Will Subprime be a Twin Crisis for the United States - Book Report/Review Example

 Will subprime be a Twin Crisis for the United States? By Michael P. Dooley, David Folkerts-Landau and Peter M. Garber Article Analysis Summary The main idea of the article is to identify the incentives generated by the Bretton Woods II systems that almost certainly contributed to the subprime liquidity crisis. At the moment, this crisis is working its way through international monetary system. There is a possibility that the liquidity crisis is or will turn into a balance of payment crisis for the US in the future. In such a case the additional costs linked with an unexpected halt of net capital flows to the state treasuries could be significant. The emerging market governments have persistently acquired US assets despite when the yields were falling. And this trend shows plenty of incentives to continue. In addition, the Bretton Woods II system which has proven to be among the strongest forces controlling the market, has consistently generated low real interest rates in industrial countries. It also continues to generate growth in the emerging markets that will help control the damage from the liquidity crisis. Explanation of the graphs The US subprime mortgage collapse and the breakdown of the financial sector technologies, which are now operating through world financial markets, was a shock in terms of the negative impact that the system caused. The projection is that it will eventually bring Bretton Woods II system to its knees. Because of this nosedive performance there are considerable doubts about the health of the US financial and asset system. It is not unlikely to predict that the market value deterioration of the US financial assets is a serious threat to Bretton Woods II system or any other international monetary system. But a more general conclusion is that Bretton Woods II system will continue to produce low levels interest rates in the international capital markets. There are sufficient examples from other countries about the strategies to adopt in case of an economic downturn. If the breakdown of the Bretton Woods II system reinforces a subprime crisis then, it is almost sure that a severe downturn in the US and the world economic activity in 2008 will occur. Halting the private and official capital inflows into the US would push the US interest rates high that will drive the investments in the US down to the level of domestic savings. In such a case the decline in the economic activity will be devastating. Buildup of the system leading to a crisis Financial experts and economists did not predict that Bretton Woods II would bring the collapse of the system. The primary concerns as outlined by the experts included; ending the official intervention in exchange markets, reserve diversification away from the US assets, a significant depreciation of the dollar against managed currencies, a considerable surge in the interest rates, swelling protectionism, increasing oil prices or any significant geopolitical event. Chart 1 tells the story of this buildup. First it draws the financial market effects, which the system created as a pretext that resulted in a crisis. As the system progressed, it lowered the long-term real rate of interest at each stage of the business cycle. It was due to the large-scale supply of net savings that the emerging market countries kept investing into the industrial countries. This downturn effect is clearly visible in chart 1 by the 10 year TIPS rates. Chart 2 shows the US current account deficit. The general array of asset prices saw an upsurge with this ongoing boom. One thing alone could not have a significant impact. This fusion of both tools created an effect of lowering credit risk and credit spreads. Initially, it was good; at any high level of real interest rates the marginal projects of the investment curve were risky. In case the long-term interest rate take a sudden nosedive coupled with non-inflationary economic upturn, unique projects start giving profits. In addition, risk spreads on older projects start to shrink. When these risk spreads return to normal levels, a new range of marginal risky projects become readily available. According to the MEI curve, the new profitable projects get exhausted. An imaginary alternative scenario can be created where industry with country financial systems would not be governed by institutions that become troublesome in a low spread environment. In such a case, the normal credit rationing of poor risks would still hold their effect. The continuous influx of cheap savings from emerging markets would then go to better risks. The effect would be lowered cost of funds. Chart 3 paints this picture where the spreads over treasuries in mortgage markets arise but the interest rate levels for conventional mortgages fall sharply as soon as a crisis start, leading to a wave of refinancing locking in the low fixed rates. If the disruption in the larger market ends this same effect will also spread there. The effect is also visible in chart 4. High-grade credit products spreads have risen to the extent that they push municipals to a positive spread over treasuries. This is not encouraging because the fall in the treasury yields has been significant enough that the yield levels paid by these borrowers have dropped since the crisis began. This is the exact opposite effect that some experts claimed when they announced an end to Bretton Woods II. As long as the system progresses it keeps pushing more savings into the industrial countries. The only change is that the riskier borrowers are now rationed. Therefore, the less risky borrowers get credit despite the interest rates going below the level at which when the crisis began. Crisis and the End of the System The key to sustaining international system is to develop a healthy relationship between the United States and the emerging market countries managing their currencies. Many experts claim that this relationship has already ended or will soon end. Nonetheless, there is no substantial change in the profile of the US current account deficit. In addition, there are no dramatic changes in the net demand for the US assets. In fact, quite the opposite occurred where the foreign central banks plus other nonresident investors persistently held and accumulated US treasury securities despite the lower yields than before the subprime crisis began. This trend has been depicted in charts five and six. Total reserve accumulation data recorded for the first quarter of 2008 distinctly shows no decline in international reserve accumulation. Currency composition of reserves data is less comprehensive and is accessible throughout the fourth quarter of the year 2007. Nevertheless, as chart 6 shows, the dollar share of reserves did not fluctuate till the end of the year. Only a small information is available about the growth and composition of sovereign wealth funds, despite participation in recapitalizing the United States financial institutions. On the surface, it seems like the official investment decisions have been and will stay a crucial part of the resolution for the liquidity crisis. It is clear from chart 7 that the value of the dollar has weakened against the euro and other floating currencies. But the argument is that it is consistent with in normal cyclical mismatch of short-term interest rates in other floating currencies as well as in the US. The Slower Chinese exports along with a slowdown in the United States might counter the effect of renminbi appreciation. The future of the dollar In this whole episode of the financial crisis, the expectations were that real rates in Europe would drop below than those in the United States. But considering the diversified market, financial assets in the European Union performed nearly the same or even worse than those in the United States. Chart 8 represents equities, charts 9 and 10 represent credit spreads and chart 11 exhibits money market performance. The US spreads over treasuries increased more than European spreads over governments in the high-yield bonds. But because of the collapse of treasury yields the level of high-yield interest rates did not rise quite as much. In other words, the United States and the European Union assets are still close substitutes for each other. The credit crisis has remained the same in its severity in the EU and the UK as it was in the United States. The general skepticism about the assets is not limited to the United States. It should be noted that the United States’ current account deficit is still getting financing at low real risk-free rates. In conclusion, the exchange rate movements resulted from asynchronous cycle. Predictions are that when Europe moves into the same cyclical phase Euro would depreciate back to its long-term range compared to the dollar. Critical review of major issues This article was published in 2008. Which means that it has already been six years, and there have been many changes in the finance world. The general prediction was that Bretton Woods system would live its natural course because the incentives it produced were operative. The imbalance in the world economics was due to the cheap excessive labor in Asia. The unemployed and underemployed labor is still regionally concentrated in Third World countries. The United States was dependent on the labor market since the Great Depression. China and later India, both of these countries are now significant global powers. The uncoordinated collection of global economic policies that defined the international monetary systems may or may not pull the system out of this depression. The questions outlined in the article to find a cure for the crisis are; can the demand grow and channelized rapidly enough to absorb the surplus of labor before the destructive politics in China or the industrial countries takes over? Can the labor force match the appropriate physical capital for producing those items that are actually wanted where the demand is located? The answers might seem very simple. For instance, if there are unemployed labor and inefficient capital in the emerging markets then reforming their domestic institutions and empowering the domestic markets will create employment and economic growth. But it is easier said than done; to some experts the reason for the Asian financial crisis and the global economic crisis were old mindsets, greed, lax supervision and cronyism (Dowling and Rena 252). With the end of the Bretton Woods and the advent of the flexible dollar standard, the hegemonic position of the dollar has been intensified (King 50). Since the gold window closed the dollar became the first world fiat money (King 50). The financial crisis created the moment of productive incoherence where on one side the United States and the IMF tried to reestablish the pattern of pro-cyclical adjustments and old structures of governance while on the other side the capital controls became increasingly common in the periphery (King 50). The value of the dollar has deteriorated, and the chances for substituting dollar as a backup reserve currency for the European Union is no longer the case. The Bretton Woods system has risen from the ashes despite its collapse under the weight of the United States accumulated deficits. The case with the previous system is still alive where the developing countries see current relationships between governments of Asia and the United States governed by maintaining the Asian countries are fixed or closely managed exchange rates (Lle and Lewis 58). The exchange-rate arrangements of East Asian countries with other developing countries is the making of a new Bretton Woods system (Lle and Lewis 58). Before the 2007-9 financial crisis this situation could not be predicted; the observers of the Bretton Woods system did not see it coming. The difference between the strategies from the 1960s to the 2000's was Europe, and Japan were replaced by the Asian and Latin American markets (Savona, Kirton, and Oldani 199). The United States was a country with tremendous privilege of issuing the main reserve currency which gave it the means to live beyond its real assets (Savona, Kirton, and Oldani 199). It was both a curse and a blessing. What should government do to avoid the problem? Financial bubbles have caused major economic crisis in the history. In the long term, all these bubbles deflate. For instance in 1987, the Dow Jones industrial average dived down 23%. Similarly, when the dot-com bubble was fully inflated, there were huge capital losses. The people who suffered the most were pensioners and household fund holders, but they hardly reached the point where they would default or become heavily indebted. If there can be a foolproof formula for preventing a financial crisis then, they would not occur in the first place. The history would be clean from horrifying financial losses. However, there should be an investigation as to what drives these financial crises. Financial bubbles and human greed are usually behind such disasters. Alan Greenspan, the American Economist, writes in the American Enterprise Institute that serial defaults form the essential pretext for an economic crisis (Greenspan, 2014). Institutions should make a policy that the financial institution can hold a significant amount of contingent convertibles that can be immediately converted to equity under predetermined crisis conditions (Greenspan, 2014). So, in case a major loss of capital when the bubble deflates, there will hardly be any serial defaults. Conclusion The upholders of the Anglo-Saxon model of transaction-oriented financial capitalism will always challenge the transparent international monetary system. However, an international monitoring system sustaining low real interest rates in the international capital markets is a safe bet to withstand an outbreak of fraud in the United States financial markets. It will also have its impact at the international level by coping with poor liability management in the UK banks, the ever increasing demise and yield by the German State Affiliated Banks and the Swiss banks, and rogue traders in the French banks. References Dowling, J. Malcolm, and Pradumna Bickram Rana. Asia and the Global Economic Crisis: Challenges in a Financially Integrated World. Houndmills, Basingstoke, Hampshire: Palgrave Macmillan, 2010. Print. Dooley, Michael P., David Folkerts-Landau and Peter M. Garber. “Will subprime be a Twin Crisis for the United States?” National Bureau of Economic Research. Cambridge. 2008. Greenspan, Alan. "How to Avoid Another Global Financial Crisis - AEI."American Enterprise Institute. N.p., 6 Mar. 2014. Web. 24 Nov. 2014. Iley, Richard A., and Mervyn Lewis. Global Finance after the Crisis the United States, China and the New World Order. Cheltenham: Edward Elgar Pub., 2013. Print. King, J. E. The Elgar Companion to Post Keynesian Economics. Cheltenham, UK: E. Elgar Pub., 2012. Print. Savona, Paolo, John J. Kirton, and Chiara Oldani. Global Financial Crisis Global Impact and Solutions. Burlington, VT: Ashgate, 2011. Print. Read More