The world saw a crisis coming. Just not this one. The widening US external deficit and the growing surpluses in China, Japan, and the Middle East reflected major global imbalances that would eventually wreck havoc on the world. Analysts such as Martin Wolf and Nouriel Roubini predicted that the world would grow tired of funding the US deficit, causing the US dollar to plunge, long-term rates on treasuries to skyrocket, and the US to go into a tailspin, bringing down the world.
As things would have it, a crisis did finally occur, but neither the dollar nor US treasuries tanked, yet things got really nasty anyway. The initial response to the crisis saw an unprecedented injection of liquidity by the Fed that was designed to normalise credit markets but which others feared would cause inflation. Neither took place. Instead, things got worse.
What caused the subprime crisis to become a global crisis?
So, what seems to be the problem? The best interpretation is that the 2008 aggravation of the crisis was triggered by major equity losses in key financial intermediaries associated with a moderate correction in asset prices. These losses caused a rise in counter-party risk triggering a major disintermediation process as investors fled towards safer assets. In the process, financial links were broken and spending collapsed precipitously and globally.
During the previous boom years, the financial industry had become more concentrated (in terms of the number of players), more leveraged, and more globally diversified (in terms of assets), so that problems in the main players would be systemically large and have global impact.
When the fan belt of the car breaks, the engine overheats, seizes, and stops. A new fan belt is no longer enough for a solution. If the Wall Street is the belt, Main Street is the engine. Since the engine has seized, even fully capitalised banks will be weary to lend into a downturn, and firms and households would be unwise to borrow, even if credit was available. Credit crunches often lead to recessions, but the eventual recovery has never been lead by credit, as Calvo, Izquierdo and Talvi (2006) have shown for emerging markets.
So, what seems to be the game plan for dealing with the crisis? The investors’ flight to quality means that those issuing the safe assets are left as the sole remaining super-borrowers. These super-borrowers – the US and Japan, mainly – are the only ones left to re-establish financial links and rewire the system. Up to now, this has had two legs:
- Propping up aggregate demand directly through fiscal reflation, and
- Recapitalising the banking system.
In the US, the recapitalisation and reflation is planned mainly for the domestic economy. But the problem and the borrowed resources are global, not American. Consequently, the solution, to be effective, should also have a global character. Restarting the global economy through a widening of the US external deficit is not the best way forward as it tries to solve one problem by aggravating another.
A more sustainable complementary alternative is to use the super-borrower capacity to reflate the global economy and to reestablish financial links globally. This can be done in several ways.
- First, multilateral development banks should be recapitalised –by issuing guarantees in the form of callable capital – allowing them to raise funds in global capital markets to on-lend to the developing world.
This would allow developing countries to compensate for the lost access to private markets. Loans should be disbursed quickly and conditional only on an ex ante assessment of the soundness of their macro stance. They should be made in an amount sufficient to prevent the inefficient, pro-cyclical contractionary fiscal adjustment that is being caused by the lack of access to finance. Part of the capital raised could be invested by institutions such as the International Finance Corporation in a diversified portfolio of private emerging market assets in order to provide for this asset class what Bernanke is doing to the US variety.
With this strategy, a global fiscal reflation can take place by preventing inefficient cutbacks in the countries shut out of finance because of the global crisis instead of the relying solely on expansion in the structurally weak US fiscal position. The programme of about $700 billion would be more or less of the right size and a now familiar ring to it.
- Second, the IMF should also be recapitalised, possibly through an issuance of SDRs, so as to make sure that the organisation has more than enough funds to help reconnect countries to finance.
But the issue is not to just funding individual countries in trouble. The goal should be to convince countries that are currently hoarding large amounts of international reserves as self-insurance against future crisis that they need not sit on so much liquidity because they will have ample access to contingent funds if needed. This will allow countries to adopt policies that are more supportive of a global reflation effort.
To make sure that this facility is used from the start, emerging market members of the G20 and others with high credit ratings should simultaneously ask for loans in order to dispel the stigma that is usually attached to borrowing from the IMF.
A lot of effort has been put into discussing issues such as global imbalances and the voting rights at the international financial institutions, but too little has been dedicated to think what these institutions should do in the context of the current global crisis. If capital markets are impaired and will take a long time to repair, the global and regional international institutions need to step up to a much bigger plate than is currently being envisioned. If this strategy is successful, it will lead to a more balanced and sustainable global recovery.
Guillermo A. Calvo, Alejandro Izquierdo, Ernesto Talvi (2006). “Phoenix Miracles in Emerging Markets: Recovering without Credit from Systemic Financial Crises,” IADB, Working Paper #570.