Financial crises have been recurring around the globe over the past three decades. The 1980s saw the Latin American debt crisis and the U.S. savings and loan crisis; the early and mid-1990s brought the European monetary crisis (tied to German reunification); and the late 1990s produced the Mexican Tequila Crisis, the Asian Flu and the Russian Virus. Now we have the Manhattan Crisis.
Globalization is often blamed for these recurring situations, but such crises were also common in previous centuries. Dutch tulip bubbles and the collapse of Mississippi shares caused major crises in the 18th century, and banking panics were common under the 19th-century classical gold standard.
Each crisis is different, of course. Unlike Mexico’s crisis, in the present case both the assets and the liabilities of the financial sector are denominated in U.S. dollars. There is no peso problem. The dollar will likely continue to adjust downward, but the movement will be more like a glider landing than a crash. This crisis will thus require a much more prolonged adjustment than the Mexican crisis.
What the current crisis has in common with past ones is uncertainty about its magnitude. To paraphrase the late Rudiger Dornbush of the Massachusetts Institute of Tech-nology, we have to step into a puddle to cross the street, but we will not know how deep it is until we step in it.
As always, doomsayers come forward. In the early 1980s, some economists talked openly about the end of the American century of progress. But the U.S. economy rebounded in the mid-80s, and the next decade was called the “roaring 90s” by Joseph Stiglitz of Columbia University. In one sense, Senator John McCain is correct: the fundamentals of the U.S. economy are sound. We have flexible labor markets relative to Europe, oil prices are not climbing as fast as we feared and the American economy has always benefited from innovation.
We should not underestimate, however, or forget the costs of financial crises. The 1980s are rightly known as the “lost decade” of growth and development in Latin America. Per capita living standards remained stagnant, resulting in lost educational opportunities for hundreds of millions of young people throughout the continent. Similarly, when the Indonesian government had to bail out the banking system in the late 1990s, the cost was borne by the poorer classes.
Whatever the final form of any federal intervention, it will also have budgetary consequences. Plans of the incoming administration for health care reform, educational or energy subsidies or tax breaks will have to be put on hold, or we will pay for this intervention through inflation. We must hope that the new administration and the new Congress will recognize that fiscally their hands will be tied for several years. Institutions that rely on charitable donations will also have to tighten belts for several years or more.
A unique feature of the finance industry is that the collapse of one’s competitor is bad news rather than good, because a competitor’s failure can lead to a systemwide loss of confidence in the banking sector as a whole, with a major withdrawal of deposits and a collapse of credit and ripple (or tidal wave) effects throughout the whole economy. At times like these, central bankers earn their salary. One of the roles of a central bank is to be a lender of last resort as well as a guarantor of price stability. One central banker who emerged as a hero in the Asian financial crisis was Joseph Yam of the Hong Kong Monetary Authority. Many foreign investors assumed that the Asian meltdown would spill over into Hong Kong’s stock market. Yam used the authority’s dollar reserves to buy up shares in order to stabilize prices and calm the markets. Later, the authority was able to sell off these shares with little or no loss.
The hope is that a similar scenario will play out in the United States. This time, the Federal Bank and the U.S. Treasury are buying up nonperforming mortgage-backed securities. Because a growing population always needs housing, sooner or later real estate prices will return to fundamental values based on underlying demand and supply. But this adjustment will take time, and costs will have to be paid in the form of lost opportunities in health care, education and social development.
Is there a silver lining? The widespread consumer habit of living on heavy extended credit, for everything from vacations to new cars to household improvements, will be curtailed by the credit crunch. With less easy credit and less demand, prices will fall from their inflated levels across a variety of goods and services. Perhaps one positive result will be that more Americans will exercise greater care in their spending.