Theme: The world financial crisis, the result of financial liberalisation and an excess of global liquidity, has pushed the world to the verge of recession. The crisis will also have major geopolitical ramifications.
Summary: This ARI analyses the causes of the international financial crisis, evaluates the economic and political initiatives that governments have undertaken and explores its geopolitical impact.
Analysis ‘We have the tools to manage the crisis. Now we need the leadership to use them’.
(Paul Volker, former chairman of the US Federal Reserve,
Wall Street Journal, 10/X/2007)
No one questions any longer the fact that we are facing the greatest international financial crisis since the Great Depression. Since September 2008, the world has seen unprecedented events that are re-shaping the international financial system and challenging liberal economic orthodoxy, which had gone practically unquestioned since the 1990s under US leadership. The sub-prime mortgage crisis that erupted in August 2007 has become a systemic financial crisis whose epicentre is no longer just in the US, but rather has spread to Europe and Japan and is having a powerful impact on the growth of the emerging economies.
Investment banks have vanished, and governments have redefined the role of lender of last resort, launching rescue packages on both sides of the Atlantic, first for specific financial institutions and then for the banking system as a whole. The G7 says it will use all means at its disposal to support financial institutions that need help, but the pledge lacks credibility because the group failed to present a coordinated plan. The US Congress, in its second attempt, approved a bail-out plan, called the ‘Troubled Asset Relief Program’ (TARP), a US$700 billion package that in the end will earmark US$250 billion for injecting funds to recapitalise the banking industry –and partially nationalise it–, something many Republicans do not approve of (the rest of the money will go towards buying up toxic assets). The UK, in a rare display of leadership, has nationalised part of its banking system and will back up inter-bank loans. The countries of the euro zone will follow the British model, although each country has set aside a different amount of money to buy preferential shares in undercapitalised banks or help them with their short-term financing problems (the funds made available for tackling the crisis in Europe exceed €2.5 trillion).
Furthermore, central banks have opened up new channels for increasing liquidity. In the US, the Federal Reserve has started making direct loans to the private sector by buying up commercial paper that is not guaranteed, which means the government is skirting bank intermediaries. In Europe, the European Central Bank has reduced auctions to zero, which means it will make available to the banking system all the liquidity that is necessary. And the Bank of England has decided to guarantee short- and mid-term debt issued by banks. Indeed, banking authorities in advanced countries have made it abundantly clear they are willing to provide as much liquidity as necessary, both to guarantee deposits and rescue institutions in jeopardy and to restore confidence in the inter-bank market and get money ploughing into companies again, nationalising banks if it is necessary. They will do this even if it means taking risks that could lead to the undercapitalisation of their own central banks. Finally, in an unprecedented action, on 9 October, the world’s main central bankers (including the one from China) carried out a coordinated, half-a-percentage-point reduction of their interest rates. This was tantamount to saying only a global response can halt the crisis.
Despite the battery of measures taken by governments and central banks –which have come late but shown that officials have learnt from earlier crises– for now the lack of liquidity and confidence remain. Furthermore, the process of contagion has been made easier by the high degree of integration in the international financial system and by the feeling that there was no clear leadership or transatlantic coordination. One factor that has shaken confidence even more is that the IMF has raised its estimate of bank losses stemming from the US sub-prime mortgage crisis. It now sees them at US$1.4 trillion (US$455 billion more than in April). What this means is that, so far, only half of the losses have been made public. In other words, more banks might fail. Furthermore, in its economic outlook for October, the IMF noted that the credit crunch has now hit the real economy, triggering recession in several developed countries and making it likely that there will be major increases in unemployment in 2009. In fact, the IMF forecasts that the world economy will slow down considerably and grow at a rate of 3.9% in 2008 and 3.0% in 2009 (1.9% if measured at market exchange rates), its slowest pace since 2002. This lower growth will help moderate inflation to a great extent (especially prices of foodstuffs, raw materials and energy). But the current context of the crisis and the ‘liquidity trap’ that many advanced economies appear to find themselves in indicates that over the mid-term deflation is a greater danger than inflation.
What initially appeared to be a liquidity problem is also turning out to be a solvency problem that requires a hefty recapitalisation of the banking system in advanced countries. And by definition this requires a government bailout (the question, mainly in the US, is to what extent the government should nationalise the banking industry). Also essential is a coordinated fiscal stimulus package in which the emerging countries, mainly China, should play a role. Raising spending and recapitalising banks will not avert recession, but they will reduce its duration and its impact on employment, so long as it is done in a coordinated fashion (unilateral solutions run the risk of being ineffective and serving only to increase the public debt of wealthy countries). Finally, it is necessary to improve regulation of the financial sector, strengthening the supervision of the credit derivatives market and raising financial institutions’ capital requirements so as to avoid leveraging and risk levels as high as the current ones.
But above all we need political leadership because history has shown that, at times like these, technical solutions alone do not restore confidence to the markets. In a multi-polar world like ours, there is no single, dominant power capable of stepping in to fix things. This does not mean that there cannot be leadership, but for better or worse, government officials can aspire to no more than shared leadership. Therefore, national institutions in advanced and developing countries must coordinate with each other. It will also be necessary to strengthen forums for multilateral cooperation, and that means boosting their legitimacy.
This paper analyses the causes of the crisis, evaluates the economic and political responses that governments have made and explores its geopolitical impact.
How did we get to this Point?
The global financial crisis is the result of the financial liberalisation that took place in the past two decades –which was not accompanied by adequate new forms of regulation– and the excess of global liquidity, generated mainly by the US. Together, they fuelled a financial euphoria that distorted perceptions of risk, leading to excess leveraging. This leveraging, added to the over-indebtedness of households and businesses and scant regulation of the non-traditional banking sector, gave rise to bubbles both in real estate and other assets. The bursting of the real-estate bubble in the US triggered the crisis and financial globalisation caused it to spread quickly around the world.
But none of this would have been possible without the radical change that the financial sector underwent in recent years. Commercial banks, whose main business was to accept deposits and make loans that showed up on their balance sheets, are no longer the main agent in the international financial system. The new model, based on the securitisation of assets, involved the practice of investment banks (the new intermediaries between commercial banks and investors) creating products called ‘Structured Investment Vehicles’ or SIVs. These allowed commercial banks to sub-divide and regroup those assets, mainly mortgages, and resell them on the market as obligations whose ultimate backing was the payment of mortgages (thus the products were known as ‘Mortgage-Backed Securities’, or MBS), frequently off the books. This model was known as ‘originate-to-distribute’ and had as one of its main advocates the former Fed Chairman Alan Greenspan. It was intended to allow both the coverage of risks and their transfer from more conservative-minded investors to those with less aversion to risk and a greater appetite for higher returns. With this model, the idea was that there would be an optimal allocation of capital, which would multiply credit in a spectacular fashion and encourage long-term economic growth. The free movement of capital allowed these financial derivatives to be marketed around the world. Today, their value is €390 trillion, nearly seven times the world’s GDP and five times the volume in existence just six years ago. Financial markets are now fully globalised.
However, with the repeated restructuring of assets and multiple sales to transfer risk, there came a time when it was impossible to determine the real level of risk of each security. In this respect, even though they will not admit it, credit-rating agencies failed to do their job. Although most of the financial derivatives had payments of US mortgages as their underlying asset, the market that grew most in recent years (up to €62 trillion) was that of Credit Default Swaps, or CDSs, products designed to protect against the risk of non-payment of the new credit derivatives. This allowed new players, such as insurance companies, to enter the derivatives market. In fact, so long as there were no defaults, CDSs were a very good way to make money.
This model generated enormous profits for its participants and contributed (although it was not the only cause) to the high and unsustainable level of growth that the world economy posted from 2003 to 2007. Furthermore, an excess of savings in emerging economies (mainly in China and oil-exporting countries) and a lack of it in the US increased capital flows towards the US, fuelling its current account deficit and with it global macroeconomic imbalances (in 2007, the US absorbed nearly half of the world’s savings, while the UK, Spain and Australia accounted for another 20% and the reserves of the central banks of developing countries exceeded US$5 trillion –US$1.9 trillion in China alone–). But most of the incoming capital went to the real estate sector and not to more productive investments. So in the end, the model was all about Americans being able to pay their mortgages, which at the same time depended on housing prices continuing to go up. Such an increase was necessary so that mortgage-holders could refinance their debt against the assessed value of the property. And the existence of a sub-prime mortgage market, in which home loans were granted to people with questionable ability to pay them back, increased the risks (we must also acknowledge that thanks to this market many Americans who until then had no access to credit were able to buy a home. And some of them are in fact still able to pay their mortgages).
Even if it had been possible to foresee that real estate prices could not continue to rise indefinitely, the world economy’s strong growth, low inflation, low interest rates (negative in real terms) and macroeconomic stability (what is known as the period of ‘great moderation’) reduced people’s aversion to risk. This led to greater leveraging, encouraged financial innovation and off-the-books transactions and gave rise to what in the end has proved to be an irrational euphoria. What is more, so long as the boom continued, there did not seem to be any need to review the regulatory measures in place or change monetary policy. No one wanted to be responsible for curbing growth. In fact, the sharp drop in interest rates that the Fed enacted to deal with the recession of 2001 (and its having kept them at 1% for a year) was considered an excellent way to tackle the recession that struck the US after the 11 September terrorist attacks. However, today it is seen as a political mistake that contributed to inflating the prices of assets, mainly real estate, preventing the adjustment that the US economy needed to post sustainable growth over the long term (it can also be argued, as did Fed Chairman Ben Bernanke in his book Global Savings Glut, that China, with its high savings rate and managed, undervalued exchange rate, was the true cause of the US’s external imbalances). Finally, the idea that financial markets work efficiently and that its forces are rational enough to assign risk adequately (especially if they use sophisticated mathematical methods) rounded out the perception that this economic model was sustainable.
But in the end, there was excessive confidence in the market; Hyman Minsky was right. Financial markets are incapable of regulating themselves and tend towards imbalance, especially after long periods of growth and stability which encourage excess and ‘obsessions’. The international financial system is inherently unstable. For this reason, according to Minsky, it is impossible to avoid periodic financial crises, the consequences of which are more devastating the longer the period of growth that precedes them.
Even so, this crisis has not developed in linear fashion and the decisions taken over the last year and a half, both technical and political, have shaped (and will continue to shape) how it unfolds, for better or worse. So it is essential that the authorities do not repeat some of the mistakes that have been made and show enough leadership to avert a prolonged period of stagnation. This is something that the UK and the countries of the euro zone have started to do.
The bursting of the real estate bubble in the US and the first bankruptcies stemming from the sub-prime crisis go back to August 2007, when a rise in the number of people defaulting on their mortgage payments triggered major losses for financial institutions. Since then, the Fed has lowered interest rates and central banks around the world have injected liquidity into the banking system. That managed to contain the situation, but it did not head off a slowdown or restore confidence in the inter-bank market. In February and March 2008, rescue packages launched for the British commercial bank Northern Rock and the US investment bank Bear Stearns sounded the first alarms over the gravity of the crisis. It marked the first time (in this crisis) that an American investment bank was saved in order to prevent a systemic collapse and that the British authorities intervened to head off a run on a bank.
But it was with the collapse of Lehman Brothers in September 2008 that the crisis took on a new dimension (the rescue of two American mortgage-lending giants, Fannie Mae and Freddie Mac, also made clear that the caving-in of the American real estate market was something of enormous proportions. But both had a semi-state-owned status so it was to be expected that the US government would use public money to save them). Allowing Lehman Brothers to go under was perhaps the biggest mistake made so far. It will never be known if the US Treasury and the Fed refrained from saving it because their free-market vision (according to which the State should not help all financial institutions which run into trouble) prevented them from analysing objectively the consequences of their actions, or because they lacked sufficient and adequate information to foresee the real impact of what they were doing. In any case, as Lehman Brothers was such a key player at the global level, its disappearance not only meant enormous losses for its creditors, but also froze the US short-term money market –a US$2.5 trillion market that companies all over the world use to finance their operations over the short term–. The global panic triggered by the collapse of Lehman Brothers also completed the drying-up of the inter-bank market and gave rise to unprecedented market volatility. The fall of a systemic institution unleashed a systemic crisis.
Just days later, the rescue and nationalisation of American International Group (AIG), the largest US insurance company, not only marked a redefinition of the role of lender of last resort (insurance companies were not traditionally considered systemic, but AIG had entered the CDS market), but also added even more uncertainty as to which institutions deserved bail-outs and which ones did not. This forced the Bush Administration to launch its US$700 billion bank rescue plan, as the investment banking industry was vanishing (Bear Stearns and Lehman Brothers had collapsed, Merrill Lynch was acquired by Bank of America and Goldman Sachs and Morgan Stanley sought permission to transform into commercial banks, which are subject to stricter regulation and able to accept deposits). At the same time, the contagion reached Europe: banks failed in the UK, the Benelux countries and Germany. This prompted unilateral action that revealed a lack of coordination and weak governance on economic issues in Europe.
According to Paul Krugman, who won the Nobel prize for economics as the crisis raged, the financial system is more integrated and leveraged than at any time in history. So as prices of real estate assets and their derivatives fell, and bank losses were made public, financial institutions found themselves with too much debt and little capital. They were forced to sell some of their shares (their lack of liquidity prevented them from seeking new loans from other banks), which drove prices down further and triggered new losses, besides denying credit to the productive sector of the economy. This vicious circle of de-leveraging and undercapitalisation was both unstoppable and global. Only strong government intervention could halt it.
The Response to the Crisis: The Leadership Challenge
Although this crisis is the biggest since the Great Depression unleashed in 1929, the two are very different. Then, the world economy experienced deflation and unemployment rates exceeding 20% at a time when governments lacked the social safety nets they have now. Furthermore, there were no emerging economies (then they were just peripheral) that could contribute growth and financing. Therefore, even though unemployment will rise in the next few years and inflation will fall, the world economy can probably avert the kind of depression seen in the 1930s. And the main reason is that much has been learned from that crisis, mainly as regards technical aspects. The big question mark continues to be the issue of political leadership.
In fact, the authorities are not repeating the two gravest errors committed in the 1930s. This is because they have embraced the two best-known explanations of the Great Depression, that of John Maynard Keynes in his General Theory, published in 1936, and that of Milton Friedman and Anna Schwartz in A Monetary History of the United States, 1867-1960, which came out in 1963. Keynes blamed the Great Depression on a lack of effective demand, which could be overcome only with an expansive fiscal policy. For Friedman and Schwartz, the crash of 1929 stemmed from bad monetary policy by the Fed, which they say did not inject enough liquidity into the economy in a timely fashion. Fortunately, as we have seen earlier, central banks are in fact injecting liquidity and governments are increasing spending. In other words, the advice of Keynes and Friedman and Schwartz has been heeded.
But it is the third explanation of the Great Depression, that of the historian Charles Kindleberger in The World in Depression, 1929-1939 (1973), from which the international community has the most to learn. The way Kindleberger saw it, the crash of the stock market mushroomed into a prolonged recession due to a lack of leadership by a dominant world power that had the means to maintain an open, free-market economic order, including providing a mechanism to supply the system with liquidity in times of crisis. During the Great Depression, the UK was no longer able to act as a dominant power because its empire was declining. And the US, the rising power, did not want to foot the bill for acting as a leader, for domestic political reasons related to the Monroe Doctrine, which called for US isolationism. This situation prompted a power vacuum which led industrialised countries to follow protectionist practices and engage in competitive devaluations that only spread and generalised the crisis until World War II broke out.
Although it is particularly difficult to forge and consolidate strong political leadership at a time of crisis, the world economy has no other recourse. In the face of panic, technical solutions are not enough to restore market confidence. The problem is that the world is multi-polar and there is no dominant power. Furthermore, the crisis is having an asymmetrical impact and speeding up a re-shaping of the balance of world power in favour of the emerging powers. Many of them see in the crisis both risks and a prime opportunity to change the rules of the global market to their benefit. For this reason, leadership can only be shared and must be based on international cooperation.
Fortunately, measures which at first were ad hoc bail-outs of specific financial institutions and uncoordinated unilateral actions have gradually become broader plans with some degree of coordination, mainly among the countries of the euro zone. Furthermore, Britain’s Prime Minister. Gordon Brown, the only G-7 leader with a significant knowledge of economics, has emerged as a political and intellectual leader, both in terms of government rescue plans and reforms of the international monetary system.
So pragmatism has prevailed over ideology, negotiations have worked and in the end coherent plans were approved in almost all of the industrialised countries. What these plans share is the acknowledgment of both the need to recapitalise the banking system by partially nationalising it and to ensure that banks start lending to each other once again. In this regard, the approval of the US rescue plan is particularly important –it was accepted by Congress only after major amendments were introduced– as are clarifications made later by the Treasury Department, which in the end will agree to nationalise part of the banking system temporarily (the technical details of the auction system under which the government will acquire toxic assets from banks have not yet been spelled out). All of this will have a major impact on government budgets. Depending on how the markets react, to some extent or another they will see increases in their deficits and debt as a percentage of GDP. But in any case, for now the government funds disbursed to deal with the crisis are estimated at around 5% of the combined GDP of the US and the EU. As a share of GDP this figure is much lower than in earlier crises.
All in all, as of mid-October, the leadership emerging from Europe and concerted government action had restored some degree of confidence. But capital continued to flee towards safer assets, the inter-bank market still had problems and the structural causes of the crisis had not been resolved. Furthermore, the impact of the financial collapse on the real economy will be significant in 2009, so there will have to be continued, shared leadership. The challenge is to include emerging powers in the imminent reform of the system of global economic governance. In fact, besides playing an important role in modifying systems of financial regulation and supervision, the emerging powers will be the main source of demand if the advanced economies slip into recession. But the decision to increase spending is a political one, and in China’s case it is linked to changing its exchange rate.
Conclusions: The global financial crisis, caused by an excess of liquidity and inadequate regulation of a highly integrated International financial system, has pushed the world’s economy to the verge of recession. Furthermore, the unilateral actions that various governments undertook initially showed how difficult it was for them to coordinate with each other in an economic world that is multi-polar and lacks clear leadership. Fortunately, rescue packages have been approved and, with the UK taking the lead, a consensus appears to have emerged on the need to recapitalise the banking system and shore up deposits and inter-bank loans. This will not avert recession, but might keep it from being deep and lasting. In that respect, lessons learned from previous crises have allowed the authorities to react with a degree of speed. Even so, major challenges remain in terms of establishing shared leadership with an eye to devising better rules for financial globalisation.
The crisis will have major geopolitical consequences, which are as yet difficult to predict. First of all, the crisis will mark a turning point in the process of economic globalisation and put an end to the period of liberalisation that began in the 1980s under Ronald Reagan and Margaret Thatcher. The crisis does not signal the failure of capitalism. But the institution of the State will recover legitimacy and power with regard to markets, and the liberal, Anglo-Saxon model will lose appeal and influence, especially to the benefit of European-style models which feature greater regulation and government intervention. Secondly, the crisis will speed up the relative decline of the US and the rise of emerging powers in the world economy (which, with their sovereign funds, will become much more attractive in wealthy nations). This, in turn, might accelerate reforms of institutions of global governance and make the changes more pronounced. In this regard it would be important to incorporate the emerging powers into discussions on reforms of international economic organisations so they will be active parties in the process and consider it legitimate. To this end the countries of the OECD should acknowledge they need to consult with emerging powers in designing new global rules. But at the same time, as it is foreseeable that the crisis will cause prices of energy and raw materials to fall, some of the emerging powers that are most at odds with the West, such as Russia, Venezuela or Iran, might lose influence.
Finally, the crisis serves as an opportunity for the EU in general and for the euro in particular as a global reserve currency. First, because it can be expected that the new international financial architecture that emerges after the crisis will have a greater similarity to that of continental Europe than to the Anglo-Saxon model. This will provide an opportunity for the Union to take on greater global leadership, if it is capable of speaking with one voice on the world stage. Secondly, because the crisis gives the euro a chance to gain ground against the US dollar as an international reserve currency, a change which needs the political-institutional structure of the euro zone to be sufficiently solid. All in all, the crisis marks an opportunity for the EU if it is capable of using the current, difficult situation to strengthen itself and improve its internal economic governance.
Analyst at the Elcano Royal Institute and Professor at Madrid’s Universidad Autónoma
Kindleberger also sees four other functions for a dominant power: providing a market that absorbs goods, generating a constant flow of capital, managing a system of relatively stable exchange rates and establishing a structure of incentives for countries to coordinate their monetary policies.