Post on 08-Apr-2018
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Global Financial Meltdown
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ACKNOWLEDGMENT
I take the opportunity to express my profound sense of gratitude and respect to all those who
helped me through the duration of the project It was a great opportunity for me to work on
this project and learn about the subject. I would like to thank my project guide Mr. RakeshDahiya, Assistant Manager, Sharekhan Ltd., who has been a constant source of inspiration for
me during the completion of this project. He gave me invaluable inputs during my endeavor
to complete this project.
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Tab l of content
1.
Introduction 5
2.
Causes of Credit Crisis 11
3. Global Transmission of the Crisis 25 4.
International Response 28
5.
Impact of crisis on trade of goods and services, remittance and tourism and FDI 30
6.
Some Facts and Figures 34
7.
Scale of Crises and Bailouts 44
8.
The financial crisis and wealthy countries 50
9.
Asia and the financial crisis 56
10. Global Meltdown and its Impact on the Indian Economy 59
11. Africa and the financial crisis 7012.
Latin America and the financial crisis 72
13. .A crisis in context 74
y
A crisis of poverty for much of humanity
y
A global food crisis affecting the poorest the most
y
Poor nations will get less financing for development
y
Odious third world debt has remained for decades; Banks and military get
money easily
13. A crisis that need not have happened 78
14. Dealing with recession 85
15. Rethinking the international financial system? 89
y
Reforming international banking and finance?
y
Reforming International Trade and the WT O y
Reforming the Bretton Woods Institutions (IMF and World Bank)?
y
Reform and Resistance
16. Rethinking economics? 103
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I NTRODUCT I ON
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I ntroduct ion
A year ago, the prospects for Emerging Economies (EE) looked very promising. There were
concerns about the effect of a shallow recession in the United States, but the general perception
was that Asia, the largest regional emerging market group, and Latin America, the second largest,
as well as other regions were doing well. In a wishful way most thought they had ³decoupled´
from the advanced economies, and wealth would grow with few restrictions.
Surely, policies had been conducive to significant improvements in fiscal and external balances,
with a few exceptions, and international reserves were at record levels. Policymakers feltcomfortable. Commodity prices were expected to continue going up, foreign demand, including
among emerging market economies, was strong and there was no serious worry about financing
as creditworthiness was solid. Problems were hitting only the United States and a few other
developed countries.
Since then, the financial crisis which the world is suffering most likely has become the worst in
the last fifty years. Some analysts consider that its intensity is equivalent to that of the Great
Depression of 1929-33. That crisis was the worst of modern times, and reflected previous
excesses and subsequent incompetence. Although the comparison with the Great Depression is anexaggeration unjustified by the facts, the damage caused to the world economy is enormous. The
complex and wide-ranging interaction between the financial world and the real economy as a
result of the present turbulence already has begun to have serious consequences for the emerging
economies, and the prospects for a fast recovery are more remote by the day.
Whereas the conditions in the financial markets have tended to stabilize from the unsustainable
position of September- October of 2008, the real economy is weakening and the prospects for a
recovery can only be envisaged for late 2009 or early 2010. In different ways, Emerging
Economies were initially able to absorb the initial impact of the crisis on account of the
considerable progress in recent years in consolidating economic performance. Nevertheless, this
group of countries is experiencing mounting difficulties. The difficulties are significant in Asia
and Latin America, but more so in Eastern Europe and Russia, as they were even more dependent
on credit and high export prices respectively.
The previous sense of strength and invulnerability is now gone. Commodity prices have declined
by about one half from their peak; demand for manufactured goods is declining sharply all over
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the world; stock market valuations have declined by about one half or more; and currencies in
many emerging countries have depreciated, as capital flows reversed seeking to find a safe
heaven. Governments were reasonably careful with their policies, but private enterprises held
³toxic´ assets to an unexpectedly large extent, with serious effects for their own financial health
as well as that of their countries. The loss of financial wealth is enormous, and the consequencesfor the economies of the world, will be unfortunately commensurate.
The authorities and economic agents were initially taken by surprise by the collapse. Now they
are responding to the challenges caused by the rapidly deteriorating external environment.
However, there are serious economic and political stumbling blocks that may well cause the
recovery to be costly and slow to consolidate. This paper reviews the origins of the current crisis
and the impact on emerging market economies, but focuses mainly on Developing Asia, the
NICs, and Latin America in the context of the global crisis. While the inclusion of Latin America
may seem extemporaneous to some, it is fitting to include it as the region has a GD P of US$4.4
trillion, somewhat larger than that of China, and about 2/3 of that of developing Asia, which has a
GDP of US$7 trillion, according to IMF data. No other region comes close to these two areas in
terms of size, and common characteristics in terms of development. Furthermore per-capita
income in Latin America is more than double that of Developing Asia both in current and PPP
terms. The paper also discusses what can be realistically expected in the short and medium term,
as financial volatility and recessionary forces may continue to prevail for a while.
The global financial crisis, brewing for a while, really started to show its effects in the middle
of 2007 and into 2008. Around the world stock markets have fallen, large financial
institutions have collapsed or been bought out, and governments in even the wealthiest
nations have had to come up with rescue packages to bail out their financial systems.
On the one hand many people are concerned that those responsible for the financial problems
are the ones being bailed out, while on the other hand, a global financial meltdown will affect
the livelihoods of almost everyone in an increasingly inter-connected world. The problem
could have been avoided, if ideologues supporting the current economics models weren¶t so
vocal, influential and inconsiderate of others¶ viewpoints and concerns.
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Recent evo lut i on of the wor ld econom ic env ironment
Over the last decade, Asian countries were able to emerge from the serious crisis that had brought
many of them down in the late 90s. Helped by the consistent growth of China, and to an
increasing extent India, the Asia region witnessed a stellar performance. Con currently, after a
period of low economic growth, persistent crises, and high volatility that extended through the
1990s, Latin America made a very strong recovery. Inflation declined; the fiscal accounts and
monetary policy showed great strength; international trade boomed; poverty declined; and the
external accounts were much sounder than they had been in decades.
Within this overall positive picture, not all countries acted in a similarly prudent fashion. The
limited initial impact of the financial crisis gave rise to a false sense of security that has now
disappeared. The crisis is now in the open, as the impact on the balance of payments and on
domestic activity becomes very serious. The adverse terms of trade effect will aggravate the
situation, compounded by a massive loss in financial wealth.
Economic growth in 2009 may decline by half among developing and emerging economies
(Table 1). It is likely to be well below 1% in Latin America; a recession among the newly
Industrialized countries of Asia (NICs); and much lower growth rates, even though still in the
order of 5% in Emerging Asia, mainly on account of the resiliency of China, and to a lesser
extent India. Of course, this is shocking for all the regions that had experienced very strong
growth from 2002 onward. Under these conditions, policy makers will need to find a balance
between the needs of economic stimulus and of financial stability.
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Genes is of the Present F inanc i a l and Econom ic Cr isis
The reasons for the current crisis are complex, and are linked to the financial market deterioration
of the last 20 months or so, after a period of extraordinary growth but fraught with dangers that
were not anticipated by most even a few months ago. For four years through the summer of 2007,
the global economy boomed. Global GD P rose at an average of about 5 percent a year, its highest
sustained rate since the early 1970s. About three-fourths of this growth was attributable to a
broad-based surge in the emerging and developing economies. Inflation remained generally
contained, even if with some upward pressures. Prosperous stage that using an abused word,
entailed a new economic paradigm. The value of financial and real assets was growing without a
perceptible limit, and commodities had reached new and sustainable heights. Concurrently, the
value of financial assets rose sharply, as described in further detail below.
The most important factor behind the increasing imbalances was the emergence of growingimbalances among the main economies of the world. The US, with low rates of savings,
embarked in consumption binge and a growing fiscal deficit, experienced growing external
current account deficits. These were financed by the surpluses of oil producing countries, China,
Japan, and to a lesser extent Europe and Latin America. These imbalances grew rapidly, but
markets did not respond significantly before 2007. However, the US dollar started to weaken in
international markets and there were growing signs of impending problems. As stated very
precisely by Jack Boorman, these trends were further complicated by an increasingly integrated
global trading and financial system which magnified and accelerated the transmission process;inadequate regulation and supervision of national financial systems and fragmentation of global
regulation; weak surveillance by the IMF and other multilateral organizations; and aggravated by
weak and uncoordinated policy responses to the initial signs of trouble in the financial system ±
responses that, as noted below, in many instances did more to shake confidence than to instill a
sense that policy was up to the task of dealing with the banking system crisis and the impact on
the real economy.
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CAUSES OF CRED I T CR I SES
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Causes of the Cred i t Cr i sis
In the midst of the most serious financial crisis in a generation, some claim that deregulation
is entirely to blame. This is simply not true and more importantly serves to grossly
oversimplify a problem whose roots run deep and involve myriad actors and issues. Thesimple truth is that many share the blame, and pointing to just one person or organization
does a disservice to the American people.
In a time of crisis, the American people cannot afford the same old partisan finger pointing;
they need and deserve real, non-partisan oversight. We need a series of hearings that will
focus on the root causes and how we can fix a system in order to avoid financial meltdowns
in the future. This minority staff analysis attempts to objectively explore the causes of the
financial crisis we are in and how companies like Lehman Brothers and AIG contributed to
this crisis.
The current credit crisis is a complex phenomenon with its roots in a number of places
involving a myriad of people and institutions. Key players and institutions include Members
of Congress, well-respected members of Republican and Democratic administrations, the
Federal Reserve Board, Fannie Mae, Freddie Mac, the Department of Housing and Urban
Development (HUD), the Securities and Exchange Commission (SEC), the major private
sector credit rating agencies, banks, mortgage brokers, and consumers.
There is no single issue or decision one can trace as a cause of the current financial crisis;
rather it was multiple decisions and issues involving many actors over time that led us to
where we are today. However, we can point to organizations that contributed greatly to the
problem and how their role was the catalyst for others to become involved and eventually
fail. Fannie Mae and Freddie Mac fall into this category. They were the central cancer of the
mortgage market, which has now metastasized into the current financial crisis. With the help
of a loose monetary policy at the Federal Reserve, an over-reliance on inaccurate risk
assessment and a fractured regulatory system, this cancer spread throughout the financial
industry.
A few key elements are critical in understanding how we got to where we are today.
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By 2005, Federal Reserve Chairman Alan Greenspan was so concerned that he characterized
the concentration of systemic risk inherent in the ever-growing portfolios of Fannie and
Freddie as, placing the total financial system of the future at a substantial risk. Recent events
have unfortunately proved him right.
The transformation of Fannie Mae and Freddie Mac into the Affordable Housing Center was
a laudable goal, but to push predatory subprime lending to unspeakable heights and to
encourage questionable lending practices believing housing prices would continue to soar
was beyond reason.
The politicization of Fannie Mae and Freddie Mac over the last decade seriously undermined
the credibility of the organizations and prevented their restructuring and reform, with
Democrats viewing any attempt at curtailing their behavior as an attempt at curtailing
affordable housing. Between 1998 and 2008, Fannie and Freddie combined spent nearly $175
million lobbying Congress, and from 2000 to 2008 their employees contributed nearly $15
million to the campaigns of dozens of Members of Congress on key committees responsible
for oversight of Fannie and Freddie. Those who opposed the restructuring of Fannie Mae and
Freddie Mac were unwittingly helping to build a house of cards on risky mortgage backed
securities.
The motivations for Fannie Mae and Freddie Mac to gamble with taxpayer money on bad
nonprime mortgage bets was not entirely a matter of good intentions gone awry. Greed and
corruption were unfortunately part of the equation as well. The size and growth of Fannie
Mae and Freddie Mac leading up to their collapse were nothing short of astonishing. From
1990 to 2005, Fannie Mae and Freddie Mac grew more than 944% to $1.64 trillion, and their
outstanding liabilities grew 980% to $1.51 trillion. These liabilities were equal to 32.8% of
the total publicly-held debt of the U.S. Government, which in 2005 stood at $4.6 trillion.
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Lehman Brothers, A I G and the Cha ll enges of Stat ist ica l R isk Mode lli ng
Lehman Brothers didn¶t cause this mess but it certainly jumped head first into trying to make
money on securitizing mortgage-backed instruments. They followed on the heels of Fannie
Mae and Freddie Mac and for precisely the same reasons. If we understand the initial causeof the cancer at Fannie and Freddie, then we can understand how it metastasized to Lehman
Brothers, Wachovia, Countrywide, and beyond.
AIG is somewhat different; bad management decisions were made in thinking that the
mortgage-backed securities and derivatives could be insured. Yet underlying its bad decisions
was the same mistaken reliance on sophisticated but inaccurate computer models, trusting the
rating agencies were accurate and that Fannie Mae and Freddie Mac couldn¶t possibly fail.
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Regu lat i on and the Cred i t Cr isi s
Democrats are wrong in insisting that de-regulation is the primary cause of the financial
crisis. Deregulation is not the problem, rather it is the fractured regulatory system that has
banks, investment institutions, mortgage brokers, and insurance companies all being overseenby different and often competing federal and state agencies. The problem is a lack of coherent
regulatory oversight that has led mortgage brokers and lending institutions to write
questionable loans and investment institutions to play fast and loose with other peoples
money in purchasing bad mortgage-backed assets.
The words regulation and deregulation are not absolute goods and evils, nor are they
meaningful policy prescriptions. They are political cant used to describe complex policy
discussions that defy simplistic categorization. The key to successfully regulating markets is
not to either create more or less regulation in an unthinking way. Government needs to design
smart regulations that align the incentives of consumers, lenders and borrowers to achieve
stable and healthy markets.
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Cred i t Rat i ng Agenc ies and the Pract ice of Rat i ng Shopp ing
Some firms that bundled subprime mortgages into securities were engaging in rating
shopping - picking and choosing among each of the three credit rating agencies in order to
find the one willing to give their assets the most favorable rating. Rating agencies willing toinflate their ratings on subprime mortgage-backed securities lobbied Congress to prohibit
notching - the downgrading of assets that incorporate risky, unrated assets - by their
competitors, on the grounds this constituted an anti-competitive practice. Unfortunately, the
Republican Congress was swayed by this argument and codified it in law.
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Mortgage Markets: A Pr i mer
Prospective homebuyers apply for mortgages from primary market lenders such as banks,
thrifts, mortgage companies, credit unions, and online lenders. Primary lenders evaluate
borrowers ability to repay the mortgage based on an assessment of risk that combines suchfactors as income, assets and past performance in repaying loans. If a borrower does not meet
the minimum requirement, the borrower is refused a loan.
Prime mortgages are traditionally the gold standard and go to borrowers with good credit who
make down payments and fully document their income and assets. Borrowers with poor
credit and/or uncertain income streams represent a higher risk of default for lenders and
therefore receive subprime loans. Subprime loans have existed for some time but really took
off in popularity around 1995, rising from less than 5% of mortgage originations in 1994 to
more than 20% in 2006. Borrowers who fall in between prime and subprime standards who
may not be able to fully document their income or provide traditional down payments are
sometimes referred to as near-prime borrowers. They generally can apply only for
Alternative-A (Alt-A) mortgages. Starting in 2001, subprime and near-prime mortgages
increased dramatically as a proportion of the total mortgage market. These mortgages
increased from only 9% of newly originated securitized mortgages in 2001 to 40% in 2006.
Subprime borrowers, in addition to being below the standard risk threshold lenders
traditionally deemed creditworthy for mortgages, were increasingly taking advantage of so-
called alternative mortgages that further increased the risk of default. For example, low- or
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zero-down payment mortgages permit borrowers who cannot afford the traditional 20% down
payment on a house to still receive a loan. Instead some mortgages allow them to pay 10%,
5%, or even 3% of the purchase price of the home. The riskiest loans even allow borrowers to
pay no money down at all for 100% financing. Another option is to allow borrowers to take
out a piggyback or silent second loan - a second mortgage to finance the down payment. Thisis possible because the larger first mortgage means some lenders give borrowers a more
favorable rate on the second mortgage. Interest-only mortgages are another alternative type
that allows borrowers to for a time pay back only interest and no principal. However, either
the duration of the mortgage must be extended or the payments amortize the remaining
principal balance over a shorter period of time, increasing the monthly payment, and
ultimately the total size of the loan, a borrower must repay. Negative amortization mortgages
are even riskier, allowing borrowers to pay less than the minimum monthly interest payment,
adding the remaining interest to the loan principal and again increasing the payments and size
of the loan.
Adjustable rate mortgages (ARMs) are the most common of the alternative mortgages. ARMs
offer a low introductory mortgage rate (the cost of borrowing money for a home loan; it is
generally related to the underlying interest rate in the macro economy) which then adjusts in
the future by an amount determined by a pre-arranged formula. There are different formulae
used to determine the new mortgage rate on an ARM, but in general one can think of these
new rates as being related to the performance of the U.S. economy. If interest rates go downduring the introductory period of the ARM, the adjusted mortgage rate will be lower,
meaning the borrowers monthly payment will go down. If interest rates go up, the borrowers
monthly payment will be larger. The prevalence of ARMs as a percentage of the total
mortgage market increased dramatically during the housing bubble, from 12% in 2001 to
34% in 2004.
Unlike other alternative mortgages, however, there are sound reasons for borrowers to take
out ARMs, under certain macroeconomic conditions. In 1984, for example, 61% of newconventional mortgages were ARMs. However, this was a rational response to the very high
interest rates at that time. High interest rates translate into high mortgage rates. This meant
that borrowers at that time were willing to bet that when their mortgage rates adjusted, they
were likely to adjust downward due to falling interest rates. This was a sensible bet and one
that turned out to be correct.
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From 2001 to 2004, however, interest rates were abnormally low because the Federal Reserve
led by Chairman Alan Greenspan lowered rates dramatically to pump up the U.S. economy
following the attacks of September 11, 2001. Correspondingly, from 2004 to 2006, mortgage
rates on 30-year fixed-rate mortgages were around 6%, relatively low by historical standards.
Borrowers responding only to these macroeconomic conditions would have been wise to lock in these rates with a traditional 30-year fixed-rate mortgage. The continuing popularity of
ARMs, at least until about 2004, relates in part to the abnormally wide disparity between
short- and long-term interest rates during this period. Since ARMs tend to follow short-term
rates, borrowers could get these mortgages at even lower costs and, as long as they were
confident that housing prices would continue to rise, plan on refinancing before their ARMs
adjusted upward.
Low short-term rates until 2004 are only part of the puzzle, however. By 2005 short-term
interest rates were actually rising faster than long-term rates, yet ARMs remained very
popular. By 2006 housing prices had started to slow significantly and yet introductory periods
remained popular. In the words of a report by the Congressional Research Service, The
persistence of nontraditional terms could be evidence that some borrowers intended to sell or
refinance quickly - one indicator of speculative behavior. However, the report goes on to note
that, in addition to speculation, alternative mortgages were marketed as affordability products
to lower income and less sophisticated borrowers during the housing boom. Some other
force was clearly at work.
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The Ro le of Fann ie Mae and Fredd ie Mac in Creat i ng the Cred i t Cr isis
Successive Congresses and Administrations have used Fannie Mae and Freddie Mac as tools
in service to a well-intentioned policy to increase the affordability of housing in the United
States. In the process, the U.S. Government created an incentive structure for Fannie andFreddie to facilitate the extension of risky nonprime and alternative mortgages to many
borrowers with a questionable ability to pay these loans back. Ultimately, Fannie and Freddie
may have purchased or guaranteed up to $1 trillion of risky nonprime mortgages. This, along
with a healthy dose of unethical and corrupt behavior by the management of Fannie Mae and
Freddie Mac, has contributed perhaps more than any other single factor to the growth of the
subprime housing bubble from 2005 to 2007, which in turn was the root cause of the current
financial crisis.
In the mortgage market, primary lenders may choose to hold a mortgage until repayment or
they may sell it to the secondary mortgage market. If the primary lender sells the mortgage, it
can use the proceeds from the sale to make additional loans to other homebuyers. This
increase in the funding available to mortgage lenders to lend was the goal behind the creation
of Fannie Mae and Freddie Mac.
Prior to the existence of the secondary mortgage market, there was no national U.S. mortgage
market. Instead, the mortgage industry was mainly concentrated in urban centers, leaving
broad swaths of the country unable to afford home financing. In response, Congress created
the Federal National Mortgage Association, or Fannie Mae, in the National Housing Act of
1934 as a purely public agency. After a number of legislative iterations, Fannie Mae morphed
into a private company, a government-sponsored enterprise (GSE), with no federal funding
by 1970.
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Secur i t isat ion and Subpr i me cr isis
The sub prime crisis came about in a large part of financial instruments such as securitisation.
Where bank would pool their various loans into sellable assets, thus off loading risky loans
on to others (For banks, millions can be made in money earning loans, but they are tied up for
decades. So they turned into securities. The security buyer gets regular payments from all those
mortgages; the banker off loads the risk. Securitization was seen as perhaps the greatest financial
innovation in the 20 th century).
As BBC¶s former economic editor and presenter, Evan Davies noted in a documentary called µThe
City Uncovered with Evan Davis: Banks and How to Break Them (January 14,2008)¶, rating agencies
were paid to rate these products (risking a conflict of interest) and invariably got good
ratings,encouraging people to take them up.
Starting in Wall Street, others followed quickly. With soaring profits, all wanted in, even if it
went beyond their expertise. For Example,
y
Banks borrowed even more money to lend out so they could create more
securitization. Some banks didn¶t need to rely on savers as much then, as long as they
could borrow from banks and sell those loans on as securities; bad loans would be the
problem of whoever bought the securities.
y
Some investment banks like Lehman Brothers git into mortgages, buying them in
order to securitize them and then sell them on.y
Some banks loaned even more to have an excuse to securitize those loans.
y
Running out of whom to loan to, banks turned to the poor; the subprime, the riskier
loans. Rising house prices led lenders to think it wasn¶t too riski; bad loans ment
repossessing high-valued property. Subprime and ³ self-certified´ loans (sometimes
dubbed ³liar¶s loans´) became popular, especially in the US.
y
Some banks even started to buy securities from others.
y
Collateralized Debt Obligations, or CD Os, (even more complex forms of
securitization) spread the risk but were very complicated and often hid the bad loans.
While things were good, no one wanted bad news.
High street banks got into a form of investment banking, buying, selling and trading risk.
Investment banks, not content with buying, selling, and trading risk, got into home loans,
mortgages, etc without the right controls and management.
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Derivatives didn¶t cause this financial meltdown but they did accelerate it once the subprimemortgage collapsed, because of the interlinked investments. Derivatives revolutionized thefinancial markets and mitigating risk.
This will be very hard to do. Despite the benefits of a market system, as all have admitted for
many years, it is far from perfect. Amongst other things, experts such as economists andpsychologists say that markets suffer from a few human frailties, such as confirmation bias (
always looking for facts that support your view, rather than just facts) and superiority bias (
the belief that one is better than the others, or better than the average and can make good
decisions all the time). Trying to reign in these facets of human nature seems like a tall order
and in the meanwhile the costs are skyrocketing.
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G loba l Transm iss ion of the Cr isis
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G loba l Transm iss i on of the Cr isis
The financial crisis that erupted in August 2007 after the collapse of the U.S. subprime mortgage
market entered a tumultuous new phase in September 2008. These developments badly shook
confidence in global financial institutions and markets. Most dramatically, intensifying solvency
concerns triggered a cascading series of bankruptcies, forced mergers, and public interventions in
the United States and Western Europe, which eventually resulted in a drastic reshaping of the
financial landscape.
When the real estate bubble busted in the US and Europe (the UK and Spain come to mind),
investors moved to commodities, where experts expected a continuous increase in prices. The
commodity bubble peaked in mid 2008, with a subsequent collapse, that only decelerated by the
end of the year. In the second half of the year commodity prices declined by some 45%; in
particular losses were large in the case of metals and oil (Chart 1).
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Chart 1: Evo lut ion of commod i ty Pr ices (2005=100 )
Source: IMF: Commodity Prices; .
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I nternat iona l Response
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I nternat i ona l Response
The national rescue operations have been followed by major swap transactions between the
Federal Reserve of the US and a number of other central banks of industrialized economies, in
order to provide sufficient liquidity in response to a steady demand for US dollars. More recently,
this was extended to the Central Banks of Brazil, Korea, Mexico, and Singapore, again to support
the currencies of those countries in the face of continued pressures in foreign exchange markets at
least through end-2008.
With high financing requirements, access to the International Financial Institutions has also
become imperative. The IMF has already indicated that it will show greater lending flexibility
and can mobilize significant resources. In the past, any borrowing had to be based on what was
seen as burdensome conditions. The IMF would now provide assistance on the basis of fewer
conditions, for countries seen as generally good performers. And conditions would be fewer and
more targeted than in the past. 7
The creation of the G-20 Summits is another noteworthy development. It follows a group formed
in the 1990s to discuss international financial issues, at the ministerial level. Up to now, many
decisions had been taken at the level of the G-7/G-8, the important group formed by the largest
advanced economies, and Russia. The G-20 includes the G-8 and the largest emerging, newly
industrialized economies, including China, India, Korea, South Africa, and in Latin America,
Brazil, Mexico and Argentina. This forum reflects better the growing importance of the emerging
world and may also open the door to a more representative governance system at the internationalfinancial institutions (IFIs). However, over-represented Europe and others will need to accept the
realities of the new world and shift their voting power to the ³new´ countries, and make IFIs
more relevant.
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I mpact of cr isis on trade of goods and serv ices, remm itace andtour ism and FD I
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I mpact of cr i sis on trade of goods and serv ices, remm i tace and tour ism and
FD I
Deve lopments in Trade of Goods and Serv ices
As part of the significant slowdown/decline in world activity, trade volumes are expected to
decline for the first time in many years²as a minimum by 3% according to IMF estimates. The
impact will be very different in various areas of the world. Over the last quarter century the
volume of world trade had grown at an average rate of 6%, or about double the rate of world
output. Asian exports have grown at a rate of 10% and those of Latin America and the Caribbean
by some 7%, with a marked transformational impact.
The NICs, which have become highly integrated with the rest of the world, recorded an average
ratio of Exports to GD P of 71% for the period 2002-07. Developing Asia recorded a ratio of 55%,
tempered by the much lower but growing ratios for China (31%) and India (12%) which were
clearly dominated by domestic developments. In Asia the ratio of exports to GD P reflected
increased volumes of trade, but to some extent also some real depreciation of their currencies.
Latin America which had become much more open in the 1990s, registered a stable ratio of
exports to GD P of 21% notwithstanding the impact of a strong real appreciation, as export
volumes increased significantly over the period.
Under these conditions, it would be easy to suggest that the countries that have been most open to
international trade may be subject to the greatest shock on account of reduced world demand,
thus justifying protectionism. However this should be viewed in a broader light.
Countries that opened more vigorously to trade grew the fastest, and benefitted more from global
prosperity. It may be the case that they will experience a significant short term loss, as is being
observed in Taiwan Province and in Korea. But this is taking place from the vantage point of
much higher gains in the past, and with the understanding that the losses, even if large, will be
temporary. More significantly, the more open traders may benefit from a more flexible productive
structure that allows them to adjust more efficiently. More closed economies, adjusted for their
size 8, may be more dependent on a few commodities, and will have more difficulty in correcting
imbalances as their domestic economies may find a lower productive base to provide for their
imports.
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Rem i ttances and Tour ism
Two other areas that can be expected to show the impact of the slowdown are remittances and
services, like tourism. Remittances over the last fifteen years have become a major channel of
prosperity. The merits of increased mobility of large numbers of workers to well-paying jobs in
prosperous destinations may be subject to debate. However, the impact of the consequent
remittances to their home countries have helped increase prosperity and reduce poverty,
particularly in Asia and Latin America- India, Mexico and the Philippines being the largest
recipients of workers¶ remittances. Remittances amounted to some US$280 billion in 2008 (some
2% of GD P of the receiving countries), with near US$110 billion to Asia, and US$70 billion to
Latin America. These flows have been very stable, and acted as a countercyclical force in the
receiving countries. 9 However, they are highly sensitive to economic conditions in the countries
of employment. With many emigrants working in the US, Europe, and the Middle East,remittances started to fall in 2008, for the first time in a quarter century. The prospects for 2009
are equally dire, with adverse consequences for the well being of many millions of households
among developing countries.
Tourism is another area of concern. Receipts from tourists are also a significant source of income,
particularly for Thailand, Maldives, India and some other countries in South and South East Asia,
and Mexico, Central America and the Caribbean, and some countries in South America. Even
though transportation costs are declining, tourism from the richer countries has fallen and will
continue to do so. With emerging economies, arguably the most dynamic segment of internationaltourism, also entering into recession the prospects for this segment of economic activity look
particularly grim for the near future.
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Fore ign D irect I nvestment
Foreign Direct Investment (FDI) will also suffer in the short run. FDI stocks and flows grew at a
very fast rate in recent years, reflecting both the emergence of new countries as origin and
destination of capital flows, and rapidly evolving capital markets, which allowed for a sharp
increase in available capital within the private sector, and resulting in a decline in lending by
International Financial Institutions or IFIs. Most interesting was the change in the composition of
these flows. While total FDI directed to developed countries retained the lion¶s share of the total
inflows (70% of the total), both Asia and Latin America became increasingly important, even
with some volatility in the case of Latin America. (Table 2) Also, the countries of the CSIS and
of Eastern and Central Europe began to receive increasing flows. 10 As an illustration of the size of
inflows and outflows, table# 2 presents the cumulative inflows and outflows of FDI and portfolio
investments for Developing Asia and Latin America for the period 1998-2007. The information isparticularly interesting as it shows the large sums of capital outflows from Emerging Economies,
as they became increasingly important investors, as opposed to the previous experience when
these outflows reflected capital flight. By early 2008 capital flows to developing countries had
started to slow down, and these flows fell sharply in the second half of the year reflecting the
financial crisis. In the end, cumulative flows for the year were only about one half of those
registered in 2007, with sharp declines both in Asia and Latin America. The Institute of
International Finance estimates that net private flows to emerging economies declined from a
record US$930 billion in 2007 to below US$470 billion in 2008 and to projected flows of onlyUS$165 billion in 2009. Net flows are projected to decline by 80% from their 2007 peak for
Emerging Asia, and by 75% for Latin America. This will complicate economic management, as
countries deal with weakening external accounts.
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Some Facts and F igures
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Some Facts and F igures
Chart 1
Growth of GDP in Deve lop ing As ia, Lat in Amer ica and the Wor ld (Annua l percent)
Source: WE O , IMF, ECLAC, .
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Chart 2
I nf lat ion ( in %)
Source: WE O , IMF, ECLAC, .
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Chart 3
Externa l Current Account, Fisca l Ba lance, Exchange Rates and Terms of Trade
Deve lop ing and Emerg ing As ia
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Chart 4
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Chart 5
Fore ign D irect I nvestment: Rec ip ient reg ions stocks (US$ b illi ons)
1980 1990 2000 2006
Wor ld 551 1779 5810 11999
Deve loped Econom ies 411 1414 4031 8454
Share in Total 75 80 69 71
Deve lop ing Econom ies 140 365 1708 3156
Share in Total 9 9 17 14
Wor ld FD I Stock 859 2388 7948 11999
MemorandumItems
Cap ita l F lows (US$ b illi on;1998-07)2/ Dev As ia LATAM
FD I I nf lows 841 728
FD I Outf lows -151 -142
Portfo li o I nf lows 127 170
Portfo li o Outf lows -102 -103
1/ Adjusted by wor ld export pr ices
2/2007 va lues for As ia are est imates
Source: UNCTAD, World Investment Report (2007),
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Chart 6
Growth of GDP in Deve lop ing As ia, Lat in Amer ica and the Wor ld
(Annua l percent)
Source IMF, ECLAC
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Chart 7:I nf lat ion ( in %)
Source: WE O , IMF, ECLAC,
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Chart 8
Se lected Countr ies-stock Market and Exchange Rate changes June-Dec 2008
Stock Market Changes % Exchange Rate Changes %
China -48 1
Hong-Kong -40 1
India -41 -13
South Korea -36 -20
Argentina -51 -13
Brazil -49 -31
Mexico -29 -26
Japan -36 18Euro Area -37 -11
USA(S& P500) -36 --Sources: Bloomberg, market data
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Chart 9
ST I M ULUS PAC K AGES: Se lected Countr ies
Country Announced Amount of St i mu l us Gross Pub li c
Debt
Pub li c Debt, net
of I nternat i ona l
Reserves
US Billion, annual (% of GD P , 2008)
Ch i na 300 (586) 1/ 7.1 18 -30
S ingapore 6.2 3.2 92 2
I ndones i a 6.3 1.3 17 5
South Korea 10.8 1.1 32 11
I nd ia 8.3 0.7 58 37Peru 3.2 2.5 31 1
Ch il e 4.0 2.2 19 6
Argent i na 3.8 1.2 59 46
Mex ico 10.8 1.1 26 18
Braz il 16.0 1.0 57 46
USA 800 (1150) 1/ 5.6 38 38
Japan 250 5.2 153 128
Germany 102 2.7 67 64
Great Br i ta i n 30 1.1 44 41
1/Estimated expenditure in 2009. Number in parenthesis reflects announced total package
Sources: National data; Press Releases; IMF; Eurostat
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SCALE OF CR I SES
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The sca le of the cr isis: tr illi ons in taxpayer ba il outs
The extent of the problems has been so severe that some of the world¶s largest financial
institutions have collapsed. Others have been bought out by their competition at low prices
and in other cases, the governments of the wealthiest nations in the world have resorted to
extensive bail-out and rescue packages for the remaining large banks and financial
institutions.
The total amounts that government have spent on bailouts have skyrocketed. From a world
credit loss of $2.8 trillion in October 2009, US taxpayers alone will spend some $9.7 trillion
in bailout packages and plans, according to Bloomberg, $14.5 trillion, or 33%, of the value of
the world¶s companies has been wiped out by this crisis. The UK and other European
countries have also spent some $2 trillion on rescues and bailout packages. More is expected
Many banks were taking on huge risks increasing their exposure to problems.When people
did eventually start to see problems, confidence fell quickly. Some investment banks were
sitting on the riskiest loans that other investors did not want. Assets were plummeting in
value so lenders wanted to take their money back. But some investment banks had little in
deposits; no secure retail funding, so some collapsed quickly and dramatically of criticism for
betting n the things going badly. In the recent crisis they were criticized for shorting on
banks, driving down their prices. Some countries temporarily banned shorting on banks. In
some regards, hedge funds may have been signalling an underlying weakness with banks,
which were encouraging borrowing beyond people¶s means. On the other hand more it
continued the more they could profit.
The market for credit default swaps market (a derivative on insurance on when a business
defaults), for example, was enormous, exceeding the entire world economies output of $50
trillion by summer 2008. It was also poorly regulated. The world¶s largest insurance and
financial services company, AIG alone had credit default swaps of around $400 billion at that
time. A lot of exposure with little regulation. Furthermore , many of AIG¶s credit defaultswaps were mortgages, which of course went downhill, and so did AIG.
The trade in these swaps created a whole web of interlinked dependencies: a chain only as
strong as the weakest link. Any problem, such as risk or actual significant loss could spread
quickly. Hence the eventual bailout (now some $150 billion) of AIG by the US government
to prevent them failing.
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The effect of this, the United Nation¶s Conference on Trade and Development says in its
Trade and Development Report 2008 is, as summarized by the Thi rd World Network , that
³ The global economy is teetering on the brink of recession. The downturn after four years of
relatively fast growth is due to a number of factors: the global fallout from the financial crisisin the United States, the bursting of the housing bubbles in the US and in other large
economies, soaring commodity prices, increasingly restrictive monetary policies in a number
of countries, and stock market volatility.The fallout from the collapse of the US mortgage
market and the reversal of the housing boom in various important countries has turned out to
be more profound and persistent than expected in 2007 and beginning of 2008. As more and
more evidence is gathered and as the lag effects are showing up, we are seeing more and
more countries around the world being affected by this rather profound and persistent
negative effects from the reversal of housing booms in various countries.´
Kanaga Raja, Econom i c Outlook Gloomy, R is k s to Sout h , s ay UNC TAD , Thi rd World
Network, September 4, 2008
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A Cr i sis so severe, those respons ib le are ba il ed out
Some of the bail-outs have also been accompanied with charges of hypocrisy due to the
appearance of ³socializing the costs while privatizing the profits.´ The bail-outs appear to
help the financial institutions that got into trouble (many of whom pushed for the kind of laxpolicies that allowed this to happen in the first place).
Some governments have moved to make it harder to manipulate the markets by shorting
during the financial crisis blaming them for worsening an already bad situation.
(It should be noted that during the debilitating Asian financial crisis in the late 1990s, Asian
nations affected by short-selling complained, without success that currency speculators²
operating through hedge funds or through the currency operations of commercial banks and
other financial institutions²were attacking their currencies through short selling and in doing
so, bringing the rates of the local currencies far below their real economic levels. However,
when they complained to the Western governments and International Monetary Fund (IMF),
they dismissed the claims of the Asian governments, blaming it on their own economic
mismanagement instead.)
Other governments have moved to try and reassure investors and savers that their money is
safe. In a number of European countries, for example, governments have tried to increase or
fully guarantee depositors¶ savings. In other cases, banks have been nationalized (socializing
profits as well as costs, potentially.)
In the meanwhile, smaller businesses and poorer people rarely have such options for bail out
and rescue when they find themselves in crisis.
There seems to be little sympathy²and even growing resentment²for workers in the
financial sector, as they are seen as having gambled with other people¶s money, and hence
lives, while getting fat bonuses and pay rises for it in the past. Although in raw dollar terms
the huge pay rises and bonuses are small compared to the magnitude of the problem, the
encouragement such practices have given in the past, as well as the type of culture it creates,
is what has angered so many people.
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The f inanc ia l cr isis and wea lthy countr ies
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The f inanc ia l cr isis and wea l thy countr ies
Many blame the greed of Wall Street for causing the problem in the first place because it is in
the US that the most influential banks, institutions and ideologues that pushed for the policies
that caused the problems are found.
The crisis became so severe that after the failure and buyouts of major institutions, the Bush
Administration offered a $700 billion bailout plan for the US financial system.
This bailout package was controversial because it was unpopular with the public, seen as a
bailout for the culprits while the ordinary person would be left to pay for their folly. The US
House of Representatives initial rejected the package as a result, sending shock waves around
the world.
It took a second attempt to pass the plan, but with add-ons to the bill to get the additional
congressmen and women to accept the plan.
However, as former Nobel prize winner for Economics, former Chief Economist of the
World Bank and university professor at Columbia University, Joseph Stiglitz, argued, the
plan ³remains a very bad bill:´
In Europe, starting with Britain, a number of nations decided to nationalize, or part-
nationalize some failing banks to try and restore confidence. The US resisted this approach at
first, as it goes against the rigid free market view the US has taken for a few decades now.
Eventually, the US capitulated and the Bush Administration announced that the US
government would buy shares in troubled banks.
This illustrates how serious this problem is for such an ardent follower of free market
ideology to do this (although free market theories were not originally intended to be applied
to finance, which could be part of a deeper root cause of the problem).
Perhaps fearing an ideological backlash, Bush was quick to say that buying stakes in banks
³is not intended to take over the free market, but to preserve it.´ Professor Ha-Joon Chang of
Cambridge University suggests that historically America has been more pragmatic about free
markets than their recent ideological rhetoric suggests, a charge by many in developing
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countries that rich countries are often quite protectionist themselves but demand free markets
from others at all times.
While the US move was eventually welcomed by many, others echo Stieglitz¶s concern
above. For example, former Assistant Secretary of the Treasury Department in the Reaganadministration and a former associate editor of the Wall Street Journal , Paul Craig Roberts
also argues that the bailout should have been to help people with failing mortgages, not
banks: ³The problem, according to the government, is the defaulting mortgages, so the money
should be directed at refinancing the mortgages and paying off the foreclosed ones. And that
would restore the value of the mortgage-backed securities that are threatening the financial
institutions [and] the crisis would be over. So there¶s no connection between the
government¶s explanation of the crisis and its solution to the crisis.´
(Interestingly, and perhaps the sign of the times, while Europe and US consider more
socialist-like policies, such as some form of nationalization, China seems to be contemplating
more capitalist ideas, such as some notion of land reform, to stimulate and develop its
internal market. This, China hopes, could be one way to try and help insulate the country
from some of the impacts of the global financial crisis.)
Despite the large $700 billion US plan, banks have still been reluctant to lend. This led to the
US Fed announcing anot h er $800 billion stimulus package at the end of November. About
$600bn is marked to buy up mortgage-backed securities while $200bn will be aimed at
unfreezing the consumer credit market. This also reflects how the crisis has spread from the
financial markets to the ³real economy´ and consumer spending.
By February 2009, according to Bloomberg , the total US bailout is $9.7 trillion. Enough to
pay off more than 90 percent of America¶s home mortgages (although this bailout barely
helps homeowners).
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A cr isis s igna li ng the dec li ne of US¶s superpower status?
Even before this global financial crisis took hold, some commentators were writing that the
US was in decline, evidenced by its challenges in Iraq and Afghanistan, and its declining
image in Europe, Asia and elsewhere.
The BBC also asked if the US¶s superpower status was shaken by this financial crisis:
The financial crisis is likely to diminish the status of the United States as the world¶s only
superpower. On the practical level, the US is already stretched militarily, in Afghanistan and
Iraq, and is now stretched financially. On the philosophical level, it will be harder for it to
argue in favor of its free market ideas, if its own markets have collapsed.
Some see this as a pivotal moment.
The political philosopher John Gray, who recently retired as a professor at the London School
of Economics, wrote in the London paper The Observer: ³Here is a historic geopolitical shift,
in which the balance of power in the world is being altered irrevocably.
³The era of American global leadership, reaching back to the Second World War, is over«
The American free-market creed has self-destructed while countries that retained overall
control of markets have been vindicated.´
³How symbolic that Chinese astronauts take a spacewalk while the US Treasury Secretary is
on his knees.´
² Paul Reynold s , US s uperpower s tatu s is sh aken, BBC, October 1, 2008
Yet, others argue that it may be too early to write of the US:
The director of a leading British think-tank Chatham House, Dr Robin Niblett « argues that
we should wait a bit before coming to a judgment and that structurally the United States is
still strong.
³America is still immensely attractive to skilled immigrants and is still capable of producing
a Microsoft or a Google,´ he went on. ³Even its debt can be overcome. It has enormous
resilience economically at a local and entrepreneurial level.
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³And one must ask, decline relative to who? China is in a desperate race for growth to feed
its population and avert unrest in 15 to 20 years. Russia is not exactly a paper tiger but it is
stretching its own limits with a new strategy built on a flimsy base. India has huge internal
contradictions. Europe has usually proved unable to jump out of the doldrums as dynamically
as the US.
³But the US must regain its financial footing and the extent to which it does so will also
determine its military capacity. If it has less money, it will have fewer forces.´
² Paul Reynold s , US s uperpower s tatu s is sh aken, BBC, October 1, 2008
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Europe and the f inanc ia l cr isis
In Europe, a number of major financial institutions failed. Others needed rescuing.
In Iceland, where the economy was very dependent on finance sector, economic problems
have hit them hard. The banking system virtually collapsed and the government had to
borrow from the IMF and other neighbors to try and rescue the economy. In the end, public
dissatisfaction at the way the government was handling the crisis meant the Iceland
government fell
A number of European countries have attempted different measures (as they seemed to have
failed to come up with a united response).
For example, some nations have stepped in to nationalize or in some way attempt to provideassurance for people. This may include guaranteeing 100% of people¶s savings or helping
broker deals between large banks to ensure there isn¶t a failure.
The EU is also considering spending increases and tax cuts to be worth ¼200 billion over two
years. The plan is supposed to help restore consumer and business confidence, Shore up
employment, getting the banks lending again, and promoting green technologies.
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As ia and the f inanc ia l cr isis
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As ia and the f inanc i a l cr isis
Countries in Asia are increasingly worried about what is happening in the West. A number of
nations urged the US to provide meaningful assurances and bailout packages for the US
economy, as that would have a knock-on effect of reassuring foreign investors and helping
ease concerns in other parts of the world.
Many believed Asia was sufficiently decoupled from the Western financial systems. Asia has
not had a subprime mortgage crisis like many nations in the West have, for example. Many
Asian nations have witnessed rapid growth and wealth creation in recent years. This lead to
enormous investment in Western countries. In addition, there was increased foreign
investment in Asia, mostly from the West.
However, this crisis has shown that in an increasingly inter-connected world means there arealways knock-on effects and as a result, Asia has had more exposure to problems stemming
from the West. Many Asian countries have seen their stock markets suffer and currency
values going on a downward trend. Asian products and services are also global, and a
slowdown in wealthy countries means increased chances of a slowdown in Asia and the risk
of job losses and associated problems such as social unrest.
India and China are the among the world¶s fastest growing nations and after Japan, are the
largest economies in Asia. From 2007 to 2008 India¶s economy grew by a whopping 9%.
Much of it is fueled by its domestic market. However, even that has not been enough to
shield it from the effect of the global financial crisis, and it is expected that in data will show
that by March 2009 that India¶s growth will have slowed quickly to 7.1%. Although this is a
very impressive growth figure even in good times, the speed at which it has dropped²the
sharp slowdown²is what is concerning.
China, similarly has also experienced a sharp slowdown and its growth is expected to slow
down to 8% (still a good growth figure in normal conditions). However, China also has a
growing crisis of unrest over job losses. Both have poured billions into recovery packages.
Japan, which has suffered its own crisis in the 1990s also faces trouble now. While their
banks seem more secure compared to their Western counterparts, it is very dependent on
exports. Japan is so exposed that in January alone, Japan¶s industrial production fell by 10%,
the biggest monthly drop since their records began.
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Towards the end of October 2008, a major meeting between the EU and a number of Asian
nations resulted in a joint statement pledging a coordinated response to the global financial
crisis. However, as Inter Press Service (I PS) reported, this coordinated response is dependent
on the entry of Asia¶s emerging economies into global policy-setting institutions.
This is very significant because Asian and other developing countries have often been treated
as second-class citizens when it comes to international trade, finance and investment talks.
This time, however, Asian countries are potentially trying to flex their muscle, maybe
because they see an opportunity in this crisis, which at the moment mostly affects the rich
West.
Asian leaders had called for ³effective and comprehensive reform of the international
monetary and financial systems.´ For example, as I PS also noted in the same report, one of
the Chinese state-controlled media outlets demanded that ³We want the U.S. to give up its
veto power at the International Monetary Fund and European countries to give up some more
of their voting rights in order to make room for emerging and developing countries.´ They
also added, ³And we want America to lower its protectionist barriers allowing an easier
access to its markets for Chinese and other developing countries¶ goods.´
Whether this will happen is hard to know. Similar calls by other developing countries and
civil society around the world, for years, have come to no avail. This time however, the
financial crisis could mean the US is less influential than before. A side-story of the emergingChinese superpower versus the declining US superpower will be interesting to watch.
It would of course be too early to see China somehow using this opportunity to decimate the
US, economically, as it has its own internal issues. While the Western mainstream media has
often hyped up a ³threat´ posed by a growing China, the World Bank¶s chief economist (Lin
Yifu, a well respected Chinese academic) notes ³Relatively speaking, China is a country with
scarce capital funds and it is hardly the time for us to export these funds and pour them into a
country profuse with capital like the U.S.´
Asian nations are mulling over the creation of an alternative Asia foreign exchange fund, but
market shocks are making some Asian countries nervous and it is not clear if all will be able
to commit.
What seems to be emerging is that Asian nations may have an opportunity to demand more
fairness in the international arena, which would be good for other developing regions, too.
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G loba l Me ltdown and i ts I mpact on the I nd ian Economy
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G loba l Me l tdown and i ts I mpact on the I nd ian Economy
With the collapse of Lehman Brothers and other Wall Street icons, there was growing
recession which affected the US, the European Union (EU) and Japan. This was the result of
large scale defaults in the US housing market as the banks went on providing risky loans
without adequate security and the repaying capacity of the borrower. The principal source of
transmission of the crisis has been the real sector, generally referred to as the µMain Street¶.
This crisis engulfed the United States in the form of creeping recession and this worsened the
situation. As a consequence, US demand for imports from other countries indicated a decline.
The basic cause of the crisis was largely an unregulated environment, mortgage lending to
subprime borrowers. Since the borrowers did not have adequate repaying capacity and also
because subprime borrowing had to pay two-to-three percentage points higher rate of interest
and they have a history of default, the situation became worse. But once the housing market
collapsed, the lender institutions saw their balance-sheets go into red.
Although at one time it was thought that this crisis would not affect the Indian economy, later
it was found that the Foreign Direct Investment (FDI) started drying up and this affected
investment in the Indian economy. It was, therefore, felt that the Indian economy will grow at
about seven per cent in 2008-09 and at six per cent in 2009-10. The lesson of this experience
is that India must exercise caution while liberalising its financial sector.
A redeeming feature of the current crisis is that its magnitude is much lesser than that of the
Great Depression of the 1930s when unemploy-ment rate in the United States exceeded 25
per cent. Currently, it stands at 6.5 per cent and is predicted to remain around eight per cent
in 2009.
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The industries most affected by weakening demand were airlines, hotels, real estate. Besides
this, Indian exports suffered a setback and there was a setback in the production of export-
oriented sectors. The government advised the sectors of weakening demand to reduce prices.
It provided some relief by cutting down excise duties, but such simplistic solutions were
doomed to failure. Weakening demand led to producers cutting production. To reduce theimpact of the crisis, firms reduced their workforce, to reduce costs. This led to increase in
unemployment but the total impact on the economy was not very large. Industrial production
and manufacturing output declined to five per cent in the last quarter of 2008-09.
Consequently, a vicious cycle of weak demand and falling output developed in the Indian
economy.
A weakening of demand in the US affected our IT and Business Process Outsourcing (B PO )
sector and the loss of opportunities for young persons seeking employment at lucrativesalaries abroad. India¶s famous IT sector, which earned about $ 50 billion as annual revenue,
is expected to fall by 50 per cent of its total revenues. This would reduce the cushion to set
off the deficit in balance of trade and thus enlarge our balance of payments deficit. It has now
been estimated that sluggish demand for exports would result in a loss of 10 million jobs in
the export sector alone.
To lift the economy out of the recession the Government announced a package of Rs 35,000
crores in the first instance on December 7, 2008. The main areas to benefit were the
following:
(a) Housing²A refinance facility of Rs 4000 crores was provided to the National Housing
Bank. Following this, public sector banks announced to provide small home loans seekers
loans at reduced rates to step up demand in retail housing sector.
(i) Loans up to Rs 5 lakhs: Maximum interest rate fixed at 8.5 per cent.
(ii) Loans from Rs 5-20 lakhs: Maximum interest rate at 9.25 per cent.
(iii) No processing charges to be levied on borrowers.
(iv) No penalty to be charged in case of pre-payment.
(v) Free life insurance cover for the entire outstanding amount.
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This means a borrower can get a loan up to 90 per cent of the value of the house. The
government hopes to disburse Rs 15,000 to 20,000 crores under the new package.
The housing package is the core of the government¶s new fiscal policy. It will give a fillip to
other sectors such as steel, cement, brick kilns etc. Besides, the small and medium industries(SMEs) too get a boost by manufacturing all kinds of fittings and furnishings.
The success of the housing package will, however, depend on the State governments efforts
to free up surplus land so that land prices come down and the cost of housing becomes
reasonable.
(b) Textiles²Due to declining orders from the world¶s largest market the United States, the
textile sector has been seriously affected. An allocation of Rs 1400 crores has been made to
clear the entire backlog in the Technology Upgradation Fund (TUF) scheme.
The Apparel Export Promotion Council (AE PC) Chairman, however, said: ³It is a
disappointing package. The allocation of Rs. 1,400 crores has been pending for many years
and thus, it is the payment of arrears only. There is nothing new in it. It would have been
much better if more concrete measures have been taken to reverse the downturn in the
exports of readymade garments and avoid further job losses in the textile sector.´
© Infrastructure²The government has been proclaiming that infrastructure is the engine of
growth. To boost the infrastructure, the India Infrastructure Finance Company Ltd. (IIFCL)
has been authorised to raise Rs 14,000 crores through tax-free bonds. These funds will be
used to finance infrastructure, more especially highways and ports. It may be mentioned that
µrefinance¶ refers to the replacement of an existing debt obligation with a debt obligation
bearing better terms, meaning thereby at lower rates or a changed repayment schedule. The
IIFCL will be permitted to raise further resources by the issue of such bonds so that a public-
private partnership ( PPP ) programme of Rs 1,00,000 crores in the highway sector is
promoted.
(d) Exports²Exports which accounted for 22 per cent of the GD P are expected to fall by 12
per cent. The government¶s fiscal package provides an interest rate subsidy of two per cent on
exports for the labour±intensive sectors such as textiles, handicrafts, leather, gems and
jewellery, but the Federation of Indian Export Organization (FIE O) felt the measures are not
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enough as they will not make the exports price-competitive and, therefore, will not boost
exports. G.K. Pillai, the Commerce Secretary, has estimated a loss of 1.5 million jobs in the
export sector alone during 2008-09 on account of the $15 billion decline in the expected
exports.
(e) Small and Medium Enterprises (SMEs)²The government has announced a guarantee
cover of 50 per cent for loans between Rs 50 lakhs to Rs 1 crore for SMEs. The lockin period
for loans covered under the existing schemes will be reduced from 24 months to 18 months to
encourage banks to cover more loans under the scheme. Besides, the government will instruct
state-owned companies to ensure prompt payment of bills of SMEs so that they do not suffer
on account of delay in the payment of their bills.
In short, the fiscal package is aimed at boosting growth in exports, real estate, auto, textiles
and small and medium enterprises. The aim is to encourage growth and boost employment
which have been threatened by the recession in the world economy, more especially in the
United States.
Just within a month, the government announced another package to bail out the Indian
economy. Dr Montek Singh Ahluwalia said: ³We should expect, from all global projections
that the next year (2009) is going to be a very difficult year for the global economy.´
The purpose of the new package announced on January 1, 2009 was to minimise the pain.With this end in view, the new package included the following measures:-
1. To boost investment and spending to revive growth, the RBI cut the repo rate, which it
charges on short-term loans to banks from 6.5 per cent to 5.5 per cent and also reduced the
Cash Reserve Ratio (CRR)²the share of deposits which has to be kept with the RBI from 5.5
per cent to five per cent.
2. To revive exports which has resulted in a contraction of industrial output, drawback
benefits have been enhanced for some exporters. Export-Import Bank also gets Rs. 5000
crores as credit from the RBI.
3. To help the realty sector, realty companies have been allowed to borrow from overseas to
develop ³integrated townships´.
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4. To boost infrastructure, the India Infrastructure Finance Company Ltd. (IIFCL) has been
allowed to raise Rs 30,000 crores from tax-free bonds. Besides, Non-Banking Finance
Companies (NBFCs) need no government approval to borrow from overseas for
infrastructure projects. This will sustain the growth momentum on infrastructure.
5. To make more funds available, ceiling on foreign institutional investments (FIIs) in
corporate bonds has been increased to $ 15 billion from $ 6 billion. The purpose is to seek
much bigger FII investment.
6. To stimulate the Commercial Vehicles (CVs) sector, depreciation benefit on commercial
vehicles has been increased form 15 per cent to 50 per cent on purchases. Besides, the States
will get one-time funding from the Centre to buy buses for urban transport. In addition,
public sector banks would provide finance firms funds for commercial vehicles. It is hoped
that Tata Motors and Ashok Leyland¶s sales would revive.
On February 24, 2009, the government announced a slashing down of excise duty from 10
per cent to eight per cent²a reduction by two per cent. Since 90 per cent of the manufactured
goods attract 10 per cent excise duty, this measure is designed to reduce the prices of colour
TV sets, washing machines, refrigerators, soap, detergents, colas, cars and commercial
vehicles. Cement prices are likely to drop Rs 4-5 per bag of 50 kg while steel prices may cost
Rs 500-600 per tonne less. In addition to this, the government decided to cut service tax form
12 per cent to 10 per cent²a reduction by two per cent. As a consequence, phone bills,
airline tickets, credit card charges, tour packages etc. would cost less. A two per cent
reduction in service tax will directly touch the lives of over 500 million persons by reducing
monthly expenses. The entire stimulus package of Rs 30,000 crores to boost demand in the
economy and thus reduce the impact of recession.
Commerce and Industry Minister Kamal Nath announced a small relief package of Rs 325
crores for leather, textiles, gems and jewellery on February 26, 2009.
Assessment of the Impact of the Fiscal Package
There is no doubt that the government is motivated with good intentions and is thus aiming to
spend a huge amount of Rs 1,00,000 crores for developing infrastructure in roads, ports etc.
which pose a serious handicap to growth. Besides, the aim of other measures is to boost
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exports and help sectors like textiles and small and medium industries which are labour-
intensive and generate more employment.
But the success of the fiscal package will depend on the quality and speed of implementation
so that delays in implementation may not aggravate the economic recession to move into thedangerous zone of depression.
One of the major stumbling blocks which may neutralise the positive effects of large
expenditure on infrastructure is corruption. In case corruption is not simultaneously curbed to
reasonably low levels, it may delay and reduce the much-desired effect in enlarging
infrastructure. It may result in the Indian infrastructure network being geared into a
temporary employment generation programme with much smaller impact on the economy as
against the intended objectives.
For reducing corruption, two things need to be ensured²transparency and avoidance of
arbitrariness. By cutting arbitrariness in decision-making, corruption can be curbed to a great
extent. Transparency instils confidence in the government.
Secondly, there is a need to orient the fiscal package towards inclusive growth so that the
weaker sections benefit. This would require special emphasis, for instance, on rural
infrastructure²rural roads and housing, instead of only highways and urban housing.
Similarly, a much larger expenditure on primary and secondary education, health andsanitation can also result in a more inclusive growth process.
Thirdly, the chances of our exports increasing are very limited unless the G-3 economies,
namely, the US, EU and Japan, are able to bring about a positive shift in their growth in the
near future for which the predictions at present are not very optimistic. The World Bank has
projected the world output to grow at 0.9 per cent in 2009 as against 2.5 per cent in 2008. If
these predictions come out to be true, there is a fear of the recession in 2008 turning into a
depression in 2009. But the Indian economy is predicted to grow at about seven per cent in2008 and about six per cent in 2009. Since the G-3 economies of the US, EU and Japan are
affected seriously by the present recession, the chances of Indian exports increasing in these
countries appear to be very dim. The natural conclusion is that the Indian economy should
concentrate on developing the domestic market. Thus, inward looking policies should be
preferred as against the outward looking approach of integrating the Indian economy to the
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world economy is followed during the last decade. It is heartening that the Prime Minister
intends to insulate the Indian economy from the world economy.
Fourthly, although there is a demand for a much larger Fiscal Package to bail out the Indian
economy, there are serious limitations faced by the government because it has to fightterrorism on the one hand and financial meltdown on the other. The government has to
undertake a huge expenditure at the Central as well as State levels to enhance security. It is
difficult to precisely estimate this expenditure at this stage since it entails larger recruitment
of police and paramilitary forces along with equipping them with the most uptodate weapons.
But there is a massive increase in expenditure to combat terrorism, along with a fiscal
package to boost the Indian economy; there is also likely to be shortfall in tax revenues.
Consequently, the Budget deficit is bound to increase. The government will not be able to
reduce the fiscal deficit to 2.5 per cent of GD P, it may increase to three to 3.5 per cent during2008-09. But this is inevitable and the target of reducing it according to the schedule
prescribed by the Fiscal Responsibility and Budget Management Act, has to be postponed.
But the Finance Minister has not agreed to the abolition of the FRBM Act since it would be
imprudent to relax or abrogate the FRBM. To quote Dr Ishar Ahluwalia: ³The FRBM is like
a chastity belt, but don¶t loosen it without a better alternative.´
It may, however, be mentioned that the quasi fiscal deficit (the deficit left out of the Budget)
is presently estimated as six per cent of the GD P. A compre-hensive view of the fiscal deficit
(as shown in the Budget and kept outside the Budget) would be in the rang e of nine to 9.5 per
cent of the GD P, though it may now be lower due to a very sharp decline in international
crude oil prices from $140 per barrel to about $ 40 per barrel at present. This is a welcome
relief. If the government is also able to push the fertiliser prices to lower levels which is
possible in the changed circumstances, eventually the total fiscal deficit (shown as well as
kept outside the Budget) may come down to 6.5 to seven per cent of the GD P. This is quite
large but it is inevitable in the present situation.
To conclude: As against the US package of $ 800 billion to bail out the US economy and the
Chinese package to $ 580 billion to salvage its economy, the Indian fiscal package of Rs
35,000 crores ($ 7.3 billion approximately) is a small measure to boost the Indian economy. It
is due to this reason that the chieftains of industry want a much bigger package to bail out the
Indian economy, as against the minuscule announced by the government.
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But the plan to spend more on housing is commendable if it can be implemented in a short
time and an effective manner. The government should have transparency and avoid
arbitrariness in the implementation so that corruption can be kept within reasonable limits.
The government has been provided relief with the sharp fall in the international price of crudeoil and this should be taken advantage of in reducing expenditure to subsidise oil imports.
Additional employment generation by helping SMEs will be a step towards inclusive growth
since they are labour intensive.
The intention to create infrastructure by expanding highways and ports and to spend Rs
1,00,000 crores through the IIFCL is commendable. However, it may be more prudent to
expand rural roads and rural housing so as to promote more inclusive growth. This would
require proper planning which may take more time and does not provide immediate benefit.
It may not be possible to reduce the fiscal deficit during 2008-09 since much larger
expenditures are needed to combat terrorism and as there is recession in the Indian economy,
but international factors will influence the process. As the G-3 economies of the US, EU and
Japan pick up, the Indian economy will also benefit from their reversal of recessionary trends.
In this situation, the expectation of seven per cent growth of the GD P in 2008-09 and six per
cent in 2009-10 reflects a fairly good performance of the Indian economy.
Now that the three packages have been announced, it is high time that the policy-makers inthe Ministry of Finance, Commerce, Industry and Rural Development should get together to
ensure that the planned expenditure²budgeted and provided in the two stimulus packages²
is quickly translated into productive capacities so as to create the much-needed multiplier
effect on private investment.
It is easier to provide funds, but it is more difficult to ensure their speedy and proper
utilisation. In infrastructure, we suffer from inordinate delays and this results in cost overruns
which the nation has to bear. The huge amount of funds placed with the India InfrastructureFinance Company Ltd (IIFCL) would require identification of new projects or expansion of
the existing projects. This is not an easy task because the IIFCL is only a funding agency and
implementation has to be carried out by other entities, may be the State governments, public
sector undertakings or private sector corporations. To upgrade the level of infrastructure
spending by a factor of two requires gigantic efforts of co-ordination between different
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agencies for speedy implementation. The government should, therefore, concentrate its
efforts to remove hurdles in the path of implementation.
The package has also provided finances to the non-banking finance companies (NBFCs), but
there is serious lack of skill with the NBFCs on project appraisals and to ascertain the credit-worthiness of the borrowers and the accompanying project risks. There has to a national
campaign for training the NBFCs in project appraisals.
Similarly, the State governments must improve the share of their implementation and co-
operate with the Central Government to improve various infrastructure projects in their
domain or in collaboration with the Centre.
It needs to be emphasised that implementation holds the key to bail out the Indian economy
from the economic crisis.
Pranab Mukherjee has suggested that to reduce the pain of recession, employers should cut
wages all along the line to reduce costs, rather than retrenching workers and thus add to job
losses. To quote: ³Jobs must be protected even if it means some reduction in compensation at
various levels.´ This is a useful tool to fight recession and it has also been tried in several
countries. This suggestion should be implemented until such time that the economy gets
revived.
(f) ICICI example:
ICICI Bank today said it might need to make an additional provision of $28 million (Rs 188
crore) on its exposure to bonds issued by investment bank Lehman Brothers, which has filed
for bankruptcy in the United States.
The country's second largest bank, which stands to lose the most among Indian lenders, is yet
to decide if the investment would be marked to market for the second quarter.
Following an analyst report this morning, ICICI Bank issued a statement saying its UK
subsidiary had an exposure of around $80 million to Lehman's senior bonds. It had already
made provisions of $12 million on these bonds and a further $28 million worth of
provisioning might be required if 50 per cent recovery is assumed, the bank said.
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"There is panic and turmoil in the overseas markets. We will see at the end of this quarter
whether to include this component of provisioning in our balance sheet, " ICICI Bank Joint
Managing Director & CF O Chanda Kochhar said.
A report issued by brokerage firm Edelweiss said ICICI Bank's UK subsidiary might have tobook mark-to-market losses of up to $200 million for its exposure to firms hit by the global
financial turmoil. Kochhar refused to comment on exposure to other firms, but Edelweiss
said the bank's profits may not see a significant impact.
For other Indian banks, which have much smaller exposure to Lehman, the impact will be
much lower.
Public sector players such as State Bank of India and Punjab National Bank have exposures
in the range of $5 million each, Bank of Baroda and SBI both said they had no direct
exposure. SBI said it has made the required provision for $5 million and had no exposure to
AIG, which is facing a cash crunch.
BoB has subscribed to credit-linked notes issued by a special purpose vehicle floated by
Lehman. The public sector bank's exposure is less than $10 million and with the S PV outside
the ambit of bankruptcy proceedings, BoB may have to make a small MTM provision.
Bank of India sources said it had a direct exposure of Euro 8 million ($11.33 million) and
may have to provide for possible losses.
Axis Bank said it had carried out an inter-bank transaction of $1.5 million with Lehman
Brothers in Singapore. "So far, we do not have a clarity on Lehman's bankruptcy. Once we
have clarity on the settlements, we will talk to our lawyers to work out the details. The
process may take about a year, " a senior bank executive said.
The ICICI Bank shares fell 5.82 per cent to Rs 591.35 on the Bombay Stock Exchange, while
SBI was the among biggest gainer with its share price rising 6.49 per cent to close at Rs
1,585.50. Bank of Baroda and PNB shares rose 4.8 per cent and 3.4 per cent, respectively.
Axis Bank shares closed 6 per cent higher at Rs 696.55.
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Afr ica and the f inanc ia l cr isis
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Afr ica and the f i nanc ia l cr isis
Perhaps ironically, Africa¶s generally weak integration with the rest of the global economy
may mean that many African countries will not be affected from the crisis, at least not
initially, as suggested by Reuter s .
The wealthier ones who do have some exposure to the rest of the world, however, may face
some problems.
In the long run, it can be expected that foreign investment in Africa will reduce as the credit
squeeze takes hold. Furthermore, foreign aid, which is important for a number of African
countries, is likely to diminish. ( Effect iv ene ss of aid is a separate issue which the previous
link details.)
In recent years, there has been more interest in Africa from Asian countries such as China. As
the financial crisis is hitting the Western nations the hardest, Africa may yet enjoy increased
trade for a while.
African countries could face increasing pressure for debt repayment, however. As the crisis
gets deeper and the international institutions and western banks that have lent money to
Africa need to shore up their reserves more, one way could be to demand debt repayment.
This could cause further cuts in social services such as health and education, which havealready been reduced due to crises and policies from previous eras.
Much of the debts owed by African nations are odious, or unjust debts, as detailed further
below, which would make any more aggressive demands of repayment all the more
worrisome.
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Lat in Amer ica and the f inanc ia l cr isis
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Lat i n Amer ica and the f inanc ia l cr isis
Much of Latin America depends on trade with the United States (which absorbs half of Latin
America¶s exports, alone, for example). As such Latin America will also feel the effect of the
US financial crisis and slower growth in Latin America is expected.
Due to its proximity to the US and its close relationship via the NAFTA and other
agreements, Mexico is expected to have one of the lowest growth rates for the region next
year at 1.9%, compared to a downgraded forecast of 3% for the rest of the region.
A number of countries in the region have come together in the form of the Latin American
Pacific Arc and are hoping to improve trade and investment with Asia. Diversifying in this
way might be good for the region and help provide some stability against future crises. For
the moment, the integration is going ahead, despite concerns about the financial crisis.
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Cr ises I n Context
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Poor nat ions w ill get less f inanc ing for deve lopment
The poorer countries do get foreign aid from richer nations, but it cannot be expected that
current levels of aid (low as they actually are) can be maintained as donor nations themselves
go through financial crisis. As such the Millennium Development Goals to address manyconcerns such as halving poverty and hunger around the world, will be affected.
Almost an aside, the issue of tax havens is important for many poor countries. Tax havens
result in capital moving out of poor countries into havens. An important source of revenue,
domestic tax revenues account for just 13% of low income countries¶ earnings, whereas it is
36% for the rich countries , as Inter Press Service notes.
A UN-sponsored conference slated for November 2008 to address this issue is unlikely to get
much attention or be successful due to the recession fears and the financial crisis. But this
capital flight is estimated to cost poor countries from $350 billion to $500 billion in lost
revenue, outweighing foreign aid by almost a factor of 5.
This lost tax revenue is significant for poor countries. It could reduce, or eliminate the need
for foreign aid (which many in rich countries do not like giving, anyway), could help poor
countries pay off (legitimate) debts, and also help themselves become more independent from
the influence of wealthy creditor nations.
Politically, it may be this latter point that prevents many rich countries doing more to help the
poor, when monetarily it would be so easy to do so.
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A cr isis that need not have happened
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A cr isis that need not have happened
This problem could have been averted (in theory) as people had been pointing to these issues
for decades. Yet, of course, during periods of boom no-one (let alone the financial institutions
and their supporting ideologues and politicians largely believed to be responsible for the bulk of the problems) would want to hear of caution and even thoughts of the kind of regulation
that many are now advocating. To suggest anything would be anti-capitalism or socialism or
some other label that could effectively shut up even the most prominent of economists raising
concerns.
Of course, the irony that those same institutions would now themselves agree that those ³anti-
capitalist´ regulations are required is of course barely noted. Such options now being
considered are not anti-capitalist. However, they could be described as more regulatory or
managed rather than completely free or laissez faire capitalism, which critics of regulation
have often preferred. But a regulatory capitalist economy is very different to a state-based
command economy, the style of which the Soviet Union was known for. The points is that
there are various forms of capitalism, not just the black-and-white capitalism and
communism. And at the same time, the most extreme forms of capitalism can also lead to the
bigger bubbles and the bigger busts.
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Paul Krugman also notes the wasted talent, at the expense of other areas in much need:
³How much has our nation¶s future been damaged by the magnetic pull of quick personal
wealth, which for years has drawn many of our best and brightest young people into
investment banking, at the expense of science, public service and just about everything else?´
² Paul Krugman, Th e Madoff Economy, New York Ti mes , Op i ni on, D ecember 19, 2008
The wasted capital, labor and resources all add up.British economist John Maynard Keynes,
is considered one of the most influential economists of the 20th century and one of the fathers
of modern macroeconomics. He advocated an interventionist form of government policy
believing markets left to their own measure (i.e. completely ³freed´) could be destructive
leading to cycles of recessions, depressions and booms. To mitigate against the worst effects
of these cycles, he supported the idea that governments could use various fiscal and monetary
measures. His ideas helped rebuild after World War II, until the 1970s when his ideas were
abandoned for freer market systems.
Keynes¶ biographer, professor Robert Skidelsky, argues that free markets have undermined
democracy and led to this crisis in the first place:
³What creates a crisis of the kind that now engulfs us is not economics but politics. The
triumph of the global ³free´ market, which has dominated the world over the last three
decades has been a political triumph.It has reflected the dominance of those who believe that
governments (for which read the views and interests of ordinary people) should be kept away
from the levers of power, and that the tiny minority who control and benefit most from the
economic process are the only people competent to direct it.This band of greedy oligarchs
have used their economic power to persuade themselves and most others that we will all be
better off if they are in no way restrained²and if they cannot persuade, they have used that
same economic power to override any opposition. The economic arguments in favor of free
markets are no more than a fig leaf for this self-serving doctrine of self-aggrandizement.´² Bryan Gould, W h o voted for t h e market s? Th e econom i c cr isis make s i t pla i n: we
s urrendered power to wealt h y el i tes and fatally underm i ned democracy, Th e Guard ian,
November 26, 2008
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Furthermore, he argues that the democratic process has been abused and manipulated to allow
a concentration of power that is actually against the idea of free markets and real capitalism:
The uncomfortable truth is that democracy and free markets are incompatible. The whole
point of democratic government is that it uses the legitimacy of the democratic mandate todiffuse power throughout society rather than allow it to accumulate²as any player of
Monopoly understands²in just a few hands. It deliberately uses the political power of the
majority to offset what would otherwise be the overwhelming economic power of the
dominant market players.
³If governments accept, as they have done, that the ³free´ market cannot be challenged, they
abandon, in effect, their whole raison d'etre. Democracy is then merely a sham. « No
amount of cosmetic tinkering at the margins will conceal the fact that power has passed to
that handful of people who control the global economy.´
² Bryan Gould, W h o v oted for t h e market s? Th e econom i c cr isis make s i t pla in: we
s urrendered power to wealt h y el i tes and fatally underm i ned democracy, Th e Guard ian,
November 26, 2008
Despite Keynesian economics getting a bad press from free market advocates for many years,
many are now turning to his policies and ideas to help weather the economic crisis.
We are all Keynesians now. Even the right in the United States has joined the Keynesian
camp with unbridled enthusiasm and on a scale that at one time would have been truly
unimaginable.
³« after having been left in the wilderness, almost shunned, for more than three decades «
what is happening now is a triumph of reason and evidence over ideology and
interests.Economic theory has long explained why unfettered markets were not self-
correcting, why regulation was needed, why there was an important role for government to
play in the economy. But many, especially people working in the financial markets, pushed a
type of ³market fundamentalism.´ The misguided policies that resulted ² pushed by, among
others, some members of President-elect Barack Obama¶s economic team ² had earlier
inflicted enormous costs on developing countries. The moment of enlightenment came only
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the idea of opening itself even more to America¶s highly subsidized banks? At least for the
moment, financial market liberalization seems to be dead.
² Jo s eph St i gl i tz, Fear and loat hi ng in D avos , Th e Guard ian, February 6, 2009
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Dea li ng w ith recess ion
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Dea li ng w i th recess i on
Most economic regions are now facing recession, or are in it. This includes the US, the
Eurozone, and many others.
At such times governments attempt to stimulate the economy. Standard macroeconomic
policy includes policies to
y
Increase borrowing,
y
Reduce interest rates,
y
Reduce taxes, and
y
Spend on public works such as infrastructure.
Borrowing at a time of recession seems risky, but the idea is that this should be
complimented with paying back during times of growth.
Likewise, reducing interest rates sounds like there would be less incentive for people to save
money, when banks need to build up their capital reserves. However, as the real economy
starts to feel the pinch, reduced interest rates is an attempt to encourage people to take part in
the economy.
Tax reduction is something that most people favor, and yet during times of economic
downturn it would seem that a reduction in tax would result in reduced government revenues
just when they need it and then spending on health, education, etc, would be at risk.
However, because higher taxes during downturns means more hardship for more people,
increased borrowing is supposed to offset the reduction in taxes, hopefully affording people a
better chance to weather the economic storm.
Finally it is at this time that public infrastructure work, which can potentially employ many,
many people, is palatable. Often, under free market ideals, government involvement in such
activities is supposed to be minimal. Even the other forms of ³interference´ is usually
frowned upon. However, most states realize that markets are not always able to function on
their own (the current financial crisis, starting in the US, being the prime example); pragmatic
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Even then, the severity of these economic problems means that these strategies are not
guaranteed to work, or it may take even longer to take effect. For example, as quarterly
figures for various companies start to come out, more and more companies are announcing
losses, closures, layoffs or other problems; people are becoming very nervous about the
economy and spending less.
The automobile industry in the US, for example, is feeling immense pressure with some of
the largest companies in the world facing huge problems and are asking the government for
some kind of bailout or assistance. Yet, the US public generally seems against this, having
already bailed out the banks with enormous sums of money. If the automobile industry is
bailed out, then other industries will all cry for more money; when would it stop?
In addition, as Joseph Stiglitz warns, some nations are turning to the IMF which is
prescribing the opposite policies:
Many are already turning to the International Monetary Fund (IMF) for help. The worry is
that, at least in some cases, the IMF will go back to its old failed recipes: fiscal and monetary
contraction, which would only increase global inequities. While developed countries engage
in stabilizing countercyclical policies, developing countries would be forced into
destabilizing policies, driving away capital when they need it most.
² Jo s eph St i gl i tz, Let¶ s t h row away t h e rule book; Bretton Wood s II mu s t e s tabl ish econom i cdoctr ines t h at work i n emerg i ng econom ies a s well a s i n cap i tal is m¶ s h eartland, Th e
Guard ian, No vember 6, 2008
In Iceland, where the economy was very dependent on the finance sector, economic problems
have hit them hard. The banking system virtually collapsed and the government had to
borrow from the IMF and other neighbors to try and rescue the economy. However, Iceland
has raised its interest rates to some 18%, partly on advice from the IMF. It would appear to be
an example where high interest rates may be inappropriate. The economic problems have ledto political challenges including protests and clashes.
It may be that this time round a more fundamental set of measures need to be considered,
possibly global in scope. The very core of the global financial system is something many are
now turning their attention to.
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Reth ink ing the internat iona l f inanc ia l system And Bank ing
System
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Reth i nk ing the internat i ona l f i nanc ia l system?
Many people are now calling for fundamental reforms of the financial systems,
internationally. This includes international banking and finance, to reform of international
financial institutions such as the World Bank and IMF.
Part of the reform suggestions also include giving more voice and power to poor countries,
who typically have little say in how the global economy is shaped.
Traditionally powerful countries have resisted these calls²that have been voiced for decades,
not just during this crisis. This crisis however has seen even powerful countries contemplate
changes that would be more favorable to emerging nations. Whether these changes can
happen is hard to predict.
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Reform ing internat iona l bank i ng and f inance?
Leaders of the Bank of England have also called for fundamental international banking
reform. Bank of England deputy governor Sir John Gieve said the ³fundamental rethink´
meant increasing capital and liquidity requirements at institutions with ³strong restraints onthe build up of risk.´
Some of the ideas considered are quite significant, such as increasing the reserves banks must
have. (Fractional reserve banking often allows banks to have small reserves against which
loans can then be made out for larger amounts as usually most people do not withdraw their
cash deposits at the same time. This works well in good times, but can then lead to a crisis
through encouraging more loans which get riskier as competition increases; a moral hazard in
reverse.)
The Bank of England¶s governor, Mervyn King, even went as far as saying a ³little more
boredom´ would not be a bad thing for the industry. This too is significant as it suggests
restraint for an industry that otherwise is a strong proponent of financial market liberalization
and supportive of very rapid growth. The recognition here appears to be that maybe slower
but more stable long term growth is better and sustainable in the long run rather than short
bursts of high growth followed by disruptive bursts, some of which can be very violent as the
current crisis is showing.
Joseph Stiglitz argues that failures in financial markets have come about because of poorly
designed incentive structures, inadequate competition, and inadequate transparency. Part of
this is because larger institutions have been resistant to changes that would actually create
more healthy competition, something Adam Smith had long noted in his Wealt h of Nat ions ,
often regarded as the Bible of capitalism. Better regulation is required to reign in the financial
markets and bring back trust in the system. In a short but very powerful article he concludes,
Part of the problem has been our regulatory structures. If government appoints as regulatorsthose who do not believe in regulation, one is not likely to get strong enforcement. We have
to design robust regulatory systems, where gaps in enforcement are transparent. Relatively
simple regulatory systems may be easier to implement and more robust, and more resistant to
regulatory capture.
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Well-designed regulations may protect us in the short run and encourage real innovation in
the long. Much of our financial market¶s creativity was directed to circumventing regulations
and taxes. Accounting was so creative that no one, not even the banks, knew their financial
position. Meanwhile, the financial system [has] resisted many of the innovations that would
have increased the efficiency of our economy. By reducing the scope for these sociallyunproductive innovations, we can divert creative activity in more productive directions.
The agenda for regulatory reform is large. It will not be completed overnight. But we will not
begin to restore confidence in our financial markets until and unless we begin serious
reform.´² Jo s eph St igl i tz, A cr isis of conf i dence, Th e Guard i an, October 22, 2008
Professor of economics at Cambridge, Ha-Joon Chang adds some additional thoughts when
commenting on Jeffery Sach¶s suggestions such as the Tobin Tax and changing emissions
trading towards a more straight forward carbon tax. Chang said a lot more could be
entertained, including the following:
y
The introduction of a country bankruptcy code that will enable orderly sovereign debt
restructuring.
y
Not just expanding the capital adequacy requirement, but also making it counter-cyclical,
rather than pro-cyclical as it currently is (i.e. making credit a bit harder to get during good
times).
y
Stricter regulations of tax havens and private equity funds, which have greatly contributed toincreasing opacity in the financial market.
y
Credit rating agencies play a critical role in today¶s financial system and given the damages
they have inflicted by blessing all those toxic assets, these agencies need to be much more
heavily regulated or even replaced by an international public body.
Chang also voices concern about IMF reforms, questioning whether trade liberalization for
poor countries is alway s good. (He has been one of the more vocal critics of that idea and
argues that rich countries developed using more protectionist policies and moved to free trade
once they were industrialized, but that they now say poor countries should liberalize straight
away, either because of historical amnesia or because they want to ³kick away the ladder´
they climbed to achieve industrialization. The Institute for Economic Democracy has also
suggested this for many years too, and is worth looking at for more depth on the political
aspects of economic dominance over the centuries.)
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Reform ing I nternat iona l Trade and the WTO
A number of developed countries have seen their automobile sectors struggling and asking
for bailouts. While banking bailouts could be understood as it affects the entire economy,
bailouts for the auto-industry is more controversial; while they support many jobs, they donot support the whole economy in the way a bank does. Bailing out car-makers could result
in other industries asking for similar bailouts.
So what have most governments done? Professor Ha-Joon Chang raises the concern that
developed countries have spun the proposed assistance as a ³green´ issue, not because of a
sudden care for the environment and climate change, but to by-pass WT O rules on subsidies,
thus revealing a fundamental problem with the World Trade Organization system:
The [major car-producing countries outside Asia] are trying to present their bail-outs [to the
car industry] as green initiatives to avoid having their subsidies declared ³illegal´ in the
WTO .
Back in the summer of 2007, the US government proposed a new subsidies rule in the WT O ,
in which government lending to ³uncreditworthy´ companies and government investments in
³unequityworthy´ companies are all to be classified as illegal subsidies. This proposal was
objected to by the developing countries, which use many of these measures, but was
supported by the Europeans, with some minor qualifications.
Having spectacularly bailed out their banks recently by investing astronomical sums in
³unequityworthy´ companies, the Americans and Europeans would be completely
undermining their position if they also lent huge sums of money to ³uncreditworthy´
carmakers. Therefore, they need to be able to say that the huge subsidies that they are giving
to their car industries are ³ legal´ subsidies aimed at greening.
What is going on in the automobile industry in Europe and the US exposes the inherent
contradictions and inequities in the current international trading system, represented by the
WTO . The system bans policy tools that developing countries use more, such as tariffs, direct
subsidies and regulations on foreign investment, while being very generous with the tools that
the rich countries need, such as the subsidies for agriculture, R&D and reduction of regional
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disparity. Now that they need to use direct subsidies in large quantity, the rich countries are
just going ahead ² only they are painting everything green.
By so blatantly going against the WT O rules, the rich countries have implicitly admitted that
the present world trading system is not working. Rather than trying to cover this up bypainting everything green, they should start a serious rethink on how to truly reform the
system so that not just the rich countries but also the developing countries can use policies
that are more suitable to their conditions.
² H a-Joon C h ang, Pa int i ng carmaker s green; D eveloped nat ions are try i ng to get around
W T O s ubsi dy rule s by portray i ng t h eir indu s try ba i l-out s as green i ni t i at iv es, Th e Guard i an,
February 3, 2009
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Reform ing the Bretton Woods I nst i tut i ons ( I MF and Wor l d Bank)?
The Bretton Woods system of international finance devised by 44 nations after the Second
World War, mostly represented by the IMF, World Bank, was designed to help reconstruct
and stabilize a post-war global economy.
In the 70s, the purpose of these international financial institutions (IFIs) shifted towards a
neoliberal economic agenda, championed by Washington, (also known as the Washington
Consensus).
It was at this time that policies such as structural adjustment started to be pushed to much of
the developing world, following a ³one size fits all´ prescription of how economies should be
structured, which had disastrous consequences for much of the world¶s population.
As journalist John Vandaele writes,
From then on the Bretton Woods Institutions (BWIs) were very asymmetrical organisations.
The rich countries didn¶t need the BWIs any more, but with more than 60 percent of the vote
they called the shots in both institutions. Developing countries really depended upon the
BWIs, but didn¶t have a lot to say there.
And so the BWIs developed into an instrument of western power.
² Jo h n Vandaele, Bretton Wood s II: New L ifel i ne for Ai l ing G iant s , Inter Pre ss Ser vi ce,
October 28, 2008
The same policy prescriptions led to predictable problems such as
y
Developing countries opening markets before they were really ready to do so (something
often forced through by ³gun-boat diplomacy´ during colonial times)
y
Rich countries became ³judge and party,´ as Vandaele puts it: ³When they forced developing
countries to open their markets, it was no coincidence that western multinationals tended to be
among the first beneficiaries.´
y
Worsening poverty from things like structural adjustment policies that sapped the ability of
poor country governments to make decisions about how their economies would be run.
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Although such institutions have rarely been held accountable for such policies and their
effects, for many years, people have been calling for their reform, or even for their abolition.
Lack of transparency in these institutions has not helped.
There have been signs of discontent, however.
As mentioned on the structural adjustment page on this site, the IMF and World Bank have
even admitted their policies have not always worked. For example, back in 2003, they
warned that developing countries face an increasing risk of financial crisis with increasing
globalization because effects in one part of the world can more easily ripple through an inter-
connected world. ³Financial integration should be approached cautiously,´ they warned. In
addition, they admitted that it was hard to provide a clear road-map on how this should be
achieved, and instead it should be done on a case by case basis.
While former chief economist for the World Bank, Joseph Stiglitz is now a well-known critic
of the IMF/Washington Consensus ideological fanaticism, as also mentioned on that previous
page, others at the IMF have also started to question things, noting that developing countries
have not benefited from following these ideologies so rigorously.
Fast forward a few years to this financial crisis and there are more calls for reform of the
global financial system, perhaps with a difference: the crisis now seems to be so deep and
affecting rich countries as well that even some rich countries that benefited from theinequality structured into the global order are now calling for reform. In addition, although
developing countries had called for reform many times before, they now have a slightly
stronger voice that in the past.
People within the IMF/World Bank are now themselves publicly entertaining the thought of
reform. The World Bank¶s own president, Robert Zoellick has said the idea of the G7 ³is not
working´ and that a ³steering group´ of more nations would be better.
With the limited role the IFIs have played in this crisis, until recently, it seems their
significance may be dwindling. Fewer countries have turned to them as last resort, and when
they have, they have been able to push for far less stringent conditions than in the past. Some
countries have looked to other countries like China, Russia and Arab countries, first.
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There are still some concerns that some countries turning to the IMF will find themselves
being prescribed the old formulas that are now quite criticized. Joseph Stiglitz also adds that
these financial institutions have been slow to respond in the past and now:
We may be at a new ³Bretton Woods´ moment. The old institutions have recognized the needfor reform, but they have been moving at glacial speed. They did nothing to prevent the
current crisis; and there is concern about their effectiveness in responding to it now that it has
hit.
It took the world 15 years and a world war to come together to address the weaknesses in the
global financial system that contributed to the Great Depression. It is to be hoped that it will
not take us that long this time: given the level of global interdependence, the costs would
simply be too high.
² Jo s eph St i gl i tz, Let¶ s t h row away t h e rule book; Bretton Wood s II mu s t e s tabl ish econom i c
doctr ines t h at work i n emerg i ng econom ies a s well a s i n cap i tal is m¶ s h eartland, Th e
Guard ian, No vember 6, 2008
French President and head of the EU presidency, Nicolas Sarkozy has called for major
changes to the IMF and World Bank. Yet, as John Vandaele added ³This is as much a rescue
operation for two organisations that have lost muscle as a call for a new financial
architecture.´
Sarkozy¶s ideas include tighter supervision of the international banking system and a
crackdown on international tax havens to address harmful tax competition between states.
These and other proposals are not new however, as many have called for this²and more²in
the past 2 or 3 decades.
As Vandaele also adds, ³if Sarkozy is serious about a Bretton Woods II, he¶d better keep in
mind that developing countries want more voice.´ Governance issues such as better
representation, more transparency and accountability are some of the things these institutions
have long tried to promote, but often faced charges of hypocrisy as these institutions lack
many of these fundamentals.
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For a while now, talk of G20 meeting rather than just the G8 has signified this possible power
shift. The G20 was actually set up in 1999 in the wake of the financial crisis that hit Asia.
However, the G8 retained its influence, until now it seems.
The G20 represents the G8, the EU as a bloc and 12 emerging economies: Argentina,Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico,
Russia, Saudi Arabia, South Africa, South Korea, Turkey, the United Kingdom and the
United States of America. As well as the EU being represented as a bloc, IMF and World
Bank representatives are usually present at G20 meetings.
Although it is an informal structure, it comprises 90% of the world¶s economic output and
some 80% of the world¶s population, although the poorest 20% (over 160 nations) are not
represented by this group.
The United States invited the G20 for a financial crisis meeting in mid-November. As many
noted, the meeting was of the G20 and not the G8, indicated how emerging nations might be
gaining more prominence.
While many emerging nations and even some European countries wanted the meetings to
discuss fundamental reforms to the global financial system, the US and others wanted to
focus on ways to address the current crisis with specific short term measures. These divergent
aims threatened to make the talks less effective.
At the same time, a more global UN conference on Financing for Development towards the
end of November has received far less media attention. This is to include all 192 member
states and is broader in scope, continuing on from the 2002 Monterrey conference.
Some emerging nations such as China are now finding domestic pressures may outweigh
their contributions to global resolutions. China for example is being asked by Britain¶s
Gordon Brown to provide billions from its dollar reserves to help out while China is worried
about the increasing slowdown in the domestic economy and the need to stimulate its own
internal markets. It has therefore poured billions into domestic stimulus packages, implying
that it is not likely to provide so much money to institutions such as the IMF.
Some are also wondering whether the resolve of nations such as China to support an
alternative to a US dollar dominated world will really hold up; China for example, has
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Reform and Res istance
Will any of these changes occur in an effective way? In recent months these institutions have
warmed to changes in these areas. For example, in April 2008, it was decided that rich
countries at the IMF would give in 3 percent of the votes; 2 percent went to emergingcountries and 1 percent to other developing countries. However, this is still not that much and
this crisis shows that more is needed in a more deeper and meaningful way.
This will be hard to predict. If history is any indicator, power and greed politics always ruin
good ideas. Those who benefit from a system are less likely to be receptive to change, or
want to steer change in a direction that will be good for them, but that may not mean good for
everyone.
And tensions, even amongst the more powerful nations are already showing. For example, the
US has not invited Spain to a financial crisis summit for mid-November. As the world¶s eight
largest economy and home to 2 of the world¶s top 16 banks, a meeting of the G20 (G7 plus
some developing nations) sees Spain (the world¶s 8th largest economy) missing out of either
classification. Spain, however, sees this as US retaliation for the country withdrawing its
troops from Iraq. It has full EU support for being present at this meeting as well as support
from a number of Latin American countries. Like France, it wants to see in-depth reform of
the global financial system and focuses on IMF reform as well as giving more representation
to emerging nations.
The eventual outcome of the G20 meeting seemed mixed. They agreed to use government
spending to fight a spreading recession, to tighten lax oversight of markets, to resist
protectionism, and to revive stalled negotiations for a new global trade pact. They also agreed
to meet at the end of March 2009 to follow up. Developing countries also got more
assurances about increased say at international financial institutions through promises of
reform at the IMF and World Bank. But others argued that the meeting outcome seemed more
vague than concrete and only these principles seemed to have been agreed without anything
more concrete.
The call to resist protectionism has been a prime concern from the Bush Administration,
sometimes (incorrectly) equating calls for regulation with protectionsim. The calls for
regulation have typically been to make companies more transparent and ensure the financial
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mess created can be avoided in the future. Nonetheless, other regions around the world agree
that generally free trade is desirable over protectionist policies. History has shown that once
economies mature they benefit from less protectionist measures (but also shows that nations
on early stages of development may also benefit from it). The A PEC trading bloc, for
example, represents almost half of all world trade. Most member states are generallyindustrialized, so as a group, A PEC nations have agreed to resist protectionist measures.
Paul Krugman suggests that protectionism may be necessary for a while as these are not
normal conditions where the case for protectionism may be on weaker grounds, at least for
industrialized nations.
Reform of the IMF and World Bank, however, will be crucial for much of the world.
Whether that actually happens and to what extent those with power are willing to truly share
power is something that we will find out in the course of the next year.
The promise of rearchitecting the global financial system more fundamentally seemed to
wither away slightly. As the Bretton Wood s Project noted, the G20 had little time to effect
much and could not do it alone, any way:
G20 governments, swept off their feet by the financial crisis, were never going to be able to
reach a consensus on deeper reforms within the few weeks taken to prepare the summit.
Critics argue that the G20 can never tackle this agenda alone.
As Miguel D¶Escoto, president of the UN General Assembly said: ³ Only full participation
within a truly representative framework will restore the confidence of citizens in our
governments and financial institutions.´ He continued, ³Solutions must involve all countries
in a democratic process.´
² Internat i onal econom i c arc hi tecture: clean i ng up t h e me ss? , Bretton Wood s Project,
November 27, 2008
Hardly mentioned in the mainstream media by comparison, the more democratic alternative
was the Doha conference on financing for development meeting at the end of November in
Doha, Qatar, held by the United Nations General Assembly. Perhaps partly because of lack of
mainstream media attention, the Doha conference also resulted in weak pledges and
disappointment.
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More generally, as Vandaele also finds,
The most powerful international institutions tend to have the worst democratic credentials:
the power distribution among countries is more unequal, and the transparency, and hence
democratic control, is worse.
² Jo h n Vandaele, D emocracy Come s to World In s t i tut ions , Slowly, Inter Pre ss Ser vi ce,
October 27, 2008
Although history often shows that those with agendas of power tend to win out, history also
shows us that power shifts. A financial crisis of this proportion may signify the beginnings of
such a shift.
And so, it is perhaps only at a time of crisis that more fundamental rethinking of the entireeconomic system can be entertained.
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Reth ink ing econom ics?
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Merchants and master manufacturers are « the two classes of people who commonly employ
the largest capitals, and who by their wealth draw to themselves the greatest share of the
public consideration. As during their whole lives they are engaged in plans and projects, they
have frequently more acuteness of understanding than the greater part of country gentlemen.
As their thoughts, however, are commonly exercised rather about the interest of their ownparticular branch of business, than about that of the society, their judgment, even when given
with the greatest candour (which it has not been upon every occasion) is much more to be
depended upon with regard to the former of those two objects than with regard to the latter.
Their superiority over the country gentleman is not so much in their knowledge of the public
interest, as in their having a better knowledge of their own interest than he has of his.
It is by this superior knowledge of their own interest that they have frequently imposed upon
his generosity, and persuaded him to give up both his own interest and that of the public,
from a very simple but honest conviction that their interest, and not his, was the interest of
the public.
The interest of the dealers, however, in any particular branch of trade or manufactures, is
always in some respects different from, and even opposite to, that of the public. To widen the
market and to narrow the competition, is always the interest of the dealers.
To widen the market may frequently be agreeable enough to the interest of the public; but tonarrow the competition must always be against it, and can serve only to enable the dealers, by
raising their profits above what they naturally would be, to levy, for their own benefit, an
absurd tax upon the rest of their fellow-citizens.The proposal of any new law or regulation of
commerce which comes from this order ought always to be listened to with great precaution,
and ought never to be adopted till after having been long and carefully examined, not only
with the most scrupulous, but with the most suspicious attention. It comes from an order of
men whose interest is never exactly the same with that of the public, who have generally an
interest to deceive and even to oppress the public, and who accordingly have, upon many
occasions, both deceived and oppressed it.´² Adam Sm i t h , Th e Wealt h of Nat ions , Book I,
(E veryman¶ s Li brary, S ix t h Pr int i ng, 1991), pp. 87-88, 231-232 (Emp h a sis added. Add i t i onal
paragrap h break s added for readab i l i ty)