The sub-prime mortgage bubble induced financial meltdown and economic recession has inflicted devastating damages, including as Paul Krugman writes, tarnishing Anglo-American capitalism and the American government and governance systems, and irreparably damaging America's credibility in a role of global economic leadership.
In a brilliant and revealing article in the Atlantic, Simon Johnson (also here) is brutally precise about the crisis and the way out. He writes that "the finance industry has effectively captured our government — a state of affairs that more typically describes emerging markets, and is at the center of many emerging-market crises. If the IMF’s staff could speak freely about the US, it would tell us what it tells all countries in this situation: recovery will fail unless we break the financial oligarchy that is blocking essential reform. And if we are to prevent a true depression, we’re running out of time."
In good times, the powerful elites within emerging economies over-reach and take too many risks, all on the firm and well-founded belief that their partners in government will bail out the joint enterprise if things turn sour. The close nexus between the private sector and the political establishment means that businesses and their lenders (most often foreign banks and institutional investors) can take risks with the belief that they will have the upside to themselves and the downside to be pushed off to the tax payers. Further, growing political support meant swifter clearances, better access to lucrative contracts, tax breaks, easier credit from government banks, and subsidies.
As the economy booms, these businesses are subject to the same set of excesses in investments and borrowings as in any bubble. Then the bubble bursts and the downward spiral starts - credit first becomes scarce and then freezes, defaults mount, lay-offs begin, business investment comes to a halt, consumption gets deferred and the economy slips ever deeper into a hole.
As Simon Johnson writes, "Yesterday’s 'public-private partnerships' are re-labeled 'crony capitalism'... The government is forced to draw down its foreign-currency reserves to pay for imports, service debt, and cover private losses. But these reserves will eventually run out. If the country cannot right itself before that happens, it will default on its sovereign debt and become an economic pariah. Needing to squeeze someone, most emerging-market governments look first to ordinary working folk — at least until the riots grow too large. The government, in its race to stop the bleeding, will typically need to wipe out some of the national champions — now hemorrhaging cash — and usually restructure a banking system that’s gone badly out of balance. It will, in other words, need to squeeze at least some of its oligarchs."
Pointing to the striking parallels between "crony capitalism" in emerging economies and the descent of the US to a "banana republic", he writes,
"In its depth and suddenness, the US economic and financial crisis is shockingly reminiscent of moments we have recently seen in emerging markets (and only in emerging markets): South Korea (1997), Malaysia (1998), Russia and Argentina (time and again). In each of those cases, global investors, afraid that the country or its financial sector wouldn’t be able to pay off mountainous debt, suddenly stopped lending. And in each case, that fear became self-fulfilling, as banks that couldn’t roll over their debt did, in fact, become unable to pay. This is precisely what drove Lehman Brothers into bankruptcy on September 15, causing all sources of funding to the U.S. financial sector to dry up overnight. Just as in emerging-market crises, the weakness in the banking system has quickly rippled out into the rest of the economy, causing a severe economic contraction and hardship for millions of people.
But there’s a deeper and more disturbing similarity: elite business interests—financiers, in the case of the U.S.—played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive. The government seems helpless, or unwilling, to act against them."
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