A new
check-and-balance order
(c) 2008
Singapore Press Holdings Limited
WHEN the dust eventually
settles, the origins of the 2008 financial crisis will probably be linked to
two key developments in the global economy since 2003.
The first was its rapid
growth. The world economy grew by an average of 5 per cent per annum from 2003
to 2007. Growth was supported by relatively low interest rates and easy access
to credit. This was especially true in the United States, where sophisticated
financial instruments made it easy to use illiquid housing wealth to support
consumption.
Economic growth was even
higher in emerging markets. Rising global demand for resources, together with
ill-advised petrol subsidies and government sponsored food-to-biofuel programmes in industrialised nations, fanned a
commodity price boom. Food prices nearly doubled between 2000 and mid-2008, and
crude oil prices reached a record high of US$146 in June this year. The
inevitable outcome was higher inflation.
The second development was
the emergence of significant macroeconomic imbalances between the US, on the one hand, and Asia
and oil exporting nations, on the other. The US current account deficit averaged
more than 5 per cent of its GDP in the 2001-2008 period,
against only 3.5 per cent during the 1980s.
Excess savings in emerging
markets and an insatiable demand for its assets enabled the US to finance
its current account deficit without significant upward pressure on interest
rates.
The potential for adverse
effects of these two developments coming together - high growth and global
macroeconomic imbalances- became apparent in early 2006. Cheap credit
contributed to US housing prices increasing by 125 per cent from 1997 to 2005.
Low initial interest rates, together with the irrational expectation of housing
prices continuing to rise, encouraged sub-prime borrowers to obtain adjustable
rate mortgages that would be difficult to service once interest rates rose.
And rise they did. For the
Federal Reserve gradually raised its federal funds rate from a low of 1 per
cent in May 2004 to 5.25 per cent in June 2006. It did so, not so much to prick
the housing bubble, as to stem inflationary pressures. Rates remained high till
August last year, when the sub-prime mortgage crisis first surfaced. The US housing
bubble would have burst anyway, but the Fed's actions merely hastened the
inevitable.
What was so special about
this housing boom and bust cycle? Cycles in housing markets are not uncommon
events. But what made the recent US housing cycle stand out, however, was the
systematic failure of market participants to appreciate the financial risks
they faced should house prices fall.
The securitisation
of mortgages in the US
had enabled more investors to purchase shares in shaky housing loans. Credit
default swaps (CDSs) - which are essentially
insurance derivatives - transferred the risk of default from holders of
mortgage-backed securities (MBSs) to CDS providers.
But the CDS market itself, being unregulated and undercapitalised, added to the systemic risk.
Investment banks, aided by
a 2004 Securities and Exchange Commission ruling that allowed them to almost
double their debt-capital ratio to 30:1, also helped multiply the volume of MBS
holdings and broaden their sales worldwide. Who would have imagined that securitised products - such as Lehman's Minibonds
and Merrill Lynch's Jubilee Notes - would end up
being sold to retirees in Singapore?
Securitisation of sound mortgages clearly has
desirable effects because they spread the underlying risks across many
investors. This crisis was caused by the systemic failure of market participants
to appreciate the size of the default risk. Moral hazard, imperfect corporate
governance and regulatory failures were largely to blame.
By March this year, an
estimated 8.8 million homeowners in the US had zero or negative equity in
their homes. The growing risk of MBS default sent shudders through the
financial system. Even financial institutions without MBS holdings became wary,
because they had made loans to institutions with MBS holdings. When several
major financial institutions failed last month, perceptions of risk escalated
and caused credit markets - the blood line of the global economy - to seize.
Having a financial crisis
with failing banks is bad enough; having one along with rapidly eroding
borrower and lender confidence and a credit squeeze is a recipe for a global
recession.
Why? Most countries are
linked by an elaborate web of international capital flows and trade linkages to
the US,
the world's biggest economy and its most important financial centre. Through
the financial linkages, a major financial crisis in the US quickly
becomes a global crisis. And because of trade linkages, a global economic
slowdown reduces world trade, further constricting growth in a vicious downward
cycle.
Indeed, the Great
Depression of the 1930s, which started in the US, lasted several years after the
initial stock market crash, largely because of competitive protectionist or
beggar-thy-neighbour trade policies. But that period
also left policy makers with many hard-earned lessons on what needs to be done to
contain a major financial crisis.
First, central banks must
expand rather than contract the money supply. Second, strong national
leadership is required to prevent bank runs and to restore confidence in the
banking system. And third, strong world leadership is required to dissuade
countries from pursuing unilateral 'solutions' that have an adverse impact on
others.
All three actions were
lacking in the 1930s. Fortunately, they were taken in the current financial
crisis. In response to the credit market freeze, central banks pumped liquidity
into the system. When this step failed to restore confidence, governments
announced plans to use public money to remove toxic assets from financial
balance sheets and even to recapitalise banks.
At the international level,
there was coordination among the major central banks to slash interest rates,
rescue banks that needed capital as well as to guarantee interbank loans,
thereby removing counterparty risk. Notwithstanding stock market meltdowns, all
these actions appear to have improved confidence in the financial system.
That said, damage has already been inflicted on the real economy by
the global stock market meltdown. There are already signs of declining growth
and rising unemployment in many countries, and commodity prices are easing. The
risk of negative feedback between the real and the financial sectors remains
high, though manageable provided confidence in the financial system is
restored.
More can be done to minimise the damage to the real economy. It is time for
national governments to unleash countercyclical fiscal measures. In this
respect, Asian economies have an advantage over the US because of their high savings
rates and large accumulated surpluses. Increased domestic spending in Asia would also narrow existing current account
imbalances in the global economy.
Last but not least,
attention must be directed to rework the regulatory system. The prime objective
of the financial sector is to serve the real economy by channelling
capital and liquidity to its most productive use. Financial markets need to be
better regulated to avoid the build-up of excesses that can damage the real
economy. But over-zealous regulation must also be avoided so as not to hamper
the efficient workings of the financial system.
It is indeed a challenge
to design a regulatory framework that balances these two competing needs.
Professor Lim is with the NUS
Business School. Professor Ouliaris holds a joint appointment with both the
NUS Business School as well as its Department of Economics. The views
expressed here are personal. This is the concluding article in the ST-NUS Business School
series on the financial crisis.