Thursday, September 17, 2009

Deficient polices caused the crisis

Market enthusiasts have argued that the financial market does an effective role in efficiently allocating resources to the most productive of activities. However, events from the past two decades provide ample proof against this and the possibility of market failures that cannot be repaired or remedied without an intrusive role by the government.

After the recent events, only the ideological zealots, ignorant and foolish would cling to the view that markets are efficient in allocating resources and are self-correcting. It is now widely accepted that governments should play an important role in not only regulating financial markets, but also in addressing macroeconomic issues and trends that have the potential of generating financial market distortions. In other words, after two decades of aggressive de-regulation and liberalization, financial market and macroeconomic policy making has taken the centerstage with a bang.

Conservatives in the US have accused China and the emerging economies of Asia for causing the asset bubbles that have caused so much financial and economic devastation over the last one year. They blame the excessive savings, depressed private consumption and a gargantuan appetite to accumulate reserves by increasing exports, among emerging economies, and their preference for the safety and liquidity of US Treasuries, as being responsible for the flood of capital into the US. It is alleged that this coupled with the cheap imports from the same countries of all kinds of consumer durables and non-durables, in turn fuelled the asset bubbles and consumption binges in the US. In other words, as some critics have claimed, the on going crisis was "Made in China"!

However, it may be more appropriate and correct to lay the blame for the crisis at the doorstep of policymakers and regulators at home. As Menzie Chinn and Jeffry Frieden write, "We view the current episode as a replay of past debt crises, driven by profligate fiscal policies, but made much more virulent by a combination of high leverage, financial innovation, and regulatory disarmament... This disaster is merely the most recent example of a 'capital flow cycle', in which foreign capital floods a country, stimulates an economic boom, encourages financial leveraging and risk taking, and eventually culminates in a crash."

Here are five resons why the aforementioned arguement may only be a convenient ruse to blame others and wash off the guilt from faulty and deficient policies followed by policymakers at Washington.

1. Fed's monetary policy - It is now well-acknowledged that the reluctance of Alan Greenspan to "take the punch bowl away when the party got going" and raise interest rates in the face of overwhelming evidence that an asset bubble was well underway, was a single biggest contributor towards asset price mis-matches and the build-up of financial market distortions. It set the stage for the "age of leverage" that both financial market actors and consumers feasted on.

2. Inadequate and weakly enforced financial market regulation - The biggest share of the blame for the financial market crisis has to be borne by the financial market regulators who allowed a large and unregulated shadow banking system with its alphabet soup of financial engineering products to emerge and pose massive systemic risks on the entire financial market and even the real economy. The financial market de-regulation of the nineties set in motion a tsunami of unregulated speculative activity and proliferation of risky instruments in the equity and debt markets that effectively forced the crisis on us.

3. Failure to prevent mis-allocation of resources - The existing policies (or the lack of appropriate ones) ended up channelling a disproportionately larger share of resources into the financial markets and the real estate, thereby inflating asset bubbles in both these markets. As James Kwak argues, the majority of external borrowings and inflows found its way into non-tradable goods, such as housing and financial services, necessarily pushing up valuations. Policy makers stayed and watched and even applauded as a spectacular mis-allocation of resources towards the financial markets (and specific instruments) inflated bubble after bubble and led the world economy into this crisis.

4. Supply-side policy of cutting taxes - The large tax cuts of the Bush administration had the effect of increasing the disposable incomes available with consumers. In the context of low interest rates, growing asset prices, and cheap imports, this increased availability of disposable incomes was an evident recipe for amplifying the bubble and the resultant incentive distortions.

The tax cuts were not only not followed up with efforts to bring down government spending, but also ran parallel with increases in government spending (on defense and the Iraq war). The result was a huge increase in public debt and fiscal deficit that found a ready source of funding from the "savings glut" in the emerging economies. Accordingly, the large tax cuts also set the stage for the huge deficits that left the government with limited fiscal space for stimulus spending when the Great Recession took hold.

5. Refusal to support efforts to create a global reserve currency - The moral hazard created by the dominant role of dollar as the global reserve currency meant that the US Government could run up massive current account deficits with the assurance that they had the luxury of simply printing more greenback if situation so demanded. It also fuelled the confidence, will all its incentive distortions among all stakeholders, that the US could borrow without limit and at low interest rates (as was prevailing) from outside. The absence of a global alternative to dollar means that this moral hazard will persist and leave open the possibility of similar incentive distortions in future.

Even as the global macroeconomic imbalances continue to build up alarmingly and as the global economic power balance shifts eastward, policy makers in Washington have tended to turn the other side and ignore the reality that dollar cannot continue to remain as the dominant global reserve currency. As Joe Stiglitz argues, the burgeoning deficits and the fear that policy makers in Washington may be tempted to reduce the real value of its debts by inflation, may be enough to undermine the role of dollar as a reliable and risk-free store of value.

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