Notes on the Financial Crisis

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Faizullah Khilji


These notes are an attempt to lay out what we know and what we do not know about the financial crisis, global imbalances, the “recovery”, and how the East Asian response to the crisis is shaping up. We begin with a brief recapitulation of events, and then consider the mechanics of the crisis, and in that context, consider the concerns relating to global imbalances. A discussion of how this crisis might unwind follows. The present financial crisis occurred chiefly in the United States and the United Kingdom, New York and London, but soon enough the impact of these developments was being felt in other financial centres of the developed market economies. East Asia though faced the crisis from a different perspective and with somewhat different concerns: chiefly as an exporter to the developed market economies where demand was slowing down on account of the crisis, and as a major investor in dollar and dollar denominated securities. We briefly consider the East Asian response. In particular we consider the proposition that there may be informal arrangements being improvised by the East Asians to solve issues in real time.

The man walking slowly by my side is haunted by something more than the uninterrupted revolution; by a gigantic conception of which neither of us has spoken …Three hundred years of European energy are now on the wane; the Chinese era is dawning… Behind our entire conversation the hope of a twilight world stood watch. Andre Malraux, 1967


“How could this happen?” begins the recent Bank of International Settlements (BIS) annual report,3  which seems to date the onset of the crisis from August 2007 when, in its words, the interbank market was “disrupted”, i.e., the beginning of the credit crunch.4 The BIS though is not alone in expressing a loss of understanding. The Queen of England, a well informed person briefed weekly by the British Prime Minister and with enviable access to other equally well informed persons including heads of state, asked of a London School of Economics professor of management “If these things were so large, how come everyone missed them?”5 And Professor Garicano of LSE too was in good company in his inability to offer a satisfactory explanation to his monarch about the limitations of economists: Alan Greenspan had earlier expressed his inability to comprehend both the nature of financial engineering as well as to regulate the markets because the two phenomena surpassed his understanding.6  Indeed that venerable spokesman for the “financial times” that we reportedly live in, did tell us that “unfettered finance” was “fast reshaping the global economy”. But our concerns were allayed because it had “proved possible to tame domestic finance in the US”; the “emerging economies” though, lacking in the sophistication found in US financial system, needed to “manage their involvement with the global financial system cautiously”; that is where there was something to really worry about, and naturally so!7

These notes are an attempt to lay out what we know and what we do not know about the financial crisis, global imbalances, the “recovery”, and, finally, how the East Asian response is shaping up. We begin with a brief recapitulation of the widely known chronology of events, and then consider the mechanics of the crisis, and in that context, the A discussion of what lies ahead for the world economy, and how this crisis might unwind follows. It is an important aspect of the present financial crisis that it occurred chiefly in the United States and the United Kingdom, New York and London. Soon enough though the impact of developments in New York and London was being felt in other financial centres of the developed market economies. East Asia though faced the crisis from a different perspective, the perspective of a region which had methodically prepared itself to cope with any repeat of the Asian crisis of 1998. And East Asia faced the new crisis also with somewhat different concerns: chiefly as an exporter to the developed market economies where demand was slowing down on account of the crisis, and as a major investor in dollar and dollar denominated securities; a currency which surely looked like losing some of its sheen, if not some of its credibility. We briefly consider the emerging East Asian response. In particular we consider the proposition that the institutions of international economic relations may have lagged in their ability to cope with developments, and that there may be informal arrangements being improvised by the East Asians to solve real issues in real time.

Chronology of events8

It was in the summer of 2007 that sustained reporting on what was then seen as the emerging “sub-prime” problem began to appear in the press. Interest rates had risen and defaults were expected on some home loans as a result. On the face of it this did not seem to be an alarming development to a lay observer as some loans do go bad whenever interest rates rise, and also because not much change was evident in the behaviour of the banks to suggest any impending crisis. The term “sub-prime” was not until then understood sufficiently well outside the banking community: the term “sub-prime”, it turned out, broadly means a loan made without much scrutiny because serious scrutiny would not justify lending. Thus the gravity of the situation did not quite filter through to the public for some time, even though some of the news reports did mention that the mortgage defaults were sending ripples through the financial system.

Public policy in the United States had contributed to the growth in housing ownership. House ownership was seen as helpful in enlarging the “Republican tent”, i.e., vote bank, and it also reportedly furthered the business interests of major donors to the Republican party.9

The first unmistakable signs of a definite turn in the public confidence and that we might be living through extraordinary times came in September 2007 with queues forming outside Northern Rock, a United Kingdom home loan mortgage institution turned bank. It had been well over a hundred years since something like this had been seen in Britain.10 For the British, this was a live example of the oft mentioned but never seen (by any living soul) textbook case of a run on the bank.

By Autumn of 2007, a deepening of the crisis was quite visible with Fed sharply reducing interest rates as bank after bank in the United States announced losses, and attributed these to “sub-prime” loans gone bad. By January 2008 the stock market movements reflected the depth of the crisis: the NYSE dutifully crashed. Later that year in March, Bear Stearns, one of the institutions that defined success on Wall St, imploded like those old buildings that look so formidable and then suddenly disappear in a puff of dust.11 In July 2008 Fed and Treasury, in a move that could only be anathema to the very spirit of the United States, nationalised the two well known home loan institutions, i.e., Fannie Mae and Freddie Mac; the word nationalisation was never mentioned, and, indeed, there was, some felt, a sense of pathos and sad irony on seeing the Treasury Secretary, Hank Paulson, make the announcements: this ex head of Goldman Sachs – for Wall St provides both the market makers and the regulators to regulate the market makers, hence setting up a situation where it is both judge and jury in its own cases – saying that the Treasury would backstop the two institutions then on the brink of bankruptcy.12

By the summer of 2008 the credit crunch was a full one year old as far as newspaper reporting went, but a belief also began to shape up that the measures taken by the central banks and the governments had largely contained the crisis. There was nothing in living memory to suggest that this was only a pit stop for what Alan Greenspan was to subsequently refer to as the financial tsunami.

Treasury decided to selectively apply their belief in the rationality and efficiency of market outcomes: it was judged best in the public interest not to bail out Lehman Brothers, a pillar of Wall St but also a noted rival of Goldman Sachs. Lehman Brothers duly collapsed forthwith, (as indeed would have any other bank in the United States that fateful day if the government had publicly withheld support), and with this collapse public confidence in the financial system went in to a free fall.13  The public obviously did not share the authorities’ faith that the markets were working for the best. For the public, collapse of Lehman Brothers was tantamount to Wall St, the very citadel of capitalism, coming apart. The crisis had turned into a global meltdown, nothing less. With the total collapse of public confidence in the financial system staring in the face, Treasury and Fed worked non-stop to launch bail out plans. But the Congress approved the bailouts only rather reluctantly, (for many in Congress too have great faith in the “magic of the market” whilst others in Congress saw these plans as handouts of “taxpayers money” to bankers), and only after President George W Bush talked at them with his usual rough-hewn man-of-authority turn of phrase: “this sucker could go down”!14

A stock market crash, greater in relative intensity than 1929, followed. The autumn and winter of 2008 witnessed the design and implementation of rescue and stimulus plans. Bank after bank was being rescued through an infusion of equity capital as well as through extension of loans at near zero rates, debt service burdens were being reduced through lowering of interest rates, and the economy was being boosted directly through policies that increased public expenditure. By December 2008 US interest rates had fallen to between zero and 0.5 percent. Interest rates in the UK were approaching zero by March 2009. Nonetheless, as 2009 unfolded, the public saw unemployment and bankruptcies going up.

The mechanics of the crisis

The alleged causes of this financial crisis were diverse. Press reports initially referred to greed and dishonesty as causes, perhaps because these two “capabilities” are easily understood by the average reporter as well as the general public; but both these factors are also an intrinsic part of the human condition, and that is why we have regulators and watchdogs. Another alleged cause was inadequate regulation,15 and that goes to the heart of the philosophy that guides present day economic policy in market economies. Some argued that the problem had its source in ”global imbalances”. And others attributed the difficulties to “complexity” of financial engineering, and markets, use of mathematics “too difficult to understand”, etc. No one though attributed the crisis to the incompetence of the bankers, or accused them of getting involved in matters way beyond their competence.

The story properly begins with the concepts and principles that guided the market makers and players as well as the regulators.

The underlying economic concepts

The conceptual framework under which the finance sector operates goes by the rubric of “efficient market hypothesis”, EMH for short. The essence of EMH is captured in the definition attributed by the Economist to Eugene Fama, of the University of Chicago, “that the price of a financial asset reflects all available information that is relevant to its value”.16 The far reaching implications of EMH are that markets would always price financial assets correctly. If the price of a share seemed low, investors (well-informed by definition) would buy it forthwith to their profit. If it looked too high, they could sell it and again end up making money. It also followed that bubbles could not form, as these would be immediately perceived by investors who would profitably prick them. Trying to beat the market was therefore futile, and, importantly, regulation was by and large superfluous.17

As the EMH did not admit of bubbles building up, it is not much help in explaining or understanding the crisis, and in an EMH world any crisis therefore must logically be on account of interference in the markets by the authorities. This sounds (and is) too simplistic, reflecting only an insistence on viewing developments through the prism of EMH; but a more plausible, albeit “non-standard”, explanation owed chiefly to Hyman Minsky goes something like the following.18

The post 9/11 part of Alan Greenspan’s stewardship at the Fed was a time when the economy was in a situation of low interest rates and experiencing good returns on equity. Banks were awash with funds.19 It follows that firms and individuals with relatively higher proportion of debt were earning relatively higher returns because of low interest rates. The advantage of contracting increasing amounts of debt to enhance the return on equity was evident. “Financial engineering” by devising instruments such as the CDOs and CDSs gave a boost to the process: CDOs by further lowering the perception of risk, and the CDSs by enabling an increase in leverage and hence increasing the funds available for investment in housing and elsewhere.20

It is worth digressing briefly to see as to how CDOs and CDSs worked to reduce, or spread, or transfer the risk element underlying a loan. The CDO instrument, a collaterised debt obligation, bundled together different loans into one package (which could be sold in parts or as a whole). By bundling together loans that were in principle uncorrelated, the risk of any one default was reduced as it was spread over the larger bundle of loans, and as all loans (being uncorrelated) were most unlikely to default at the same time. Once this logic was accepted, it was a small step to use the CDO “technology” to rationalise extending credit to persons with a poor or no credit history, i.e., the “sub-prime” loan.

The other instrument was the CDS, the credit default swap. This CDS made it possible for the bank to transfer the risk attaching to a loan or other asset either by paying someone to carry the risk, or by insuring against the risk of default, whilst retaining the loan as well as its income stream. The implication was that if the risk attaching to default was transferred, then the capital that the regulator required of the bank to keep as a reserve against the loan had been freed and could be “re-used” for advancing more loans. In the event the regulators found the proposition in keeping with “markets know best” concept, and hence acceptable. And those among the regulators who did not quite see it like this were shown the door.21  The result was two-fold. Firstly, insurers such as the AIG insured the risk of default and thus took on huge risks even  though  this  particular  insurer  had  no  previous  experience  of such business! Just the lure of profit was enough: the premiums were trivial but the immensity of the volume of business raked in a large income. And insurers did not face the capital reserve requirements that were reining in the banks. Secondly, as a bank transferred the risk but retained the loan, the loans made by a bank kept growing as a factor of that bank’s capital and leverage shot up. At the time the crisis became evident, these leverage ratios for the main investment banks had reached levels associated with hedge funds!22

The lowered perception of risk encouraged optimism about returns on proposed projects, and this caused the value of assets to increase.23

The bubble

It is important to remember that one of the defining characteristics of the market economy in the present context is the relentless pursuit of profits.24  In the circumstances therefore it is clearly advantageous to contract higher debt at the prevailing low rate of interest so as to increase the returns.25  Firms and individuals were therefore motivated to undertake riskier projects and ventures, and to contract more debt to enable them to do so. The decline in risk aversion set of an increase in the volume of investments being undertaken. As investment volume increased,  there  was  a  consequent  increase  in  asset  prices.  Rising asset prices raised the prospect of capital gain, encouraged yet more investment, and speculative behaviour gained strength. Finance was increasingly sought from the banks to fund investments and asset purchases. The banks were very willingly forthcoming with loans as they shared the general optimism of the borrowers regarding rising asset values and potential capital gains.

All these forces worked themselves out to increase home loans in the US economy, and indeed elsewhere too. The housing industry experienced a boom of such extraordinary dimensions that houses were being built even though demographic and other data showed that there would be no demand as far as one could see for these units for habitation purposes.26

This is also the euphoric moment in Minsky’s formulation. Lenders as well as borrowers feel that the future is assured. In the build up to the present crisis the regulator too felt that the future was assured and the economy and its financial sector had shifted to a new trajectory, where risk had been correctly priced so that the system worked safely.27

In this situation, which is characterized by rising asset prices and high investor excitement, a particularly risky type of investor appears. This investor trades on a market where asset prices are rising sharply, and in the process incurs substantial debt, in the widely shared expectation that expected capital appreciation on the assets far exceeds the servicing costs of the debt, even though these costs are well in excess of the net cash inflows of the business. The first round consequences of this act include pushing up asset prices to yet higher levels, pushing up the demand for credit yet another notch, and consequently maintaining the upward momentum in the rate of interest, and thus increasing the fragility of the system to any reversal in the growth of asset values. This configuration of events is referred to as a Ponzi scheme, and the investor is referred to as Ponzi financier, in deference to one of the better known practitioners of this particular art form.28

Liquidity  though  tightens  as  the  indebtedness  of  the  economy, and its debt / equity ratios (i.e., leverage) increase. As growth in credit accelerates, ceteris paribus, the ratio of interest payments to profits also rises.

Highly liquid but relatively low yield financial instruments such as bonds fall in price; in response, the purveyors of these instruments raise interest rates to help them compete better for investor funds. Thus the interest rates in the market rise, without any intervention on the part of the authorities. With increasing leverage and interest rates also moving upwards, a situation of tight liquidity develops and the vulnerability of the business and the economy to any further upward shifts in credit, leverage or the rate of interest increases dramatically.  But the increase in borrowing to invest in assets continues even at higher interest rates, as long as the expected returns from investment significantly exceed the cost of such borrowing.

With time this dynamics of high interest rates combined with high leverage begins to tell. The upward drive of credit and asset prices falters, and these stumbles render sound business speculative,29 speculative business begins to resemble a Ponzi scheme, and the Ponzi financier needs to sell assets immediately to cover the current debt service, as perhaps do others.

The asset sales prick the asset price bubble and the prices of assets come under pressure to move down. With a downward move in asset prices, investors other than the Ponzi financier also wish to sell. If an investor is levered up, even modest market movements can force a sale in a hurry to stop losses becoming catastrophic.

The Ponzi financiers find themselves with assets that can only be sold at a loss, and levels of debt that simply cannot be serviced. Banks find that customers cannot pay back the loans, and this prospect of losses causes the banks to further jack up the interest rates. Credit becomes dearer, liquidity in the system tightens, and this squeeze, combined with the continuing need for funds, further intensifies the need to off- load assets, specially the illiquid ones. The asset market is flooded with sellers. A state of panic exists. The boom is fast turning into a slump.

The credit crunch

The credit crunch in the present crisis was characterized first and foremost by the extreme reluctance of the banks to lend to each other, and even overnight loans disappeared. This reluctance was arguably owed to the likelihood that the banks simply did not trust each other’s valuation of assets as the crisis unfolded.30 They did not trust one another’s valuations because the assets in question were the CDOs and products derived from the CDOs. The credibility of these assets, (which caught the label toxic), suffered on two counts. Firstly, these assets were derived from “sub-prime” mortgages in whole or part, and in the light of day “sub-prime” loans were finally recognised for what they always were: loans advanced to a punter (often with no income or assets or a job) gambling on a continuing increase in the price of the house (the underlying collateral).

And, secondly, CDOs were bought and sold by banks, not individuals.

The prices at which these transactions occurred were kept private, known only to the transacting parties. The assets were never publicly traded and their prices were not a public fact.31 It was therefore impossible to judge whether the CDO transactions met some market criteria. Frequently, the extent of SPV or SIV operations was also not disclosed by the investing bank in its balance sheet.32  Hence, in a situation of a crisis when there was no evident demand for CDOs, one could not realistically attribute a market value to them. And if the assets of a bank were a mystery at best and worthless at the other extreme, how could one lend money to such an entity. Eventually, the fair value accounting or the mark to market condition, a requirement with the consequence that a bank acknowledge and therefore write off the implicit losses on the assets it owns, was relaxed.33 Even though the continued application of this rule would show the banks to be in a far worse situation than is now being reported, and the crisis to be far more grave, the dangers of this relaxation are only obvious and have been noted.34

The carry trade

There was at least one other factor deepening the crisis as it unfolded. The ease of flow of capital and investments across national borders that characterises the world increases the scope and range of any developments in the markets, making them increasingly interlinked. Such free flow of capital combines with instantaneous flow of information, and enables the markets to respond to policy and other developments almost immediately, arbitraging in the process between the differences in applicable prices or regulations such as might obtain in different countries. An “investor” capable of profiting from these differences is always lurking on the scene.

In this context, one set of developments (that are quite apart from the developments related to the asset bubble that originated with the United States non-banking financial sector, but have added to the gravity of what followed) is the “carry trade” issue. “Carry trade” involves borrowing in a low interest currency regime and investing in a high interest currency regime. In the present situation such traders were borrowing in Japanese yen to invest in New Zealand, Iceland and Hungary in particular. Investing borrowed money in a different currency exposes the borrower-investor to foreign exchange risk, and the critical assumption is that any exchange rate variation would not wipe out the gains. The unexpected appreciation of the Japanese yen, chiefly reflecting a flight to safety once the crisis set in, turned the tables on this trade, and traders moved out of Hungary, Iceland and New Zealand currencies very very fast so as to meet their yen liabilities and hence limit their yen losses. Problems naturally ensued for Hungary, Iceland and New Zealand banking systems (and consequentially economies), as capital outflows accelerated. Even Iceland with its traditional remoteness from the news made the front page repeatedly at one point.

Thus there were elements unrelated to the CDO and CDS developments, particularly on the foreign exchange markets, that furthered the sense of financial fragility and crisis, but these constituted only a sideshow in the larger scenario.

Profits and bonuses

The combination of high leverage with low interest rates and lowered perceptions of risk made possible the unusually high profits for the banks as well as others in the financial sector. Profits were booked even when the underlying assets could not be sold because there was no market for them. This was done through applying mathematical formulas.35 These formulas were fraught with unrealistic assumptions inherent to the EMH world. But high profits attract negative attention, and one approach adopted to lower the profile of these profits was to jack up costs. The easiest of the costs to jack up were the salaries and bonuses; the share of salaries and bonuses for the finance sector in the national economy has shot up over the years.36  The profits, as has been widely reported, reached new heights, and even after meeting these higher salary and bonus costs, the profits in the finance sector significantly increased their share in national income!37

Global imbalances


“Global  imbalances”  is  often  mentioned  as  an  answer  to  why the banks were flooded with funds. But the label global imbalance covers a range of narratives, old as well as new, and the issue of global imbalances may well be at the heart of the continuing problems with the international monetary system, including the financial crises that we see from time to time. The history here though is not the simple kind, i.e., the kind that repeats itself in varying forms, or even the kind where historians repeat each other. Indeed, part of the problem is that we do not have enough history; and, even where we have history, perhaps it has not been studied carefully enough.

There are two basic issues, and these have been with us at least since the gold standard was abandoned. The first issue is that of the nature of a world currency. Ideally a world currency should be a super sovereign and stable unit, and not subject to vicissitudes of a national economy and its policies. A stable super sovereign unit imposes a certain monetary and fiscal discipline on national policies. The second issue is a consequential one. Some economies save relatively more than others whilst some other economies are not able or willing to save very much. Yet others are more inclined to spend against future income, i.e., dis-save for the present and perhaps also dis-save for the foreseeable time horizon. Given that the world economy is a closed system (i.e., expenditure by one country in excess of its income must be balanced by savings of another country), those who save lend to those who dis- save on a world scale, and these balances are reflected in trade and capital flows. The existence of a super sovereign world currency would impose a certain discipline on these balances. In the absence of such a currency, the balances are held in dollars by default (and these balances are variously described as “global imbalances”, “savings glut”, and in an earlier era, the 1960s, as the “dollar glut”), and this aspect gives rise to all the concerns that relate to United States economic policy as well as behaviour.

Even as the Bretton Woods system was being contemplated, the issue of policies that would impose adjustment on a country that was in external surplus for long periods was on the table along with proposals to counter such an eventuality (the scarce currency clause). The surplus country at the time was the United States, which also then accounted for half the world economy. The United States as the surplus country was not willing to accept potential constraints on its monetary conduct, and the rest of the world had neither the will nor the authority to include such conditions in the IMF articles. Preparations for the Bretton Woods conference also included discussion on a super sovereign international currency unit defined in terms of a bundle of commodities, which could in principle be used for reserves as well as to settle international balances, i.e., the Bancor.38 But such a currency too would have constrained national policy, and was not in keeping with the spirit of the times, being inconvenient for the United States.

What finally emerged from the Bretton Woods deliberations was the gold-dollar standard. Countries would peg their currencies to the dollar, and the dollar would have a stable value in relation to gold. With two-thirds of the world’s gold in the coffers of Fort Knox,39 the United States undertook to convert dollars held in official accounts into gold on demand. The dilemma in due course of time for countries holding dollars was that if a demand was indeed made for gold, and a sufficient supply of gold was not forthcoming from the United States, then the dollar might well be devalued against gold.40 But a demand for gold leading to a devaluation of the dollar would mean a loss in gold value of reserves held in dollars, and could thus be counterproductive. In any event “gentlemen” were clearly not expected to make such demands for converting their official dollars into gold.41

Alas, the concept of a gentleman made little sense in a republic founded on the creed: Liberté, Égalité, Fraternité. President Johnson’s preference for financing the Vietnam war through printing dollars rather than raising taxes or curtailing expenditure brought matters to a head with France.42 President Charles de Gaulle, advised by Jacques Rueff, saw the dollar-gold system as a sort of expropriation of his country’s business firms and as exposing him to the charge of financing the United States war in Vietnam, financing United States assistance to Chiang Kai-Shek, financing the ill fated US intervention in the Dominican Republic, etc.43

Thus there were picturesque moments in 1971 when a French battleship lifted anchor off New York with gold from Fort Knox in exchange for the paper dollars in its hold. The French demand to exchange what they saw as paper IOUs for gold had indeed been honoured by the United States.44 But in the wake of this battleship, the world witnessed a turning point in the international monetary system: President Nixon announced the de-linking of the dollar from its gold peg, the world went on to a new paper dollar international monetary regime, and the United States entered an era of continuing external deficits and mounting accumulation of dollars overseas. “Global imbalances” had arrived, but in a time when the United States Treasury Secretary John Connolly could still credibly say to the Europeans who were holding the dollars: the dollar is our currency but your problem.45

The situation now

Today it is no longer just the Europeans who are holding the dollars. A number of countries have been following export-led growth policies. This is not a particularly novel development, and such policies are frequently attributed to successful East Asian economies, beginning with Japan, then Hong Kong, Korea, Singapore and Taiwan, and more recently to China among others. In addition, Germany too continues to be the major net exporter. As a result of such export orientation of the economies, receipts for exports well exceed payments for imports, leading to surplus in the balance of payments. Equally, exporters of natural resources, chiefly oil, also generate trade and balance of payments surpluses.

These balance of payments surpluses, in turn, add to reserves, and a substantial build up of reserves thus comes about over a period of time.46

These piles of reserves do not yield any income unless invested. One relatively secure investment is the United States government debt, also referred to as United States Treasury Bonds. Purchase of these bonds raises the price of these bonds, and hence lowers the interest rate in the United States economy. These purchases of United States Treasury Bonds by the surplus economies thus inject additional liquidity into the United States economy. It is in this manner that the overseas trade and balance of payments surpluses facilitate credit in the United States, and as the influx of funds lowers the rate of interest, it is argued that credit at low rates of interest is facilitated. The argument though short circuits logic at this point and attributes the surfeit of lending by the bank to these deposits. It is a strange argument: just because money has been deposited in a bank, it is not reason enough for the banks to lend it out to borrowers with no jobs, no incomes, and no assets! The bank is expected to hold the deposits in trust.

Thus a good part of what the United States pays for its imports is voluntarily handed back to the United States as a loan at relatively low rates of interest, making it possible for the United States to acquire yet more goods and services with the same funds. One might surmise that the United States would not be unhappy with living beyond its means in this manner, and therefore has little reason to tinker around with an international monetary system that works so well to its advantage. Indeed, the fact that this phenomenon has endured for so long is some testimony to the likelihood that these arrangements must suit all involved politically, if not in terms of finance and economics. In his time Jacques Rueff had summed up the “system” and its advantages quite admirably in simple prose that is difficult to match in its brevity and effect.47  A positive adjustment out of this for the United States would be one of high and sustained growth that increasingly diminishes the debt and creates confidence in the economic performance of the United States. In such an eventuality, the dollar may quite naturally acquire even greater authority as a world currency.

But if the United States were to continue on the present path, the question whether a country could go on borrowing year after year and pile up debt with no suggestion as to how these sums are to be eventually settled would be pursued with increasing vigour, and, also, as the share of the United States in the world economy shrinks, with increasing relevance. It is important to remember that this is no longer simply a matter of getting the arithmetic right. These imbalances represent deeply ingrained lifestyles. Forcing a change of lifestyle towards a lot more frugality has political consequences as well as implications for trade policy and openness. Given the size of the United States economy, its engagements with respect to a global socio-economic agenda as well as a global security agenda imply that the world would be greatly affected by any developments involving curtailment of expenditure in the United States. Indeed, the big question is whether the required discipline can be imposed; can it be done at all. Jacques Rueff’s answer was a definite no; not in a democracy.48

Nonetheless there is a view shared by informed and reputed academics in the United States that a change in the role of the dollar to a more modest stance is essentially an adjustment of asset portfolios in financial markets,49 and, indeed, if it were to decline as an international currency it may follow the path of sterling, and similarly settle down to a more affordable existence.50  This view increasingly looks simplistic and questionable.

The “recovery”

With economics in disrepute,51 more so the prevalent “efficient market hypothesis” version of economics, it would be a brave economist indeed who would try and predict what comes next for the world economy. What we do know is that the some major economies, particularly the United States and the United Kingdom, now face a gross mismatch between debts incurred to purchase assets, and the cash flows generated by these assets to service the debts. The business firms and the households therefore need to reduce their respective debt to bring it more nearly in line with their respective ability to meet interest payments. The debt, it would seem, may only be brought down through frugality and higher savings: a policy of inflation, an option for lowering the real debt burden, if pursued, may help reduce its real value only up to a point, before debasing the currency altogether and hence landing the economy in a different ballpark of problems. Any frugality by households also does not spell well for the business sector that produces goods and services, and hence for the economy and employment. In addition, banks would be cautious in lending until they have rebuilt their capital base, and this too would take time. This configuration appears to be the reality that may of necessity have to be faced; and efforts at changing sentiment by “talking up the economy” may not be sufficient to undo this reality, no matter how authoritative and credible the speakers.

How long might such an adjustment of debt reduction take: the answer is that one does not really know any where near enough about the behaviour of economies through time to predict with confidence. Economic change does not occur in isolation, there are invariably political and  social  consequences. And  when  change  involves  a  potentially downward adjustment in an economy the size of United States, there are surely implications for the working of international economic relations as well.

Comparison with Japan’s lost decade

One previous situation of an economy finding its way out of a real estate bubble is that of Japan in the 1990s. Japan’s bursting of the real estate bubble and collapse of its property market was followed by long years of stagnation, commonly referred to as Japan’s “lost decade”; many years were taken up with “repairing the balance sheets”, i.e., deleveraging or reduction of debt. In this respect Paul Krugman has made a comparison of United States now with Japan then. Krugman’s comparison shows leveraging up to the bubble (the borrowing frenzy) in the case of the Japanese and American economies, and he also displays the trajectory of deleveraging, i.e., adjusting the level of debt, that followed in the Japanese case.52 The chart below illustrates.

Source: Paul Krugman, The Return of Depression Economics Part 2: The eschatology of lost decades, Lionel Robbins Memorial Lecture, London School of Economics, June 9, 2009.

In considering the comparison charted by Krugman, it needs to be borne in mind that the financial system that suffered the present crisis is arguably more complex than the Japanese one of the nineties, and the United States trajectory of leveraging up too is indeed some what different, showing a concave profile. The chart shows that the Japanese build up of leveraging was convex in shape, and the Japanese deleveraging process seems to have mirrored in time scale the pace of its leveraging process. It would not be wise to hazard a guess on how long United States might take to deleverage, American social and cultural practices differ appreciably from those of the Japanese, but the unspoken implication behind Krugman’s comparison is that the crisis will only be behind us once the deleveraging has taken place; the logic of this proposition is difficult to fault. Any comparison with Japan has at least one other important limitation though: the Yen was not the world’s currency; the dollar is! And this latter fact has deep implications for international economic relations.

Comparison with the great depression

Another historical situation with which the present crisis is frequently compared is that of the great depression, chiefly 1930s. Eichengreen and O’Rourke have made a comparison of the movement of a range of economic indicators in the present crisis with the great depression.53 The charts below show how industrial output and trade volume compare for the two periods, i.e., the great depression and now.

Source: Barry Eichengreen and Kevin H O’Rourke, A tale of two depressions, June 4, 2009, at

Consider first the world industrial output. Thus far this indicator seems to be following the great depression trajectory rather faithfully,

as the chart shows. One important qualification to be considered is that industry accounted for a substantially larger share of the economy at the time of the great depression than it does today. Hence movements in an indicator on industrial output may have less relevance to the overall state of the current world economy, and this fact might arguably reduce the relevance of the indicator as a predictor of how long the crisis might last. Equally, the question may be asked as to why a services indicator might follow a different trajectory. There is no clear answer.

Consider next the volume of world trade. As is clear from the chart, world trade volumes have plummeted much more sharply now than was the case at the corresponding stage in the great depression.54  This is an extremely disturbing development; one would expect a negative feedback loop from this fall in trade volumes to output of goods and services. It is worth recalling that in the 1930s, protectionism was on the rise and contributed to deepen and prolong the depression.

Eichengreen and O’Rourke also review the policy response in the two situations, i.e., the present crisis and the great depression. Here the developments differ significantly between the two episodes as the charts below illustrate in respect of interest rates and fiscal deficits.

World budget surpluses

Source: Barry Eichengreen and Kevin H O’Rourke, A tale of two depressions, June 4, 2009, at

In the case of interest rates we find that the present crisis started at a much lower level of rates, and there has been a sharper reduction since then. With interest rates well below 1 per cent, there is little scope left for further easing now as there is not much further to go! Equally, the fiscal deficit has been building up much faster in the present case. The fiscal action too has been quicker and much larger.

There is a sense of alarm arising from the sharp decline in trade volumes, as shown in the illustration above, and proposals have been made to relax some of the trading rules so as to facilitate trade flows as well as to use moral suasion to deter any overt or covert protectionist measures.55 Again one cannot be overly optimistic on this count; trade negotiations tend to be extremely contentious and drawn out even at the best of times, and actual developments are not encouraging. In course of the current crisis, the area of trade relations seems to have suffered policy neglect at best and stirrings of protectionist sentiments if not implementation of actual measures at the other end of the scale (support to auto and finance sectors undertaken recently in a number of economies may be recalled, as may the recent safeguard measures taken by the United States against the import of Chinese tyres). Trade environment could well suffer if the high levels of unemployment continue for some time.

Given the nature of the processes leading up to the current crisis, the Eichengreen and O’Rourke graphical comparison with the great depression does not hold out much hope of an early sustained recovery either; the considerable macroeconomic easing notwithstanding. Looking at the underlying factors at work, it is not difficult to see why the trends may continue downwards for a while before reversing direction. We may recall that consumers are indeed saddled with debts and a good number are without jobs and incomes. Businesses too have accumulated debt and need to repay. Business may be reluctant to invest until the finances have been sorted out. To repeat, banks too need to rebuild the capital base, and are cautious in making new loans in an uncertain environment.

Some other considerations in a recovery

An important consideration, which may weigh increasingly with time, is the impact on any recovery of the present policies of monetary expansion and fiscal stimulus in the drive to overcome the crisis. The major economies are awash with money as a result of monetary policies to combat the crisis, and sooner or later this will fuel demand but it would also likely engender inflation. The fiscal burdens, that are a consequence of stimulus packages and are also to be settled in the future, are unprecedented, and imply hefty taxation in the years to come. Hence there may be tight macroeconomic policies on the extended horizon.56

If the events take this likely turn towards strong contractionary policies to counter inflation and to achieve fiscal balance, there would be plenty of scope in the ensuing political milieu of hardship for developing a case for protectionism. And it may be difficult to counter this because an organised anti-protectionist lobby, quite unlike the finance sector,57 is simply non-existent outside the ranks of academics.

Another aspect of the stimulus packages is whether the “green shoots” would remain green when the existing measures come to an end, or whether new stimulus packages would be necessary. There is no clarity on this point, and it would take considerable political courage to make an informed statement.

It follows if an economy was not highly leveraged then it should not have suffered the financial crisis to the same extent that the United States and the United Kingdom did. This provides one important explanation why the financial sectors in the Asian economies have fared better thus far, and may be expected to survive the global downturn much better. But a slowdown in the United States impacts Asian economies through two obvious channels. Firstly, the slowdown in the United States, on account of the financial crisis, chokes demand for Asian exports, and thus far Asian exports, along with the rest of world’s exports, have indeed suffered (as noted above). These negative effects may be offset or at least minimized with some foresight, and one approach towards that objective could be for Asia to further increase intra-regional commerce as well as domestic demand. China’s reflationary package aims at the latter aspect, as do similar albeit more modest measures by other East Asian countries. The second channel through which the crisis affects Asia is investment by Asians of their savings in “toxic” assets in the US financial system.58

The East Asian response

And it is indeed the East Asian59 context of international economic relations that offers a particularly interesting study. It is important for East Asia that output growth and employment in the region and its rapidly expanding intra-regional and international trade not be hostage to speculators or any lack of visible capability on the part of East Asia to respond to speculation as required. Views as well as institutional arrangements have been evolving for some time in East Asia on how best to cope with the instability arising from speculative capital flows, as well as with the quandary of global imbalances and consequent reliance on the dollar as a world currency.

The East Asian riposte to the Asian crisis of 1998

With the benefit of hindsight, it would seem that the experience with the financial crisis of 1998 deeply influenced East Asian thinking on the existing international monetary arrangements, and added a sense of urgency to its concerns. The East Asians saw the crisis as an outcome of the failure of the international monetary system (centred on the IMF) to check investors and currency speculators profiteering at the expense of public welfare. By contrast, the IMF saw the Asian crisis as gross mismanagement on the part of Asian governments, and there were widespread references in the media to the event being an outcome of long standing policies of “crony capitalism”. In the event wrenching contractionary policies were applied, on the insistence of the IMF, as a condition of the latter’s support. Having developed some understanding through the disruptive experience over 1998-2000 of how the international monetary arrangements really worked out for those in trouble, the East Asian then seem to have proceeded in a quiet and determined manner to develop regional mechanisms (in addition to national measures) that would help defend their economies and societies from the impact of currency speculators, and also avoid what they perceived as unjustified public humiliation of the governments and peoples, and unnecessary disruption of their economies in the future. Two regional measures in particular need mentioning.

The first of these developments was the Chiang Mai currency swap arrangements. These arrangements facilitate drawing upon another’s foreign exchange resources in the event of a foreign exchange crisis, and were put in place in 2000; subsequently the size of the potential facility was expanded.60  The creation of these swap arrangements for a good part also expressed the view that the IMF could not be reliably counted upon to either correctly diagnose the problem or to provide really useful and timely relief. The Asian crisis had shown that damage would be done by the time IMF came around to help, and because the IMF might diagnose the developments differently (“crony capitalism” rather than speculation) such help would likely be accompanied with conditions that might worsen the prospects of output and income growth for some time, apart from imposing unnecessary humiliation on the nation.

One important feature of these Chiang Mai arrangements was that agreement had been reached without any protracted negotiations, or without numerous well publicised ministerials, etc., as is generally the case.

The second development of note was the build up of reserves by the East Asian economies, almost in concert; this arguably is again work to develop self-help capability, being the only kind of help one can count on, in case of a financial crisis. Thus, in the event of need, these economies would not go hat in hand to the IMF for assistance, and be obligated to follow policies, counterproductive in the East Asian reading, that are a condition of any IMF support.

Wittingly or otherwise, in instituting these policies of regional currency swaps and large reserves, the East Asians have reduced much the applicability and relevance of the international monetary system centered on the IMF to East Asian economies! The East Asians have effectively put in place a substitute informal regional monetary system of their own for some limited purposes. This though was not the intent of the IMF efforts in 1998, and the IMF, it seems, had misjudged both the seriousness of the mood and the effectiveness of capabilities with regard to the East Asians. IMF thus overplayed its hand this one time too often, and now finds itself without its traditional role in East Asia! This view of developments is lent some credence by the discussion amongst East Asian central bankers.61

The East Asian response to the current crisis

Thus with the deterrent of large reserves and the regional swap arrangements in place, the financial crisis of 2007-2009 passed Asia by,62 except for the worrying thought that their reserves were for a large part composed of dollar related securities, albeit chiefly government debt; and that it was the United States and hence the dollar that was in the eye of the storm. In this environment the East Asians voiced two related concerns, albeit in a moderate tone. The first concern was security and safety of dollar denominated assets.63 The second concern was the need for stable international monetary arrangements that would be independent of the vicissitudes of political and economic cycles such as may characterise any world currency that is primarily a national currency. Such an approach would also provide a neutral means to help equilibrate any global imbalances. In itself the issue was not a novel one, having been brought to prominence as noted earlier, by Robert Triffin in the 1960s. This issue resurfaced publicly in the East Asian context in 2009.64

A reflective piece by Zhou Xiaochuan appeared in China Daily.65

The argument was broadly as follows. The existing system of using the dollar, a national currency, presents problems; even though the “crisis may not necessarily be an intended result of the issuing authorities, it is an inevitable outcome of the institutional flaws” noted the article, and went on to make the point that, in any event the “acceptance of credit- based national currencies as major international reserve currencies, as is the case in the current system, is a rare special case in history”.66

The problem with the use of a national currency is the existence of the well known “Triffin Dilemma67, i.e., the issuing countries of reserve currencies cannot maintain the value of the reserve currencies while providing liquidity to the world”. Therefore the issuing country “may either fail to adequately meet the demand of a growing global economy for liquidity as ..(it tries).. to ease inflation pressures at home, or create excess liquidity in the global markets by overly stimulating domestic demand.” And the “frequency and increasing intensity of financial crises following the collapse of the Bretton Woods system suggests the costs of such a system to the world may have exceeded its benefits”. What was being said was that in the East Asian perception it was the inadequacy of the existing international monetary arrangements centred on the dollar that were leading to creation of excess liquidity and hence contributing to the occurrence of financial crises; the excessive quantities of dollars in the world economy were causing problems. The Zhou Xiaochuan article pointed out that the need is for a “super-sovereign” international reserve currency that “not only eliminates the inherent risks of credit- based sovereign currency, but also makes it possible to manage global liquidity”. Such a reserve currency “managed by a global institution could be used to both create and control the global liquidity”. Arguably, a world monetary authority is being proposed, and this authority and the global currency it issues would naturally impose a discipline on national currencies. And when a country’s currency is no longer used as the yardstick for global trade and as the benchmark for other currencies, the exchange rate policy of the country would be far more effective in adjusting economic imbalances. This will “significantly reduce the risks of a future crisis and enhance crisis management capability.” The East Asians seemed to be recalling Rueff’s concerns as well as the Triffin plans of 1960s!

The proposal by Zhou Xiaochuan goes on to advocate short run and long run measures to address the reserve currency question. “In the short run, the international community, particularly the IMF, should at least recognize and face up to the risks resulting from the existing system, conduct regular monitoring and assessment and issue timely early warnings.” In the present circumstances, one can surmise that in the article it is the United States economy that the IMF is being asked to monitor and issue early warnings about, and that the suggestion is that IMF should proceed to do so immediately.68 The proposal then says that “special consideration should be given to giving the SDR a greater role” and for this purpose SDR allocations be increased. And such measures could also “lay a foundation for increasing SDR allocation to gradually replace existing reserve currencies with the SDR”.

In the long run, the proposal suggests, the best course would be to create an international reserve currency. The example of Keynes’s Bancor is recalled.69 The proposal recognizes that any scheme that aims to create “an international currency unit, based on the Keynes’s ideas, is a bold initiative that requires extraordinary political vision and courage”. Then there is the three-fold criteria to be met by any international reserve currency and this is laid out in the proposal: the international reserve currency should firstly be anchored to a stable benchmark and issued according to a clear set of rules in order to ensure orderly supply; second, its supply should be flexible enough to allow timely adjustment according to the changing demand; third, such adjustments should be disconnected from economic conditions and sovereign interests of any single country. There is also mention of using SDR in the long run, but one may infer that the character of the SDR would change significantly if it were to resemble Keynes’s Bancor, and meet the three-fold criteria. This aspect of matter is not spelt out in any detail in the proposal.

Whether the East Asians were seeking support for a change in the existing international monetary arrangements, or just seriously airing an idea, this scheme for an international reserve currency has found some support outside Asia as well; in particular Brazil as well as Russia have responded positively.70  The United States response was initially to consider the proposal, but no sooner had Secretary Geithner uttered these words that the markets saw the dollar plummeting, and plummeting very, very fast. Within fifteen minutes of the announcement, no more, Geithner “corrected” the “misunderstanding” created by his remarks.71

Governor Bernanke followed up to further set the record straight, and then President Obama himself spoke to remove any remaining doubts about the dollar’s future. The Chinese officials too confirmed that the intent was not to undermine the dollar. And, finally, Richard Cooper, the Keynesian éminence grise of international monetary affairs, wrote up a brief to say that dollar would continue in its present role for years.72

Thus calm has returned for now.

Aspects of this East Asian currency proposal have been explored by Fred Bergsten.73    Bergsten suggests the creation of an open-ended SDR-denominated fund at the IMF into which dollar balances could be exchanged for SDRs, instead of converting unwanted dollars through the market.74   There is also awareness now in the United States for “a large increase in China’s voting rights at the IMF, where Europe to develop the informal ‘G2’ partnership… needed to provide global economic leadership”.75  Whilst American scholarship on China is no doubt first rate, and those at the Peterson Institute are behind none, yet the Bergsten proposal seems to interpret China as a different kind of United States, and, for this reason, seems to be off the mark. For the foreseeable future at least, the East Asians are seeking nothing more than measures to defend their economies from the uncertainties of the world economy; to this end they feel the discipline of an international currency should be created and applied. And they feel that they have the capability to live and work within the discipline of an international currency. The East Asians certainly do not appear to be seeking to run the world or pursue global agendas.76 Furthermore, the Bergsten idea of using SDRs and a SDR based fund fall short of the three-fold criteria specified in the East Asian proposal: the dollar/sterling combination on which the SDR is inter alia based does not perhaps amount to being “anchored to a stable benchmark”, and it also does not offer a unit that is “disconnected from economic conditions and sovereign interests of any single country”.

Whilst the East Asian idea of an international currency germinates, at an immediate policy level three recent measures taken in East Asia seem to be aimed at reducing the recourse to dollar as an international currency.

The first development is the East Asian effort to use currencies other than the dollar in international transactions. China, the largest trader in East Asia, is reportedly discussing a number of agreements to conduct bilateral trade in the currencies of the countries involved,77 and, once in place, such arrangements may help to insulate some of the trade flows from the effects of fluctuations in the value of the dollar.

Secondly, China has also authorized some of its corporations to conduct their trade in Renminbi. The latter measure is said to aim at providing stability for local exporters buffeted by the dollar’s fluctuating value.78

It needs mentioning here that the significance of using a particular currency in actual trade has to be seen in context of China’s large external trade and the importance of China’s trade in the East Asia region. There are two aspects to this. First is the remarkable fact that even in the absence of formally binding agreements, the intraregional trade for the five economies of Northeast Asia (China, Japan, two Koreas, and Taiwan Province) now accounts for 52 percent of the total trade of these economies. This integration has been achieved in a natural fashion, without formal agreements a la the EU to force integration and harmonization. By comparison, the EU intra-trade is 60 percent of the total EU trade, and it took the EU countries protracted negotiations leading to formal agreements, besides a period of over fifty years, to get to this 60 per cent statistic. The intra-trade volume is both large and seems to be growing in an organic manner. Second, in this intraregional trade, China is a net importer from most of the trading partners in the East Asian region, and regional exports to China have expanded at record rates over the past 20 years. In this manner China’s situation with regard to bilateral trade balances in East Asia may be somewhat akin to that of Germany in EU.

The third development, that may be read as lessening the importance of the dollar, is the use to which official reserves are being put. China appears to be articulating a position that has been fairly common historically, i.e., substituting real assets for financial assets through the export of capital as direct foreign investment. Premier Wen Jia- Bao is reported to have said recently that China should hasten the implementation of its ‘going out’ strategy and combine the utilisation of foreign exchange reserves with the ‘going out’ of its enterprises.79 ‘Going out’ refers to China’s direct foreign investment policy, and includes efforts of the larger state-owned industrial groups such as Petro China, Chinalco, and China Telecom. This policy appears to aim at “reserve diversification in a broader sense”.80  In this manner more of overseas long-term corporate real assets substitute for dollar foreign exchange reserves. To a considerably lesser extent India and other Asian surplus countries too seem to be pursuing similar policies.

It is a reasonable and prudent inference that the East Asians take this crisis at least as seriously as the Asian crisis of 1998, and wish to develop capacity to meet any recurrence of another event such as the 2007-2008 crisis. And given that the response in the case of the Asian crisis of 1998 was to solve the problem, there is every reason to believe that international reserve currency issue would be pursued further to some logical and practical conclusions. Given the determination and persistence, which have been evident characteristics of the East Asians thus far, some solution that meets the regional East Asian requirements would be found, even though it may be short of the Bancor concept and its usefulness may largely lie in East Asia.81 If the lesson that East Asia drew from the Asian crisis was to build up reserves and put in place currency swap arrangements, then the lesson it is drawing from the present crisis is to gradually lower its exposure in terms of the dollar.82

This may also be interpreted as a pragmatic and evolutionary approach to further lessening the region’s dependence on the international monetary system centred on the IMF.

The fact that the Asian economies faced the present crisis fairly confidently may partly, if not wholly, be owed to the credibility that the  reserves  and  swap  arrangements  offered.  Taken  together,  the recent moves in East Asia, from which the United States as well as the EU appear to be absent, aim to reduce the role of traditional reserve currencies, for China as well as its trading partners, and lend something of a new significance to the Renminbi in the region. These arrangements also further reduce the potential need for recourse to the IMF and its facilities, should there be another crisis. Change is afoot, even though the shape of things to come is far from clear.


1     S M Naseem first raised the idea of writing on the theme of the financial crisis and reviewed draft versions, making pertinent comments on each occasion on how it might be improved. Apart from making relevant and useful suggestions to sharpen the text and improve the content, Wei Liang also very generously undertook the painstaking task of reviewing some of the citations. Stephen Browne, Khalil Hamdani, Gary Hufbauer, Nasir Khilji, Taimur Khilji, Changlin Ma, Hafiz Pasha, Eric Rahim and Yang Guotao, all provided helpful suggestions on the draft version. The author is deeply indebted to all of the above, but remains solely responsible for the opinions and views expressed.

2              Andre Malraux, account of a conversation with Mao Zedong in Beijing, in Antimemoires, Paris 1967, translated by Terence Kilmartin, (London, Hamish Hamilton, 1968), p. 395.

3              Bank for International Settlements, 79th Annual Report, Basel 29 June 2009, p. 3.

4              Bank for International Settlements, 79th Annual Report, Basel 29 June 2009, p. 15.

5              And, Professor Garicano is reported to have replied that “at every stage, someone was relying on somebody else and everyone thought they were doing the right thing.” See Alan Beattie, Good question, Ma’am Financial Times, November 14 2008.

6              Alan Greenspan writes “Markets have become too huge, complex, and fast moving to be subject to twentieth century regulation. No wonder this globalized financial behemoth stretches beyond the full comprehension of even the most sophisticated market participants…Only belatedly did I, and I suspect many of my colleagues, come to realize that the power to regulate administratively was fading…Since markets have become too complex for effective human intervention, the most promising anticrisis policies are those that maintain maximum market flexibility – freedom of action for key participants.” See Alan Greenspan, The age of turbulence (New York, Penguin, 2007), p. 489.

Curiously, the belief about the incomprehensible complexity of the financial system is shared by others in authority, even though the social usefulness of such complexity is not subjected to any searching or critical examination. Thus we have the Bank for International Settlements annual report saying the following: “ The modern financial system is immensely complex – possibly too complex for any one person to really understand it. Interconnections create systemic risks that are extraordinarily difficult to figure out.” See Bank for International Settlements, 79th  Annual Report, Basel 29 June 2009, p. 4.

7              See Martin Wolf, Unfettered finance is fast reshaping the global economy, and Risks and rewards of today’s unshackled finance, Financial Times, June 18 and 27, 2007, respectively.

8              Tables summarizing the chronology may be seen in Bank for International Settlements, 79th  Annual Report, Basel 29 June 2009, and 78th  Annual Report, Basel 30 June 2008, pages 15 and 18-19, and 95-96 respectively.

9              Joe Becker, Sheryl Gay Stolberg and Stephen Labaton, The reckoning: White House philosophy stoked mortgage bonfire, The New York Times, December 20, 2008. This news report carries a telling photograph of President George W Bush looking pleased as he speaks with a banner behind him carrying the evocative text “A Home of Your Own”.

10   Niall Ferguson notes that the last run on a bank in Britain was in 1866. See Niall Ferguson, The ascent of money, (New York, Penguin, 2008), p. 336.

11   The building still stands in good shape.

12 One wit on a television newscast saw it as “Chinese socialism with American characteristics”.

13   The “permitted” collapse of Lehman Brothers presents something of a “mystery”. No other institution of this size was allowed to collapse, even though some of these institutions such as AIG may have been in even worse shape. One view is that Mr Fuld of Lehman Brothers “did not help matters by riling Hank Paulson, the former boss of Goldman Sachs turned treasury secretary, at a private dinner in early 2008” (see Lehman Brothers and the crisis: A year on, in The Economist, September 10, 2009). Another view, attributed to Kenneth Rogoff is that “the standard playbook is to let the fourth or fifth largest bank go under and you save everybody else”, without offering any credible reasoning for a such a “playbook” rule, or, indeed, why Lehman Brothers was chosen (see Economic focus: What if??, in The Economist, September 10, 2009).

14   As cited in Andrew Gamble, The spectre at the feast, (Basingstoke, Palgrave, 2009), p.33.

15   With the benefit of hindsight, regulation, or rather inappropriate regulation, did not work in public interest.

Firstly, the Glass Steagall Act was repealed in 1999 to permit deposit-taking institutions to conduct investment business. This brought the banks in a big way into this – CDO package, slice and dice, CDS, spread the risk – business, without an appropriate regulating framework. Whilst this state of affairs is often referred to as “too complex”, etc., for the human mind, no credible reasoning is forthcoming as to why this complexity was permitted to build up by the regulator, or as to its social usefulness.

Secondly, leverage built up very fast. One reason was that the regulator accepted the transfer of the risk that attaches to a loan (via CDS) and the consequent idea that such transfer meant that the bank could “re-use” the capital earlier tied up with the loan; the regulator also accepted that some of these activities (which, to remind, involved funds held in public trust by the banks) could be carried on outside the reporting framework, i.e., off balance sheet. This led directly to the high leverage ratios for the banks, and the missing piece here is the need for clarity on the prudent capital ratio for the bank and the need to bring “off balance sheet” activity on to the balance sheet. There is nothing here that can really be labeled as too difficult or complex to be understood.

Thirdly, conflict of interest situations were “over-looked”: the remuneration of the mortgage broker who helped arrange the loan was directly dependent on the volume of lending furthered by that broker, and that a good quantum of loans was being made to persons without income or jobs or assets was glossed over (one cannot conceive of any “complex mathematics too difficult to understand” that would make such loans safe

– in such cases at least it is more likely that the “complex mathematics too difficult to understand” may have only helped conceal the poor nature of lending); and, the credit rating agency was paid by the party whose risk was being assessed, hence raising an obvious conflict of interest.

Fourth, there are factors that engender herd behaviour. The ratings industry is dominated by a couple of firms. Their assessments, i.e., ratings, are highly correlated, causing investors and speculators to act in unison, and thus generate a procyclical movement causing euphoria or pessimism as the case may be. Another aspect that creates herd movement is that the models used by different financial institutions to assess risks and to guide buy and sell decisions, tend to be homogeneous, giving broadly similar results. This is probably owed to the fact that modeling work is generally outsourced and there are only a few firms that provide this service: if a firm is modeling for half a dozen banks, the models it produces would likely give similar directional results in a given situation. This factor thus leads to a number of different institutions buying the same asset at a given time (and vice versa), quite unlike the concept of a market, which has optimists and pessimists in relation to any given situation. (See Zhou Xiaochuan, Changing pro- cyclicality for financial and economic stability, People’s Bank of China website:  http://

Fifth, and most importantly, the Fed believed that asset bubbles were not on its watch. The only development the Fed needed to monitor, as a part of its function, was the price level, more specifically the consumer price index. In the event, the Fed provided a big push to the whole process by following an easy monetary policy for extended periods, boosting the demand for financial and other assets in the process, and hence contributed to the bubble.

16   See Financial economics, Efficiency and beyond, in The Economist, July 16, 2009.

Robert Lucas in a subsequent article in The Economist offered a more nuanced definition of EMH:

“One thing we are not going to have, now or ever, is a set of models that forecasts sudden falls in the value of financial assets, like the declines that followed the failure of Lehman Brothers in September. This is nothing new. It has been known for more than 40 years and is one of the main implications of Eugene Fama’s “efficient-market hypothesis” (EMH), which states that the price of a financial asset reflects all relevant, generally available information. If an economist had a formula that could reliably forecast crises a week in advance, say, then that formula would become part of generally available information and prices would fall a week earlier. (The term “efficient” as used here means that individuals use information in their own private interest. It has nothing to do with socially desirable pricing; people often confuse the two.)”

See Economic focus: In defence of economics, guest article by Robert E Lucas, in The

Economist, August 6, 2009.

17   Alan  Greenspan  seems  to  have  shared  this  conviction,  as  did  Ben  Bernanke.  See Alan Greenspan, The age of turbulence, cited above, and Ben Bernanke, The great moderation,        February    20,    2004, SPEECHES/2004/20040220/default.html

18   With prescience, Minsky had noted his reservations about the applicability of EMH-like propositions of neoclassical economics in the following words: The major theorems of the neoclassical synthesis are that a system of decentralized markets, where units are motivated by self-interest, is capable of yielding a coherent result, and in some very special cases, the result can be characterized as efficient. These main conclusions are true, however, only if very strong assumptions are made. They have never been shown to hold for an economy with privately owned capital assets and complex, ever evolving financial institutions and practices. Indeed we live in an economy which is developing through time, whereas the basic theorems on which the conservative critique of intervention rests have been proven only for “models” which abstract from time. See Hyman P Minsky, Inflation, recession and economic policy, (Brighton, Wheatsheaf, 1982), p. xii.

19   This point is discussed at greater length later in the essay.

20   See discussion in Bank for International Settlements, 79th Annual Report, Basel 29 June 2009, as well in earlier issues of the annual report.

21   Alan Greenspan, as one important guardian of public interest, frequently affirmed that Wall St had mastered risk, in contradiction to the assessments by George Soros and Warren Buffett (two persons perhaps forced into thinking with greater clarity because their own funds were on the line). Greenspan’s views seem at best to be unfounded articles of faith combined with goodwill towards Wall St. “Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient”, said Greenspan in 2004, and his book “The age of turbulence” (cited earlier) is replete with expressions of similar sentiments. There were others among the regulators though who were more aware and alert and less caught up with the charms of Wall St bankers. One such reported case is of Brooksley E Born who was heading the Commodity Futures Trading Commission. She testified before Congress that unfettered, opaque trading in derivatives could “threaten our regulated markets or, indeed, our economy without any federal agency knowing about it”, and called for greater disclosure of trades in derivatives and reserves to cushion against losses. These views drew fierce opposition from Alan Greenspan, Robert Rubin (the then Treasury Secretary), and Larry Summers (then Deputy Treasury Secretary). Greenspan is reported to have told Born that she did not know what she was doing and would cause a financial crisis, Rubin saw the move as threatening to the markets, and Summers phoned her to chastise her. The two principals, Greenspan and Rubin, then called on Congress on June 5, 1998, to prevent Born from taking any further action. Congress obliged, and duly froze Born’s authority for six months, and, shortly thereafter, she departed from the Commission. Evidently, Ms Born was not among those who are born to be a Treasury Secretary or even a Treasury Secretary’s adviser. She did however get the JFK Profiles in Courage award in 2009. See Peter S Goodman, Taking a hard look at a Greenspan legacy, The New York Times, October 8, 2008. Also see http://www.


22   An extreme ratio of 134:1 was reported for Bank of America in a talk in London by Niall Ferguson on November 8 2008; the video link is: vision-videos/niall-ferguson. Also, Philip Augar gives the following data in this respect: Goldman Sachs 24:1, Morgan Stanley 25:1, Lehman Brothers 32:1, Bear Stearns 33:1. See Philip Augur, Chasing Alpha, (London, Bodley Head, 2009), p. 169.

23   For a fully reasoned statement of how a financial crisis develops, see Hyman P Minsky, The financial-instability hypothesis: capitalist processes and the behavior of the economy, in Charles P Kindleberger and Jean-Pierre Laffargue, editors, Financial crises: Theory, history and policy, Cambridge, Cambridge University Press, 1982, pp. 13-47. This volume puts together the proceedings of a conference. The three well known and distinguished discussants of Minsky’s paper at this conference rejected his hypothesis. The first, J S Fleming, stated that he was “rejecting claims implicit in Minsky’s exposition”. The second, Raymond W Goldsmith, did not believe that Minsky’s hypothesis “provides an explanation of the financial development of a modern economy”. The third, Jacques Melitz, said that some of Minsky’s arguments “evade me completely”, and then went on to express his disagreement with bits that did not evade him completely.

Also see Hyman P Minsky, Inflation, recession and economic policy, Wheatsheaf, Brighton, 1982, and Stabilizing an unstable economy, McGraw Hill, New York, 2008.

24   In relation to the current crisis, the bonuses of those who worked in the financial sector and the banking industry were tied to profits. There was a clear incentive to show as high a profit as possible and as soon as possible as this work force tends to be footloose. In some cases this quest for high and quick profits also led to playing with the accounting definitions and rules as well as taking on risks that ordinarily would not be seen as prudent. Giving the labyrinthine nature of the transactions, it is not uncommon for the higher management to be unaware of all the operations in the field.

25   See discussion in Bank for International Settlements, 79th Annual Report, Basel 29 June 2009

26   For example, Robert Solow has written that “By 2005 the country had clearly built many more houses, maybe two or three million more, than it could afford to occupy and finance”, and that “this housing boom was enhanced by riskier and more opaque financial products that entangled a wider variety of highly leveraged financial institutions. The word “bubble” is often misused; but there was a housing bubble. Rising house prices induced many people to buy houses simply because they expected prices to rise; those purchases drove prices still higher, and confirmed the expectation. Prices rose because they had been rising.” See Robert M Solow, How to understand the disaster, New York Review of Books, May 14, 2009.

27   See Alan Greenspan, The age of turbulence, cited earlier, and Ben Bernanke, The great moderation, also cited earlier.

28   In the present crisis the Bernard Madoff case offers a good example of the Ponzi financier on a grand scale. See for example discussion in Diana B Henriques, Madoff is sentenced to 150 years for Ponzi scheme, New York Times, June 29, 2009.

29   This would be true of the major banks in the present episode. They had borrowed to the hilt. See leverage ratios cited in footnote 22 above.

30   See discussion in Bank for International Settlements, 79th Annual Report, Basel 29 June 2009

31   This point has been discussed in a number of articles. Jeff Madrick writing in the New York Review of Books says: “One problem was that the Fed did not have adequate information about these markets because derivatives were not traded openly and the latest CDOs, including mortgage-backed obligations, were mostly on the books of the shadow banking system. It was a serious lapse of judgment, not to mention responsibility, on the part of the Federal Reserve under Greenspan and the Securities and Exchange Commission under Christopher Cox to fail to seek more comprehensive information far earlier about the surge of lending.” See Jeff Madrick, How we were ruined and what we can do, New York Review of Books, February 12, 2009. A more detailed discussion of the relevance of public facts for functioning of financial markets may be seen in Donald MacKenzie, End-of-the-World Trade, London Review of Books, May 8, 2008.

32  SPV and SIV are widely used acronyms for Special Purpose Vehicle and Structured Investment Vehicle. These were names given to entities set up by the banks outside the ambit of their balance sheets to transform loans and other receivables into CDOs. The Bank for International Settlements notes as follows: “Beyond the problems with incentives and risk measurement was the fact that financial institutions found it relatively easy to move activities outside the regulatory perimeter. Inside the supervisors’ sphere of influence, banks are required to hold capital in order to engage in risky activities. While it may be hard to believe, the regulatory capital requirement did limit the build-up of leverage on bank balance sheets. However lower leverage meant lower profitability, so bank managers found ways to increase risk without increasing the capital they were required to hold. That is the story of the structured investment vehicle.” See Bank for International Settlements, 79th Annual Report, Basel 29 June 2009, p.10.

33   A striking perspective on the change of rule is offered by Benjamin M Friedman who notes that “the Financial Accounting Standards Board—the independent organization designated by the SEC to set accounting standards—acting at the strong urging of Congress, recently changed its rules to allow banks more latitude to claim that assets on their balance sheets are worth more than what anyone is willing to pay for them. (Next time you apply for a loan, try mentioning FAS 157-4 and telling your banker that you should be allowed to calculate your net worth with your house priced not at what comparable houses are selling for now but at what you paid for it and what you hope you’ll get for it if you hold on to it for some years. The banker will laugh, even while the bank applies just such standards to its own balance sheet.)” See Benjamin M Friedman, The failure of the economy & the economists, New York Review of Books, May 28, 2009.

34   See, Robert Kaplan, Robert Merton and Scott Richard, Disclose the fair value of complex securities, Financial Times August 17 2009

35   See discussion in Bank for International Settlements, 79th Annual Report, Basel 29 June 2009, p. 8.

36   The finance industry’s share of US wages and salaries is reported to have increased from 3 percent in the early 1950s to 7 percent in the current decade. See Benjamin M Friedman, The failure of the economy & the economists, New York Review of Books, May 28, 2009.

37   Benjamin M Friedman reports that the “share of the ‘finance’ sector in total corporate profits rose from 10 percent on average from the 1950s through the 1980s, to 22 percent in the 1990s, and an astonishing 34 percent in the first half of this decade.” See Benjamin M Friedman, The failure of the economy & the economists, New York Review of Books, May 28, 2009.

38   J M Keynes, Proposals for a currency union, December 15, 1941, in John Maynard Keynes, The collected writings of John Maynard Keynes, volume XXV, Activities 1940-44, Shaping the post-war world, The clearing union, (London, Macmillan, 1980), pp.69 94.

39   Barry Eichengreen, Global imbalances and the lessons of Bretton Woods, (Cambridge, MIT Press, 2007), p. 15.

40   Those with large holdings of dollars today are said to experience a similar fear: any efforts to diversify out of dollars involves selling dollars and may cause a flight from the dollar with the consequent fall in the value of their dollar assets.

41   Robert Triffin wrote: “Our old friend, Sir Roy Harrod, was the first to characterize these moves, many years ago, as institutionalizing the inconvertibility of the reserve currencies through gentlemen’s agreements.” See Robert Triffin, The international monetary system, Yale University, Economic Growth Center, Center paper no 76, 1966, p. 4.

42  Robert Triffin, The paper exchange standard 1971-19??, in Paul A Volcker, et al, International monetary cooperation: Essays in honor of Henry C Wallich, Essays in international finance no 169, Princeton University, December 1987, p. 80.

43   See  Robert  Triffin, The  international  monetary  system, Yale  University,  Economic Growth Center, Center paper no 76, 1966, p.6.

44   Following the French, the British, notwithstanding their gentlemanly characteristics, too sent out a battleship to obtain gold for dollars but Nixon’s announcement came through before the exchange could materialise.

45   Some see this statement of the problem as quite valid in our time. See William Buiter, Our currency and our problem, November 17, 2007 at our-currency-anhtml

46   Unlike the time when Connolly had firmly stated that the dollar was America’s currency but the rest of the world’s problem, the large dollar balances currently outside the United States are sometimes seen as conferring power on those who hold these balances. It is also recognised that the holders cannot exercise their power without inflicting damage to their own positions. In this context, Larry Summers introduced a new phrase and spoke of the “balance of financial terror” as between the United States and those who have the large dollar balances. See Lawrence H Summers, The US current account deficit and the global economy, Per Jacobsson lecture 2004, (Washington DC, Per Jacobsson Foundation, 2004). But concerns, which visualise East Asian governments as a kind of currency speculator, are, as anyone observing these matters would judge, far from the truth. Such scenarios are closer to plots of those odd Hollywood movies such as might centre on evil foreigners with bent minds who are keen on damaging good honest America. The inexplicable fact is that persons in authority sometimes do indulge in propagating a “Hollywood scenario” of the evil other.

United States for example – it pays the creditor country dollars, which end up with its central bank. But the dollars are of no use in Bonn, or in Tokyo, or in Paris. The very same day they are re-lent to the New York money market, so that they may return to their place of origin. Thus the debtor country does not lose what the creditor country has gained. So the key-currency country never feels the effect of a deficit in its balance of payments. And the main consequence is that there is no reason whatever for the deficit to disappear, because it does not appear.

“Let me be more positive: if I had an agreement with my tailor that whatever money I pay him he returns to me the very same day as a loan, I would have no objection at all to ordering more suits from him.”

Jacques Rueff quoted in Fred Hirsh’s interview of Jacques Rueff in The Economist, February 13, 1965, cited in Filippo Cesarano, Monetary theory and Bretton Woods, The construction of an international monetary order, (Cambridge, Cambridge University Press, 2006), pp. 191-192. The text of the whole interview, also issued as a Princeton essay in international finance (Jacques Rueff and Fred Hirsch, The Role and the Rule of Gold: An Argument, Essays in International Finance 47, Princeton University, International Finance Section 1965) may be seen at php?t=7281

48   “And they (the United States) have had for five years an enormous deficit in their balance of payments. If they have not done by credit policy what the gold standard would have done by automatically restricting purchasing power, it is proof that it is not possible. And why is it not possible? I cannot imagine any parliamentary country with a democratic regime in which you could do such a difficult thing.” Jacques Rueff cited in Fred Hirsh’s interview of Jacques Rueff in The Economist, February 13, 1965.

49   Paul R Krugman, Currencies and crises, (Cambridge, MIT Press, 1992), pp. 179-183.

50   Barry Eichengreen, Global imbalances and the lessons of Bretton Woods, (Cambridge, MIT Press, 2007), pp. 123-148.

51   It is revealing that the discussion about the limited usefulness of the “efficient market hypothesis” has reached newspapers, and that most of this discussion reflects negatively on the economics that is taught and on the common sense of those who choose to believe in the doctrine. See for example discussion in the Financial Times economistsforum/ and the newspaper articles cited there. See also the extensive discussion in The Economist, July 16, 2009.

52   Also see Dick K Nanto, The global financial crisis: Lessons from the Japan’s lost decade of 1990s, CRS report for Congress, Washington DC, May 2009.

53   Barry Eichengreen and Kevin H O’Rourke, A tale of two depressions, June 4, 2009, at

54   One point of note is that in the great depression trajectory, for both the world industrial output and trade volume indicators, shows momentary upward ticks in what was a essentially a downward movement. The question whether these upward ticks qualified as “green shoots” at the time does arise, and the answer we believe is that they did.

55   See for example discussion in Gary Hufbauer, Trade policy in a time of crisis: Suggestions for the developing countries, lecture at the Geneva Institute of Graduate Studies, Geneva, July 9, 2009, and Jeffrey J Schott, Trade and the global economic crisis: If it’s not part of the solution, it’s part of the problem, Remarks presented at the APEC symposium, “Addressing the economic crisis, preparing for recovery,” Singapore, July 17, 2009. debt, private expenditure would not recover until the private debt comes down to more manageable levels. And, public expenditure, Koo argues, must therefore continue to substitute for any “shortfall” in private expenditure until the latter recovers. A policy based on these ideas would naturally imply fiscal deficits for some time to come. The obvious question then would be whether the economies suffering the downturn would have the fiscal space. See Richard C Koo, The holy grail of macroeconomics, Lessons from Japan’s great recession, (Singapore, Wiley, 2009), especially pp. 253-293.

57   To take some recent examples, Rubin and Paulson have worked in the major banks as well as the government. Tony Blair has been affiliated with one of the banks since the end of his tenure in the government.

58   Japan is reported to present a case where a large volume of savings had been invested in “toxic” CDOs and CDSs. See Anton Brender and Florence Pisani, La crise de la finance globalisee, Editions La Decouverte, Paris 2009 (translation by Francis Wells distributed as Anton Brender and Florence Pisani, Globalised finance and its collapse, Brussels, Dexia, 2009)

59   The term East Asia is used here in a broad sense to connote China, the Asean economies, Taiwan province, Hong Kong SAR, Japan and Republic of Korea.

60   As at the end of April 2009, these arrangements provided access to US $ 92 billion in total. See

61   At the 50th  Anniversary ceremony of Bank Negara Malaysia, Kuala Lumpur, February 10, 2009, People’s Bank of China Governor Zhou Xiaochuan’s remarks included the following:

We notice that the drastic increase of imbalance of savings and trade started after 1997. It is therefore worthwhile looking at the impact of the Asian financial crisis on the savings behavior of these countries.

Asian countries were seriously shocked and alarmed by the Asian financial crisis. The attack of speculative capital led to plunging exchange rates and capital flight and nearly exhausted all foreign reserves, leaving a great sense of vigilance for East Asian countries in macroeconomic management. In the years that followed, countries in the region boosted exports, amassed trade surplus and accumulated large foreign reserves. It is fair to say that the high savings ratio and massive accumulation of foreign reserve in recent years in East Asian countries reflect the lessons learnt from, and the natural reaction to the Asian financial crisis.

The large savings and foreign reserves of these countries are also the result of defensive reactions against predatory speculation. At the time, large capital inflows and the ensuing sudden stop and reversal as well as the rampant speculations of the hedge funds exacerbated the situation. People were shocked and frustrated by these speculative behaviors. At the onset of the crisis, Malaysia saw a weakening export, plummeting stock market and sharply depreciating currency. Despite criticism from some countries and international institutions, the Malaysian government imposed temporary capital restrictions and safeguarded currency stability. In Hong Kong SAR, which was also attacked by hedge funds, stock prices plunged, and its linked exchange rate regime was severely tested.

The belief prevailed in the region that unregulated predatory speculation was an important factor behind the crisis, and it highlighted tremendous potential risks to the international financial system. It was hoped that the international community would bring it under necessary regulation. However, for some reason, the authorities of the countries the need to adjust the regulatory frameworks. At the same time, international financial institutions failed to perform its regulatory responsibility over abnormal capital flows. East Asian countries are thus forced to amass foreign reserves to defend themselves.

To some extent, the increase of savings ratio and current account surplus in East Asian countries are a result of the rescue plan of the international financial institutions. The rescue  plan  kept  silent  on  international  speculative  capital  flows, which  otherwise should have been put under scrutiny. Instead, excessive and stringent conditionalities were imposed, demanding that the crisis countries adopt stringent fiscal and monetary policies, raise interest rates, cut fiscal deficits and increase foreign reserves. In the decade thereafter, East Asian countries have learnt the lessons, increased savings and foreign reserves and successfully enhanced their resilience to financial crisis. SeePeople’sBankofChinawebsite: The view is widely shared across East Asia; for example, Governor Dr Zeti Akhtar Aziz  expressed  broadly  similar  sentiments  in  his  keynote  address  at  the  same ceremony.  See  the  Bank  Nagara  Malaysia  website: php?ch=9&pg=15&ac=310

62   The concerns about exports and toxic assets have been discussed earlier. The financial sectors of the East Asian economies have not suffered and these economies seem to be maintaining growth. See David Pilling, Asia banks for a world turned upside down, Financial Times, September 16 2009, and Martin Wolf, Wheel of fortune turns as China outdoes west, Financial Times, September 13 2009.

63   Premier Wen Jiabao is reported to have said: “We have lent a huge amount of money to the United States and of course we’re concerned about the security of our assets and, to be honest, I am a little bit worried, … That’s why … I would like to urge the US to keep its commitment and promise to ensure the safety of Chinese assets.” See Olivia Chung, Wen puts US honor on the debt line, March 14, 2009, Asia Times Online. Also see Michael Wines, China’s Leader Says He Is ‘Worried’ Over U.S. Treasuries, New York Times, March 14, 2009.

64   Discussion of a reserve currency is an ongoing matter. This is the first time though that central bankers publicly discussed the matter since the 1970s.

65   Zhou Xiaochuan, Reform the International Monetary System, China Daily, March 23,

2009. Also see:

66  The article by Zhou Xiaochuan brought to mind the more summary assessment by General Charles de Gaulle in his press conference of February 4, 1965. “We consider that international exchanges must be established, as was the case before the great worldwide disasters, on an unquestionable monetary basis which does not bear the mark of any individual country.”

67   Robert Triffin wrote extensively on these issues, from 1950s to 1970s, and first formulated the specific issue, just as the Bretton Woods system was coming apart because of an excess of dollars. Triffin identified the problem for the US Congress in 1960 but it took another 10 years before the system came apart.

68   There has been some development in context of monitoring economies by the IMF since Zhou Xiaochuan’s article appeared. At the recent G 20 meeting in Pittsburgh “The leaders pledged to rethink their economic policies in a coordinated effort to reduce the immense imbalances between export-dominated countries like China and Japan and debt-laden countries like the United States, which has long been the world’s most willing consumer. and address its huge budget deficit. Countries like China, Japan and Germany will be expected to reduce their dependence on exports by promoting more consumer spending and investment at home.

“The ideas are not new, and there is no enforcement mechanism to penalize countries if they stick to their old habits. But for the first time ever, each country agreed to submit its policies to a “peer review” from the other governments as well as to monitoring by the International Monetary Fund.

“That in itself would be a big change, given how prickly national leaders have often been toward outside criticism of their policies.” See Edmund S Andrews, Group of 20 Agrees on Far-Reaching Economic Plan, New York Times, September 26, 2009

The Economist though noted that the “Developing countries are uneasy about formalising such a realignment. They are publicly supportive, but that may only be because they suspect it will be impossible to police.” See The G20 summit, Regaining their balance,, September 26th 2009.

69  Back in the 1940s, Keynes had already proposed the introduction of an international currency unit named “Bancor”, based on the value of 30 representative commodities. Unfortunately, the proposal was not accepted. The collapse of the Bretton Woods system, which was based on the White approach, indicates that the Keynesian approach may have been more farsighted.

70   Andrei Denisov, Russia’s first deputy foreign minister, said: “This proposal is aimed at a practical realisation of the idea about a new global accounting unit or a new global currency. It is a question that should be discussed to create a consensus.” See Julia Kollewe, Global currency flies with push from Russia and slip from Geithner, the Guardian, March 26, 2009.

71   See Anahad O’Connor, Geithner Affirms Dollar After Remarks Send It Tumbling, The New York Times, March 26, 2009

72   See Richard N Cooper, The future of the dollar, Peterson Institute Policy Brief, September 2009.

73   C. Fred Bergsten, We Should Listen to Beijing’s Currency Idea, Financial Times, April 8, 2009.

74   The SDR, as Bergsten notes, “is denominated in a basket of currencies – 44 per cent dollars, 34 per cent euro and 11 per cent each of yen and sterling”, and this would not appear to meet the criteria laid down in the Zhou Xiaochuan article (see discussion above). Bergsten also notes that this is “essentially the substitution account idea negotiated in the IMF in the late 1970s and for which detailed blueprints were developed. Similar anxieties about the dollar at that time prompted its sharpest plunge in the postwar period, intensifying the double-digit inflation and soaring interest rates that brought on the deepest US slowdown since the 1930s, until now”. See Fred Bergsten, We should listen to Beijing’s currency idea, Financial Times, April 8 2009

75   See Fred Bergsten, We should listen to Beijing’s currency idea, Financial Times, April 8 2009

76   As noted above ‘Wen told a press conference after the conclusion of a two-week meeting of the country’s legislators that he was “a little bit worried” about the safety of Chinese assets in the US, and called on the US “to maintain its good credit, to honor its promises and to guarantee the safety of China’s assets.”’ See Olivia Chung, Wen puts US honor on the debt line, March 14, 2009, Asia Times Online. 2009

78   See Richard McGregor, China to allow Renminbi trade payments, Financial Times, July 2 2009.

79   See Jamil Anderlini, China to deploy foreign reserves, Financial Times, July 21 2009. Also see for a specific example, Justine Lau and Geoff Dyer, CNPC boosts war chest with $30bn loan, Financial Times, September 9, 2009

80   Remarks made by the Chief Economist, HSBC, cited in Jamil Anderlini, China to deploy foreign reserves, Financial Times, July 21 2009.

81   “China is a country with a record of continuous self-government going back 4,000 years, the only society that has achieved this. One must start with the assumption that they must have learnt something about the requirements for survival, and it is not always to be assumed that we know it better than they do. “It is imperative to realise that we cannot do in China in the 21st century what others thought to do in the 19th, prescribe their institutions for them and seek to organise Asia……and though we need not agree with every action taken by Chinese leaders, we cannot simply set ourselves up as their critics.”

Henry Kissinger cited in Stephen Graubard, Lunch with the FT: Henry Kissinger, Financial Times, May 23 2008.

More recently, Kissinger wrote in context of China and the current crisis:

“China has a major interest in a stable — and preferably growing — U.S. economy. But China also has a growing interest in reducing its dependence on American decisions. Since American inflation as well as deflation have become for China nightmares as grave as they are for America, the two countries face the imperative of coordinating their economic policies. As America’s largest creditor, China has a degree of economic leverage unprecedented in the U.S. experience. At the same time, the quest for widening the scope of independent decision exists in ambivalent combination on both sides.

“A number of Chinese moves reflect this tendency. Chinese officials feel freer than they did previously to offer public and private advice to the United States. China has begun to trade with India, Russia and Brazil in their own currencies. The proposal of the governor of China’s central bank to gradually create an alternate reserve currency is another case in point. Many American economists make light of this idea. But it surfaces in so many forums, and China has such a consistent record of pursuing its projects with great patience, that it should be taken seriously. To avoid a gradual drift into adversarial policies, Chinese influence in global economic decision-making needs to be enhanced.” See Henry A Kissinger, Rebalancing relations with China, Washington Post, August 19, 2009.

82   See Peter Garnham, Beijing’s dollar trap, Financial Times, July 30, 2009.