Global Financial Challenge: Post-Tsunami Era

7/30/2019 Global Financial Challenge: Post-Tsunami Era

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Global Financial Challenge:Post-Tsunami Era

Professor Tsang Shu-kiSenior Research Fellow

Institute for Enterprise Development, School of

Business, Hong Kong Baptist University

www.sktsang.comSeptember/October 2011


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Outline

1. A Brief Review of the Financial

Tsunami

2. Policy Responses

3. The Second Phrase of the Downwave4. QE1, QE2, and QE3?

5. Fiscal and policy dilemma6. Historical Lessons and Prospects


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(1) A Brief Review of the Financial Tsunami

If one looks at international economic history, one couldobserve long waves which had an internal length of 60 to

70 years (Tsang, 2003). Because of governmentintervention and other factors (such as demography andtechnology), the timeline might vary.

The long wave phenomenon was first discovered by the

Soviet economist and statistician Nikolai Kondratieff () in the 1920s. Kondratieff did not provide any in-depth analysis of the

driving factors behind the long waves. Scholars

subsequently have proposed different explanations. Four factors driving the long wave can be identified (Tsang,

2003):


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1) Over-investment: In the upwave, optimistic expectations bringabout massive investments. Because of the self-ordering effectin the capital goods sector, a reinforcing spiral is formed,leading to over-capacity.

2) Under-consumption: Income and wealth distribution tiltstowards the capitalist class and against the middle and lowerstrata of the society and the rest of the world. Disparitydampens aggregate purchasing power, resulting in a

realisation crisis for paper profits on the part of national andmulti-national corporations.

There is no contradiction between the under-consumptionthesis stated here and the trend of over-spending in

advanced capitalist economies that has caused the financialtsunami. The exploitation of the lower classes in the lessdeveloped economies has been subsidizing their counterparts inthe first world.


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(1) A Brief Review of the Financial Tsunami3) Demographic cycles: Because of political or social

factors (e.g. the end of a war), baby boom leads to

rapid growth in population and eventually providessufficient labour supply and market demand. Buthedonism, materialism and other cultural changesfollow; birth rates plunge; and the whole process isreversed.

4) Technological cycles: Investments pour into the neweconomic sector, which later turns outmoded. Anyway,parties of vested interests resist even newer

technologies, forming a technological stalemate.Production efficiency slips, resulting in a vicious supply-demand circle. However, technological break-throughcan also prolong the life of an upwave or delay thearrival of the downwave.


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Source: Robert Sahr, Inflation conversion factors for dollars 1665-est.2013


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Long waves in the past 200 yearsWorld trade/world GDP

SourcesEstevadeorda, Frantz and Taylor (2003) , see(2009)


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Long waves in the past 200 yearsInternational investment/world GDP

SourcesTaylor (2002) ; Obstfeld and Taylor (2003), see(2009)


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What Geithner once proposed as a warning line.

Which was not followed by the U.S. before the crisis.

Mid-1970s

Source: IMF


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U.S.: The ratio of NIIP/GNI

-30.00

-25.00

-20.00

-15.00

-10.00

-5.00

0.00

5.00

10.00

15.00

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

Year

Source IMF

(%)

Mid-1980s

From the largest debtee to debtor


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Given the imbalances, it was clear, what the world needed arethe reduction of debt , the rebalancing of the triangularrelations among consumption, investment and saving. The

relative experience of Iceland (which defaulted) versus Ireland(which did not) has become an issue for debate amongeconomists (Krugman, 2010; Bloomberg Businessweek, 2010)

Instead, the U.S. went on with the process offinancial

liberalization, which started when the Depression era GlassSteagall legislation was repealed in 1998. The CommodityFutures Modernization Act of 2000 was an unusual piece ofderegulatory legislation, creating a new world of uniquely self-regulated financial instruments.

Since the bursting of the IT bubble in 2000, the U.S. Fed underAlan Greenspan increased money supply and forced downinterest rates. George W. Bush, the Republican president,obviously favoured Wall Street in his policies.

13


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(1) A Brief Review of the Financial Tsunami In 2004, the SEC issued the Bear Stearns exemption, which

changed the net capitalization rule from 12 to 1 leverage toessentially unlimited for Goldman Sachs, Morgan Stanley,Merrill Lynch, Lehman Brothers and Bear Stearns. After thetsunami, none of these companies now exist in the samestructure as before the rule change.

Because of low interest rates and financial liberalization, plusthe IT revolution, derivatives became a way for banking andnon-banking institution to earn profits. Often the productswere highly leveraged and not transparent.

It also gave birth to real estate bubbles and the sub-prime

mortgage boom.

Hence the amount of debt did not decline. On the contrary, itrose quickly, sowing the seeds for the eventual bust.


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151515151515151515


0.00

5.00

10.00

15.00

20.00

25.00

%

MonthSource IMF

U.S. Fed Funds Target Rate


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Nominal contract value of OTC transactions of

derivatives in the world and as multiple of global GDP

0

100000

200000

300000

400000

500000

600000

700000

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Year

Sources: BIS, World Bank

USDbillio

0

2

4

6

8

10

12

multipleofwo

rldGDP


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Because of free market ideology, as well as limited insight,many central banks had not implemented effectivesupervision on the proliferation of financial products andderivatives. The rise of highly leveraged debt triggered

the financial tsunami.

It was the adverse consequence of the vicious cycle of laxmacroeconomic policies and undisciplined micro pursuitof profits.

The tsunami has turned out to be the most seriouseconomic crisis since the Great Depression of the 1930s.The fundamental dynamic has been the long wave ofcapitalism. The procrastination of governments indealing with deep-seated contradictions and carrying outstructural reforms has aggravated the seriousness of theproblems.


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(2) Policy Responses Confronted by the financial tsunami, the United States

and Europe and other developed economies took an evenbigger, unprecedented step towards loose monetary andfiscal policies, coupled with direct and indirect

government intervention to rescue financial institutionsand large enterprises and to relieve the pains ofmortgagors and consumers.

Under the first round ofmonetary quantitative easing

(QE1), the balance sheets of the United States, Europe,and the U.K. rapidly inflated, interest rates fell to nearzero levels. The short-term effect was that the first waveof the financial tsunami retreated, providing a breathingspace. Unwittingly, the huge liquidity generated evencaused asset bubbles in some developing countries/regions.


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(2) Policy Responses The following chart is from Interim Projections of the

OECD Economic Outlook in September 2010 :http://www.oecd.org/dataoecd/22/10/45971907.pdf.

Please note that the monetary units vary, one shouldlook at the national / regional historical trends.

I use the average exchange rate of each unit. Afterharmonizing, I find that among these four economies,the U.S. Federal Reserve released more than 80% ofthe added funds under QE1, showing the leading

position of the U.S. financial system in the world.


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2020202020202020

Rapid expansion

Reduction was slight

QE1 in the U.S., Euro area, UK and Japan

U.S.

U.K.

Euro area


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(2) Policy Responses: Fed Funds Target Rate

Fed Funds Target Rate

71 74 77 80 83 86 89 92 95 98 01 04 07 10

(%

)

0.0

2.5

5.0

7.5

10.0

12.5

15.0

17.5

20.0

(%

)

0.0

2.5

5.0

7.5

10.0

12.5

15.0

17.5

20.0

Down to near zero


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(2) Policy Responses: Monetary

Source: Harding (2010).


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2323232323232323The tsunami temporarily retreated after QE1


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(2) Policy Responses

As for fiscal policy, governments resorted to capitalinjection, semi-public ownership, tax breaks, subsidies andpublic expenditure, which supported monetary easing so

that the real economy would not fall into a deep recession. The consequence was that fiscal deficits rose sharply. In the

EU, fiscal-monetary crises emerged from five non-corecountries - Portugal, Ireland, Italy, Greece and Spain

(PIIGS).

These five countries are subject to restrictions of the euroarea, there is no independent monetary policy. Hence theycould only use fiscal deficits to ward off the recession and

issued bonds to finance them. Unlike Japan, most holderswere foreign financial institutions and investors. Anydecline in confidence could lead to shocks.


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(3) The Second Phrase of the Downwave

In any case, despite the unparalleled governmental efforts, theexpected recovery has lacked momentum in developed economies,as unemployment remains high. It appears in the first phrase ofthe downwave, monetary, fiscal and other rescue measures have

failed to genuinely reverse the recessionary forces.

The reason is that money channeled to the banks, largeenterprises and subsidies on consumers as well as incentives ofnear-zero interest rates etc. have not significantly enhanced

effective demand, because they are skeptical of the long-termeffects of these short-term policy maneuvers. They are reluctantto spend the new money, but rather choose to prepare forsomething worse in the future.

Moreover, even as QE1 reduced short-term interest rates, long-term interest rates pressure did not subside. U.S. yield curve inthe past two years actually became steeper, showing that the lackof market confidence, especially concerning the fiscal situation.

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(3) The Second Phrase of the Downwave

In response, instead of exit from QE1, the U.S.Federal Reserve launched a second round ofquantitative easing (QE2) in November 2010.

Compared to $ 1.725 trillion under QE1, 600 billiondollars of new funds, plus the maturity of loans toFreddie and Fannie and mortgage-backed securities,bonds, to the tune $250 to 300 billions, would be

employed to purchase Treasuries, mainly five or six-year bonds.

The goal of QE2 was ostensibly to flatten the yieldcurve. Would it be successful? Many economists were

skeptical. There was a focus on the future of morelong-term debts. QE3 or even QE4 was consideredpossible.

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(4) QE1, QE2, and QE3?

The steepening of the yield after QE1 and QE2


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Theoretically, if QE were successful in flattening the entireyield curve, businesses and consumers would be willing tospend more money in the short term instead of putting it

aside for an uncertain future. Effective demand wouldincrease, enhancing real economic growth.

The problem is that because ofregional imbalances in theworld economy under QE1, the internal effects within the

U.S. and Europe were significantly reduced. Instead, a hugeflow of capital, most destined to emerging economies withbetter prospects (such as BRIC and ASEAN), alleviated theadverse impact of the financial tsunami on them.

Moreover, it has caused unexpected asset bubbles plusunpalatable consequences on consumer price inflation. Someof the emerging economies have had to take floodprevention measures, including interest rate increases andtightening of capital controls.

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U.S. dollar rose soon after the tsunami, because the crisis resulted in a lack of the dollar ininternational markets, and other countries had to sell their currencies to get it. This reflected the

dollar's dominant position. But with the historical accumulation of unfavorable factors, coupledwith QE1 and QE2, the consequence would be the long-term decline of the dollar.


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The upward pressure on USD/SGD and USD/KRW


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Upward pressure on Japanese Yen


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(5) Fiscal and policy dilemma

Regarding fiscal policy, Japan has been in deep mudfor a long time, and Europe is bothered by the crises inPIIGS. The situation in the U.S. was not too bad beforethe tsunami, but has deteriorated (see the table on thenext slide).

Theoretically, facing a liquidity trap, where moremoney does not create effective demand, fiscal

expansion would be an alternative, as argued by someKeynesians like Paul Krugman (2011) and McKinleyand Cozzi (2011) .

However, the stalemate in U.S. politics, as testified by

the recent quarrels over the national debt ceiling,shows how difficult it is for Obama to implement anyNew Deal type of fiscal stimulus a l Roosevelt after theGreat Depression of the 1930s.


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SourceIMF World Economic Outlook, April 2011


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Japan

U.S.

France

Greece

Ireland

Germany

(5) Fi l d li dil


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The recent downgrade of the U.S.s treasuries rating byS&Ps only aggravates the dilemma of the ObamaAdministration.

QE3 seems to be on hold, although the Fed has said thatnear-zero interest rate would stay until mid-2013,indicating a possible shift from quantitative to pricetargeting.

How would the Fed Funds target rate affect the whole yieldcurve except by the purchase of longer-term treasuries bythe Fed? Would new funds be employed? Bernankesrecent Jackson Hole speech did not give much clue.

Anyway, the U.S. yield curve has flattened, perhapsbecause of the fear of a double-dip recession.


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The steepening of the yield curve until the recent fear of double-dip

(5) Fi l d li dil


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(5) Fi l d li dil


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(5) Fiscal and polic dilemma


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Not much improvement

Mid-1980s

Source: IMF


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(5) Fiscal and policy dilemma In early September, Obama unveiled the

Administrations job plan through fiscal stimuli,

amounting to USD447 billion. It represents about3% of U.S.s GDP in a year.

It is not clear whether the package could pass the

Congress and how it would be implementedwithout taxing the rich (the Buffet Tax?), giventhe cap on national debt ceiling. Moreover, 2012will be a year of presidential election.

Some estimates put the benign effect of thepackage as reducing the unemployment rate by0.5% to 0.75%, not a very encouraging prospect.


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(5) Fiscal and policy dilemmaUSD bill ion

1 Employee payroll tax holiday 175

2 Employer payroll tax holiday 65

4 Aid for state and local governments 85

5 Infrastructure projects 50

7 8

8 Others 10447

Tax relief for firms taking on new

employees

6

5

Unemployment benefits for long-term

unemployed

49

Tax break for companies investing in

new plant and equipment

3

(6) Historical Lessons and Prospects


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From the historical perspective, the financial tsunami has notbeen effectively addressed by the unprecedented effects of theadvanced economies. The stabilization has failed to feedsignificantly into real growth (Puplava, 2011).

The downwave has entered into the second phrase. No disasterfinishes one-off. Here some past evidence is provided.

Compared the Great Depression of the 1930s, this particulardownwave has also been complicated

(1) differences in policy responses by leading economies (2) a shift in global economic balance: the migration of growth

engines to the East from the West.

It appears that the interest of the U.S. government in reforming

the international trade and financial infrastructure and reining inits over-arching financial sector is basically for the sake ofconvenience. It has no intention of conceding its dominantposition.

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(6) Hi t i l L d P t


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DJIA around the Great Depression381.17

(03/09/1929)

41.22(08/07/1932)

lowest - 89.2%



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DJIA through the tsunami

Lowest: -54%

What disaster? Ask Wall Street.



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Nikkei 225

38,916(29/12/1989)

7,608

(28/04/2003)

Lowest 81.9%

7,055(10/03/2009)

The lost decade? Double-decade? Triple-decade?



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Source: IMF

The contribution of the emerging G20 economies



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52

Investment

SourceIMF



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I am not predicting the end of the world, not at all.However the downwave works out, there probably wouldbe another golden era. Hopefully nations might have

learnt the appropriately historical lessons. Contrary to the Great Depression, this crisis has been

coupled with a geo-political and geo-economic shift. Anobvious piece of evidence is the rise in commodity prices.

This could herald a tectonic movement, reflectingstructural transformation. With Asia, BRIC and otheremerging economies strengthening, there might be afight for resources as the phoenix rises from the ashes.

Facing the unique challenges, some of the emergingeconomies, e.g. BRIC, have had to resort to tighteningpolicies and measures.



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CRB Index


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Food and tropical beverage


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Brazil

India

China

Euro area

U.S.

Brazil recently lowered interest rate in view of the deterioration in international economic environment.

Japan



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The U.S. is only a hurt tiger, but still the dominant powerin the world. It will be a waste of time to directly challenge it,although the push for the reforms in international trade andfinancial architecture must go on, so as to redress the global

imbalances. As I have argued that China and other emerging regions

should reconsider the meaning of internationalization. It isdifferent from globalization. Internationalization means

extending beyond a countrys border and nurturing cross-border cooperation. In short, regionalization is an alterantive,building bloc or fall back position (Tsang, 2009) toglobalization run by irrepsonsible superpowers.

Only when emerging economies have built regional strength,will they be in a position to challenge the hegemony of the U.S.and Europe as irresponsible leaders in the global trade andfinancial order.

References


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References

Bloomberg Businessweek (2010), Iceland Bankruptcy-to-Rebound Reveals Models Ireland Won't Take, 2 December2010 (http://www.bloomberg.com/news/2010-12-02/iceland-bankrupting-self-to-recovery-reveals-policy-ireland-dared-not-take.html).

Harding, Robin (2010), Some enchanted easing , FinancialTimes, 28 October 2010, p.9.

Krugman, Paul (2011), The Hijacked Crisis , New York

Times, 11 August 2011, OP-ED. Krugman, Paul (2010), Eating the Irish, New York Times,

25 November 2010, OP-ED.

McKinley, Terry and Cozzi, Giovanni (2011), Fiscal

Contraction or Fiscal Expansion in the US: Which WillPromote Growth and Employment? Development ViewpointNumber 66, September 2011, CDPR, SOAS.


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References Puplava, Chris (2011), A Pictorial Review of the Weakest

Recovery since the Great Depression, Financial Sense, 16

September 2011.(http://www.financialsense.com/contributors/chris-puplava/2011/09/16/a-pictorial-review-of-the-weakest-recovery-since-the-great-depression)

(2011) (13/18/2011) http://www.sktsang.com/RF/downwave-again.pdf Tsang Shu-ki (2011), Two-Speed Recovery under

Tectonic Effect? -- Comments on IMF Regional

Economic Outlook: Asia and Pacific (28/4/2011)(http://www.sktsang.com/ArchiveIII/Com%20on%20IMF%20AREO.pdf).

References


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References

(2010) (6/11/2010)http://www.sktsang.com/ArchiveIII/Tsang-DWII-20101106.pdf

(2010)3R -()131-153 Tsang Shu-ki (2009), Dragons Weathering the Storm:

Blue Sky Ahead? Whither the global polity/economy?(28/9/2009) (http://www.sktsang.com/ArchiveIII/Tsang-CPU-DRC-090928.ppt).

(2009) 3R(28/10/2009)www.sktsang.com/ArchiveIII/Tsang3R091028.ppt

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References

(2008) (11/10/2008)www.sktsang.com/ArchiveIII/CBC_sktsang_081011

.pdf Tsang, S.K. (2008), The Economic Basis of

Regionalization, The Pan-Pearl River Delta: Anemerging regional economy in a globalizing

China, in Y.M. Yeung and Shen Jianfa (eds.), TheChinese University Press: pp.89-113. Tsang Shu-ki (2008), How to save the economy as

an irresponsible central bank" (20/4/2008)www.sktsang.com/RF/CB_2008A.pdf.

References


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References

Tsang Shu-ki (2005), History unfolding - economic crisisin an uneven world" (4/5/2005)www.sktsang.com/ArchiveIII/History_unfolding.pdf.

Tsang Shu-ki (2004), Delayed calls: the paradox ofdemand side deflation versus supply side inflation(16/5/2004)

(www.sktsang.com/ArchiveIII/Delayed_calls.pdf). (2003) (27/6/2003)

www.sktsang.com/ArchiveIII/Long-WaveAgain.pdf Tsang Shu-ki (2001), Kondratieff Long Waves

Unsynchronized KLUWs at Last (8/4/2001)

(http://www.sktsang.com/ArchiveIII/Lwsal.pdf).

References


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References

Gail Tverberg, Why the US Debt Limit Agreementis Only a Temporary Solution, 3/8/2011, Financial

Sense(http://www.financialsense.com/contributors/gail-tverberg/2011/08/03/why-the-us-debt-limit-agreement-is-only-a-temporary-solution#.TjolU_rAAyQ.facebook)

Jia Lynn Yang, Neil Irwin and David S. Hilzenrath,Fed aid in financial crisis went beyond U.S. banks toindustry, foreign firms, December 2, 2010,Washington Post

(http://www.washingtonpost.com/wp-dyn/content/article/2010/12/01/AR2010120106870.html?sid=ST2010120106876 )

Global Financial Challenge: Post-Tsunami Era

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