US Financial Crisis and Its Impact on Global Economy

Toshihiko KINOSHITA (Professor, Waseda University)

On October 10, it was announced at the G7 meeting that an action plan was adopted to actively inject public funds to financial institutions in the G7 nations in an attempt to deal with the credit crunch which has resulted from capital deficiencies at those institutions. This plan has been supported by the G20 nations including such developing countries as China and India. Right after this announcement, the US government, following some of the EU nations, has decided to infuse 250 billion dollars into the banking system as new capital, where this amount of public funds is coming from the 700 billion dollar economic rescue package previously announced. Furthermore, federal insurance will be expanded to cover most of the interbank credit as well as all non-interesting bearing accounts for small businesses, in addition to the purchase of commercial paper by the Federal Reserve Board.

Although at first the stock markets responded quite positively to these developments, stock prices seemed to level off after a day or two, and went down again in New York and elsewhere. Investors around the world are still very much concerned about the future of the real economy. Basically, the announced measures were for emergency treatment, but they have fallen short of creation of a new financial and supervisory scheme to deal with fundamental causes for the US financial crisis or adoption of effective policy measures to prevent a further worsening of the real economy due to the current crisis in the world. Therefore, we are still standing at a crossroads with no visibility into the future of the post-war world economy. Aside from immediate actions to be taken by major countries, let us consider more fundamental problems of the international financial system.

First, the US authorities have been arguing that the financial system in Japan and other Asian countries should be reformed from the troublesome system based on banks, that is, indirect financing, to the American-style direct financing system based on the stock market. Now this argument should seriously be questioned in view of the bubble resulting from securitization of subprime loans in the US and the devastating impact of its burst on US and European financial institutions, which are badly needing capital infusion. Probably, the US authorities may have been complacent about their ability to deal with the bubble economy by learning from Japan's experience, as they claimed, but in fact failed to handle it until they (and the other Western nations) have taken the same actions as Japan did in the later period of the "lost decade." In other words, the US does not have a superior financial system that could effectively prevent the bubble economy. What makes the situation worse is that the US financial system is of the contagious character to the rest of the world as it is a global system, and that is a basic difference between Japan and the US regarding bubble bursting. There may be various problems such as the problem of incomplete regulation and supervision on financial institutions including hedge funds, as well as the problem of a more fundamental socio-political background for the financial system as a whole. Thus, a serious question remains as to what kind of "philosophy" should be adopted to rebuild the existing financial system of the American style.

Second, the US economy has been able to grow at a relatively high rate, at least among developed countries by mobilizing its financial resources through the potentially troublesome financial system while continuing the so-called "twin deficit" in the past. This has made possible by the huge inflow of investment funds from outside and the resultant appreciation of the dollar due to apparent (disguised) high growth performances and potentials in the US economy. Most probably, this could not continue any longer. Now that it has become clear to foreign investors that the value of the dollar is being supported by the mercy of such countries with abundant foreign reserves as China Japan, oil producing nations, etc. (even many Americans are trying to diversify their dollar-dominated assets), after the failures of giant investment banks and insurance companies in the US, the US authorities are under strong pressure in their handling of the economy, which used to be easily managed just by printing dollar bills (Treasury Bills, etc.). In other words, the future value of the dollar is anxiously being look at by other countries and regions, other than the US, and their anxiety will not go away too easily, meaning that the instability and concerns regarding the international currency system will basically persist.

Third, another problem, related to the points above, is about the international financial system, namely, the "Bretton Woods system," to support developing nations, especially in economic crises. The Bretton Woods system, consisting of the IMF, the World Bank and other organizations including the WTO, based on what is often called the "Washington consensus," have been criticized and pressed for reform since the Asian financial crisis in 1997-98, when various problems with IMF's prescriptions were widely pointed out (see, for instance, Philip Bowring "Asia's reawakening resentments," International Herald Tribune, October 14, 2008; http://www.iht.com/articles/2008/10/14/opinion/edbowring.php). However, the direction of its reform has yet to be clarified. More recently there has been a problem of declining use of funds through the IMF.

In the meantime, the Japanese government has announced a new scheme to assist developing nations in financial trouble by utilizing Japan's abundant foreign reserves, although not directly but through the IMF, and this proposal seems to be supported by China and some oil producing nations that would be willing to join this scheme. As it happens, Japan's proposal has just been accepted in principle by the IMF in assisting Iceland and Ukraine. However, as IMF finance is ordinarily made with severe conditionality and surveillance, there is a possibility that this time new loans are being extended with looser scrutiny than otherwise, because of the current emergency situation, but still under some conditions in order to avoid moral hazard. It could be reasonably argued that the IMF should not extend its finance unconditionally to any country, as some countries may well be facing not only the liquidity problem but also the solvency problem, unlike Asian countries at the time of the financial crisis a decade ago. In this respect, we should carefully watch how the new IMF scheme will be implemented.

In view of all these developments, we can conclude the following: (1) the global financial structure that was established in the late 20th century for the US to finance its large current deficit through the financial markets will no longer work in the post-subprime era in the 21st century. (2) It seems unlikely that the US, looking more and more inward, will take bold actions by itself to reform the current financial system which has long been benefiting itself. However, the US may well be forced to take necessary measures, though reluctantly, as the pressure from outside becomes stronger and stronger in the near future. That would likely reduce US consumption and imports for many years to come. (3) Japan as well as China will probably not propose a brand new financial scheme to fundamentally change the status quo despite their discontent with the self-centered behavior of the US, since their economies are now too closely intertwined with the US economy and they have no choice but to cooperate with the US. But at the same time, we need carefully watch China's domestic politics in relation to this issue, as China's position might be divided between an "international" group and a more "inward-looking group, sticking to its independent stance" (we should somehow encourage the former group, though not directly but indirectly).

On the other hand, EU nations apparently have a more free hand than Japan and China, and actually French President Sarkozy, along with other European leaders, is making a proposal for creation of a "New Bretton Wood system," which is to be led not only by the US and other advanced nations, but also by emerging economies. However, no convincing “philosophy” to support such a system has been offered yet.

Thus, the world is now losing its flagship, that is the US, which has so far provided international public goods based on the Washington consensus, while no one would be able to replace the US position, somewhat like an inter-regnum period. During such a period, it often leads to just a gathering with differing aims at best, or a division with no morals at worst. In other words, we are still in a very precarious condition of the world. Hopefully, the leaders of the G7 (or G8) nations will commit themselves to take more joint actions for the world economy to recover from the contagious financial crisis and there by prevent the proliferation of self-centeredness such as the extreme form of "market fundamentalism" or "xenophobia," which would politically divide the world. At the same time, China, India and possibly other emerging economies should become new members of the expanded G7 (or G8), if they are ready to be responsible stakeholders in the world by sharing obligations to create and maintain international public goods.