This month's featured article
Policy Recommendations for Dealing with the Global Financial Crisis - Part 1
KOBAYASHI KeiichiroSenior Fellow, RIETI
Dr. Kobayashi has been a Fellow since RIETI's establishment in April 2001. His research pursuits include endogenous growth theory, general equilibrium, business cycles, and the non-performing loan problem. Dr. Kobayashi is also a Visiting Professor at Chuo University and a Lecturer of the Institute of Economic Research at Kyoto University. Prior to joining RIETI, he worked with the Industrial Policy Bureau at the Ministry of International Trade and Industry (MITI). His book, Nihonkeizai no wana [Trap of the Japanese Economy] (Nikkei Publishing, 2001) won the Nikkei Economics Book Award, one of the most prestigious awards for young economists in Japan. Dr. Kobayashi holds an M.S. in Mathematical Engineering from the University of Tokyo and a Ph.D. in Economics from the University of Chicago. His recent major publications include: "Payment Uncertainty, the Division of Labor, and Productivity Declines in Great Depressions," Review of Economic Dynamics, vol. 9, no. 4 (2006); "Forbearance Impedes Confidence Recovery," Journal of Macroeconomics, vol. 29, no. 1 (2007); and "Business Cycle Accounting for the Japanese Economy," Japan and the World Economy, vol. 18, no. 4 (2006).
Collapse of Lehman Brothers: U.S. financial crisis and the future of the key currency
(Part 1 of a two-part series)
(Japanese version published on September 18, 2008)
Impact of the collapse of Lehman
On September 15, Lehman Brothers, the fourth largest securities company in the United States, went bust and filed for protection under Chapter 11 of the U.S. Bankruptcy Code. At the same time Bank of America, which had been seen as a leading candidate to buy Lehman, made a surprising about-face and agreed to buy Merrill Lynch, another major U.S. securities company. With these two events, the global financial turmoil moved into a new stage. Shortly after the Lehman Brothers news broke, the U.S. financial crisis intensified and a liquidity crisis deepened at American International Group (AIG), the biggest U.S. life insurer. On September 17, only two days after the collapse of Lehman, AIG received emergency loans worth about nine trillion yen from the Federal Reserve and was effectively bailed out and placed under government supervision. Even after that, the financial markets remained rattled and the media began to report on Morgan Stanley's search for a buyer.
In the latest series of events, the U.S. authorities let Lehman fail by refusing to offer financial support when it was in desperate need of public funds. On the other hand, while bailing out AIG U.S. Treasury officials reasoned that its failure would have made too great of impact on world financial markets. The double standard has been causing great fear and anxiety in the market. Generally, a financial crisis has two aspects: liquidity shortage and bank insolvency. In the ongoing crisis, the Federal Reserve and the U.S. government have taken measures in quick succession in preparation for a possible liquidity shortage. Indeed, the financial system would not run into trouble simply as a result of a liquidity shortage. However, liquidity shortage and bank insolvency have become so intertwined with one another that this is now the most difficult part of addressing where the financial crisis lies. It can be inferred that liquidity problems at financial institutions mostly stem from solvency problems. The problem of bank insolvency is bound to worsen in the coming months. Financial institutions with weak solvency positions must have been frightened as they watched the divided fates of Lehman and AIG; the standards of eligibility for a government bailout appear so arbitrary that struggling firms are now unable to predict their own fate.
Financial institutions with weak solvency positions would intensify moves to sell off assets with declining values, such as mortgage-backed securities (MBS), even at a loss so as to prevent further deterioration of their balance sheets, which in turn may result in further declines in asset prices. This same pattern of events was observed in the U.S. Great Depression of the 1930s, as well as in the debt deflation in Japan in the 1990s that was triggered by the burst of the bubble economy. The current problems roiling financial markets may be defined as a recurrence of the same kind of crisis. Debt deflation refers to a vicious spiral in which distress selling of collateral assets by financial institutions and corporations, a move intended to reduce their debt burden, causes an even further reduction in collateral asset values, or asset-price deflation, which ends up resulting in an unintended and unwanted increase in debt burden. There is strong concern that the U.S. government's decision vis-à-vis Lehman may accelerate asset-price deflation. Given the grave nature of the insolvency problem, the U.S. government should have used public funds to recapitalize Lehman, or it should have introduced a new mechanism for asset protection and liquidation applicable to financial institutions which would involve significant institutional reform comparable to the establishment of the Resolution Trust Corp. (RTC).
It is feared that with worsening asset-price deflation, bankruptcy contagion may spread to U.S. banks, eventually forcing the U.S. government to use an enormous amount of public funds to prop up the financial system. At the moment, however, the U.S. is in the midst of a presidential race and any attempt to inject taxpayers' money into the financial system would encounter strong political resistance. This may delay policy decisions and, as a result, prolong the present state of confusion over an extended period of time.
Current state of financial uncertainty
The U.S. financial crisis that began in the summer of 2007 is deepening. The problem began when subprime mortgage loans turned sour as U.S. housing prices declined. Subprime mortgage loans held by banks had been securitized by utilizing leading-edge financial technology, and then sold to investors across the world. When these loans began going bad, global financial markets were thrown into panic amid mounting uncertainty and the inability to figure out who would end up holding bad assets. The collapse of a European hedge fund in August 2007 triggered the panic that quickly spread to U.S. and European financial institutions. Although the European Central Bank (ECB) and the Federal Reserve promptly and repeatedly pumped in liquidity, market turmoil continued, leading to today's crisis.
The root cause is the across-the-board declines in U.S. housing prices. With Lehman left to fail, it heightened the risk of sending housing prices into more acute deflation. The problem is no longer confined to the financial sector and has become a problem for the whole economy, i.e., the problem of a huge hole in the balance sheets of the U.S. economy. As a "liability" called fixed-amount mortgage loans remains stable while an "asset" called mortgaged homes continues to fall in value, this hole (or asset-liability gap) in the balance sheets of the U.S. economy continues to expand.
The hole in the U.S. economy disrupted the stability of the financial system and, one after another, financial institutions faced a liquidity problem. To prevent a threatening liquidity crisis, the Federal Reserve aggressively eased its monetary policy by extending lending facilities to boost liquidity and cutting rates to help private-sector banks cope with their liquidity problems. The extra dollars released into the U.S. economy created an oversupply of money in the market and lead to inflation that originated in the U.S. but was quickly exported to the rest of the world, particularly emerging economies.
Problems facing the world
The problems facing the world economy can be better understood by classifying them into two categories, namely "financial" and "macroeconomic" problems.
Liquidity shortage is one of the financial problems, but the biggest challenge on the financial front is the holes in the balance sheets, or capital deficits, of U.S. and European financial institutions. If housing prices continue to decline, the holes in the balance sheets will continue to expand and, not in the not-too distant future, it will become difficult for these financial institutions to cover liquidity shortfalls through their own efforts to raise capital.
Macroeconomic problems can be boiled down to the question of how to cope with the meltdown of the world's ultimate market, or the world's ultimate consumers. In the past 15 years, global economic development has been sustained as American consumers continued to consume products made in China. The severe and long-lasting stagnation of the U.S. economy that is expected down the road means the collapse of that growth pattern of the world economy. The U.S. has been supporting the global economy as a powerful consumer of the world. Thus, when U.S. consumption withers, pressure will mount for other countries, such as China, to increase their domestic demand. In terms of currency relationships, this means greater downward pressure on the dollar and upward pressure on the renminbi (RMB).
These problems facing the world economy concern the methodology of how to plug the hole in the balance sheets of the U.S. economy. In the event that bank capital positions deteriorate to the point where capital replenishments by individual banks would not be enough to resolve the issue, conceptually, there are three possible ways to plug the holes in their balance sheets.
The first way is to inject public funds, i.e., American taxpayers' money, into banks to shore up their capital positions.
Over the past 12 months since the onset of the subprime crisis, U.S. and European financial institutions recorded losses on subprime write-downs worth about 50 trillion yen. In order to make up for the resulting capital shortfalls, they raised capital from private-sector investors as well as from overseas sovereign wealth funds. However, if housing prices continue to fall, financial firms will suffer further losses that will make it more difficult to raise future capital from investors and sovereign wealth funds. Should this happen, the injection of massive public funds into U.S. investment banks and housing finance corporations would emerge as an issue of practical concern.
The second method is to generate seigniorage by printing extra greenbacks and devaluing the dollar to offset liabilities.
The injection of public funds into banks, combined with decreasing tax revenues resulting from the economic downturn, would cause the U.S. fiscal deficit to explode and exert greater downward pressure on the dollar. When the dollar weakens, dollar-denominated claims held by foreigners against the U.S. government and U.S. companies will erode in real value, thereby alleviating the burden on the U.S. debtors (government and companies). Meanwhile, when the Federal Reserve prints more money, it will generate seigniorage, which has the same impact as increasing tax revenue for the U.S. government. Since the dollar is the key currency, the U.S. government can earn seigniorage from investors in dollar-denominated assets across the world by issuing and devaluing the dollar.
The third possibility requires the cooperation of major countries in a concerted international effort to contribute their public funds to strengthen the capital positions of U.S. financial institutions.
Normally it is unthinkable as a financial-system stabilization measure for a country to offer public funds to help shore up the capital positions of financial institutions in another country. At the time of Japan's financial crisis, the government did inject public funds to replenish banks' capital levels, but tapping into other countries' funds was not an option. Primarily, when a country needs to inject public funds into financial institutions, taxpayers of that country are to bear the burden. However, as will be discussed later, from the viewpoint of preserving the stability of the international monetary system, it would be justifiable to argue that to eliminate the ongoing financial uncertainty in the U. S. is to safeguard the dollar as a global public good. Other countries - those other than the U.S. - benefiting from the global public good should bear some of this burden.
In reality the disposal of U.S. bad debts, i.e., filling in the hole in the balance sheets of the U.S. economy, would proceed by applying solutions that combine elements from all three of the above methods.
What would be the most likely course of events if the U.S. financial crisis continues to worsen? Based on relevant theoretical models and real-world examples from past financial crises that have occurred in emerging economies, the U.S. will likely follow the following pattern: (1) the financial crisis will increase the U.S. fiscal deficit; (2) the dollar will depreciate against other currencies; and 3) the U.S. economy will eventually achieve an export-driven recovery. In the past 12 months, the dollar has been on the decline in value relative to other currencies, which has helped boost U.S. exports and improve the U.S. trade balance. In other words, foreign demand is propping up the weakening U.S. economy. Export-led recovery following significant currency devaluation is how Latin American countries and others have typically emerged from past financial crises.
If U.S. housing prices continue to fall, the U.S. economy will likely follow the same path. First, the problem of bank capital shortfalls will intensify, and then, following a swirl of political controversy similar to what Japan witnessed in the 1990s, public funds will be injected into private-sector financial institutions. Decreasing tax revenue and the use of public funds will result in a significant expansion of the U.S. fiscal deficit, thereby causing the dollar to depreciate at a much faster pace than expected. Then, other countries would come under growing pressure to expand domestic demand and upwardly revalue their own currencies. Particularly problematic will be the impact on the Chinese economy. As its economy and the dollar weaken, the U.S. will step up pressure on China to revaluate the RMB, which would force the Chinese economy to go through extremely painful structural adjustments.
Should China continue with revaluing the RMB at its current moderate pace, the resulting effect would be similar to that of pegging to the dollar. That is, as it is dragged down by the easing of U.S. monetary policy, China would be forced to ease its own monetary policy to the extent it would thereby spur inflation in China. The young and the poor are always the hardest hit by inflation. Should inflation escalate further in China, it could give rise to serious political and security problems such as disruption of public safety, ethnic violence, and terrorism. These can be defined as enormous costs resulting from delaying RMB revaluation.
On the other hand, what if China accelerates the pace of RMB revaluation? This would boost its people's dollar-denominated purchasing power. However, Chinese exports would shrink sharply and the current growth pattern of the Chinese economy, i.e., growth led by exports and capital investments, would become unsustainable. It is highly likely that the Chinese economy, albeit temporarily, would fall into a very acute depression similar, but of greater magnitude, to the "high-yen" recession experienced by Japan in the 1980s. This too, would cause significant disruptions in Chinese society. China may be forced to make a stark choice between either pegging to the dollar or accelerating RMB revaluation. The Chinese economy will face a painful ordeal regardless of which choice is made - high inflation as a result of pegging to the dollar, or acute depression caused by accelerating RMB revaluation.
The U.S. financial crisis, through lower U.S. demand and a weakened dollar, will eventually force the rest of the world to go through painful adjustments.
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