Major crises always come out of distortions. At the level of the global financial system, the basic problem has been the undervaluation of Asian(managed) exchange rates that have led to trade deficits for Western economies, forcing on them the choice either of macro accommodation or recession. The choice of easy money policies results in excess liquidity, asset bubbles, and leverage. Distortions always come through major crises. In the global financial system, the problem has been drawing in the undervaluation of Asian-managed exchange rates which is leading to trader deficits and forcing the choice of macro space or recession. The basic lesson of the past solvency crises is that three steps are always required:(1) Insure all relevant deposits during the crisis to prevent runs on banks. (2) Remove the “bad assets’ from the balance sheet of banks. (3) Recapitalize the asset-cleansed banks.
Micro side and principal agent pertinent issues: At the micro level regulatory, tax, and structural distortions create principal-agent problems. Principals are taxpayers, shareholders, bondholders, and depositors. The agents are central banks, regulators/supervisors, treasury/tax/competition authorities, and CEOs/Boards of companies, especially within banks. The agents together have failed the principals by creating incentives that lead to excess leverage, too little capital, and the formation of systemically important companies. The mixing of equity and credit culture in this process, and the incentive to maximize private benefits through excessive risk-taking while socializing much of the losses, has led to the biggest crisis since the Great Depression and a massive bill for global taxpayers. But the lessons were not learned. In essence, it is a solvency crisis, and that has led to liquidity problems and deleveraging that is bearing down on the economy.
Phases to exit the issues: There are a number of phases in dealing with such a crisis. Some of this follows the standard psychological paths, and this has certainly been a strong feature of the current crisis: shock and denial in the early stages i.e. particularly by the agents such as banks and policymakers; blame, as disowning becomes less defensible; then anger and/or depression i.e. particularly by investors and taxpayers. It is at this latter stage that crisis measures to minimize the impact on the real economy really get underway. Proper reform, however, requires acceptance of past mistakes and hopes for a better future returning. Crisis measures need to be accompanied by genuine reform of the regulations and other incentive structures that caused the crisis. Finally, exit strategies from the emergency measures towards a sustainable long-term financial system. This latter phase will require some very careful thought about the issue of “exit back toward whatever”. It would be entirely inappropriate to exit the principal-agent structure that led to the crisis in the first place.
Avoiding tendency and crisis remain in different stages: The countries involved most in the crisis remain at quite different stages. Most transparent disclosures are obvious, both in its financial reporting and with its recent stress tests and policy measures. Others remain in aspects of denial about the crisis perhaps with a view to keeping markets calm or because poor reporting standards make it hard to know how concerned one should be. While keeping markets calm always has some merit, there are costs, too, which come from trying to minimize the crisis and not getting to the stage of genuine reform. Governments will always throw enough money at the problem as the economy is hit, and should succeed in generating a government-spending-tax-led period of positive growth. But this carries risks for the future, including that of a double-dip recession and/or another major financial crisis in the longer run.
Assets risk and difficulties in valuation: If bank assets have been cleansed in anyways will private investors participate in recapitalization? Key issues in dealing with impaired assets, there are a number of key issues to think about when dealing with impaired assets, some of which are quite different this time compared to previous crises. The assets are especially difficult to value. This is less so for standard- non-performing loans on a bank’s balance sheet, but very much the case for securitized assets much of which sit in off-balance sheet conduits. The reasons for this are twofold: (i) they are not traded in an open market, and so price discovery via supply and demand flows is not present; (ii) and while some securities and conduits are conforming in the sense of being single-name pass-through certificates that are rated and can be valued on the basis of underlying mortgages, other assets. Because of great uncertainty about valuation, the risk to the taxpayer of buying at too high a price in the emergency measures phase is quite high. It must be stressed that the canals are a special feature of this crisis. It is not simply a matter of cleansing the observed balance sheet assets, if the canals are unconsolidated vehicles of the banks, they must be dealt with too if solvency and/or liquidity problems arise in special purpose vehicles.
Thinking and creditability: The financial markets are looking for credible crisis response policies that fit together and are also consistent with longer-run economic goals. Crisis measures should be consistent with a sensible approach to „exit‟ and with sustainable long-term strategies. Actions to deal with the crisis now will be more credible to the extent they are consistent with long-run goals or at least are
accompanied by a clear strategy and timeline for making it so later on. The long-run goals include the effective balance between prudential risk control and competition; competitive level playing fields; open investment markets; transparency in corporate structures and reporting; and reduced agency problems
through better governance. These objectives are concerned with realigning incentive structures to minimize the chances for crises of this sort to recur in the future. However, in the near term, they will need to be pursued in a manner that does not exacerbate deleveraging or inhibit lending, which would worsen the impact on the economy. Striking the right balance between the near-term and the longer-run goals is needed to reinforce credibility and instill confidence in financial markets.
The impact on the real economy vs. the impact vs. dealing with the financial crisis: Inadequate capital forces banks towards deleverage and in a situation of financial stress to tighten lending standards. This has already had a devastating effect on the economy. Banks are obliged to cut lending, including to sound businesses and credit-worthy consumers. As people lose their jobs they are unable to meet their financial obligations, and this leads to further loan impairment and drops in asset prices. Deleveraging accelerates. The vicious circle turning through falling asset prices, the economy, and the financial system will continue to worsen. The impact on the real economy from a credit crunch is rapid and powerful. One way to think about this is in terms of the inflows and outflows from the unemployment pool. Stopping the inflow of unemployment should be the main priority, and this means arresting the deleveraging process as quickly as possible. This is a priority because small and medium enterprises (SMEs) are responsible for huge numbers of jobs and are more highly dependent on banks having little access to the capital market. Spending policies to raise the outflows from unemployment, such as fiscal spending, are very important, too, but can take a long time to get underway and spending and tax multipliers are likely to be low in the current uncertain environment. To stop inflows to unemployment via deleveraging removal of impaired assets and recapitalization is crucial. It will not help to deny losses or to define them away with accounting changes and special purpose vehicle „tricks‟. Bank management and sophisticated investors will focus on the underlying situation, which must be dealt with before intermediation and the ability to invest safely in banks returns to normal – why, for example, would investors buy any bank shares with hidden problems that will be a drain on earnings for years to come. Aggressive priority to the financial rescue and the cleaning up of impaired assets is the most effective way to do this. This requires a strong global effort. While the cost of the crisis must be socialized via the taxpayer, these costs must be contained by sensible steps that avoid creating new private benefits to special interest groups, anti-competitive market structures, and protectionist sentiment.
Reform and exit strategy: For the longer run, budget deficits are projected to rise country’s gross financial liabilities are expected to rise too. Budget deficits have to be reduced and the loans, guarantees, and investments on the public balance sheet have to a very large extent to be transferred to the private sector. This cannot be achieved without major shifts in financial prices interest rates and exchange rates during the exit strategy phase. It is difficult to see this process being completed within a few time. The design of crisis measures cannot be divorced from thinking about 'exit' and the sustainability of the strategies undertaken. The more that policy actions to deal with the crisis are consistent with long-run goals, or at least accompanied by a clear strategy and timeline for making them consistent later on, the more markets will judge these actions as credible. Credibility also requires these aims to be achieved in a manner that does not exacerbate deleveraging and its rapid negative impact on the economy. The most important considerations of such a strategy are (i) the order in which things are done, and (ii) favoring choices that will promote positive adjustment where feasible. Some issues along these lines are set out below, touching on financial markets, competition, corporate governance, savings, and investment issues.
Concluding remarks: Central banks across the world simultaneously hike interest rates in response to inflation, the world may be edging toward a global recession in 2023 and a string of financial crises in emerging markets and developing economies that would do them lasting harm. Global growth is slowing sharply, with further slowing likely as more countries fall into recession. It is a deep concern is that these trends will persist, with long-lasting consequences that are devastating for people in emerging markets and developing economies. Tightening monetary and fiscal policies will likely prove helpful in reducing inflation. Policymakers will need to join in the fight against inflation particularly by taking strong steps to boost global supply other required actions are easing labor-market constraints, boosting the global supply of commodities, and strengthening global trade networks.
Daily Messenger/MI
