Making Sense of the Current International Financial and Economic
Turmoil*
Srikanta Chatterjee
Professor on International Economics
Department of Economics and Finance
Massey University
Palmerston North
New Zealand
Abstract
The global economy, after a prolonged period of economic growth and low inflation,
appears to be ‘heating up’ in recent months, leading to the fear that the international
financial architecture, built up since the Asian Financial Crisis of the late 1990s, is on
the verge of collapsing. The United States economy and currency, widely accepted as
the major props on which the economy of the rest of the world has come to depend,
are showing signs of systemic weakness and vulnerability. This essay analyses the
background to the current financial problems facing the global economy, and
prognosticates its immediate future prospects. It also investigates the problems a wellfunctioning international monetary system must resolve for its long term stability, and
how the problems might be addressed in a globally coordinated fashion. The roles of
the two Asian giant economies, India and China, and of the economies rich in some
strategic resources, such as petroleum and other forms of energy reserves, in meeting
the current global economic challenges are examined in the context of seeking a
workable solution to the financial and economic problems
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* The presentation at the Professional Development Programme will be built around
this brief article which was written before the more recent developments in the
ongoing saga of the turmoil. Some of these developments will be fleshed out in the
presentation and, time permitting, in the discussions.
Research Motivations
To understand

What has been happening in the international financial arena and in the real
sectors of many economies that is worrying

Why the financial system has turned unstable and vulnerable

What needs to be done to restore stability and confidence to the system
The crux of the current international financial problem
Plenty of money sloshing about in the system, but not enough confidence that they
will all retain their values.
The factors and forces behind the phenomenon

Lack of balance between savings and investments, globally – the US
spends the savings of countries like China, Japan and others with external
surpluses – Why and how?
The US, the largest economy in the world has emerged as a net debtor nation since the
mid 1980s. More than 50% of its government debt is held by foreigners who have
been lending so that the Americans can keep spending, including on imports, in
excess of their incomes. This shows up as the USA’s current account deficit, currently
around 6% of its GDP.
For long a net investment-creditor nation internationally, the US has emerged as a
net investment-debtor nation. The value of the US’s total foreign investment of
$12 trillion compares with the total investment of other nations in the US of $15
trillion (2007 figures).
US’s debt service costs more than the returns on its foreign investments.
These imbalances affect the dollar exchange rate, both upwards - when foreigners
buy more dollars than they sell- and downwards (such as more recently) – when
they sell more.
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They - the lenders and the borrowers - however, are all in it together, and the
lenders cannot afford to do anything ‘drastic’, like getting out of the increasingly
volatile US dollar in a hurry! They will lose more than their proverbial shirts, if
they did!
A Relatively Recent Historical Perspective on the Current Financial Turmoil
After the era of ‘stagflation’ that gripped much of the global economy from the
first oil shock of the early 1970s to the early 1990s came the more comfortable era
of low inflation, moderate growth in the developed world, and the rise of the two
Asian Giants, China and India.
The Asian Giants, together with the Asian Tigers, kept supplying the world
market with ever cheaper consumer goods through the 1990s; this helped the
developed economies achieve stable prices that lowered their inflationary
expectations which, in turn, generated economic and employment growth and
improved living standards. Brazil and Russia have joined this set of fast-growing,
dynamic, economies more recently.
In addition, China emerged as an aggressive exporter on the back of a steadily
declining yuan (it fell from US$1:1.5 in 1980 to 1:8.62 1994), and low real wages.
These ever- increasing external surpluses needed safe havens, and the US external
deficits provided a perfect fit! This is a practice that Japan too had found effective,
and for a long time.
The Asian Financial Crisis of the late 1990s was sharp enough it is immediate
impact, but passed through soon enough to resume the favorable trend outlined
above.
Several other safe havens such as Australia and New Zealand attracted the ‘spare
cash’ of (mainly) the Japanese investors who borrowed at low interest rates in
Japan and acquired (mainly) short term assets such as government bonds (‘carry
trade’) in high interest economies, pushing the exchange rates of these countries
up.
Some Proximate Causes of the Financial Turmoil: Enter the spoil-sport in the
form the Sub-prime Mortgage Crisis
While the financial imbalances have long been in the making, some events of
more recent origin help precipitate the current crisis.
Cheap and plentiful supply of (largely) foreign-sourced capital encouraged banks
and other institutional lenders to finance ‘profligate’ spending, including spending
on real estate. This contributed to the residential house-price boom in many
countries since the mid 1990s, accelerating in the period 2000- 2006.
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In turn, this encouraged house-buyers and real estate investors/speculators to take
more risks and over-leverage themselves in the expectation of ever-rising house
prices to keep them solvent and, eventually, make them rich(er).
New financial instruments came to emerge to take advantage of the ‘cheap’
money by lending it to the otherwise non-creditworthy borrowers to enable them
to acquire real estate. The hidden costs of such loans soon began to catch up with
many of these buyers, and many started to default.
The real estate boom slowed at first, and then prices started to decline, while interest
rates started to rise in line with the perceived increased risks of lending.
Many (reputable) financial institutions had acquired these high-yield, securitized,
‘structured financial assets’, without always caring to check out their original assetbacking, which in most cases was linked to mortgage lending, often to sub-prime
borrowers. These high-risk loans were bundled and repackaged with prime-quality
loans to make them attractive, often with not only the knowledge of the credit rating
agencies, but with their involvement in the packaging!
The size of the sub prime loans is estimated to be around $2 trillion, and potential
losses of up to $400 billion which are high, but considered to be bearable. The real
reason for the panic in the market is that the hyper-leveraged outstandings of all credit
derivatives is thought to be of the order of $50 trillion, based on a 100:1 leverage in
the typical instance to create new capital which extends far beyond ‘prudential limits’
of responsible banking.
While the sub-prime phenomenon is mainly an American one, it is proving to be
contagious, as many European banks also got involved in the game of re-packaging
the sub-prime assets, and they too are suffering in the form of asset write-downs and
defaulting debts.
The Routes to Correction
The Real Sector
The real sector consequences of the financial turmoil threaten to cause the US
economy to go into recession which, in turn, will have a dampening effect on the
world economy over the next few years.
The recession will make Americans spend less, thus helping to improve the trade
balance; the decline in the dollar will help export growth, and boost the trade balance.
The effect of a 10% fall in house prices has already taken the equivalent of 14% of
US GDP from household wealth; the US Treasury Secretary has estimated a drop of
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about 25% over 2007 and 2008. The wealth effect on consumption will help the
correction process.
The adverse effect on the global economy will be cushioned however by the strength
of the two Asian Giants, China and India which together account for over 25% of
world GDP growth, and over one-half of the GDP growth of the low and middleincome countries. Russia and Brazil too, both with oil resources, are becoming
stronger influences in the global economy.
The Financial Sector
The old-fashioned goal of having an international financial system that has
adequate liquidity, inspires confidence or credibility in its operations, and has the
means to adjust to changed circumstances is still relevant, if achievable only
through international coordination and collaboration.
The credit crunch that has gripped the entire commercial banking sector of the
OECD, is being mitigated by both the US FD and the British and European
Central Banks pumping liquidity into the system.
Sovereign Wealth Funds (SWFs) from developing countries, many with
commodity boom surpluses, are being channeled into the private banking sectors
to boost their liquidity.
Abu Dhabi Investment Authority and Kuwait Investment Authority have invested
almost $50 billion to provide liquidity and recapitalize major international banks
like UBS, Citigroup, Merrill Lynch, Morgan Stanley and, and alas, even Bear
Stearns!
All these will help restore the international financial market to its functional best,
in time. But just how long it will take to get to normality is anybody’s guess.
J. K Galbraith expressed the depressing prediction in his grimly funny book A
Short History of Financial Euphoria that money did not permit many innovations
as, at the end of the day, there must be some real asset to secure it, however much
it may be packaged and sliced to make it look attractive!
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