Do the Answers to Our Current Financial Woes Lie in the Past?Published: October 01, 2008 in Knowledge@Wharton
Bad debt. Frozen credit. Stock market panic. Popular outrage. Political paralysis. The financial crisis that has dominated September's headlines may feel unprecedented to many Americans. But it feels altogether familiar to scholars who have examined the economies of at least 15 other nations around the world that have undergone banking crises in the past three decades. What can the United States learn from the past tribulations of markets as diverse as Japan, Mexico and Turkey?
A day after the Dow Jones Industrial Average plunged a record 777 points, the subject drew a group of Wharton and University of Pennsylvania professors to a panel discussion at the school's Lauder Institute of Management & International Studies.
University of Pennsylvania political science professor Jennifer Amyx, a Japan expert who has written a book about the protracted financial crisis that began in that country in the early 1990s, argued that "financial crises are ultimately political" and recovery requires reforms in the way government oversees finance. The "lost decade" that followed the 1990 collapse of Japan's asset bubble -- stock prices didn't actually bottom out until 2003 -- was abetted, she said, by a governance system consistently unable to respond to the series of shocks that accompanied the end of the country's vast expansion of the 1980s.
"The country was in crisis on a number of different dimensions following the bursting of that bubble," Amyx said. Asset prices fell. Stocks followed. And banks, accustomed to a cocoon of government protections that had prevented even a single bank failure in the postwar era, trembled. But well after the first big bank failure, in 1995, the government mustered little effective response. An early dose of taxpayer money did little good. "Over the next few years, what you would see would be ad hoc measures by the government and the Ministry of Finance to try to deal with emerging, growing and increasingly severe problems in the financial sector." By 1997, as the dominant Liberal Democratic Party lost control of the upper house of parliament, still bigger banks were teetering on the verge of failure.
Those failures ultimately prompted major changes in the way banking was run. "Ultimately ... a new enacting coalition would emerge, a bipartisan group of legislators, but a different group," Amyx said. "Solutions to financial crises have to get at the heart of confidence, market confidence, and it really required, in Japan, a new set of actors to emerge who had a new set of ideas."
In the case of the United States, she noted, "the bipartisan wrangling over a legislative response has also involved a kind of closed group of actors that are seen as part of the problem [and] that have not brought forth really new ideas. They are proposing to throw a lot of money at the situation without changing the rules of the game first." In Japan, she said, "the rules of the game were fundamentally changed in terms of regulator-financial institution relationships" before public funds were injected to recapitalize the banks. "It was only with [the rule changes] as a prerequisite that injecting funds into the financial system produced new confidence in the market."
A Bank Governor's Views
Turkey's 1994 financial crisis didn't last nearly as long as Japan's. Still, the cycle of currency flight and banking doom felt about as long to Wharton finance professor Bulent Gultekin, an expert on capital controls and international financial markets, who was at the time the governor of his country's central bank. Gultekin expressed sympathy for what his American analogue, Federal Reserve Chairman Ben Bernanke, must currently be experiencing. "You live a month and it's probably like 10 years in condensed time," he said.
Gultekin noted that since the 1970s-era oil shocks, all major economic crises have been in the financial industry -- and all of them were in part the products of flawed public policy and then cleaned up in large part through taxpayer money. "There's always an accommodating public and economic policy that tries to sustain an unsustainable situation," he said. "There's also a high correlation between inadequate or misdirected regulation and financial crises. It's a myth that financial markets regulate themselves. They simply don't. Markets, just like individual, do respond to incentives, and if there are distorted incentives, they react in a distorted fashion. And that also results in very poor resource allocation. In hindsight, we look back and wonder how we could have dedicated so many resources to the financial sector."
Turkey's 1994 crisis -- there would be another in 2000 -- ultimately socked the country with a 6% drop in GDP. And though he noted that the parallels between an emerging economy and America's only went so far, Gultekin said his experience made him confident in one other thing: Taxpayers would eventually pony up. "The banking system is the bloodline of the economy," he said. "Without that system, nothing can happen. You have to bail them out." In Turkey's case, of course, that was made more politically feasible by a media -- in many cases owned by banks -- that agitated for a rescue, and by outside intervention from the International Monetary Fund.
As for the United States, Gultekin said Americans should be leery when financial markets love the central bank chief. Such figures should be "respected," he said, but should also be the ones who "take the punchbowl away at the end of the party." Likewise, Americans remain unprepared to correct some of the distortions that abetted the crisis. "You just cannot have 20% of corporate profits [coming] from the financial sector," he said. Echoing Amyx, Gultekin was sharply critical of the bailout bill that was defeated in Congress on Monday, saying the spare, two-and-a-half page document "had the mindset of a trader" in failing to lay out the extent of the crisis and thus encouraging Congress to take the White House's word. "We have better finance economists than that," he said.
Wharton accounting professor Luzi Hail, an expert on international accounting and financial disclosure and who was formerly with the Swiss Bank Corporation, said Switzerland's early-1990s bank crisis halved the number of banks in the country. But the fallout featured mainly private-sector solutions because none of the banks was deemed too big to fail. That would be different were a crisis to strike today. Just as the woes of America's banks have left the country with a small handful of consolidated superbanks, the Swiss troubles led to a new status quo that makes future bailouts difficult. The giant UBS, he noted, had liabilities five times greater than those of the national government. "'Too big to fail' is not the appropriate point," he said. "They are 'too big to save.'" Today, it is the largest of the banks that are caught up in the U.S. crisis -- something that demonstrated how they were beyond the reach of even the best Swiss regulations. "Not only too big to save, but too big to manage," he quipped.
Nonetheless, Hail said bank crises are a tremendous opportunity for a country to upgrade its oversight system of regulations, capital standards, and risk-management rules.
China Offers Lessons
Wharton China expert Marshall Meyer said that for those grappling with the American banking implosion, China's current economic situation is more relevant than its financial sector's experiences during the 1990s Asian financial crisis. With a stock market that recently fell 70%, a sharp rise in inflation, and billions of dollars in undeclared U.S. currency in the market, China's current woes are in the "real economy" rather than just the financial sector. With a trade and especially export-oriented economy, China faces a serious threat when recession curbs the appetites of American or other foreign spenders. "Don't bank on China to drive the global economy," Meyer said. "Ultimately, I think the Chinese economy must and will turn inward."
Penn political scientist Heiner Schulz, an expert on bank liberalization in emerging markets who also spent time as a visiting scholar at the Bank of Korea, said the aftermath of Mexico's 1994 financial panic left him unhappily certain that America's current woes would be more expensive that predicted, longer-lasting than predicted -- and would likely take a real bite out of the real economy.
Schulz, who worked as a management consultant to firms doing business in the country at the time, said the possible collapse of the Mexican banking sector had prompted a full-fledged government response, complete with a takeover of bad loans, recapitalization of banks and direct intervention into failing institutions. Legal changes also allowed foreigners, and their capital, into the industry -- which they came to dominate in the ensuing decade. The crisis did little to hurt economic growth, which trucked along for much of the decade.
Why will the United States be different? Just as the costs to the Mexican treasury grew beyond initial forecasts, Schulz said he believes costs here will be far higher than advertised. At present, predictions about bailout costs for the current crisis amount to 6%-7% of GDP. But the $300 billion savings and loan rescue was initially forecast to be just $50 billion to $60 billion, Schulz said. And in Mexico, where the banking sector was unsophisticated and smaller than that of the U.S., the 1994 rescue wound up costing 15% of GDP. It also took 10 years to clear up the bad debt, which at its peak amounted to just under 19% of loans. But those were simple, basic loans. Schulz believes that America's debt problem, which is centered around complex financial instruments, will be much harder to even calculate. "It takes a lot of work to deal with a bad debt problem," he said. "This is tough even for simple loans." According to Schulz, Mexico's nonfinancial sectors escaped much damage because the economy was far less tied to the banking industry. By contrast, he said, the U.S. has a degree of "financialization" that is 10 times higher.
Schulz fears that the possible effects of the American crisis may include a backlash against financial innovation, something he sees as disastrous since complex mortgage-backed securities, especially in emerging economies, help lower-income people buy property. He also fears a broader backlash against Western models of development by countries wary of being lectured by Washington during their own economic troubles. "They might turn to other models" -- such as China -- "after watching what they have been told is the gold standard turn out to be not so strong," Schulz said.
Schulz did, however, offer a grain of salt to anyone who would extrapolate too much from the recent financial crises the Wharton panelists had studied: Parallels between past and present are always tricky, especially between emerging and developed economies. "Like the generals who are always trying to fight the last way, the regulators are always trying to fight the last crisis," he said.
Schulz's own prescription for preventing a recurrence of the 2008 meltdown would focus on improving America's balkanized financial regulatory system and on reducing moral hazard and information asymmetry. The latter is especially tough since an age of innovation necessarily means bankers may be inventing things faster than regulators can figure them out. "This is, in my view, another of those rare opportunities in the U.S. to change the regulatory system that's in place," Schulz said.
"In order to be a cat, you have to have been a mouse," Meyer added. "Maybe our MBAs should have to be regulators before they are bankers."