Reasons for Global Recession – Part Two

In one of my earlier posts, I wrote about the causes of global recession. This post become quite popular and hundreds of people thanked me for the simple explanation of this phenomenon. This is article is in continuation of what I wrote in that post.

Sub-prime mess which was the main theme of that post and the prime reason that eventually sparked a world wide recession is at best an immediate cause of the recession. In this post, I will throw some light on the reason behind the very emergence of a sub-prime situation and why despite pumping of billions of dollars into the world economy, it is still not showing any sign of recovery.

In my first post on recession, I told you about how availability of an easy credit situation prompted the US lending institution to lend money to sub-prime borrowers and how these risky deals turned into a nightmare for big financial institution. In this post, we will be discussing three main issues :

(1) How American economy became so full of cash that made availability of loans for almost everything so easy?
(2) Why American banks could not foresee the risk involved in sub-prime loans?
(3)  Why the situation is not improving as fast as expected despite stimulus package of billons of dollars?

From where the Cash came in US ?

In order to understand how US economy got flooded with dollars, we need to go back in time by a decade. In 1997-98, the tiger economies of Asia (a term used to refer the countries of South East Asia like Thailand, Malaysia, Indonesia etc) suffered a major economic crisis. Though it is not necessary to know the details of this crisis, a brief overview of that crisis will help us understand the current mess in world as it is all linked.

During those years, several countries of South East Asia had developed worrying financial weaknesses which were the results of heavy investment in highly speculative real estate ventures, financed by borrowing either from poorly informed foreign sources or by credit from under regulated domestic financial institutions.

The crisis began with wrong banking practices.  In those countries crony capitalism (where borrower had the connections with government) became too dominant.  The minister’s nephew or the president’s son could open a bank and raise money both from the domestic populace and from foreign lenders, with everyone believing that their money was safe because official connections stood behind the institution. Government guarantees on bank deposits are standard practice throughout the world, but normally these guarantees come with strings attached. The owners of banks have to meet capital requirements (that is, put a lot of their own money at risk), restrict themselves to prudent investments, and so on. In Asian countries, however, too many people were granted privilege without responsibility, allowing them to play a game of “heads I win, tails somebody else loses.” And the loans financed highly speculative real estate ventures and wildly overambitious corporate expansions.

This bubble was inflated still further by credulous foreign investors, who were all too eager to put money into faraway countries about which they knew nothing (except that they were thriving). It was also, for a while, self-sustaining: All those irresponsible loans created a boom in real estate and stock markets, which made the balance sheets of banks and their clients look much healthier than they were.

However, this bubble had to burst sooner or later. At some point it was going to become clear that the high values Asian markets had placed on their assets weren’t realistic. Speculative bubbles are vulnerable to self-fulfilling pessimism: As soon as a significant number of investors begin to wonder whether the bubble would burst, it did.

So Asia went into a downward spiral. As nervous investors began to pull their money out of banks, asset prices plunged. As asset prices fell, it became increasingly doubtful whether governments would really stand behind the deposits and loans that remained, and investors fled all the faster. Foreign investors stampeded for the exits, forcing currency devaluations, which worsened the crisis still more as banks and companies found themselves with assets in devalued baht or rupiah, but with liabilities in lamentably solid dollars.

In 1996 capital was flowing into emerging Asia at the rate of about $100 billion a year; by the second half of 1997 it was flowing out at about the same rate. Inevitably, with that kind of reversal, Asia’s asset markets plunged, its economies went into recession, and it only got worse from there.

Eventually International Monetary Fund (IMF) had to step in to save these economies. How these economies later recovered and at what cost is a different story.  However, this crisis brought with it some major lessons for the Asian economies. One of the most important lessons for them was to create a solid Foreign Exchange Reserve so as to withstand the most volatile exit of the money from their markets. High reserves promise safety in a storm. Therefore, most major economies of Asia (including the big China and India) adopted a strategy of maintaining high forex reserve so as to ensure safety from any such crisis in future.  This shift in priorities created a very interesting situation.

In the mid-1990s, the emerging economies of Asia had been major importers of capital, borrowing abroad to finance their development. But after the Asian financial crisis of 1997-98 these countries began protecting themselves by amassing huge war chests of foreign assets, in effect exporting capital to the rest of the world.

To say in other words, the Asian economy came in to a Saving mode. In order to maintain huge foreign reserve, they also started buying US securities. This resulted in a huge inflow of dollars into the US economy. As more and more dollars kept coming into the US economy from world over, the American investors started devising very sophisticated and innovative methods to convert the flood of money from Asia into a borrowing and spending spree for American consumers.

Now instead of writing as to how and why this saving tendency of Asian Economies has resulted into the current global mess, I would like to point you towards two excellent articles on this issues written by two of my favorites economists. These articles are very well written in a layman’s language and they will clarify all your doubts about the role Asian economies in current global recession.

The first article is : High forex reserves can worsen recession

Written by Swaminathan S. Anklesaria Aiyar who is Consulting Editor, Economic Times, the popular financial newspaper of India. He is my favorite columnist.

Second article is :  Revenge of the Glut

Written by noted economist, the Nobel winner Paul Krugman. In this article he has concluded that the world is suffering from a global paradox of thrift.

The above two articles provide useful information on how a global saving glut is worsening the recession. I did not feel the need to write on these topics as these two excellent articles are sufficient in explaining the role of Asian economies in the present global recession.

So let us again reconsider the three issues we started with:

(1) How American economy became so full of cash that made availability of loans for almost any thing so easy?

It was all because of the insistence of Asian economy to generate a huge Foreign Exchange Reserve that ultimately created an imbalance of global money flow. If you read the above two articles, you will understand this clearly.

(2) Why American banks could not foresee the risk involved in sub-prime loans?

As Paul Krugman has pointed in his article, it is because of the depth and sophistication of the country’s financial markets. In his own words, “American bankers, empowered by a quarter-century of deregulatory zeal, led the world in finding sophisticated ways to enrich themselves by hiding risk and fooling investors.”

In America which has such a long history of free capital markets, financial institutions have mastered the art of hiding risk and fooling investors. When a huge inflow of money is coming your way, a sense of wealth and greed becomes dominant in our mind. After all capitalism is all about profit and maximizing your return. Isn’t it?

(3) Why the situation is not improving as fast as expected despite stimulus package of billions of dollars?

One of the top global economist of the world (I don’t know his name)  has declared that the present crisis is a structural one , reflecting a serious global misallocation of money in recent years, which had created many bubbles that had now burst. Pumping in more money could not resolve the problem, since it amounted to an attempt to reflate the old bubbles. Instead painful structural change are the need of the hour, he said, and this could take years.

What we are seeing the world today is a global saving phenomenon.  American who were the front runners of global borrowing and spending spree have started savings seriously.  The national savings rate of America has bumped up to 5% in January from 3.9% in December. A year ago, it was at 0.1%.

Saving is not a bad idea. But if everybody on earth starts saving and no one choose to spend, the saving will lose all its meaning. It is a well documented theory in economics known as the Paradox of Thrift.  Suppose people decide to become more thrifty, that is, they decide to save more at each level of income, one might expect that this would increase the total amount of savings. But the simple Keynesian multiplier model predicts a paradox of thrift that total savings will remain the same and income will decline.

So when the situation will improve?

I believe in the spiritual mantra of “This too will pass”. This is not the first recession the world has ever seen and certainly this is not going to be the last. I think the need of the hour for individuals is to not loose hope and prepare themselves for future. Keep learning new things, improve your skills and above all don’t loose heart. The best brains in the world are at work to find solution to this recession. Eventually, we’ll find a cure. And even if nothing works, the greatest healer of all – the time – will subside this recession one day.

For every problem under the Sun,
there is a solution or is none
if there is one, try to find it,
If there is none, never mind it.

We all have a limited time span on this earth. A Recession, not matter how lengthy or worse it appears now, is a momentary phenomenon when compared on the global scale of our entire life time. Don’t allow this momentary phenomenon to overshadow the wonderful days of happiness and wealth which will definitely come in your life in the days to come.