Global economic turmoil — towards a paradigm shift?

Chiranjib Sen

Regulators must reassert control over leverage as this is at the root of excessive lending. This will lower the profitability of financial firms but this is a price that has to be paid.

The world economy has been in turmoil for nearly a year, driven by persistent problems in the financial sector of the U.S. and Europe. Since August 2007, central banks of the U.S., Europe and Japan have repeatedly injected liquidity into the banking system in order to rescue it from the ravages of the sub-prime housing loan defaults. The damage is widespread, and not confined to any particular region or sector. Most leading banks have been badly hit by the crisis. Large financial firms such as American Home Mortgage, BNP Paribas, and Countrywide Financial faced severe liquidity problems. In an unprecedented intervention by the Federal Reserve Bank, Bear Sterns was recently sold off to JP Morgan at $2 a share.

Yet, the global economy remains troubled. The liquidity transfusions may actually be contributing to the latest crisis related to increasing commodity prices — notably oil and food. This has exacerbated stagflationary pressures. The Bank for International Settlements in its recent annual report has joined in the chorus of gloomy forecasts.

The dominant paradigm animating policy approaches is “market fundamentalism.” This mindset, a Reagan-Thatcher legacy, holds that the market is always right. Under its influence, deregulation has swept aside government interventions of all types. Monetary policy became the dominant tool of macro-economic intervention. However, monetary policy alone seems unable to remedy the current situation.

The ailing global financial system is at the root of today’s turmoil. What went wrong after 30 years of high profits and dramatic innovation in financial engineering? Influential western financial lobbies embraced the fundamentalist paradigm. Deregulation allowed convergence of commercial banks, investment banks and insurance businesses despite the possible conflicts of interest. New complex financial securities were created and marketed without regulatory oversight.

A series of financial crises have brought serious economic costs and erosion of financial wealth since the 1990s. The burden on ordinary people has been severe. These episodes include the 1997 Asian financial crisis, the insolvency and bailout of the leading hedge fund Long Term Capital Management (LTCM) in 1998, and the protracted U.S. stock market slump following the technology bubble burst of 2000. Several other episodes occurred earlier during the 1980s. Policy followed a pattern of bailing out the endangered entities. Whenever the solvency of major western lenders was threatened, some form of bail-out package was usually arranged by financial authorities. In the Thai crisis of 1997, inaction triggered the so-called contagion that hammered the entire Asian economic region.

Policy response avoided institutional reform or regulatory safeguards in the advanced countries, for fear of restraining the profitability of international financial firms. The typical response of the market fundamentalist lobby after each new crisis was to demand even more ‘reform.’ Though repeated intervention by central banks on an ever-increasing scale proved necessary for the survival of financial markets, the myth that markets are always right with has been perpetuated. Can this situation continue indefinitely? Economic paradigms shift every three or four decades. With solutions remaining elusive, another paradigm shift seems imminent. Many U.S. academics, legislators, and market practitioners are calling for serious re-examination of policy. Concerns are mounting about perverse incentives and dubious practices in financial markets, and about destabilising speculation in commodity markets. Regulation may re-enter the policy agenda. But first, market fundamentalist blinkers must go.

Leading academics, such as Joseph Stiglitz and Paul Krugman, as well as investor George Soros, have long criticised market fundamentalism. In particular, Alan Greenspan’s fundamentalist bias when he was Fed Chairman induced a lax regulatory posture, and allowed the technology bubble to grow. More important, his reluctance to regulate condoned flawed incentive structures and turned a blind eye to conflicts of interest. Financial services firms followed questionable practices that boosted short-term profits, but laid the foundation for subsequent busts. Many originators of problem products managed to make profits and shield themselves from the downside. Nowhere is this clearer than in the case of the sub-prime housing loans. Banks kept dubious exposures from balance sheets. Investors lacking the ability to assess the underlying risks absorbed mortgage-backed securities.

In the backdrop of the crisis, George Soros has written a new book calling urgently for a paradigm shift. (The New Paradigm for Financial Markets — the Credit Crisis of 2008 and What it Means; Public Affairs Books, 2008.) Mr. Soros may well be the most successful fund manager and speculator in recent history. He does not view speculators as demons. Nor is he against capitalism or markets. He applauds their role in an ‘open society.’ Yet, he opposes market fundamentalism, based on long experience with financial markets. We cannot dismiss Mr. Soros as someone who does not understand how financial markets work. He argues that unless appropriate intervention is devised, it will be increasingly difficult to avoid a catastrophic collapse of the global economy.

Mr. Soros’ unconventional argument goes as follows. Financial markets are subject to fundamental uncertainties and irresolvable indeterminacy of outcomes. Market valuations cannot reflect fundamentals, because market observation and manipulation operate simultaneously. Expectations can induce behaviour that affects the fundamentals. Hence, prices can affect the very “fundamentals that they are supposed to reflect”. When this happens, ‘boom-bust’ sequences can emerge because the change in the fundamentals can “reinforce the biased expectations in an initially self-reinforcing but eventually self-defeating process”. Usually, this happens when a “short-circuit” develops between market-valuations and fundamentals. In real estate markets, the short circuit is caused by leveraging of debt. Relaxation of lending standards, combined with a misconception that the value of collateral is unaffected by the willingness to lend causes the bubble. Ultimately, the high expectations cannot be met, and the bust ensues.

Mr. Soros’ ability to spot these bubbles and predict their dynamics underlies his success. It also validates his conceptualisation. He argues that conventional economic analysis of financial markets greatly overestimates the stability of markets. Similarly, the modelling and measurement of risk by rating agencies are seriously flawed, because these rely only on past information about returns, but do not factor in risks linked to participants’ current actions.

Policy actions

What is to be done? There is a whole range of policy actions that are being proposed. Regulation of financial markets is necessary, but it must be crafted carefully. Regulatory design must ensure that dynamism is not choked completely. Regulatory capacity must improve. Regulators must fully understand the nature of the new financial instruments and methods. They must manage systemic risks, and block practices that they do not understand. Reliance on the assessments provided by the very groups that are being regulated cannot continue. There should be a new compact whereby all financial market participants (including hedge funds and sovereign wealth funds) provide regulators with adequate information. Regulators must reassert control over leverage, since this is at the root of excessive lending. This will lower the profitability of financial firms, but this is a price that has to be paid. On the macro-economic policy front, asset price inflation also needs to be controlled. Asset prices should be included in the regulators’ concept of inflation — not just goods and services. This requires focus on credit rather than on money supply. Finally, there must be policies to deal with the social downside of economic crisis. Fiscal policy may need to be resurrected to channel taxpayer money towards stabilising damaged sectors and markets. In the housing sector, for example, the sanctity of market contracts may need to be temporarily moderated. Foreclosures must be slowed down, through state-supported efforts to modify mortgage contracts. There may also be a useful role for corporate social responsibility in stabilising affected neighbourhoods. The good news is that new initiatives along these lines from both policymakers and private sector are beginning to emerge.

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