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Economics & Finance

Living with uncertainty

Stuart Pallister |

The authorities in the US and Europe have the right policies in place to tackle the financial crisis, but it will take time to restore confidence in the markets, according to speakers at the World Knowledge Forum.

James Wolfensohn, who had led the World Bank during the Asian financial crisis in the late 90s, told the forum’s ‘Live on Wall Street’ session that the markets have ‘yet to be convinced of the utility of these interventions.’

James WolfensohnThe US government, along with governments in Europe, will be pumping billions of dollars and euros into the financial system to bail out banks.

Echoing Fed chairman Ben Bernanke, Wolfensohn said by satellite link from New York: “What we need, of course, is to restore confidence,” especially as the upcoming US presidential elections were helping to create a “sense of uncertainty in our country.”

“Of course, we are all hoping things will modulate and we’ll get used to it and it will turn around but as chairman Bernanke says, it probably will not happen right away.”

Citigroup vice chairman of global banking Jeffrey Shafer agrees with Wolfensohn, saying it will take time to resolve the crisis. “We are in the middle of what is, for people in financial markets, the scariest time since the 1930s in the US and much of the rest of the world. That is real. I do think we have the policies in place that will see us out of it. But it’s not going to happen overnight and it’s not going to happen in a straight line and so we will have to become accustomed to living with a great deal of uncertainty at the same time.”
On the background to the crisis, Wolfensohn says the financial markets had become “very complex and very sophisticated” in terms of instruments traded. “And this US complexity was also transmitted internationally as the international markets developed along those lines as well.”

“Along with this, and supporting it, was the substantial increase in consumer borrowing, where in this country we reached a level of the consumer borrowing 130 per cent of its income, an enormously high figure, which was paralleled by a reduction in the savings of US citizens that became negative, as distinct from having some money in the bank. So we were very significantly extended.”

“This negative savings rate, combined with the overspending and the encouragement to spend more than you had or could earn, put us in this most difficult situation which led first and foremost to the collapse of the two mortgage agencies, Freddie Mac and Fannie Mae, and thereafter the collapse of financial institutions Bear Stearns and Lehman Brothers and, of course, a huge challenge to … AIG which has also had support,” Wolfensohn adds.

This then led, he says, to a ‘critical situation’ with the US government seeking to calm the markets with a $700 billion rescue package, the first step of which involves a $250 billion scheme to buy stakes in leading US banks.

Another speaker by video link from New York, Lewis Alexander, chief economist at Citigroup, said the crisis had started with a housing bubble in the US in the early part of this decade. But after peaking around the end of 2005, early 2006, prices had started to correct, generating “losses for the core institutions of the financial system” and resulting in tighter financial conditions as new lending was reduced.

The tightening of financial conditions, Alexander says, had two main sets of effects. “Our system was more dependent on liquidity and leverage than most of us had recognised. That has meant that this adjustment has proven to be more difficult to correct and longer lasting than I think was originally expected.”

“In addition to that, it’s feeding back materially into the economy. Now the US economy was dealing with the correction in the housing market for several years before the crisis really broke, but now we’re dealing with the consequences of these tighter financial conditions and that we’re seeing across the economy in a variety of ways.”

House and share prices have fallen, credit is tighter and that’s having an impact on spending. “Most recently, with this extreme turmoil which has followed the failure of Lehman Brothers, we have also started to see a sharp loss in confidence and sharp increase in risk aversion across the economy, which is leading to a very sharp slowdown. So we’re facing a quite significant economic challenge.”

Even though significant policies should go a long way “towards putting us on the right track,” don’t expect a quick rebound, Alexander says.

“Moreover, “we’ve started seeing some meaningful spillovers in emerging markets. Obviously currencies have been affected, you’re starting to see strains on some financial institutions, so this is becoming a much more global crisis.”

Citigroup vice chairman of global banking, Jeffrey Shafer, outlines three areas of failure. In the US, a ‘very serious’ failure of consumer protection, with people systematically encouraged to take out inappropriate home loans and misstate application data.

There were also major failures of risk management, such as failures of modelling and the loss of information.

Then, there is the ‘critical problem we’re dealing with now’ – the failure to recognise “the vulnerability of a modern financial system to a systemic loss of confidence and loss of liquidity.”

Shafer says he had thought the markets would respond positively to the Fed’s rate cuts and injection of liquidity, but these actions hadn’t solved the problem. ‘To get out (of the crisis), the first thing we have to do is to get the money markets working, then get the credit markets working, then get the economy moving ahead again. It has to have that sequence.’

“It’s going to take time to build confidence in what’s been put in place. I think the right thing is to continue down this road. The governments (in the US and Europe) have to demonstrate to the markets that they are fully implementing, on a rapid basis, what they’ve committed to and with that, one will begin gradually to see more confidence.”

“I remember back when I was working with the Korean government in early 1998 (at the time of the Asian financial crisis), we would go through and have the first step and the second step, and things weren’t responding,” Shafer says. “But it took some time, and the government kept at it, it stayed on its course, and the confidence did return. And once it returned, there was a wall of money that surfaced that began to support Korea’s recovery. That’s where we need to get to now.”

Picking up on Shafer’s comments, Kenneth Rogoff, Professor of Economics and Public Policy at Harvard University, says “we built up this elaborate financial edifice with all sorts of rocket-science ideas like options, securitisation and lots of fancy innovations.” Even so, the financial system “has proven as vulnerable to good old-fashioned bank runs as (it) was in the 1930s.”

The financial edifice had grown too big and needed to shrink. Rogoff says the financial services sector in the US was accounting for some 30 per cent of corporate profits and 10 per cent of wages. It should have made things more efficient, he adds, but should not have taken such a big chunk of the economy.

“Some of the changes that we are seeing, although they’re at lightening speed, may possibly ultimately lead to a healthier system despite this painful process.”

Outlining the ‘many, many parallels’ between what’s happened in the US and other crises, such as housing bubbles and increased levels of indebtedness, Rogoff says “there were a lot of warning lights blinking.”

The US authorities had been in denial and that’s “more dangerous than the problem itself”, he says, adding that he now hopes the period of denial has passed. “You can’t always be a day late and a dollar short with your policies,” Rogoff says.

“Clearly what needs to be done,” says former World Bank president James Wolfensohn, “is to try and give the consumer in this country a sense of confidence that he can go out and start spending again, but doing so in a climate also where hopefully he will also start saving again.”

Saving and spending at the same time? It may prove something of a conundrum, but the former World Bank president says there needs to be a combination of the two activities for the US to build some stability into its financial system, yet get its economy moving again.

“The solution is not just a spending spree, we need to go back in our country at least to some fundamentals and try and get saving re-established as a worthy activity, as well as appropriate spending as the consumer becomes more confident.’

While the planned injection of funds by governments won’t be enough to prevent recessions in the US, Europe and Japan, Rogoff says that if the US had not intervened, “we were really looking at an abyss.”

“It was an extremely dangerous situation. All confidence had been lost.”

Moves to guarantee bank debt have also been important, he says, with the Americans having little choice but to follow Europe’s lead in backing its banks. 

“We’ve been talking about a financial crisis since August last year but the last month, that was the financial crisis. It really went to a whole different level. The worst has stopped but that doesn’t mean there aren’t still very difficult times ahead,” says Rogoff, a former chief economist at the International Monetary Fund.

There will also be many difficult decisions ahead, such as how to recreate the financial system and bring about a more diverse structure.

“There are some very, very difficult challenges ahead but if they had not done this bailout plan, we really would have been looking at the Great Depression again.”

There are still many weaknesses in the system but market discipline is helping to correct some of those. Citi chief economist Lewis Alexander says there should be less reliance on leverage in future and the system should be more robust with more diverse financial institutions.

“Many of the worst practices that led to this crisis have already stopped,” Alexander says. “For example, the issuance of so-called structured credit products, some of the very complex financial instruments that were at the core of this, has essentially gone to zero. So, to some extent, there is a process of market discipline in place which is driving the transformation.”

The securities markets, which have proved to be vulnerable, will also see important changes, he says. “For example, we’re going to see greater uses of exchanges, we’re going to see greater uses of central clearing counterparties in the derivatives market. These are technical things, but they will have the potential to make the system more robust and they are going to be very important changes.”

There will likely be more and different sorts of regulation and higher capital standards, he says.

“The changes you are going to see at the core of the system can provide a model for how emerging economies can have their financial systems develop in a more robust way,” Alexander adds.

Jeffrey Shafer, a former Undersecretary at the US Treasury, says it’s not a question of increasing or decreasing regulations - it’s a question of changing them. For example, consumer protection will have to be taken more seriously and risk management looked at in a ‘coherent way.’

US Treasury Secretary Hank Paulson had already begun looking into the regulatory structure, he says. That’s an appropriate thing to do, but Shafer says he’s sceptical about the outcome, as vested interests in the US would probably mean greater complexity rather than less.

Even so, Shafer hopes ‘this shock was big enough that it may bring about some of the more fundamental changes we need.’

There will be a parallel need for a systemic approach to regulation in the euroarea and it will also be important, he says, to redefine the role of the state and that of private firms, such as those in the financial services sector.

Using the analogy of a baseball team, Shafer argues the government should play the role of an umpire to enforce the rules – rather than try to manage or even play.

“For 30 years or more, the world had been trending towards freer markets and more scope for markets,” Shafer says. “Then suddenly you’ve got the icon of the American capitalist system, Goldman Sachs, accepting government share ownership imposed on them by the former CEO of Goldman Sachs. That’s a fundamental change and I hope it doesn’t start momentum in the wrong direction.”


FINANCE is not a natural science where financial returns are normally distributed. This is because FINANCE is driven by human behaviour which is erratic compared to the force of gravity. Erratic behaviour triggers financial returns to follow some kind of extreme value distribution. But the area below the normal or the extreme value distribution, the "cake", is the same. Thus, regulating financial markets is a question of societies' preferences, that is, whether the cake of financial returns is distributed more or less evenly amongst market participants. Still regulators have to consider that too harsh rules could shrink the cake by more than in the case of too loose rules since a lame financial sector automatically means a tendency for a lame real sector.

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