Nowhere to Hide (Part 2 of 2)

Mr. Lim is a professor of economics the Ateneo de Manila University and a member of the management collective of Action for Economic Reforms. This piece was published in the December 6, 2010 edition of the BusinessWorld, pages S1/4 to S1/5.

Nowhere to Hide: The Great Financial Crisis and Challenges for Asia follows this path of breakthroughs in modern economic thought by documenting the main theories, conditions and events related to the great global financial crisis of 2007–2009. The book shows clearly that what happened involved market failures and the breakdown of mainstream economic theories in the financial sector. The assumption that firms maximize profits leads to very efficient results, with returns to labor and capital commensurate with their productivity. But clearly contradicting the assumptions of the efficient market school, financial institutions in the US in recent decades followed the Economic Value Added school, which is about maximizing shareholders’ value with other stakeholders’ interests taking a peripheral role. The result was an unprecedented explosion in unnecessary leveraging and rise of mortgage-backed securities (MBS), credit debt obligations (CDO) and credit default swaps (CDS) all backed by just one tangible asset – payments of mortgages or, if in default, the value of the mortgaged property. Read the book to understand how these securities were created and multiplied like nuclear fission. Once defaults in the subprime market erupted and property prices had plunged, the entire investment housing system and banking sector was ready for total collapse. “Too big to fail” and systemic risks forced the Fed and US government to bail out the large investment houses (especially after the bankruptcy of Lehman Bros. caused global panic and the freezing of all financial and money markets) and capitalize the major banks.

The book uses all the major advanced theories in economics concerning market failures, which are not taught to students in economics, except perhaps at the graduate levels of the better schools. The global financial crash that started in the US in the period 2007–2009 was precipitated by processes which involved asymmetric information, bounded rationality, herd mentality and systemic risks. Asymmetric information pervaded the system when the mortgage borrowers, initially given low interest rates and sweeteners (minimal down payment), were not informed of the big risks that they faced. Such risks eventually became realities which led them to default and which pushed the financial system to the brink of disaster. The buyers of the securities – and even the sellers of the securities – did not quite know what the financial products were, and when the going got rough, valuation of the financial products became impossible.

Asymmetric information and bounded rationality (a concept from institutional economics) were breakdowns of the assumption of the efficient market school, which assumes that market players have equal and perfect information about the product and about the future. In financial markets where transactions take place over time, bounded rationality ensures that people cannot have perfect information because the future is unknown. Thus the growing inflation fuelled by oil price and commodity price increases in the period 2004–2008, which led to high interest rates and the default situation of subprime borrowers, were not part of the scenarios considered by both borrowers and lenders in the mortgage market and the creators of the highly leveraged financial securities backed by these mortgages.

Finally, the assumption that people are rational – the lynchpin of the efficient market and neoclassical economics – goes down the drain when greed, speculation and Ponzi (pyramid) financing become the norms in financial markets. Thus there was herd mentality as everybody scrambled to buy property at low interest rates while investors scrambled to buy securitized financial products such as the MBS, CDO and CDS – without knowing what they were getting into. Rapidly increasing asset prices inspire greed and the herd mentality. But when the bubbles burst and defaults explode, everybody scrambles to get out – even out of supposedly safe products backed by non-subprime loans. Panic does not usually result in very rational behavior. Thus systemic risks arise as the highly leveraged system resulted in financial institutions highly interlinked with one another through loans and credit. The “too big to fail” situation became inevitable.

The book is comprehensive since it links the problem of global imbalances to the crisis. Current account surplus and growing reserves in East Asia, the Middle East and other developing countries sustained the growing debt-led growth and high current account deficits in the US as these countries invested their growing foreign exchange reserves in US treasuries. This is a classic perverse case of the poor lending to the rich.

Most interesting is the book’s observation that growing income inequalities in both the US and China led to two very different results: high current account deficits for the US and high current account surplus in China. The main factor was the highly leveraged and debt-dependent system in the US that allowed the ordinary consumers and workers to borrow beyond their means. In China, without this sophisticated credit-infested financial sector, worsening income inequalities led to more savings from the ordinary folks (in a system where social insurance is still inadequate) and high investments from the richer folks. In China, the danger of a property bubble was nipped in the bud early on in 2009 as the Chinese authorities risked growth and cut credit in the system. Now, Chinese high growth has resumed and the property bubble risk has abated.

The book also devotes a chapter to prospects for East Asia in the post-global financial crash period. No doubt Asia is leading the economic recovery as the shift to domestic demand became more successful in Asia than in the Western countries given that Asian financial sectors remained strong and healthy throughout the crisis and afterwards. It should be added that the rebalancing towards domestic demand that the book recommends should be accompanied by higher final goods trade among Asian economies and among developing countries. The final destination of export products of developing countries should shift away from crisis-prone US, Europe and Japan.

But danger still looms on the horizon. With global risk appetite rising again in recent months, foreign investments have inundated the equities and bond markets of emerging markets, especially in East Asia. The stock indices of most East Asian economies have surpassed the peak in the pre-global financial crash period. The inflow of foreign investments may lead to a stock market bubble and has led to unnecessary and unhealthy appreciation of currencies in the region. In some Asian countries, high liquidity may lead to property bubbles.

The present situation resembles much the situation a few years before the Asian financial crisis. Somehow we still haven’t learned the lessons of the market failures of the global financial system. Capital controls were talked about in the G20 meeting in early November 2010, but no emerging market is eager to adopt them as the “good days” of massive capital inflows seem to be continuing into the future. The only danger that is seen is a double-dip in the US or a sovereign debt crisis in Europe. But this is another story of market failures.

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