Sunday, February 16, 2014

Should we still be worried about the Financial Crisis?


Just finished reading The Creation and Destruction of Value: The Globalization Cycle by Harold James. James is a professor of history and international affairs and provides in his book an interesting take on the financial crisis. He views the Financial Crisis through the lens of the history of the Great Depression. Everyone generally believe that the primary cause or problem was when the stock market fall in 1929, but he would argue differently. The real focus should be on the banking crisis in 1931. The stock decline caused a fall in wealth. Real value declined. The banking crisis created a decline in value but of ideals and trust. Contagion creates a more value destruction in institutions. 

The focus of the 1931 global banking and currency crises is not on the destruction of traditional value as seen through the price decline in stocks but on the destruction of institutional structural value through trust. Countries went off the gold standard. Loans were not paid. Inflation moved to destructive levels. Institutional structure as the glue that kept markets functioning broke.

Contagion in banking was the problem that lead to global value destruction at a higher level. The currency system was destroyed. We are now five years away from the Financial Crisis and we have not had a banking contagion like 1931, but we still have institutional and structural problems that have to be addressed. There is less policy coordination on currencies. This has been the "currency wars" discussed in the popular press, but we had not made progress at stabilizing policies. Trade agreements have not been signed and capital controls are more evident. Even with banks regulatory changes like Dodd-Frank and the Volcker Rule, we have not solved the problem of too big to fail. We have moved forward on systemic risk monitoring but the preparations for any future banking crisis in not clear. Basel II and new regulations in the EU still do not solve the problem of large global financial institutional risk and the still existing problem that financial globalization is declining as banks pull back to their core national interests.

Contagion banking liquidity issues require global coordination and communication. Forward guidance on an individual central bank level is not enough. We have not had to deal with another round of crisis post Greece. The ECB has said it will do whatever it takes, but there are limits to what a central bank can do when we are at the zero bound. Clearly, the Fed is finding that quantitative easing does not affect the credit channel if there banks do not feel as though there is a positive lending environment.

There was a vacuum of power politics in the 1930's and there is a similar problem today. The US is unable to impose any new world order. It is viewed by many as the problem, yet Fed policy also affects the world order through the liquidity it provides or doesn't when it cuts back on funds based on domestic goals. The EU and China are both not able to impose a new world order in financial markets because they still do not have the financial power that existed with the US in the post-WWII period. We still need policy coordination to avoid problems like the 1930's. We are not in the same predicament, but there are similar issues that have to be addressed.


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