No respite, five years after Lehman

Five years after the Lehman Brothers collapse triggered the global financial crisis and the recession that followed, there are still no effective financial regulations in developed countries, while the developing countries face big new challenges.

Martin Khor

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SEPTEMBER marks the fifth anniversary of the collapse of Lehman Brothers that was the immediate trigger for the United States and global financial crisis.

Lehman was the tip of the iceberg. Below the surface were many contributory elements. They include financial deregulation and the conversion of finance from serving the real economy into a beast that thrived on speculation, creaming layers off the productive sectors and unsuspecting consumers through new manipulative instruments.

The US subprime housing mortgage crisis was the boil that burst - where massive loans were given to homeowners who could not pay, the loans were securitised and sold to unsuspecting investors, derivatives magnified the proportions of the crisis, while the bankers made billions selling very risky 'financial products' as very creditworthy investments. Many collapsed or collapsing banks in the US and Europe had to be rescued in bailouts totalling trillions of dollars.

The crisis also exposed the deep deficiencies of the global financial system. The globalisation of finance meant a crisis in one part could be quickly transmitted to other parts of the system.

The deregulation of capital flows caused booms and busts in emerging economies that received inflows and then suffered sudden reversals. The lack of a stable system of currency rates results in big fluctuations.

The lack of an international arbitration system for resolving sovereign debt crises meant indebted countries could be mired in a debt-income death spiral for years.

Five years later, the lessons have not been learnt with respect to the US, according to Princeton University economist and former Federal Reserve vice-chairman Alan Blinder, in a Wall Street Journal article. The US Dodd-Frank Act of 2010 was a weak response to the crisis which, worse, is withering in the poor follow-up.

'Far from being tamed, the financial beast has gotten its mojo back and is winning. The people have forgotten and are losing,' Blinder concludes, giving four examples of how Dodd-Frank is not working.

First, on mortgages and securitisation, the rule that Wall Street firms that issue asset-backed securities retain at least 5% of the credit risk (to make them cautious on what they securitise) has definitional escape clauses that allow exemption for up to 95% of all mortgages.

Second, the attempt to rein in the deadly derivatives that were the source of reckless leverage that blew up in the crisis, has been woefully inadequate. Dodd-Frank calls for greater standardisation with a safer and more transparent trading environment - but the law exempts the vast majority of derivatives, and the implementation of this already-weak law has run into resistance.

Third, although credit rating agencies were blamed for their role in the crisis by blessing financial junk with top ratings, the US Congress has so far only asked for a study to reform the way the agencies work. The report has come out but is gathering dust.

Fourth is the attempt to ban banks from 'proprietary trading', i.e., gambling using their own funds. The so-called Volcker rule has not been implemented since Dodd-Frank became law in July 2010 because of resistance from the banks and bureaucratic squabbles.

Blinder warns that the Dodd-Frank Act is 'taking on water fast' (meaning: the ship is sinking) and proposes that the new Federal Reserve chair must move bureaucratic mountains and fend off banking lobbyists, instead of sympathising with Wall Street.

But the tone of his article is pessimistic indeed. We can conclude we can't expect effective changes in the US, where inadequate policy response and rollback are caused by the strong banking lobby, the weak bureaucracy and an accommodative Congress and administration.

Five years after Lehman, if the situation is bad on the regulatory front, it has even worsened in two other areas.

One is in economic policy to counter the recessionary effects of the financial crisis. The Keynesian-type reflationary actions of major economies coordinated by the G20 (through its London summit of 2009) did not last long, as conservative forces hit back with austerity-centred fiscal policies that seem to rule today in Europe and the US.

The big economies resorted instead to a cheap-and-abundant-credit strategy, the most important of which was the 'quantitative easing' (QE) policy of the US Federal Reserve pumping $85 billion a month into the banking system.

But critics point out that this is planting the seeds of a new crisis in both developed and developing countries.

A significant outcome was the renewed boom of speculative capital to emerging economies, thus continuing the boom-bust cycle.

This brings us to the worsening in the second area. Many developing countries which had recovered fast from the 2008-10 crisis now face new potential crises. Their economic growth rates are dropping, their currencies falling, capital flows are reversing, and prices and demand for commodities are weakening.

Developing countries' leaders correctly point out that their economies have been victims of the developed countries' monetary policies, especially the Federal Reserve's QE.

A lot of the QE funds ended up in developing countries' equity and bond markets, as US investors searched for higher yields there, since the US interest rates have been kept near zero.

However, when the Fed chairman indicated the QE would be 'tapering off' and long-term interest rates started rising in response, the capital invested in developing countries has been flowing back to the US.

Vulnerable emerging economies have been hard hit, and worse may yet come. Especially vulnerable are those which have a current account deficit, since they depend on capital inflows to fund these deficits.

The outflow of needed capital and the increased risk have caused their currencies and their stock markets to plunge. This in turn leads to more capital outflow, due to anticipation of further falls in equity prices and in the domestic currency itself. The currency depreciation also fuels inflation.

Thus, former stalwarts India, Indonesia, Brazil, South Africa and Turkey are now the victims of a vicious circle.

The countries affected have a few policy tools to deal with the situation. One is to try to stabilise the currency through the central bank purchasing the local currency by selling the US dollar.

But this is expensive, and the country may draw down its reserves, especially if speculators keep betting that its currency will fall by more. This is the bitter lesson that Thailand and others learnt in the 1997 Asian financial crisis.

Another policy measure is capital controls. Ideally this should be imposed to prevent inflows. But most countries allow the inflows in the good times, and then when these suddenly turn into outflows, the boom-bust problem is laid bare.

Malaysia in 1998-99 imposed controls on outflows of both residents and foreigners, which was effective in stopping the crisis. It was heavily criticised at that time, but now even the International Monetary Fund is recommending capital controls if the situation is bad enough.

Ultimately there have to be international reforms to prevent excessive capital flows from the source countries, and developed countries have to be disciplined so that their economic policies do not have negative fallout effects on developing countries.

But we will have to wait for such useful international coordination on capital flows and economic policies to take place.

Other required reforms in the global financial system are also still lacking: there are as yet no adequate measures to discipline credit rating agencies, to reform the reserve currency system, to set up a sovereign debt resolution mechanism, and to assist developing countries facing financial and trade shocks.

One bright spot is that developing countries are taking measures to help themselves. The Chiangmai Initiative - in which Asian countries can avail themselves of funds to fight off speculative attacks and fill in gaps in a balance-of-payments crisis - has been joined by a similar type of arrangement with $100 billion funding by the BRICS countries (viz., Brazil, Russia, India, China and South Africa), announced at the sidelines of the recent St. Petersburg G20 summit. A BRICS development bank is also to follow.

It is at times of crisis or impending crisis that countries are spurred on to new initiatives to defend themselves.                                            

Martin Khor is Executive Director of the South Centre, an intergovernmental policy think-tank of developing countries, and former Director of the Third World Network.

*Third World Resurgence No. 276/277, August/September 2013, pp 17-18