Nepal: Global Financial Crisis, Lessons Taught
The classic feature of financial crisis is that failure of one firm inflicts losses on its creditors, and they in turn fail to repay their debts, bringing down a widening circle of firms resulting in the epidemics of failure. This in turn results in general decline in production and employment. If banks are allowed to collapse one after another without any care to their creditors, the eventual situation may result in slowdown, recession, depression and even deflation. The worst case scenario for the global banking system is the collapse of the entire financial system. But the situation is not as grim as there is still scope to further reduce interest rate, the government can guarantee for creditors or to directly buy assets. However, if policy interventions fail to lift up the expectations, any amount of resource injection into the financial system may fall into the Keynesian liquidity trap. Similarly, as the recent Japanese experience has shown, very low or even negative interest rate may fail to trigger aggregate demand. Fortunately, the newly installed Obama administration appears to have rekindled hope in the United States. In his campaign speeches and also recently president Obama has committed tax reform to the benefit of the poor and the middle class. Furthermore, he has also promised to bolster spending on infrastructure. But still, the current scenario does not completely preclude the fear of deflation. The pressure on the US administration to intervene began to emerge from the early 2007. Around July/August, 2007; the US president George Bush rejected the increasing requests for government intervention to ease the crisis in the home mortgage market and kept his strong faith on the ability of market to clear the financial mess.
But the crisis began to so deepen that he later pledged help for struggling home owners to help ease the mortgage crisis. But, as the situation began to worsen further, the White House on September 19, 2008; requested for $700 billion bailout plan for all financial firms with bad mortgage securities to free up tightening credit flow. The House of Representatives on September 29 rejected the mammoth bailout plan. On October 1, the US Senate adopted the plan by adding sweeteners to get House acceptance. With such bail out package, the Fed and central banks in the west are moving rapidly from a lender of last resort to an investor of the last resort. The $700 billion figure was the limit set for acquisition of the troubled assets, whose total value has been guesstimated at upward of $3 trillion. This figure would have been even higher had the US Treasury been given the discretion to add any other assets it considered worthy of similar support. It should be expected that the money would be used to buy the worst assets and “unclog” the system so that the less impaired and frozen securities can find their values. The private financial sector too strongly lobbied for such a move since the worst assets are the securities they want off their books. This implies that $700 billion is enough to clear the mess of these securities though the basis for that assumption is by no means clear. On December 2, 2008, the US Federal reserve announced a new package of another US Dollar 800 billion in addition to the $700 billion announced by the George Bush White House. The cost of rescuing the financial system has now risen to US Dollar 1.5 trillion, or an astonishing 10 percent of the US GDP. Of the latest $800 billion package, the Fed will use $600 billion to buy the mortgage-backed assets and the remaining $200 billion is to be used to support consumer and small business loans. This paper dealt at length about the US and partly with the European crisis. This does not mean that the rest of the world is immune from the crisis. Countries such as Japan, Russia, Singapore are also feeling the pinch of the crisis. It has also spread to countries near our home to India, China, and Pakistan.
The question that now arises is the manner in which prices of these securities to be acquired are set. The bailout plan seeks to use market-based methods, including reverse auctions in which sellers looking for a buyer bid down the price at which they are willing to sell their assets. Since the most impaired securities are near worthless, their prices should be closer to zero for every dollar worth of such assets in terms of their accounting or par values. Setting them there would also permit the government to acquire a substantial volume of securities when seeking to unclog the system or to even save a part of tax payers’ money it is authorized to spend to achieve this objective.
The current crisis is an important event in the economic history of the world. This event has been generating political, sociological and economic debate. This article, however, confines to draw lessons from economic stand point. The first lesson is that we live not in a Robinson Crusoe’s but in a globalized economy where development in one place affects all over the world directly or indirectly. What this calls for is the need for every country of an institution which can closely monitor the global economic/ financial developments and timely warn the national authorities for precaution. Financial institutions were considered as backbone of the US economy which now many believe is in the verge of collapse. There was a general belief that the self-interest of lending institutions would automatically protect shareholders’ equity and that market left on its own has in-built self correcting mechanisms. But in this crisis, the financial markets failed to work, rather contagion crossed the US border and affected financial institutions in other countries which had a big exposure to US sub-prime based mortgage securities in expectation of windfall profits.
The current experience suggests that given market imperfection characterized by asymmetric information, adverse selection and moral hazard; the market on its own is not self correcting. Therefore, for all the markets in general and for the financial market in particular, there is a need for accountable oversight, regulation, supervision and disclosure requirement. This new experience suggests that the pace of reform needs to be regulated by the decision makers. Regulators and policy makers have to think of reform in term of benefits that will accrue not only to the well off and fraudulent speculators but also to the small investors and household depositors. Another lesson is that bailing out, rather than punishing the chief executive officers (CEOs) and chief financial officers (CFOs) who earned billions at the cost and misery of the common people all over the world may result in moral hazard and set bad precedence.
The central bank and all the public policy makers and regulators have been found to be focusing their attention only on the consumer and wholesale inflation. The undergoing financial crisis has taught us that as the economy advances financially, asset prices (the price movement of real estate, stocks and debts) are more important; hence movement in asset prices should also be made the policy target. For economies like Nepal which is in its early stage of modernization, the central bank, the government and the media needs to constantly monitor the asset portfolio of banks and financial institutions, particularly to real estate, stock market and consumer lending. Those who play on public money need to be closely monitored, and the management and the board who are found to be involved in reckless lending practices should be made personally liable for any loss they can inflict on the owners of the money that they play with. The bail out has been an example of privatizing gains and socializing or nationalizing losses. This should teach us a lesson that such perverse situation does not recur in future. This means that designing complex products like CDOs and CDSs should be subject to prior public approval. What is surprising is that the crisis originated in countries that are advanced, highly literate and have access to varieties of information including on the financial developments. If people in US, UK, Switzerland, and Germany can be cheated, there is apprehension that the mass of illiterate and uninformed Nepali people can easily be cheated. What this calls for is the need for financial education financed by the resources made by huge profit making financial institutions. Still another lesson is that dependence of the global economy into a single economy entails risk. This lesson may contribute to lessening of the over dependence of the global economy on the US economy.
Since the late 1970s, and more particularly since the 1980s and 1990s, there had been a paradigm shift in economic development strategy. The shift suggested too much emphasis on export led industrialization.
This strategy worked for east, and south east Asian countries and recently for Indo-Chinese countries, in particular, Vietnam. These are the countries which are worst affected from the current crisis, and are planning to encourage domestic demand. In the same vein as consumerism as a mode of life provided the initial basis for eruption of the crisis, unbridled consumerism fuelled by unsustainable fiscal deficits needs to be monitored.
Similarly, the c rrent crisis also teaches us the virtue of enhancing domestic savings. Thus, while planning growth strategy for Nepal, the policy makers should take this lesson in the back of their mind.
Finally, people are also raising philosophical question of whether finance and money should be means to some other ends or are an ultimate end in themselves. This question is worth pondering as the current crisis emerged not from the real but from malfunctioning of the financial sector. The economic and political policy makers need to deeply reflect on the role the finance needs to play vis-a- vis the rest of the economy, particularly to the real economy.