[ Global finance and development ]

“Uncharted territory”

The world’s banking system is teetering. In the United States and in Europe, huge financial institutions need government bailouts. So far, it remains difficult to accurately assess all consequences for the world economy. Shortly before we went to press at the end of October, E+Z/D+C discussed the outlook with economist Jan Priewe.


[ Interview with Jan Priewe ]

How should governments and central banks react to the financial mess?
Five tasks have to be tackled in an internationally coordinated manner:
– Central banks have to pump liquidity into the financial sector (so-called lender of last resort function). Otherwise, banks will go under. Monetary policy must thus become reflationary, even though fighting inflation would normally require a different stance.
– The banks are refusing to lend each other any more money because they are unable to assess the risks. The crucial inter-bank market has practically ground to a halt. The central banks cannot solve this problem since their additional liquidity is an insufficient substitute for lacking trust. So the state has to step in to unlock frozen credit. Governments must take over risks, whether by buying up bad loans, stepping in as guarantor or other means.
– Banks, however, are not only struggling with liquidity problems, but also with those of solvency. Many have had to reassess the value of assets. Write downs mean that they can no longer lend as much as they used to, which, of course, further compounds the liquidity crisis and can lead to a broad credit crunch. Many banks need fresh capital. Given that private investors will hardly buy bank shares at this moment, it is the governments that have to inject the capital needed.
– On top of that, governments must not allow panic to set in among savers. If they withdraw their deposits or sell assets en masse, that will only exacerbate banks’ liquidity issues, and the danger of bankruptcies will grow. So governments have to guarantee the deposits with the banks, and not just those tied up in savings and checking accounts.
– Finally, it is crucial to alleviate the consequences for the real economy as much as possible, or else we will face a massive global recession. Economic growth had already been weakening in most OECD countries. The financial crisis is exacerbating this trend, which, in a kind of feed-back, is adding to the financial woes.
All interventions must be coordinated internationally, because otherwise money and assets will flow to where governments offer the most guarantees, with the result of matters further deteriorating everywhere else.

Why is this crisis so particularly harmful?
This is more than just the bursting of a speculative bubble, with prices of real estate, stocks and other assets suddenly dropping. Several crises are taking place at once. It all began with the subprime crisis, itself the product of irresponsible mortgage loans in the US. On top of that, there is a crisis involving securitisation. This practice made certain assets tradeable, even though their risks can only be assessed with great difficulty. In some cases, risks are outright obfuscated. Beyond that, there’s a looming crisis in the market for financial derivatives (credit default swaps, in particular). The volume of this market has grown to huge proportions. Derivatives are actually supposed to shield against risks, but the speculation that took place really made risks a lot worse.

But actors in the financial markets knew what was going on, didn't they?
Hardly anyone understood the extent of the risks. What we are seeing is ultimately a crisis of risk assessment and risk management, a crisis among the banks and the financial regulators. Financial innovations started on Wall Street and in London, and they were only possible thanks to neoliberal deregulation of the financial sector. Derivative deals were immensely profitable. Until recently, 30 % of all company profits in the US came from the financial sector. So we are also witnessing a crisis of financial-sector dominance over the real economy. Fighting this crisis will be tougher than after 1929. The only comfort lies in the fact that the political mistakes made then will hardly occur again.

Why do you think that the financial meltdown in the rich world will not affect financial institutions in emerging markets as badly?
Financial institutions there have not followed Wall Street’s lead. So far, they have not used finance innovations much. Banking is still strictly regulated in China and India, by far the developing world’s two largest economies. Both countries still enforce capital controls, and that further reduces the danger of contagion. Moreover, most financial companies from emerging markets are primarily active in their home countries. However, the pressure to deregulate has been growing, with demands to at last introduce modern “Western” financial products. This was happening in a blind drive to modernise, amid a great deal of naiveté about the risks.

How will emerging economies feel the crisis?
Problems within the OECD countries are making financial investors all over the world more risk-averse. Expect them to withdraw investments from emerging markets, and in particular from Eastern Europe and Central Asia, where high current account deficits are being financed with short-term capital injections. However, other countries are also affected, especially if current account deficits are high. A few Latin American countries – Mexico, for example – are closely interlinked with the US. And in many countries, speculative bubbles have built up in the stock or real estate markets. When the stock market dropped in early October in New York, London and Frankfurt, the knock-on effect was felt in Shanghai, Jakarta and elsewhere.

And all this will affect the real economy?
Yes, it will. The biggest danger is that developing countries will be infected by the possible recession in OECD countries. And that will be particularly tough for the poorest nations. Exports by developing countries to Europe and North America will slow down considerably. The International Monetary Fund forecasts a serious danger of world recession in 2009, since growth will slow to three percent – and that is the IMF definition of a global recession. In recent years, the global rate of growth was above five percent annually.

What scenario is the most likely one?
In an ideal case, growth will fall slightly; in the worst-case scenario, a global recession looms. The IMF has forecast 0.1 % growth for the United States and 0.2 % for the euro zone in 2009. Developing countries are in far better shape with a forecasted six percent. But rarely has uncertainty been as pronounced as today. The IMF expects only a dent for the global economy, one that will be overcome by the end of 2009. This prognosis contains a lot of wishful thinking. Most serious financial crises left longer-lasting skid marks.

Isn’t such a crisis necessary to lay the foundation for a new and sustainable recovery?
Well, crises have a cleansing and healing effect, but they also cause serious collateral damage. How severe the downturn will become also depends on macroeconomic policy. What matters most is to move rapidly from fighting inflation to stabilising the economy – especially in developing countries still struggling with food-price inflation.

What is your take on the $ 700 billion bailout package in the USA?
It is a desperately needed, albeit late step in the right direction. But it won’t be enough. I think it is problematic that the US government plans to buy up “toxic” assets, freeing banks from some of their load. Placing a value on such assets is difficult. In some cases, they have no value at all, and then the banks’ balance sheets have to be corrected. Apparently, US Treasury Secretary Hank Paulson is in the process of adapting the bailout package to the much smarter British model. The government in London is injecting capital into the banks, in what is, in effect, a temporary and partial nationalisation of the banks. The greatest problem, however, is that the real economy in the US needs some kind of bailout too.

What do you suggest?
As Federal Reserve’s key interest rate is already relatively low, the Fed has hardly any room for counter-cyclical reflationary policy. Accordingly, the federal budget will have to provide some sort of stimulus through increased spending and/or tax cuts. No one knows whether the $ 700 billion dollar package – that amounts to about five percent of US GDP – will be enough. It is obvious, however, that the bailout will strain the federal budget, which in turn should hamper the willingness to take on new debt, even though doing so would make economic sense in this situation.

How do you assess Europe?
It is remarkable that coordinated international action did occur. The US was rebuffed when it first called on other OECD countries to coordinate rescue packages. Those leaders severely misjudged the situation. Several European governments, including Germany’s, wanted to tackle the banking crisis on a case-by-case basis. But following a series of missteps and bad judgment, they are now addressing the issue in a systemic and coherent manner. They are largely following the British model. No one knows what the long-term effects will be – we’re in uncharted territory.

Will more have to be done?
One of Europe’s weaknesses – even more pronounced than in the US – is that there is no agreement on accompanying measures to stimulate the real economy. Europe has no policy options for dealing with recessions. That is a major deficiency of Europe’s monetary union. Any profound recession cannot but deepen the financial crisis. It is too early to give the all-clear signal. Everything that Europe and the US have done so far amounts to little more than deploying the fire brigade. The causes of the blaze remain untackled.

What kind of government regulation could have prevented the current financial crisis?
In short:
– Sub-prime mortgages should have never happened.
– Regulators should have overseen the securitisation of loans and the trading of derivatives.
– A few finance innovations should never have occured.
– Policies to reduce global imbalances should have been implemented at an early stage.
– The world needs an internationally coordinated system of banking and finance oversight, and that system must reach beyond a given currency’s borders.
Even where rules are strictly enforced, national banking regulators are easily bypassed in a globalised financial world where money is transferred in a largely unchecked manner. We are now seeing the consequences of unbridled globalisation. Globalisation critics are even more in the right than they may think they are.

But the real problem is not speculation itself, is it?
No, speculation is part and parcel of the capitalist system – capitalism is unimaginable without it. What happened here, however, is speculation out of control, based upon new, hardly controllable financial products, along with a crisis in the regulation of banks and capital markets.

Dominique Strauss-Kahn, the French socialist at the helm of the IMF, wants to take up the task of regulating and overseeing global finance. What do you think of that?
We urgently need international regulations, but they also need to be approved by the big industrialised countries, in particular by the USA and Britain. Their governments managed to block many reforms in the past, for example greater oversight of hedge funds.

Since Reagan and Thatcher, radical free-market ideology has dominated international economic policymaking. Is that obsolete now that the US government has nationalised the greatest risks in the financial sector?
Free-market fundamentalists always want a strong state. They know how crucial it is in an hour of need. In other times, it is less urgent. Nationalising losses and privatising profits may not be on page one of the neo-liberal textbook, but the attitude is consistent with the interests of those that back neoliberal ideology. Sometimes there is no workable alternative to nationalising losses in the short term – and that is obviously the case now.

Has Europe’s market-based model of the welfare state also been discredited? Or has this model perhaps even gained credence internationally?
I would not take it so far. After all, many of Europe’s welfare states are in serious trouble; they need to be redirected. However, the entire world is now learning the lesson that state intervention is required in the most privileged sector of modern capitalism, and that this sector needs fundamental restructuring. An employee with the Chinese Central Bank wrote me the following lines: “We Chinese were apprentices of the United States. But now we know that something is wrong with the teacher. What should we do now? China is feeling unsettled.” Many feel this way, especially bankers around the world. Wall Street was, after all, the global paradigm.

Governments will take stock of the 2002 Monterrey Consensus on financing for development in Doha at the end of November. How will the current global crisis affect that debate?
Predictions are quite difficult, but one thing is clear: the huge bailout packages in Europe and the US are expensive, and political pressure will grow to cut other public spending. Development aid for the South is unfortunately not a high priority in most OECD countries.

Questions by Hans Dembowski

D+C, 2008/11, Tribune, Page 427-429