Origins of the crisis

Even as the United States and other developed countries are desperately seeking the right policy measures to contain the financial crisis, there is unanimity that the global economy will not recover until the financial sector recovers.

Even outright nationalisation is being discussed as a means of saving the troubled banks. As much as finding a cure, understanding the origins of the crisis is a precondition for avoiding future mistakes and possibly mitigating the intensity of the present crisis.

According to one influential school of thought represented by among others Nobel laureate Paul Krugman and former U.S. Treasury Secretary Hank Paulson, the financial crisis ought to be traced to "global imbalances," the phenomenon of huge current account surpluses in China and a few other countries coexisting with the unsustainably large deficits in the U.S. Global imbalance, well documented since the middle of this decade, has been caused by the propensity of countries with high saving rate to park their savings, often at low yields, in the U.S.

The flood of money from these countries into the U.S. kept interest rates low, fuelled the credit boom, and inflated real estate and other asset prices to unsustainable levels. The bubble burst eventually, precipitating the financial crisis. A lasting solution to the problems of the world economy therefore lies in unwinding these imbalances in an orderly manner.

The IMF in a recent paper however argues that imbalances have contributed to the crisis only indirectly.

The main culprits were the deficient regulation of financial sector, the failure of market discipline, and the systematic flouting of rules and regulations. Leading banks developed new structures and instruments to cater to investors' demands for higher yields.

These turned out to be more risky than they appeared. Financial sector regulation was flawed, ineffective, and too limited in scope. A very large "shadow banking" system comprising the investment banks, hedge funds, and the like was loosely regulated.

Big banks parked a significant portion of their normal business in these to get around regulatory requirements such as capital adequacy. As these institutions grew enormously in size, they became systemically important: a failure of one of them would inevitably have adverse consequences for the entire system.

Ahead of the forthcoming G-20 meeting, the debate on the causes for the crisis assumes a certain topicality. The IMF has recommended an enormous increase in the scale and scope of financial sector regulation. Shadow financial institutions should be subject to the same prudential norms as commercial banks.

Those who see the roots of the crisis in the global imbalance would rely more on macroeconomic policy to provide solutions.

Policy makers obviously need to come up with a mix of regulatory overhaul and right economic policies to contain the crisis.

(The Hindu Editorial. March 11, 2009)