THE GLOBAL FINANCIAL CRISIS

The Major Causes of the Global Financial Crisis

The Major Causes of the Global Financial Crisis

Introduction

This paper we discuss the major causes of the global financial crisis and progress made by China in these crises. Current account imbalances? easy US monetary policy? and financial innovation are not the causes to blame for the global crisis. It says that attacking Bretton Woods II as a major cause of the crisis is an attack on the world trading system and a sure way to metastasise the crisis in the global financial system into a crisis of the global economic system.

The current crisis is likely to be one of the most costly in our history? and the desire to reform the system so that it will not happen again is overwhelming (Bernanke? 2007? 13-15). Our fear is that almost all this effort will be misdirected and unnecessarily costly. Three important misconceptions could lead to a disastrous reform agenda: That the crisis was caused by current account imbalances? particularly by net flows of savings from emerging markets to the US. That the crisis was caused by easy monetary policy in the US. That the crisis was caused by financial innovation.

In our view? a far more plausible argument is that the crisis was caused by ineffective supervision and regulation of financial markets in the US and other industrial countries driven by ill-conceived policy choices (Bernanke? 2007? 13-15). The important implication of the crisis itself is that for the next few years? at least? the misbehaviour that flourished in this environment will not be a problem? unless replicated under government pressure to restore the flow of credit to the uncreditworthy. If anything? excessive risk aversion and deleveraging will limit effective private financial intermediation. So the first precept for reform is that there is no hurry (Dooley? 2004? 33-41).

When markets recover? the key lesson is that the industrial countries need to focus on moral hazard? public and private? as the source of the problem and apply the prudential regulations they already have to financial entities that are too large to fail. It is not sensible to try to limit international trade and capital flows? to ask central banks to abandon inflation targeting? to stifle financial innovation? or to regulate entities such as hedge funds1 that do not generate systemic risks.

International capital flows

One “lesson” that seems to be emerging is that international capital flows associated with current account imbalances were a cause of the crisis and therefore must be eliminated or at least greatly reduced.2 The idea that fraud and reckless lending flourished because US financial markets were unable to honestly and efficiently intermediate a net flow of foreign savings equal to about 5% of GDP? while having no problem with intermediating much larger flows of domestic savings? is astonishing to us (Dooley? 2004? 33-41). If so? would not the much larger gross capital flows into and out of the US also cause an outbreak of bad behavior even without a net imbalance? If this ...