Thinking Beyond the Crisis

ETHOS Issue 06, July 2009

In what way is the current global crisis similar to ones in the past, such as the Asian financial crisis of the nineties?

As in the Asian case, this financial crisis was triggered by what you might call “overinvestment” or “irrational exuberance”, the effects of which then become orders of magnitude greater than the original problem.

The quantity of bad investments made in Thailand in 1993 to 1996 was quite small relative to the collapse in Asian financial values in 1997 and 1998. Similarly, the amount of bad subprime mortgage loans made in the US is at the most US$1 trillion, and yet we have a US$20- to US$30-trillion collapse in global financial asset values as a result.

In 1997 to 1998, you had a slight collapse of the financial market’s risk tolerance and a flight to the safety of the US dollar. This meant that domestic central banks could do little to calm the markets or diminish the amount of risk held by the private sector. It took the International Monetary Fund (IMF) six months before it recognised that it was faced with a crisis which didn’t originate in bad government policies, but instead, was due to the collapse of the private sector’s risk tolerance. But once that was acknowledged, and the US Treasury and Wall Street banks made their move, things turned around remarkably quickly.

In fact, this was the sort of nightmare crisis Nouriel Roubini predicted years ago—that the US housing sector would go bust and cause a panic flight from dollardenominated assets, leading to a collapse in the financial system. If the People’s Bank of China saw its dollar-denominated portfolio shrinking and decided to dump its assets, the US Federal Reserve would be powerless to respond. We’ve heard about organisations being too big to fail, but the US in a full financial crisis would be too big to rescue.

Fortunately, however, what we seem to have at the moment is a much smaller crisis: there is still a rush toward dollardenominated assets which are still seen as safe in the global economy, and that is much easier to handle. The People’s Bank of China knows that it would be very difficult to get out of dollardenominated assets fully; its best course is to postpone its paper losses into the future where they will no longer matter as much.

Was there anything policymakers and regulators could have done to prevent the crisis?

After the fact, it always seems clear that you should regulate more. But then, you might also have halted financial innovations which were nevertheless useful.

Economists believe that the world’s safe real interest ought to be around 2% per year in real terms—reflecting stable growth rates. And the global equity premium—the expected return you get by investing in riskier stock and corporate equities—is about 2.2%, if you do the sums.

Yet when you look at the real world, the safe interest rate is close to 0% per year and the risky rate is around 8%. We seem to be doing a really poor job of mobilising the collective risk-bearing capacity of the global economy.

In other words, we should be able to do a much better job of diversifying everyone’s financial portfolio, so that people would then be much more willing to hold risky assets and much more willing to invest. We ought to have more sophisticated financial systems and portfolio diversification, more confidence in safety and much higher investment.

While financial innovation that leads to profoundly foolish portfolios like those seen in the current crisis should be curbed, the market would not be able to do its job of spreading more of the collective risk-bearing capacity of the world—and a lot of it isn’t mobilised—if financial innovations were restrained.

Look at the Industrial Revolution: it introduced factories, canals, railroads and so on, all of which required the mobilisation of the savings of huge numbers of individuals to fuel different enterprises. There was also diversification, which assured individual savers that if any enterprise they didn’t control or didn’t understand went bankrupt, it wouldn’t carry all of their wealth down with it.

Can the US continue to increase spending in order to stimulate the economy?

Fiscal-driven recovery in Japan failed in the 1990s and early 2000s: it led to disastrous long-term government debt-to-GDP ratio. But it has to do with limits to Japan’s debt-bearing capacity—it is the ultimate ageing society; immigration is not going to be high. The debt-bearing capacity of the Japanese economy isn’t growing, so they were rightly concerned about unsustainable debt accumulation patterns.

In contrast, the US is much more optimistic about its long-run productivity growth rate. We believe we invent a lot of new technologies and spread them all around the population, as opposed to Japan where new technologies appear to be confined to the exportoriented manufacturing sector and to consumption in the Ginza. So we think our economy’s going to grow faster than the Japanese think their economy will grow for the long run.

Plus, the US government is relatively small for an advanced industrial country. Our debt is relatively low. The projections (once you assume something will be done about government healthcare spending) are quite good that we will have an economy whose productivity is growing at 2% per year, with a population that is growing from immigration by 0.5% to 1.5% per year.

How might the crisis change the global balance of power?

Had a steep fall in the dollar accompanied a crisis of this magnitude, as it could have, import substitution from manufacturing within the US would have left Singapore and the rest of Asia stranded. But the dollar has not declined much against Asian currencies. This is in spite of global imbalances, long-term merchandise trade deficits, and the fact that international accounts have to balance in the long run. The US is the importer of last resort, which means that Asia is going to be one of the boats lifted fastest by the rising tide. China and Asia are going to be coupled to the North Atlantic core for a long time to come, unless they can magically find some way other than export-oriented development to grow.

The US is going to emerge from the crisis as the world’s only hyper–power still. The smart thing that a hyperpower does is, it uses its time at the peak to create a world that is peaceful and congenial, for it to exist in after it is no longer the global hyper-power.

This is one way to view the history of the second half of the nineteenth century, where around 1840, the British government realised that there was a rising superpower across the ocean, and that its best policy in the long run was to ally with and shape the development of the US in such a way, that when not Britain but the US became the global superpower, it would still be a comfortable world for Britain to be in. Thus, British policy towards the US was very different from say its aggressive behaviour in Guangzhou and China. So when the 20th century rolled around, the US sent armies to Britain’s aid in Europe twice.

Once you understand that that is the most important fact about the global diplomatic history of the late nineteenth and early twentieth centuries, the implications for the US today are, I think, obvious. The odds are overwhelming that India or China will become the most important power to come; the capital where everyone sends their senior Ambassadors to in 2100s isn’t going to be Washington. It’s going to be either Beijing or New Delhi. So the question is how the US should be acting now to shape this world 100 years from now.