For all the talk of greed, fraud and excesses in the analysis of what went wrong and how it caused global capitalism to suffer one of its worst crises in almost a century, one would have expected at least as much talk about the fundamental causes of the crisis. Those causes are rooted in US economic policymaking dating back to 2001. The burst of the housing market bubble in the US, which took the prices of other assets like stocks and corporate bonds with it, should not be looked at independently of the dotcom bubble burst in 2001. Indeed, the seeds of the housing market bubble were planted in reaction to the dotcom bubble burst, which ushered in one of the strongest policy easing responses the US market has ever witnessed, an expansionary monetary policy, very low interest rates and an easing of constraints on credit growth.
The reasons behind the massive easing may have been justifiable at the time; the burst of the dotcom bubble threatened to inflict huge losses on the American private sector due to its overexposure to the stock market. The events of September 11 aggravated policymakers’ fears that a combination of wealth effects, plus loss of confidence, could have disastrous effects on consumer spending and hence investment. Of course, under normal circumstances easing could indeed stimulate investment. But the US economy, coming out of a long productive period, was already over-invested and so the extra money was not put to productive use. Instead, it helped inflate the price of another asset: real estate, which was the easiest candidate in light of low interest rates and further financial deregulation.
Policymakers were not unhappy to see housing prices rise fast. In fact, there was a strong need for another asset to rise in value in compensation for the wealth lost in the stock market and for the confidence lost after September 11. But a fast rise in housing prices brought both the speculators and the subprime buyers into the market, which fueled the bubble even more and made the housing sector vulnerable to a sudden reversal. This was all but guaranteed in light of the monetary tightening that was later adopted to control inflation. The dynamics that came together to set in motion the expansion were reversed and caused an equally steep contraction. Poor regulation and excessive leverage guaranteed that the crisis spread to the banks and hence to the rest of the economy, while globalization and financial linkages guaranteed its spread to the rest of the world.
The implications of the crisis will be severe. The developed countries, especially the US, have yet to see their housing prices bottom out, which will be the first step to bringing the skeletons out of the closet. The late but definite understanding by US policymakers of the breakdown of the monetary transmission mechanism (i.e. the inability of low policy rates to translate into lower term lending rates) and hence their shift to direct intervention through the purchase of bad assets as well as the injection of capital into banks, should help the credit cycle take off again in time. The massive infrastructure upgrade proposed by President-elect Obama is surely the correct, massive fiscal response needed in times like these. But just like monetary policy, fiscal policy will need sometime to be transmitted. As a result, we are surely looking at weak, most likely negative, growth in 2009, while the house is put back in order.
The developing world
The implications of the crisis on developing countries may be less severe in the short-term, but may have longer- term implications. The strongest implication has to be the end of the “decoupling myth,” the belief held over the last couple of years that emerging markets, particularly the big four (China, India, Brazil and Russia) have decoupled from the US and are hence capable of carrying world growth on their own. The collapse of world trade and with it commodity prices, the withdrawal of foreign portfolio investments, the freezing if not reversal of foreign direct investments and the expected steep decline in global remittances are all factors that make emerging markets look quite vulnerable at this stage. Of course those with high current account deficit, and hence balance of payments funding needs, will be the ones to show the first signs of strain as we have seen in Eastern Europe.
How long it will take for the world to emerge from the crisis depends to a great extent on how quickly the credit mechanism is restored within the US and globally. One thing to keep in mind, however, is not to repeat the mistakes of 2001. Creating an alternative bubble is not a sustainable way to handle the burst of a bubble. A related and equally important lesson is that fast credit growth and financial innovation have been given significantly more weight than sustainable credit growth and financial stability. A model of capitalism that reassigns weight in favor of sustainability and stability may be one of the few good outcomes of the crisis. Hopefully another good outcome is the restoration of basic economic fundamentals, of basic banking principles and of the basic code of conduct and work ethics. That may be the only way for capitalism to save itself. And that it must, for no viable alternative is yet available.
MAZEN M. SOUEID
is chief economist at BankMed