The Global Financial Crisis: Governments, Banks and Markets
Thomas D. Lairson
Forthcoming in Ralph Carter, (ed.) Contemporary Cases in US Foreign Policy, Fourth Edition Washington: CQ Press, 2010
BEFORE YOU BEGIN
Who are the primary actors in the global financial crisis?
US
Secretary of Treasury
Henry Paulson (appointed by George Bush; to 1/20/09)
Timothy Geithner (appointed by Barack Obama; from 1/20/09)
Chairman of the Federal Reserve Board
Ben Bernanke
President of the New York Branch of the Federal Reserve
Timothy Geithner (to 1/20/09)
Secretary of State
Condalezza Rice (to 1/20/09)
Hillary Clinton (from 1/20/09)
AIG; Morgan Stanley; Lehman Brothers; Bear Sterns; Bank of America; Hedge funds; Goldman Sachs
Government Sponsored Enterprises
Federal National Mortgage (Fannie Mae)
Federal Home Loan Mortgage Co. (Freddie Mac)
China
President
Hu Jintao
Premier
Wen Jiabao
Foreign Mnister
Yang Jiechi
State Councilor
Dai Bingguo
Vice Premier
Wang Qishan
Governor of the Central Bank
Zhou Xiaochuan
Great Britain
Governor of Bank of England
Mervyn King
European Union
President of the European Central Bank
Jean-Claude Trichet
International Organizations
World Bank
Robert Zoellick, President
International Monetary Fund
Dominique Strauss-Kahn, Managing Director
Financial Stability Board
Questions to Consider:
What are the long-term and short-term causes of the financial crisis?
How did government policies contribute to the crisis?
How did bad investment decisions by private firms contribute to the crisis?
How did the system of financial markets contribute to the crisis?
Why did governments intervene in the economy and bailout banks? What are some potential negative consequences of such actions?
What foreign policy choices are involved in efforts to solve problems created by the crisis? How are cooperation and competition among nations engaged by efforts to coordinate creation of a new regulatory regime?
How will the financial crisis affect power relations in international politics? How will these changes affect foreign policies?
Does the concept of state capitalism expand our understanding of financial statecraft?
Foreign Policy and Financial Crises
The examination of the foreign policy of the global financial crisis requires a bit of clarification of terms. Typically foreign policy is associated with the management of political, strategic and military relations among states. Foreign economic policy has meant any use of the range of foreign policy capabilities to affect economic ends and purposes. Another term, economic statecraft, has referred to the use of economic capabilities for strategic ends.
We are less concerned with distinctions about ends and means. This is because matters such as trade and finance are now as important as military force in influencing the strategic relationships of the most powerful nations. In a financial crisis, these issues can take on even larger strategic import based on the immediate and potential impact on economic power and national income. The foreign policy actions relating to the global financial crisis, because they involve matters of large strategic import, deserve the term economic or financial statecraft. States in such situations use economic policies and negotiations to preserve or enhance their power and influence in global affairs; at the least, these actions always have large actual and potential strategic consequences whether intended or not.[1] It makes little difference whether a nation is using economic or political capabilities as a means or an end; either way, the nation’s strategic fate is at risk in such a crisis.
Globalization has had profound consequences for economic and financial statecraft. The rising weight of global economic transactions has raised the stakes for economic relations among nations and this has more deeply engaged the interests in domestic politics. Globalization has thus expanded the players in economic statecraft, not only inside but also outside nations, including more government officials, more firms, more NGOs, more nations and more international organizations. Recurring financial crises have contributed to this process of rising stakes and expanding actors. Continuing efforts by the United States to enhance and expand free markets in the global economy often led to intense negotiations among the expanding arc of global players.
What do we mean by a financial crisis? Generally, a financial crisis involves a large and rapid collapse in the value of financial assets. This could include stocks, the exchange rates of one or more currencies, bonds and other financial instruments or assets related to finance, such as houses. There are two kinds of financial crises, systemic and limited. A systemic crisis has two special features. First, price declines in one market are linked to those in other markets and this interdependence means declines in one market bring down prices in other markets.[2] This can mean, as in the current instance, declines in house prices leading to declines in the value of derivatives, which damage economic expectations and lead to declines in stock prices. Or, it could mean a sharp drop in one nation’s exchange rate leading to drops for other nations’ exchange rates followed by declines in stock markets. A second characteristic of systemic financial crises is the declines in financial markets damage confidence in credit markets (for making loans) or in future levels of economic growth and this leads to a cutback in investing, lending and employment and a significant decline in the economy. A limited financial crisis is one in which the price declines are restricted to one market and the overall economic effects are small.[3]
Our concern here is with the current systemic crisis and its strategic consequences as they bear on the foreign policies of nations. What follows is a discussion of the background to the financial crisis, a detailed review of the events of the crisis and an examination of the foreign policy related to the crisis.
I. Introduction to the Case
The interactions among powerful states during the time of the global financial crisis – August 2007 to April 2010 – were during a time of great drama. The collapsing values of equities, real estate and currencies combined with the potential for bankruptcy of the financial and credit systems of many nations to create considerable fear and anxiety. Questions were raised about a possible repeat of the depression of the 1930s and about the viability of capitalism itself. The chance of a global economic system spiraling out of control was not small and political and ministerial leaders made decisions in a genuine atmosphere of crisis. Missteps could have catastrophic consequences. There was considerable fear for the future among many seasoned and powerful leaders, whose responsibility for the national and global economy weighed heavily on them.[4]
In the end, there was much reason for worry. The cost of the crisis in various forms of governmental support was $15 trillion, equal to nearly one-quarter of global GDP.[5] In addition, the losses in home equity and in investments (potentially recoverable) were as much as $28 trillion.[6] Financial institutions sustained several trillion dollars in losses, as will many firms operating in other areas of the economy. Unemployment rates around the world rose substantially, driven up by the severe economic downturn that followed.
This chapter examines the origins and nature of the 2007-2010 global financial and economic crisis, in particular as it relates to US foreign policy. There is much to learn about and discuss. The global character of the crisis, the substantial interdependence of national economies, and the long tradition of attempted cooperation among nations on economic and financial policies create a substantial set of foreign policy implications. Chief among these are the effects of large global financial imbalances, efforts to coordinate financial rescue actions and stimulus policies across nations, efforts to restructure and coordinate new regulatory regimes, and difficulties in adjusting to changes in global power relations.
The fact of global economic and financial interdependence confronts the reality of a fragmented global political order and great differences in economic development and political systems. Interdependence creates substantial need for cooperation and coordination in managing such a system. Variations in national economic capabilities, in economic ideologies and in national interests create barriers to common political management. The origins of the crisis in the United States, hitherto the nation providing leadership in global affairs and the nation perhaps most damaged by the crisis, complicated a global response to the crisis. The rapid accumulation of economic resources by China, and its relative insularity from the crisis, created the potential for a stunning shift of global power away from the US.
Tracing the sources and consequences of the crisis illuminates the capacities of governments, the power of financial interests, political and power relationships between the US and China and raises important questions about the sustainability of contemporary forms of capitalism.
Background: Financialization of the Global Economy
The global economic crisis emerged out of a three-decade era of financialization: a rapid global expansion of financial transactions that assumed a vastly greater size and geographic scope.[7] This has generated substantial changes in the structure of the financial industry and greatly intensified global competition.[8] The political leadership for this effort came from the government and financial industry of the United States, which pressed hard over thirty years for a liberalization of national policies for the movement of goods and money. This era overlapped with and even contributed to the end of the Cold War.
Globalization involves a rapid expansion of trade relative to domestic production but also leads to a much tighter integration of global financial markets, increasing the potential for changes in one market to cascade across the system and affect many nations and markets. The financial crisis of 2007-2010 was by no means the first during this era of globalization; indeed, the expansion of markets and number of market players seems to be associated with an increase in the frequency of such crises. Over the decade before 2007, many persons with limited experience in global markets became participants. Not surprisingly, many investment mistakes were made and financial markets became decidedly unstable with frequent crisis situations. Financial crises involving governmental borrowing from global banks occurred in 1982,1994, 1998, 1999 and 2001; crises involving private sector borrowing occurred in the US from 1988-1991 and in Asia from 1997-1998; global stock market collapses took place in 1987 and 2000; and the massive collapse of stocks, real estate and debt instruments in came upon us in 2007-2010.[9]
This era of globalization and financialization was also one in which governmental responsibilities for regulatory oversight of financial institutions changed character: both expanding in consistency across nations and contracting in practice within many nations.[10] Though international efforts to coordinate regulatory rules for banking increased, the effect of those rules can only be understood in terms of an overall relaxation of regulatory restraints across many nations and a decline in effective regulatory consistency.
Perhaps the most striking element of the financialization of the global economy was innovations in the types of financial instruments and in the processes by which investments were made. Ever since the end of fixed exchange rates for most advanced nations in the 1970s, foreign exchange markets and especially futures markets have grown enormously. By mid-2007, daily turnover in these markets was over $3 trillion, more than three-fourths of which involved dollars, Euros, yen and pound sterling.[11]
Using much the same logic as foreign exchange futures, complex derivatives were developed and expanded as primary trading instruments in global financial markets.[12] A derivative is a security whose value is a time-based result of the value of some other security, asset or event. Derivatives usually are highly leveraged so that small changes in the value of the underlying asset lead to large changes in the value of the derivative. A derivative could be based on a stock price or on the flow of income coming from bundling together a variety of mortgages on houses (Collateralized Debt Obligations). Even more exotic derivatives are Credit Default Swaps, which are insurance policies that pay off in the event a particular borrower fails to pay the interest or principal of a bond. These are securitized and traded in shadow markets, based on the market-based risk of defaulting on a bond.[13] In 2008, before the financial crisis had begun in earnest, total global derivatives contracts pending (excluding foreign exchange) were over $600 trillion or about nine times the entire global GDP for 2008.[14]
Financialization was also enhanced by the enormous globalization of production, in particular the shift of manufacturing to several Asian nations and the resulting imbalances of trade. Competitive complementarities among the economies of the US and several Asian states led to large and persistent imbalances in the global economy.[15] US firms shifted manufacturing capabilities to Asia through foreign direct investment and then exported these products back to eager US consumers, thereby creating large and growing trade deficits for the US. However, surplus nations in Asia often chose to retain the accumulating dollars as foreign exchange reserves rather than exchange them and push up the value of their currency. Moreover, high growth rates over several decades meant much higher incomes for Asians. When combined with high savings rates, the foreign exchange reserves produced an enormous pool of capital for investment. High budget deficits and large private borrowing in the US created a large demand for money. But low savings rates in the US (the flip side of high consumptions levels) meant US funds could not meet this demand. Much of the Asian capital pool found its way back into purchases of US government debt and an unlikely supply of capital from “poor” nations to “rich” nations.[16] Many of these investment decisions were the result of choices made by Asian governments. Thus, the globalization of production and trade combined with financialization to see initial flows of US investment into Asia to finance production of goods for sale in the US. US money then flowed to Asia to pay for the products and then flowed back to the US in exchange for debt. The US financed much of its consumption spree with debt owed to Asia governments.[17]
Source:Charles Roxburgh, et al. Global Capital Markets: Entering a New Era, McKinsey Global Institute, 2009, 20.
Globalization and financialization created many important consequences that contributed to the global economic crisis.[18] Perhaps most significant were the vast size of the markets and the giant role in those markets of highly leveraged assets vulnerable to risks not appreciated by most investors.[19] Some scholars and analysts trace the crisis to the rise of “money manager capitalism,” a system involving highly leveraged investments aiming at maximizing profits even as investment managers have incentives to underestimate the risk of loss.[20]Second, imbalances of trade and finance were inherent in a system based on dramatic asymmetries of capabilities and interests as between the US and China. These imbalances were unsustainable in the long run but continued as a result of the preferences of powerful states and actors. Finally, the vast size of markets and profits generated interests in governments and private actors intensely committed to preserving and extending the system.[21]
The global economic crisis emerged out of a particular global regime of political economy, involving trade and production, global finance and investment, deregulation and political relations that began to emerge in the 1970s. The explosion of global finance created high demand for new investment opportunities and this was increasingly met with exotic derivatives that were thought to manage risk even while providing high returns. These securities rested on the ability to expand high risk home mortgage lending based on expectations of rising home prices. An unprecedented rise in public and private debt in the West was financed in significant part by the resources of relatively poor nations selling manufactured products to rich nations.
Background: The Nature of Financial Markets
Scholars of markets have debated the degree to which financial markets are prone to instability and crisis or whether crises are the result of factors outside of markets that affect them negatively. This debate has considerable implications for whether governments accept a limited or proactive role in regulating markets.[22]
On one side are those with a strong belief in the efficacy of free markets for allocating resources (in this case capital) rationally and efficiently to those best able to use it. Such a view counsels minimal efforts to regulate or manage markets by government, believing such actions always make things worse in terms of efficiency. This assertion rests on one of two alternative assumptions: one is that market participants are themselves rational and their choices produce the efficient allocation of resources, or alternatively that markets are themselves rational and always reflect the best available information. Consequently, free markets always generate a “correct” price.[23]
Countering this position is a collection of scholars who study markets and market crises and those who examine the actual behavior of market participants. The examination of past market panics reveals a set of common features, including a strong tendency for investors to follow and emulate winners especially when a new and successful product or technology emerges. When this coincides with substantial expansion of credit and several markets are interdependent, the resulting overinvestment can ultimately lead to panic selling in an effort to escape losses. The consequent cascading of prices across several markets leads to damage to the entire economy.[24] Others have looked at the behavior of market participants, finding considerable evidence for the view that many investors exhibit significant limits to rationality and invest based on emotion as much as clear calculation.[25] One study modeling a stock market composed of players with limited information who form expectations based on the expectations of others found a high frequency of booms and busts in prices.[26]