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The macro question

By Andrew Sheng (chinadaily.com.cn)
Updated: 2008-11-17 10:27

Special Coverage Exclusive: An Asian view of the global financial crisis

Contents:  Preface  A historical inflexion point  The macro question  The micro origins  Lessons for China and Asia  Back to basics  One world, three paths  Status quo  The rise of regional markets  Romance of the three regions  Conclusion

As I explained in my forthcoming book, "From Asian to Global Financial Crisis" to be published by Cambridge University Press, the more recent origins of the current crisis can be traced to four major mega-trends.

The first was the appearance in 1989 of 3 billion labor force into the market economies following the end of the Cold War that gave rise to a global flood of cheap goods and low inflation for nearly two decades.

The second was the monetary policy responses to the Japanese bubble/deflation since 1990, which gave rise to over two decades of almost interest free yen loans globally, creating the famous Yen carry trade.

Recent estimates of the global carry trade, essentially the arbitraging of differences in national interest rates and exchange rates, amounted to $2 trillion, of which half is probably the Yen carry trade . The supply of almost interest free funding was effectively to subsidize the rise of financial engineering, which were applied with great effect in the Asian crisis period.

The success of such carry trades were then applied and magnified through leverage and derivatives, a hallmark of the new investment banking and hedge fund class. The increase and reversal of carry trades using low interest rate currencies added to volatility and volume of global financial trading and flows.

The third force therefore was the emergence of financial engineers, a trend that was already evident with the layoff of scientists and physicists at the end of the Cold War, who applied their technical and statistical skills to financial markets.

They created the financial models to manage risks and staffed the business schools, investment banks and hedge funds that dominated financial markets globally. Underlying their sophisticated models was one fatal flaw, that the world of risk was a bell-shaped statistical curve that ignored the long-tailed black swan risk. It was the underestimation of once in 400 year risks that proved their undoing.

The fourth was the phase of global deregulation of markets, from the reduction of tariffs under WTO, the removal of capital controls under IMF and the philosophy that minimal intervention and letting markets determine prices and competition would create global efficiency. Such philosophy permeatted both the basic textbooks and the international bureaucracy.

Essentially, these mega-trends were four arbitrages that created converging globalization – wage arbitrage, financial arbitrage, knowledge arbitrage and regulatory arbitrage.

At the policy level, the failure of state planning also saw the ebb-tide of Keynesian economics, which called for greater government intervention in the economy. The dominance of Friedmanite free market capitalism unfortunately over-emphasized the use of monetary policy tools and the importance of central banks. Fiscal policy was relegated back to minimizing fiscal deficits, whilst elegant monetary targeting theories were propounded based on consumer prices that ignored the crucial role of asset prices.

It was a grave intellectual blindspot that the endowment effect of cheap labour into the world economy deluded many Western central bankers that their monetary policy was working wonders on global inflation.

In hindsight, that intellectual blindspot was minor compared to the macro-economic policy mistake to ignore the bubble in real estate prices. The naive belief that widespread house-ownership was good for long-term social stability irrespective of affordability and supply constraints had the unintended consequence of creating social expectations that house prices would rise and never drop.

The central importance of housing within household balance sheets is often taken for granted. However, real estate accounts for the bulk of assets of households and certainly the most important collateral asset of the banking system.

In many countries, the desire for greater home ownership was not backed by sufficient supply side responses, so that larger and more lending for housing created upward price push that became self-fulfilling.

In the US, house prices rose almost non-stop from 1991 to 2006, with total private sector real estate rising to 225 percent of GDP. Between 2003 to 2007, real estate assets of the US households rose by $6 trillion, but household liabilities increased by $4.5 trillion, implying that households consumed a large part of the increase in house prices.

This was made possible because the financial system pushed loans to the consumer sector. Mortgage loan to value (LTV) ratios rose to 90 percent for housebuyers and credit evaluation deteriorated by lending to no-income, no job assets (NINJA) subprime borrowers.

These subprime mortgages were then sliced and diced into packaged derivatives by the financial engineers without supervision of the regulators and sold to the financial markets that were hungry for yield during the low interest environment from 2003-2007.

By 2007, gross savings in the US had fallen to 14 percent of GDP, net savings to 1.7 percent of GDP and current account deficit (funded from abroad) had risen to $720 billion or 5.2 percent of GDP.

To be continued...

The author is chief advisor at the China Banking Regulatory Commission and former chairman of the Hong Kong Securities and Futures Commission.