Sujeewa Mudalige Partner - Pricewaterhouse Coopers President - The Institute of Chartered Accountants of Sri Lanka

Learnings from the global financial crisis for Sri Lanka

Almost two years ago, the global economy and financial system entered a severe crisis. The incidence and ramifications of the crisis were obscure. Even now, the full dimensions and consequences are not known, but almost certainly this crisis will prove to be the most severe in the extent and severity of its global impact and depth since the end of World War II.

The first images associated with a financial crisis are often those of balding, middle aged stockbrokers yelling frantically at each other as they helplessly watch their stocks tumble from the exchange floor.

However, such images belie the true impact of a crisis.

Those hardest hit by a financial crisis are inevitably low-skilled factory workers who, having never owned a stock in their life, suddenly find that their economic livelihood has been pulled right out from under them.

Protecting citizens’ economic and social well-being in the face of such a crisis poses an enormous challenge to governments around the world.

However, the events and circumstances surrounding a financial crisis can also lead to a fundamental revaluation, not just of economic theory and the structure of financial regulations, but of the very nature of the relationship between a state and its citizens.

The challenge for policy makers will be to build upon the lessons of past crisis in responding to the present crisis. In so doing, states are also presented with an exciting opportunity to enhance long-run economic growth and international economic co-operation.

The consequences for those who lose their jobs as a result of a financial crisis can be devastating. Yet it has long been recognised that financial crises are an inevitable part of the cycle of booms and busts that characterise the capitalist system.

It is during a recession that inefficient, old technology firms are replaced by newer and more efficient firms, shifting capital and labour to where they are most highly valued, and ultimately creating the preconditions for long-term economic growth.

Causes of the crisis

Conventionally, causes of this financial crisis include some or all of the four following elements:

1. Macroeconomic policies,

2. financial-sector supervision and regulation,

3. Financial engineering and

4. the global activities of large private financial institutions.

It is argued that macroeconomic policies in the United States and the rest of the fully developed world were jointly responsible for the crisis we are now experiencing to a substantial degree.

In the United States, fiscal policy contributed to a decline in the US saving rate and monetary policy was too easy for too long. In Japan the mix of monetary and fiscal policies distorted the global economy and financial system.

Finally, any other countries also had very easy monetary policies in recent years, including other Asian countries, energy and commodity exporters and in effective terms, a number of countries within the euro area.

The impressive accumulation of foreign exchange reserves by many countries also distorted the international adjustment process, including but not limited to taking some of the pressure off of the macroeconomic policies of the United States and other countries.

The result was not just a housing boom in the United States, but also housing booms in many other countries, some to a greater extent than in the United States. However, in addition to housing booms, there was a global credit boom fuelling increases in the prices of equities and other manifestations of financial excess.

Financial-sector supervision and regulation, or the lack thereof, over several decades also played a role. However, without the benign economic and financial conditions that prevailed in the wake of the dot-com boom and the associated belief that “this time it is different,” this crisis would have taken a deferent form.

Benign conditions lead to lax lending standards, just as the night follows the day. In principle, financial-sector supervision could have helped to curb the excesses, but it did not do so in the United States or in many other countries around the world.

Finally, some argue that the lack of comprehensive supervision of about 50 large private financial institutions with operations around the world caused the problems faced by the global economy today.

Thus, it is said that two major causes of the global financial crisis of 2007-09 were failures in macroeconomic policies and in financial supervision and regulation.

It may well be that a crisis of this magnitude was necessary to uncover those flaws.

Whether they would have been revealed without the macroeconomic failures is at least a debatable question.

It is not unusual for a crisis to begin in the financial sector, spread to the real economy, cycle back to further weaken the financial sector and thereby further weaken the real economy. If the proximate cause of the financial crisis was the US housing boom, housing is a feature of the real economy.

Subprime mortgages were a manifestation of financial excess or worse, but they were not the principal cause of the housing boom, which was easy credit and low interest rates. What is real and what is financial? In this case, we really cannot say.

Lessons from the crisis

Based on the lack of consensus about the causes of the crisis, it is suspected that, for the next several decades, scholars and policymakers will be debating the many lessons of this specific crisis and whether the right lessons have been learned. Moreover, the list of possible lessons already has filled hundreds of pages of reports.

Against the background of that reality, I have limited myself to 11 lessons grouped under five headings: too good to be true is probably false; be better prepared; the myth of self-insurance; the role of the IMF; and the future of globalization.

Too good to be true is probably false

If something is too good to be true, it probably is not true or eventually will not be true. This lesson for macroeconomic policies also extends to policies for the financial sectors in many economies. Policymakers and the heads of financial institutions extrapolated the good times far into the future, often without qualification.

Whether or not one agrees with that proposition, one lesson of the crisis is that all good things have to come to an end.

If the times are extraordinarily positive, and they continue for an extended period, there is a high probability that the end will be painful.

The broader lesson of this crisis is that globalization of trade (in both goods and services, such as tourism), finance (in both the availability and cost of credit) and labour (in terms of the direct and indirect demand for labour and the flow of remittances) had tied countries together to a much greater extent than they had been for about a century, since the early 1900s.

This reality was underappreciated. The consequence is that in today’s world any crisis that affects a major country or group of countries in the global economy or financial system will have some, largely adverse, effects on all other countries.

It follows that the citizens and authorities of all countries, large and small, have a common interest in the quality of the economic and financial policies in other countries, in particular in the systematically important countries.

It should be noted that not all countries were equally prepared for the global financial crisis. The policies and circumstances of some countries not only made them vulnerable to contagion, but they also had little or no room to cushion the effects of the slowdown in the global economy, the deleveraging of the global financial system, and the increase in risk aversion.

Thus, for example, a number of countries in Eastern Europe and elsewhere have found it necessary to turn to the IMF for assistance designed to support strong programs of economic policy reform that in most cases would have been needed eventually in the absence of this crisis.

In some cases, these countries probably would have had their own crises without the contribution of the global meltdown.

The clear be-better-prepared lessons from the crisis are two: First, those countries that were better prepared in advance of the crisis have been better able to deal with its effects. Second, going forward, more countries should endeavour to adjust their policies so that they are prepared, or better prepared, to deal with the inevitable global crises of the future, including through the adoption of countercyclical measures.

The myth of self-insurance

Should countries seek to self-insure against future crises by building up their foreign exchange reserves in order to prepare better for future crises? It is argued that, this is the wrong lesson to learn from this global crisis. Countries should self-insure against future crises by putting in place as best as they can robust economic and financial policy frameworks.

One element of that type of self-insurance should be adequate holdings of foreign exchange reserves, but alone that is insufficient.

The role of the IMF

A year ago, the International Monetary Fund was on the sidelines of the global financial crisis. Some observers bemoaned that fact. Other observers saw it as proof of the Fund’s irrelevance in the 21st century.

On IMF financing, the clear lesson from the crisis for members of the Fund is that the IMF has an important, continuing role in providing potential financial to member Governments in precrisis, incipient-crisis, and actual-crisis situations.

The lesson is that in today’s global economy and financial system, financial rises are inevitable. We can hope that efforts to improve the global adjustment process and to implement financial reforms at the national and international level will be successful in limiting the virulence of future financial crises, but that is the most we can expect.

Financial supervision and regulation will remain for the foreseeable future predominantly a national responsibility, but with international consequences as we have seen.

The future of globalization

An underappreciated and dangerous area of lessons from the global financial crisis involves the future of globalization. The lesson is: Don’t turn back on globalization.

The growing integration of the world economy vial trade, financial and other channels guaranteed that any economic and financial crisis on the scale that the United States and other advanced countries have experienced would become global in scope.

If these lessons are not learned, then I fear that the course of globalization could well go into reverse. The risk is that the globalization trend will be replaced with inward-focused regionalism, selfish nationalism and disguised and overt protectionism.

Learning the right lessons from the global financial crisis of 2007-09 is a challenge not only for the leaders of the advanced economies and the larger emerging economies whose policies individually and collectively will determine the evolution of the global economy and financial system over the next several decades.

Learning and applying the right lessons is a challenge for the leaders of smaller emerging and developing economies that will have to live with the consequences.

Their own words should be clear and their policies should be examples for all of us. This is the most difficult lesson.

The economic and social disruption caused by a financial crisis can also lead to a radical reconsideration of the social contrast between a State and its citizens.

Whilst providing for the poor was traditionally seen as a private or local Government obligation, the enormous unemployment created by the Great Depression meant that federal Governments were the only agencies with sufficient power to prevent large segments of their societies from falling into poverty.

This led developed countries around the world to implement groundbreaking public work and social security programs.

In particular, Governments will have to create incentives for workers to move to regions or industries less affected by the downturn. In regions where depressed house prices make moving unviable, Governments should create financial incentives for new industries to move there, in order to provide jobs for local citizens.

Uncertain economic times also make temporary employment contracts more attractive to employers. In Spain, the number of workers on temporary contracts has risen to a third of the workforce. Governments will thus have an enhanced role, not only in supporting the reallocation of workers to newer, more efficient industries, but also in protecting existing workers’ rights. Countries with relatively sound banking systems and regulatory practices, like Australia, suddenly find themselves facing a shortage of credit because of unsustainable lending practices on the other side of the world.

Profitable factories owned by foreign multinationals close down because of disruptions in their home markets, or are forced to search for even cheaper labour elsewhere.

The increased interconnectedness of the global economy means that financial crises pose greater challenges than ever before. Financial crises will disrupt the lives of individuals in industries and nations far removed from the initial disturbances.

Yet to a large extent these disturbances are an inevitable product of the economic adjustment inherent in the capitalist system.

In Keynes’ words, the “animal spirits” of investors will never be wholly consistent with economic stability. Asset prices inflated by reckless speculators will inevitably return to their fundamental values.

However, this process of correction also creates opportunities for new growth, as inefficient, old economy firms are replaced by more efficient, new firms and labour and capital is reallocated to where it is most highly valued.

Financial crises also teach us invaluable lessons about economic management. Despite countries being more economically interconnected than ever before, the present financial crisis is unlikely to be as severe as the Great Depression because we have learnt some crucial policy lessons from it (though forgotten others). Contemporary ideas about the need for Government spending, social safety nets, supporting banks at all costs and free trade are very different from those prevailing in 1929. Moreover, if policy-makers learn their lessons from the present crisis, the way we approach financial regulation will be very different in the future.

Perhaps most importantly, however, financial crises provide us with an opportunity to reflect on the society we want to build.

As Gordon Brown put it: “Sometimes it’s a crisis that forces change.” Whilst the present crisis may prompt fundamental changes to economic regulation and skills development at the national level, an increasingly globalised world means that national solutions are sometimes no longer enough.

By requiring international co-operation on macroeconomic policies, trade and financial regulations, the present financial crisis may more importantly provide an opportunity for States to take the first step towards the consensus required to address far deeper global problems.

Lessons to be learnt:

1 Lesson number one is not a lesson but a reminder

2 Act fast when a company is in distress

3 Good governance is a must

4 The key to risk control is diversification

5 The importance of liquidity

6 When the environment changes, be prepared to change

7 Regulation has to change

8 Auditor scepticism has to improve

9 Rating agencies has to take responsibility for their ratings

10 Media has an important role to play

“The crucial lesson of the present crisis is that policy-makers need to regard financial regulations not as an economic burden on the market, but as an investment in reducing future Government bailout obligations.”