The world saw a crisis coming. Just not this one. The widening US external deficit and the growing surpluses in China, Japan and other countries reflected major global imbalances that would eventually wreak havoc on the world. Some analysts predicted that the world would grow tired of funding the US deficit, causing the dollar to plunge, long-term rates on treasurys to skyrocket, and the US to go into a tailspin, bringing down the world.
A crisis did finally occur, but neither the dollar nor US treasurys tanked, yet things got really nasty anyway. The initial response to the crisis saw an unprecedented injection of liquidity by the Federal Reserve that was designed to normalize credit markets, but which others feared would cause inflation. Neither took place. Instead, things got worse.
So, what seems to be the problem? The best interpretation is that the 2008 aggravation of the crisis was triggered by major equity losses in key financial intermediaries, associated with a moderate correction in asset prices. These losses caused a rise in counter-party risk, triggering a major disintermediation process as investors fled towards safer assets. In the process, financial links were broken and spending collapsed precipitously.
During the previous boom years, the financial industry had become more concentrated (in terms of the number of players), more leveraged, and more globally diversified (in terms of assets), so that problems in the main players would be systemically large and have global impact.
So, what seems to be the game plan for dealing with the crisis? The investors’ flight to quality means that those issuing the safe assets are left as the sole remaining super-borrowers. These super-borrowers—the US and Japan, mainly—are the only ones left to re-establish financial links and rewire the system. Up to now, this has had two legs: propping up aggregate demand directly through fiscal reflation, and recapitalizing the banking system.
In the US, the recapitalization and reflation is planned mainly for the domestic economy. But the solution, to be effective, should also have a global character. Restarting the global economy through a widening of the US external deficit is not the best way forward.
A more sustainable alternative is to use the super-borrower capacity to reflate the global economy and to re-establish financial links globally. This can be done in several ways. First, multilateral development banks should be recapitalized—by issuing guarantees in the form of callable capital—allowing them to raise funds in global capital markets to lend to the developing world.
This would allow developing countries to compensate for the lost access to private markets. Loans should be disbursed quickly and conditional only on an ex- ante assessment of the soundness of their macro stance. They should be made in an amount sufficient to prevent the inefficient, pro-cyclical contractionary fiscal adjustment that is being caused by the lack of access to finance. Part of the capital raised could be invested in a diversified portfolio of private emerging market assets to provide for this asset class—what Ben Bernanke is doing to the US variety.
With this strategy, a global fiscal reflation can take place by preventing inefficient cutbacks in the countries shut out of finance because of the global crisis instead of relying solely on expansion in the structurally weak US fiscal position. Second, IMF should also be recapitalized so as to make sure that it has more than enough funds to help reconnect countries to finance.
The goal should be to convince countries that are currently hoarding large amounts of international reserves as insurance against future crisis that they need not sit on so much liquidity because they will have ample access to contingent funds if needed. This will allow countries to adopt policies that are more supportive of a global reflation effort.
If capital markets are impaired, the global and regional international institutions need to step up to a much bigger plate than is currently being envisioned.
Edited excerpts. Printed with permission from www.VoxEU.org. Ricardo Hausmann is director of Harvard University’s Center for International Development. Comment at firstname.lastname@example.org