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Riding Out the Economic Storm


The global economic tsunami has washed away capitalism's prosperous heyday, leaving individuals, companies and governments, including Taiwan's, wondering what values and directions to embrace for the future.



Riding Out the Economic Storm

By Fuyuan Hsiao
From CommonWealth Magazine (vol. 409 )

On September 15, the collapse of Lehman Brothers, one of the world's most venerable investment banks, triggered a domino effect in financial and economic markets. Plummeting stock markets, a massive credit crunch, contracting liquidity and rising unemployment appeared one after the other, plunging September and October into darkness.

World systems theorist Immanuel Wallerstein boldly predicted that a global economic depression had begun.

Many have identified the key factors triggering the financial meltdown, but at the core of the systematic crisis was the lack of responsibility shown by governments, businesses and individuals and a widespread departure from core values.  

Twin Evils: Leveraging and Debt-driven Consumption

Excessive leveraging set the stage for the financial crisis, as companies left themselves vulnerable to margin calls by turning a dollar worth of assets into 30 dollars of liabilities. Wall Street's financial wizards then repackaged the debts into products that were marketed around the world, ignoring the risks involved.

The epicenter of the U.S. financial earthquake that shook global markets was unrestrained, debt-driven consumption. The U.S. federal government has run large budget deficits in recent years, peaking at an estimated US$454.8 billion in 2008. Those deficits have pushed the national debt above US$10 trillion, making the United States the world's largest debtor nation.

At the same time, U.S. households have amassed US$14 trillion in debt, driven by gluttonous consumption reaching US$800 billion annually. At the height of the feeding frenzy, homebuyers could get a mortgage without a down payment or documentation to prove their credit-worthiness.

Leveraging, easy credit and excessive consumption have all conspired to plunge the United States into a morass of debt.

Nobel laureate economist Joseph Stiglitz unreservedly criticized this profligate consumption behavior as violating the first rule of economics: There's no such thing as a free lunch.

The problem now is that the consumption binge is coming back to haunt Americans. Foreclosures have skyrocketed in the United States, averaging 2,700 a day from July to September, compared to 1,200 a day a year ago.

Michael Mandel, chief economist at U.S.-based BusinessWeek, takes the debt issue a step further, saying it, along with weak growth, was behind the financial meltdown. Mandel found that the 2.7 percent average growth rate in the U.S. over the past 10 years was largely driven by "an illusion created by excess borrowing." If debt-driven consumption is excluded from the economic equation, U.S. economic growth in the past decade has averaged a paltry 1.3 percent, the lowest in 50 years. 

The ancient Greek scientist Archimedes realized the power of leverage when he said, "Give me a place to stand and a lever long enough and I will move the world." Wall Street's tycoons and golden boys exploited the principle to the max.

Ironically, the instigator of the leveraging fury that created the huge financial bubble is the man who now carries the responsibility for cleaning up the mess after the bubble burst: U.S. Treasury Secretary Henry Paulson. When Paulson was CEO of Goldman Sachs, Wall Street's most influential investment bank, he openly pressured the U.S. Securities and Exchange Commission to loosen regulations requiring investment banks not to exceed a debt-to-net capital ratio of 12:1 (meaning banks could not borrow more than 12 dollars per dollar of capital).

Eventually the SEC buckled and opened a Pandora's box. Investment banks competed aggressively to borrow capital, resulting in companies like Merrill Lynch with a debt-to-equity ratio of 28:1, and some European banks levered 30:1 (compared to a 4:1 leverage ratio industry wide in Taiwan). Debt at American financial institutions soared, rising from 21 percent of GDP in the 1980s to 116 percent of GDP in 2007.

Leveraging enabled banking systems to reach scales far bigger than the economy of the nation in which they were located. The most dramatic example is Iceland, considered a major success story less than a year ago, where its three banks' aggregate assets grew to nine times the country's GDP. The collapse of the three banks turned a prosperous country with per capita income of US$63,000 into a failed state on the edge of bankruptcy.

Avoiding Responsibility

Another fundamental value that was cast aside during the money chase was a sense of responsibility.

Alan Greenspan, who chaired the Federal Reserve for more than 18 years and was nicknamed "the Maestro" for his seeming magic touch in controlling financial markets, has had his reputation tarnished by what he called "a once-in-a-century credit tsunami." Speaking before the House Oversight Committee on mid-October, the 82-year-old admitted that he had made a mistake in believing that banks, operating in their own self-interest, would do what was necessary to protect their shareholders and institutions.

The free market philosophy advocating less government intervention and a reliance on market mechanisms that gained currency during the Ronald Reagan years also suffered a major blow from the financial crisis.

Today, most critics are hammering at the U.S. government for giving free rein to market mechanisms, poorly regulating markets, and relying too much on other countries managing their own markets well. But with recriminations flying in all directions, nobody is willing to assume responsibility for the financial disaster.

Felice Chen, the former vice chairman of investment banking at UBS Asia, recalls attending a recent gathering of financial sector representatives, at which the participants roundly attacked bankers, because in the run-up to the crisis the banks were only concerned about business performance and completely forgot what their role actually was.

Banks, for example, did not fulfill their traditional role of serving as a check on new financial products. As soon as a new product was developed and produced results, those involved would immediately receive generous bonuses, but when the risks of the instruments emerged a few years later, it was the average investor who was hit hardest.

Wall Street financial engineers, known as "quants" for their dedication to quantitative methods, designed complex mathematical models that underpinned many forms of debt securitization, which were then repackaged as attractive derivative products. The derivatives market grew so big that it morphed into a structured-note Godzilla that was beyond anybody's control.

According to statistics from the Basel, Switzerland-based Bank for International Settlements, the derivatives market has doubled in size every two years over the past decade and last year was worth US$514 trillion, 11 times global GDP.

While those in the financial industry acted irresponsibly, many retail investors did not fulfill their responsibility to themselves to thoroughly understand their investment portfolio. A 50-something middle manager at a computer company couldn't help feeling petrified when he looked at the monthly account statement recently for an investment-linked policy and saw a remaining balance of just over NT$20 million, slightly more than one-quarter of the NT$80 million he invested. In the three years since buying into the investment-linked policy, he never really knew what he had purchased, leaving his financial adviser to handle the account.

"A year ago, the return on investment was 50 percent. This month it lost 70 percent, and I have no idea how the money disappeared into thin air," he said, unable to fathom what compelled him to buy complex products that he couldn't hope to understand.

Global Coordination, Regional Alliance

Wall Street also became a magnet for criticism in the economic upheaval, and its investment banks have vanished, giving New York's financial center the feeling of a wasteland. But today's flat world is trying to rebuild a brave new world from the financial rubble. In the aftermath of the global collapse, a new order is gradually taking shape.

One of the new system's features is that countries around the globe have demonstrated a willingness to take up the fight together and regional cooperation has grown closer.

On October 8, U.S. Federal Reserve chairman Ben "Helicopter" Bernanke (so nicknamed because he once said he would drop dollars from a helicopter to keep the economy going) led an unprecedented coordinated rate cut by the world's six major central banks. In a historical first, the central banks sacrificed their independence as guardians of a country's or region's financial integrity to join together to think of ways to rescue the global economy.

Such global coordination was followed by regional cooperation. The late management guru Peter Drucker predicted more than 10 years ago in his book Post-Capitalist Society that regionalism would become a mainstream trend in world affairs. At the time, Drucker called for a regional institution to be built that would share responsibility with national governments and be entrusted with handling especially important tasks.

Drucker's premonition is now being realized. In late October, China, Japan and South Korea renewed a proposal to set up an Asian currency fund together with the 10 ASEAN (Association of Southeast Asian Nations) countries, and, as a result, the ASEAN + three grouping pledged to set up a US$80 billion emergency fund to help countries ease liquidity crunches, especially at a time when Asian financial institutions lack U.S. dollar liquidity.

Unable to join many of these international or regional groupings, Taiwan must follow even more closely this trend toward cross-border collaboration.

"If Taiwan runs into trouble, the IMF won't come to the rescue. Taiwan can't even issue overseas debt," says a worried Chen in summarizing the country's predicament. The senior financial specialist believes that under the circumstances Taiwan must exhibit even more model behavior and adhere to international norms to avoid being completely isolated and cut off from help.  

"Wen Jiabao can call Bush on a hotline. Who can Taiwan form an alliance with? Every country in the world is so preoccupied with its own problems, they have little time for others. Still, we have to do everything we can to participate in related international forums and form alliances," Chen emphasizes.

Role of Government to Grow in Importance

Aside from close cooperation, another element of the new world order is that with free market economic concepts being viewed with skepticism, the role of government will grow increasingly important.

In the 1980s when laissez-faire capitalism was the prevailing economic philosophy, Drucker was outspoken in his criticism of a system that spawned higher government expenditures with less interference, which he described as turning inactive government into incompetent government. To rescue the economy, Drucker explained, governments must help turn the situation around and actively create a positive economic climate by increasing resistance to a downturn, making timely adjustments, and maintaining their countries' competitiveness. This more active role implies that governments cannot simply loosen their reins and rely on a free market to regulate itself.

In the foreseeable future, the world economy will see more control and interference. But Taiwan's government seems to be going in the opposite direction. President Ma Ying-jeou has repeatedly stressed the need to loosen regulations and return to market mechanisms. Liberalization, however, is not the solution for every problem, especially now, when the world believes markets have lost their touch.

Taiwan's Path to Revival

It is even more critical for Taiwan to figure out how to face this strategic juncture as a new global order emerges. Compared to its main competitors, Taiwan has little foreign debt, a high savings rate, and relatively good fundamentals, and therefore should not be too pessimistic.

But can the government turn itself around and become a better government? Delegation without leadership, liberalization without regulation, markets without values – none of these are approaches that can help Taiwan avoid economic contraction or navigate through this critical turning point. Only if the Ma administration improves its capabilities and the people strengthen their vigilance can Taiwan successfully ride out the economic storm.

Translated from the Chinese by Luke Sabatier

Chinese Version: 金融風暴啟示錄