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For all Dodd-Frank’s complexity, Basel III’s severity, and “solutions” offered in a raft of other schemes to prevent future financial crises, markets will remain vulnerable until something is done about the effects of globalization. Global financial flows, more than any other influence, have fostered the exaggerated boom-bust markets of the last 20-plus years. But even as globalization continues, there is no need to tolerate this destructive pattern. A change in U.S. Federal Reserve policy could break it. Sadly, neither Dodd-Frank nor the Fed’s leadership shows any sign of pursuing such a course.
Alone, the size of international funds flows speaks loudly to the vulnerability of even America’s vast financial markets. Global trade and investment yearly push more than $50 trillion through the world’s financial markets—a figure that more than triples the size of the U.S. economy and exceeds even the annual trading volume in U.S. government securities, the largest and the most active market in the world. But more than the undeniable impact of such staggering funds flows, financial volatility springs from a much more specific source, a chain of causality that begins with China’s currency policies, and those of other emerging economies, and runs through all the dynamic structures of modern capital markets. Break any of the links in this chain, and the boom-bust pattern will end or moderate significantly.
The problems begin with China’s decision to promote its exports by keeping the value of its currency, the yuan, cheap to the dollar. The effort keeps the price of Chinese goods cheap on global markets. But because of its success in luring foreigners to buy Chinese goods, it creates a huge demand for yuan that the People’s Bank of China (PBC) must offset by selling huge volumes of yuan almost daily and buying equally sizable amounts of dollars (in a process called sterilization). These transactions have averaged a staggering $800 billion a year during the past 10 years, have increased China’s official dollar holdings at an annual rate of 31%, and caused Beijing to amass a reserves hoard of more than $3.0 trillion.1 China is not alone, either. Other export-oriented emerging economies have followed, and continue to follow, variations of this policy. In each case, because these nations cannot sell those dollars without undermining their respective currency strategies, they invest them abroad, largely in U.S. Treasury bonds.
It is these flows—“excess savings” in the words of Fed chairman Ben Bernanke—that have fostered the volatility. Alone, such a tsunami of financial liquidity could artificially raise asset prices and produce financial bubbles, but since financial actors in the United States and other markets leverage these flows, they have redoubled the effects. The inevitable bubbles periodically have taken prices well beyond any relation to economic reality. They have, then, burst when some event, not necessarily a large one, called attention to how far asset prices diverged from reality. Though financial markets have an inherent tendency toward boom-bust patterns, it is the size and independent nature of these liquidity flows that have made something much larger and more dangerous than global financial markets have had to cope with previously, or at least not for a very long time.
Of course, China and these other export promoters do not deserve all the blame for these destructive cycles. Private financial participants have contributed by permitting the excess of liquidity to wipe away any sense of financial prudence, propriety, or even longer-term planning. Regulators also have failed, largely because they have found it impossible to keep up with this fast-moving environment and, in hindsight, seem at times not even to have tried. Much blame also lies with the Federal Reserve and other central banks that could have counterbalanced the effect of these foreign flows via sterilization, but consistently have failed to do so. Wherever the blame may lie, the pattern is clear. It has repeated at least three times since the end of the Cold War in the early 1990s, when globalization first gained momentum.
The first round came with the crisis commonly referred to as the “Asian Contagion.” In the early 1990s, what were then called Asia’s “Tigers”—Malaysia, South Korea, Taiwan, Singapore, Hong Kong, Thailand, and Indonesia prominent among them—realized, as China has since, that exports are a powerful way to accelerate growth. They sought to ensure attractive global prices for their products by keeping their respective currencies cheap to the dollar. And just as China has done more recently, these economies kept down the price of their currencies by selling them into foreign exchange markets and buying dollars. In this way, they accumulated vast dollar hoards. Taiwan’s official dollar reserve, for example, jumped by almost 40% between 1991 and 1995,2 and Thailand’s by almost 120%.3 And, again like China more recently, these nations had to retain their dollar hoards, investing them in U.S. Treasury and like securities, which during that time grew by an astounding 26.7% a year.4 Though former Fed chairman Alan Greenspan worried about the effects of this excess liquidity, referring in 1996 to its power to create “irrational exuberance,” he did nothing to offset the impact on domestic financial markets.
Supplied with huge excess funds, lending and investment activity in the United States exploded, growing much faster than economic activity, and so, presumably, any fundamental need. Between 1991 and 1995, for example, while the economy’s basic nominal liquidity needs grew a mere 5.6% annually,5 actual liquidity, according to a classic measure, the monetary base, jumped 7.0% a year,6 and overall borrowing shot up by 11.4%. Under pressure from this clear excess, asset prices throughout American markets rose, and investors, searching for still more opportunities, turned back, surely unknowingly, to where the liquidity had emerged: to the fast-growing, export-oriented Asian Tigers themselves.
Pursuing the opportunities of rapid growth, Americans invested in and lent freely in Asia, to private firms, local governments, and development agencies. Effectively transferring back to these countries the reserves that their central governments had accumulated through their currency manipulations, American lending in the Tiger economies grew between 1990 and 1996 to $42 billion a year, a leap of 500% from the $7.0 billion a year averaged between 1985 and 1989.7 While initially these loans and investments served the Tigers’ legitimate development needs, the excessive flow of liquidity back across the Pacific eventually pushed asset prices there far beyond anything that even their fast-developing economies could sustain.
When that fact at last became apparent, the collapse came. Tradition dates the start of the crisis to July 2, 1997, when Thailand, by then long denied credit by the Americans controlling the funds, could no longer sustain the value of its currency, the baht. But that event was less a cause than a symptom of a collapse that had begun much earlier. The seeds of the Tiger bust, in fact, were actually planted in 1994, more than three years before the baht fell. Back then, China decided to go into competition with the Tigers for a share of lucrative export markets and suddenly devalued its yuan by more than 50% against the dollar, keeping it rigidly locked at that low level thereafter. Because the Tigers had tied their respective currencies to the dollar, the yuan’s drop powerfully undercut the export support for their rapid growth and was the principal motive behind American eagerness to redeploy funds back to the Tigers.
Matters took time to have their effect. For a while, the liquidity filtering through American markets was so immense that the flow of funds back to the Tigers was sufficient in itself to make those economies seem prosperous, albeit on borrowed monies. Also because China then was a new player on the global economic stage, it took time for market arrangements to reorient themselves. But China’s huge export-pricing advantage eventually took its toll. Between 1994 and 1997, Chinese exports to the United States grew far faster than the exports of any other economy, including the Tigers. American bankers and investment managers, assessing the change, began to rethink the loans and investments they had made in the once-favored Tigers.
With the loss of both exports and the flow of lending, demand for Tiger currencies began to slacken. Officials there found themselves in a strange situation. After years of resisting upward pressure on the values of their currencies, they suddenly had to deal with downward pressure. Rather than accept the new direction as a way to regain their export-pricing advantage, the authorities in the Tiger countries were by then so beset by overseas debt obligations, and so desperate to sustain the international value of their assets, that they fought to hold up the values of their currencies. They failed, however. Thailand was the first to give up the fight, and when the baht fell in mid-1997, panic ensued. American creditors, fearing that borrowers throughout the region would fail to meet their obligations, ceased investing and lending and, where they could, called in the loans. Tiger currencies fell still farther. Starved for credit and undercut by China, these economies plunged into steep recessions. Governments fell. It took until late 1999 for the economic situation to stabilize.