The Financial Crisis: 10 years on

This year’s September 15th marked the 10th year anniversary of the crisis that shook the world by its very core. Serving as a renaissance to the Great Depression of the 1930s, it seemed to be unwarranted- or so many felt that way. We were in a happy bubble that burst due to restrained space accommodating this incompatible happiness. How something as perceptible as piling debts hid itself behind the veil of catastrophe? How does one fail to progress from the lessons of the 1987 stock market crash and the 1998 collapse of the Long-Term Capital Management (LTCM) hedge fund, where in both cases, bizarre bets arising from operational inefficiency and leverage, ruptured the markets? The answer lies in what seemed to be appealing to the eyes of many financiers and economists who did see an imminent crisis, but failed to recognize the accurate one.

The foundation of viewing the crisis was itself defaulted. Of course, global cross border transfers impact a country’s balance sheets, shedding and supporting many dynamics of it. But was that the actual problem? The prediction of how a surplus country such as China would shatter by catering to the incessant demands of an extravagant nation as the United States, twinkled the foresight of many economists around the globe. The abolition of Bretton Woods by the Nixon government in the 1970s was the first time in history when no currency was pegged against a metallic standard, leading to the demise of many countries’ strong fundamentals. This soon was balanced by the policy-makers as they lauded themselves with the need for low inflation rate in an economy, failing to accommodate within it, the real-estate prices.

Soon, in the mid-2000s, it was realized that although US’s claims of it being worthy enough to fetch support and that printing money its way through an alligator’s mouth was no liability, some started raising their doubts on its sizeable trade deficits and how it might eventually lead to its downfall- shooting rates, inflation and a jolt to the dollar’s value.

Why, but the situation that was ultimately revealed was a striking contrast to the aforementioned predictions. Deflation severed, just as the dollar surged and interest rates spiked. It was therefore not the problem of US’s outstanding public debt but its private debt that would create a cataclysmic impact due to the inability of “subprime” borrowers to repay. Just like the many sequences of predicament in emerging markets in the 90s, it was investors’ confidence bailing out on these asset prices. China prevented itself from undergoing a calamity as such by keeping the value of its currency artificially low, thus, a shield against ever needing the IMF. China’s trade surpluses with the US rose to astonishing highs as they continuously bought dollars to devalue the Renminbi. Oversupplied with cash from the poor farmers and factory workers in China, the long term rates too, not caring to budge, and to gain a better return in the name of innovation(credit default swaps played a significant role in AIG’s downfall), subprime mortgages entered the picture. Imagine the riskiest pool of investments arising out of a glut of cash, propagated and blessed further by the credit rating agencies for providing loans with margin requirements as low as 3%- helped boost this make-believe world of temporary gala.

Many wanted a piece of this pie, from big German banks to the small ones, European and British banks ended up disbursing almost 1/3rd of these risky mortgage-backed securities.

Thus, capital flows across the trans-Atlantic region than the ones across national boundaries, provide a substantial argument as to how this contagion spread and fogged the lenses of policy-analysts to focus on the Sino-American trade imbalances than the Euro-American transfer system. However, as much as claims the US banks had on the European ones because of the trade flows, the European bankers were persuaded to earn big bucks by implementing the basic business idea of cheap cost financing to earn decent returns. This is how, from its origin in the 2000s, finance had globalized itself. A complicated banking system, restricted competition, poorly conceptualized government programs to help the disadvantaged and the lack of mindful analysis, played role as catalysts to an impending crisis.

What now? Has a crisis as hysterical as this been fully averted? Of course, lending rules in the US are firmer, such that individuals with good borrowing credentials find themselves in a tight spot. But, more people in their 30s and 40s are risk averse and less willing to take on debts in their portfolios. A study, focusing on the behavioral impacts since the crisis, tells us that the share of people owning homes haven’t increased much since the crisis came about. This has created a psychological scar leading to a cautionary environment. Entrepreneurship too, is less vigorous than the pre-crisis level. People no longer treat their houses as piggy banks and therefore are not keen on borrowing against their houses (as those who did before the crisis found the value of their houses plummeting tremendously). A very curious insight also indicates people ditching the streams of humanities for the STEM subjects as they ensure better prospects career wise. Companies find themselves spending slowly on new equipment and choosing to pay their employees in bonuses by gingerly raising wages- to not commit for the long term and safeguarding their flexibility. These are a few of the lingering effects of the crisis. Then, why has the promotion of low cost student loans surfaced credit markets? How about the notorious nexus between the sovereign and banks?

How to predict a crisis? We are guided by the Greeks to follow the classical ideologies of constancy and unanimity, even then, weather forecasting with its efficient computing and other technological advancements, has improved just marginally. Seemingly so, prediction of an economic crisis in itself doesn’t always seem evident. Effectiveness due to economic rationales and conformities do sometimes fail to capture a forthcoming emergency-like situation. Mitigation of risk through the available tools than prophesying theories onto the universe could help prepare ourselves better. Therefore, to batten down the hatches, incorporating the psychological and future expectations of people by adopting measures of common sense (in our case, house prices were rising faster than their owner’s income), should be a viable and forward-looking strategy. Are we, if not prepared, waiting to learn from another crash? Paradigms haven’t come to a standstill. A “macro-financial” approach to better study the mechanisms on which the global banking balance sheets change shape, both at the national and global level, in a “pro-cyclical” approach, has been worked out as a framework for resolution. A view that is “macro-prudential” with its new set of instruments to monitor not just the credit cycle but the key drivers of the world’s largest banks. However, the political facets of this new approach must work as a coherent whole to balance interests and technicalities of regulation.

We are likely to know the outcome in the following few years, till then, let’s hope our fate chooses us justly.

Tanya Rana