Friday, March 13, 2009

End of the era of financial liberalization?

Martin Wolf has this excellent obituary to the era of deregulated and liberalized financial markets that started in the early eighties. He argues that the last three decades has seen "massive growth in the scale and profitability of the financial sector, frenetic financial innovation, growing global macroeconomic imbalances, huge household borrowing and bubbles in asset prices", all of which, ironically enough, contained the seeds of destruction of the system that generated them.

He gives some figures to demonstrate the extent of these imbalances that blew one bubble after another.

1. To give an idea of the magnitude of the leverage driven growth of the financial markets, in the US, the aggregate debt of the financial sector jumped from 22% of GDP in 1981 to 117% by the third quarter of 2008, while in the UK the gross debt of the financial sector reached almost 250% of GDP.

2. By intervening to keep their exchange rates down and accumulating foreign currency reserves, governments of emerging economies generated huge current account surpluses, which they recycled, together with inflows of private capital, into official capital outflows: between the end of the 1990s and the peak in July 2008, their currency reserves alone rose by $5,300bn.

3. These huge flows of capital, on top of the traditional surpluses of a number of high-income countries and the burgeoning surpluses of oil exporters, largely ended up in a small number of high-income countries and particularly in the US. At the peak, America absorbed about 70% of the rest of the world’s surplus savings.

4. In the US, the ratio of household debt to GDP rose from 66% in 1997 to 100% a decade later. Even bigger jumps in household indebtedness occurred in the UK. These surges in household debt were supported, in turn, by highly elastic and innovative financial systems and, in the US, by government programmes.

5. In the US, overall debt reached an all-time peak of just under 350% of GDP – 85% of it private, up from just over 160% in 1980.

The results of all these are now for everyone to see - "massive and prolonged fiscal deficits in countries with large external deficits, as they try to sustain demand; a prolonged world recession; a brutal adjustment of the global balance of payments; a collapse of the dollar; soaring inflation; and a resort to protectionism."

In the emerging economies, "the number of people in extreme poverty will rise, the size of the new middle class will fall and governments of some indebted emerging countries will surely default. Confidence in local and global elites, in the market and even in the possibility of material progress will weaken, with potentially devastating social and political consequences." He also feels that these events will "endanger the ability of the world not just to manage the global economy but also to cope with strategic challenges: fragile states, terrorism, climate change and the rise of new great powers".

Wolf points to a paper by Andrew Haldane that shows how little banks understood of the risks they were supposed to manage and ascribes these failures to "disaster myopia" (the tendency to underestimate risks), a lack of awareness of "network externalities" (spill­overs from one institution to the others) and "misaligned incentives" (the upside to employees and the downside to shareholders and taxpayers).

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