Opinion | Global financial crisis imparted lessons that no textbook could ever offer

September 14
17:29 2018

Neelkanth Mishra

“I can’t handle the stress of losing my job again,” said a colleague who had resigned to move out of financial services. It was a few years after the Global Financial Crisis (GFC), but the dust was refusing to settle. On being told that he had no reason to fear a job loss, and that even senior management was impressed by his work and his potential, he asked “What if they get fired too, Neelkanth? What if the firm shuts down?”

Irrational as those fears may seem now, I found it hard to argue with him. The GFC had seen the obliteration of storied and large firms all over the world at a pace rarely seen before, and long-held beliefs were being questioned. And he spoke from experience; a high-performing graduate from a leading Indian business school, his first job was with Lehman Brothers abroad. But just over a year into it, he had to live through the decimation of the whole division he worked in.

It was as if nothing was certain anymore. Wise old folks know nothing is, but Yuval Harari’s book ‘Sapiens’, which popularized the phrase ‘shared myths’, got published much later. This conversation happened around the time the Greek crisis had started, and even the ability of the European Union to stay together was being debated openly. Doomsday forecasters were explaining in detail the cataclysmic impact of such a development on the global economy and markets.

Economists had lost credibility due to the group-think that prevented a proper diagnosis of the build-up of risks that drove the GFC. Economic theory was being questioned too. The belief that free markets solve all problems got badly shaken up, mostly in a beneficial way, driving necessary course corrections, but sometimes harmfully too. For example, by emphasizing the role of the government and the failure of markets, it gave ammunition to supporters of a state-owned banking system in India. Even as the excesses that showed up many years later were building up, policymakers and politicians praised the government ownership of banks: it took a decade and trillions of rupees of losses to reverse that view again.

To a whole generation of analysts and economists the episode imparted lessons that no textbook or course could ever give. It was as if the covers had come off a car, and one could see all the moving parts even as it ran. Take for example the role that trust plays in the economy. As financial firms stopped trusting each other, not only did the weaker ones blow up (exacerbating the damage), global trade froze for several weeks, as letters of credit became useless. For many years the more fearful among savers stocked up on physical gold, as even gold exchange-traded funds (ETFs) were considered too risky. “What if the firm offering the ETF itself blows up?” went the question.

Or take the role of liquidity, and the “supply-chain bull-whip”, which one had only seen in classroom simulations. As liquidity shrank, supply-chains de-stocked at a never-before-seen pace. In one example, as funding became harder to get, truck dealers de-stocked, and the demand as seen by truck manufacturers fell by more than the actual decline in truck sales. They in turn reacted to the sharp perceived decline in demand by cutting production and also started to shed inventory, including cold-rolled steel that is used to make truck bodies. The demand as seen by cold-rollers of steel weakened so much that they completely stopped ordering hot-rolled coil (the principal input for cold rolling). The further away an industry was from the end demand, the sharper the fall in perceived demand: very similar to the bull whip, where the handle moves slowly, but the end of the whip can move faster than the speed of sound. Fascinating as it was to put together this analysis in late 2008, it added to the sense of unease on how shaken the foundations of the economy were.

Thankfully that phase ended relatively quickly (though not quickly enough). But ten years after the failure of Lehman, the point at which the GFC visibly spiraled out of control, the after-effects are still playing out. Many sociologists and political scientists believe the GFC and the policy responses to it catalysed and perhaps even caused the widespread backlash against globalisation and the rise in populism. Debates on the necessity and the efficacy of the unconventional monetary policies that followed have never really ended, even as some of these are beginning to be wound down.

Contrary to what many feared early on, all the “money printing” by central banks did not cause hyper-inflation. It is only now when labor and capital utilization are reaching pre-crisis levels that inflation is beginning to make a comeback in the developed world. However, the spillover effects these policies had on less mature economies are now being discovered as their reversal starts. The International Monetary Fund (IMF), in a report last year, estimated that nearly half of the capital flows into Emerging Markets (EMs) were driven by the quantitative easing (QE) and extremely low/Zero Interest Rate Policies (ZIRP) of the US Federal Reserve. As QE and ZIRP now unwind, EMs are seeing significant volatility again, posing a new set of policy challenges in an interconnected world.

The GFC also triggered dramatic and seemingly permanent reversals in economic flows and even geopolitics. Even as developed market economies started growing again, it took them many years to reach prior levels of output (some have still not crossed that high-water mark), prompting an intense and as yet undecided debate on whether they were going through “secular stagnation.” While rapid growth in the Chinese economy had started many decades back, it was only after 2008, when a massive Chinese stimulus played an important role in stabilising and then reviving global demand, that the world woke up to the might and the importance of the Chinese economy. China’s current account surplus has fallen from a record-high and distortion-inducing 10 percent of GDP in 2007 to a much more reasonable less than 2 percent of GDP. That the first time the heads of state of G20 countries (an organization that had started in 1999) met was only after the GFC emphasizes its geopolitical impact.

The financial landscape changed radically. Post-GFC regulatory changes, intended to make financial firms safer, forced global financial firms to shrink and exit many businesses. This provided an opportunity for local, regional and sector-specific organizations to grow, but also hurt liquidity in some markets. Corporate behavior changed too. In the recent spate of rupee weakness, fears of unhedged foreign debt owed by Indian firms are notable by their absence. A combination of diligent work by the Reserve Bank of India (RBI) and the pain suffered by companies after 2008 has meant that foreign currency debt without explicit or natural hedges is now much smaller than it used to be.

Crises, while painful and damaging, are cathartic events that release built-up pressure, provide important lessons to the generation living through them, and also provide policymakers an opportunity to drive radical reform. It may still be too early to assess if the opportunities were adequately availed.

(The writer is India Equity Strategist for Credit Suisse. Views are personal)

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