No system should be too big to fail
Early this month, I was in Hanoi to attend the annual meetings of the Asian Development Bank. Hanoi was all spruced up for the visit by thousands of bankers, academics and members of the press. The city is a blend of the old and the new; Hanoi has preserved much of its colonial French architecture, while building outside the city centre. Everyone seemed to be on the move, a city chock-full of young people on mopeds, simultaneously driving while chatting on their mobile phone. There was a buzz in the air, as if the city and the country were reaching for the Asian century.
The Sofitel Metropole by the lake in central Hanoi is as elegant as ever, with old-world service and new-world amenities. Hanoi is the ideal place to reflect on the future, even as we look backwards to our history and our culture.
To look forwards, it may be worthwhile looking back in two ways. First, it was not that long ago that the world suffered the Asian financial crisis - between 1997 and 1999. Few who went through the pain of that crisis would forget that the journey out of darkness involved months of sleepless nights and stress-filled days. But that pain was worth it because there was sufficient change that allowed us to weather the current global financial crisis. There was enough creative destruction to ensure that new competitors and better governance emerged out of the ashes. Having said that, there is still a long way to go for Asian standards to meet global standards. Hence, reform in Asia is still a work in progress.
Second, to judge whether Asia has made sufficient progress in the past decade, we need to look back from the hypothetical point in the future when Asia overtakes the West in terms of total gross domestic product. What must Asia achieve to attain that goal, recognising that competition is never static? Indeed, the pain and humiliation that advanced countries are going through may be precisely the spur for the needed structural reforms that they have delayed for years.
The current momentum of growth in Asia and other emerging markets cannot be taken for granted. This global financial crisis is a stark reminder that, for all the improvements in macroeconomic management, we have not avoided the trade cycle.
Nor must we forget that Asia is still dependent on the advanced countries for exports, innovation and technology. If they slow down further in the next five years and Asia mismanages this current round of overheating, the next global crisis will again be Asia-based.
What did Asia do right during the Asian crisis, what are the advanced countries doing wrong this time round and what should Asia do in the years ahead?
With the benefit of hindsight, the Asian crisis was due to excess leverage in the corporate sector, bad credit management by the banking system and the weak macromanagement of inconsistencies in handling the 'impossible trilemma' - rigid exchange rates, open capital markets and effective monetary policy. What the crisis revealed was a governance crisis, famously labelled crony capitalism.
Post crisis, there were big efforts to undertake the necessary reforms, assisted by better and clearer international standards. But the key lesson was the higher degree of self-insurance, with larger current account surpluses and higher foreign exchange reserves, so much so that this action has been blamed as one of the causes of the global imbalance.
Looking back at the intervening years, it is clear that reforms of the international financial architecture were insufficient, because the International Monetary Fund surveillance mechanism was largely ignored by the advanced countries when it came to their own affairs. No one heeded the real lesson of the Asian crisis that all financial crises are caused by excess consumption financed badly. No one paid heed to frail balance sheets and what was vaunted as sound macromanagement was premised on the misplaced hope that free markets could discipline financial engineering greed.
Although the real causes of the current global crisis will be debated for years to come, there is sufficient consensus that it was a systemic crisis, badly diagnosed and flawed in prognosis. There was flawed macroeconomic theory, lax monetary and fiscal policies and weak financial supervision over a turbo-charged finance industry that was subsidised by public guarantees.
Finance has become a political force by being too big to fail, too important to jail. Have we solved the root causes of the current crisis?
No, because there are collective action traps at the national level as well as globally. At the national level, there is no willingness to impose higher taxation to dampen excess consumption, relying on more public debt to replace losses in private debt. Internationally, there is no agreement to cede sovereignty to global central banking, fiscal management and financial supervision.
Without leadership and statesmanship, we have a crisis of global fiat money, caused by excessive credit creation with no hard budget constraints.
What should Asia and emerging markets do? Macroeconomic management is particularly difficult in a world of highly distorted prices, led by zero interest rates and highly leveraged capital flows.
For Asia to lead, it must maintain higher standards of fiscal probity, sound money and prudent supervision. If we cannot solve the global gridlock, we should put our own houses in order. Most of our real-sector objectives are universal - higher quality of life, sustainable ecology, less inequality and better governance. Finance must remain a servant of the real sector, not its master.
Andrew Sheng is adjunct professor at the University of Malaya and Tsinghua University, and author of From Asian to Global Financial Crisis