firmly in place has been confirmed through an abundance of historical evidence.
One year after the financial crisis: exit strategies now in need
The real culprit is government intervention
The 2008 global financial crisis started from the burst of the U.S. subprime loan. The U.S. government revised the Community Reinvestment Act to urge banks to lend more funds to those with low credit ratings and offered the state guarantee for the losses incurred by the mortgage agencies Fannie Mae and Freddie Mac.
Those policies prompted many market players to seek for higher risks, producing a widespread moral hazard. It led to overinvestment in the housing sector and the excessive liquidity created by the U.S. Fed's keeping low interest rates since 2001 added to the property bubble.
With the ample liquidity elevating inflationary risks, the Fed abruptly raised the interest rates. Then the demand for home loan fell and housing prices tumbled. At higher interest rates, sub-prime mortgage borrowers declared foreclosures en masse, which resulted in a surge in bad assets at banks. The delinquency rates at sub-prime loans surged and the market value of the subprime loan-based mortgage and mortgage-backed assets (MBS) tumbled. As such, giant investment banks heavily exposed to the MBS, such as Bear Sterns and Lehman Brothers, collapsed with huge loss. Meanwhile, a large number of international banks and hedge funds who invested in the collateralized debt obligation (CDO), a derivative based on the MBS, reported considerable losses, sparking the worst global financial crisis in many decades.
The current global financial crisis is not due to the market failure or neo-liberalism. The real culprit is a wrong policy of the U.S. government. It is the consequence of its heavy market intervention and loose monetary policy. This is not the failure of the free market but the failure of the market caused by the government intervention.
Problems caused by government intervention are tackled with another government intervention
Although the government intervention was the main trigger of the financial crisis, many governments around the world drastically slashed their interest rates and poured massive public funds for rescuing failed companies, beefing up liquidity and pulling the economy out of a deep recession to combat with the crisis. The U.S. pulled the federal fund rate from 5.75 percent down to near zero level and injected $700 billion for financial bailout and about $800 billion for fiscal stimulus. The U.K. cut the base rate to 0.5 percent from 5 percent and spent 600 billion pounds in rescuing the financial market and boosting the economy. Japan also reduced the rate to 0.1 percent from 0.5 percent while drawing up 130 trillion yen in fiscal stimulus.
South Korea sliced the base rate to record-low 2 percent from 5.25 percent and pledged fiscal support amounting to151 trillion won, including state funds for financial institutions and ailing corporate sector and the Bank of Korea's special subsidies. It also added 29 trillion won in extra budget to the already record-high original budget for 2009.
Among the emergence measures, the financial easing with sharp rate cuts appears to have been very effective. When the financial market slips into a panic with shares crashing, investor appetite for safer assets increases. Since the safest asset is cash in a highly instable financial market, people tend to hoard cash. Under the current financial system, unless the central bank increases money supply, it would face a cash shortage and credit crunch, which in turn makes the financial market more vulnerable and has a fatal impact on the real economy.
In this sense, the liquidity expansionary policies taken by the central banks in the wake of the collapse of Lehman Brothers in September have contributed much to stabilising the financial market. In fact, global credit crunch has eased significantly and South Korean banks are now in a far better position in borrowing overseas. Major currencies have recovered much of their steep declines against the U.S. dollar.
However, other government measures to stabilize the market, such as bailout and fiscal stimulus, are not useful for the economy in the long run. The rescue package only increases risky behaviours of financial institutions and investors, or the so-called moral hazard.
The Wall Street fell into deeper moral hazard in the wake of the financial crisis. This could bring about a bigger shock. Furthermore, bailout can delay the economic recovery by hampering the market's resource allocation function to correct wrong investments. It can also constrain corporate investment by keeping fragile firms afloat and letting them waste the scarce resources of the economy at the expense of healthier companies. In fact, corporate investment remains sluggish in most countries.
Increasing fiscal spending and keeping the rates low to boost the economy is not a desirable policy as it alone cannot survive the economy. To spend more, the government should either collect more taxes or issue bonds to foot the bill. The money eventually comes from the citizens' pockets. Since it is costly to manage the taxes and they can be used for various political purposes, an increased government spending results in the inefficient use of resources and dampens the economy. The New Deal policy, widely known as the cure for the Great Depression in the 1930s, had opposite consequences. It only brought about a contraction of the production activities and a deepening of the depression. The U.S. economy began to revive from the Great Depression after the private sector investment rebounded thanks to tax cuts and deregulations under the Roosevelt and Truman administrations.
Exit strategies and new monetary financial system in need
Low interest rate policy should be used to stabilize the financial market by supplying liquidity to meet the surging demand for money. When applied to boost the economy, the accommodation policy is not effective and would cause only asset price bubbles. Once the financial market restores stability and inflationary pressures begin to mount, money demand starts to decline. At the moment, the central bank is at a crossroad between tolerating higher inflation for growth and raising rates for stable prices. Now is the very time for the decision.
The global financial markets have restored much of stability. In Korea, the overnight call rate stayed below the base rate since early April, a signal of thawing credit crunch. Since then, the liquidity risk at Korean financial companies has significantly declined and the short-term money market has stabilized. The won has stayed around 1,200 per dollar since May after tumbling to multi-year low of 1,500 at the peak of the global financial crisis last November. Foreign exchange reserves rebounded to $245.5 billion at the end of August from $200.5 billion at the end of November, recovering the pre-crisis level.
Signs of inflation are spotted around the world. International oil and grain prices have jumped more than 50 percent so far this year. Stock and property prices have soared in most countries. For Korea, the consumer price index rose only 2.2 percent in August from a year ago while nationwide housing prices increased 3.1 percent in 2008. Gyeyang District at Incheon City and Uijeongbu soared nearly 20 percent last year due to large-scale development projects. Nationwide apartment prices rose for 13 consecutive weeks as of end-August. Some old apartments slated for rebuilding in affluent Kangnam area enjoyed up to 70 percent price rise over the past five months. The KOSPI, which started this year at 1,100 points, jumped to 1,600 points, up about 40 percent. Although the base rate stayed at 2 percent, the three-year treasury bond yields hit 4.38 percent at the end of last month, suggesting inflationary expectations were in place.
Against this backdrop, the authorities should take appropriate exit strategies to control the liquidity and inflationary expectations before the excessively increased liquidity triggers a bubble. They should absorb liquidity gradually to help the economy make a soft-landing. The Bank of Korea should withdraw liquidity from the financial system through reverse repurchase agreement while raising interest rates in a measured pace not to kick the financial market into a shock. It must give a proper signal to the market that it will tighten the liquidity, heading off asset price bubbles and inflationary expectations.
What's more important is a reform of the monetary and financial system. The real culprit of all major crisis, including the current global financial crisis, the Great Depression in the U.S. during the 1930s, and Japan's decade-long recession in the 1990s, is the indiscriminate monetary expansion. The lessons are that the burst of a bubble fuelled by loose monetary policy is very painful and requires too much effort to resolve. Therefore, in order to avoid another financial crisis, the current monetary financial system should be revamped in such a way as to ensure a stable money supply. ■
By Ahn Jae-wook / Dean of the Graduate School of Kyunghee University