January 2009

By Lim Mah Hui

As world and consumer prices continue to drop, there is renewed fear of deflation. The nightmare scenario is Japan’s ‘lost decade’. Michael Lim Mah Hui explains what happened in Japan and considers the prospect of a similar fate.

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By Michael Lim Mah Hui
Article appeared in Straits Times, Singapore December 5, 2008

Beside the deregulation that encouraged financial players to engage in financial innovations, there are three structural causes for the current global financial and economic crisis: current account imbalances between the United States and the rest of the world; wealth and income imbalance between the haves and have-nots in advanced economies; and the sectoral imbalance between the financial and real economy.

The last three decades has seen a significant shift in the structure of many advanced economies, particularly the US. The financial sector has come to overshadow productive sectors. From 1950 to 2004/5, the financial sector’s share of US GDP rose from 11 per cent to 20 per cent, while that of manufacturing dropped from 30 per cent to 12 per cent. And the financial sector’s share of corporate profits went up from 10 per cent to 40 per cent, while that of manufacturing plummeted from 50 per cent to under 10 per cent.

The dominance of the financial sector has influenced corporate behavior in various ways. Debt has become more important than equity as a source of financing; and much of the new debt was used to finance equity buy-backs rather than new productive investments. Managers focused primarily on quarterly share price increases, rather than long-term growth and profitability. Corporate behavior came to follow the dictates of the financial sector. The tail wagged the dog.

This brings us to an important point – namely the degree of leverage that enabled the financial sector to earn such high rates of return. Return on equity is always boosted with leverage. In 2004, a Securities and Exchange Commission ruling allowed investment banks to double their leverage from 14 times of capital to 30 times. What we witnessing now is the destrutive impact of de-leveraging.

Remedial measures and policies should be informed by proper diagnosis. What are the policy implications of the above diagnosis?

Most central banks have focused on price stability, and to a lesser extent, growth and employment. But all have been errant in controlling asset price increases, contenting themselves with picking up the pieces after bubbles burst. It is becoming clear that the costs to taxpayers of cleaning up the mess after bubbles burst exceed the costs of anticipating and deflating such bubbles before they burst. Moreover, there is an obvious inequity when the benefits of booms are privatized while the costs of busts are socialized. Central banks should adopt a counter-cyclical rather than pro-cyclical stance, take a lean-against-the wind approach rather than a cleaning-up-the-debris approach.

The economist Hyman Minsky once presciently noted that stability breeds instability. In periods of growth, low interest rates and prolonged financial stability, financiers and borrowers tend to become over-confident. One way to smooth out booms-and-bust cycles is for regulators to require banks to adopt “dynamic provisioning” when their assets grow quickly, as the Spanish central bank does. 

An important source of instability is excessive speculation in the financial sector. Serious consideration should be given to increasing capital gains taxes on assets held for short periods. This will not only reduce speculation but also provide a source of revenue for governments, part of which can be used for financial relief efforts.

Financial players have managed to circumvent regulation through off-balance-sheet vehicles, over-the-counter activities and shadow banking activities. Unfortunately all these products and activities are intimately connected to the regulated banking system through contingent guarantees and counter-party trading. It is these shadow-banking activities that have sucked banks into the financial vortex. Hence regulators have to bring the shadow players within their ambit. The leverage levels of hedge funds and private equity funds should be reviewed and controlled. 

Since these activities are fully globalized, a new financial architecture that requires international coordination and regulatory powers should be set up. Otherwise, the players will move from strict regulatory regimes to lax regulatory ones. While European authorities are more open than the US to an international framework, Asian nations can build on and strengthen their present efforts at coordination and regulation.

The role and structure of rating agencies should also be reviewed. There is undeniably a conflict of interest when rating agencies are paid by the issuers of securities. One way to reduce this conflict would be for rating agencies to be paid by investors and also from a general pool funded by issuers. This way the rating agencies would not be beholden to any particular issuer.

Much has been written about restructuring the incentive and compensation structure for financial executives. The current structure encourages rewards for excessive risk taking. While the details can be debated, the principle should be established that rewards be aligned to performance over a longer time horizon than just a year. 

Making huge loans or undertaking risky trades and getting rewarded immediately for them, and not taking responsibility if they go bad at a later time, encourages risky behavior. According to the New York State Comptroller, US financial groups paid out US$33 billion in bonuses in 2007 even as the financial industry racked up hundreds of billions of dollars in losses.

Some of these measures may seem radical. But we are not living in ordinary times and this is not an ordinary financial crisis. Simply implementing conventional policies like lowering interest rates, increasing liquidity, recapitalizing banks, and so on, without addressing the fundamental causes of financial instability, would just set up the global economy for a repetition of the current crisis – only in a more virulent form.

The writer is a Senior Fellow in the Asian Public Intellectuals’ Program of the Nippon Foundation. He worked for 22 years in various international investment, commercial and development banks.