“Global Debt Crisis: The World on Stranger Tides”

The financial crisis and the great recession that followed it in 2008 was a culmination of years of overspending and borrowing in major parts of the developed world fueled by the skewed savings and consumption pattern in the world. In order to save their economies Governments all across the world responded with massive stimulus and central banks followed a ultra easy monetary policy. This crisis soon gave away to a sovereign debt crisis. With some countries in European Union periphery almost facing a sovereign debt default which if happened would cause a global contagion and would result in breakup of European Union the way we know it today. Downgrading of US debt ratings by S&P sent a very strong signal that US should get its house in order and even if the status of dollar being a global currency allows it borrow without strings and at a very low cost in the long run there is a fear that dollar would lose its status a global reserve currency status if US does not stabilizes its borrowing. While the emerging economies and commodities due to the QE1 and QE 2 faced massive flows of funds resulting in fears of asset price bubbles. Many emerging economies even placed capital controls in order to regulate the flow of money. We think that it is inevitable that US has to cut down its fiscal deficit but in the short run US should continue with its expansionary fiscal and monetary policy as the US economic recovery is not that solid and there is a real fear of a double dip recession. In Europe we think it is inevitable that the strong economies like France, Finland etc led by Germany have to bail out the troubled European economies if EU has to survive and the question is not if they will but the question is when. Current measures being undertaken by EU are very inadequate and it is only postponing the inevitable. Going forward we will see a  union of monetary as well as fiscal policy as the current system of only a monetary union and fiscal policy being independent of countries clearly unsustainable. We think in the long run the skewed global consumption and savings pattern need to change in order for the global economic growth to be more sustainable.

It has always been the case that capital has flowed from the developed world to the developing world. But things began to change in the late 1990s. The developing economies started running huge surpluses which were channelized to the developed economies mainly the US. This allowed developed countries to run huge deficits mainly the US and at one stage US consumed 90% of world’s savings. This resulted in artificially low borrowing cost for Americans and their counterparts in the developed world. This allowed the Federal Reserve to keep interest rates low for an extended period of time which coupled with lax regulations and financial innovation gave way to massive housing bubble which through securitization and use of derivatives led to Subprime debt being circulated throughout the financial system and throughout geographies in US and Western Europe. When Fed started raising the rates the entire pack of cards began to unravel and after Lehman brothers bankruptcy the world saw a financial crisis of the scale not seen after the great depression. There was a fear the economies in the developed world may go into a depression and in Keynesian wisdom to support the economies, governments across the world unveiled massive stimulus packages along with a very easy monetary policy by central banks. Eventually the entire banking system was bailed by the Government in countries like US, UK and Ireland. In US to fund government bailout the Federal Reserve resorted to a massive programme of buying US treasury bonds called as Quantitative Easing. While Quantitative easing 1 and 2 had mixed results. They clearly could not pump up the economy. All this was funded by borrowing. The US consumer after years of spending beyond its means has started saving. This has result in weak consumption demand which is not helping the economy recover. The Fed in US faces a difficult choice whether to continue with QE  . While as economies around the globe slowed down, countries like Greece, Portugal, Spain and Ireland which had not been fiscally imprudent started facing financial troubles. Years of financial mismanagement and non transparency did not help. Soon the bond markets started reacting to the bad news and yields on sovereign debt of countries facing financial problems started rising. This aggravated the debt problems of these economies. If these countries which shared a common monetary system and a common currency Euro defaulted on their debt it would result in breakup of the monetary union. While markets expected rich countries in EU like France, Finland and the bulwark of EU. Germany  to provide a bailout of their beleaguered European partners which was highly unpopular in these countries where the common man on street was against the idea of providing bailout with tax payers money to fiscally imprudent counterparts in EU. The problem started when in the wake of Lehman Brother Bankruptcy, Angela Merkel, Chancellor of Germany announced that the responsibility of bailing out banks with problem will be dealt by individual countries on their own and it won’t be a joint EU effort. This German procrastination aggravated the Greece and other troubled economies problems and it is today a question about existence of a common monetary union. This signaled the German unwillingness to go all out to support troubled economies with its own funds.  The Germans want Euro to survive but are not ready to bear the cost. While the European central bank started buying bonds of Greece and other troubled countries. This was a stop gap arrangement and it did not result in any substantial fall in yields on these bonds. There is no mechanism in EU for a country to systematically leave the union and any disorderly withdrawal or exit from the union even of an small economy like Greece would precipitate a banking crisis of the scale seen during the Great Depression. Without help from other member nations Greece will be forced to withdraw from the union and it will sound death bell for other countries facing similar problems as the financial markets will increase their borrowing cost by dumping their sovereign bonds. What Europe wants is a strong monetary union coupled with a strong fiscal union.  The global debt crisis according to some commentators has accelerated the process of transition of power to the East specially Asia with China leading the pack. With Asian economies having done reasonably well during the crisis and their banking system looked very robust , China and India became the drivers of global economic recovery. China and US are two ends of the spectrum when we speak of the imbalance in global savings and consumption. Chinese model of economic growth which is highly dependent on US consumption is highly unsustainable and China needs to change to a more balanced domestic consumption driven growth.  “Till when can the world’s biggest debtor be world’s superpower?” the question raised by Larry Summers , former economic advisor to President Bill Clinton. US debt to GDP ratio is expected to touch 100% by 2011. If EU breaks up it will be a catastrophe many times the size which we saw after Lehman Brother Bankruptcy. The global debt crisis has major implications for the global community. The world economic outlook is bleak and if the problems are not addressed we may soon see the global economy again sliding into recession again.

Eurozone crisis: Given the situation half hearted efforts won’t help. While European Financial Stability Fund has been established to deal with solvency issues, its size is too small.  They have fallen short of creating a creating a credible fiscal authority for the Eurozone which is the long term solution to the problem.  If very stringent fiscal austerity measures are imposed on these troubled European economies it will not help them achieve economic growth which is the most important thing required to stabilize their fiscal situation. The cost of bailout has to be borne by Germany and other rich countries in order to save Euro as well as their own banking system which is highly exposed to debt from these countries. Even a partial default or restructuring will make it impossible for other troubled economies to avoid a default as market would dump their bonds resulting in a self fulfilling prophecy. Germany which was the driving force behind the European Union has to take the lead.  German politicians have to make people understand that its in Germany’s long term interest for Euro to survive and they will have to bite the bullet.

US situation: The Federal Reserve should continue its bond buying programme if the yields on US treasury paper shoots up or the economy falters. While in the short run the US economy needs to stimulated with monetary and fiscal measures in the long run US has to cut its fiscal deficit . Its needs to reform the social security schemes or else we can see a serious debt problem in the future.

China: China has to increase its consumption and save less.  It will also allow China to allow Yuan to appreciate which will help in addressing the problem of managing massive  its forex reserves which have already touched 3 trillion dollars.  

The world clearly is on stranger tides and there are no clear answers and some tough policy decisions needs to be taken to address the challenges before the World.  

Abhishek Jain and Chandan Meghwani. This was written for a competition at IIT-M

Global debt Crisis and the way forward.

Issue and Position 

The crisis that we see in the world today is not actually a crisis of just debt face by the governments all over the world. It is result of the over leveraged balance sheets of banks internationally that has sparked off the global meltdown in the markets all over the world, not just capital markets but also the overall economic activity. The governments all over the world have resorted to borrowings to provide a stimulus to their economies. Some economies like China are also pursuing a policy of aggressive stimulus to escape at a velocity which would surpass any upcoming slow growth phase. However the governments do not realize one basic fundamental principle that when the problems are structural, it should be tackled to strengthen the fundamentals. For example, The BASEL Committee norms on ensuring banks’ capital adequacy to ensure cover against systematic risk is one such fundamental improvement. However the Budgets of the countries over the world are in bad shape. The reason the crisis have emerged again this year is because the resurgence in the world economy was spurred by artificial stimulus created by governments and since the government money is now drying up, the fundamentals are now floating up again, which unfortunately are in no better than in 2008. Thus it is not the right direction that governments have taken since the start of the crisis.

Detailed Background

The Historical origin of the crisis has taken place mainly from the failure of banking systems especially in the major western economies. Their failures lead to financial system’s failure and also of the insurance companies like AIG and others. The sub-prime papers of the markets were also the underlying for the (toxic asset) derivative products like MBSs and CDOs. Thus overleveraging of assets was the main reason for the banks’ failure. Also another important reason for the current GDP growth in US and Europe is the unemployment and the resultant lower disposable income in the hands of consumers. Thus the domestic economy has not much strength left. The lifestyle of the people in the west is the main reason behind the emergence of the crisis which has grasped the world.

Relation to International Community

The countries of the world are no longer in isolation. Thus a decrease in interest rates in US results in greater FII flows in India to catch opportunity to make extra money because of high interest rates in India. Thus it is a crisis which affects all the countries equally. They all need to bail out one another in order to take the world economy back to the growth trajectory. If one country defaults, it is followed by a series effect since trading partners are all connected to the economy of the defaulting country.

Previous Actions

There have been many previous actions taken by the various governments in this regard. The European governments (EURO Region) are bailing out smaller countries to keep Euro afloat. PIGS countries are the primarily affected. The US government bought the toxic assets and also rolled out massive stimulus in the form of very low fed interest rates of 0.25%. This means the cost of money is virtually free in the US. In China and India and other emerging markets too the Central banks reduced the central bank lending rates to stimulate the flow of money in the economy. Also the US government brought restrictions the jobs given to migrant workers and students working in US. Also stress was given to bring back jobs to US. Similar steps were taken by UK. The Emerging countries diversified their reserved to save themselves from the situation. Commodities became the hot spot and that is where China invested. This lead to a rally in commodity prices and Inflation shot up in world.

Success & Failures

The actions taken by the governments have been successful for some time. The capital markets were back on track and confidence was back in the banking industry which was most delicate in the crisis. There were few quarters of good GDP growth. But problems emerged again when the stimulus lead growth ran out of steam for countries and fundamental again started to emerge. The important development was investment by CHINA IN COMMODITIES. This lead to a global race between countries to conquer natural resources to buy them at cheaper costs today than to pay a high price later on. Thus Demand went up and inflation shot up significantly. This has lead to fear of stagflation in western countries. Also the unemployment numbers are consistently weak in US at around 10% since a year.

Problem not addressed

The main problem not addressed by the west, and which the emerging market is paying for, is the problem of bank leveraging. The banking system is too flexible and instruments floated are too complex to make sense of the sustainability of the economy as a whole, leave alone the banking system. Also the typical western habits of Outsourcing had led to the habit of deriving more profits consistently by hiring cheaper labor elsewhere. This has pushed up unemployment and greater responsibility on governments to stretch their budgets. The typical spending habits has led to the creation of their own problems.

Proposed Solutions:

1) Banking System: There is a need to very strictly regulate the banking system. Like in India there needs to be systematic watches and curbs on too much leveraging. Also banks need to have more CASA deposits in west to cover for their underlying securities. The US government and Federal Reserve need to hike interest rates. Also the spreads for banks should be allowed to be hiked. This may be uncompetitive but it is better for the economy in the long run. The demand for credit will come down and over leveraging will reduce. This will indulge bring down the habit of over leveraging by people and high deposit rates will indulge saving habit in people.  This can significantly impact the financial system. The FII money can get diverted back to US with increasing rates of interest. Same thing can be applicable to European companies as well. The global imbalances in trade can be reduced through this and capital markets will be more stabilized.

2) Employment: One of the main reasons for the slower growth of domestic GDP of west is the lack of disposable income in hands of the people. The government should implement laws to bring back the outsourced jobs and employ the citizens of the country. This may be painful in short term since it impacts the profit margins hard especially in downturn, but in the long run, it will be good for the domestic growth of the economy. This policy can be implemented gradually on case to case basis. 

3) Greater involvement of Emerging Market Group in World Economy: There should be a greater participation of Emerging markets in major organizations. For example India and China are actually powering the growth engines of the world economy today and helping it keep its head above water. Thus these countries should be given better say in international politics and decision making. This will make the world politics a multipolar affair. Hence there can be no single country or superpower whose economy once affected will affect the entire world. Example of US is perfect in today’s scenario. The participation or greater number of countries especially emerging nations will bring together resources, knowledge and wisdom to solve the current Dect Crisis which is standing on a Stranger position today. It is like investing in a portfolio of assets which is diversified to as to absorb the risk of loss of one to another and enjoying the co-relation between them to make the portfolio grow along with shock absorbing capacity.

Jigar Jatania,Hardik Mehta,Kunal Sodhani, Shrenik Jain. This position paper was written as a part of competition at IIT -M