Expectations have been mixed before this weekend’s meeting of the G20. It was widely believed that George W. Bush would try to block change, and that change would only come later with President-elect Barack Obama. No surprises then that exactly this has happened. However, I believe that the G20 did not recognize the root cause of the financial crisis. The final declaration of the G20 states:
4. Major underlying factors to the current situation were, among others, inconsistent and insufficiently coordinated macroeconomic policies, inadequate structural reforms, which led to unsustainable global macroeconomic outcomes. These developments, together, contributed to excesses and ultimately resulted in severe market disruption.
That is gibberish. Can you be more imprecise than macroeconomic policies? And who is at fault for the inadequate structural reforms? It was even too much, it seems, to ask for an opinion on how much these causes contributed to the financial crisis. The only outcome of this meeting is that developed and emerging economies work on this together (while still marginalizing developing economies). The main message is that tariffs and turning inwards are not the answer:
13. We underscore the critical importance of rejecting protectionism and not turning inward in times of financial uncertainty. In this regard, within the next 12 months, we will refrain from raising new barriers to investment or to trade in goods and services, imposing new export restrictions, or implementing World Trade Organization (WTO) inconsistent measures to stimulate exports. Further, we shall strive to reach agreement this year on modalities that leads to a successful conclusion to the WTO’s Doha Development Agenda with an ambitious and balanced outcome. We instruct our Trade Ministers to achieve this objective and stand ready to assist directly, as necessary. We also agree that our countries have the largest stake in the global trading system and therefore each must make the positive contributions necessary to achieve such an outcome.
This means that the mistake of imposing trade barriers committed during the Great Depression will (hopefully) not be repeated. This is certainly good news, but again not a surprise. What is critical are the roots of the crisis. I hope that these were but into incomprehensible gibberish because someone (probably the US president) would not want to have the truth published at this time. Let me elaborate on the roots of the financial crisis.
An international financial system is not a must have for the world economy. If countries trade by barter, there would not even be a need for exchange rates. It would be a tit-for-tat game which would make everybody happy (if not, why trade?). However, this system would make trade very difficult. Countries could only import as much as they export, speaking of value and not quantities.
Since economies might want to vary their level of consumption because of demographic change, they might be interested to either invest their savings abroad or to take out loans from abroad in order to finance their current consumption. This would call for the establishment of an international financial system, allowing for capital imports and exports, exchange rates and trade surpluses and deficits. A country that is saving for later, like China, would export more than it imports. Since the US at the same time must import more than they export, they cannot pay all imports in the Chinese yuan, which they have gained by exporting to China. Hence, they must pay with US dollars. If China is willing to accept them (or treasury bonds or any other dollar-denominated asset), an imbalance in the world economy can arise.
Also, there might be countries which offer better investment opportunities than others. According to orthodox economic theory, capital scarce countries would offer higher rewards to capital. An example would be European investors that financed the US railways in the 19th century. An international financial system should foster development. This would lead to global imbalances as well. There are more reasons for an international financial system, like portfolio diversification (which did not work so well in the last months), but let us assume that we already accept the idea that such a system should be created.
In a nutshell, countries that export more than they import must accept assets in foreign exchange for their net exports. That is why China is piling up dollar denominated assets at its central bank, and that is also why German banks suffered so much from the US sub-prime mortgage crisis. In theory, being a net exporter should change the value of your currency. As your trade partners scramble for your currency, they increase its demand. If supply is given, that leads to an appreciation: the currency of the net exporter gets more expensive in terms of other currencies. This has happened to the euro, and without the Chinese central bank’s intervention in the foreign exchange market that would happen to the yuan as well.
Some imbalances in the world economy have existed throughout most of recent history, and we have seen above that there are good reasons for them. However, there are limits to imbalances. Why is that? Well, let us assume that Germany and China, the world’s biggest exporters, send their exports to the US which does not export as much. (I might as well pick other countries, like the oil-exporting economies.) That means that Germany and China will have to accept US dollars as payment. Some of it comes in treasury bonds, some of it will be invested in the US stock market or provided for other forms of investment. Given the imbalances are massive, capital flows to the US will reach such a high level that capital will not be a scarce resource anymore in the US economy. Capital is abundant, given that net capital inflows to the US have reached $700 bn last year.
How is this possible? In theory, the dollar should depreciate against all other currencies because the US needs to exchange them for euros, yuan and other currencies. If all trading partner accept dollar assets as payment, this mechanism does not work. Hence, imbalances will rise and rise and rise. And so they did until the US economy was awash with capital, provided by the rest of the world, including the capital scarce developing countries. This triggered probably the New Economy, allowing entrepreneurs with goods ideas to collect unprecedented amounts of capital through IPOs. Then, the stock market bubble burst, but the real estate bubble was started right in time. All the while the IMF struggled to understand why capital flows from poor to rich countries.
All these capital inflows to the US had to be invested into something. However, the supply of good investment projects is limited. If capital is so abundant, then people will come up with creative ways of how to invest the capital, promising high returns to eager investors. This, I believe, is what started the sub-prime mess. Wall Street came up with the idea of bundling mortgage-backed assets, then slicing them into nice parts and selling them to people who did not understand the risk associated with these products. It was all a Ponzi scheme, but probably not even most of the people in the financial industry understood what was going on.
Let’s sum this one up: the US financed their consumption and government (mostly the Iraq war) spending by going deep into debt with her trade partners. The rest of the world readily accepted assets denominated in US dollars. That way, the demand for US assets increased. When the imbalances ballooned, capital became so abundant in the US that the country ran out of ways to invest it in a profitable manner. In this climate, Wall Street invented the Ponzi scheme of mortage-backed assets, which worked fine while house prices kept rising. When finally prices arrived at stellar levels and nobody would get in, the Ponzi scheme went belly up. Since over investment was a problem in the stock market as well, the crisis spread.
As the US financial system suffered, it became clear that highly leveraged financial institutions (mainly hedge funds and off-balance finance vehicles) had connected asset markets worldwide by holding assets from all over the world. Their scramble for liquidity caused the selling of assets world wide (so much for portfolio diversification). While prices fell, more and more institutions came under pressure. Irving Fisher described debt-deflation in the stock market crash of 1929, and in 2007/08 we saw a repeat on a global scale.
Where does all this leave us today? The acute problem is that of falling demand on a global scale. Monetary policy has lost most of its effectiveness, so fiscal policy is back. Governments can sell bonds to the public at low interest rates and then spend the money. They should do so in a quick and coordinated manner, as I argued before. (Net exporters should pay special attention, since net importers might be unable to finance their net imports with the current credit crunch.) Government debt is a problem of its own, but it should not be the top priority right now. This can be left for later, to be taken up with the topic of financial regulation.