DECEMBER 2008
Volume LXXIV No. 12$8.00
The besT ThoughTs of The besT minds on currenT naTional quesTions
ImpartIal • ConstruCtIve • authentIC
Address by RICHARD MCCORMACK, Vice Chairman, Merrill Lynch, ormerUndersecretary o State or Economic Aairs, and G-7 Sherpa or President GeorgeH.W. Bush
Address by RICHARD J. HARDY, Proessor and Chair o the Department o PoliticalScience at Western Illinois University
I
eel deeply honored to be with you today, and to partici-pate in this important conerence with the distinguishedPresident and Vice President o Taiwan, and this audienceo successul achievers. We have just heard a remarkable representation romVice President Siew about Taiwan’s vision or overcomingthe challenges presented by the global nancialstrains, and or regaining Taiwan’s productivity-drivengrowth and competitiveness. There are tremendousopportunities or Taiwan, her people, and investors inthe decade ahead as this vision is gradually realized andglobal economic conditions normalize.Taiwan is a very important trading partner o theUnited States. Hundreds o American companies havesuccessully invested here, directly or indirectly, overthe years. Some o our companies have been here ordecades, represented by people in this audience.Today, because I have been involved in themanagement o a number o past nancial criseswhile serving in the American Government and theInternational Monetary Fund, I have been asked by theconerence organizers to say a ew words about the latestglobal nancial crisis, the roots and causes o this crisis,the strategies in place to address the global nancialstrains, the lessons learned, and the prospects ahead orthe global economy.
3
Crisis Background
Two months ago, the annual report o the Bank orInternational Settlements (BIS) in Basil, Switzerland,stated that the nancial crisis acing the globe was themost dangerous since the end o the second world war,and that we were rapidly approaching a tipping points inthe crisis.As you know, the BIS is where central bankers meetprivately to consider global nancial and economicproblems. So, when this alarming report appeared,governments everywhere took immediate notice.The BIS report, however, was only the latest in aseries o warnings that had been voiced in public andin private by increasingly alarmed ocials, such asGovernor Gramlich in the U.S. Federal Reserve. Some o these concerns appeared in a book I helped write whileserving at CSIS, a public policy institute in Washington,D.C. (
International Financial Architecture: G7, IMF, BIS,Debtors and Creditors
- Palgrave Macmillan, 2005)It is important to understand that some o theroots o the present crisis go back to l997 and the Asiannancial crisis. When banks and markets collapsedthroughout Asia in l997, the American government,decided to stimulate its own economy to help to addressthe defation in global net demand that was createdby the implosion in Asia. The American central bankslashed interest rates, which gradually uelled a liquidity-driven boom in technology investment and providedincreased global net demand.This was the right decision, but by holding interest
Seizing the Opportunities
PERSPECTIVES ON THE GLOBAL FINANCIAL CRISIS
Address by RICHARD MCCORMACK, Vice Chairman, Merrill Lynch, ormer Undersecretary o State or EconomicAairs, and G-7 Sherpa or President George H.W. Bush
Delivered to 2008 Taiwan Business Alliance Conerence, Taipei, Taiwan, October 6, 2008
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DECEMBER 2008
531RICHARD mCCORmACk
rates too low or too long and providing too much creditat too low a cost, a dangerous bubble in equity marketswas triggered. The bubble burst in 2001, erasing nearly7 trillion dollars in equity values in the U.S. alone. Byholding interest rates too low or too long, it turned agood idea into a bad idea. When the bubble burst, the leadership o theAmerican central bank decided to create a smallerbubble, a housing bubble, to ll part o the gapingeconomic hole created by the collapse o the rst bubbleand to help lit the country rom a threatened recession.Again, that was probably the right decision, but again,by holding interest rates too low or too long, it turned agood idea into a very bad idea, and housing prices rose130 percent between 200l and 2006. The Federal Reserveand other supervisory bodies, despite the concerns o individual ocials, also ailed to stop the dangerouspractices that were developing in the mortgage markets,believing that the markets would police themselves.The problem was complicated by the globalcurrent accounts imbalances that gradually developed.These came partly as a consequence o U.S. consumerdemand that was created in part by the soaring value o real estate. Consumers began borrowing large amountso money rom their home equity, and spending it,oten recklessly.The country as a whole began to develop titanicand sustained current account decits. Eventually,this process produced the greatest transer o wealthin the history o the planet, as trillions o dollarso trade decits mounted or the U.S. It was clearlyunsustainable, but the continuing market demandencouraged excessive investment in export industriesall over the world. This resulted in gradually weakeningprots rom many o these industries through cut-throatcompetition among themselves.In some countries, huge trade surpluses beganto appear, creating diculties in managing monetarypolicy, since the excess dollars had to be bought upby the central bank in local currency. This resultedin very low interest rates, excess capacity, bubbles instock and real estate markets, and gradually increasinginfationary pressures.Fuelled by titanic monetary stimulus, globaleconomic growth began to explode upward, eventuallyreaching 5.2 percent on an annual basis. At this point,more than two years ago, some leading central bankersin Asia grew alarmed and began warning privately thatthe natural resource base to supply the global economyat a 5.2 percent growth pace did not exist. There wasn’tenough oil, coal, copper, and other resources to sustainthis growth without triggering shortages and infation.These voices urged squeezing liquidity to bring downglobal growth to 3.5 per cent, where gradually the globaleconomy could accumulate the necessary quantities o oil and other materials at a reasonable non-infationaryprice to keep the global growth sustainable.About this time, the IMF began warning that riskwas not being priced into the cost o money. Bonds werebeing sold without regard to traditional risk premiums,even in countries with bad political and economichistories. Houses were being sold to people at prices theycould not aord and were being nanced by mortgagecompanies that quickly passed on the risky mortgagesand bonds to others through complicated derivativepackages. These, in turn, were sold throughout theworld to people and institutions happy to purchase suchleveraged and protable investments.This was also the case or some banks that werenot able to make much prot on traditional loans in anenvironment o very low interest rates. Thus, they werelooking or other ways to improve their protability.Elaborate credit derivatives were deployed to dealwith potential deault risk. These insurance policies,which were purchased or issued by banks and otherinvestors and nancial institutions, rose at an explosivepace to nearly 70 trillion dollars in notional value.Concerns began to mount in Central Banks about thestability o some o this insurance in a potentially chaoticuture nancial environment. Crash eorts, led by theFederal Reserve Bank o New York, were mounted tobring order to this process. Some reorms were instituted.However, more and more nancial business wasestablished on shorter and shorter credit terms, withinvestors believing that they would be able to disengagethemselves i the nancial environment were to becomedangerous. Nearly three years ago, the Federal ReserveBank o New York warned o a potential uture rush bynervous investors to the exit during a crisis, which, inturn, could produce a atal shortage o market liquidity.Markets paid little attention to this warning, which wasrepeated several times by Mr. Geithner.All these conditions o easy money, lax supervision,and the complacency brought about by a multi-yearperiod o ever-increasing wealth, prosperity, prots,leverage, and growth, produced the greatest credit boomand asset infation in history.Last August, Mr. Geithner’s concern about a rushby investors to the exit, suddenly materialized. Housingprices began alling and those holding the derivativepaper based on housing mortgages panicked. Much o the global banking system simply roze, with nobodyknowing who had the bad paper, who had the goodpaper, and who might go suddenly bankrupt; creditorswere let holding the bag.Central banks backed by governments rushed intothe credit vacuum, provided a saety net or imperilednancial institutions with loans in unprecedentedamounts to keep them afoat. These institutions includedFanny Mae, Freddy Mac, and a number o other critical
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