A New Perspective on the Global Economic Crisis

I. Introduction

In his latest article "Rebalancing the US-China Economic Relationship" on Project Syndicate, Professor Kenneth Rogoff points out rightly that "the US and China are not solely responsible for these imbalances (in global trade and current-accounts), but their relationship is certainly at the center of it". In the last few months, many economists have been discussing in the media about how to address this problem of imbalances in global trade, savings and current-accounts. The prime motivation for focusing on these global imbalances is that a consensus seems to have developed among economists that these imbalances are among the main causes for the severe crisis that has been afflicting the American finance industry.

In this article, I propose a new perspective on the ongoing global economic crisis, a perspective that is quite different from those that have so far been discussed publicly (in print, television and online media). My approach requires, for the most part, only minimal changes to the status quo that prevails in the global financial system and the national economies of the world. However, I do propose one major reform which has been completely overlooked so far, namely the de-centralization of the American financial system. As a corollary of my new approach to the global economic crisis, I recommend continued increases of imbalances in global trade and savings, and in current accounts (as measured currently) for the next decade. Instead of expending efforts to re-balance global trade, savings and current-accounts, the policy goal for the next decade should be to regain America's lost credibility in the geo-political scene, and exchange rate stability should be the main economic tool for achieving this goal.

II. Current Theories of Global Imbalances

The reigning theory on global imbalances is that there has been a global savings glut. Over the last 20 years, the American consumer has been carrying the responsibility of consuming the large surplus savings of the world, or so this theory proposes. Alas, now that the American consumer is over-burdened with great debt, she has no choice but to become more frugal. So, the American government has to step-in to fill the slack in consumer demand, no matter that this stepping-in would involve trillions of dollars of deficit-spending during the next decade. Anyways, in this process of replacement-spending to sustain demand, the government should also revive America's own manufacturing industry, so that this industry could compete effectively against Chinese imports. In this way, the balance in global trade and current-accounts would be restored. This is the strategy for re-balancing that the Savings Glut Theory proposes.

The other popular policy framework is the De-coupling Theory. According to this theory, the global supply chain that stretches from the consumers in advanced economies like America and European Union, to the producers in the emerging markets of Asia and Latin America, would break-down as a result of the severe stresses exerted by the ongoing worldwide economic and financial crises. Moreover, this theory postulates that the emerging market economies have already reached a level of strength that enables them to continue on their own along their rapid-growth paths, 'de-coupled' from their reliance on exports to the advanced economies. A few weeks ago, Professor Dani Rodrik had written an interesting article "A De-Globalized World?" on Project Syndicate. This article provides a road-map for the industrial policies that developing countries could follow in a 'de-coupled' world.

One should also note that if 'de-coupling' were to happen in earnest, then the influence that the emerging market economies have on America, to help preserve the value of the huge dollar reserves that they have already piled up on account of their persistent trade surpluses, would decline significantly. In particular, the only option left for China, which holds about 2 trillion dollars worth of foreign reserves currently (about 70 percent of it in dollars), would be to enact massive deficit spending of its own, closely following the deficit spending in America, exactly to the extent that the dollar-yuan exchange rate remains stable. On the flip-side, in a 'de-coupled' world there would be much less global trade and cross-border flow of funds. Hence, the need for a global reserve currency would be significantly reduced. As a result, it would be difficult for America to pursue an expansionary monetary policy.

The Savings Glut Theory and the De-coupling Theory represent highly influential opinions among sections of economists. However, neither of these theories gives adequate consideration for the powerful forces of globalization that have been unleashed by the end of the cold war, and by progress in technology and communication during the 20th century. Both these theories assume that the advanced nations would be inclined to forego the benefits and conveniences of globalization, and that they would necessarily erect protectionist walls through political activism. Moreover, the Savings Glut Theory treats saving and spending as two sides of the same coin, something that is disconsonant with centuries of economic thought. As a result, one could not be confident that the Savings Glut Theory is a mature and well-developed theory. One would wonder if this theory relies too much on Keynesian economic thought.

Also, in both these theories, certain elements entertain wishful thinking. Even if the emerging market countries are capable, economically, of pursuing self-reliant rapid-growth paths, as the De-coupling Theory postulates, do these countries have the political, judicial and financial infrastructure that are necessary for the functioning of modern economies? For its part, the Savings Glut Theory does not acknowledge that the trillions of dollars of investment in the mortgages of American homes and commercial properties amounts to anything more significant than an international flow of funds. This theory assumes implicitly that the flow of these trillions could easily be re-directed from the mortgage industry towards the health-care and the manufacturing industries, or to finance the government's budget deficits in the next decade. Moreover, is it such a simple matter to engineer the revival of entire industries in the advanced economies, industries that have been languishing for decades?

A less popular theory, although a more promising one, is the Life Goes On Theory, which predicts that global imbalances would continue in the near-term, until structural adjustments are made in a few years time. Professor Barry Eichengreen has explained in his Project Syndicate article, "Will Global Imbalances Return?" that China would need several years to develop (i) its social safety net that would encourage Chinese households to reduce their pre-cautionary savings, (ii) its own financial markets that could provide good returns for its reserves and household savings, (iii) its infrastructure programs and private industries that would replace its export-driven growth model. So, for now, the global imbalances would persist, and perhaps grow bigger. It is particularly notable that in this article, Professor Eichengreen recognizes the vulnerability of America in correcting these imbalances on its own, as he writes "Whether there is a permanent reduction in global imbalances will depend mainly on decisions taken outside the US, specifically in countries like China".

A theory that is closely related to the Life Goes On Theory is the somewhat indignant, Life As Usual? Theory, which senses acutely that since the global economy has been stabilizing in recent months, there is no prevailing sense any longer among the policy-makers that major reforms are needed. "China continues to run giant trade surplus, and the US continues to spend and borrow", as Professor Rogoff has observed in his article, quoted above. Throughout last Fall, I had also subscribed to this Life As Usual? Theory, particularly to its insistence on reforming the international financial institutions so that the chances of financial crises occurring in the future are minimized. However, alarmed by the conceits and prejudices of the policy changes, touted as much needed reforms of the world's financial infrastructure, that were being proposed by the power-brokers, I have now taken a new approach to the global economic crisis.

III. The Financial Crisis is More Than a Crisis of Liquidity and Solvency

At the end of the year 2000, if a professional economist were to analyze the prospects for America in the 21st century, she would have expected that, other things being equal, the American economy would face a severe crisis sometime in the decade after 2020. This crisis would have been expected to occur due to the confluence of several major failures all happening within a few years of each other. Prominent among these failures would have been (i) the imbalances in social security and in the retirement benefits system, (ii) the unaffordability of health care expenses, (iii) the massive amounts of debt in credit card and mortgages that American households were taking on, (iv) the low savings rate among American households, (v) the aging of the population, (vi) the global scarcity of commodities like oil and metals, (vii) unsustainable levels of energy consumption, (vii) environmental degradation and climate change, and (viii) large deficits in trade and current-accounts.

Due to the unbelievable incompetence of the previous George W. Bush administration, a crisis which would have occurred after 2020, primarily due to natural factors, was pre-poned by more than a decade, and was amplified several times over, entirely through man-made policy disasters. In retrospect, the single major policy failure seems to have been the indiscriminate abuse of the rules and conventions of the international systems of law, which have been in effect implicitly for so many centuries. However, this is not to say that the current partnership between the Barack Obama administration and the US Federal Reserve bank is competent enough to fix the global economic crisis anytime soon. This partnership seems unwittingly to be headed for an abuse of the global financial system, in proportions approaching that of the abuse of the international systems of law by the previous George W. Bush administration. What does seem undeniable though, is that President Obama's personal charisma and popularity around the world, and the huge relief of seeing the George W. Bush administration leave office have been the major reasons for the recent surge of hopes for an immediate and sustained economic recovery.

Already by the end of 2008, the US Federal Reserve and the previous Treasury Department had spent upwards of 4 trillion dollars on account of the broad economic crisis, which includes the mortgage crisis and the financial crisis. The Congressional Budget Office's projections for the budget deficits (under the President's budget plans) during 2009 -- 19 is about 11 trillion dollars. The Federal Reserve bank has been keeping its target for overnight funds rate at 0 - 1/4% for more than 6 months now. The Fed has also been purchasing treasuries and mortgage securities in order to keep long-term interest rates down. Moreover, claiming to be hard at work to prevent the return of the Great Depression, the Fed has gone on over-drive to pursue its policy of Quantitative Easing. Yet, even with all this spending and relaxation of monetary policy, it is clear that the financial crisis has not been addressed properly. The finance industry is faced with the same massive gaps in its accounting books that it was faced with during the tumultuous weeks of September 2008.

Before this debate about global imbalances, economists were pre-occupied in the media, with addressing the question whether the financial crisis is just a crisis of illiquidity in the banking system, or were the banks actually facing insolvency. As a result, there is now a wide-spread misconception among the general public that the financial crisis is a crisis not just of illiquidity, but also of insolvency. If this was all it was, this crisis would have been solved by now. To address problems of liquidity in the banking system, the Federal Reserve is willing to provide unlimited zero-percent financing. To address problems of solvency, the Treasury Department is ever-willing to devise new programs to take the toxic assets off the banks' balance sheets. Yet, these efforts have proved insufficient to solve the financial crisis. This is because the financial crisis is concerned with the future expected profits of the financial system, as explained in the next section.

IV. The Greatest Arbitrage Opportunity in History

The Wall Street banks are sitting on a gold-mine of above 20% annual returns on over half-a-trillion dollars of their own capital (assuming just a 24 to 1 leverage ratio, and 0.8% difference between the interest rate they receive from the property-owners for the mortgage securities they hold, and the interest rate they pay to their bond-holders, the banks would get 20% return on capital). These 20% annual returns are expected to flow in year after year for the next 30 years or so. According to the approach taken by the Federal Reserve bank and the US Treasury Department during the last 9 months, the Wall Street banks need to do nothing further to collect on their 20% profits for the next 30 years. The payments on the mortgage securities that the banks hold are being financed by the payments from the owners of homes and commercial properties on their mortgage loans. These property-owners are liable for the mortgage loans because of the mortgage contracts they have signed. The US government has taken it upon itself to preserve this situation, including dealing with any deterioration in foreclosures.

One can be reasonably certain that at no time in the whole history of economics has there ever been such a bizarre transaction. No modern economic theory could possibly admit such a transaction that guarantees a 20% return for the next 30 years on over half-a-trillion dollars of capital. Capitalism, even in its most rugged form of Schumpetrian gales of creative destruction, would expect that due to competitive pressures, profit opportunities are driven down over time, and hence a firm would be forced to innovate to find new ways to make money. Modern portfolio theory would expect that the bank is taking some risk that is commensurate with the return. Modern growth theory would be hard-pressed to find a return of 12% for one year, let alone identify an economic process that could return 20% every year for 30 years on an investment exceeding half-a-trillion dollars. One could examine theory after theory in modern economics. None of them would admit that having gotten the proprety-owners to sign mortgage contracts, the Wall Street banks are entitled to sit back and receive 20% annual returns on over half-a-trillion dollars of capital for the next 30 years.

It is very important for the Federal Reserve and the Treasury Department to realize that they have essentially been defending a massive arbitrage opportunity for the Wall Street banks, and they would be obligated to do so permanently, if they do not re-examine the economic principles behind their bailouts. The US government has unnecessarily bet its own solvency on upholding the sanctity of the mortgage contracts on American homes and commercial properties. Does this mean that the government should get the mortgage contracts re-written as a way out of the crisis? Not at all. In fact, the government has been pursuing policies that indirectly relax the mortgage contracts. The government has been working to develop a procedure for re-negotiating mortgage contracts in the bankruptcy courts. Moreover, by following a lax monetary policy in the short-term, the Fed aims to keep the long-term mortgage rates low enough so that the home-owners could re-finance their mortgages. Even though the principal on their mortgage loans remain the same, the property-owners would find that lower interest payments would shave off a a large portion of their monthly mortgage payments. As a result, foreclosures would be mitigated.

However, commendable as these efforts have been, it has become clear as the months go by, that these programs that aim to relax the mortgage contracts would not solve the crisis. This is because financial crisis is big enough to actually endanger the solvency of the US government, all the more certainly, if the government's attempts to ensure the solvency of the financial system go awry. One might ask, then what is the solution to this financial crisis? A viable solution to the financial crisis cannot be achieved without completely understanding why the housing bubble of 1998 -- 2007 occurred in the first place. In my judgment, such a clear understanding is at least several years into the future. So far, we only have a few pieces of the puzzle. The most substantial among these pieces is an article, "From Bubbles to Depression?" by Professors Vernon Smith and Steven Gjerstad that appeared in the Wall Street Journal on April 6, 2009. This article provides several penetrating insights into the causes of the housing bubble.

V. A Natural Price Adjustment Mechanism for Mortgage Securitizations

However, America need not wait for several years, till the housing bubble is clearly understood, before it takes measures to prevent the massive arbitrage opportunities that the Fed and the Treasury have created for Wall Street banks. What is needed is a price adjustment mechanism that allows the banks to recover their complete profits during the years when the economy is performing well, but facilitates discounts for the property-owners in the downtrodden years. Such a mechanism would inherently take into account the risk-reward trade-off that modern portfolio theory expects. Consequently, it would not be an arbitrage opportunity, but instead would provide a robust and stable framework over the 30 years of duration that the mortgage contract specifies the property-owner and security-owner to be in an agreement.

A significant step in this direction could be taken by establishing a direct channel of communication between the property-owners on Main Street and security-owners on Wall Street. The technology for establishing such a direct channel is already available ubiquitously with computer companies like e-Bay, Amazon, Google, Microsoft, Verisign, Dell, Intel, Cisco, Yahoo, etc. This direct channel could enable the Wall Street banks to provide discounts and incentives to the property-owners, so that they would be encouraged to keep meeting their monthly mortgage payments. The property-owners could bid among themselves for the discounts that the security-owners offer. This would be useful, for example, if a bank wants to get rid of some of its toxic assets. Then by holding a bid among the property-owners the bank could get a much higher price than the fire-sale price it is stuck with now.

Such a price adjustment mechanism like I propose would avoid the middle-men and hedge-fund managers that the Treasury is trying to enlist in its Public-Private Investment Program (PPIP). Moreover, unlike the TARP, TALF and other existing government programs that jeopardize trillions of dollars of public money, this price adjustment mechanism that I propose would allow the bankers and the property owners to address each other directly, and would require less than $1 billion of the government's money. On another note, a major problem about the current crisis is that the financial industry has created financial instruments that are so complicated and arcane, and that these instruments are used so pervasively, that there is a huge systemic risk even if the status quo is rocked only slightly. In my mechanism, I connect the two ends of this complicated maze of financial instruments that stretch from the property-owner at one end to the security-owner at the other end. So, the unwinding of the complex financial system happens automatically.

Unlike the bailouts of home-owners that have been proposed in the media regularly, the price adjustment mechanism I propose does not suffer from the moral hazard problem. The moral hazard is that property-owners who have been paying their mortgages sincerely are being left to fend for themselves, while irresponsible property-owners who took loans that were disproportionate to their incomes, or did not pay their mortgages on time, are being bailed-out. In my price adjustment mechanism, any property-owner whose mortgage loan is held as collateral for a given mortgage security could take part in the bidding for that security. The government is, of course, free to help the poorer sections on its own.

To understand this price adjustment mechanism better, let us consider the American consumer, as an analogy. The global supply chain connects, on one end, to factories where goods are produced. These factories connect to the distribution networks that apply just-in-time technology to stock their retail outlets. The American consumer then goes through the shopping experience at the shopping malls and online stores. Consumer shopping trends are cyclical, with each annual cycle having several seasonal cycles as well. In case there is an over-production of goods during one particular shopping season or a dullness in consumer demand, the stores immediately announce discounts and price cuts. These price reductions benefit the consumer directly, and they work all the way back through the distribution channels and the supply chain.

In this way, a sustainable feedback loop helps to implement an 'informal contract' between the consumer as one party, and all the other participants of the supply network as the other party. And this unwritten contract, in effect, extends over many years. In fact, this mechanism for price adjustments has become an integral part of the consumer culture of the 20th century. The price adjustment mechanism that I have proposed above, for mortgage securitizations, aims to provide an analogous feedback loop that connects the security-owners on Wall Street with the property-owners on Main Street. Sooner or later, in one form or the other, America would have to settle on some such plan for a price adjustment mechanism to get out of the financial crisis. So, I would not suggest that the very same price adjustment mechanism that I propose is the one to follow.

VI. A De-centralized American Financial System

As explained in the third section, the financial crisis of 2008 is actually an early warning 'stress-test' for a crisis that would have otherwise arrived after 2020. The results of the stress-test are encouraging in some respects. During the last 30 years, the American finance industry has demonstrated expertise in rapidly implementing sophisticated theories of risk management using very powerful computational infrastructure. In many countries around the world, capitalism has taken root mainly through the stock markets and the credit markets of these countries. The American finance industry routinely enters into billion dollar deals in these markets through financial derivatives, insurance contracts and other risk management tools. These developments tie the business communities in these countries closely to America. In fact, they look to the American finance industry as the model of capitalism. As a result, capitalism exerts significant influence on the polity of these countries.

On the other hand, the financial crisis, viewed as a stress-test, has exposed the under-belly of America's financial system as hopelessly outdated and needing urgent reform. The debate among economist has largely focused on regulations on the finance industry as the means of minimizing the chances of the financial crisis occurring again. There are many good regulations that economists have proposed to address systemic risk. Curiously, no one, to my knowledge, has focused on the centralized nature of decision making in finance as a potential source of instability. Historically, financial centers have played important roles to finance a government's budget, as happened in the early days of the American republic. In colonial times, financial centers in Europe have responded, as a service to their empires, to raise emergency funds during war-time. So, one could argue that the close connections of the finance industry with the seat of government required a centralized mode of operation. Is that true any longer?

In a recent article in The Atlantic, Professor Richard Florida argued that the financial centers of the world, like New York and London, have developed their financial expertise over the course of several centuries. A city that functions as a global leader in finance needs to develop a community of experts, including traders, accountants, programmers, financiers, economists, lawyers, journalists, newscasters, managers, scientists, mathematicians, insurers, judges, notaries, etc. Moreover, a global financial center needs the political and military protection of its government, in order to take part in financial deals around the world. Consequently, it would not be easy to facilitate the creation of many more global financial centers. Perhaps, we could see Shanghai, Dubai, Hong Kong and a few other cities emerge newly as global financial centers in ten years, as a result of the current financial crisis, but not many more.

Professor Florida's arguments are indeed quite persuasive. But do they exclude the possibility of new national financial centers emerging within America? The current financial crisis leads one to ask whether excessive reliance on the accumulation of financial expertise and talent in a single city like New York, ignores the problem that with trillions of dollars accumulating on Wall Street and being traded on split-second information, America is unnecessarily taking on huge risks that make its financial system inherently unstable. Most of the money managers are influenced in their decision-making by standardized information that comes to them through channels like CNBC or Bloomberg. Wouldn't diversification of financial decision-making help to disperse systemic risk?

After all, the most credible information about mortgage defaults are spread throughout the local property markets in the various states of the United States. So, if the finance industry had been de-centralized, it would have been in a much stronger position to quickly take into account the data from the foreclosures and the falling house prices around the country. With several financial centers actively processing the information on mortgages, New York could still function as a mega-center that disperses the risk among these local financial centers. Also, New York would still be the gateway to the inflow of funds from around the world.

VII. A New Perspective on the Global Economic Crisis

With the concepts introduced in the previous sections, we are now ready to take a new perspective on the global economic crisis. In this perspective, the financial crisis, that originated in America, is seen as a stress-test on the American financial system that has exposed the need for certain reforms. The American finance industry is seen as being mid-way through an evolutionary phase of de-centralization and better regulation. However, there is a very real possibility that, under the influences of the Savings Glut Theory and the De-coupling Theory, America would take to excessive spending and lax monetary policy without regard for exchange rate stability. The goal might be that through this currency-debasement, a large part of the losses that the American financial system assumes could potentially be transmitted to the financial system of the rest of the world. For this reason, it is important to note that the price adjustment mechanism described in Section V shows that the American finance industry is quite capable of solving the current financial crisis on its own, although it could take several years to figure out all the causes of the housing bubble. It is not necessary to put trillions of dollars of public money at risk, nor is it necessary to transmit trillion-dollar losses to the rest of the world.

After completing its evolutionary phase, the American financial industry would be in a position to absorb larger global imbalances in trade, savings and current-accounts. This absorption of global imbalances is necessary because it is no longer the case that America is the engine of growth in the world economy. China growing at over 8% with its annual GDP of 3.5 trillion dollars, in exchange-rate terms, adds the same amount to the annual output of the world economy as does the United States with its annual GDP of 14 trillion dollars and growing at 2%. If one added the contributions of the other emerging market economies to the world output, then it is clear that, unlike the past 30 years, the rest of the world would not look to America to fuel growth. Hence, for the rest of the world to continue to value its relationship with the United States, the US would have to make efforts to preserve the value of the dollar. Maintaining such valued relationships could provide valuable growth opportunities for America through globalization. Since last Fall, the Federal Reserve has maintained a standing commitment for over half-a-trillion dollars in currency swaps with foreign banks. Throughout last Fall, there was a huge demand for dollars, as there was a flight to quality among investors. The Fed's action demonstrated a commitment for exchange rate stability, which would pay off in the dollar continuing to be the reserve currency of the world.