We are far away from the the protectionist, economically isolated world of FDR and the New Deal. More complex international financial transactions and spillover effects among national economies require a reform of the way policy is conducted, both at the international and national level. The longstanding refrain of Catholic social teaching for global solidarity in the formulation of public policy has never been more relevant.
As the downturn continues, policy makers around the world are slowly learning three important new lessons about global finance and adjustment in the “real” sectors of their economies (in particular, production, employment, consumer demand, and investment). The first lesson is about the global nature of the crisis, the second is about dangers of financial complexity, and the third is about the structure of policy-making in the new, more complex global environment.
All of this will take time, of course. National leaders quite rightly are concerned with putting out the immediate fires of rising unemployment and financial collapse in their respective countries. But there is a lesson to learn from the last century. In March 1942, soon after the United States entered World War II and well before V-E day was in anyone’s mind, a consultant for British Treasury journeyed to Washington to meet with the U.S. Treasury to begin plans for post-war German and European reconstruction. While FDR, Churchill, and Eisenhower were fighting the war, John Maynard Keynes was setting up the post-war economic and financial framework.
We need forward-looking thinking and debate about new structures of international finance and policy coordination. We cannot fully prevent crises, to be sure. But having a more effective global structure for oversight and policy-response will go a long way toward reducing the costs of such crises.
At a recent meeting of the Latin American and Caribbean Economic Association (LACEA) in Brazil, a panel of central bank governors from the region had the consensus view that we are in for a protracted global recession with even harsher consequences for the emerging-market countries of Latin America than for the industrialized countries of North American and Europe. The reason is twofold: First, demand for their exports will decline sharply, and second, so will investment in Latin America, as investors flee to safe and secure short-term government securities in their own home countries.
What is especially troubling is that most Latin American banks were not players in the mortgage-backed securities trade, yet many Latin American countries, culpable or not, are bearing the consequences. For countries in the developing world, when it rains, it pours.
In a world of global trade and financial linkages, focusing on each country’s fiscal stimulus package in isolation may be missing the point. Recovery in the United States may depend more on what China and the emerging markets of Asia do with their exchange rates and financial market regulations, than on what Obama does with his budget or Congress does with the industrial bailouts. In a context of strong global linkages, responding to a truly global recession will require global policy coordination and planning.
Guillermo Calvo of Columbia University once described the reluctance of China and many other emerging market countries, particularly in Asia, to let their currencies appreciate against the U.S. dollar as the “fear of floating.” For the rest of the world, he notes, this fear of floating in Asia translates into a “fear of sinking.” Asian countries have an unusually large amount of dollar reserves, but they should not brag too much about their reserve accumulation. The time has come for them to start spending these reserves. The advice to save for a rainy day does not imply that we should save even more when it does rain.
Saying that a global downturn requires global oversight and policy coordination, of course, does not make much difference if we do not have a framework, much less effective institutions, for coordinating policy in a time of crisis. We have international institutions that are very much alive, finding ways to justify their continued existence by providing new and different services, but they are incapable, by their very charter, of providing an effective base for global oversight and policy coordination. The Bank for International Settlements (BIS) in Basel was set up to administer the Dawes-Young Act for the German Transfer Problem after World War I. The International Bank for Reconstruction and Development (IBRD), or World Bank, and the International Monetary Fund (IMF) were set up to administer the Bretton-Woods fixed exchange rate system after World War II. The Organization for European Cooperation and Development (OECD) was set up by the Marshall Plan.
The global nature of the crisis has also made it hard to estimate or predict how deep or how protracted this crisis will be. The famous mortgage-backed securities were packaged and resold, and then guaranteed by other derivatives through swaps in a world-wide market. Different countries have different accounting and auditing practices, reporting obligations, and regulations, so finding out the true extent of the damage will take time and a considerable amount of expertise. How much has been lost, and how much it will take to restore the normal stability of the financial sector across the world, are anyone’s guess.
When in the late 1940s and early 1950s penicillin hit the market, medical doctors readily gave injections of penicillin to almost anyone, including small children, suffering even a common cold. Penicillin was the wonder drug to be used in any and every case. The result, of course, is that we have multi-millions of baby boomers allergic to penicillin. At the time, the regulatory authorities were not showing proper and due diligence in testing the drug before allowing its widespread use.
A similar argument can be made with respect to the current financial derivatives mess. Regulatory authorities, housed in different and perhaps competing agencies, simply did not understand the potential losses of permitting widespread use of these instruments, too often by less-than-astute practitioners.
Those who developed and studied derivatives as a tool for risk management know all too well their limits. In statistical decision-making, when we talk of significance of risk factors, we usually take any result above 1 percent or 5 percent very seriously. What we are concerned about is not the probability itself, but the expected loss, the probability multiplied by the underlying value at risk.
Why then, did the issuers of derivative securities not pay more attention to the expected values at risk? There are many reasons, one, of course, being greed. Make money by selling the asset and get out just in time, before the expected loss. Another compelling reason, suggested by Patrick Honohan of Trinity College, Dublin is that many people who worked with these securities did not know their limits and how to interpret the signals of underlying risk. Whether due to greed or ignorance, the result is the same.
The danger of over-reaction, of course, is ever present. Antibiotics were not banned after the indiscriminate use of penicillin in the 1950s. Yet there is a very real possibility, perhaps inevitability, that financial authorities across the globe will now ban derivatives and thereby prevent their legitimate, limited, and helpful role in financial markets. Along with big government spending, regulation will be back big time.
The basic lesson is that the introduction of more complex financial contracts in transactions, especially international transactions, requires much more care. This means better education for the professionals using these contracts and more oversight on the use of these contracts, with limits on the overall exposure to downside risk.
One of the key questions being asked by international observers is why the Treasury and the Board of Governors of the U.S. Federal Reserve System were so inept in responding to the onset of the crisis in September 2008. After all, it is not as if there were no early warning signals. In August 2007, major central banks rapidly injected cash into troubled banks across the world, as the first signs of a mortgage-backed security crisis emerged, when banks refused to lend even to each other.
Why were the Treasury and the Fed so unprepared? One reason, suggested by Christopher Sims of Princeton University, is that we take it as a dogma of political economy that the central bank or monetary authority of a country should be independent of the national Treasury or Finance Ministry. Economists have long advocated this independence, because too often central banks that reported to the Finance ministry or national Treasury were forced to print money to make up for tax revenue. The result was high inflation and macroeconomic instability.
In a time of crisis, however, things are different. The central bank cannot simply print large amounts of money to bail out banks and related financial institutions. Such a bailout is a quasi-fiscal activity. It requires that the money for such actions be raised by the Treasury issuance of government bonds, with Congressional approval for raising limits on national debt. Yet the Federal Reserve only seemed to start talking to the Treasury in September 2008, and the joint response did not impress the U.S. Congress or the international financial community, which only compounded the uncertainty in the markets.
The Treasury’s and the Fed’s lack of preparedness for the crisis is akin to the U.S. intelligence community’s lack of preparedness prior to the September 11 terrorist attacks. Each organization was used to doing its own business, in its own way. Just as we have seen the creation of the Department of Homeland Security and the appointment of a Director of National Intelligence as belated responses to correct the earlier lack of intelligence coordination, we will likely see similar mechanisms put in place to promote coordination and planning between the Federal Reserve and the Treasury Department.
Clearly the new administration has a lot on its menu. Let’s hope that the policy makers and members of Congress do not take too much inspiration from the heyday of the New Deal. Keynes journeying to this country to meet with the Treasury in March 1942 to plan postwar global finance is a powerful reminder that long-term planning is very important, even in the midst of a major crisis. If not, we will have more to fear than fear itself. Global solidarity matters now, more than ever.
Paul D. McNelis, S.J., is Robert Bendheim Professor of Economics and Financial Policy at Fordham University's graduate school of business administration.