December 1998 Vol 4, No. 2
December 1998 Vol 4, No. 2
FINANCIAL MELTDOWN, FINANCIAL REDEMPTION
Making sense of the chaos: Why are global financial markets so unpredictable?
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Controlling capital: How can we lessen our vulnerability?
The phrase "roller-coaster ride" is an overused cliché. But it nevertheless remains an apt description of the experience of global financial markets over the past eighteen months. Rocked first by a currency crisis in many formerly-successful east Asian economies, then by Russias default of much of its foreign debt, the world financial system seemed poised on the brink of collapse.
But then the cavalry rode to the rescuespecifically the U.S. Cavalry, in the form of the Federal Reserve Bank (also called the "Fed") which is responsible for setting interest rates in the U.S. (and hence strongly influencing interest rates throughout the world economy). The Fed cut interest rates three times in six weeks, slowing the tidal wave of financial capital that had been surging into the U.S. and destabilizing any economy standing in its way. U.S. stock markets enjoyed their best October in history, the Canadian dollar and other small currencies stabilized, and financial analysts were once again sporting "What, Me Worry?" grins.
Its not clear that the global economy is quite out of the woods yet. Despite a diminished sense of panic in North America and Europe, many countries in Asia, Eastern Europe, and Latin America are enduring Depression-like economic contractions, with a vast human toll. What can we learn from the financial ups and downs of the past year?
The Issue: A Stable, Sensible Financial System
- The collapse in many of the worlds financial marketsfrom Asia to Russiais causing severe economic hardship for billions of human beings. But because the collateral damage to markets in North American and Europe has apparently been contained, there is a widespread but wrong tendency to say "the worst is over."
- We must learn from the nail-biting experience of the past two yearsbecause left to its own devices, the current financial system will keep delivering periodic episodes of rampant expansion followed by crisis and contraction.
- The Asian crisis and its fall-out have revealed some deep-rooted flaws in our current financial systemand suggested some equally deep-rooted solutions. Many reforms that are often proposed in current discussions of this topic (such as the Tobin tax) are simply not strong enough to address the true problem.
- In particular, we need to consider direct controls on the freedom of individual investors to speculate internationally in portfolio (or "paper") assets, such as equities or currencies. And we need to ensure that money-creation and investment in our economy reflects broader social needs, not just the interests of private investors.
Between Greed and Fear
October 1998 was not a month for the faint-of-heartespecially for anyone who reads the financial pages. The crisis that wracked world financial markets beginning in 1997 reached a turning point that month. In the wake of the default by the Russian government on much of its foreign debt, continuing turmoil in Asia, and signs that major investment houses in the U.S. and Europe might be brought down by huge losses in hedge and derivative trading, there was real fear that what had started a year earlier as a serious but regional crisis might become a truly global catastrophe.
Despite their supposed economic rationalism, financial professionals superstitiously believe that October is the "worst month" of the year for stock markets. The historic market crashes of 1929 and 1987 both occurred during October. What would October of 1998 bring?
World finance ministers convened an emergency summit in Washington. The usually slow-moving U.S. Federal Reserve cut its main interest rate three times in six weeks to stabilize markets. Policy prescriptions which only months previously would have been dismissed as leftist claptrap began to be bandied about freely by Nobel prize winners and heads of state alike: emergency controls should be imposed to limit international capital flows; central banks should print money to bail-out shaky banks and boost the purchasing power of worried consumers; beleaguered debtors should declare unilateral moratoria on their obligations.
This represented an astounding turn-around. Global economic policy in the 1990s had been dominated by the so-called "Washington consensus," which demanded deregulation (especially financial deregulation) and public sector restraint in return for financial support from the IMF and other international lenders. Suddenly, in the wake of this most spectacular failure of private finance in 70 years, all bets were off.
Even countries which had followed the Washington prescription to a fault (such as Mexico) had been hammered by the panicked flight of investors buying U.S. dollars in fear that any emerging economy could be the next Indonesia or the next Russia. The panic even battered the currencies of smaller developed countries such as Canada, Australia, and Norway. In the wake of this unpredictable and destructive financial havoc, the free global reign that has been granted to private finance is open to serious question for the first time in decades. It is no longer accepted that the unconstrained, self-interested actions of the financial industry are even rational, let alone optimal.
As that most critical October began, the Globe and Mail carried a front-page analysis proposing how the world might emerge from its financial mess. Titled "How greed can save the world," the article described how global markets had been hammered by a sudden shift in the subjective sentiments of investors.
In recent years, money had been sucked into hot marketswhether in emerging economies such as Asia, or at the centre of the economic universe on New Yorks Wall Streetby "greed." Hopes of rising asset prices motivated more and more investors to crowd in on the action. This herd mentality itself produced the rising prices the investors sought. But when "greed" turned to "fear," the whole process reversed itself. Fearing a downturn, investors tried to be the first ones to bail outbut in so doing they brought the market crashing down around them. The Globe article quoted knowledgeable experts exhorting investors to rediscover a healthy sense of "greed." Only in this manner, the article suggested, could the crisis of confidence that had humbled world markets be resolved and reversed.
This metaphysical explanation of a real global crisis is striking for several reasons. Perhaps most notable is its fundamental acceptance that the subjective emotional state of private financiers is an acceptable, logical, or at least "natural" foundation on which to erect a global financial system. In the bizarre world of modern finance, the economic well-being of the entire human race seems to depend on mood swings among that small subset of the population which owns most financial wealth. Even more bizarre is that this state of affairs is not fundamentally questioned. Rather, discussion is limited to thinking about how to "cheer up" investorsin other words, how to once again stoke their hunger for vast but illusory paper gains.
One is reminded of the Queen in Alice in Wonderland, who beheads selected subjects solely on the basis of her current mood. Her poor subjects will naturally devote considerable energies to trying to predict and where possible improve the mood of their leader. But at some point they will want to ask a more fundamental questionnamely, why it is that one persons mood should determine whether they live or die? Perhaps greed will again replace fearas the Globe and Mails experts fervently hoped, and as seems to have occurred late in 1988. While this will allow financial markets to begin their ascent once again, it seems that other important questions remain unanswered. What is to stop fear from suddenly erupting again in the future? How many economies will be devastated by the next bad-mood panic? More fundamentally, cant human beings find a more predictable and efficient way of organizing important financial transactions than on the basis of primeval and fluid instincts like greed and fear?
"A balloon that has been punctured does not deflate
in an orderly way."
- John Kenneth Galbraith
How Financial Markets Rise and Fall
How can such intangible factors as shifts in the mood of investors carry such dramatic consequences for financial marketsand for the real economies which depend on them? The answer lies in the very nature of individual ownership of easily-traded financial assets whose prices fluctuate on a day-to-day basis.
Financial assets turn over at a remarkable pace: on average, each stock, bond, or currency is bought and sold dozens of times in its lifetime. The potential profits that can be captured through this eternal buying and selling can become more important that the original purpose of the financial asset in the first placenamely, the real profitability of a company, or interest payments on a government bond. Buying low and selling high becomes the prime motive force for financial market activity, instead of raising and allocating capital for real economic purposes.
By buying assets in the hope that their price will increase (allowing them to sell at a later point for a profit), financial investors can set in motion a self-fulfilling and circular chain of events that culminates in a financial bubble. If it seems that asset prices (say the stock market, or the value of a specific currency) are on their way up, more investors buy it. This in and of itself pushes the price up even further, motivating still greater investor interest.
To some extent, the growth of apparent paper wealth in the accounts of companies and individuals can encourage them to spend more on real investment projects or consumer goods. This causes expanding output, higher corporate profits, and hence a further rise in asset values.
Unfortunately, the same process works in reverse. If asset prices start to fall, investors bail out. This creates a self-fulfilling prophecy: the fear that asset prices might fall can actually cause them to fall. Big losses for those investors who didnt jump ship accelerate the outward rush of capital. As the former paper wealth which companies and individuals thought they possessed suddenly disappears, they in turn cut back on their real investment and consumer spending. Ironically, this slows down the whole economy reducing profits and further undermining asset prices.
Banks, Money, and Growth
The banking system plays an important role in accentuating the ups and downs of private financial markets. Private banks are literally allowed to create money in the form of new loans to their customers. How much money they are allowed to create depends on their own internal financial reserves. If a bank is financially strong (with ample cash reserves, and a valuable portfolio of good loans and other assets), it can expand its lending. This injects newly-created credit into the economy, fueling spending, demand, and job-creation. But if a bank is financially weak, it must cut back on its lending (lest worried customers start a "run" on the bank). This translates into less spending, stagnant demand, and unemployment.
Ironically, the financial health of banksand hence their own lending behaviouris tied into the boom-and-bust cycle of financial markets. Banks themselves own paper assets whose value rises and falls with the financial tides. And the ability of their customers to repay debts (especially when the money was used to speculate on financial assets) also reflects the state of the markets. When markets are booming, banks expand their lending (for both real and speculative purposes), and this further fuels the expansion. But when markets contract, banks retrench in order to conserve their internal reserves. This creates a "credit crunch" which sends shock waves through the whole economy. The nature of our private, for-profit banking system is perhaps the greatest source of the real economic damage which accompanies the bursting of financial bubbles.
Paper Wealth and Real Wealth
Private financial markets will always demonstrate a boom-and-bust pattern, driven by the speculative actions of private investors. But the negative impacts of those cycles are exaggerated by the growing divide between the "paper" economy (which trades in financial assets) and the "real" economy (which produces the concrete goods and services that people use in their day-to-day lives). When the paper assets that trade on the stock market are closely linked to real investments in things like factories, mines, office buildings, and technology, then at least some limits are placed on fluctuations in paper markets. Real investments carry an ongoing, stable value that underpins their paper representations; and the real capital stock provides an objective measuring stick against which the supposed worth of financial assets can be evaluated.
Recent years, however, have seen the emergence of a large and growing chasm between the paper and real sides of the investment process. Since about 1980when economic policy in Canada shifted to an emphasis on low inflation and financial profits, rather than growth and job-creationfinancial markets have become largely unhinged from the process of real investment in concrete assets that is still the driving force of economic growth. Real investment and growth have stagnated, under the weight of continuing high real interest rates and public-sector downsizing.
But financial investments in Canada have boomed during the same period. Lured by high returns on financial assets and the relaxation of regulations on banks and other financial institutions, the overall financial sector has thrived even as the real economy languished. In 1980 there was roughly one dollar in some real asset (a factory, building, or real estate property) underlying each dollar in financial assets (a stock, bond, or derivative). This closer connection between the real and the financial sectors moderated the extent to which financial markets could take on a life of their own.
Today, in contrast, there is only about 55 cents in real assets underpinning each dollar of financial assets. In short, the connection between the wheelings and dealings of the financial sphere, and the concrete work of accumulating real productive capital in Canadas economy, has been largely broken. Even when the financial sector is booming (as it was in Canada until the Asian crisis), there is little trickle-down into real investment and job-creation. And when the bubble collapses, there is less of a real underpinning to stop the fall in capital markets.
Negative Savings, Rising Wealth
Even the financial state of Canadas households reflects this gap between the paper and real economies. The financial net worth of Canadas household sector rose through most of the 1990s. Of course, some households became richer, while others became poorer; but on the whole, Canadian households have more wealth than they used to (at least on paper).
But the amazing thing about this growing household wealth is that it occurred despite an absolute stagnation in the income of those same households, and the consequent collapse of household saving. Chronic unemployment, record-low wage and salary increases, and large cutbacks in government social programs all contributed to the very slow growth of personal incomes in Canada during the decade. In fact, after adjusting for taxes and inflation, personal incomes are almost 10 percent lower than they were a decade ago. Household savings rates have declined as a natural resultin fact, by spring 1998 the aggregate personal savings of Canadians actually became negative for the first time in our postwar history. Yet paradoxically, household wealth continued to grow.
How can household wealth be growing if Canadians are no longer saving? The rising net worth of Canadian households was driven by the expansion of the financial sector during the 1990s: mutual funds, stock markets, and RRSPs. Yet the stagnation of household incomes reflected the corresponding stagnation of the real economy where most Canadians earn their living. Thanks to the booming paper economy, many Canadians looked richer on paper, even though their real incomes were falling. Obviously this illusion could not continue foreverand it didnt. The same households saw tens of billions of dollars of paper wealth disappear during 1998, with negative consequences for consumer confidence and spending.
A Chronology of Chaos
- March 1997: U.S. Federal Reserve raises interest rates by one-quarter point, and signals that further increases are on the way. Financial capital starts flowing back into the U.S. to profit from higher interest rates and a rising dollar.
- July 1997: Hammered by capital outflow, Thailands government devalues its currency. Investors try to pull out of other Asian countries before they devalue too, and thus produce the very result they so feared: markets collapse.
- November 1997: The Asian crisis "hits home." Stock markets in North America and Europe tumble by 5 percent or more. But the "correction" is short-livedby years end the markets record highs have been regained.
- August 1998: After months of pressure as financial investors continue to flee "emerging" markets, the Russian government defaults on its foreign debt. Stock markets around the world fall dramatically, and the Canadian dollar hits record lows. A major U.S. hedge fund collapses and is bailed out. There is real fear of global financial collapse.
- September 1998: Global finance ministers meet in Washington to discuss capital controls. No agreement is reached.
- October 1998: The U.S. Fed cuts interest rates 3 times in 6 weeks. By late November U.S. stock markets have regained their record highs, and the panic (for North Americans, anyway) seems over. But could it really be that easy to "fix" the problemor is another panic lurking in the wings?
Capital Controls: Whats Required?
Many proposals for financial reform have been floated in the aftermath of the Asian crisis. Even conservatives admit that the global financial system is too fragile, but their proposals are generally limited to demanding greater financial disclosure by the "emerging" economies, and greater oversight powers for bodies such as the International Monetary Fund. This shifts the blame for the crisis to its true victimsthe developing economies which were hammered by the sudden about-face of Western investorswhen the true problem lies with the unregulated and self-interested actions of those investors in the first place. Given how badly the IMF handled the 1998 crisis (imposing high interest rates and spending cutbacks on hard-pressed economies which needed exactly the opposite), it is hard to believe that even more powerful international regulators would prevent the outbreak of future chaos.
The measure most favoured by progressive critics of the financial system has been the so-called Tobin tax. It would impose a very small tax (perhaps 0.1 percent) on all international transactions, thereby discouraging those transactions aimed at profiting from very small changes in exchange rates or stock markets. A Tobin tax would be a step in the right direction (despite problems inherent in trying to implement it internationally), and would collect billions of dollars in new revenue from the financiers who have wreaked such havoc. But the actual usefulness of a Tobin tax in controlling the sorts of financial crisis we have witnessed lately should not be overstated.
The Tobin tax accepts the structures of the current financial system as given, and merely hopes to guide those structures (through a small tax) to more efficient outcomes. Hence a Tobin tax would have made no difference in the 1997-98 global crisis: the swings in asset prices, and the size of the gains and losses that motivated investor actions, were hundreds of times greater than the "disincentive" of paying a small Tobin tax.
Recent instability demands more far-reaching measures. The core problem arises from individual efforts to profit from swings in asset prices. To resolve the instability, the very system of private portfolio investment must be reigned inand the role of private banks in amplifying the mood swings of financiers must be addressed. We need:
- Limits on international portfolio investment: foreign investment should occur through real assets (direct investments in real businesses) that cant pack up and leave on a moments notice.
- Tighter oversight on the banking system: moderate the boom-and-bust cycle of private lending with pro-active reserve requirements, and use public lending institutions to smooth the banking cycle.
- Social investment and social pools of capital: use public funds rather than stock markets to finance social programs (like pensions), and use public investment banks to pump capital into real growth and job-creation projects.
Canadas Battered Loonie: What Does it Mean to Workers?
One casualty of the financial turmoil of 1998 has been the Canadian dollar. The loonie started the year trading at about 70 cents (U.S.), and most analysts expected the dollar to rise significantly in the wake of Canadas newly-balanced budgets and low inflation. But after the Asian crisis, the dollar went the other way reaching as low as 64 cents (U.S.) in August, and forcing the Bank of Canada to increase interest rates by a full percentage point despite a weak domestic economy.
The falling dollar prompted a chorus of complaint from Canadas financial community, who argued that the decline reflected Canadas allegedly big government, high taxes, and low productivity. In reality, though, the loonie was pushed downward by three other factors:
1) Falling world commodity prices: Despite burgeoning manufacturing exports, Canada remains an important producer of many resource-based commodities: oil and gas, lumber products, minerals, and grain. Prices for all of these commodities fell steeply as a result of falling demand in Asia and elsewhere. This pulled down the dollaralong with the currencies of other resource producers (such as Norway and Australia). In fact, the decline in the loonie helped to insulate Canadian resource industries from the global collapse, by moderating the price declines (measured in Canadian dollars) faced by domestic producers.
2) A weak economy: Canadas expansion was far weaker during the 1990s than the economic recovery in the U.S. This was largely because of the unilateral pursuit in Canada of anti-inflation and deficit-cutting measures which were far harsher than corresponding American policies. The result: slower growth, higher unemployment, and lower inflation. Canadas domestic economy badly needed low interest rates, even while interest rates were rising elsewhere (especially in the U.S.). This exacerbated the downward pressure on the dollar.
3) Financial flight to safe havens: The response by individual financial investors to the chaos in global markets was to move many of their liquid assets into so-called "safe-havens": low-risk assets (like government bonds) denominated in low-risk currencies (especially the U.S. dollar). In this atmosphere of fear and uncertainty, any small currency will be undermined. It is important to note here that the root problem is not so-called "speculators"although once a downward trend in a currency is established, they can certainly make the problem worse. Speculators are merely the paid traders acting on behalf of those who truly own and control the wealth. The true source of difficulty is the greedand the freedomof individual investors.
The falling loonie was a major headache for Canadas financial industry. For investors who had counted on a rising dollar to offset low interest rates on Canadian bonds, the fall in the loonie translated into losses of tens of billions of dollars. The financial community demanded high interest rates to defend the dollar, regardless of the consequences for the rest of Canadas economy. And eventually they got what they wanted.
But what was the impact of the falling dollar for those Canadians who live on Main Street, not Bay Street? Contrary to the fear-mongering of the financial industry, the lower dollar itself had little impact on the standard of living of most Canadiansthose who do not spend much of the year outside of the country, and those who do not have large bank accounts denominated in foreign currencies. Yes, a lower dollar means more expensive imports, and increases the price of foreign travel. But for most Canadians, the final impact is modest.
Despite the growth of foreign trade in recent years, most household purchases in Canadahousing, energy, public and private services, and many manufacturesare still made right here in Canada, and hence are unaffected by the loonies fall. Even for goods that are imported, the rise in prices caused by a falling dollar is partly offset by market conditions which reduce profit margins for importers. The fact that inflation in Canada continued at rock-bottom levels (less than 1 percent over the last year) even as the dollar tumbled is further evidence that the alleged impact of the dollar on consumer prices is vastly overstated. In fact, since the Canadian dollar began its long depreciation relative to the U.S. dollar in the early 1970s, wages in Canada have fared much better than in the U.S. relative to consumer prices (see Figure 2). The dollars fall has helped to preserve our standard of living, not undermine it.