HOW TOXIC FINANCE CREATED AN UNSTABLE WORLD / THE FINANCIAL COMMENTARY & ANALYSIS ( RECOMMENDED READING )

How toxic finance created an unstable world


By Wolfgang Münchau

Published: August 23 2009 18:46

Two years on, what do we know about the global financial crisis? We still lack a conclusive theory, but we know a lot more than we did in August 2007. We know, for example, that simple monocausal explanations are at best insufficient and most likely paranoid and lazy. If you still blame Alan Greenspan, former chairman of the Federal Reserve, or central bankers in general, you have not got it.

Nor can you explain it by “soft” factors such as greed and bonus payments. These played a role but none can serve as an adequate explanation of why the crisis broke out when it did, since they had been present for many years.

My own gut feeling: this has been a crisis of economic policy first and foremost. The financial crisis was necessary for the economic crisis to occur but it was not sufficient on its own. Each depended on the other.

The best description I have found of how economics and finance interacted is by Anton Brender and Florence Pisani*. The two French economists describe in great detail how money from European and Asian exporters ended up in US consumer or mortgage debt and how risk was transformed in the process. The main point is that global imbalances would not have become so extreme if global finance had not provided exotic new instruments.

Dollar-rich Chinese, Japanese and German investors did not lend the money directly to the subprime mortgage market but they invested in opaque credit products, such as collateralised debt obligations, which they mistakenly deemed to be as safe as US government bonds.

Securitisation dumped the risk on those unsuspecting investors. It also transformed long-term debts, such as mortgages, into marketable short-term securities, which were in demand in countries with current account surpluses, particularly Germany and Japan. It is no surprise that those two countries ended up with large portions of the junk, as they had the greatest need to invest their surplus savings.

Without a global credit market, the pre-crisis level of imbalances would have created an intolerable degree of demand for US triple-A rated securities that could simply not be satisfied by the US government.

The story was different in China. Chinese exporters gave the dollars to their central bank in exchange for domestic bonds. The central bank accumulated those dollar holdings, which it invested in securities, Treasury and agency bonds, and other seemingly secure dollar funds, some of which were also ultimately secured by dodgy private-sector loans. In the process, the Chinese central bank prevented a disorderly increase in the renminbi exchange rate, and this in turn helped to make global imbalances more persistent.

If this interpretation is correct, is it good or bad news for us today? On the surface, it is good news. If you add the absolute value of all global current account deficits and surpluses, then divide by two, you get a metric for global imbalances. These, according to the two French authors, were about 1 per cent of world output during most of the 1970s, ‘80s and ‘90s. Since 2000, the imbalances have trebled.

Without securitisation, the world cannot sustain such extreme imbalances indefinitely. There is no way that Wall Street and the City of London will recreate the pre-crisis levels of securitisation, even if we make no changes to financial regulation. Rebalancing is likely to occur eventually. The US will run a large budget deficit for a few years, which partially offsets the sudden increase in US private sector savings, but it cannot do this forever. It is theoretically possible that American households will have repaired their balance sheets in a few years and will return to binge spending by then, but I doubt it.

I am not comforted by this scenario. Both China and Europe are likely to continue with broadly the same policies, trying to rely on exports for future growth while failing to produce sufficient domestic demand. The noises we hear from Germany in particular suggest that politicians and industry are looking forward to returning to the status quo ante.

So if all we do is stimulate the economy in the short term through monetary and fiscal policies, and tighten financial regulation, we are not really solving the problem. We can regulate to prevent another subprime crisis, but another subprime crisis is unlikely to occur even we did not regulate at all.

In the absence of another credit boom, which is improbable given the weakness of the global banking sector, imbalances will contract one way or the other. Without an increase in domestic demand from Europe and China, there is nothing to take up the slack created by the saving of the US private sector.

Once the US stimulus expires, and the budget deficit starts to narrow, global demand will settle at a new lower level. Under those circumstances, it is difficult to see how the world economy can return to the pre-crisis levels of growth, or even close to them.

This is why we should be worrying more about global economics right now than about global finance.


Copyright The Financial Times Limited 2009.