NIXON CENTER PERSPECTIVES
Volume 3, Number 5
The Global Financial Crisis
by Maurice R. Greenberg
(Mr. Greenberg is Chairman of The Nixon Center and Chairman and CEO of American International Group.)
Foreword
The global financial crisis has clearly become a leading foreign policy priority of the Clinton Administration. Few people are as qualified to evaluate the crisis, its consequences for the United States, and possible solutions as Maurice R. Greenberg. As the Chairman and CEO of American International Group, an insurance and financial services firm that does business in 130 countries, and a former Chairman of the Federal Reserve Bank of New York, Mr. Greenberg has enormous first-hand knowledge of the world economy.
Mr. Greenberg, who is also Chairman of The Nixon Center, originally presented his highly informative and thoughtful remarks during the October 7, 1998 session of the Study Group on America as the Sole Superpower, chaired by Senator John McCain (R-AZ). Organized under the auspices of The Nixon Center, the Study Group is a small, top-level bipartisan panel which includes key members of Congress, former senior officials – among them former Secretaries of State and Defense and four National Security Advisors – business leaders, and prominent academics. Its purpose is to assess U.S. priorities, opportunities, and constraints in the new vastly different post-Cold War environment. Mr. Greenberg’s paper makes an important contribution to this objective.
Dimitri K.
Simes
President
The Risk of Global Recession
The current global financial crisis is among the greatest challenges to the world economy since the end of World War II. Unlike past financial crises, which were confined to particular regions, the current financial contagion is quickly spreading across continents. Unless action is taken in the next few months to shore up faltering countries and restore confidence in the global economy, the world will face a deep and prolonged recession.
G-7 countries, in particular the United States, were slow to realize the scope and seriousness of the crisis, which began in Thailand in the summer of 1997. For example, at the 1997 G-7 summit in Denver, Japan proposed the establishment of a $100 billion Asian fund to help deal with the crisis. The U.S., however, opposed the plan for fear it would undermine the IMF’s more limited rescue program and out of concern over the implications of a Japan-led effort. Only after U.S. stock markets experienced a sharp downturn this past summer did Americans wake up to the crisis. Though economic and political leaders throughout the world now acknowledge the seriousness of the situation, a combination of politically weak governments and lack of consensus has prevented quick and decisive action on the part of the industrialized nations.
The IMF Is Still Critical, But Its Focus Must Change
With the global economy teetering on the brink, now is not the time to abandon existing international institutions in search of new, unproven mechanisms. Aid through the International Monetary Fund remains the best means to stabilize financial markets. However, the approach taken by the IMF to date has failed to turn the tide. Strict conditions imposed by the Fund have forced recipient countries to raise interest rates and lower budget deficits even as they face recession. In many cases, looser fiscal and monetary policies are needed to increase demand and stimulate growth.
The IMF was created in 1945 with a mission to stabilize currencies, not to restructure economies. To fight this present crisis, the IMF must get out of the business of managing entire economies and instead concentrate on reducing exchange rate fluctuations. Conditions for recipient countries should focus more narrowly on banking transparency. Countries in need of IMF loans should be expected to adopt internationally accepted accounting standards, pass adequate bankruptcy legislation, and produce a clear and thorough accounting of foreign debt. In other aspects of fiscal, trade, and monetary policy, however, recipients should be given more latitude to set their own policies to maintain growth.
The United States must continue to contribute its share to the IMF. By withholding funds, the U.S. only reduces its influence and its ability to convince the IMF to change its tactics. Congressional approval of the $18 billion replenishment should encourage other nations to follow suit. The U.S. contribution of $18 billion will thus mobilize $90 billion, a substantial sum the IMF should use solely for currency stabilization. Japan has revised its proposal for an Asia-based stabilization fund, this time pledging $30 billion instead of the original $100 billion. Japan, however, should be encouraged to make this money available to the IMF through the General Agreements to Borrow (GAB) so the IMF will remain the main distributor of funds.
Small Countries Need Relief From Currency Speculation
Smaller countries like Thailand are unable to defend themselves against international currency speculators, many of whom control billions of dollars. Managers of huge hedge funds often sell short simultaneously on a country’s currency and stock markets. When smaller economies are the target of such speculation, these short positions can become self-fulfilling prophecies. China and India have both limited their exposure to the financial turmoil because their currencies are not freely convertible and thus not subject to speculation. While shorting of the dollar or the pound, even by the largest currency speculators, would have little effect on Britain or the U.S., smaller economies have no means to defend themselves.
Unrestricted speculation is working to kill free-market thinking in many developing and newly developed nations. Some countries should be allowed to outlaw certain types of short selling and to place some controls on short-term portfolio investments. There is nothing wrong with imposing penalties on investors who buy in and then pull out of a market on the same day. In this sense, the Hong Kong government’s recent intervention in the stock market is justified. Such measures do not violate free market principles when the aim is to combat certain kinds of speculative trading.
Japan: Both Problem and Solution
The world financial crisis will not improve until Japan, the world’s second largest economy and Asia’s biggest market, returns to the path of economic growth. Though Tokyo’s offers of financial aid to its neighbors are welcome, Japan can only give real help to Asia by boosting its own domestic demand. Japan’s lingering economic malaise has exacerbated currency fluctuations. The yen has gone from ¥80/$ a few years ago to ¥147 this past August. In the week of October 5 alone, the yen suddenly strengthened from ¥134 to ¥117. Such fluctuation by a major world currency has grave consequences. This volatility makes it impossible for businesses to do any meaningful planning and is delaying Asia’s recovery. The problems in the Japanese economy thus jeopardize everyone’s economic security, not just Japan’s.
Perhaps no other industrialized country (with the obvious exception of Russia and some of the emerging markets undergoing major transitions) has suffered from worse political paralysis than Japan. Despite years of stagnant growth, Japan’s leaders have been unable clean up their country’s decrepit banks. On October 3, Bank of Japan Governor Masaru Hayami told Treasury Secretary Robert E. Rubin and Federal Reserve Chairman Alan Greenspan that many of Japan’s banks do not meet the 8% capital reserve standard set by the Bank of International Settlements (BIS). If true, this means that Japanese banks do not have adequate capital reserves to operate internationally.
United States officials should privately, but firmly, insist that the Japanese government guarantee that their banks meet the 8% BIS standard or Japanese banks will no longer be allowed to operate in America. Mr. Hayami’s statement appears to have been a deliberate move to get the United States to put more pressure on Japan’s politicians to deal with the banking crisis. A more hard-line stance by Washington would be useful because it would give Japanese leaders the political cover to initiate tough reforms. Once the necessary reform measures pass the Diet, including a bankruptcy law, then the Japanese public may be more willing to allow the government to use some of the money in Japan’s huge postal savings system to help the banks.
Leadership Needed, Not Cure-Alls
Though the present crisis is often referred to as the "financial contagion," in reality it is not a single disease with a single cure. Each country has its own unique set of difficulties and the solutions for each country will be different. South Korea, for example, is still running a healthy trade surplus and enjoys $43 billion in foreign currency reserves, money which could be used to purchase the stock of ailing companies. This would help to revitalize the companies by providing capital at the rate of the day and would provide incentives for foreign banks to convert debt into equity. In Thailand, meanwhile, the government can later dispose of the shares they own in an orderly fashion in the market. The Thai government has much lower foreign exchange reserves. Banks are still paralyzed, but signs are emerging that they are raising new local funds. Thai companies are having difficulty getting trade financing. Malaysia, Indonesia, and Russia are now facing deep political and social problems that cannot be solved through financial means alone.
A global lack of investor confidence is at the heart of the current problem. Once investor confidence is lost, it is very hard to restore. Time should not be wasted debating what new institutions or global financial regimes are needed for the future. Rather, all energy must be spent finding solutions to the present situation. Both the industrialized nations and the IMF must not dictate overly strict conditions for aid that will reduce demand and economic growth in the recipient countries. The G-7 members will need to maintain demand in their own economies. A lowering of interest rates in Europe would help, but interest rate cuts alone will not head off an economic slowdown without additional remedies as described above. Together these actions would help to restore investor confidence.
The only way out of the financial crisis is for the United States to show leadership. For its part, the Congress was wise to approve funding for the IMF. After that, the initiative must come from the White House. A positive step would be for President Clinton to oversee the formation of a special commission, preferably composed of experts from all G-7 nations, which would travel to each country to study and recommend country-specific solutions. The IMF is a useful lender of last resort, but it is not equipped to build a new global financial architecture. Such an endeavor requires not only economic expertise but political effort as well. It is beyond the mandate of the IMF; thus, the G-7 should assume a leadership role. Failure to act quickly will carry the risk of plunging the world into a downward spiral that could turn into a recession or worse.
