Are We in a Global Economic Crisis?

Barry Eichengreen
University of California, Berkeley

April 1999

The interesting question is not “are we in a global crisis” but rather “why didn’t we end up in one in the autumn of last year?” For a brief period in the autumn, the risk of a depression was on the cover of every business magazine and newspaper, and financial journalists were tying up the telephone of every economic historian. The outlook two quarters later is noticeably less gloomy. Despite the battering absorbed by the world economy, the IMF projects growth at the rate of 2.2 per cent in 1999. This is slow growth, to be sure, but it is growth nonetheless. The events of late 1998 may have set the stage for a more serious global crisis than anything seen in 70 years, but they did not result in a Great Depression.

Why not? The answer, it seems to me, has to start by the factors that created such exceptional scope for a global crisis in late 1998. I would point to four.

1) Leverage. The problems that leverage can create are well known: commercial banks engaging in fractional-reserve deposit banking may not have the liquidity to meet a depositor run, creating scope for self-fulfilling banking panics, while investors in securities taking positions on credit may be forced to sell into a falling market to meet margin and collateral calls, amplifying asset-price volatility. These linkages appear to have operated powerfully in 1997-8, in the run on the Indonesian banking system, when Korean banks that suffered losses from the Asian crisis were forced to sell off their holdings of Brazilian Brady bonds, and when Russia’s default forced highly-levered institutions like Long-Term Capital to liquidate assets in other markets in order to meet margin calls. One can see how these mechanisms reinforced created positive-feedback dynamics in financial markets and worked to transmit financial distress across borders.

While leverage ratios are difficult to estimate and compare, there are good reasons to believe that leverage has been rising. Advances in financial engineering have made it easier for market participants to acquire leverage. The growth of markets in derivative securities has allowed them to unbundle leverage from positions in specific instruments that are subject to different margin and capital requirements. Modern risk-management practices (value-at-risk models, for example) create the belief, real or illusory, that high levels of leverage can be safely managed. The growth of hedge funds, managed-futures funds, and a population of high-income investors prepared to assume the risk of doing business with them have swollen the ranks of leverage-hungry collective investment vehicles operating outside the regulatory net. All these factors heighten leverage.

2) Financial Deregulation. A key lesson drawn from the Great Depression was the need to tightly regulate financial institutions and markets. Governments in industrial and developing countries alike laid on a heavy regulatory hand for several decades after World War II.That the policies of “financial repression” had costs in terms of economic efficiency and growth is now widely accepted.But keeping a tight lid on the operation of financial markets, notwithstanding these costs, nonetheless succeeded in limiting the scope for financial instability. Even if countries purchased faster growth and greater economic efficiency by buying into financial deregulation, those same policy reforms lifted the lid on the box in which financial crises had been confined for several decades after World War II.

3) Capital Account Liberalization. Capital account liberalization created new channels for financial distress to spill across borders. It allowed financial institutions under water and gambling for redemption to borrow abroad as a way of levering up their bets. And — especially in countries committed to the maintenance of a currency peg — it severely constrained the capacity of the monetary authorities to act as a lender of last resort.

4) Commodity Market Integration. The growth of trade is not usually cited as increasing the scope for a global crisis. In fact, countries’ macroeconomic fortunes are linked not just by the financial linkages but by trade and production linkages as well. In Asia, shifts in competitive advantage due to currency depreciation (the “competitive-devaluations” channel) was one factor contributing to the contagious spread of the crisis. More generally, as commodity markets have become more integrated, business cycles have become more synchronized. The evidence shows clearly that countries that trade more heavily with one another tend to have much more tightly synchronized business cycles.When one countries experiences a crisis and its economy turns down, it thus drags down its trading partners with it. Trade liberalization, like financial liberalization, has manifest benefits in terms of efficiency and growth, but it also increases countries’ vulnerability to disturbances from abroad, creating additional channels through which national financial problems can turn into international financial problems. 

And yet the turbulence of 1997-8 did not precipitate a global slump like that of the 1930s. This brings meto the contrasts between the two episodes.

1) Continued Strong Growth in the United States. This may be the most significant difference with 1929. In 1929 the U.S. economy had descended into recession even before serious financial difficulties developed at home or abroad. The business-cycle peak (in August) preceded the stock market crash by several months. It preceded the eruption of bank failures and the spread of currency devaluation by even longer intervals. Thus, the U.S. was unprepared to act as an importer of last resort as the crisis spread beyond its borders. By imposing the Smoot-Hawley Tariff, it pulled the plug on the international trading system.In 1998, in contrast, the U.S. economy continued to grow robustly, even accelerating in the final quarters of the year. The country’s trade gap widened as it absorbed exports from Latin American and East Asian economies under pressure.

2) G-7 Interest Rate Cuts. In 1998 the G-7 countries, led by the United States, quickly cut interest rates in an effort to re-liquify international financial markets. Interest rates having been cut, financial-market participants who had taken losses in Russia and on other high-risk, high-yielding assets found it easier to finance their positions, obviating the need to sell into a falling market. Investors who wished to take advantage of the distress sales of others similarly found it easier to finance their positions. Overly-excited financial markets thus began to settle down.

Why this difference from 1929? The simple answer is that central banks had learned a powerful lesson from history and were concerned to avoid the mistakes committed 70 years before. A subtler answer is that the major economies, not being on a gold standard, enjoyed more freedom of action. In the 1930s, financial uncertainty caused flight from national currencies and a scramble for the limited global stock of gold. Even the largest central banks, committed to defending their gold parities, had little scope for cutting interest rates. In 1998, with the dollar, the yen and the major European currencies floating against one another, this constraint no longer bound. However unfashionable the argument, there is little question that floating exchange rates had a stabilizing influence on the world economy. 

3) Intervention on Behalf of Distressed Financial Institutions. The New York Fed-led rescue of Long-Term Capital worked in the same direction. The rescue of LTCM signaled that major financial institutions would not be allowed to fail.Again, social learning explains the contrast with the 1930s, when officials stood by as the banking system collapsed around their ears. The banking panics of that year left an indelible mark on policy.In addition, that this problem showed up in a nonbank firm like Long-Term Capital rather than a major U.S., European or Japanese bank points up the other important difference with the 1930s: supervision and regulation have been strenghened, and deposit insurance has been extended, heading off the panic problem (in the advanced-industrial countries at least).

4) Japanese Bank Restructuring. While the Japanese economy continued to contract in the final quarter of 1998, significant progress was made in bank restructuring. The bank rescue package announced in the autumn was massive. More than $100 billion of public funds was pledge to underwrite capital injections and to help the banks write off bad loans (and also to finance the takeover of weak banks and buttress the deposit insurance fund). This approach may be second best to a U.S.-Savings-and-Loan-style workout, in which bad loans are removed from the books of the financial institutions and auctioned off to the highest bidder. But for those who believe that its banking system has been holding back Japan’s recovery and that Japan has been holding back Asia’s recovery, it is far better than nothing.

5) The Brazilian Firewall. In 1998 the IMF leapt into the breach with a multi-billion dollar package of financial assistance for Brazil. This is in contrast to the failure of the Bank for International Settlements to marshal support for the Central European countries engulfed bycrisis in 1931.Observers blessed with 20-20 hindsight criticize the Fund for supporting yet another unsustainable currency peg and invoke Brazil’s ultimate abandonment of the real peg in favor of their argument. It would have been better, in their view, for the IMF to have acknowledged the inevitable and to have pushed Brazil to devalue three or four months earlier. But it is worth recalling that, from the vantage point of 1998, the situation was not so clear. Financial markets were still in the intensive-care ward. The flight to quality was still underway, and international investors were ill prepared to take another hit. Although Brazil devalued anyway, there is an argument that its devaluation would have had much more devastating effects on global financial markets had it been allowed to occur three or four months before. From this point of view, IMF assistance may have provided a critical window of opportunity for market participants to rebalance their portfolios and restore their liquidity. This is a plausible explanation for why, when devaluation finally came, the global fallout was surprisingly mild. 

6) A Robust Trading System. The depression of the ‘thirties was greatly aggravated by the all-but-complete collapse of the world trading system. One country after another, starting with the U.S. in 1930, raised tariffs on imports from the rest of the world. The Smoot-Hawley Tariff, imposed in response to financial distress in the farm belt and lobbying by the farmers, was particularly hard on agricultural imports. While the average tariffs of six European countries more than doubled between 1927 and 1931, the largest increase falling on imports of agricultural goods. The quantitative restrictions imposed by exchange-control countries were more draconian still. Developing countries dependent for foreign exchange earnings on their exports of primary commodities were thus forced to default on their debts and turn inward, adopting import-substituting policies.

The current international trading system has so far resisted this fate. Regional arrangements like NAFTA and Mercosur and the multilateral bindings and arbitration procedures of the WTO have worked to discourage countries experiencing macroeconomic difficulties from turning their backs on international markets. The crisis countries of Asia and Latin America have not turned away from international trade but have instead rededicated themselves to market opening. Until recently, exports were the only growing component of aggregate demand for the countries of Asia. Say what you will about the U.S.-EU Banana War, U.S. pressure for anti-dumping duties on steel, and Argentine calls for protection against the arbitrary effects of a falling real, the world trading system has remained remarkably resilient to protectionist pressures.

Thus, a global economic and financial crisis was averted by a combination of good policies, good institutions, and good luck. That’s the good news. The bad news is that we cannot assert with confidence that the pieces will again fall into place so neatly in the event of another equally serious shock. This creates a critical need to further strengthen institutions and policies in the effort to make the international system more robust. That in turn raises the issues that fall under the aegis of the “new international financial architecture.” Lack of time prevents me from going into them. Fortunately, we have Ted Truman, who is privy to official discussions of this question, following me on the panel.