Unheeded Lessons: What Did We Fail to Learn From the Financial Crisis?

Nearly two years after the financial meltdown of September 2008, is the global economy any less risky? Or do the conditions that led to the crisis still persist? These questions and more were at the heart of a conference titled "Global Risk: New Perspectives and Opportunities," organized at Wharton by Penn Lauder CIBER (the Center for International Business Education and Research) and Santander Universities. The consensus: We managed to respond to the immediate threats, but the longer-term drivers of instability are still active. 

According to Nouriel Roubini, an economist at New York University's Stern School of Business, the major risks to the U.S. economy include "deleveraging of the household sector, high unemployment, a housing double dip, state and local government problems, and gridlock in Congress." Pushing these issues off to the future could cause a bond market revolt. High-growth developing countries are another source of risk. "Emerging markets are growing very fast," Roubini said, noting that there is a danger of their overheating.

Excerpts from the conference report appear below. Download the 
complete report.

There is a growing consensus among experts that the underlying conditions that produced the crisis have not been neutralized. We managed to respond to the immediate threats of the financial meltdown and to avoid the most devastating scenarios, but the longer-term drivers of global instability remain active.

In fact, the crisis has accelerated long-standing trends that could bring about volatility and confusion, including the rise of the emerging economies, some of which are overheating and could suffer from the bursting of their own bubbles "sooner than we think," according to Yasheng Huang, a professor at the MIT Sloan School of Management; the changing age composition of the population; a potential rise in nationalism and/or protectionism; the limited ability of highly indebted governments in the rich countries to cope with further economic problems; and the enhanced competition for scarce natural resources and energy. "We can conclude that many of the underlying causes of the crisis have actually not been addressed -- which is potentially ominous," said Ann Harrison, a professor at the University of California, Berkeley.

Government interventions, noted Stijn Claessens, assistant director of research at the International Monetary Fund, were largely what had been seen before in past crises -- "liquidity support, bank recapitalizations -- with the same mistakes as before. As we take stock today, we have to admit we didn't go as far as we wanted to with regard to reform and restructuring."

"The initial vector of contagion," stated Richard Herring, a professor of finance at the Wharton School, "was that after Paribas refused to pay out, the banks lost confidence in each other. Trade finance depends heavily on that trust. We wasted a whole year trying to interpret that as a liquidity crisis, and it was evident to the banks themselves that it was a solvency crisis. All the central banks were just pouring liquidity into the markets instead of dealing with the solvency issue."

"Entire countries can have destructive discount rates," said Jack Goldstone, a professor of public finance at George Mason University, "if they become focused on short-term rather than long-term futures. One reason the East Asian Tigers had done well developmentally is that they were lucky to have leaders who put a higher value on their countries as a whole moving up in the global league tables than on their personal power and position. How we do this for a whole country may be a matter of leadership or may be a matter of events changing the discount rate. We keep making the same mistakes because we don't seem to have a lever saying, 'Here's something that may happen in 30 years.' We have a 'What has posterity ever done for me?' attitude."

"It would be interesting to see whether there's a categorical difference between democracies and non-democracies," suggested Bruce Carruthers, a professor of sociology at Northwestern University, "particularly within the democracies as populations age -- older people make more claims on resources but also have more political weight, which means that political solutions to this problem will get tougher in democracies -- maybe not so much in different political systems."

Claessens noted that there still don't exist "robust enough institutions that can limit bubbles as they start to get more risky. We don't have well enough developed regulatory governance, controls on revolving doors, accountability, and adequate supervision."

Harold James, a professor of history at Princeton, agreed that the causes still existed: "While the housing market isn't as big of a problem, poor people are still taking on too much debt. This time it's through other kinds of debt, like credit cards -- compensating for decreased incomes."

Instead of giving credit rating agencies more bite, James said that "getting rid of ratings agencies would be an important step forward." Because they are essentially in bed with issuers, "this is why they get into the position of being so uniquely important to market outcomes," he noted.

"People are trying to wrestle with the question of wrong incentives in banks and institutions that are too large, but it can't be done quickly. It may well be that the geography of the next financial crisis is slightly different, which wouldn't be surprising. They don't exactly strike in the same place," James added.

"As far as global imbalances, we got a slight contraction of the imbalance in the Great Recession but not a complete unwinding," James noted. "That's good, because if you keep unwinding it, you get a reversal of the global flows -- that's indeed the kind of thing that pushes a Great Depression rather than a recession. They're increasing again, though, and we're also in an era in which cheap money is fueling new commodity booms and asset booms. So the problem is that we're still living in a world that produces these crises."

Business as usual on Wall Street
According to Nouriel Roubini, "The problems of the financial system on Wall Street have not been resolved. People talk about Dodd-Frank [the Wall Street Reform and Consumer Protection Act, signed into U.S. law in 2010], but have we really changed the system of compensation? Have we dealt with the corporate-governance problem? Have we divided commercial banking and the more risky shadow banking and investment banking? No. So that remains."

The U.S., said Roubini, risks having an anemic recovery. "If and when the public sector deleverages, raising taxes, reducing transfer payments, cutting spending -- it will force another round of deleveraging of the household sector. Also, the labor market is improving, but unemployment is still very high."

Most conference participants agreed that the incipient recovery could be threatened by a return to "business as usual" on Wall Street, with little change in executive compensation, perhaps a greater concentration of risk and a worsening of the "too-big-to-fail" problem, and the lingering issue of shadow banking practices.

Sovereign debt
Another issue to monitor closely, Roubini said, is sovereign risk in advanced economies. "Public debt will rise to more than 100% of GDP for most advanced economies in the next two to three years," he noted. "So the problems of sovereign risk, of reducing budget deficits and of stabilizing public debt are not just challenges for the eurozone periphery; they will be the biggest challenges advanced economies will be facing."

Several factors in the United States in particular bear considering, Roubini added, including "deleveraging of the household sector, high unemployment, a housing double dip, state and local government problems, and gridlock in Congress." Pushing these issues off to the future could cause a bond market revolt. The high-growth developing countries are another source of risk. "Emerging markets are growing very fast," Roubini said, noting that there is a danger of their overheating. "They have been slow in tightening monetary policy or using exchange rates to control inflation, and now inflation is rising. In many of these countries, two-thirds of the consumption basket is energy, food, and transport. So the tradeoff is between wanting to maintain high growth for political reasons, and controlling inflation."

In the eurozone periphery, the issue is not merely one of public debt, Roubini stated. "Many of the financial systems are in trouble, especially in countries where the housing bubble burst. They need to clean up the banks and may have to restructure liabilities and deal with bad assets. These countries were exporting low value-added labor-intensive goods and lost market share to China, central Europe, and other emerging markets. So wages were rising faster than productivity. There was a widening of current account deficits, and the final nail in the coffin was the sharp appreciation of the euro. How will they restore competitiveness and growth? While the risk of a eurozone collapse is much less than it was a year ago, these are chronic fundamental problems that will take many years to resolve."

The best solution might not be the most palatable one, he noted. "The crisis started with too much private-sector debt; socialization of private losses then caused public debt. Some of these sovereigns got into such debt that they lost market access. Now we have super-sovereigns like the IMF, [European Central Bank], you name it -- bailing out sovereigns. So we're kicking the can down the road: private debt, public debt, supranational debt. Now, there's not going to be anybody coming from the moon or Mars to bail out the IMF, European Central Bank, etc."

Roubini said there were essentially four options: "One is to grow the denominator -- to have enough economic growth. But with too much private and public debt, economic growth will be slow, so we're not going to grow ourselves out of the debt problem. The second way would be to save more. But if everybody suddenly consumes less and saves more, demand falls, output falls, and therefore your debt-to-GDP ratio rises again. The third option would be inflation -- but this causes lots of collateral damage. Realistically, the fourth solution is debt restructuring. We haven't wanted to do this, but it may be necessary or unavoidable in some situations."

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