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T
HE
G
LOBAL
F
INANCIAL
C
RISIS
:C
AUSES
,A
NTI
-C
RISIS
P
OLICIESAND
F
IRST
L
ESSONSM
AREK
D
ABROWSKI
*
When the US subprime mortgage crisis erupted insummer 2007 few people expected that it could hitthe entire world economy so hard.One year laternobody had already doubts that we faced a financialsystem crisis on the global scale with dramaticmacroeconomic and social consequences for manyregions and countries.Few local analysts and politi-cians would dare claiming that their country isshielded from the financial crisis effects as the stormunfolds worldwide.Left to the unknown is its scale,sequencing,distribution effects between regions andcountries and the consequences for the future archi-tecture of the financial system.As critical as thequality of the day-to-day management of the crisis isthe understanding of what has happened and whatmay happen,whence the need for an interim diagno-sis,even one incomplete and involving a certain mar-gin of misperceptions and wrong interpretations.This short commentary tries to analyze the extent towhich monetary policy and financial market regula-tion failures bear responsibilityfor the eruption of this crisis andits further spread,the zigzags of anti-crisis management,crisisimpact on emerging marketsand,finally,to present some ten-tative lessons for policymakers.
Monetary roots of the currentcrisis
The primary causes of the cur-rent financial crisis are imput-able to lax monetary policies conducted by the USFederal Reserve Board and other major centralbanks (e.g.the Bank of Japan) from the mid-1990s.Enjoying record-low inflation and low inflationaryexpectations,central banks reverted to more inten-sive fine-tuning in order to avoid the smallest risk of recession.As a result,the Fed aggressively reducedits interest rate three times over the last ten years(see Figure 1),starting with the series of crises inemerging markets (Mexico,South-East Asia,Russia,the pre-crisis situation in Brazil) and the Long-TermCapital Management troubles in the United States atthe end of 1998.This was followed by the 2001-2002post-9/11 drastic interest rate cuts,down to 1 per-cent,and the bursting of the dot.com bubble.Onboth occasions,the Fed provided relief to troubledfinancial institutions,helping to circumvent (1998)and reduce (2001) the danger of a US recessionwhile fueling global economic growth.The thirdintervention occurred in the wake of the current cri-sis (end of 2007 and beginning of 2008):the federalfunds rate was reduced from 5.25 percent to 2 per-cent within a few months and then to a low of 1 per-cent in November 2008.Fearing recession and deflation (in the early 2000s),the subsequent tightening of monetary policy alwayscame too late.Such an excessively lax Fed attitudecontributed to a systematic building up of excess liq-
CESifo Forum 4/2008
28
Focus
*The CASE – Center for Social andEconomic Research,Warsaw.This is arevised and updated version of Dabrowski (2008).
01234567
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
F
ED S
F
EDERAL
F
UND
R
ATE
in %
Source: Federal Reserve Statistical Release.
,
Figure 1
 
CESifo Forum 4/2008
29
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uidity both in the United States and the world.Distracted by the supply shock flowing from eco-nomic reforms and market opening in China,Indiaand in other developing and transition countries,many policymakers and analysts were misled by thetemporary lack of visible inflationary consequences.The Uruguay Round,especially the Agreement onCotton and Textiles,and the ensuing liberalization of world trade further exerted downward pressure onprices in the manufacturing market.However,the excess liquidity had not vanished andbrought on three asset bubbles:one in the real estatemarket (primarily in the United States but also inseveral European countries such as the UnitedKingdom,Ireland,Spain,and Iceland,the Balticcountries and Greece),a second in the stock marketand a third in the global commodity markets.Thesebubbles had to burst sooner or later.Serious macroeconomic concerns had also started tosurface,namely an increasing current account deficitin the United States,and recently,mounting globalinflationary pressures triggered by rising commodityprices (seen as an external price shock by nationalmonetary authorities in individual countries),rapid-ly growing official international reserves in manyemerging market economies and a depreciating USdollar.
Regulatory failures
Monetary policy is not the sole culprit.A large shareof responsibility weighs upon regulations and regu-latory institutions that lagged well behind rapidfinancial market developments.Two major inconsis-tencies are particularly apparent when looking atinstitutional issues:•the global character of financial markets and thetransnational character of major financial institu-tions as opposed to the national nature of finan-cial supervisory institutions (even inside the EU);•the increasing role of financial conglomeratesoperating in various sectors of the finance indus-try and the innovative,cross-sectoral financialinstruments versus the sectoral segmentation of financial supervision;only a few countries canboast of consolidated financial supervision.TheUnited States presents additional institutionalpeculiarities with two levels of responsibilities(federal and state) for financial supervision.The blame should also be borne by rating agenciesand supervisory authorities that failed to under-stand the nature of innovative financial instrumentsand that provided excessively short-sighted riskassessment by not taking sufficiently into accountthe actual risk distribution in the long intermedia-tion chain between the final borrower and creditor,thus underestimating the actual risk.The same rat-ing agencies which granted excessively positivegrades to financial institutions and individual finan-cial instruments in times of boom hastily started todowngrade their ratings at the time of distress,adding to market panics.Precautionary regulations,usually meant to enhancethe safety and credibility of financial institutions,such as capital-adequacy ratios (especially whenassets are risk-weighted and mark-to-market priced)or tight accounting standards related to reserve pro-visions against expected losses,also unveiled theirperverse effect as they led to sudden credit stops andmassive fire selling of assets.They proved to bestrongly pro-cyclical,especially as the crisis hadalready erupted.
Zigzags of crisis management
The crisis management roved chaotic and centeredon calming nervous financial markets in the short-term rather than addressing fundamental challengeslike the massive insolvency of financial institutions.The lack of international institutions able to managemacroeconomic and regulatory policy coordinationvery often led to hasty national actions as exempli-fied by the Irish government’s unilateral decision toprovide full deposit guarantees,prompting other EUgovernments to follow suit or by the Iceland-UKconflict over cross-border deposit guarantees.The drastic cuts in Fed rates at the end of 2007 andat the beginning of 2008 are another instance of ashort-sighted unilateral policy.The cuts added toinflationary pressure and the commodity marketsbubble worldwide.And when combined with theappreciation of the euro and the yen,it exportedthe risk of recession to Europe and Japan while fail-ing to restore domestic US financial market confi-dence,as demonstrated by increasing spreads andperiodic liquidity crunches.The initial diagnosispointing to liquidity rather than solvency as the cri-sis’
raison d’être
now appears to have been erro-neous.Indeed,US authorities wasted time and
 
potential ammunition needed at the moment and inforthcoming months on suboptimal monetary andfiscal interventions (interest rate cuts and broad-based tax rebates) in order to stimulate the econo-my and provide more liquidity rather than concen-trating their resources on fixing the insolvency of financial institutions.The belated and costly interventions of some gov-ernments to rescue their financial sector look con-troversial to many.These doubts are at least partly justified.On the one hand,rescue plans represent anadditional burden on taxpayers,though part of thecurrent recapitalization costs may be recovered bysubsequent privatizations.Those countries,howev-er,with an already high debt to GDP level must par-ticularly be cognizant of the limits of their fiscalinterventions as they are prone to illiquidity andinsolvency.Furthermore,the prospect of worldwide economicstagnation/recession adds to potential fiscal stress inmany countries.Thus,fiscal policy requires a verycareful approach.While rescuing large insolventfinancial institutions may be sometimes unavoidableat least in short term (see below),the idea of using alarge-scale fiscal stimulus to overcome reces-sion/stagnation must be treated with a large dose of skepticism.The experience of Japan,which tried tofight the post-bubble recession in the 1990s withaggressive monetary easing and large-scale fiscalstimulus,should be studied very seriously.Japan’s fis-cal activism failed to overcome stagnation,but con-tributed to building up the large public debt(175percent of GDP in 2006).In this context,therecent IMF call for global fiscal expansion is contro-versial (IMF 2008).Whether government intervention is sufficient toguarantee market confidence,considering govern-ments’ failure to avoid the crisis and provide an ade-quate response right from the onset,is a legitimatequestion to ponder.In general,private sector andmarket-oriented solutions,like arranging the take-over of a bank in trouble by a new private investor if available at a given time,will always prove a bettersolution than its nationalization.The bottom line isthat the current crisis cannot serve as the excuse forturning to government interventionism and state(public) ownership of financial institutions as a long-term solution.On the other hand,as learned from the GreatDepression,governments must intervene in large-scale financial crises to prevent a systemic bankingcrisis and total collapse of the financial system and aresulting deep recession spiral.This lesson seems tobe well understood by contemporary policymakers(others analogies referring to the early 1930s are notalways correct).The very nature of financial institu-tions – a high level of leverage and mismatchbetween their assets and liabilities (borrowing shortin order to lend long) – makes them extremely vul-nerable in times of distress and confidence crises.The collapse of one large bank or investment fundmay cause a far-going chain reaction as was experi-enced recently after the bankruptcy of LehmanBrothers.Hence,a government rescue of troubledfinancial institutions cannot be compared to the bail-ing out of loss-making non-financial corporations.Regarding moral hazard,it is difficult to expect gov-ernment bail-outs to reward irresponsible bank man-agers and owners because they are already runningout of business.
How is the crisis spreading to emerging markets?
Amidst shattering hopes of ducking the side-effectsof the current financial crisis,emerging marketeconomies are nonetheless feeling its blow.From2006 onwards,these economies have experiencedrising inflationary pressure resulting in numerouseconomic and social problems.This pressure isunlikely to subside quickly,even if the price of some commodities has started to decrease and theUS dollar has recovered in recent weeks.Moreover,a slower world economy means a weaker demandfor many commodities,as well as investment andconstruction-related products.Plus,the global cred-it crunch and liquidity problems of many transna-tional corporations have already led to net capitaloutflows from emerging markets,halting newinvestment projects.Finally,banks in many emerg-ing market economies are vulnerable to a globalliquidity crunch due to short-term internationalfinancing exposure and risky lending practices.Putotherwise,new waves of crises in emerging marketeconomies appear rather unavoidable,much moreso in countries that have not built up sufficientinternational reserves or have not run fiscal sur-pluses.Ukraine,Hungary,Belarus and Pakistan,forinstance,have already filed for IMF emergencysupport.
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The same concerns Iceland which does not belong to the group of emerging-market economies.
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