Photo: Bloomberg
Photo: Bloomberg

Seven years of global financial crisis

Asset bubbles led to a leveraged consumption binge that, in turn, created an unsustainable growth bubble

The collapse of the investment bank Lehman Brothers on 15 September 2008 following a fatal misjudgment by the US government that it was not big enough to warrant a bailout rapidly morphed into a credit freeze in interconnected global financial markets. A global recession followed.

An empowered Group of Twenty (G-20) nations led an unprecedented, coordinated and aggressive economic policy response to the escalating crisis. Largely credited for the V-shaped recovery that followed, the G-20 jumped the gun at its third summit in Pittsburgh in September 2009, declaring victory when past history pointed to long and painful recoveries from financial crises.

This time was no different. The green shoots of 2009-10 yielded to a protracted double dip from which the world is still recovering. The crisis spread from the US to the euro zone, and finally to so-called decoupled emerging markets, led by China, widely expected to cushion the global demand shock.

The global economy continues to wobble in the strong wake of the biggest crisis since the Great Depression, characterized as the Great Recession or the Great Stagnation. The optimistic forward-looking growth forecasts of the International Monetary Fund (IMF) presented at its spring meetings in the form of the World Economic Outlook have been revised down in subsequent quarterly updates each year. The year 2015 is no different. Where did policymakers, especially the G-20 and the IMF, go wrong?

The defining mistake was to have initially treated the crisis as just another business downturn. The problems were much deeper, and structural: too much leverage, facilitated by lax financial regulation and easy monetary policy, and unbalanced global demand. This policy error is surprising since the root causes were correctly diagnosed early on during the crisis.

Macroeconomic policies cannot fix structural fault lines. Indeed, they can exacerbate them. This is exactly what happened. While financial regulation was tightened, easy monetary and fiscal policies ensured that there was little deleveraging. Countries that needed to expand consumption—especially China—expanded investment instead, and those that needed to expand investment—such as the US—tried to stimulate consumption by replacing private leverage with public. In the euro zone, too, more liquidity was thrown to douse out a fire caused by a structural flaw—a monetary union without fiscal and banking integration. In short, a crisis caused by leverage and an asset boom was quelled through more leverage and another asset boom.

With the roots of the crisis remaining unaddressed, is it surprising that both the fault lines and the underlying crisis remain with us, even as stimulative macroeconomic policies continue to push on a string. The IMF’s latest Surveillance Note for the G-20 finance ministers and central bank governors meeting in Ankara on 4-5 September advises them to continue pushing.

The danger signals that there were deep structural problems in the global economy were there in full view long before the crisis erupted, in the form of anomalies for which standard economic textbooks had no explanation. Labour participation rates were declining and real wages stagnant, and yet consumption was booming in one part of the world. Consumption was stagnant, but growth was booming in another part. High growth and low consumer price inflation seemed to coexist peacefully, confounding central bankers and undermining the widely used Taylor Rule. Asset price inflation became a one-way street as it became the target of monetary authorities only when it went into negative territory—the central bank put.

Asset bubbles led to a leveraged consumption binge that in turn created an unsustainable growth bubble. Once the asset bubble was pricked, with the sub-prime housing crisis in the US, growth eventually collapsed.

It is not that that the macroeconomic policy response under the aegis of the G-20 was entirely inappropriate. When economies go into freefall, an aggressive economic policy response is warranted. But these are short-term hormones whose protracted use is destabilizing. They need to be phased out quickly. For a long time, it seemed that the G-20 was bent on recouping the output lost calculated with respect to the unsustainable growth rates of 2003-07.

The Bank of International Settlements’ sage advice to a administer short-term shock through rapid deleveraging was never considered, as this was politically inexpedient. Public debt in major advanced economies has now reached unsustainable levels that has damaged growth in the past; their central banks have trapped themselves into a corner through zero-bound interest rates and unprecedented expansion in their balance sheets that they don’t quite know how to unwind; and whereas before the crisis asset price inflation was out of sync with consumer price inflation, it is now out of sync with economic growth as well. The demand dividend remains elusive despite the continuing central bank put.

It is only in the action plans of the last few G-20 summits that there has been serious focus on some of the difficult structural reforms that go to the root of the problems in the global economy, even as economists flounder in comprehending the new architecture of globalization and reorienting their discipline. But the ammunition to cushion the shock of what are undoubtedly politically difficult reforms has long been exhausted as have they run up high levels of public debt in trying to consume their way to high growth. Since emerging markets remain dependent on demand in advanced economies they cannot escape the strong wake.

Alok Sheel is a civil servant. These are his personal views.

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