervision, they have been given responsibility for overall financial stability. What this means in terms of support of markets needs to be better defined. "Whether central banks stripped of regulatory responsibilities will be able to obtain information they require when they need it, to use their emergency liquidity support powers wisely and effectively in a market-driven world remains a very open question. In continental Europe, the additional complication of a supranational central bank interacting with diverse national supervisors also need careful attention."
In an introduction, titled, "the darker side of the market processes", the BIS said of the events of last year that while financial markets in Asia had stabilised and the deep recession seen in many Asian economies had bottomed out, some potentially worrisome trends continued globally in both the real and financial sectors:
Divergences in economic growth both between and within country groups were remarkable. So too were trade imbalances. Real commodity prices hit 40-year lows and prices of many tradable goods fell as well. Credit growth in most industrial countries was surprisingly strong, though still weak in economies hampered by fragile banking systems. Equity prices continued to reach record high in many industrial countries and property prices began to move up. And the US dollar stayed generally firm, despite the increasing weight of external indebtedness, and the perception of the euro as a competing reserve currency. And due to past excesses and recent deregulations, financial restructuring continued apace.
Global disinflation under way for almost two decades quickened in 1998. But it would be unwise to extrapolate the experiences in industrial economies (of headline inflation falling to 1-1/2%), of unusual price stability in South-East Asia, exchange rate stability in China and Hong Kong SAR or domestic price falls in Latin America, and conclude that "global deflation is the principal policy concern."
There was an unusually high degree of divergence in economic performance between the advanced industrial and emerging economies, and significant differences among major industrial countries as well. Even within many industrial countries, the gaps between surveys for consumer confidence (high) and business confidence (low) were striking.
On various proposals for preventing future crisis, the BIS says that given how jealously nations guard their sovereignty, proposals for establishment of a global central bank, an international lender of last resort, a global super-regulator or an international bankruptcy court are unlikely to be acted on in the near future.
Given the scale of private capital flows, the private sector will inevitably have to become more fully and directly involved in crisis management and resolution. Many of the recommendations in this regard of the G-10 deputies, made after the Mexican crises, have been recently reiterated, "although they have not been acted upon to date."
Having suffered heavier losses in 1998 than at any time since the 1980s debt crisis, creditor have become much more aware of their risk exposure. But welcome as these might be in terms of reducing future excessive capital inflows into emerging markets, "they may have increased the tendency for private sector capital that is already there to be withdrawn pre-emptively."
The sharp drop in bank credits to Brazil in the third quarter of 1998 has indeed been interpreted by some as a pre-emptive move by banks fearing they would otherwise be forced into rolling over existing credits or providing new ones, within the context of the anticipated IMF-adjustment programme.
The Malaysian recourse to capital controls, as a response to the crisis, has given further impetus to the debate on whether full- scale capital account liberalisation is premature for most emerging market economies.
In particular, support has grown in recent years for measures to slow the inflow of short-term capital until markets, institutions and regulatory frameworks have been sufficiently strengthened. Measures to contain capital flows, when implemented through market-based instruments, such as reserve requirements that tax shorter-term inflows more heavily, can be useful, and if carefully devised, can avoid a domestic credit boom and asset price bubble, while maintaining a liberal attitude towards longer-term flows.
But there has been much less acceptance for imposition of controls on outflows, in particular where a liberal regime was already in place. While such controls may give authorities necessary room to formulate and implement adjustment programmes to restore investor confidence, controls could also be abused either to maintain an inappropriate policy far too long or delay restructuring a weak financial sector. The effectiveness of controls also decline as loop-holes are found and exploited, and the process set in motion to plug them become ever more complex.
As for monetary policy in industrial economies, with inflation approaching zero in some countries and prices even declining in others, issues regarding appropriate conduct of monetary policy in conditions of near price stability took on new importance in major industrial countries. An inflation rate close to zero suggests central banks may experience brief episodes of declining prices more frequently in the future.
A potential concern is that nominal wages may be rigid downwards, and this means that with price falls real wages may be raised, depressing employment and economic activity. A second concern is that nominal interest rates cannot be made negative, and if a contractionary demand shock occurs and prices start to fall, real interest rates will rise and could reduce aggregate demand further. (SUNS4450)
The above article first appeared in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.
[c] 1999, SUNS - All rights reserved. May not be reproduced, reprinted or posted to any system or service without specific permission from SUNS. This limitation includes incorporation into a database, distribution via Usenet News, bulletin board systems, mailing lists, print media or broadcast. For information about reproduction or multi-user subscriptions please contact < suns@igc.org >
Higher bank capital requirements on the way
Higher bank capital requirements on the way
A new capital adequacy framework for banks is in the pipeline which seeks to better align capital charges to the lending institutions' underlying risk profile. The proposed new requirements are being drawn up in the wake of the recent turmoil in financial markets that brought to light the inadequacies of the existing Basle standards.
by Chakravarthi Raghavan
--------------------------------------------------------------------------------
GENEVA: A consultative document on a new capital adequacy framework for banks, made public on 3 June by the Basle Committee on Banking Supervision, suggests that when it is finalized and made effective, banks would face an increase in their capital adequacy requirements in relation to sovereign risk loans and collaterals.
The Committee has sought comments from all interested parties by 31 March 2000. In the light of these, the proposals will be finalized and a decision taken as to when the framework should be made effective.
While the Basle Committee's jurisdiction is over the G-10 banks, the standards are now being applied in over 100 countries.
While a critical assessment of the proposals requires study of the detailed document (only a press release was available at time of writing) and comparison with the existing Basle standards, the press release issued by the Bank for International Settlements suggests that the supervisors have resisted demands from the private sector for loosening some requirements, such as lowering the weighting on mortgage loans to commercial real estate, and plan to tighten others.
One area of some controversy among the G-10 countries not touched in the proposals relates to the idea aired publicly by the US Federal Reserve Chairman, Alan Greenspan, for higher capital ratios for inter-bank lending.
Three essential pillars
The chairman of the Basle Committee, New York Federal Reserve President and Chief Executive Officer William McDonough, who introduced the new paper, said the three elements of the proposed new capital framework are:
minimum capital requirements - which seek to develop and expand on the standardized rules set in the 1988 Basle Accord;
supervisory review of an institution's capital adequacy and internal assessment process, and
effective use of market discipline as a lever to strengthen disclosure and encourage safe and sound banking practices.
Taken together, McDonough said, these three elements are essential pillars of an effective capital framework.
The Basle standards have been the cornerstone of the international financial architecture, but the recent crisis on the financial markets has shown up their inadequacies in the face of the ability of the private-sector banks to get around rules through use of the vast array of new financial instruments .
In the proposals for minimum capital requirements, the Basle Committee wants to revise the current approach so as to align capital charges better to underlying risks.
For sovereign risks (loans to governments of countries), the Committee proposes to replace the existing approach with a system that would use external credit assessments for determining risk weights.
Such an approach is intended also to apply, either directly or indirectly and to varying degrees, to the risk weighting of exposure to banks, securities firms and corporate loans.
The Committee says this will result in reducing risk weights for high- quality corporate credits and introduce higher-than-100% risk weights for certain low-quality exposures.
A new risk-weighting scheme to address asset securitization is also proposed, as is the application of a 20% credit conversion factor for certain types of short-term commitments.
In regard to mortgages on commercial real estate, the Committee has decided that in principle such loans do not justify other than a 100% weighting of the loans secured.
The appropriate capital treatment of various types of assets, including those secured by commercial real estate, will continue to be reviewed by the Committee during the consultative period and after it has received comments.
The BIS press release says the Committee recognized that for some types of transactions, the 1988 Accord does not provide proper incentives for credit risk mitigation techniques.
For example, there is only minimal capital relief for collateral, and in some cases, the Accord's structure may not have favoured the development of specific forms of credit risk mitigation by placing restrictions on both the types of hedges acceptable for achieving capital reduction and the amount of capital relief.
The Committee is seeking to devise a more sound and consistent approach for capital treatment of credit risk mitigation techniques, including proposals for expanding the scope for eligible collateral guarantees and on-balance-sheet netting.
The Committee's proposals are intended to provide a basis for a standardized approach to set capital charges at the majority of banks. The Committee recognizes that for some banks, internal credit ratings could become a viable basis for regulatory capital requirements, subject to supervisory approval and adherence to quantitative and qualitative standards. The Committee also plans to develop an approach to regulatory capital based on the internal ratings of banks.
As for use of portfolio credit risk models to set regulatory capital requirements, the Basle Committee has suggested continued development of such models and their use.
Expanding coverage of risk
The Committee is also planning expanded coverage of the Accord to incorporate other major categories of risk - such as market risk, interest rate risk and other risks such as operational risk. The original Accord focused mainly on credit risk, but the growing significance of these other risks has led the Committee to conclude that they are too important not to be treated separately within the capital framework.
The Committee plans to develop a new capital charge for interest rate risk in the banking book for banks where the interest rate risk is significantly above average. It also proposes to develop an explicit capital charge for other risks, principally operational risk, and the practical ways this could be done.
It is also planned to extend the proposal to holding companies that are parents of banking groups.
As for supervisory review of capital adequacy, it is proposed that such review would seek to ensure that a bank's capital position and strategy is consistent with its overall risk profile and strategy, and encourage early supervisory intervention if the capital does not provide a sufficient buffer against risk.
The report notes that supervisors should have the ability to require banks to hold capital in excess of minimum regulatory capital ratios. This point has been underscored in the Committee's discussions with supervisors from emerging markets.
The new framework also stresses the importance of bank managements developing an internal capital assessment process and setting targets for capital that are commensurate with the bank's specific risk profile and control environment, with this process being then subjected to supervisory review and intervention where appropriate.
Supervisors, says the Committee, have a strong interest in facilitating effective market discipline as a lever to strengthen the safety and soundness of the banking system.
Effective market discipline requires reliable and timely information that enables market participants to make well- founded risk assessments.
Market operators want supervisors to publish all the details and reports arising out of their supervision, but there is some understandable resistance from supervisors to publish their own "assessments" which, by their very nature, are "subjective".
The Committee plans to issue more detailed guidance on the disclosure of capital structure, risk exposures and capital adequacy later this year. (Third World Economics No. 212, 1-15 July 1999)
The above article first appeared in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.
[c] 1999, SUNS - All rights reserved. May not be reproduced, reprinted or posted to any system or service without specific permission from SUNS. This limitation includes incorporation into a database, distribution via Usenet News, bulletin board systems, mailing lists, print media or broadcast. For information about reproduction or multi-user subscriptions please contact < suns@igc.org >
A new capital adequacy framework for banks is in the pipeline which seeks to better align capital charges to the lending institutions' underlying risk profile. The proposed new requirements are being drawn up in the wake of the recent turmoil in financial markets that brought to light the inadequacies of the existing Basle standards.
by Chakravarthi Raghavan
--------------------------------------------------------------------------------
GENEVA: A consultative document on a new capital adequacy framework for banks, made public on 3 June by the Basle Committee on Banking Supervision, suggests that when it is finalized and made effective, banks would face an increase in their capital adequacy requirements in relation to sovereign risk loans and collaterals.
The Committee has sought comments from all interested parties by 31 March 2000. In the light of these, the proposals will be finalized and a decision taken as to when the framework should be made effective.
While the Basle Committee's jurisdiction is over the G-10 banks, the standards are now being applied in over 100 countries.
While a critical assessment of the proposals requires study of the detailed document (only a press release was available at time of writing) and comparison with the existing Basle standards, the press release issued by the Bank for International Settlements suggests that the supervisors have resisted demands from the private sector for loosening some requirements, such as lowering the weighting on mortgage loans to commercial real estate, and plan to tighten others.
One area of some controversy among the G-10 countries not touched in the proposals relates to the idea aired publicly by the US Federal Reserve Chairman, Alan Greenspan, for higher capital ratios for inter-bank lending.
Three essential pillars
The chairman of the Basle Committee, New York Federal Reserve President and Chief Executive Officer William McDonough, who introduced the new paper, said the three elements of the proposed new capital framework are:
minimum capital requirements - which seek to develop and expand on the standardized rules set in the 1988 Basle Accord;
supervisory review of an institution's capital adequacy and internal assessment process, and
effective use of market discipline as a lever to strengthen disclosure and encourage safe and sound banking practices.
Taken together, McDonough said, these three elements are essential pillars of an effective capital framework.
The Basle standards have been the cornerstone of the international financial architecture, but the recent crisis on the financial markets has shown up their inadequacies in the face of the ability of the private-sector banks to get around rules through use of the vast array of new financial instruments .
In the proposals for minimum capital requirements, the Basle Committee wants to revise the current approach so as to align capital charges better to underlying risks.
For sovereign risks (loans to governments of countries), the Committee proposes to replace the existing approach with a system that would use external credit assessments for determining risk weights.
Such an approach is intended also to apply, either directly or indirectly and to varying degrees, to the risk weighting of exposure to banks, securities firms and corporate loans.
The Committee says this will result in reducing risk weights for high- quality corporate credits and introduce higher-than-100% risk weights for certain low-quality exposures.
A new risk-weighting scheme to address asset securitization is also proposed, as is the application of a 20% credit conversion factor for certain types of short-term commitments.
In regard to mortgages on commercial real estate, the Committee has decided that in principle such loans do not justify other than a 100% weighting of the loans secured.
The appropriate capital treatment of various types of assets, including those secured by commercial real estate, will continue to be reviewed by the Committee during the consultative period and after it has received comments.
The BIS press release says the Committee recognized that for some types of transactions, the 1988 Accord does not provide proper incentives for credit risk mitigation techniques.
For example, there is only minimal capital relief for collateral, and in some cases, the Accord's structure may not have favoured the development of specific forms of credit risk mitigation by placing restrictions on both the types of hedges acceptable for achieving capital reduction and the amount of capital relief.
The Committee is seeking to devise a more sound and consistent approach for capital treatment of credit risk mitigation techniques, including proposals for expanding the scope for eligible collateral guarantees and on-balance-sheet netting.
The Committee's proposals are intended to provide a basis for a standardized approach to set capital charges at the majority of banks. The Committee recognizes that for some banks, internal credit ratings could become a viable basis for regulatory capital requirements, subject to supervisory approval and adherence to quantitative and qualitative standards. The Committee also plans to develop an approach to regulatory capital based on the internal ratings of banks.
As for use of portfolio credit risk models to set regulatory capital requirements, the Basle Committee has suggested continued development of such models and their use.
Expanding coverage of risk
The Committee is also planning expanded coverage of the Accord to incorporate other major categories of risk - such as market risk, interest rate risk and other risks such as operational risk. The original Accord focused mainly on credit risk, but the growing significance of these other risks has led the Committee to conclude that they are too important not to be treated separately within the capital framework.
The Committee plans to develop a new capital charge for interest rate risk in the banking book for banks where the interest rate risk is significantly above average. It also proposes to develop an explicit capital charge for other risks, principally operational risk, and the practical ways this could be done.
It is also planned to extend the proposal to holding companies that are parents of banking groups.
As for supervisory review of capital adequacy, it is proposed that such review would seek to ensure that a bank's capital position and strategy is consistent with its overall risk profile and strategy, and encourage early supervisory intervention if the capital does not provide a sufficient buffer against risk.
The report notes that supervisors should have the ability to require banks to hold capital in excess of minimum regulatory capital ratios. This point has been underscored in the Committee's discussions with supervisors from emerging markets.
The new framework also stresses the importance of bank managements developing an internal capital assessment process and setting targets for capital that are commensurate with the bank's specific risk profile and control environment, with this process being then subjected to supervisory review and intervention where appropriate.
Supervisors, says the Committee, have a strong interest in facilitating effective market discipline as a lever to strengthen the safety and soundness of the banking system.
Effective market discipline requires reliable and timely information that enables market participants to make well- founded risk assessments.
Market operators want supervisors to publish all the details and reports arising out of their supervision, but there is some understandable resistance from supervisors to publish their own "assessments" which, by their very nature, are "subjective".
The Committee plans to issue more detailed guidance on the disclosure of capital structure, risk exposures and capital adequacy later this year. (Third World Economics No. 212, 1-15 July 1999)
The above article first appeared in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.
[c] 1999, SUNS - All rights reserved. May not be reproduced, reprinted or posted to any system or service without specific permission from SUNS. This limitation includes incorporation into a database, distribution via Usenet News, bulletin board systems, mailing lists, print media or broadcast. For information about reproduction or multi-user subscriptions please contact < suns@igc.org >
Only minor improvements in near-term
Only minor improvements in near-term
by Chakravarthi Raghavan
--------------------------------------------------------------------------------
Geneva, 1 July -- After two years of financial turbulence, the world economy is no longer weakening, but for the majority of countries, for the foreseeable future, growth will fall far short of that necessary to effect substantial improvement in living standards or reducing numbers living in poverty, the UN said Thursday.
In a report on the World Economy in 1999, by the UN Department of Economic and Social Affairs, the UN said for the majority of developing and transition economies, growth in 1999 remains inadequate, and the outlook for rest of 1999 and beyond suggests only a minor overall improvement.
Gross world output is forecast to rise only 2 percent in 1999, almost the same as in 1998, and by only 2-1/2 percent in 2000, the UN report says in its near-term outlook.
Growth of output in developing economies is expected to recover only gradually from the sharp deceleration of 1998 - to reach rates of 2-1/2 percent in 1999 and 4-1/2 in 2000. And while a number of afflicted developing countries and transition economies show signs of slow recovery, others are expected to remain in, or enter into, economic recession.
The recession which swept over several countries of S.E.Asia in late 1997 and 1998, and hit a number of Latin American countries in late 1998, is expected to persist, but moderate, in 1999, with growth returning in 2000.
While S.E.Asian developing countries have begun to recover from their financial crises, none is likely to return in the near future to the high growth rates before the crisis. China is expected to decelerate, but remain in the 7-8 percent range, while India's strong growth should continue.
African developing countries are expected to post a three percent growth on average, but due to fast population growth, substantial gains in per capita output is unlikely.
While Caribbean and Central American economies would have overcome the damage inflicted by the El Nino and severe hurricanes, Latin America as a whole is experiencing a recession in 1999, owing to adjustment measures in Brazil and other countries.
Not only is this pace of expansion far from satisfactory for many countries, but in addition some serious downside risks remain, arising from globalization, says the UN.
These risks aren't necesarily associated with a group of countries, but can stem from a national problem that, because of today's integrated world economy, has global consequences. The forecasts are, thus subject to errors (producing slower or faster growth), but with a preponderance of downside risks.
The worst such would be a hard landing for the US - either because of a stock-market fall or authorities reacting to a sign of inflationary pressure and tightening of monetary policy sharply to produce deceleration of output -- which would mean main stimulus for world growth could go into reverse.
[But the US Federal Reserve's latest announcement putting up a 1/4 percent rate rise has been combined with indications of a neutral stance for rest of the year - and no sharp increases.]
But there are also several downside risks in developing and transition economies says the UN - in Brazil which still has a formidable task of addressing large fiscal sector imbalance, China where export sector growth is declining faster than expected and consumer demand is weak, and a further decline in output in the Russian Federation.
A simulation exercise, by Project LINK, of a possible impact of another major financial crisis, suggests that in such an event world growth could slow down markedly, with a further contraction in global trade. The impact on developing countries would be particularly pronounced, while the transition economies would experience a sharp drop also.
In 1998, the UN said, of 95 developing countries for which reliable data are available, those experiencing decline in per capita output numbered 40 - more than double the 18 in 1997.
About one in four in the developing world, or roughly 1.2 billion people, live in countries that suffered a decline in per capital output in 1998 - as compared to 160 million people or less than 4 percent of the population of developing regions.
For developing world a minimum 3% per capita output growth is needed to allow some progress in raising living standards and reducing poverty.
Only 23 countries in 1998 met this criteria, as against 39 in 1996.
And only 13, including China, will have a per capita output growth of more than three percent in 1999 - one in Latin America (nine in 1996), 6 in South and East Asia (13 in 1996), and 6 in Africa (14 in 1996).
These data show that adjustments in real economic sectors will take a much longer period of time to be implemented and to bear fruit, than changes in monetary and financial indicators.
And resumption in employment and real wages, and reversing social setbacks of the crisis, will trail well behind resumption of output growth.
And while there appears to be a consensus on need to reform the architecture of the international financial and monetary systems, progress to date has been limited. And, "without successful systemic reforms, the global economy remains highly vulnerable to future international crises."
With an average growth of only 1.7 percent in 1998 well below that of developed countries, and for the first time since the 1980s and the 5% growth achieved earlier in 1990s.
Only China and India were able to sustain rapid growth in 1998, and are expected to continue to do so in 1999 - auguring well for the large proportion of the world's poorest who are citizens of these two countries.
With the reversal in the growth rates, the disparity between levels of living and personal incomes in developed countries and the rest of the world widened.
Since the Asian currency crisis, not only has growth in the developing world been slower than in developed,but the shift in relative prices "has amplified the deterioration in the position of the average person in the developing and transition countries: average output has fallen and average incomes have fallen even more."
And the average consumer in the developed countries has not been affected by the international financial crisis: output growth has slowed, but per capita output has continued to rise and, due to changes in relative prices, real incomes have increased faster than real output.
"Individual consumers in most developed countries have benefited directly from lower prices for primary commodities and imports of manufactured goods."
And in addition to the increased income gap, developing and transition economies have also to confront the social consequences.
Liberalization and globalization should have resulted in an increase in numbers entering formal employment, paying taxes to government, getting loans from the financial system to expand their business and providing employment to those in the informal sector.
Instead, the crises has delayed or pushed back movement of people from poverty to more modern commercial sectors, and in Asia and Russia the continued expansion of the more modern sector in these countries has been put at risk.
In recent years, while many of the developed countries were able to take advantage of globalization, the effects on developing and transition countries have been perverse. Referring to the financial crisis that first struck South East Asia in 1997, and the responses, and controversies on macro- economic and financial policies to meet them, the UN report underlines that there is now some agreement that the extent of fiscal austerity initially pursued by the Asian economies was inappropriate.
In Asia, where neither monetary nor fiscal policy excesses were the cause of the crises, increasing the fiscal deficit was an appropriate response. In Russia and Brazil, widening fiscal deficits was one of the causes of the crises, and the deficits were structural -- while in Asia they were cyclical and it was appropriate to stimulate the economy.
And for countries integrated into the world financial markets, the room for manoeuvre in using fiscal policy is limited - because of the need to balance domestic needs with perceptions of markets.
An internationally coordinated plan to cut interest rates in major industrialized economies and increase official transfers to the crisis-hit Asian economies would have had a better response. And while the major European countries did stimulate consumption through interest rate cuts, it was belated and an indirect response to the crisis, whereas if it had been taken earlier, the slowdown in their economies would probably not have occurred. And even the cuts in the European rates were only coordinated within the euro zone, and not globally.
Underscoring the need to address social and human dimensions of the crisis, the report argues that the experience of the recent crisis shows that social dimension has to be integrated into the formulation of economic policies - by ensuring consistency between short-term economic objectives, like financial stability, and longer-term social and developmental goals such as poverty eradication. And social protection measures are more effective if they are in place before a crisis, and not when hastily put together after.
"The social dimension therefore needs to be incorporated in economic policy as a matter of course." (SUNS4468)
The above article first appeared in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.
[c] 1999, SUNS - All rights reserved. May not be reproduced, reprinted or posted to any system or service without specific permission from SUNS. This limitation includes incorporation into a database, distribution via Usenet News, bulletin board systems, mailing lists, print media or broadcast. For information about reproduction or multi-user subscriptions please contact < suns@igc.org >
by Chakravarthi Raghavan
--------------------------------------------------------------------------------
Geneva, 1 July -- After two years of financial turbulence, the world economy is no longer weakening, but for the majority of countries, for the foreseeable future, growth will fall far short of that necessary to effect substantial improvement in living standards or reducing numbers living in poverty, the UN said Thursday.
In a report on the World Economy in 1999, by the UN Department of Economic and Social Affairs, the UN said for the majority of developing and transition economies, growth in 1999 remains inadequate, and the outlook for rest of 1999 and beyond suggests only a minor overall improvement.
Gross world output is forecast to rise only 2 percent in 1999, almost the same as in 1998, and by only 2-1/2 percent in 2000, the UN report says in its near-term outlook.
Growth of output in developing economies is expected to recover only gradually from the sharp deceleration of 1998 - to reach rates of 2-1/2 percent in 1999 and 4-1/2 in 2000. And while a number of afflicted developing countries and transition economies show signs of slow recovery, others are expected to remain in, or enter into, economic recession.
The recession which swept over several countries of S.E.Asia in late 1997 and 1998, and hit a number of Latin American countries in late 1998, is expected to persist, but moderate, in 1999, with growth returning in 2000.
While S.E.Asian developing countries have begun to recover from their financial crises, none is likely to return in the near future to the high growth rates before the crisis. China is expected to decelerate, but remain in the 7-8 percent range, while India's strong growth should continue.
African developing countries are expected to post a three percent growth on average, but due to fast population growth, substantial gains in per capita output is unlikely.
While Caribbean and Central American economies would have overcome the damage inflicted by the El Nino and severe hurricanes, Latin America as a whole is experiencing a recession in 1999, owing to adjustment measures in Brazil and other countries.
Not only is this pace of expansion far from satisfactory for many countries, but in addition some serious downside risks remain, arising from globalization, says the UN.
These risks aren't necesarily associated with a group of countries, but can stem from a national problem that, because of today's integrated world economy, has global consequences. The forecasts are, thus subject to errors (producing slower or faster growth), but with a preponderance of downside risks.
The worst such would be a hard landing for the US - either because of a stock-market fall or authorities reacting to a sign of inflationary pressure and tightening of monetary policy sharply to produce deceleration of output -- which would mean main stimulus for world growth could go into reverse.
[But the US Federal Reserve's latest announcement putting up a 1/4 percent rate rise has been combined with indications of a neutral stance for rest of the year - and no sharp increases.]
But there are also several downside risks in developing and transition economies says the UN - in Brazil which still has a formidable task of addressing large fiscal sector imbalance, China where export sector growth is declining faster than expected and consumer demand is weak, and a further decline in output in the Russian Federation.
A simulation exercise, by Project LINK, of a possible impact of another major financial crisis, suggests that in such an event world growth could slow down markedly, with a further contraction in global trade. The impact on developing countries would be particularly pronounced, while the transition economies would experience a sharp drop also.
In 1998, the UN said, of 95 developing countries for which reliable data are available, those experiencing decline in per capita output numbered 40 - more than double the 18 in 1997.
About one in four in the developing world, or roughly 1.2 billion people, live in countries that suffered a decline in per capital output in 1998 - as compared to 160 million people or less than 4 percent of the population of developing regions.
For developing world a minimum 3% per capita output growth is needed to allow some progress in raising living standards and reducing poverty.
Only 23 countries in 1998 met this criteria, as against 39 in 1996.
And only 13, including China, will have a per capita output growth of more than three percent in 1999 - one in Latin America (nine in 1996), 6 in South and East Asia (13 in 1996), and 6 in Africa (14 in 1996).
These data show that adjustments in real economic sectors will take a much longer period of time to be implemented and to bear fruit, than changes in monetary and financial indicators.
And resumption in employment and real wages, and reversing social setbacks of the crisis, will trail well behind resumption of output growth.
And while there appears to be a consensus on need to reform the architecture of the international financial and monetary systems, progress to date has been limited. And, "without successful systemic reforms, the global economy remains highly vulnerable to future international crises."
With an average growth of only 1.7 percent in 1998 well below that of developed countries, and for the first time since the 1980s and the 5% growth achieved earlier in 1990s.
Only China and India were able to sustain rapid growth in 1998, and are expected to continue to do so in 1999 - auguring well for the large proportion of the world's poorest who are citizens of these two countries.
With the reversal in the growth rates, the disparity between levels of living and personal incomes in developed countries and the rest of the world widened.
Since the Asian currency crisis, not only has growth in the developing world been slower than in developed,but the shift in relative prices "has amplified the deterioration in the position of the average person in the developing and transition countries: average output has fallen and average incomes have fallen even more."
And the average consumer in the developed countries has not been affected by the international financial crisis: output growth has slowed, but per capita output has continued to rise and, due to changes in relative prices, real incomes have increased faster than real output.
"Individual consumers in most developed countries have benefited directly from lower prices for primary commodities and imports of manufactured goods."
And in addition to the increased income gap, developing and transition economies have also to confront the social consequences.
Liberalization and globalization should have resulted in an increase in numbers entering formal employment, paying taxes to government, getting loans from the financial system to expand their business and providing employment to those in the informal sector.
Instead, the crises has delayed or pushed back movement of people from poverty to more modern commercial sectors, and in Asia and Russia the continued expansion of the more modern sector in these countries has been put at risk.
In recent years, while many of the developed countries were able to take advantage of globalization, the effects on developing and transition countries have been perverse. Referring to the financial crisis that first struck South East Asia in 1997, and the responses, and controversies on macro- economic and financial policies to meet them, the UN report underlines that there is now some agreement that the extent of fiscal austerity initially pursued by the Asian economies was inappropriate.
In Asia, where neither monetary nor fiscal policy excesses were the cause of the crises, increasing the fiscal deficit was an appropriate response. In Russia and Brazil, widening fiscal deficits was one of the causes of the crises, and the deficits were structural -- while in Asia they were cyclical and it was appropriate to stimulate the economy.
And for countries integrated into the world financial markets, the room for manoeuvre in using fiscal policy is limited - because of the need to balance domestic needs with perceptions of markets.
An internationally coordinated plan to cut interest rates in major industrialized economies and increase official transfers to the crisis-hit Asian economies would have had a better response. And while the major European countries did stimulate consumption through interest rate cuts, it was belated and an indirect response to the crisis, whereas if it had been taken earlier, the slowdown in their economies would probably not have occurred. And even the cuts in the European rates were only coordinated within the euro zone, and not globally.
Underscoring the need to address social and human dimensions of the crisis, the report argues that the experience of the recent crisis shows that social dimension has to be integrated into the formulation of economic policies - by ensuring consistency between short-term economic objectives, like financial stability, and longer-term social and developmental goals such as poverty eradication. And social protection measures are more effective if they are in place before a crisis, and not when hastily put together after.
"The social dimension therefore needs to be incorporated in economic policy as a matter of course." (SUNS4468)
The above article first appeared in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.
[c] 1999, SUNS - All rights reserved. May not be reproduced, reprinted or posted to any system or service without specific permission from SUNS. This limitation includes incorporation into a database, distribution via Usenet News, bulletin board systems, mailing lists, print media or broadcast. For information about reproduction or multi-user subscriptions please contact < suns@igc.org >
Asia's financial crisis
Asia's financial crisis
There is no basis for the claim that the Asian financial crisis was due to a lack of sound economic fundamentals. The currencies of the affected countries were forcibly devalued and their financial systems were brought to ruin by the activities of speculators. The crisis has, however, revealed one glaring weakness: the absence of a lender of last resort for the region.
by Chandra Hardy
--------------------------------------------------------------------------------
THE Asian financial crisis was not caused by macroeconomic imbalances. The fundamentals of Malaysia, Indonesia, Philippines and Korea were and are sound. These economies have high domestic savings and investment rates, high rates of output growth, strong export performance, low inflation and more egalitarian economic policies than any other region.
Many knowledgeable commentators can be cited who have said that the size and the pace of capital outflows from the fast growing economies of East Asia had nothing to do with fundamentals.
The Director of the World Bank's office in Indonesia went so far to say, as he watched the decline in the value of the currency caused by the rapid pace of capital outflows, that 'This has nothing to do with economics.'
The President of the World Bank characterised the crisis as a 'hic-cup' in September, and the head of the International Monetary Fund (IMF) said in May that the government of Thailand was taking courageous steps to address the problems of the financial sector, and doing exactly what is needed to be done to prevent a Mexican-type crisis, and that he 'did not see any particular reason for this crisis to develop further.'
A real estate bubble burst in Thailand. The bubble had been created by huge inflows of external capital. Private capital flows into Thailand between 1988 and 1995 totalled 52% of GDP. The government took all the recommended measures to control the impact of these large inflows on the economy. The most commonly used measures were designed to reduce the expansion of the domestic money supply through sterilised intervention. However, these measures did not reduce the scale of capital inflows which continued throughout 1996. Investment rates jumped to over 40% of GDP.
But no country can productively absorb such large inflows in such a short period.
The experience accumulated by the World Bank over a number of decades indicates that the average period to prepare a large investment project is two years and it takes another four years from the start of construction to full production. Economists refer to this as the lumpiness of investment. Consequently, capital inflows averaging 12% of GDP per annum over a seven-year period cannot find productive use, especially when like Thailand, the investment rate is already very high.
The only investments which can be quickly undertaken are in real estate construction, and this explains how the surge in inflows is channelled through the banking system and creates a bubble in the prices of real estate and stocks.
Reports in the Western press paint a picture of the economy of Thailand that is totally negative. It might be helpful to offer some facts.
Thailand is a middle-income country with a population of 60 million, and a per capita GNP of around $3,000 in 1995. The country has experienced output growth of 8% per annum since 1980, low inflation (less than 5% per annum since 1980), and a rate of growth of exports which has increased from 14% per annum in the 1980s to 22% per annum in the 1990s.
A2 bond ratings
This impressive and stable economic performance over the past 15 years had earned Thailand the highest bond ratings among the emerging markets. As of 24 June 1997, the bond rating for Thailand was A2, and the only country in the region which had a higher rating at that time was Malaysia (A1).
The collapse in real estate and asset prices in Thailand left some financial institutions with a large proportion of non-performing loans. But this problem was largely confined to second and third tier finance companies.
The position of the country's major banks was far stronger. At the end of 1996, the non-performing loans as a share of total loans ranged between 4.3 and 8.0% for the five largest banks, and 7.7% for all banks in the country. (J P Morgan, Emerging Markets Watch, February 1997)
These are not figures which suggest a crisis or overall weakness in the country's banking system. Moreover, the government and the Bank of Thailand were taking steps to deal with the problem in the financial sector, as noted by the Managing Director of the IMF.
At the beginning of 1997, none of the macroeconomic indicators of Thailand were worse than at the start of 1996. The share of short term debt to total debt was lower than it was a year ago and the trade deficit was narrowing in the first quarter of 1997.
But beginning in July, there was a run on the currency.
As a result of financial liberalisation, there was a rapid and uncontrolled build up of short term debt by the private sector. The liabilities to non-residents as a proportion of total domestic credit of the banking system was estimated at more than 45%. (J P Morgan, April 1997). These non-resident 'investors' borrowed in local currency and bought dollars knowing that they would be able to repay the domestic loans with fewer dollars after a devaluation. Short term lenders asked to be repaid.
In mid 1997, the problem in the second tier financial institutions in Thailand was being addressed and the crisis could have been contained. Other countries routinely have crashes in real estate and other asset markets without jeopardising the whole economy. The Asian financial crisis should have stopped at the correction in Thailand.
But why did the capital outflow spread to Malaysia which did not have large short term debt or weak banks, and to Indonesia, the Philippines, Singapore, Hong Kong, Korea and Japan in that order?
In November, the Managing Director of the IMF said in Singapore that while the origins of the crisis in Thailand was clear, 'what is less evident and therefore more unsettling' to all who are trying to make sense of broader regional developments is how the crisis spread to Indonesia, Malaysia and the Philippines.
'HOUSECLEANING'
ACCORDING to a report in the Asian Wall Street Journal, the US is hoping that some of its most intractable trade disputes with South Korea can be quietly swept away by the massive 'housecleaning' of the financial services sector there. Under the IMF conditionality package, South Korea is obligated to end certain practices which the US finds objectionable. The US has some pending trade actions against Korea over the automobile sector. The US has initiated some 'Super 301' trade actions. The AWSJ report said that the IMF conditionalities when carried out by Korea would meet these concerns of the US automobile sector which is worried by the Korean competition. The report said 'there is little doubt that the IMF programme is being laid out with these US concerns in mind, and that US Treasury Secretary Rubin has assured key lawmakers that he is in touch with the IMF and Korean officials responsible for carrying out the reforms.
- Chakravarthi Raghavan
No evidence
The currencies of strong economies were being forcibly devalued and their banks and financial institutions were being brought to ruin by the unfettered forces of the market. The new dogma says that the market is always right. Many senior officials in the US said that the market was punishing Asia for its lax economic policies but they offered no evidence to support these charges of lax policies.
In the meanwhile, the currency speculators roamed around the waters of East Asia like sharks smelling blood. Hong Kong, Singapore and Taiwan were weakened but may have survived this attack.
The countries whose currencies and well-being were under attack needed large amounts of liquidity. They tried to get help from neighbouring central banks but the neighbours had provided help to Thailand and they were concerned about the level of their own reserves in case of a run on their own currencies.
South Korea is the world's 11th largest economy with an unmatched record of economic success spanning more than four decades. There is probably no economy in the world whose economic fundamentals are stronger.
South Korea's currency came under attack and the country found itself with no lender of last resort in the region or any where else.
The Asian financial crisis has exposed a glaring gap in the economic policy coordination of the region which will need to be remedied as soon as possible. This weakness is the absence of lender of last resort for the region.
The proposal for an Asian Fund which has been around for some years has considerable merit and the delay in putting it into effect will prove to be costly.
The Bank of International Settlements (BIS) is an institution located in Switzerland which was established to promote cooperation among the central banks. But the BIS does not include among its 29 members any central bank from Asia or any of the emerging markets. Of the 29 members of the BIS, 24 are from Europe. The non-European members are the US, Japan, Canada, Australia and South Africa.
Korea appealed to Japan for help, but Japan had already provided help to other countries in the region and there was increasing concern about a run on its own currency. Any indication that Japan did not have liquidity to spare would have set in motion a speculative attack on the yen. Japan had no option in the circumstances but to tell Korea that it could not provide all the liquidity that might be needed.
Imagine a man who has been running a successful factory producing cars, electronics, machine tools, ships etc. He had been enjoying good growth, rapid exports, sound investment and rising productivity.
One day the roof came off his factory in a major hurricane. He needed help but his neighbours had been hit by the same storm. Finally, the man had to go to the bank which is owned by his competitors.
The bank manager said that he would help but that there were some conditions:
First, the man had to reduce his output so that his competitors would regain their market share and then the man had to sell shares in his company to his competitors.
Korea's reluctance to go to the IMF was not simply a matter of pride as some reports in the press indicated. Korea has borrowed in the past and Korea has a good grasp of global economic trends.
Korea's reluctance to go the IMF had to do with the conditions of the loan.
Korea has managed to produce a growth rate of over 8% per annum for the past 30-40 years without advice from the IMF. Why is the IMF demanding that Korea cut its growth rate in half?
Why should a country doing well before a speculative attack on its currency have to deflate its economy?
How is reduced growth in Korea and Asia going to help the region, the developing countries or the world economy?
Why should Korea fix an economy that is not broken?
The IMF should provide an explanation of why the Asian countries are being asked to agree to conditions on financial market liberalisation as a condition of IMF loans.
Why is the IMF using the crisis to get countries to agree to conditions to which they are not willing agree in multilateral or bilateral negotiations? These are all questions that deserve answers. (Third World Resurgence No.89, January 1998)
Chandra Hardy is a retired senior economist of the World Bank. The above is part of her forthcoming larger study on capital flows to developing countries.
There is no basis for the claim that the Asian financial crisis was due to a lack of sound economic fundamentals. The currencies of the affected countries were forcibly devalued and their financial systems were brought to ruin by the activities of speculators. The crisis has, however, revealed one glaring weakness: the absence of a lender of last resort for the region.
by Chandra Hardy
--------------------------------------------------------------------------------
THE Asian financial crisis was not caused by macroeconomic imbalances. The fundamentals of Malaysia, Indonesia, Philippines and Korea were and are sound. These economies have high domestic savings and investment rates, high rates of output growth, strong export performance, low inflation and more egalitarian economic policies than any other region.
Many knowledgeable commentators can be cited who have said that the size and the pace of capital outflows from the fast growing economies of East Asia had nothing to do with fundamentals.
The Director of the World Bank's office in Indonesia went so far to say, as he watched the decline in the value of the currency caused by the rapid pace of capital outflows, that 'This has nothing to do with economics.'
The President of the World Bank characterised the crisis as a 'hic-cup' in September, and the head of the International Monetary Fund (IMF) said in May that the government of Thailand was taking courageous steps to address the problems of the financial sector, and doing exactly what is needed to be done to prevent a Mexican-type crisis, and that he 'did not see any particular reason for this crisis to develop further.'
A real estate bubble burst in Thailand. The bubble had been created by huge inflows of external capital. Private capital flows into Thailand between 1988 and 1995 totalled 52% of GDP. The government took all the recommended measures to control the impact of these large inflows on the economy. The most commonly used measures were designed to reduce the expansion of the domestic money supply through sterilised intervention. However, these measures did not reduce the scale of capital inflows which continued throughout 1996. Investment rates jumped to over 40% of GDP.
But no country can productively absorb such large inflows in such a short period.
The experience accumulated by the World Bank over a number of decades indicates that the average period to prepare a large investment project is two years and it takes another four years from the start of construction to full production. Economists refer to this as the lumpiness of investment. Consequently, capital inflows averaging 12% of GDP per annum over a seven-year period cannot find productive use, especially when like Thailand, the investment rate is already very high.
The only investments which can be quickly undertaken are in real estate construction, and this explains how the surge in inflows is channelled through the banking system and creates a bubble in the prices of real estate and stocks.
Reports in the Western press paint a picture of the economy of Thailand that is totally negative. It might be helpful to offer some facts.
Thailand is a middle-income country with a population of 60 million, and a per capita GNP of around $3,000 in 1995. The country has experienced output growth of 8% per annum since 1980, low inflation (less than 5% per annum since 1980), and a rate of growth of exports which has increased from 14% per annum in the 1980s to 22% per annum in the 1990s.
A2 bond ratings
This impressive and stable economic performance over the past 15 years had earned Thailand the highest bond ratings among the emerging markets. As of 24 June 1997, the bond rating for Thailand was A2, and the only country in the region which had a higher rating at that time was Malaysia (A1).
The collapse in real estate and asset prices in Thailand left some financial institutions with a large proportion of non-performing loans. But this problem was largely confined to second and third tier finance companies.
The position of the country's major banks was far stronger. At the end of 1996, the non-performing loans as a share of total loans ranged between 4.3 and 8.0% for the five largest banks, and 7.7% for all banks in the country. (J P Morgan, Emerging Markets Watch, February 1997)
These are not figures which suggest a crisis or overall weakness in the country's banking system. Moreover, the government and the Bank of Thailand were taking steps to deal with the problem in the financial sector, as noted by the Managing Director of the IMF.
At the beginning of 1997, none of the macroeconomic indicators of Thailand were worse than at the start of 1996. The share of short term debt to total debt was lower than it was a year ago and the trade deficit was narrowing in the first quarter of 1997.
But beginning in July, there was a run on the currency.
As a result of financial liberalisation, there was a rapid and uncontrolled build up of short term debt by the private sector. The liabilities to non-residents as a proportion of total domestic credit of the banking system was estimated at more than 45%. (J P Morgan, April 1997). These non-resident 'investors' borrowed in local currency and bought dollars knowing that they would be able to repay the domestic loans with fewer dollars after a devaluation. Short term lenders asked to be repaid.
In mid 1997, the problem in the second tier financial institutions in Thailand was being addressed and the crisis could have been contained. Other countries routinely have crashes in real estate and other asset markets without jeopardising the whole economy. The Asian financial crisis should have stopped at the correction in Thailand.
But why did the capital outflow spread to Malaysia which did not have large short term debt or weak banks, and to Indonesia, the Philippines, Singapore, Hong Kong, Korea and Japan in that order?
In November, the Managing Director of the IMF said in Singapore that while the origins of the crisis in Thailand was clear, 'what is less evident and therefore more unsettling' to all who are trying to make sense of broader regional developments is how the crisis spread to Indonesia, Malaysia and the Philippines.
'HOUSECLEANING'
ACCORDING to a report in the Asian Wall Street Journal, the US is hoping that some of its most intractable trade disputes with South Korea can be quietly swept away by the massive 'housecleaning' of the financial services sector there. Under the IMF conditionality package, South Korea is obligated to end certain practices which the US finds objectionable. The US has some pending trade actions against Korea over the automobile sector. The US has initiated some 'Super 301' trade actions. The AWSJ report said that the IMF conditionalities when carried out by Korea would meet these concerns of the US automobile sector which is worried by the Korean competition. The report said 'there is little doubt that the IMF programme is being laid out with these US concerns in mind, and that US Treasury Secretary Rubin has assured key lawmakers that he is in touch with the IMF and Korean officials responsible for carrying out the reforms.
- Chakravarthi Raghavan
No evidence
The currencies of strong economies were being forcibly devalued and their banks and financial institutions were being brought to ruin by the unfettered forces of the market. The new dogma says that the market is always right. Many senior officials in the US said that the market was punishing Asia for its lax economic policies but they offered no evidence to support these charges of lax policies.
In the meanwhile, the currency speculators roamed around the waters of East Asia like sharks smelling blood. Hong Kong, Singapore and Taiwan were weakened but may have survived this attack.
The countries whose currencies and well-being were under attack needed large amounts of liquidity. They tried to get help from neighbouring central banks but the neighbours had provided help to Thailand and they were concerned about the level of their own reserves in case of a run on their own currencies.
South Korea is the world's 11th largest economy with an unmatched record of economic success spanning more than four decades. There is probably no economy in the world whose economic fundamentals are stronger.
South Korea's currency came under attack and the country found itself with no lender of last resort in the region or any where else.
The Asian financial crisis has exposed a glaring gap in the economic policy coordination of the region which will need to be remedied as soon as possible. This weakness is the absence of lender of last resort for the region.
The proposal for an Asian Fund which has been around for some years has considerable merit and the delay in putting it into effect will prove to be costly.
The Bank of International Settlements (BIS) is an institution located in Switzerland which was established to promote cooperation among the central banks. But the BIS does not include among its 29 members any central bank from Asia or any of the emerging markets. Of the 29 members of the BIS, 24 are from Europe. The non-European members are the US, Japan, Canada, Australia and South Africa.
Korea appealed to Japan for help, but Japan had already provided help to other countries in the region and there was increasing concern about a run on its own currency. Any indication that Japan did not have liquidity to spare would have set in motion a speculative attack on the yen. Japan had no option in the circumstances but to tell Korea that it could not provide all the liquidity that might be needed.
Imagine a man who has been running a successful factory producing cars, electronics, machine tools, ships etc. He had been enjoying good growth, rapid exports, sound investment and rising productivity.
One day the roof came off his factory in a major hurricane. He needed help but his neighbours had been hit by the same storm. Finally, the man had to go to the bank which is owned by his competitors.
The bank manager said that he would help but that there were some conditions:
First, the man had to reduce his output so that his competitors would regain their market share and then the man had to sell shares in his company to his competitors.
Korea's reluctance to go to the IMF was not simply a matter of pride as some reports in the press indicated. Korea has borrowed in the past and Korea has a good grasp of global economic trends.
Korea's reluctance to go the IMF had to do with the conditions of the loan.
Korea has managed to produce a growth rate of over 8% per annum for the past 30-40 years without advice from the IMF. Why is the IMF demanding that Korea cut its growth rate in half?
Why should a country doing well before a speculative attack on its currency have to deflate its economy?
How is reduced growth in Korea and Asia going to help the region, the developing countries or the world economy?
Why should Korea fix an economy that is not broken?
The IMF should provide an explanation of why the Asian countries are being asked to agree to conditions on financial market liberalisation as a condition of IMF loans.
Why is the IMF using the crisis to get countries to agree to conditions to which they are not willing agree in multilateral or bilateral negotiations? These are all questions that deserve answers. (Third World Resurgence No.89, January 1998)
Chandra Hardy is a retired senior economist of the World Bank. The above is part of her forthcoming larger study on capital flows to developing countries.
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