Road to Recovery: The Economic World is in Our Hands
Christopher Angelos reflects on the lessons of the ‘global financial crisis’.
“We face the greatest challenge to the world economy in modern times … [a] global crisis requires a global solution.”
– Group of 20, London Summit, ‘The Global Plan for Recovery and Reform’ (2 April 2009)
Do you remember a time when mortgage defaults were the overriding concern in markets worldwide? You may be forgiven for thinking that this was not so long ago. Since early 2007, the world has witnessed a wave of defaults evolve into a systemic crisis for U.S. financial markets and, more recently, for the global economy. Developments have occurred at a “frightening velocity”, as described by UN Secretary-General Ban Ki-Moon. Attention has rapidly shifted from financial regulators to governments and how they formulate plans to stimulate economies.
Though most undergraduate students consider ‘financial crisis’ a novel concept, such crises have occurred in one form or another around the world in recent decades. Most notable among these was the Asian financial crisis in 1997, where failed institutions and broader economic downturns were felt deeply in Thailand, Indonesia, South Korea, and many other countries.
In a Working Paper for the U.S. National Bureau of Economic Research, Professor John Taylor of Stanford University explains that the term ‘crisis’ is most commonly associated with excess, which leads to a market ‘boom’ and an inevitable ‘bust’. This is consistent with the broader theory that almost all financial crises begin with the development of a market ‘bubble’ or upward pressure in a market causing unnatural growth. As for this ‘global financial crisis’, its truly ‘global’ nature is its true differentiator from earlier crises, but like its predecessors, its origins can ultimately be traced to some form of excess.
Locating the excess
At its core, this crisis is a story of the rise and fall of risky debt in the U.S. Underlying this rise and fall was a boom and bust of a real estate price bubble. The most accepted explanation for this bubble is the excess in ‘easy money’ policies of the U.S. Federal Reserve. These policies cut the short-term federal funds rate from 6.5 per cent in January 2001 to 1 per cent by 2003, the lowest in 45 years since the bust of the dot-com bubble in March 2000. This encouraged a substantial flow of international investment that had turned to U.S. high-technology stocks leading up to their bust, to gravitate instead towards real estate in many countries.
“The term ‘crisis’ is most commonly associated with excess, which leads to a market ‘boom’ and an inevitable ‘bust’.”
In the U.S., mortgage products for borrowers with weak credit grew in popularity in the face of rising prices. ‘Subprime’ mortgages subsequently became popularised in the media as a major part of the American real estate landscape. Subprime mortgages are defined with reference to a borrower’s unfavourable credit history and carry the highest default risk. Exposure to subprime risk was spread far across the financial system by banks through the Collateralised Debt Obligation (CDO). This instrument packaged subprime mortgages alongside other loans into bonds and was sold to financial institutions such as large funds and other banks. These investors sought to take the risk inherent in the mortgages underlying these CDOs in order to potentially gain a higher return on investment than more traditional bonds. Investors relied on the word of credit rating agencies that deemed CDOs to be much less of a risk than what was truly the case. This failure on the part of rating agencies can partly be attributed to their inability to perform sufficient analysis due to the complexity of these CDOs.
However, this profitable system of risky debt fell down just as quickly as it had been built up. The downturn in U.S. housing prices in late 2006 led to an increase in defaults, especially at the subprime level. Consequently, as rating agencies continually downgraded ratings on CDOs, banks were forced to rethink the plummeting value of the instruments they had issued. Uncertain of the value of their assets, banks became increasingly unsure of their lending capacity and of the credit risk posed by borrowers. This situation came to a head in August and October 2007 when banks froze critical lines of lending between themselves and other companies.
The spread of this uncertainty was by far the most devastating aspect of the crisis. Credit uncertainties have quickly spread through other large developing markets due to the spread of initial subprime exposure. However, Asia and other emerging economies have been somewhat sheltered from the worst effects of the crisis. Without reasonably priced credit, businesses have less money to put to work. In turn, this has a negative impact on job security and consumer spending, as consumers tend to restrain their spending, fearing job loss. In a wide variety of industries, the position of companies worsened as investors worldwide moved money from equities and other risky assets to safer investments.
A time for serious reflection
The global impact of this crisis is unprecedented in modern history. The most affected nations have started to discuss the range of actions to be taken in response. The crisis has also prompted leaders to reflect upon the sustainability of the current economic system. U.S. and European figures, particularly British Prime Minister Gordon Brown, have advocated a ‘new world order’, referring to a fundamental change in approach to global economic issues.
Although the notion of a ‘new world order’ has been criticised for being too radical, it is difficult to deny the emergence of a global economic interconnectedness among developed nations. After the Asian financial crisis, the Group of Eight (G8) developed nations formulated economic solutions for developing nations. The G20 Washington Summit in November 2009 was the first time since the inception of the G20 in 1999 that leaders from all member nations met at a heads-of-government level. The Washington Summit was initiated directly in response to the severity of the economic crisis late last year.
Further evidence of this increased global economic interdependence is the agreement on the Plan for Recovery and Reform at the most recent G20 Summit in London. The fact that developing economies, such as China, for the first time had a real seat at the table for global economic policy formulation is of significant symbolic value. It has taken a ‘global crisis’ for developed nations to recognise that their developing neighbours must participate in a ‘global solution’ from the start if any viable progress is to be made. If the Plan translates into meaningful action, then the G20 will have a chance to consolidate its position at the September Summit in Pittsburgh and thereby become a permanent feature of the global political architecture.
“It is difficult to deny the emergence of a global economic interconnectedness among developed nations.”
From words to actions
The practical viability of the G20 Plan is very much up for debate. The only concrete action taken at the Summit was the combined pledge of $US1.1 trillion to assist developing nations, though there was no universal agreement on the potential effectiveness of such a measure. It is also concerning to observe only a verbal affirmation, rather than firm action, to uphold the Washington Summit anti-protectionism promises that have been broken by no less than 17 member states, according to the World Bank. Even so, real progress on anti-protectionism can only begin with the completion of the Doha round of trade negotiations.
One barrier to the viability of the G20 Plan is the lack of enforceability of economic agreements. Despite a call from Gordon Brown, the G20 remains without a permanent Secretariat to enforce the progress of its members. Besides member nations’ own initiatives to combat economic conditions, there is little incentive to accede to the collective Plan. This is especially pertinent considering the poor record of progress from the Gleneagles Summit of the G8 in 2005, where only eight nations agreed to collective action, let alone twenty nations in this context.
Another barrier lies in the structure and perception of the International Monetary Fund (IMF). The IMF was established as a lifeline for embattled economies, and has been given a renewed frontline role for the long-term at the London Summit. Not only has its lending capacity been tripled, but the G20 has also called on it to monitor the impact of member state policies on local economies. However, the quota system that governs the current balance of power within the IMF threatens its legitimacy. European countries and the U.S. together have almost 50 per cent of votes. Developed countries do not regard the IMF as seriously as they should and developing countries distrust the Fund as they are essentially excluded from its decision-making processes. There is no easy or quick solution to this issue.
Ultimately, the global economy’s road to recovery is fraught with difficulty. G20 nations must repave this road anew by repairing a frayed banking system and rebuilding shattered investor confidence in major markets around the world. These nations must ensure that they translate words into actions in a way that reflects a multilateral approach to problem solving. In the words of Rahm Emmanuel, Chief of Staff to Barack Obama, “you never want a serious crisis to go to waste”.
