The Worst is Yet to Come

Foreignpolicy.com features five articles on the current world financial crisis. It would seem we are not out of the woods yet. In fact, International Monetary Fund chief Dominique Strauss-Kahn said the world's advanced economies -- the U.S., Western Europe and Japan -- are "already in depression,". While the definition of that term is debatable, these five authors delve into more detail...

NORIEL ROUBINI

This crisis is not merely the result of the U.S. housing bubble’s bursting or the collapse of the United States’ subprime mortgage sector. The credit excesses that created this disaster were global. There were many bubbles, and they extended beyond housing in many countries to commercial real estate mortgages and loans, to credit cards, auto loans, and student loans. There were bubbles for the securitized products that converted these loans and mortgages into complex, toxic, and destructive financial instruments. And there were still more bubbles for local government borrowing, leveraged buyouts, hedge funds, commercial and industrial loans, corporate bonds, commodities, and credit-default swaps—a dangerous unregulated market wherein up to $60 trillion of nominal protection was sold against an outstanding stock of corporate bonds of just $6 trillion.

STEPHEN S. ROACH

In the United States, asset-dependent growth was concentrated in two parts of the economy: home-building activity and personal consumption. Sustained weakness is now likely in both sectors, which at their peak accounted for nearly 80 percent of U.S. GDP.

That brings export-dependent Asian economies into the equation. In effect, they were driven by export bubbles, which, in turn, were a levered play on the U.S. consumption bubble. Asia was also aided and abetted by sharply undervalued currencies. And to keep their currencies cheap, countries such as China had to recycle massive amounts of foreign exchange reserves into dollar-based assets—suppressing U.S. interest rates and sustaining the very asset and credit bubbles that fueled a bubble-dependent U.S. economy. That virtuous circle has now been broken. And because Asian economies lack vigorous support from internal private consumption, regional growth risks have tipped decisively to the downside.

DAVID M. SMICK

Here’s why this is a huge problem: Developing economies allowed themselves to become dangerously export dependent, while tying their currencies to the U.S. dollar and building mountains of excess savings. That growth model is crumbling fast as global demand is plummeting. But if too many of these emerging markets go down, the IMF lacks the necessary resources to mount rescue operations. To put things in perspective, Austrian banks have emerging-market financial exposure exceeding $290 billion. Austria’s GDP is only $370 billion.

The one silver lining is that the world does not lack capital. It’s simply sitting on the sidelines, including $6 trillion in global money market funds alone. The faster Obama and his global counterparts can fashion credible financial reforms that enhance transparency while preserving capital and trade flows, the sooner that sidelined capital will reengage. In the end, markets crave certainty—in this case, certainty that our leaders have a credible game plan. That plan is not yet in place.

ROBERT J. SHILLER

So far, the measures we’ve taken to resolve this crisis have thrown the rational principles of finance out the window. We are going on a crash diet—contradicting mortgage contracts on an ad hoc basis and giving away handfuls of money—when we should be coming up with an eating regime we can live on indefinitely. Instead of making whatever short-term patches seem necessary, we might take a more systemic, market-based approach, such as stipulating that mortgage values always be linked to housing prices and adjusted each month.

Speculative excesses are an endemic problem of the market system, but capitalism also provides its own self-correcting mechanisms. There’s no reason to abandon those tools now.

DEAN BAKER

But once the financial situation begins to return to normal (which might not be in 2009), investors will be unhappy with the extremely low returns available from dollar assets. Their exodus will cause the dollar to resume the fall it began in 2002, but this time, its decline might be far more rapid. Other countries, most notably China, will be much less dependent on the U.S. market for their exports and will have less interest in propping up the dollar.

For Americans, the effect of a sharp decline in the dollar will be considerably higher import prices and a reduced standard of living. If the U.S. Federal Reserve becomes concerned about the inflation resulting from higher import prices, it might raise interest rates, which could lead to another severe hit to the economy.