Lessons from a decade of financial misfortunes

This decade has been quite fascinating to say the least. It ended with a recession at its tail quite similar to the way it had started off with. The IT bubble gave way to the real estate bubble both of which burst with equal tenacity leaving the taxpayer at the mercy of the Capitalist system. As these huge financial institutions gambled away the savings of the common man, the brunt of the losses was borne by the hapless tax payer who was left in a lose-lose situation .The cherry on the other hand was taken by the few who actually recklessly gambled away the savings of the many who diligently paid their dues to society. An insight into these financial crises gives us an understanding of what happened, how it happened and why it happened as these are a critical part of stabilizing the financial system in the long run.
The learnings from these crises are one too many but the biggest of all has been that of the importance of regulation in our financial markets. Without adequate regulation markets become susceptible to manipulation and lose their self correction mechanisms. The invisible hand remains invariably invisible.
As in the case of the recent Global financial crisis the “invincible” sector – Real Estate also revealed the mess that was underneath the massive housing market. Right from the late 1990’s to the mid 2000’s housing prices in US rose at a CAGR of 8%. The expansionary monetary policy followed by the Clinton administration led to extremely low lending rates due to which more and more people were able to afford houses thus leading to growth in the economy in general.

But this growth was temporary as the housing bubble burst sending a ripple effect throughout the financial system. Default on mortgages and foreclosures became commonplace, thus leading to a credit crunch for the banks that had lent out these subprime loans. Soon these banks went insolvent which triggered the downward spiral that engulfed the entire global financial system. Globalization of these toxic assets made this the local problem global. Thus an understanding of complex financial products requires great expertise and judgment.
During the first half of this decade American-style consumption offered a new model of economic development. The world revolved around American consumerism. During the recession the savings rate of the debt ridden economies shot up due to reduction in disposable income of these economies. This led to a further deepening of the crises while revealing the massive overcapacity of the US retail market. So while the last decade was an age of Consumerism the next one is sure to be one of the Service Economy which would emphasize human interaction more than individualistic consumption.
Another learning from these difficult times has been the impact of labour and financial markets on the economy. The inefficiencies of the labour markets lead to escalated costs on society. On the other hand capital market failures strongly affect the labour markets. The recent global recession has left the United States with approximately 8 million jobless while the global unemployment levels have reached to around 220 million. Such weakness in the job market takes a huge toll on economic and personal well-being.
We also know that not all innovation leads to a more efficient and productive economy. Financial engineering did not create products that would help ordinary citizens manage the simple risk of home ownership. Instead, innovation was directed at perfecting the exploitation of those who are less educated, and at circumventing the regulations and accounting standards that were designed to make markets more efficient and stable. As a result, financial markets, which are supposed to manage risk and allocate capital efficiently, created risk and misallocated wildly. Thus to check the excessive leverage of the last decade, stiffer capital adequacy norms need to be put in place.
In the current crisis, China, India, and certain other emerging-market countries are coping fairly well. These countries all had strong external balance sheets and ample room for fiscal maneuver before the crisis, which allowed them to apply countercyclical policies to combat external shocks. They have also nurtured industries in line with their comparative advantage, which has helped them weather the storm. In today’s competitive global marketplace, countries need to upgrade and diversify their industries continuously according to their changing environments. The focus now should be on establishing well-functioning markets that enable developing countries to fully tap their economies’ comparative advantage.
With the advent of globalization, integration and synchronization of the business cycles across the world has become a common fact. It has its pros as well as its cons. Increased financial integration can lead to a positive effect on the exports of neighbouring countries through inter-linkages between monetary policies of these nations. On the other hand we can also have demand shocks in one country severely affecting the output of another. As was the case when the demand in US declined it affected the exports of India and as well as China immensely. The developing economies need to build up their own demand levels and reduce the burden on exports to mitigate the impact of such crisis on their growing economies. Decoupling of major economies is not a viable option as the self-sustained growth can only be possible after decades of superlative growth.
All in all this decade has proven to be one of great hurdles which have taught us important lessons about the role of greed and fear in the markets. We need to take our learnings forward and make sure that the next decade can handle all the impediments that come across its path.