Five dimensions of the economic crisis

UNLESS they have been living under the proverbial coconut shell, Malaysians would know by now that the world economy is going through one of the most wrenching periods ever.

The global financial crisis impacts every country and individual, both rich and poor, in varying ways and degrees.

While the risks of a depression – great or otherwise – are contained by the more-or-less concerted actions of the advanced countries at the moment, its effects on a growing number of countries have been nothing short of devastating.

Already, countries like Iceland, Pakistan, Hungary, Serbia and the Ukraine have been forced to go to the International Monetary Fund (IMF) for short-term liquidity.

At the time of writing, Turkey is negotiating with the IMF and an agreement is expected to be concluded soon.

Depending on the depth and duration, more potential clients for the Fund from South America, Eastern Europe, Africa and even East Asia may be lining up.

News reports emerging from the world’s financial capitals often give a confusing picture with different aspects being emphasised at different times.

In presentations to the public, I have adopted a five-fold way to explain the various dimensions of the crisis (see table).

In future columns, these will be elaborated and some ideas put forward on what could be done.

First, and perhaps the most obviously, the financial crisis has resulted in large drops in asset values, and therefore capital and wealth.

US housing prices, a key asset price, started tanking from the end of 2006, and continued to do so through 2007 and 2008.

This inevitably led to rising defaults on housing mortgage payments, and the securities and derivatives on which they were based.

As the subprime mortgage crisis gained strength, losses began to be reported by financial institutions. This led to the collapse of financial institutions shares, followed by the broader market.

Most equity markets today are 40% to 60% lower than at the start of the year.

The second dimension of the financial crisis is the failure of financial institutions.

One of the earliest banks to close its doors was Northern Rock, a large British bank that had to be nationalised in early 2008.

This, along with the US Federal Reserve-engineered takeover of Bear Stearns, the acquisition of Countrywide Financial by Bank of America and a spate of other collapses, should have sounded a clear warning to regulators and markets that things were going seriously wrong.

It was not until the failure of Lehman Brothers, however, when markets hit the panic button and law makers were forced to react.

The third manifestation of the financial crisis is the credit crunch or the inability and/or unwillingness of financial institutions to lend.

More than other businesses, financial institutions need capital to operate. They cannot do so if their balance sheets have been wiped out or impaired by large losses.

What they need to do is to reduce debt and build up their capital base.

This process is called de-leveraging and it hurts just about every economic activity that depends on the financial system.

Governments, particularly the US Federal Reserve system, have flooded the world’s main financial centres with liquidity but little of this is finding its way to the man in the street.

Dimension number four is the shortage of US dollars.

It is damning evidence of the present state of international monetary affairs that the world’s most financially fragile economy, the one whose deficits and public indebtedness are rising by the trillions, and the one whose printing presses are running overtime, is also the one whose currency is in greatest demand.

No other country in the world could monetise debt in this way. But because the US dollar is the world’s foremost reserve currency and there are few alternatives, it can get away with it.

Countries can have the most competitive industrial systems but still end up in deep trouble simply because they have restricted access to US dollars.

With fewer dollars, they cannot import energy, food, raw materials, intermediate products and services. They also cannot service their external debt.

Of late, even South Korean banks have encountered dollar shortages and South Korea has the world’s sixth largest holdings of official foreign reserves.

Fifth and finally are the combined and self-reinforcing effects of all the above forces in collapsing aggregate demand.

That the world economy has entered into economic recession is now a given. Governments, however, cannot afford for the recession to be a deep and prolonged one because this will make the efforts to rescue their troubled financial institutions all the harder.

The stimulus packages undertaken, therefore, have to be sizeable. China’s recently announced US$586bil spending plan is indicative of the quantum that is needed to re-ignite the world economy.

The incoming Obama administration in the US has promised a quick and large effort when he takes office on Jan 20 next year. Some analysts speculate that the package may be as high as US$1 trillion.

All of these spending will not come without cost. As Milton Friedman used to say, “There is no such thing as a free lunch.”

The tremendous rise in debt will eventually have to be accompanied by rising interest rates and will be paid for by future generations in the form of higher taxes.

The consequences of the crisis will therefore be around for some time to come.

Steve Wong is assistant director-general of the Institute of Strategic and International Studies (ISIS) Malaysia, responsible for the bureau of economic policy studies.