THE GLOBAL FINANCIAL CRISIS: HOW DID WE GET HERE AND HOW DO WE MOVE - PDF document

THE GLOBAL FINANCIAL CRISIS: HOW DID WE GET HERE AND HOW DO WE MOVE FORWARD By Dr. Maurice Odle 1 Economic Adviser to the Secretary-General Caribbean Community INTRODUCTION: The financial sector of the developed countries and emerging market economies has been severely traumatized since the beginning of the last quarter of 2008 with what began as a USA mortgage backed securities crisis (triggered by the burst of a housing bubble). This evolved into a full-fledged financial crisis impacting the investment and commercial banking sectors and the insurance industry, with international transmission of the crisis to Europe and Japan and, eventually, to mainly the larger and more advanced developing countries. The financial crisis then took on the peculiar characteristics of a credit crisis, with the banks not wanting to lend (even after receiving bailout resources) because of a lack of confidence. This led to a real sector economic crisis. The decline in real sector production activity and growing unemployment then worsened the crisis for the financial sector (eg increased foreclosure in the USA) with a spiraling downwards effect on the global economy. We are therefore in the midst of a deepening recession that has not been equaled since the 1930s and which many economists feel will not bottom-out before the end of 2009. Tens of millions are being thrown out of a job and millions are slipping back into poverty and being denied very basic needs. It is therefore appropriate for us to ask the question: “How did we get here and how do we move forward?.” 1 Paper prepared for presentation at the ILO Caribbean Tripartite Conference on Promoting Human Prosperity Beyond the Global Financial Crisis, 1-2 April, 2009, Kingston, Jamaica

(1) HOW DID WE GET HERE In trying to answer this question, we shall refer to the significance of the following issues: (a) Systemic weakness in the global financial system; (b) Financial sector weakness as a product of an extremist market philosophy; (c) Diminished role of the State; and (d) Globalisation and the paradigm of free trade (a) Systemic Weakness in the Global Financial System Foreign exchange crises have not been an infrequent occurrence in the world’s post-war economy. In fact, according to the IMF, there have been over 120 international, regional or national financial crises since the 1970s, when the USA came off the gold standard and the avalanche of dollars commenced. For example, in the USA, major financial crises included the Savings and Loans Crisis of the 1980s and the hedge fund related Long Term Management Fund Crisis of the 1990s and, in the 1980s, Britain had to be bailed out by the IMF. However, most of the financial crises occurred in the developing countries, particularly in the larger and more industralized ones that are known as emerging market economies, such as Mexico in 1982, Chile in 1985, Turkey in 1994 (and again in 2000), Mexico again in 1995, South East Asia in 1997-98 (starting with Thailand and spreading to Indonesia, Korea, Malaysia and Philippines, inter alia ), Russia in 1998 and Argentina in 2001-2. The crises in these emerging market economies, that started in the financial sector and then impact the real sector, almost invariably resulted from some unfavourable economic development indicator resulting in a loss of confidence 2

and a sudden withdrawal of foreign portfolio capital, in the context of a failure to impose adequate capital controls, except in the case of Malaysia. The Caribbean has also experienced its own essentially home grown financial crises due to weak regulatory systems, rather than the flight of portfolio capital. For example, Trinidad and Tobago experienced problems in the financial system in the 1980s and, again, in the 1989-93 period when three financial houses became insolvent and were placed under Central Bank supervision. In Jamaica, a significant part of the country’s financial sector collapsed during the 1990s and, besides instituting financial reforms, a Financial Sector Adjustment Company (FINSAC) was established by the Government in 1997 to honour depositors’ liabilities and which resulted in a near doubling of the public debt. Also, in Guyana, there was failure of an Investment Bank, Globe Trust, in the late 1990s and, in the case of Antigua and Barbuda, a financial house had to be rescued by the Antigua-Barbuda Investment Bank. It is because of the international nature of many financial transactions and the pivotal role of the USA economy that weakness in that country’s regulatory structure was able to result in a global financial meltdown. The weakness was primarily of a systemic nature in that financial regulation was too limited in scope and did not effectively include a US$10 trillion interconnected network of non- commercial bank type institutions, such as investment banks, hedge funds, mortgage originators and the like who engaged in extreme forms of risk taking via various derivative instruments and inspired by mathematical model builders. In this regard, there were a number of related weaknesses of a structural nature, including the absence of a strong corporate governance role by stakeholders and complicit and co-opted behaviour at times on the part of the gate keepers – lawyers, accountants and auditors; and interlocking/cronyism relationships between corporate managers and regulators. In addition, the UK’s financial regulator is reported in the Financial Times of 10 February 2009 as saying that “attempts by the International Monetary Fund to warn of risks posed by large 3

countries’ financial systems have been frustrated by governments watering down the criticism”. In order to address the issue of regulatory gaps and lack of market discipline in the financial system, the administration of USA President Obama unveiled on 26 March 2009, proposals for a major reform of the system, including: • Imposing tougher standards on financial institutions judged “too big to fail” • Regulation of financial derivatives, especially credit default swaps • Requiring large hedge funds and other private pools of capital, including private equity funds and venture capital funds to register with the Securities and Exchange Commission • Creating a systemic regulator role (b) Weak Financial Regulation as a Product of the Neo-Liberal Paradigm Weak financial regulation in the USA (and other developed countries) is not an accident of history. It is a product of a neo-liberal philosophy that took off in the 1980s and which took the laisser-faire market tenets of Adam Smith to new heights are reflected in the Washington Consensus that had strong institutional (including IFI) academic and media support. The notion was propounded that the market was not only an efficient allocator of resources but, also, that it had certain self-correcting properties, a significant advance on the Adam Smith “invisible hand” notion. This blind faith in the market or market fundamentalism actually led to a certain amount of financial de-regulation during the 1980s and 1990s. In fact, President Clinton in the late 1990s declined the opportunity to introduce hedge fund regulations. 4

(c) Diminished Role of the State The corollary of market fundamentalism is a diminished role for the State. Ex- President Reagan of the USA and Prime Minister Thatcher of Britain had their followers in both developed and developing countries who executed privatization programmes with gusto and delighted in the downsizing of other areas of government, including the regulatory arms, and the demonizing of government intervention in general. The International Financial Institutions (IFIs) for their part, imposed various conditionalities in their lending to developing countries including expenditure limitations on education, health, subsidies and other transfers of benefit to the most vulnerable that impacted negatively on social safety nets and tended to be inconsistent with their proclaimed poverty alleviation policies and targets. Maximization of employment became a secondary objective of government, despite the fact that a system of well paid jobs constitutes the most effective safety net and medium for social stability. Similarly, the State became less concerned with ever widening disparities in the distribution of income or with the falling incidence of unionization. It is this lack of concern, coupled with an exaggerated view of the worth of capital vis-à-vis labour, that contributed to the exponential growth of compensation for managers and the latter’s resultant penchant for taking excessive risk in the hope of generating huge short-term gain for themselves and shareholders. The system has struggled to find the happy mean between economic efficiency and social justice. (d) Globalization and the Paradigm of Free Trade The significantly increased internationalization of trade, finance and investment has served to make the financial crisis and economic recession a truly global phenomenon in which not only the USA, Europe and Japan, but also, China, India and the other developing countries are very much affected. During the 5