Column : Ten year itch

Written by Dhiraj Nayyar | Updated: Dec 31 2008, 06:01am hrs
2008 will always be remembered as the year of the most far reaching financial crisis since the Great Depression. It was a crisis that actually began in 2007 with the subprime unraveling in the US but took its full toll with a lag. In the midst of comparisons with the Great Depression, what are often missed are important parallels between this crisis and the East Asian crisis of 1997-98 which unraveled ten years ago.Interestingly, both the East Asian crisis and the current financial crisis had their roots in the private sector. In that sense they are similar to the crisis that began in 1929, and very different from the public (government) debt crises which hit mostly developing countries (in Latin America and Africa).

The global financial crisis and the East Asian crisis were the result of a confluence of different policy and non-policy circumstancesand not a single identifiable cause like macroeconomic mismanagement. Thats what makes understanding these crises harder and makes the search for solutions tougher.

In brief these crises are explained by a Molotov cocktail of the following: excessive leverage, unprecedented international capital flows, asset bubbles, suspect government guarantees (implicit or explicit), dodgy borrowers, ambitious central banks, and panic.

Leverage is one of the fundamental features of a capitalist system so one can hardly say thats it bad per se. However, if financial sector firms (including banks) incur excessive leverage with inadequate capitalisation, they raise their risk. Of course, such a strategy yields very high returns in good times (as it did in both the West now and East Asia in the 1990s) but in the event of a downturn and credit squeeze, financial sector failures and a systemic crisis knocks the door.

Combine leverage with international capital flows and things get more risky. Especially if the foreign flows are short term flows which are being leveraged for long term use. This issue of maturity mismatch goes beyond just international capital flows and there are no easy answers on how to solve this problem without decapitating a well functioning capitalist system.

There are, of course, different uses for leveraged capital and foreign capital. It can be put to productive use in the real economy or it can be used to speculate and create asset price bubblesreal estate boom and bust was a culprit in both 1997-98 and 2007-08. Most often, asset price inflation of the kind seen in real estate or stock markets isnt reflected in traditional inflation indices which usually dissuades Central Bankers from taking action to control an irrational boomafter all no one wants to bust a party.

This is where the role of government and regulators comes in. They too become a part of the boom and bust game with the private sector. Alan Greenspan fuelled asset price inflation with a low interest rate regime. The US government, through the government sponsored Freddie Mac and Fannie Mae also played up the housing boom. The government, basically, played the subprime game with willing financial institutions by lending to what were essentially dodgy borrowers who were unlikely to be able to repay a loan if house prices fellwhich they were bound to.

In this, there is a parallel with East Asia. The dodgy borrowers in this case were the infamous crony capitalists whom the government directed credit to. A lot of them were never gong to be able to repay if the boom collapsed. East Asia had its own version of government guarantees and central bank action. The most prominent was the fixed exchange rate regime, which allowed borrowers to eliminate currency risk while borrowing abroad. Of course, governments forgot the cardinal impossible trinity rule: you cant have open international capital flows and fixed exchange rates together unless you sacrifice an independent monetary policy. In trying to juggle all three, policy makers were asking for a crisis.

In both the crises, the final stage is when panic sets in and nervous investors begin to withdraw their money from stock markets and other assets, ordinary consumers begin to withdraw their money from banks prompting bank runs and such like. At this stage, any preventive measure is ruled out and the curative policies have to kick in.

In East Asia, the IMF rescue packages had three main features: raise interest rates, cut government spending, let insolvent banks and financial institutions fail. Together they ended up worsening the crisis, by completely stalling economies and causing massive failure of firms in both the real and financial sector.

In the West in 2008, governments lowered interest rates and increased government spending, which is, in fact, the right policy response. The US, however, dithered on the third major decision (on rescue) and finally decided to let Lehman sink. Like in East Asia, the failure of a major financial institution made the crisis take a turn for the worse. The clear lessons for the next crisis are: follow Keynesian macroeconomics and do not let any major financial institutions fail.

But surely, prevention is better than cure. The knee-jerk reaction would be to suggest curbing international capital flows, but that may be mistaking wood for the trees and throwing the baby out with the bath water. For an economy to grow fast, it needs all the capital it can get. Instead of shutting down the system the focus should be on how to make it work better, to ensure that capital is used for the best productive purpose. There must be tougher rules on capitalisation and leverage for financial institutions. Independent regulation must ensure that dodgy borrowers are kept at bay. Governments and Central Banks must avoid the fatal temptation of fuelling bubbles through policybetter to prick a small bubble than waiting for large one to explode.

dhiraj.nayyar@expressindia.com