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| Deepak Lal: The global financial crisis |
| Deepak Lal / New Delhi Nov 25, 2008, 00:14 IST |
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Unlike the Third World debt crisis of the 1980s, bailouts today are the norm not the exception.
The 1980s Third World debt crisis and the current global financial crisis have great similarities but different outcomes. Why?
First, both the crises arose because there was a surplus of savings in a number of countries— the oil producers in the 1970s, the Asian economies and commodity exporters today— which was recycled through the international banking system, to maintain world aggregate demand. Second, highly liquid banks imprudently funneled cheap credit to un-creditworthy borrowers: the fiscally challenged and inflation prone countries of Latin America and Africa in the 1970s, the ninja (those with no income, no jobs, no assets) sub prime mortgagees of the current crisis. Third, there was a rise in commodity prices and a worsening of the terms of trade of the OECD, posing the stagflation dilemma for their central banks, having aided and abetted the earlier asset boom. Fourth, the imprudent banks sought bailouts from taxpayers, claiming their demise would fatally damage the world's financial system.
But, the outcomes have been different. The 1980s crisis was finally solved after a prolonged cat and mouse game when the banks accepted substantial write downs of their Third World debt, sacked their imprudent mangers and shareholders suffered large losses. But no systemic threat to the world's financial system (or the global economy) emerged. By contrast, today the Western financial system seems to be dissolving before our eyes, and with the US Fed's ever expanding balance sheet, bailouts are no longer the exception, but the norm. Many now foretell a deep and perhaps prolonged recession, with deflation, rising unemployment, and Keynes' famed liquidity trap about to engulf the world's major economies.
What explains this difference in outcomes? It cannot be purported 'global imbalances', which were the origins of both crises. It is the differences in financial structures within which these temporally separated but largely similar crises occurred. In the 1970s the recycling of the global surpluses was undertaken by the offshore branches of Western money centre banks, which were neither supervised nor had access to the lender of last resort facilities of their parent country's central bank. Hence, when their Third World Euro dollar loans went into 'default', there was no direct threat to the Western banking system.
The present crisis emerged in a radically different financial structure: the rise of universal banks from the UK's Big Bang financial liberalisation in the 1980s, and the Clinton era abolition of the Glass-Steagall Act, which had kept a firewall between the commercial and investment banking parts of the financial system since the 1930s. The former had implicit deposit insurance and access to the central banks' lender of last resort facilities. The latter did not. As explained in detail in my columns on the credit crunch (Dec 1997, Jan 2008), with deposit insurance, the public utility part of the financial system which constitutes the payments system must be kept separate from the gambling investment banking part, which is an essential part of a dynamic economy. For these gambles impart the dynamic efficiency through the cleansing processes of creative destruction. But if these gambles are protected against losses by taxpayers, as the payment system activities have to be because of deposit insurance, the gamblers will always win: keeping their gains when their gambles are correct and passing their losses onto taxpayers when their gambles turn sour.
Given this 'moral hazard', many classical liberals have favoured free banking. Banks combining the payment and investment functions and issuing their own notes would be monitored by their depositors, who would stand to lose if their banks undertook imprudent lending. But with the near universality of deposits as a means of payment, there is little likelihood of this monitoring function being effectively exercised. Whilst Demos precludes any government being able to resist pressures to bail out imprudent banks to protect their depositors. This makes deposit insurance inevitable.
The recent emergence of universal banking was followed by a number of public policy mistakes on the path to the current crisis. The first was the bail-out of LTCM in 1998. Its failure posed no obvious systemic threat. Its public salvation changed expectations of market participants that non bank financial institutions could also hope for bail-outs. Next the infamous Greenspan 'put' which put a floor to the unwinding of the dotcom stock market bubble, promoted excessive risk-taking. Third, the promotion of 'affordable' housing for the poor by the Clinton administration through the unreformed and failed Freddie mortgage twins, led to the development of subprime mortgages. Fourth, the Basle II capital adequacy requirements led banks to put their risky assets into off-balance sheet vehicles— the SIVs— leading to the opacity currently being bemoaned. Fifth, when the housing bubble burst, and the credit crunch began with the gambles taken during it turning sour, the Fed chose to bail out Bear Sterns, sending the signal that the Fed's balance sheet was open to non-deposit taking 'banks' as signaled by the earlier LTCM bailout. Sixth, and most heinously given all that had gone before, the US authorities then chose not to bail out Lehman's— like a fallen woman suddenly finding virtue. This dashing of the bailout expectations that the authorities had endorsed only in the spring, led to the intensification of the credit crunch. Seventh, as the authorities finally seemed to tackle the toxic subprime infected financial assets which caused the crisis through TARP, it calmed the markets. Now, with TARP to be used only to recapitalise banks, markets have gone into free fall. The essential step, of forcing banks to come clean on their balance sheets, and then removing the toxic assets they reveal into a newly created institutional 'cordon sanitaire', has not been taken. Worse, instead of recreating a firewall between the payment part and the gambling part of the banking system, even the pure investment banks, like Goldman Sachs, are being pushed into becoming universal banks with access to the Fed's balance sheet and thence taxpayer's money.
Given these public shortcomings, the near universal calls for greater regulation and state intervention is astounding. Public agents, not private ones— who reacted rationally to the implicit or explicit 'rules of the game' promoted— are to blame for the crisis. It would be foolish to blame the puppets for the failings of the puppeteer.
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