The Global Financial Crisis: Genesis, Policy Response and Road Ahead

305 Pages·2013·2.8 MB·English

by  Satyendra Nayak

The Global Financial Crisis

Satyendra Nayak
The Global Financial Crisis
Genesis, Policy Response and Road Ahead
Satyendra Nayak
Center for Advanced Banking
and Finance Studies
ICFAI Business School
Mumbai, Maharashtra, India
ISBN 978-81-322-0797-9 ISBN 978-81-322-0798-6 (eBook)
DOI 10.1007/978-81-322-0798-6
Springer New Delhi Heidelberg New York Dordrecht London
Library of Congress Control Number: 2012956054
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Preface
My earlier book on globalization was published in December 2007. It focused on
the genesis and impact of major global economic policy change in the postwar
period which has brought a dramatic shift in global trade, investments, and fi nancing,
thereby causing the most pronounced reduction in the global economic divide. It
was time to move on to my next assignment which I was ruminating on and was my
natural interest and obsession for years. The US Dollar at Crossroads was the theme
I have been working on since the demise of the Bretton Woods. Although the fl oating
exchange rates and globalization gave fresh lease for the US dollar, the institution
of American capitalism was under stress. The New Deal formed the cornerstone of
American capitalism since the Great Depression days of the 1930s. Despite some
minor hiccups, the system continued to serve as the engine of economic prosperity.
Communism collapsed as it took the shape of hierarchical, bureaucratic, and totali-
tarian machine devoid of market signals and individualism that engender innovation
and enterprise. American capitalism succeeded as the invincible political economic
doctrine but still remained under pressure to achieve its goal of sustained growth,
full employment, and price stability. Yet nobody expected the major crisis as it did
in 2008.
In September 2008, I had meetings in the IMF and with Paul Volcker giving
presentation of my book. Coincidentally, in the same month later, the economy
witnessed an unexpected bolt from the blue—the USA experienced its worst
fi nancial and economic crisis since the Great Depression of the 1930s. My op-ed on
the subject titled “Keynes: Savior of Capitalism” was published in Washington
Times on October 1, 2008. My attention for research and analysis naturally shifted
from the future of dollar to much larger and more fundamental issues of the struc-
ture and dynamics of the US economy, American capitalism, backlash of globaliza-
tion, and the need for the further reform of the global economy and monetary
system. The global fi nancial crisis, the function and dysfunction of dollar, and its
future role became the focal point of the book.
The crisis demonstrated the weaknesses in the functioning of the economy,
institutions that govern, and policies that direct and regulate the economy. It also
v
vi Preface
underscored the need for introspection into the current state of knowledge and
theoretical basis of economics that have molded the contemporary policies.
The draft of the book took shape in New York, Boston, and Mumbai, the nerve
centers of the global and Asian fi nancial markets. I bene fi tted immensely from the
excellent collection of books of the New York Public Library (NYPL) and Boston
Public Library (BPL).
The book is divided into three parts. The fi rst part deals with the genesis of the
crisis and policy measures that prevented the culmination of the crisis into another
great global depression. It examines the microeconomic origins of the subprime
debt crisis but also goes on to look into its macroeconomic roots. In dealing with
both the approaches, it highlights the systemic lacunae and policy changes that trig-
gered the crisis. Part two gives the backdrop of evolutionary view of the global
economic and monetary system from the Bretton Woods of 1944 until the phase
globalization that began in the 1980s. The phenomena of the Great Crash of 1929
and Great Depression of the 1930s are revisited in the light of the current crisis. The
third part covers the structural aspects of the American capitalism and the global
economy. It examines why and how the American capitalism survived the onslaught
of several crises in the past and why it is at the crossroads now. The demise of com-
munism in USSR and East Europe, and its reform in China are analyzed. In addition
to the study of fundamental changes in the dynamics of the US economy, it high-
lights the implications of changing structure of global trade and investments. The
issues of the global savings gap and liquidity re fl ux are compared. The fourth part
deals with road map of reform for the future. Since the fi nancial markets have been
the focus of the crisis, it draws and articulates the peculiar features of the fi nancial
markets which make them more volatile and which need regulation. It shows why
and how fi nancial markets crash by introducing the concept of Niagara effect. It also
deals with the limitations of the use of sophisticated models for pricing fi nancial
products for trading. There is an exercise on relearning from Keynes’ writings in
dealing with economic management. Finally, the last chapter, Agenda for Global
Economic Reform, the New Bretton Woods, outlines the measures which the USA,
China, IMF, and Eurozone need to take to evolve a sustainable crisis-free global
economy. Coincidentally this draft was fi nished in the beautiful surroundings of the
Bretton Woods, New Hampshire.
January 1, 2013 Satyendra S. Nayak
Contents
Part I The Crisis: Micro-Macro Perspective
1 Pathology of the Crisis ........................................................................... 3
The Crisis: Then and Now ........................................................................ 3
US Economy Revives and Skips Depression: Thanks
to Keynesian Wisdom ............................................................................... 6
American Economic Boom of 1990s: An Overview ................................ 8
Lower Inflation and Higher Unemployment Thresholds:
2-3-4% Economy ...................................................................................... 10
Genesis of Real Estate Boom .................................................................... 11
Housing and Real Estate: Driver of Economic Growth ............................ 13
Government Initiatives in Housing ........................................................... 15
Housing and Real Estate Boom: 2002–2007 ............................................ 16
Role of Debt Securitization in Housing Sales ........................................... 18
Favorable Trend in Fed Funds Rate .......................................................... 20
Keynes Effect (Wealth Effect) and Real Balance Effect ........................... 22
Wealth Effect, Consumption, and Investment, 1990–2008 ....................... 23
Lessons from Theories of Growth and Business Cycles ........................... 24
References ................................................................................................. 26
2 Subprime Debt Imbroglio: Risks–Rewards
of Financial Sophistication ..................................................................... 27
The Backdrop and Genesis of Securitization ............................................ 28
Financial Innovation: Mortgage Debt Securitization ................................ 29
Subprime Adjustable Rate Mortgage: Promoting Home Ownership ....... 31
Pillars of Subprime Debt Securitization ................................................... 32
Housing Collapse: The Crisis Trigger ...................................................... 34
Credit Derivatives and Credit Default Swaps ........................................... 36
Indexed Credit Default Swaps (CDS) ....................................................... 38
Flaws in Risk Management and Collapse of Risk Trading ....................... 38
vii
viii Contents
Accounting Fallacy That Triggered the Crisis: Mark-to-Market
Versus Fair Valuation Accounting ............................................................ 39
Interest Rate Shock: Tipping Point for the Crisis ..................................... 40
The Niagara Effect .................................................................................... 42
Economic Crisis Causation ....................................................................... 43
Dot-Com Bust Versus Subprime Crisis..................................................... 46
What Went Wrong? ................................................................................... 49
Could the Crisis Be Averted? .................................................................... 50
References ................................................................................................. 51
3 Policy Response ....................................................................................... 53
Economic Wisdom and Political Vision ................................................... 53
Quick Policy Response ............................................................................. 56
Economic Policy Measures ....................................................................... 56
Macroeconomic Policy Action ................................................................. 57
How Did the Fed Do It? ............................................................................ 58
Operation Bailout ...................................................................................... 61
Fiscal Stimulus Packages .......................................................................... 61
American Recovery and Reinvestment Act .............................................. 62
Troubled Assets Recovery Plan (TARP) ................................................... 62
Micromanagement: Tackling Corporate and Banking Failures ................ 63
Specter of Protectionism ........................................................................... 64
Falling Oil Prices: Great Stimulus ............................................................ 65
G-20 Agenda: Quick Stimulus and More Effective Regulation ............... 65
Financial Reform (Dodd–Frank) Act and the Volcker Rule ..................... 68
Quantitative Easing 2 (QE 2) .................................................................... 70
Central Banks and Financial Regulators: Countervailing
Force Against Market Abnormality .......................................................... 71
Keynes on Slump and Management of Economic Cycles ........................ 73
Metaphysics of Money and Markets ......................................................... 75
Keynesianism, Friedman’s Monetarism, and Turns
in Monetary Policy .................................................................................... 76
Some Fallacies on Interest Rate Policy: Zero Interest Rates,
Money Traps, and Interest Rate Illusion ................................................... 79
Interest Rate Illusion ............................................................................ 79
Zero Interest Rate Policy ...................................................................... 79
Reference .................................................................................................. 81
4 Why Is the Economy Not Taking-Off? .................................................. 83
Monetary Mechanics ................................................................................. 83
Sluggish Investment .................................................................................. 86
Infrastructure: The Growth Driver ............................................................ 87
5 Eurosclerosis: Causation and Control:
Euro and Eurozone Management: Lessons from Greek Tragedy ..... 91
Strong Euro and Worsening BoP .............................................................. 92
Contents ix
Currency Stability as a Deterrent for Fiscal Profligacy ............................ 96
Dilemma of Common Currency in Pluralistic Community ...................... 97
Part II Evolutionary Economics: A Systemic View
6 Benign Neglect of Dollar: The Bretton Woods and Its Demise ........... 101
Evolution of Global Economy: The Bretton Woods Architecture ............ 103
Era of Stable Financial and Trade Milieu ................................................. 104
Benign Neglect of Dollar: Bretton Woods Drill ....................................... 105
Gold–Money Rift, Collapse of Bretton Woods: Obsolescence
of “Benign Neglect” .................................................................................. 106
1971 Dollar Crisis: A Global Systemic Problem ...................................... 108
Divergent Trade Propensities .................................................................... 109
Moving to Fiat Money .............................................................................. 111
Decade of Economic Uncertainty and Stagflation .................................... 112
References ................................................................................................. 113
7 Enter the Globalization: A Paradigm Shift .......................................... 115
Foreign Aid and Trade for Development .................................................. 117
Sovereign Debt Crisis and Brady Bonds ................................................... 117
The Setting for Globalization: 3W
(Washington-World Bank-Wall Street) Policy Model .............................. 119
Globalization: Smith-Ricardo-Keynes (SRK) Model ............................... 121
The MOT Revolution ................................................................................ 122
Gresham’s Law in Reverse Gear ............................................................... 124
Economic Compulsions of Globalization: Genesis .................................. 125
Financing Globalization ............................................................................ 127
References ................................................................................................. 128
8 Great Crash and Depression: Last Economic
Apocalypse: A Relook ............................................................................. 129
Birth of Capitalism sans Economic Insecurity: Fail-Safe Capitalism ...... 129
The 1920s Economic Boom: Golden Age of Prosperity .......................... 131
Stock Market Boom: 1920s ...................................................................... 133
The Great Crash of 1929 ........................................................................... 134
Political Reaction to the Great Crash: Measures in Desperation .............. 136
Great Crash and Monetary Implosion ....................................................... 137
Onset of Great Depression ........................................................................ 138
Gold Standard and Depression .................................................................. 139
Income Inequalities and Deficiency of Demand ....................................... 140
The New Deal: Roosevelt’s 100 Days of Silent Revolution:
American Capitalism Under Reform ........................................................ 141
Budget Deficit, Depression, and Economic Revival ................................. 145
Stock Market Crash and Banking Crisis: Then and Now ......................... 146
References ................................................................................................. 148
x Contents
Part III Structural Gaps
9 Metamorphosis of American Capitalism .............................................. 151
American Economic Psyche: Adaptive and Resilient ............................... 151
The Laissez-Faire Capitalism ................................................................... 153
The Fall of Laissez-Faire Model: Noncompetitive Market Reality .......... 156
Birth of American Welfare Capitalism:
New Deal—Antidepression and Communism Pill ................................... 157
The Countervailing Power Under Capitalism ........................................... 159
Paradox of Affluent Society: Social Imbalance ........................................ 161
The Cold War and Military–Industrial Complex ...................................... 162
Culture of Contentment ............................................................................. 164
Powerhouse of American Capitalism: The Wall Street............................. 166
Democratization of Stock Market and Equity Ownership ........................ 168
Institutional Investors: Dominant Monitors of Corporates ....................... 170
New Liberal Democrat: Non-Keynesian Economic Boom ....................... 170
Age of Universal Banking—Repeal of Glass–Steagall Act:
A Calculated Risk ..................................................................................... 171
The Challenge of Crisis of Capitalism ...................................................... 172
References ................................................................................................. 174
10 Downfall of Communism: God That Failed ......................................... 175
Marx: Vision of Manifesto and Premise of Communism ......................... 175
Demise of Communism ............................................................................ 178
Collapse of USSR: Transition Under Perestroika and Glasnost ............... 179
Free Market Capitalism Versus Central Planning ..................................... 181
Schumpeter’s Creative Destruction: The Seed of Growth
of Capitalism and Fall of Communism ..................................................... 183
References ................................................................................................. 185
11 Structural Shifts ...................................................................................... 187
Backdrop: The Setting .............................................................................. 187
Systemic Context ...................................................................................... 188
Internal Stressors on the Dynamics of US Economy ................................ 188
American Capitalism: Mature and Migrating ...................................... 188
Slopping Savings and Eroding Capital ..................................................... 189
Consumption Dominant Economy ............................................................ 191
Predominance of Permanent Income and Wealth Effect ........................... 191
Income Inequality ..................................................................................... 192
Return on Capital Under Squeeze ............................................................. 192
Structural Trade Deficit ............................................................................. 193
Slowing Exports Growth ........................................................................... 194
Most Favored Nation (MFN) for Global Capital ...................................... 195
Political Economy of Ideology of Capitalism: Size of Government ........ 198
Welfare Capitalism and the Fiscal Cliff .................................................... 199
Sixty-Year Cycle of American Capitalism ................................................ 200
Market Failure: Microanalysis and Macro Picture ................................... 203